Cummins Inc.

ladies and gentlemen, and welcome to the Cummins Inc. Q3 2022 earnings conference call. All lines have been placed on a listen-only mode, and the floor will be open for questions and comments following the presentation. If you would like to enter the queue for questions, please hit star 1 on your telephone keypad. At this time, it is my pleasure to turn the floor over to your host, Chris Kulow, Vice President of Investor Relations. Sir, the floor is yours.

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 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 in 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 will turn you over to our president and CEO, Jennifer Rumsey, to kick us off.

Thank you, Chris, and good morning. I'll start with a summary of our third quarter financial results, then I will 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 third quarter financial performance and our forecast for the year. Before getting into the details of our performance, I want to take a moment to highlight a few major events from the third quarter. On August 3, Cummins completed the acquisition of Meritor, a leading global supplier of drivetrain, mobility, braking, aftermarket, and electric powertrain solutions for the commercial vehicle and industrial markets. The integration of Meritor's people, products, and capabilities in axle and brake technology will position Cummins as a leading provider of integrated powertrain solutions across the internal combustion and electric power applications. We've been excited to welcome our new colleagues into our company. The company announced several collaborations that further enable our customers to achieve their decarbonization goals and advance our Destination Zero strategy. During the third quarter, Cummins announced collaborations with Werner Enterprises, Transport Enterprise Leasing, and Versatile to deliver 15-liter hydrogen internal combustion engines when available. The X15H hydrogen engine, part of Cummins' fuel agnostic platform, will enable a more timely solution to reduce carbon emissions by providing customers with an option that has powertrain installation commonality and end-user familiarity. The new power business continued to expand its green hydrogen presence globally as demand continues to rise in the key markets of North America, Europe, and China. Cummins announced it will expand PEM electrolyzer manufacturing capacity at its Oval Belgium factory to one gigawatt. The company also announced it will begin producing electrolyzers in the United States, underscoring our continued dedication to advancing the nation's green hydrogen economy. Electrolyzer production will take place at our Fridley, Minnesota facility, starting at 500 megawatts of manufacturing capacity annually and scalable to one gigawatt in the future. In addition, we continue to make progress in preparing for the separation of our filtration business. The addition of Meritor and the planned separation of the filtration business are positive moves for our future. However, there are upfront costs associated with both transactions, which you can see from our press release and earnings materials, heavily influenced our reported results this quarter. We expect that the most significant costs associated with both transactions are behind us and we look forward to updating you on our progress in future quarters. Now I will comment on the overall company performance for the third 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 the notable exception of China, resulting in strong revenues in the third quarter. Third quarter revenues totaled $7.3 billion, excluding the Meritor business. Third quarter revenues were $6.6 billion, an increase of 11% from the same quarter in 2021. EBITDA in the third quarter was $884 million, or 12.1% of sales, excluding the Meritor business results and the $25 million related acquisition and integration costs, EBITDA was $907 million, or 13.8% of sales, compared to $862 million, or 14.4% of sales, a year ago. Third quarter results include costs of $16 million, or 9 cents per diluted share, related to the planned separation of the filtration business. Adjusting for these costs, EBITDA without meritor and filtration costs was $923 million, or 14% of sales. My comments moving forward will exclude the results of Meritor, the costs associated with its acquisition, and the costs associated with the expected separation of our filtration business. Our EBITDA percentage declined in the third quarter for three main reasons. First, we saw a 32% drop in joint venture income from the third quarter of 2021, driven primarily by the slowdown in the China markets. Second, we increased investments in research and development as we continued to invest in the products and technologies that will create competitive advantage in the future, particularly in the engine and new power segments. And finally, we made an investment in our people through a one-time bonus in recognition of their intense work and commitment to meet customer demand and navigate supply chain and other challenges. This bonus did not apply to company officers. A motivated and highly effective workforce is critical to delivering our customers, executing on our strategy, and to creating shareholder value, and this bonus will pay dividends over time in the retention and engagement of our people. We continue to make positive progress in improving gross margins of our business and offsetting the impact of elevated supply chain and other inflationary costs that we have experienced since the start of 2021. Gross margin percentage improved in the third quarter compared to the third quarter of 2021, as the benefit of higher volumes and pricing exceeded the manufacturing, logistics, and material cost increases and higher product coverage costs during the quarter. Our third quarter revenues in North America grew 19% to $4 billion, driven by improved pricing, higher volumes, and higher aftermarket demand. Industry production of heavy-duty trucks in the third quarter was 64,000 units, up 23% from 2021 levels, while our heavy-duty unit sales were 25,000, up 15% from 2021. Industry production