康明斯 (CMI) 2021 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Cummins Inc. Third Quarter 2021 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Jack Kienzler, Executive Director of Investor Relations. Thank you, sir. Please go ahead.

Thank you, and good morning, everyone. Welcome to our teleconference today to discuss Cummins' results for the third quarter of 2021. Participating with me today are our Chairman and Chief Executive Officer, Tom Linebarger; our President and Chief Operating Officer, Jen Rumsey; and our Chief Financial Officer, Mark Smith. We will all be available for your questions at the end of the conference.

Before we start, please note that some of the information that you will hear or be given today will consist of forward-looking statements within the meaning of the Securities Exchange Act of 1934. Such statements express our forecasts, expectations, hopes, beliefs and intentions on strategies regarding the future. Our actual future results could differ materially from those projected in such forward-looking statements because of a number of risks and uncertainties. More information regarding such risks and uncertainties is available in the forward-looking disclosure statement in the slide deck and our filings with the Securities and Exchange Commission, particularly the Risk Factors section of our most recently filed annual report on Form 10-K and any subsequently filed quarterly reports on Form 10-Q.

During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP financial measures.

Our press release with a copy of the financial statements and a copy of today's webcast presentation are available on our website at www.cummins.com under the heading of Investors and Media.

With that out of the way, we will begin with our Chairman and CEO, Tom Linebarger.

Thank you, Jack, and good morning. Welcome to everybody. I'll start with a summary of our third quarter financial results and our market trends by region and finish with a discussion of our outlook for the rest of 2021. Mark will then take you through more details of both our third quarter financial performance and our forecast for this year.

Demand remained strong in the third quarter as the global economy continued to improve, driving strong sales growth across most businesses and regions outside of China. In China, industry-wide sales of trucks and construction equipment has slowed sharply but in line with our expectations.

We remain encouraged by the economic trends in our markets, which point to strong end-user demand extending into 2022. We also continue to see orders for our products outpace our competition as a result of their strong performance in the field.

Unfortunately, supply chain constraints continue to significantly impact our ability to produce and ship products, driving up costs and limiting sales growth in the short run. These supply chain constraints are impacting our OEM customers in much the same way.

Before getting further into our results, I want to take a moment to highlight a couple of strategic milestones in the evolution of our next-generation products and technologies.

In October, we announced that we will bring a 15-liter natural gas engine for heavy-duty trucks to the North American market. This engine was launched earlier this year in China and has been well received in the market, demonstrating excellent performance and reliability thus far. The 15-liter natural gas engine is an important part of our path to zero emission strategy by offering a significant reduction in both criteria pollutants and greenhouse gases in a product that's available today and utilizes existing infrastructure. Equally exciting is that this engine is designed to accept a range of gaseous and renewable fuels, including hydrogen in the future. In fact, all of Cummins' engine platforms are being designed with the same fuel flexibility.

At the same time, we are working with Chevron and others in the energy industry to increase the availability of renewable natural gas and other renewable fuels to ensure infrastructure is in place to meet our customers' needs.

We also signed a letter of intent to establish a joint venture between Rush Enterprises and Cummins, which will produce Cummins-branded natural gas fuel delivery systems for the commercial vehicle market in North America, combining the strengths of Momentum Fuel Technologies' compressed natural gas fuel delivery systems and Cummins' powertrain expertise, along with the engineering and support infrastructure of both companies. These are important steps in expanding our portfolio of power solutions options to help customers meet their business goals and operational objectives while also meeting increasingly stringent emission standards and achieving our customers' sustainability goals.

Now I will comment on the overall company performance for the third quarter of 2021 and cover some of our key markets.

Revenues for the third quarter of 2021 were $6 billion, an increase of 17% compared to the third quarter of 2020. EBITDA was $862 million or 14.4% compared to $876 million or 17.1% a year ago. Higher freight and logistics expenses, rising material costs and other manufacturing inefficiencies associated with the ongoing supply chain challenges in our industry more than offset the benefits of global volume increases compared to the third quarter of last year. As a reminder, EBITDA in the third quarter of last year was helped by temporary salary reductions, which lowered our costs by approximately $90 million.

Our third quarter revenues in North America grew 13% to $3.4 billion driven by higher engine and component shipments across the heavy- and medium-duty on-highway markets.

Industry production of heavy-duty trucks in the third quarter was 55,000 units, an increase of 10% from 2020 levels. Cummins sold 22,000 heavy-duty engines in the same period, up 30% from 2020 levels.

Industry production of medium-duty trucks was 26,000 units in the third quarter, a decrease of 5% from 2020 levels, while our unit sales -- our Cummins unit sales were $23,000, an increase of 25% in 2020.

We shipped 43,000 engines to Stellantis for use in the Ram pickups in the third quarter of this year, a decrease of 2% from the 2020 levels but still a very strong quarter.

Revenues for power generation grew by 2% due to higher demand in recreational vehicle, standby power and data center markets.

