Cummins Inc

NYSE:CMI

Earnings Call Transcript 2022-Q1

[Operator]

Greetings, and welcome to the Cummins Inc. First Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Chris Clulow, Vice President, Investor Relations for Cummins Inc. Thank you. You may begin.

[Chris Clulow, Vice President-Investor Relations]

Thank you. Good morning, everyone. And welcome to our teleconference today to discuss Cummins’ results for the first quarter of 2022. Participating with me today are Tom Linebarger, our Chairman and Chief Executive Officer; Jennifer Rumsey, our President and Chief Operating Officer; and Mark Smith, our Chief Financial Officer. We will all be available to answer questions at the end of the teleconference.

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 and 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 will 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 within the Investor Relations section at cummins.com.

With that out of the way, I'll turn it over to our Chairman and CEO, Tom Linebarger to kick us off.

[Tom Linebarger, Chairman and Chief Executive Officer]

Thank you, Chris, and good morning. I'll start with the summary of our first quarter financial results. Then I'll discuss our sales and end market trends by region. And I'll finish with a discussion of our outlook for 2022. Mark will then take you through more details of both our first quarter financial performance and our forecast for the year.

Before getting into the detail on our performance, I want to take a moment to highlight a few major events from the first quarter. The company announced two significant acquisitions. They expand our product portfolio and are critical to advancing our decarbonization goals, the acquisition of Jacobs Vehicle Systems and the definitive agreement to acquire Meritor.

Jacobs Vehicle Systems is a supplier of engine braking, cylinder deactivation, start/stop control and thermal management technologies, which are key components to meeting current and future emissions regulations. The integration of Meritor, a global leader of drivetrain, mobility, braking and electric powertrain solutions for a commercial vehicle and industrial markets will position Cummins as one of the few companies able to provide integrated powertrain solutions across the full range of power technologies, including combustion engines, battery electric, and fuel cell electric systems.

In February, Cummins also unveiled the industry's first unified fuel agnostic internal combustion powertrain platforms. This technology approach to our new engines will be applied across Cummins X-series, L-series and B-series product platforms, it will help fleets reduce carbon emissions today by enabling vehicles to run on low to zero carbon fuels. The platforms will utilize the leading engine technology that customers are familiar with and have a high level of parts commonality across fuel types to reduce costs and complexity.

Also Florida Power & Light Company, a division of NextEra announced Cummins will supply a 25-megawatt electrolyzer system for the groundbreaking FPL Cavendish NextGen Hydrogen Hub. The hydrogen hub will be Florida's first of its kind green hydrogen plant, and will use solar energy to power the electrolysis process. Once built, this will be the largest PEM electrolyzer installation in North America. These acquisitions, product development announcements, and project wins, are all part of our Destination Zero strategy to evolve our company, our products and our customers products to the technologies needed for a decarbonized world.

The strategy which we reviewed with you at Analyst Day includes reducing carbon emissions now by making improvements in the technologies we know today while rapidly advancing the zero emissions technologies of the future. Another important development during the first quarter was the company's decision to indefinitely suspend our operations in Russia, as the conflict in Ukraine persists with no peaceful resolution site. We are continuing to evaluate the best way to support our employees during this difficult time in accordance with local laws and regulations. We are also actively working with community organizations, especially in Romania and Poland, to determine how we can assist refugees as they arrive.

Now, I will comment on the overall performance for the first quarter of 2022 and cover some of our key markets starting with North America, before moving on to our largest international markets. Demand for our products remains strong across all of our key markets and regions with a notable exception of China, resulting in record revenues for the first quarter of 2022.

Revenues for the first quarter were $6.4 billion, an increase of 5% compared to the first quarter of last year. EBITDA was $755 million or 11.8% compared to $980 million or 16.1% a year ago. First quarter results include costs of $158 million related to the suspension of operations in Russia and $17 million related to preparations for the separation of the filtration business, which we have discussed in previous calls.

The costs incurred relating to the indefinite suspension of our operations in Russia include inventory write-downs, reserves on accounts receivable, the impairment of a joint venture investment and other costs. My comments moving forward will exclude the one-time financial impact of the suspension of Russian operations.

EBITDA percentage declined in the first quarter as joint venture income dropped from a record high in the first quarter of last year, driven primarily by the slowdown in China markets. Research and development expenses also increased in the first quarter of 2022, as we continue to invest in the products and technologies that will create advantage in the future, particularly in the engine and new power segments.

Gross margin percentage improved compared to the first quarter of last year as the benefit of pricing we implemented at the beginning of this year exceeded the manufacturing, logistics and material cost increases during the quarter. This pricing only partially offset the impact of elevated supply chain and other inflationary costs that we carried through from 2021.

Our first quarter revenues in North America grew 12% to $3.7 billion, driven by improved pricing and higher aftermarket demand. Industry production of heavy duty truck in the first quarter was 65,000 units, up 8% from 2021 levels, while our heavy duty unit sales were 23,000 flat with 2021. Industry production of medium duty trucks was 29,000 units in the first quarter of 2022, a decrease of 9% from 2021 levels, while our unit sales were 26,000, down 3% from 2021.

We shipped 42,000 engines to Stellantis for the use in RAM pickups in the first quarter of 2022, flat with last year. Engine sales to construction customers in North America increased by 60%, as non-residential construction spending rose and rental companies increased capital spending.