of medium-duty trucks was 29,000 units in the third quarter of 2022, an increase of 26% from 2021 levels, while our unit sales were up 27,000, up 20% from 2021. We shipped 41,000 engines to Stellantis for use in their RAM pickups in the third quarter of 2022, down 4% from 2021 levels. Engine sales to construction customers in North America increased by 16% over 2021 due to strong capital spending by rental companies and pricing. Power systems North America sales were up 30% compared to 2021, driven by higher volumes and strengthened aftermarket. Power Systems North America industrial sales were up 122% compared to the third quarter of 2021, driven by strong oil and gas demand. North America power generation sales also increased by 10% from the third quarter of 2021. Our international revenues decreased by 1% in the third quarter of 2022 compared to a year ago. Third quarter revenues in China, including joint ventures, were $1.2 billion, a decrease of 18% due to lower sales in on-highway and construction markets. Industry demand for medium and heavy duty trucks in China was 164,000 units, a decrease of 25% from 2021. Weaker new vehicle demand, contracted property investment, and economic impacts from the shutdowns as the country continues to respond to the COVID-19 outbreaks have pushed the market to the lowest level in a decade instead of our projected recovery of the market in the second half of the year. Our sales in units, including joint ventures, were $30,000, a decrease of 27%. The light duty market in China decreased 8% from 2021 levels to 387,000 units in the third quarter, while our units sold, including joint ventures, were 24,000, a decrease of 30%. Industry demand for excavators in the third quarter was 57,000 units, an increase of 3% from 2021 levels. And our units sold were 7,800 units, a decrease of 8%. Sales of power generation equipment in China decreased 29% in the third quarter due to the economic impacts of the COVID-19 resurgence. Third quarter revenues in India, including joint ventures, were $614 million, an increase of 18% from the third quarter a year ago. Industry truck production increased by 37%, while our shipments increased 20%. lagging the industry production due to the lower growth in the heavy commercial vehicle segment. Demand for power generation increased in the third quarter as economic activity continued to improve, resulting in record revenue in the quarter for that market. Now let me provide our outlook for 2022, including some comments on individual regions and end markets. To provide clarity in our projections, we will first provide guidance excluding the results of Meritor from the acquisition date through the end of 2022. We will then provide a view of the expected Meritor results for 2022. Based on our current forecast, we are maintaining full year 2022 revenue guidance of up 8% versus last year. This guidance reflects stronger performance in North America and a continued weak market outlook in China. as well as the indefinite suspension of our operations in Russia. We are forecasting higher demand in global mining, oil and gas, and power generation markets, and expect aftermarket revenues to increase compared with 2021. EBITDA is now expected to be approximately 15% of sales, excluding the marital results and costs associated with the acquisition and integration. The cost of the indefinite suspension of our operations in Russia and the costs associated with preparing for the expected separation of our filtration business. This is below our previous guidance of approximately 15.5% of sales as a result of the lower than expected market in China in the second half of 2022 and the one-time employee bonus investment made in the third quarter. This guidance reflects our expectations of increased profitability in the fourth quarter as we continue to drive the improvements we've seen throughout the year on pricing relative to inflationary costs and improve our operating efficiency. Based on our current forecast, we expect production of heavy duty trucks in North America to be at 260,000 units in 2022, a 15% increase year over year. The supply chain constraints in our industry is expected to continue to limit our collective ability to fully meet the sustained strong end customer demand. In North America medium duty truck market, we are continuing to project the market size to be 120,000 to 130,000 units. A 5 to 10% increase from 2021. We are projecting our engine shipments for pickup trucks in North America to be flat compared to 2021, consistent with prior guidance. In China, we now project total revenue, including joint ventures to decrease 25 to 30% in 2022. An update to our previous guidance of down 20 to 25%. We now project a 55% reduction in heavy and medium duty truck demand and a 15 to 20% reduction in demand in the light duty truck market compared to a 50% decline and 15% 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 difficult economic and market environment in China, we have continued to improve our presence in the region through the down cycle and are well positioned for continued outgrowth across our end markets in the region. As we look ahead, industry volume of NS6 product will continue to increase as the new regulations are implemented more broadly. Our technological expertise and emissions experience positions us well to outgrow the market and support our partners through this transition. with our NS6 share continuing to run ahead of our NS5 share. We also continue to ramp production and expand our presence in automated manual transmissions as our market share increases and the heavy-duty market is increasingly adopting this technology. In India, we project total revenue, including joint ventures, to increase 15% to 20% in 2022, an improvement from our previous guidance of up 15%. We expect industry demand for trucks to increase approximately 30% in 2022. Strong performance in power generation within India is also contributing to this improved outlook. Most major global high horsepower markets are expected to remain strong through the end of 2022. Sales of mining engines are now expected to be up 5% compared to the prior year. An