Our international revenues increased by 22% in the third quarter of 2021 compared to a year ago. Third quarter revenues in China, including joint ventures, were $1.5 billion, a decrease of 11% due to lower demand in the medium- and heavy-duty truck markets. Industry demand for medium- and heavy-duty trucks in China was 217,000 units, a decrease of 53% as the industry works through the National Standard V truck inventory on hand and lower demand for newer, higher-cost National Standard VI units.

Our unit sales and units, including joint ventures, were 40,000, a decrease of 49% versus the third quarter last year.

Our light-duty engine sales were 33,000, a decrease of 40% driven by supply chain constraints and weaker market demand.

Industry demand for excavators in China in the third quarter were 56,000 units, a decrease of 15% from 2020 levels. Our units at Cummins sold were 88,600 units, a decrease of 20%.

Power generation sales in China increased 52% in the third quarter compared to a year ago based on strong demand in data centers and other backup power applications. We continue to hold a market-leading position in the data center segment in China driven by strong end-user relationships and a compelling product offering.

Third quarter revenues in India, including joint ventures, were $520 million, an increase of 76% from the third quarter of 2020. Industry truck production increased by 120%, while our shipments increased 135% as our joint venture partner continued to gain share. Demand for power generation and construction equipment also rebounded strongly in the third quarter compared to a very low base a year ago.

In our power systems markets, industrial engine revenue increased 33% in the third quarter compared to the same period last year driven by mining and oil and gas.

In Brazil, our revenues increased 26% driven by increased demand across all end markets.

Now let me quickly cover our outlook for the remainder of 2021. Based on our current forecast, we expect our revenue to be at the lower end of our guidance or up approximately 20% versus 2020.

EBITDA is now expected to be approximately 15%, below our previous guidance of 15.5% to 16% of sales. Our expected EBITDA margins are lower because of the persistence of the supply chain constraints and disruptions, which are now exacerbated by escalating material and freight prices.

We've lowered our forecast for industry production of heavy-duty trucks in North America to 228,000 units, up 25% compared to 2020 but below our prior guidance of 264,000 units. This is again due to the supply chain constraints impacting our customers rather than a lack of end-user demand.

In the medium-duty truck market, we are decreasing our forecast for industry production to 118,000 units, up 15% year-over-year but below our prior guidance of 134,000 units.

We expect our engine shipments for pickup trucks in North America to be up 25% compared to 2020, an increase of 7.5% from our expectations 3 months ago.

In China, we continue to expect domestic on-highway demand to decline from record levels a year ago. Our 2021 outlook for medium- and heavy-duty truck market demand is 1.65 million units. And our 2021 outlook for light-duty truck market is 2 million units, both unchanged from our previous guidance.

We continue to expect industry sales of excavators to be flat with the record levels achieved in 2020 and unchanged from our previous guidance.

In India, we anticipate industry demand for trucks to be up 75% compared to levels experienced in 2020. And our other businesses are showing promising growth due to continued infrastructure investment. This is also unchanged from previous guidance.

We now expect demand for mining engines to increase 60% in 2021, up from our expectation of 45% 3 months ago based on continued strength in commodity prices.

We continue to expect global power generation revenue to increase 15% primarily driven by the data center and recreational vehicle markets.

Summing up the quarter, strong demand across many of our markets drove continued sales growth in the third quarter. Despite this strong demand, supply chain constraints continue to significantly impact both our operations and those of our customers, resulting in higher material and logistics costs as well as capping revenue growth. We are working collaboratively with our customers and suppliers to navigate these challenges and position the company for better performance in 2022.

Customers are recognizing the strong performance of our products, resulting in our sales growing faster than industry demand in a number of important markets. We continue to invest in bringing new technology to our customers, outgrowing our end markets and providing strong cash returns to our shareholders. The company expects to return over 75% of our operating cash flow to shareholders in 2021 in the form of dividends and share repurchases.

Thank you for your time today, and now let me turn it over to Mark.

Thank you, Tom, and good morning, everyone. There are 4 key takeaways from our third quarter results. End customer demand remained strong in the third quarter, driving sales growth -- strong sales growth across most end markets and businesses outside of China where truck and construction demand has weakened in line with our expectations. Global supply chains remain constrained, impacting our industry's ability to meet strong customer demand and resulting in higher freight, labor and logistics expenses and rising material costs.

As a result of the continued supply challenges and associated costs, we are lowering our full year sales and profitability outlook, even though underlying demand remains very strong.

Finally, we'll return $345 million to shareholders through cash dividends and share repurchases in the quarter and a total of $1.83 billion for the first 9 months of the year, consistent with our plan to return 75% of operating cash flow to shareholders this year.

Now let me go into more details on the third quarter. Revenues were $6 billion, an increase of 17% from a year ago. Sales in North America grew 13%, and international revenues rose 22%.

EBITDA was $862 million or 14.4% of sales for the quarter compared to $876 million or 17.1% of sales a year ago. As a reminder, EBITDA in Q3 last year was boosted by $90 million of temporary salary reductions and a $44 million VAT recovery in Brazil.