Revenues for North America power generation declined by 3% as supply chain constraints limited our production for both U.S. military and mobile power applications. Our international revenues decreased by 3% in the first quarter of 2022, compared to a year ago. First quarter revenues in China, including joint ventures were $1.5 billion, a decrease of 31% due to lower sales in on-highway and construction markets. Industry demand from medium and heavy duty trucks in China was 264,000 units, a decrease of 55% from last year.

Last year's numbers were unusually strong, supported by a pre-buy ahead of NS VI, but weaker new vehicle demand and economic impacts from shutdowns as the country responded to a COVID-19 resurgence have pushed the market below normal levels. Our sales and units, including joint ventures were 35,000, a decrease of 62%. The light-duty market in China decreased 20% from 2021 levels to 468,000 units. While our units sold, including joint ventures were 34,000 units, a decrease of 24%.

Industry demand for excavators in the first quarter was 77,000 units, a decrease of 39% from record 2021 levels. The decrease was driven by declining demand within the property market and the COVID-19 impact on infrastructure. Our units sold were 13,000, a decrease of 41%. Sales of power generation equipment increased 58% in the first quarter, primarily driven by data center customers.

First quarter revenues in India, including joint ventures were $621 million, an increase of 8% from the first quarter a year ago. Industry truck demand increased by 18% while our shipments increased by 16%. Demand for power generation and construction equipment also increased in the first quarter as economic activity continued to improve. In Brazil, our revenues increased 10% driven by improved demand in most end markets.

Now let me provide our outlook for 2022, including some comments on individual regions and end markets. We have raised our forecast for total company revenues for 2022, to be up 8% compared to our prior guidance of up 6%. This guidance reflects a stronger outlook in North America and a weaker outlook in China, as well as the indefinite suspension of our operations in Russia.

We are forecasting higher demand in global oil and gas and power generation markets and expect aftermarket revenues to increase compared with last year. We are maintaining our forecast for heavy duty trucks in North America to be 250,000 to 260,000 units in 2022, a 10% to 15% increase year-over-year. The supply chain constraints, our industry is experiencing continual limit supply relative to strong end user demand. In the North America medium duty truck market, we are continuing to project the market size to be 120,000 to 130,000 units of 5% to 10% increase from 2021. Consistent with our guidance, our engine shipments for pickup trucks in North America are expected to be down 5%, compared to 2021.

In China, we project total revenue, including joint ventures to decrease 10% in 2022. We now project a 40% reduction in heavy and medium duty truck demand and 12% reduction in demand in a light-duty truck market compared to a 30% decline and a 5% reduction respectively in our previous guidance.

Industry sales of excavators in China are expected to decline 30% from record levels in 2021, consistent with our prior guidance. Despite the projected decline in China and current economic uncertainty, we remain well positioned for continued outgrowth across our end markets in this region. Industry volumes of NS VI product will increase this year, as the new regulations are implemented more broadly.

Our experience in meeting similar standards in the United States and Europe has prepared us to meet these standards, allowing us to offer strong support to our partners through the transition. We continue to ramp production and expand our presence in automated manual transmissions and build momentum in the new power space through partnerships and in-country capabilities to establish a leadership position in that developing market.

In India, we project total revenue, including joint ventures to increase 10% in 2022 in line with our previous guidance. We expect industry demand for trucks to increase 20% this year. We continue to project most major global high horsepower markets will improve in 2022. Sales of mining engines are expected to be flat this year compared to the prior year, a decrease in our prior guidance of up 10%. Demand driven by continued strength in commodity prices is now being offset with a volume decline from our suspension of operations in Russia.

Demand for new oil and gas engines is expected to increase by 95% in 2022, albeit off a low base. Our previous guidance for oil and gas engines was an increase of 25%. Fortunately, we were able to reallocate a significant number of our build slots from planned mining sales into Russia to meet increased demand in the U.S. oil and gas market. Revenues in global power generation markets are expected to increase 5% driven by increases in non-residential construction consistent with our prior guidance.

We are now projecting aftermarket sales to increase 15% from 2021, up from our previous estimate of up 10%. This is driven by parts demand within our North American on-highway business, as well as global power systems markets. In New Power, we continue to expect full year sales to be approximately $200 million. We have a growing pipeline of electrolyzers, which we expect to convert to backlog and be delivered over the course over the next 12 to 18 months.

In the first quarter, new order intake for electrolyzers was the strongest we have seen to date contributing to an already healthy backlog. We will continue to accelerate our collaboration with OEMs on both electrified power and fuel cell power for applications in 2022. As a recent example, we are partnering with Scania, a world leader of trucks and buses for heavy transport applications to deliver 20 fuel cell electric trucks by next – end of next year, demonstrating hydrogen’s viability as an alternative power due to its energy density and flexible use.

In summary, we are increasing our revenue outlook for the year with year-over-year growth expected most major regions except China. We are maintaining our full year 2022 EBITDA guidance of approximately 15.5%, excluding the impacts of an index of our indefinite suspension of operations in Russia, and the costs associated with repairing for the expected separation of our Filtration business.

We expect to deliver this strong profitability despite the supply chain constraints and rising inflationary costs that we are experiencing. During the quarter we returned $518 million to shareholders in the form of dividends and share purchases consistent with our plan to return approximately 50% of operating cash flow to shareholders for the year. Strong execution resulted in record sales in the first quarter, despite the very difficult operating environment, the ongoing supply chain constraints through the industry, the continued COVID-19 related impacts and the effect of the competency in Ukraine, all present challenges to operating our business normally.