improvement from our previous guidance of FLAT. Demand for new oil and gas engines is expected to increase by 120%, consistent with our prior guidance. Strong demand in the U.S. and other oil and gas markets amid energy insecurity has fueled this strong outlook. Revenues in global power generation markets are expected to increase 10%, driven by increases in non-residential construction. This is an increase from our prior guidance of up 5%, driven by the increased production as supply chain constraints slightly eased and improve pricing. We are projecting aftermarket sales to increase 15% to 20% from 2021, consistent with our previous estimate. This strong outlook is driven by parts demand within our North America on-highway business, as well as global power systems markets. In new power, we expect full-year sales to be approximately $180 million, down from our previous guidance of $200 million, due to customer scheduling and supply chain impacts. We have a growing pipeline of electrolyzers, which we expect to convert to backlog and be delivered over the course of the next 12 to 18 months. And we are seeing increased momentum in North America following the passage of the Inflation Reduction Act. Additionally, we will continue to accelerate our collaboration with customers on both electrified power and fuel cell applications in 2022. This was demonstrated in the third quarter as we successfully launched the Cummins HD120 fuel cell system in China. by delivering 52 units to those in gang government for a bus application. For Meritor, we are expecting full year revenues since the date of acquisition to be between $1.7 billion to $1.9 billion. EBITDA is expected to be approximately 4.5% of sales during the same period, including the impact of required purchase accounting and integration costs. This represents the financial impact of Meritor across our components and new power businesses. During the quarter, we returned $245 million to shareholders in the form of dividends and share repurchases, consistent with our plan to return approximately 50% of operating cash flow to shareholders for the year. As I sum up the third quarter, I want to emphasize that we are making progress in our strategy to lead in decarbonizing our industry. Although profitability dropped from the second quarter levels, the fundamentals of our business have not changed. Our products are performing well, leading to record demand from customers and rising market share in some of our core markets. This is a direct result of the contribution from our outstanding workforce. I do want to acknowledge the clear improvement in the financial performance of Power Systems business this quarter, and I'm enthusiastic about the prospects for future earnings growth. We do expect total company profitability to improve in the fourth quarter, from third quarter levels, as implied in our guidance for the fourth quarter. We are committed to improving the underlying financial performance of our business and delivering strong incremental margins through the remainder of 2022 and beyond. Now let me turn it over to Mark.

Thank you, Jen, and good morning, everyone. There were a number of factors that impacted our reported results in the third quarter, and I will step through them to provide clarity on the underlying performance of the company and allow for comparison to our prior guidance. But the key takeaway I want you to leave with is that the fundamentals of our business remain strong. As you are aware, we completed the acquisition of Meritor in August and are actively working through the business integration. Our third quarter results included two months of operational performance for the Meritor business, resulting in $737 million of sales, and the total EBITDA loss of $23 million, which includes both the impact of purchase accounting and acquisition and integration costs. Our third quarter results also included $16 million of costs related to the planned separation of the filtration business. To provide clarity on the operational performance of our business, excluding the acquisition and comparison to our prior guidance, I am excluding the impact of these items in my following comments. Now let me get into more detail on our third quarter performance. Revenues were $6.6 billion, up 11% from a year ago. Sales in North America were up 19%, while international revenues decreased 1%, driven by the decline in China, the impact of the suspension of our operations in Russia, and the unfavorable foreign currency fluctuations primarily due to a stronger U.S. dollar, which reduced our reported sales by 3%. Earnings before interest taxes and depreciation and amortization, or EBITDA, were $884 million, or 12.1% of sales. Excluding the merit or business results, acquisition and integration costs, and the costs associated with the separation of filtration, EBITDA was $923 million, or or 14% of sales for the quarter compared to $862 million, or 14.4% of sales a year ago. The lower EBITDA percent was driven primarily by an increase in engineering support, engineering spend to support new product development, weaker joint venture earnings in China, and the one-time bonus to recognize the commitment of our employees. This one-time bonus totaled $56 million, and impacted the reported results of all operating segments, with $41 million of those costs reported within gross margin and $15 million reported within selling, admin, and research costs. Now let me go into more detail by line item. Gross margin of $1.6 billion, or 24.7% of sales, increased by $213 million, or 100 basis points compared to last year, due to the benefits from stronger volumes and higher pricing, which more than offset higher material and people costs. Selling, admin, and research expenses increased by $110 million, or 13%, primarily due to higher research costs supporting the development of products critical to achieving our Destination Zero strategy, including the fuel agnostic engine platform, battery electric, hydrogen fuel cell, and PEM electrolyzer technologies. Joint venture income declined by $30 million compared to last year, primarily driven by lower demand for trucks and construction