Along with the strong demand, the key feature of our performance in Q3 is that our gross margin continues to be challenged by the supply chain constraints and elevated costs. Gross margin of $1.4 billion or 23.7% of sales increased by $65 million but declined as a percent of sales by 270 basis points.

Global supply chain constraints continued to impact the industry's ability to meet elevated end customer demand and have resulted in higher costs. We incurred approximately $90 million of additional freight, labor and logistics costs in the third quarter, in addition to rising material costs, partially offset by increased pricing in the aftermarket.

SG&A expenses increased by $38 million or 7%, and research expenses increased by $42 million or 19% from a year ago primarily due to higher compensation expenses.

As a reminder, due to the significant uncertainty at the onset of the COVID-19 pandemic, we implemented temporary salary reductions in April of 2020 through the end of September last year. The salary reductions resulted in approximately $90 million of pretax savings for the company last year and impacted gross margin and our operating expenses and impacted the comparisons of the results of all of our operating segments.

Joint venture income was $94 million in the third quarter, down slightly from $98 million a year ago due primarily to weaker demand for both trucks and construction equipment in China.

Other income of $32 million increased by $11 million year-over-year.

Net earnings for the quarter were $534 million or $3.69 per diluted share compared to $501 million or $3.36 per share from a year ago primarily due to a lower tax rate and a reduced share count.

The effective tax rate in the quarter was 19.9%, and our income tax expense included favorable discrete items of $11 million or $0.08 per diluted share.

Operating cash flow in the quarter was an inflow of $569 million compared to $1.2 billion a year ago. An increase in working capital led to the lower operating cash flow for this quarter.

Now let me comment on segment performance and our latest guidance for the full year 2021.

The Engine segment third quarter revenues increased 22% from a year ago driven by increased demand for trucks in the U.S. and construction equipment in the U.S. and Europe. EBITDA decreased from 18.1% to 15.2% primarily driven by higher supply chain costs, lower joint venture income and higher compensation expense, partially offset by the benefits of stronger volumes and lower warranty expense.

For the full year, we've reduced our revenue guidance to be up 24% at the midpoint, down 1% for the full year. We now expect EBITDA margins to be between 14.2% and 14.7%, a little below our prior year guidance of 14.5% to 15% primarily due to the weaker sales and ongoing supply chain challenges.

In the Distribution segment, revenues increased 14% from a year ago. EBITDA increased in dollars but decreased as a percent of sales from 10.6% to 9.8% primarily due to some of the supply chain challenges and, again, the higher compensation costs. We have maintained our 2021 outlook for Distribution segment revenues to be up 8% and increased EBITDA margins to 9.3% of sales at the midpoint of our guidance.

Components segment revenues increased 16% in the third quarter driven primarily by stronger demand for trucks in North America. EBITDA decreased from 16.9% to 14.1% primarily due to higher supply chain costs and higher warranty expenses compared to very low cost of quality in the year ago quarter.

For the full year, we now expect Components revenue to increase 28%, lower than our prior guidance of up 32% primarily driven by a weaker outlook in North America and slightly lower outlook for China truck. We have also lowered our forecast EBITDA margins for the segment to be at 15.5% of sales at the midpoint, down from our prior guidance of 17% as the segment has been more hardly -- has been hit harder by the supply chain challenges and the slowdown in truck production in North America and China.

In the Power Systems segment, revenues increased 19% in the third quarter driven by stronger demand for power generation and mining equipment. EBITDA increased by $33 million and expanded from 10.3% to 11.5% of sales primarily due to the benefits of higher volumes and lower product coverage expense, partially offset by elevated supply chain costs.

For the full year, we're increasing our Power Systems revenue guidance to be up 22% from our prior guide of 18% growth driven primarily by a stronger outlook in the mining segment. We're also increasing our EBITDA margin forecast to be 11.5% of sales at the midpoint from our prior guidance of 11.25%.

In the New Power segment, revenues increased $23 million, up 28% due to stronger sales of battery electric systems. EBITDA losses for the quarter were $58 million as we continue to invest in new products and scale up ahead of widespread adoption of the new technologies that we're developing. For the full year, we now project New Power revenues of $120 million at the midpoint and EBITDA losses to be in the range of $200 million.

We expect total company revenues now to grow approximately 20%, at the low end of our prior guidance. We're also lowering our EBITDA margin guidance to be approximately 15% for the full year, down from our prior guidance of 15.5% to 16%. A slower pace of improvement in North American truck production and continued elevated costs associated with the global supply chain challenges are the primary drivers of the lower outlook.

We expect joint venture earnings to be up 10% for this year, in line with our prior expectations. We're forecasting our full year effective tax rate to be 21.5%, excluding discrete items.

Capital expenditures were $150 million in the quarter, up from $116 million a year ago. And we continue to expect full year capital spend of between $725 million and $775 million.