I’m humbled by the commitment and resilience of our employees and leaders around the world who are navigating through these difficulties, delivering for our customers and generating strong financial performance at the same time. Cummins has never been in a stronger position, allowing us to invest in the products and technologies that will fund future growth, drive advantage for our customers and help decarbonize our industry. And we will accomplish this while generating strong financial results and return cash to shareholders.

Now, let me turn it over to Mark Smith.

[Mark Smith, Chief Financial Officer]

Thank you, Tom and good morning everyone. Four key takeaways from my comments today. Number one, that global demand remains strong and we delivered record revenue in the first quarter. Second, we also delivered solid profitability in the quarter as gross margins improved compared to a tough Q4 of last year, Tom said we returned $518 million to shareholders in the form of dividends and share repurchases and we’ve raised our full year outlook, despite the many challenges around the globe. We have suspended our commercial operations in Russia indefinitely, which resulted in a pre-tax charge of $158 million in the first quarter of 2022. To provide clarity on operational performance, I’m excluding the impact of this charge in my comments. We have provided a breakdown of the costs associated with Russia in our earnings material, broken out by operating segment and P&L line item with wage analysis.

Now, let me go into more details on the first quarter performance. First quarter revenues were $6.4 billion, up 5% from a year ago. Sales in North America were up 12% and international revenues dropped 3% due to a sharp slowdown in China. Unfavorable foreign currency movements impacted international sales by 2%. EBITDA was $913 million or 14.3% of sales for the quarter compared to $980 million or 16.1% of sales a year ago. Though lower EBITDA percent was driven by negative other income, lower joint venture earnings, primarily in China and higher operating expenses, principally engineering expense to support future product development. Gross margins improved year-over-year and also from the fourth quarter, both of which were relatively tough quarters from a gross margin perspective.

Now let me discuss each line item in more detail. Gross margin of $1.6 billion or 24.9% of sales increased by $105 million or 50 basis points compared to a weak Q1 last year. The benefits of stronger volumes, including aftermarket and higher pricing more than offset a higher freight costs and material costs from a year ago. Selling, admin and research expenses increased $79 million or 9% primarily due to higher research costs, which support future growth as well as $17 million of expenses associated with the plan separation of our Filtration business. Joint venture income declined by $39 million versus a year ago, driven by lower demand for trucks and construction equipment in China.

Other income was a negative $52 million, $45 million worse than a year ago. During our Analyst Day in February, we highlighted our new advanced range of fuel agnostic combustion engines, which are receiving very strong customer interest. As we finalized our product plans for the new platforms, we wrote down the value of certainly existing assets, which negatively impacted other income by $36 million. In addition, we experienced $37 million of mark-to-market losses on investments that underpin our unqualified benefit plans in the first quarter. This compares to a $32 million mark-to-market loss a year ago.

Net earnings for the quarter were $565 million or $3.95 per diluted share compared to $603 million or $4.07 from a year ago. The costs associated with Russia and the plan separation of the Filtration business reduced current Q1 EPS by $1.12. The effective tax rate in the quarter was 26.8%, which included unfavorable discrete tax items of $31 million. Operating cash flow in the quarter was an inflow of $164 million versus $339 million in Q1 of 2021. The lower cash flow result was result of lower earnings and a higher payout of variable compensation this year compared to the payout in 2021.

I’ll now comment on segment performance and our guidance for 2022. For the Engine segment first quarter revenues increased 12% from a year ago, while EBITDA increased from 14.4% of sales to 15.4% as the benefit of stronger volumes and pricing actions more than offset lower joint venture income and increased input costs. In 2022, we expect revenues to be up 8% from our prior guidance, primarily driven by higher aftermarket sales in North America.

2022 EBITDA is projected to be approximately 14.5% down 100 basis points from our prior guidance, primarily due to lower joint venture income in China, as well as acknowledging the impairment cost in Q1. In the Distribution segment revenues increased 15% from a year ago to $2.1 billion, a record for the segment.

EBITDA increased as a percent of sales to 9.9% compared to 8.7% a year ago, primarily due to higher aftermarket volumes and pricing. We expect 2022 distribution revenues to be up 11% compared to 2021 in line with our prior guidance. The increase in revenue is primarily driven by stronger aftermarket demand globally. EBITDA margins are expected to be in the range of approximately 10.5% up from our prior forecast of 10%, primarily driven by strong aftermarket.

Component segment revenue decreased 8% in the first quarter, primarily driven by weaker demand in China. EBITDA decreased from 19.6% of sales to 16.4% driven by the negative impacts of lower volume, as well as higher material and logistics expenses. We expect revenues to increase 6% up from our prior forecast of 4%, primarily due to higher aftermarket sales, which more than offset weaker demand in China. EBITDA margin is projected to be 16.75% up from last year and our prior guidance, primarily due to stronger volumes and some efficiency gains.

In the Power Systems segment revenues increased 14% in the first quarter, and EBITDA decreased from 12.3% to 9.5% of sales as the benefits of stronger volumes were more than offset by higher supply chain expenses. In 2022, we expect revenues to be up 8%, 3% higher than our prior forecast, primarily due to higher demand for oil and gas and power generation equipment globally. EBITDA is projected to be 11% for the full year in line with our prior guidance.

In the New Power segment revenues were $31 million down from $35 million a year ago, due to the timing of electrolyzer sales. Our EBITDA loss was $67 million in the quarter in line with our expectations as we continue to invest in the products infrastructure and capabilities to support strong future growth. For the New Power business, we still anticipate full year 2022 revenues to be approximately $200 million representing an increase of 72%. Net expense in that segment is still projected to be approximately $290 million as we continue to make targeted investments.

We are raising our full year 2022 expectations for company revenues to be up 8% from our previous guidance of 6%, primarily driven by strong demand in North America, while maintaining our guidance for company EBITDA margins at approximately 15.5%. This guidance excludes the first quarter charge for Russia and any expenses associated with the separation of the Filtration business. We continue to see challenges with global supply chain performance and rising input costs and have raised prices to counter the inflation. We will continue to monitor costs closely and evaluate the need for further price increases.

We expect earnings from joint ventures now to decline 20% this year, excluding the impact of our suspension of Russia operations. This is down from our prior guidance of down 15% to 20% due to a weaker outlook in China. We are projecting our effective tax rate to be approximately 21.5% in 2022, excluding any discrete items. Our outlook for capital investments has also been changed at $850 million to $900 million for the year. We anticipate returning approximately 50% of operating cash to shareholders in the form of dividends and share repurchases.

To summarize, demand remained strong in nearly all of our end markets with China the notable exceptions. We delivered record sales and solid profitability in the first quarter and have raised our outlook for the full year. We remain focused on strengthening our position in our core markets, investing in technologies that will accelerate our plans for future profitable growth and generating strong returns.

Thank you for your interest today. And now let me turn it back to Chris.

[Chris Clulow, Vice President-Investor Relations]

Thank you, Mark. And we’re ready for our Q&A session now. Out of consideration to others on the call, I’d ask that you limit yourself to one question and a related follow-up. If you have an additional question, please rejoin the queue. Operator, we’re ready for our first question.

[Operator]

[Operator Instructions] Our first question comes from the line of Jamie Cook with Credit Suisse. Please proceed with your question.

[Jamie Cook, Credit Suisse]

Hi. Good morning and nice quarter. I guess my question and follow-up. One, can you talk to sort of pricing actions you’ve taken since last quarter. Your assumptions on price costs and like to what degree do the pricing actions that we’re taking this year make up for whatever we’re losing and to what degree do pricing actions this year can help 2023 margins? I’m just guessing, can we recoup, I guess, if we’re losing price cost in 2022. And then my second question, Tom, if you could just sort of update your assumptions, given with Russia, Ukraine, China, like what your assumptions are for supply chain in the back half of the year. Thanks.

[Jennifer Rumsey, President and Chief Operating Officer]

Jamie, it’s Jennifer. I’ll give an answer and then Mark can talk about some of the numbers. As you know, we saw growing material and supplier inflation over the course of 2021. And as we talked about a quarter go, we took actions entering this year to increased pricing in first fit and aftermarket and also add some surcharges in response to that. And so we continue to see that cost pressure growing, material cost, supplier inflation and logistics cost and also impacting the efficiency of our operation.

We were able to recover some of that with the pricing actions that we took in Q1. And those went in place over the course of the quarter, as we worked through our backlog and new pricing went into place. And we are continuing to monitor those cost pressures and take additional pricing actions over the course of the year. So I think to answer your question about go forward, it really depends on what we see over time with material costs and logistics costs, which have just continued to grow at this point in the market.

From a Russia business perspective, as Tom alluded to, we were able to – we see strong underlying demand. And so we’ve been able to repurpose some of the material that we do have in place into other markets and continue to maintain our revenue guidance given the strong underlying demand in oil and gas, and on other markets and offset the impact of Russia. From a supply perspective, we’re really watching Tier 2 and Tier 3s impact on us. At a Tier 1 level is not a big risk, but we’re monitoring what’s going on in some of the underlying material that comes out of Russia, like palladium and beyond gas. And so at this point we don’t anticipate significant impacts, but it’s something we’re paying attention to.

[Tom Linebarger, Chairman and Chief Executive Officer]

And Jamie, hi. Good morning, by the way. The only thing I guess I would add to Jen’s comments is that, as I said, in my remarks, we have – we did make improvements in pricing, but we didn’t make up for all the of costs cumulatively through the year. Just to kind of draw a tighter line on it. You asked about how margins will be next year. If we don’t take further pricing action, we will be worse on the same sales as we would’ve been before all the COVID pandemic stuff started.

So suffice it to say, as Jen said, we are continuing to look at future pricing actions to make up that difference because inflation continues all the things Jen said. So right now I’d say we’re still lower than we need to be to get back to zero on gross margins. So our expectation is that we’ll continue to try to recover through pricing. As she said though, there’s a lot of uncertainty about supply chain.

So you asked about the effect of China and Russia. I think we’re still very concerned about supply chain impacts in the second half. So as you know, in our original guidance for the year, we kind of expected things to improve in the second half. We still expect that, but our concerns grow, especially in chips and electronics and then with some of the shutdowns in China. Our concerns grow that we may not see as much impact in the – positive impact in the second half on supply chain, as we’d hoped, which isn’t to say that we don’t know what to do about that. We’ve been working on that for two years. We’re getting better and better at dealing with uncertainty.