To summarize, we faced incredibly strong demand in many of our core markets but continue to face global supply chain challenges, which have impacted our cost base more so than we'd expected in the second half of the year. However, this end customer demand remains strong, outpacing supply in many important markets and setting us up for a strong 2022, assuming the global economy remains strong.

I want to thank all of our employees for their tireless work this year to ensure that we meet the needs of our customers while continuing to deliver solid financial results. We continue to prioritize improving our performance cycle over cycle, investing in the technologies that will power profitable growth and returning excess capital to shareholders.

Thank you for your interest today, and now let me turn it back over to Jack.

Thank you, Mark. (Operator Instructions) Operator, we are now ready for our first question.

(Operator Instructions) Our next question is -- sorry, our first question is coming from Stephen Volkmann of Jefferies.

Maybe I'll just dive in on some of the supply chain issues. Is it possible to just kind of bucket the impact that you guys have seen? I'm thinking about price cost being a headwind. I'm thinking about logistics costs. I think you gave us a number for that, Mark. I'm guessing there's probably some productivity headwinds. I'm just trying to see if we can kind of better understand exactly what you're seeing relative to the supplier interruptions.

Yes, happy to do that. So yes, we are almost 2% worse between the price we've recovered -- or not recovered, the price increases that we've made principally in the aftermarket this year, which has added about 70 basis points to our results. And we've lost more than 2.5 points between the premium freight, rising material costs and inefficiencies in our operations. And that's a little bit -- that's higher obviously than we anticipated 3 months ago. We did see a reduction in premium freight from the second quarter to the third quarter, but we start to see more increase on the material cost side.

And Mark, is it too early -- I mean I'm assuming for 2022, your goal will be to get right with that or maybe even a little bit better. I don't know. Any commentary you can make as we go out into '22?

I would just say this continues to be a high area of focus both on our operations side and also working through this with suppliers and customers and implementing price increases.

Steve, this is Tom. The one thing that everybody is still -- worry about in our industry is semiconductors. It's not that things haven't improved, some because they have, but it's marginal improvement. It's still a really tight supply chain. So there's a lot of issues across the supply chain, labor shortages, freight, et cetera. But semiconductors look like they have a longer-term capacity issue. And I'd also say the freight side of things just seems like it's not quite getting better yet, and when you look at where containers are and what ports look like.

So there's no question that, as Mark said, internally, we are working as much as we can to address our cost side, inefficiencies. He talked about going out and negotiate, getting price increases. And as you know, on the material cost side, those come automatically, but we'll have to negotiate for the rest.

It's just that some of these things look like they are likely to be somewhat persistent. That doesn't mean we're not hoping to improve them all. I just want to be realistic about there'd be some element that looks like it goes into next year, too.

Understood. I guess high freight costs are probably good long term for you, guys, but we'll have to wait and see how that plays out.

Our next question is coming from Jamie Cook of Credit Suisse.

I guess, Tom, I just wanted to get some more color from you on how you're thinking about China as we head into 2022. That's an important market for you. And what -- in terms of like the power shortages and outages over there, how that's impacting your business both from a negative perspective and potentially a positive perspective over time. So I guess I'll start there.

Yes. Let me let Jen talk a little bit about how the China market is now and how we're seeing it, and I can jump back in and see -- talk about sort of longer-term things.

Yes, as you heard from Mark and we've been forecasting, we've seen a dropoff at the middle of the year in the China market, on-highway market, in particular, with the changeover between NS V and NS VI emissions standard. So we saw inventory building up in the first half of the year, and we're now seeing that coming down and getting sold in regions that are still allowing NS V product sales. And so that, combined with a higher cost of the new emissions product, as we expected, driven a drop in on-highway demand, which we expect to come back to some degree. 2020 was a record year for China, though. So our expectation is that market is going to come back to be more in line with what we saw in '19 for on-highway.

We are benefiting in China from additional content in the Components business with new emissions requirements and also the launch of the Endurant transmission now in China. So we see that benefit. And we think our NS VI products are going to perform well in the market as well and give us some upside potential. But the market overall is down. The construction market has also come down some. And we are continuing to see some strength in the power gen market there.

We are watching the impact of those -- the power shortage issues in China very closely with our suppliers. It's not created a major disruption for us to this point, but it is something we continue to watch closely.

Yes. I would just pick up from where Jen dropped. The power shortages, as she said, some impacts on production but not a huge cost impact. But as you suggested, Jamie, we do think it helps us in the market. And as I mentioned in my remarks, our power gen business is positioned well in China. And now I look at China and I see us positioned across all of our markets. The truck side, as Jen said, we've got -- now got -- our automatic transmissions are taking off, our content across the engines is growing, there's more consolidation in the market. So as things start to come back, I think we're better positioned than we've ever been.

Add to it that we're now doing electrolyzers with a partner in China. We've got fuel cell launches in China. So on the New Power side, while things are moving slower in China than maybe people anticipated several years ago, that's just allowed us to position ourselves to be in those markets more strongly as they take off.