In our supply chain and disruptions and as we said, we’ll continue to look at pricing to offset some of those costs. But the supply chain is not settling to a degree that we’d hope again, it’s not the second half yet. But the China shutdowns did not help at all and the electronics components that we expected to get better onward from the suppliers, we’re just losing confidence that they’re actually going to deliver so much better than we – than they – than we’d hoped.

[Jamie Cook, Credit Suisse]

Okay. Thank you very much.

[Tom Linebarger, Chairman and Chief Executive Officer]

Thank you.

[Jennifer Rumsey, President and Chief Operating Officer]

Thanks Jamie.

[Operator]

Thank you. Our next question comes from the line of Noah Kaye with Oppenheimer. Please proceed with your question.

[Noah Kaye, Oppenheimer]

Thanks so much. So just wanted to highlight that green hydrogen electrolyzer win, NextEra, Florida Power & Light had talked about that previously. But it’s a – I think a great reference point for how to build the hydrogen economy with green power. Can you talk a little bit more about the pipeline of opportunities potentially in Europe where there’s more policy support, but here in North America?

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. Exactly, as you said, that project is a great demonstration project. Our previous largest installation was in Canada that was 20 megawatts. This is larger at 25. So it’s two things. One is, it’s a North American operation with green energy going directly into green hydrogen available for off-takers. That’s a first for the U.S. That’s really good. Second thing is that it’s a large scale use of PEM electrolyzers. And as we’ve discussed on this call before, our view is PEM electrolyzers – electrolysis is the right solution for the future, both because it’s the technology it’s improving faster and the flexibility of the technology means that you can build any size, any place.

So we think it’s the winning technology, but suffice it to say we haven’t built as many large installations as we have in alkaline and other technologies. So anyway, it’s a great reference project. NextEra is of course a leader in this kind of work. So we’re excited about that.

In Europe, we continue to see strong interest in similar kind of projects. As you said, there’s policy support there, because there’s a carbon tax, which increases the cost of gray hydrogen, meaning green hydrogen projects look that much better, plus there’s EU funding. So those projects are easier to finance than ones in the U.S. still today. But growing interest in the U.S. for sure and our backlog continues to grow in the electrolyzer space as a result.

[Noah Kaye, Oppenheimer]

Great. If I could sneak one more in. Can you give us a little bit of update on the Jacobs integration thus far? And then, if you can comment on it obviously it’s not expected to close till the end of the year. But how you’re doing some planning in advance for integrating Meritor?

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. Super. I’ll say a word about Meritor and then I’ll let Jen talk about JVS, which is we’ve sort of already done that. So we’re on with the integration there. But in Meritor case, you remember, we had both antitrust reg approvals to get, we still have some of those to get, plus the shareholders meeting is later this month the 26th I believe of May. So we won’t really be able to advance even our discussions about that until after the shareholders vote.

But so far things, things have gone along as expected. There have been no curve balls, nothing strange happening. So all going well, we just have to wait for the shareholders vote before we can begin pre-planning activities and other things. So we’re still very positive on Meritor. But we have to wait for that. And then Jen, why don’t you talk about how we’re already started with Jacobs?

[Jennifer Rumsey, President and Chief Operating Officer]

Yes. So we’re excited to complete the transaction with Jacobs a few weeks ago. We’ve now integrated that business into our components business. And as you recall, one of the big reasons for doing that acquisition was the opportunity for engine breaking and variable valve timing as a part of our component technology going forward. And so we’re excited to have that as a part of the components business. You’ll see us starting to talk about that as a part of components business, and partnering with Cummins Engine business for future platforms, as well as other customers to meet their needs with that technology. So off and running and excited to have it as a part of the Cummins team.

[Noah Kaye, Oppenheimer]

Great. Thanks for taking the questions.

[Tom Linebarger, Chairman and Chief Executive Officer]

Thank you.

[Operator]

Thank you. Our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.

[Jerry Revich, Goldman Sachs]

Yes. Hi, good morning everyone.

[Tom Linebarger, Chairman and Chief Executive Officer]

Good morning, Jerry.

[Jerry Revich, Goldman Sachs]

Tom, you folks have obviously gained share in medium duty engines. I’m wondering ahead of the CARB regulations how optimistic are you of incremental opportunities, particularly for some lower volume engines for the industry around 11 liter? Do you think CARB will be a meaningful opportunity for you folks? Thanks.

[Tom Linebarger, Chairman and Chief Executive Officer]

Well, CARB regulations are challenging, complicated and unclear exactly what is going to prevail. But yes, we continue to think that we’ve got the right offerings for the market, especially during these, when regulations get tougher and more challenging, we think we’ve got more solutions for customers. As Jen was talking about, we now have these new technologies that we can add to combustion engines. So we’re offering entire range of platform – platform, excuse me, of fuel agnostic engines.

That means that if natural gas is going to be what people need in California, we think we’ll have natural gas offerings for them. We will also have engines that are very – diesel engines, which are very low knocks and competitive in the market. And then of course we will have these zero emissions offering. So I guess, there’s a lot to play out in carbon, so I’m low to speculate exactly. But we are definitely positioning ourselves that with each regulatory move we will have more solutions for customers and therefore more likely to gain share in the market. That’s our strategy in a nutshell. And we think we’re well positioned for that. But there’s just a lot of work left to be done about how the CARB’s regs are going to play out.

[Jerry Revich, Goldman Sachs]

Super. And then separately in New Power, you spoke about a meaningful order in the quarter. I’m wondering if you could just share with us what the backlog looks like for that business and what cadence of new awards you expect over the balance of the year? Just put a finer point on that if you don’t mind.

[Tom Linebarger, Chairman and Chief Executive Officer]

I don’t mind. So, our backlog is now in excess of 100 megawatts and again, it’s building. And the reason it’s building is interest levels continue to grow in projects like the one that I mentioned with Florida Power & Light. A lot of them are smaller. I think as Amy discussed in Investor Day, we have a few big ones and then a lot of small ones. The big ones we’re excited about because they give us demonstration points to show that PEM electrolyzer solutions can work in big, bigger projects, which are going to be necessary to fuel the hydrogen economy. But they also take longer to finance and longer to build.

And smaller ones give us business sooner and are easier to deploy. So we’re excited about both types. But we’re seeing both put – being put into backlog today. And as I mentioned, we’re at something like 100 megawatts or more now, and we’re continuing to build it. We built faster in the last quarter than we built ever before. So we’re excited about that.

[Jerry Revich, Goldman Sachs]

Terrific. Thanks.

[Tom Linebarger, Chairman and Chief Executive Officer]

Thank you.

[Operator]

Thank you. Our next question comes from the line of Rob Wertheimer with Melius Research. Please proceed with your question.

[Rob Wertheimer, Melius Research]

Good morning, everyone.

[Tom Linebarger, Chairman and Chief Executive Officer]

Hi, Rob.

[Rob Wertheimer, Melius Research]

I’m going to continue the theme of interest in electrolyzer business, which seems to be gaining some momentum. I assume the orders and backlog increase you’ve discussed kind of predate whatever accelerated transition Europe may do on energy into the events and the war in Ukraine. Is that the case? Is there any stepped up activity on future project that goes a little bit beyond backlog? And then just a competitive question on that, what is the process like? Do you have any comments on market share on how you’re winning the deals that you are winning on efficiency, on price, on whatever, if you could flush out that that would be great?

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. Thanks for that, Rob. So couple things. One is there is definitely increased inquiry and quotes as a result of energy challenges in Europe. There’s also increased level on finding new supplies for oil and gas. So I think we see in our oil and gas sector to huge demand for engines there. So it’s kind of a split decision, I guess, I’d say Rob, a whole bunch of – there’s a whole bunch of actors that think that the ActionRush should say that we should be moving to green energy fast, and there’s a whole bunch of actors that think we should back up on – we should use oil and gas now because it’s too dangerous. I’m not sure exactly what all that means. But let’s just say there is definitely more inquiry level for electrolyzers.

So we’ll see how much of that converts to actual backlog. But we are seeing more inquiries. Whether it’s more than we expected, I really don’t know the answer. But it’s a lot. Let’s just say it that way. And I guess, I would just further add that. I think the big reason that we’re seeing so much activity for Cummins is because we are the premier supplier of PEM. And I do believe that more and more companies think that PEM electrolysis is the technology, the future. It’s not a given, there are still people that think alkaline because it’s already been demonstrated in large projects. And because it’s also improving, although I would argue at a slower rate that. That’s still going to be a technology for a long time.

But more and more companies are growing in their comfort with deploying PEM and want to grow it. I think that’s one of the reasons that we’re seeing so many inquiries and that’s going to impact share. There are other providers of PEM electrolyzers, but fewer, and certainly fewer with a scale that we have.

The only place I think we are not a European company and so there is some interest in national champions in Europe. So if you know what I mean, like if you’re a French company, French projects would like to choose a French company and things like that. So we are of course trying to be as local as we can in every country operate. We put our plant in Spain as a result of trying to be a pseudo national champion anyway, in Spain. So we will continue to try to make it feel like we’re local in each place and that we’re the technology of choice for them.

[Rob Wertheimer, Melius Research]

That’s great. Thanks for the comprehensive answer. One follow-up on profits in New Power. How should we think about that as you’re ramping the more and more revenues? I assume the gross margins are positive. I don’t know there’s a lot of startup costs in a lot of different ways. And then, any update on how long and how much you’re willing to invest in the business. I don’t know if $2 of EBITDA as R&D and that'll continue at this level – for years at this point or any update you have there, and I will stop. Thank you.

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. So it's a great question and totally reasonable. The answer is on electrolyzers, we are gross margin positive and that's not surprising given the fact that the demand is strong enough now that we're able to scale up some. And of course, we can price for those, because there is demand. In fuel cells and batteries, it's project-by-project because we're still – the rate of improvement in those technologies in terms of cost is still a pretty sharp ramp downward.

And of course, they're not really in the money, most of the – most battery and fuel cell transportation applications anyway, they're essentially working on subsidies or some kind of project. So I would say, we're much less consistent there to cut a project-by-project, but in electrolyzers, we are indeed gross margin positive. And our view is with each of these, as we start to ramp technologies, gross margins will go positive quickly. And then, as revenue increases, then we will go positive in the whole sector.

We are definitely investing ahead of demand, so you talked about, is it all just R&D expense? Not exactly. We are delivering projects that are live and running, like for example, our fuel cells into trains in Europe and our electrolyzers that we just talked about, but we are also doing a lot of projects like the 20 units I mentioned in partnership with Scania that look more like engineering prototypes to try things out than they look like commercial sales. And so it's a blend, I guess, and we are investing ahead of sales for sure.

[Rob Wertheimer, Melius Research]

Thank you.