So again, to date, looking where I am today, I'd say our position in China has really never been stronger. So yes, do I wish the market was stronger this year? Sure. But I think as it turns back down, we're able to consolidate more and strengthen our position.

Yes. And we have a new -- the new M15 natural gas product launched in China as well now. And that, I think, positions us better for what's a fairly sizable natural gas market in China as well.

Okay. And then just as a follow-up, can you just talk to how far your order book extends today and to what degree there's risk that the order book is -- has unfavorable pricing in it? And are you concerned about double-ordering at all?

Yes. I mean, at this point, the demand out there is very strong. We're seeing growing back orders in some of our businesses. And I've been out in recent couple of months talking with both OEMs and end customers, and there's strong demand out there that, for sure, is real at this point. Customers are not getting all the trucks that they would like to get this year and do not believe -- even looking into next year, they think that, that -- there's going to be some limitations. So I think that orders are strong.

And as Tom said, we've got some contractual pricing on metals that we'll get as we go into next year. We've been taking pricing actions where we go direct to the market and aftermarket and power gen, and we're continuing to work with our OEM customers on first-fit to negotiate pricing just in light of the cost environment we see right now.

Our next question is coming from Ann Duignan of JPMorgan.

Just a follow-up on the supply chain. A quick follow-up, please. Would you expect the announcement that we're eliminating the European tariffs on steel and aluminum to have any impact on U.S. steel prices in 2022?

Ann, Tom, it's good to hear you. I really don't know because, again, there are, as you know, export -- I mean, sorry, import caps on that, too. So how much that's going to really impact prices is unclear to me. And demand, of course, for metals is pretty high now. So the markets are pretty well supported. In fact, in our mining -- you saw our mining numbers are up, and that's primarily driven by metal prices.

So just in the U.S., it feels to me like it's going to have moderate long-term impact. Short term, it may provide a little bit of a -- a little bit of relief, but I would have said that given the import caps, it's probably not a big move medium or long term.

Okay. I appreciate the color on that. And my real question, though, is more fundamental. I mean you're talking about the 15-liter engine being able to use fuels like hydrogen as their major fuel. If it's so easy to convert a 15-liter internal combustion engine to burning hydrogen, why are we investing in fuel cells at all? I mean if we can do it with just a new fuel injection system or some minor reengineering of an internal combustion engine, why go down the path of hydrogen investments or, in particular, fuel cells at all?

Well, as you know, the hydrogen investments would be the same. Still, we would need to generate -- of course, we need green hydrogen in order to actually reduce the CO2 impact of the fuel. And really, hydrogen and combustion is a good answer, it's just not as efficient as a fuel cell. So if you're running a long-haul, heavy-duty truck where fuel is your #1 cost or power energy is, then that efficiency increase from a fuel cell is going to be worth it to you. If you have a relatively short range or you have a vocational truck, our view is maybe a hydrogen engine might work for you, especially if the conversion to fuel cell is too expensive and you're not having that many units.

So our view is there's a place for both. But if you want to think what's going to really drive the transportation economy 20 years, 15 years from now, you're going to need the efficiency that a fuel cell, especially with an electric system, is going to provide. So our feeling still is fuel cells win for the majority of the trucking industry. But we -- hydrogen engines are a real addition to the portfolio of products that can be available across our markets.

And there's a time factor, too, as you can imagine, as fuel cells advance and costs come down or maybe there are a period of time where hydrogen engines have an economic advantage. As Tom said, over time, costs come down. That efficiency benefit for customers that are really driven strictly by total cost of ownership may -- we think will drive a shift towards fuel cell and applications like long haul.

Okay. I'll take my more engineering-related questions off-line then and maybe...

Yes. I mean I would be happy, Jamie, to have a lot of -- I'd be happy to have a longer conversation.

Because I'm sure I'm oversimplifying just a simple fuel injection system reengineering...

Exactly. I mean -- and taking 30 seconds on it, we're designing this platform, the physical hardware for flexibility, exactly as you said, there's fuel systems and some other component differences. And then the tuning, of course, the calibration and control of the engine is different based on the fuel, but we're able to leverage some of that manufacturing and engineering investment in a common platform.

Our next question is coming from Tim Thein of Citigroup.

The question really is just hoping you could give some help in terms of how we should think about the relationship between heavy- and medium-duty engine sales for Cummins versus industry truck production both in the fourth quarter and then as we get into '22. I'm just thinking about how you're outpacing the industry, but as your OEM customers deal with all these red tank trucks, how should we think about kind of that, again, relationship and obviously, global impact, but maybe just thinking about the heavy-duty segment here in the near term?

Yes, there's a couple of dynamics. So of course, we've added some additional OEM customers. So when you think about our sales through OEMs and medium duty and heavy duty, and you've heard some of the numbers around how much of the total market we're seeing with Cummins engine, so we feel really well positioned. Our products are performing well. There's a lot of end user pull. And we've seen good position in the market.