[Operator]

Thank you. Our next question comes from the line of David Raso with Evercore ISI. Please proceed with your question.

[David Raso, Evercore ISI]

Hi, thank you. My question relates to components and it'll dovetail into my follow up on China. The rest of the year, the numbers look strong, obviously, Jacobs Vehicles is a big part of the reason why you have strong margins, especially starting in the second half for components, but even pulling out Jacob, it feels like a fairly strong number. And when 15% of that business consolidates China and 50% of its JV income is also China. I just want to make sure I understood where there other elements in there that are improving that maybe I don't appreciate, at least again, even pulling out Jacob at growth rates, 9.5% for the rest of the year ex-Jacob, you were down in the first quarter, the margins are still up sequentially.

Even if you pull out a nice margin for Jacob, I know the margins are above segment average. So I'm just trying to level set that with your China comments, taking China down for the rest of the year. Thank you.

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. I think there's a couple of factors in there. Neither of them are enormous, but they are contributor with stronger outlook. So we are seeing stronger demand across pretty much all of our businesses for aftermarket, which is also true for the components business, certainly here in the U.S. and in some of the aftermarkets. That's an important factor.

And I think it's fair to say, the components business was heavily impacted, particularly in the second half of last year with a lot of the inefficiencies and rising costs. So we have been making sequential pricing improvements in that business, and we expect to continue to generate more operating efficiencies as we go forward. But there's no one big missing assumption out of the analysis that is really just improving ops more aftermarket incremental pricing.

[David Raso, Evercore ISI]

I appreciate that. And then thinking about China exiting 2022, the way you're playing out China in your numbers, where do we sort of leave China at the end of 2022, when it comes to national five standard trucks? Is that inventory gone? Just curious also if you're hearing anything on stimulus in China that we should be thoughtful about given where the market is going to be at the end of all this in 2022?

[Jennifer Rumsey, President and Chief Operating Officer]

Yes. I think we don't expect a return to the levels we saw a year ago in China. However, we feel like we're at a low point now, as you said, because of inventory burn off, because of COVID lockdowns and the overall economic situation in China. And so we do expect improvement to a more normal level. At some point I think again, COVID is a big question mark, will there be any stimulus? We haven't seen that yet, right. I think those are great questions that could positively impact that. And then we are well positioned with our NS VI product as the market does come back to a normal level with increased components content, and we think a really strong product in the market that we perform well against the competition. So as China does come back, I think it'll be positive for us in components and engine business.

[Tom Linebarger, Chairman and Chief Executive Officer]

But simply put Dave, we are below trend. I mean, there's no question. End of 2022, we finish well below like normal levels. It's not that these sales levels aren't kind of like market filling. These are below market filling numbers, whether it's snap – to Jen's point, whether it snaps back in Q1 or it takes longer, we really just don't know. But what we do know is we are a below trend.

[David Raso, Evercore ISI]

All right. Thank you.

[Mark Smith, Chief Financial Officer]

History would say a boost in Q4 would be a positive sign, but we're not seeing anything yet this point in time.

[David Raso, Evercore ISI]

Thank you.

[Operator]

Thank you. Our next question comes from the line of Tim Thein with Citigroup. Please proceed with your question.

[Tim Thein, Citigroup]

Thank you. Just wanted to circle back to a comment earlier on with respect to pricing and as to – is there a way to help think about with all the pricing actions that were implement as well as some of the contractual stuff? How do we think about incremental pricing from 1Q to 2Q? And I don't know if you did – if you've set it out, but how you think that – does it enough to cover material cost? Just again, thinking about that progression as we go from 1Q to 2Q both pricing and material cost?

[Mark Smith, Chief Financial Officer]

What I would say is the pricing isn't going to change dramatically from 1Q to 2Q, we'll continue to evaluate it. There's always something of a lag where we're responding to input costs. I will say Tim though, there's clearly going to be more pricing for this year than we anticipated. Three to six months ago, we're looking at around 3% for the full year. And the reason for that is our costs have continued to rise. So three months ago, we said about 1.9% in pricing. Now we're talking about probably 3% pricing. There will be some additional aftermarket pricing in the midyear but nothing significant in Q2, I would say.

[Tim Thein, Citigroup]

Okay. All right. That's helpful, Mark. Thank you. And then just on power systems that the margins for the full year, I mean, one – you highlighted, as you did pretty much every segment that strengthened aftermarket and then I would think that maybe I'm wrong in this but I would think that selling engines into oil and gas is probably a better trade than selling engine – mining engines to BelAZ. But – and again, I know there's more to it and certainly the supply chain issues that you've highlighted when your large peer there has highlighted that as well. So maybe just take us through the revenues up from before and then what's dragging on the margin side. Thank you.

[Mark Smith, Chief Financial Officer]

I'll elevate this up a little bit. So I think the big picture Tim is that we put in place some pricing increases last year. Supply chain lead times are longer on those large engines. And so we're into that situation where costs have continued to rise. We've continued to revisit pricing, but there's going to be a bit of a lag there before that all flows through our P&Ls. We're expecting stronger margins into the second half of the year.

And then this business has been particularly disrupted by Russia. And so Tom talked about efforts we've made to redeploy engines, but that isn't instantaneous. And I think your explanation oil and gas versus mining isn't the thing. The thing is disruption and rising costs, which we're trying to address through pricing and redeployment.