The dynamic that is happening in the fourth quarter, in most cases, we have been able to work through the supply constraints and continue to supply to our OEM customers and have not, in most cases, been the reason they've not been able to build trucks. So as they take down some of their build rates, stabilize their production and complete these trucks that they build short of some components, we have seen some reduction in demand on the engine itself as they're working to really stabilize and get to more efficient build rates to make sure they're building with what supply and inventory they have and level that out. So that is impacting us in the fourth quarter and part why we adjusted our revenue guidance.

What I would add, Tim, is what we see is our products are performing incredibly well. We see it in our financials with very positive results on cost of quality and overall strong sense of enthusiasm for the products that we're putting in the market. Invariably, you're going to get some volatility quarter-to-quarter, as we always do. But we feel really good about the position of our products in the market. I think that's the message. When you step back and when we're done with this year and we look at it, that's the message we want you to leave with, and of course, we're optimistic about picking up more business over time.

Got it. And then, Mark, just on the margin impact in Components, obviously, a lot of metals and platinum and palladium and et cetera used there. And I know there's always a time lag. Is there a way to think about the margin impact this year that's effectively a timing gap that you presumably -- presuming things stabilize, which maybe is a wrong assumption. But is there a way to think about what is kind of more of a short-term impact that gets reversed next year? Or is that -- is it too hard to kind of piece that apart?

If I just step back -- because there's a lot of noise year-over-year because some of the actions we took last year that boosted results. If I just step back from the noise of the numbers, I'll come back to that in a moment, really, we're wrestling with 3 issues in that business that are somewhat different than we'd anticipated 3 or 6 months ago.

Number one, truck production in North America has not picked up in the second half of the year. If anything, it's drifted down a little bit and we were counting on that in our guidance. So we think underlying demand supports a robust environment for next year and that should take care of itself.

Number two, whilst we anticipated a sharp drop in the second half of the year in China, and that's playing out largely as we've expected, this business is doing a major product transition from NS V to NS VI. And invariably, when we start with the launch of new products, we're below optimal scale, demand is still pretty light for NS VI. So as we ramp up there, we'd expect margins to recover.

The bigger challenge or the more knotty challenge is the rise in supply chain costs, which is really what we've seen, where in the first half of the year, we saw our ECMs' principally availability impacting our operations and supply chain in the Engine business. We've seen that spread more to more electrical components. And what's happened is the Components business has picked up more costs and inefficiencies.

So that one is knotty. We're working through all that. Yes, we've got the metal costs. We've got the normal contractual adjustments around that. But it's that focus on the supply chain and the other actions that we talked about at the start of the call that we're focused on here. But I just wanted to try and simplify the message. There's a lot of noise out there.

I would just say one other thing, just -- you didn't ask me, just to clear up some noise here. Whilst in the explanations we mentioned higher product coverage costs in this segment, it's compared to an extraordinarily low number last year. There's no big charge for product coverage or warranty in the segment. So I just wanted to clear that up for other listeners.

Our next question is coming from Jerry Revich of Goldman Sachs.

Tom, you folks target structural improvements in the business every cycle. And I'm wondering, as you look at the supply chain challenges that the entire industry has faced here, how are you folks thinking about potential changes in the way you manage inventories or the way you manage the supply chain going forward? Is there an opportunity to reduce some of the volatility by meaningfully increasing inventories given where cost of debt is, et cetera? Wondering how you're thinking about positioning Cummins coming out of this pretty complex environment we're facing here.

Jerry, it's a terrific question. And as you can imagine, it's been on my mind for a while. We did -- early in the pandemic, we did do some structural reform. I think we talked about it in some previous calls, trying to say, hey, while the market is down, let's make sure that we get our capacity rightsized. And I think we did some good work early on, on that.

But with the supply chain challenges, we've also seen a bunch of new problems that we weren't seeing before. You highlighted some of them. Do we have enough inventory in the right places? Are we outsourced in places we should be insourced? And then, of course, with trade challenges between countries, are we relying too much on cross-border trade? So all those things now are in our strategy looking forward about how we want to reposition our supply chain.

So today, what we're doing is trying to get our costs down, trying to get our production up to meet customer demand and trying to keep our supply chain people at work when it's -- they're basically working 24/7. It's been really, really rough. So I would just say that the strategic elements, while we're doing a lot of work and analysis on them, there's no question that we've taken a back seat to try to keep operations going in the last couple of quarters.

But those issues are first and foremost for us in the leadership team, thinking about how we want to position. And I'll just say this, broadly speaking, what we're thinking about is we do need to reposition what we outsource and what we insource for the future, partly because of some of the supply chain challenges we've seen here but also because the industry is likely to consolidate further. And we need to make sure that we can be the reliable supplier that we need to be for our customers. So we will be looking at that and thinking through where the right way to position ourselves in different supply chains is. But I think you've hit on a key point that there will be some optimization that will be helpful to us, both from a cost and reliability point of view over time.

Terrific. And on a separate note, I'm wondering if you could talk about the outlook for your electrification opportunities in off-highway markets. Obviously, a pretty fragmented supplier base in terms of other engine systems in the market now. How do you see that as an opportunity set for Cummins? And are there significant major new product milestones that we should look forward to as you folks electrify the off-highway offerings?

As you said, off-highway is more fragmented. And generally speaking, conversations are a phase behind on-highway in battery electric powertrains, but they are common. I mean, as you guess, every major off-highway producer is trying to figure out what their long-term strategy is from a carbon point of view and sustainability point of view. So we are having conversations with many of them.

In all cases, I think the battery electric conversation, these, at a high level, strategically is the same thing. All of them need a solution. All of them want to figure out when is their cost -- the total cost of ownership for end users work out, and it generally doesn't today unless you're in a publicly financed application. If you're in a train or a bus or a ferry, okay. If you're in a commercially viable thing, it doesn't quite work out yet. And the -- but the numbers, as you know, are changing quickly, but it still doesn't work out. So they're trying to figure out how to position themselves for when it does work out, who they partner with and how.

And today, most of those partnership conversations are pushed out because there's not a viable offering to make today nor is there a way to get to a viable offering with the technologies and the costs as they are now. So everyone is looking forward and trying to figure out what does it look like.

Off-highway, I believe, strategically, will be in the same challenge that they're in today, not enough volume to justify a special one but very specific needs to their application. And our view is that Cummins will be well positioned because we'll have products in on-highway, which will give us volume and scale, and then we'll have an understanding of their application and how to adapt the technologies most effectively to off-highway so that we'll represent a good partner to them. And that's -- as you guess, that's sort of the pitch I'm making to them now that we'd be the right partner for them in battery electric as we are with engines.

Our next question is coming from Noah Kaye of Oppenheimer.

Tom, I wonder if you could kind of update us on how the electrolyzer pipeline is developing. I think we've seen some of the companies in the industry, just a really robust demand growth since the start of the year. And if you can also comment, obviously, it's not set in stone, but there appear to be some pretty healthy incentives for hydrogen production in the [reconciliation] provision. So just wondering if you could comment on potential impact of that to help grow the business.

I appreciate your question. And the answer is we have continued to see backlog growth in the electrolyzer business. And I'd say the big strategic move we wanted to make was to add some bigger projects to the backlog. And those conversations have been going much better. Backlog, I think last time we checked, was 60 megawatts or something, quite a good backlog, some newer, larger projects which were exciting to add in there. And of course, the problem with larger projects, they take longer to get together, so -- and more likely delays in funding. But that's where the market is going. We need to have those big ones. So it was good to see some of those come in the backlog. And I would just say that the interest in electrolyzers is still quite strong.

As you mentioned, the bill, the Build Back Better plan has some incentives in there for producing hydrogen or especially low -- carbon-free ammonia. We think that's going to be a good use of electrolyzers in the early phases of electrolyzers. We see it in Europe where there's a carbon price already, that we see some fertilizer-related projects, and it's an area where there's a lot of carbon used in fertilizer through gray hydrogen. And making that hydrogen green is a way -- there's already demand. Calculations about how to get cost equivalency are pretty straightforward. They're not easy. They take some funding and they take some incentives, which is why you see those in the bill. But what -- once you do the calculations, you can see how you can get there. So I do expect that to be one of the markets that's likely to move more quickly, especially if those incentives make it through into law. I do think it will promote the green hydrogen -- green nitrogen, I guess, the green ammonia business pretty quickly in the U.S.

And then just on a different topic. I wonder if we could get any update on the Filtration business, particularly in light of the comments made earlier about some of the operational changes or realignment from a high level that you're planning. Where are you at in terms of exploring the alternatives for that business?

This is Mark. Yes, we continue to make progress in pursuing the alternatives for that business. Our plans are unchanged and you should expect an update in the new year as we continue that work. There'll be no -- I don't anticipate any significant change in the remaining 3 months, but an update in the new year. And the direction and the enthusiasm for that process remains unchecked. And I would just say the performance of that business has also been very strong this year, though. It's embedded within the Components business, but the business continues to do very well.

Our next question is coming from Matt Elkott of Cowen.

So guys, in the U.S., we're looking at significant up cycles in truck production as well as construction and mining equipment. As these up cycles begin to unfold, are there opportunities for you guys to increase the percentage of your engines with your customers both on-highway and off-highway? And if I take it a bit longer term, are there opportunities for potentially gaining new customers who may currently be fully integrated?

Yes, great question. We are constantly working to make sure that we have the most competitive engine in the market that drives end user pull and grows our position in the market and also ensuring that we have capacity to meet OEM needs through strong cycles. And we continue to have conversations. You've seen announcements around the partnerships with Isuzu, with Hino, with Daimler. We're continuing to have those conversations with customers that may not offer Cummins' engines today to introduce those in the future. So we expect that those opportunities will continue over time.

So generally, during an OEM cyclical production up cycle, does the vertical integration usually go up or down for the OEMs?