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. I mean, Tim, just at a nuts and bolts level. So, we redeployed – we redeployed the engines, but we had to modify them. So you essentially taken an engine that was line set go into a mine truck, and then you're having to take it offline and do something else to it to make an oil and gas and reprogram and change the timing. And so you lose the margin and the markets don't have significantly different margins as a general matter. But I would just say that redeployment and everything you redo anything in a plant it's just costs more money. It's just that simple, but we're super excited that we could do it, because of course losing the sales and losing the margin would've been really bad and we were able to do it. It's just that the incremental margin is a little worse than it would have been if we just sold the mine engine.

[Tim Thein, Citigroup]

Okay. All right. Maybe a wee bit of an oversimplification in my part. So I apologize.

[Tom Linebarger, Chairman and Chief Executive Officer]

Just a wee bit though. Tim, it's okay.

[Mark Smith, Chief Financial Officer]

I'll take more.

[Tom Linebarger, Chairman and Chief Executive Officer]

We'll take more where we can get it.

[Tim Thein, Citigroup]

There you go. Thank you.

[Operator]

Thank you. Our next question comes from the line of Matt Elkott with Cowen. Please proceed with your question.

[Matt Elkott, Cowen]

Good morning. First, a quick follow up on the diesel question in relation to the conflict in Europe. I think you guys said mid to late decade is when you expect diesel to peak and then aftermarket growth for a decade after that. Based on the energy insecurity associated with the conflict, do you think that this timeline might be a bit too soon? Do you think the peak diesel might happen actually later?

[Tom Linebarger, Chairman and Chief Executive Officer]

It's a great question, Matt. Not – as you remember from our Investor Day, we gave you kind of an outlook that we thought was a reasonable outlook. And we also gave you some ranges of outlooks from other market watchers, McKinsey and other people who study this. And you remember the range, we gave you kind of a late 20s peak and other people have it earlier and other people have it later.

And I would say that the fact that people are worried about energy security does indeed make people wonder if it slips later, makes me wonder. But I just don't think it's clear. Climate change is a gigantic problem that is existential in its nature. Russia conflict is terrible and tragic and it's affecting people's lives and it's probably temporal. So it's hard to know how a temporal issue affects existential crisis. I just don't – I mean, I know that's maybe putting it to broadly, but it's just unclear to me.

What I think is that Europe continues to work on making carbon intensive industries find ways to decarbonize. They have – they didn't relax very many rules. They haven't – I mean, but I also – there's a lot more discussion about energy security. So let’s just watch the space and revisit, maybe next February around Investor Day kind of time again and say, do we see – would we move our trend line out. Right now, it'd be difficult to move it, but it would also be – it would also be dumb of us to lock down. It's got to be then I think we just have to keep watching.

[Matt Elkott, Cowen]

Yes, makes sense. I mean the conversation has certainly shifted around diesel and new power technologies since the continuation of the conflict. And just one, my key question actually. Can you talk about any other parts of the business that you guys are evaluating for potential sale? And if you could us on what the criteria are that would make a part of the business, a good candidate?

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes, sure Matt. So just – let me just say that. Jen and I host a strategy session twice a year. We have strategy meetings every single month with our leadership team, but twice a year we do something where we step back a lot higher and ask ourselves portfolio questions. Like do we have the right portfolio? Do we have – are there things that we should be looking at very, very differently, just to make sure that we don't get kind of stare at our table, don't just look down, but look up and out. And we have a process by which we look at our portfolio and say, is there any reason to think strategically, we need to shift it one way or the other. That was the process that led us to make all the acquisitions and get moving in new power.

That was the same process that caused us to drive the preparation for the – separation business. I would love to announce any division of our company that might be up on in that review process because you can imagine if you work in that division, how disappointing that would be to hear that you're in that sector. So suffice it to say, I will not identify any for you on this call. But what I wanted to say is the criteria is simple. The criteria is, do we think that we can continue to create advantage in that technology and/or does that having that technology create advantage in our related businesses. For example, we're pretty clear that our ability to do emission solutions systems creates advantage for both those and for engines because we're good at those things.

And so if one of those things or both of them are true, we think the division is worth keeping as long as we can earn returns that satisfies shareholders. And if those aren't true, even if it is a strong share return company, we will likely cite it because we think there's probably another owner that would make – take more advantage of it. That's kind of our criteria.

[Matt Elkott, Cowen]

Great. Tom, thank you very much. Appreciate it.

[Tom Linebarger, Chairman and Chief Executive Officer]

Yes. Thank you.

[Operator]

Thank you. Ladies and gentlemen, that's all the time we have allowed for questions. I'll turn the floor back to Mr. Linebarger for any final comments.

[Tom Linebarger, Chairman and Chief Executive Officer]

Good. Thank you everyone for joining the call today. As you can tell, we have plenty of challenges to operating the business normally us and probably every other company that you listen the call. However, we are incredibly well positioned with our technologies to both work on decarbonizing our industry. One of the critical things at least in my lifetime that we need to do and we have a very – we have a good portfolio of both internal combustion and zero emission technologies, which means as we work on decarbonization, you will see Cummins continue to generate strong profits, strong returns, and therefore, being a shareholder of Cummins is a way that you can not only help decarbonize our industry, but you can also earn a return along the way. Thank you very much for your interest.

[Operator]

Thank you everyone that concludes our teleconference for the day. Appreciate you participating and your continued interest. As always the Investor Relations team will be available for questions this afternoon.