Matt, it depends. But at the very top of the market, generally speaking, penetration goes up a little bit because they run out of capacity if they use both, if they have both their own demand and ours, but again, generally is not a good indicator for a given quarter. And as Mark was saying earlier, quarter-to-quarter variation is pretty high because they may have backlog. In this case, they may have unfinished trucks with more of their engines. So just quarter-to-quarter, it's hard to see.

What's more is because of the supply chain challenges, right now OEM truck production is capped by suppliers. So they're not -- we're not anywhere near the maximum production of the industry today. I mean we hope to be, based on what engine user demand was, but we're not. We're in an area where there's -- they can produce more if they could get more parts. So I think we're not really near the spot that you're asking about in terms of industry production.

Got it. Makes sense, Tom. And then just one follow-up question on the natural gas engine. In the U.S., it's very small. I think it's -- you guys produce about 10,000 engines and you dominate the market. With the 15-liter engine, can you talk about the growth opportunity and when you could see it unfold? I mean, is it going to be a meaningful opportunity next year? Or is this more longer term?

Yes. So the plan, we've announced that we're bringing the M15 engine -- natural gas engine that we have in production in China now into the U.S. market by '24. So we're a couple of years out from offering that product. As I've talked to end customers, they are very excited about this product and, in particular, as they pursue their own goals for carbon reduction. In the coming years, they see natural gas as a great way to meet those, including using renewable natural gas. So we expect some upside opportunities as we bring that new platform into the market and also some growing interest in natural gas in the market.

Which again should boost our share given our position in natural gas.

Our next question is coming from Rob Wertheimer of Melius Research.

You guys touched on pricing earlier. Could you remind us, maybe just give a quick recap overview of how pricing works on engine platforms? Is that the only one where you have sort of constraints on what you price? That includes material cost escalators but not freight maybe, if I understand right. And then what portion of the mix do you then have to go after things like freight on?

Broadly speaking, Rob, the way it works is that we have OEM long-term agreements with large customers for engines and the major components. That's the sort of sectors where you see some of those long-term agreements. The benefit of those, of course, is that we can count on continued customer orders over a period of time, over a phase of production of trucks and engines. And the pricing arrangements in those, for the most part, again, each one is a little different, but the general deal is on basic material cost, there's an escalator or a pass-through. And on the rest, you need to negotiate if you want to make a change. It doesn't mean you can't negotiate, just means you have to negotiate with your partner. And then on generator sets and aftermarket where we go directly to retail customers, then we only have what's on the order book as what you can price on.

So as Mark and Jen said, this year, we priced in the aftermarket early in the year. We priced in the aftermarket again in the middle of the year. And we always are looking back at that to see if we should do more. And in gensets, we also move pricing right away. And then now what we're doing is talking with all of our OEM customers about the fact that we've had these escalators, not just freight, by the way, freight, logistics, material costs, special shipments as a result of delays in semiconductors and other products that we want to recover from them and we're in negotiations with them now.

Okay. That's helpful. And then I don't know, Tom, if you can give an overview on -- you touched on it earlier, on semiconductors. Do you have a sense on when you think the industry will be in better shape? And then what is Cummins doing specifically? I don't know if you're requalifying supplier, qualifying new suppliers, redesigning chips, et cetera, before the industry gets better. And I'll stop there.

Yes, I'll comment on that one. So it's something we've been working really closely throughout the year. We've started to see some improvement quarter-over-quarter since the middle of the year and supply of microprocessors for most of our components that use those. We've seen some growing disruption on other electrical components. So that has become a bigger issue for us in the second half of the year. And we have also, in parallel, been working. I think we'll revisit inventory strategies as we are able to build inventory, not today in the current very constrained environment. And we're also looking at sourcing strategy and doing dual sourcing back all the way to a Tier 3 level to make sure we've got more flexibility in the future.

And Rob, the thing we really need in the U.S., of course, is we need domestic semiconductor production that's targeted at the automotive industry. That's -- I mean, that's -- I don't mean to be pie in the sky about it, but that -- strategically, it's kind of a nightmare that we only have all those semiconductor wafers are coming from pretty much one factory or one set of factories in Taiwan and that we're a very small part of that company's output. That's not the ideal situation for a supply chain.

So if you had said, hey, what's the strategic plan, the strategic plan has to be to find semiconductor manufacturers who think the automotive industry is more critical to their success and ideally to have some closer to shore or onshore so that we can look at the total capacity and demand because right now, most automotive, most trucks and buses are adding a significant portion of electronics. Each revolution, each time that their new product rev come out, they add 30% more chips or sensors or something. And that's not the way the industry semiconductor -- the capacity for semiconductors is moving. So we need to add more capacity and we need to add it targeted at those customers.

Thank you, Tom, and thank you, everybody. I believe that concludes our teleconference today. As always, thank you to everybody for your continued interest in Cummins and for joining today. I will be available for questions after the call. Thank you again.

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