equipment in China. Other income was $10 million, $22 million lower than a year ago, driven by $29 million of mark-to-market losses on investments that underpin our unqualified benefit plans. and this compared to a gain on those investments of $1 million a year ago. Interest expense increased by $33 million due primarily to financing costs related to the acquisition of Meritor. Net earnings for the quarter were $468 million, or $3.30 per diluted share, down from $534 million, or $3.69 a year ago, with the decrease primarily attribute to an increase in the effective tax rate for the quarter. The all-in effective tax rate in the quarter was 32.7%, including $57 million, or 40 cents per diluted share, of unfavorable discrete items primarily related to the planned separation of the filtration business. Operating cash flow in the quarter was an inflow of $382 million, versus $569 million in Q3 of last year. Now let me comment on the segment performance and our guidance for 2022. For the engine segment, third quarter revenues increased 8% from a year ago to $2.8 billion, and EBITDA decreased from 15.2% to 13.1% of sales as the benefits of pricing were more than offset by higher manufacturing and product coverage costs and lower joint venture income in China. For the full year 2022, we expect revenues to be up 10%, consistent with our prior guidance. EBITDA is expected to be approximately 14.25%, a decrease from our previous guidance of 14.5% due to a weaker outlook in China, and the impact of the one-time employee bonus. In the distribution segment, revenues increased 14 percent from a year ago to $2.2 billion. EBITDA increased as a percent of sales to 10 percent compared to 9.8 percent a year ago due to pricing and stronger demand for parts, engines, and power generation equipment. We expect 2022 distribution revenues to be up 11% compared to last year in line with our prior guidance. EBIT is now expected to be approximately 10.5% of sales consistent with our prior projection. Components revenue increased 10% in the third quarter, primarily driven by strong demand in North America. EBITDA increased from 14.1% of sales to 16.2% of sales, driven by the benefits of pricing actions and lower warranty expense. We expect full-year revenues to increase 3% and project EBITDA margins to be approximately 16.75% unchanged from our view three months ago. Clearly, the component segment results are most impacted by the acquisition of Meritor, and I just want to underline that the performance excluding the addition of Meritor was exactly in line with our guidance for the quarter and for the full year. In the power systems segment, revenues increased 16% in the third quarter to $1.3 billion, a record for the segment. EBITDA increased from 11.5% to 14.3% due to higher volumes, strong price realization, and the increased demand for aftermarket parts. In 2022, we expect revenues to be up 10%, an increase from our prior guidance of up 8%. EBITDA is projected to be approximately 11.25%, also up from our prior guidance of 11%. driven by stronger price realization and continued strength in sales. In the new power segment, revenues were $45 million, up 96% from a year ago, due to stronger demand for battery electric systems. Our EBITDA loss was $86 million in the quarter, as we continue to invest in the products, infrastructure, and capabilities to support strong future growth. For the full year 2022, we expect new power revenues to be up approximately $180 million, down slightly from our prior guidance of $200 million due to delays in some customer projects and some supply chain constraints. Underlying demand, however, continues to grow for both battery electric systems and electrolyzers. Net expense for this segment is now projected to be $310 million compared to our prior guidance of $290 million driven by increased investment to scale up electrolyzer production capacity and bring new products to market. As Jen mentioned, we are maintaining our 2022 expectations of total company revenues to be up 8%, and we now expect our EBITDA margins at approximately 15% for the full year. To be clear, once again, that this guidance excludes the merit or business and related acquisition and integration costs the impact of the indefinite suspension of our operations in Russia, and then any expenses associated with preparing for the separation of the filtration business. This guidance does imply an improvement in profitability in the fourth quarter. We expect earnings from joint ventures to decline by 25% to 30% in 2022 due to the ongoing weakness in China and the impact of suspension of our business in Russia and that is slightly worse than our prior guidance of down 25%, all due to the conditions in China. Our effective tax rate is now expected to be approximately 22.22% in 2022, lots of 22's there, excluding any discrete items, an increase from our prior guidance of 21.5%. Excluding Meritor, our capital expenditures in the quarter were $179 million, up from $150 million a year ago, and we're maintaining our full-year guidance for capital expenditures to be in the range of $850 to $900 million. We return $245 million to shareholders through dividends and repurchase of shares in the third quarter, bringing our total cash return to shareholders to $1 billion year-to-date. For the full year 2022, we still anticipate returning approximately 50% of operating cash flow to shareholders through dividends and share repurchases. And as I've already mentioned, we expect the Meritor revenues to be in the range of $1.7 to $1.9 billion for the five months of this year. Under our ownership, an EBITDA to be approximately 4.5%, including the impact of purchase accounting. Closing, I want to again reinforce that Cummins is in a strong position, growing our leadership in our core markets while setting up the company for a stronger future through investment in new products and capabilities. And we are adjusting our portfolio of businesses, all while returning cash to shareholders. We do expect to deliver stronger profitability in the fourth quarter, as implied in our fourth full-year guidance. Thank you for your guidance today. Your interest today, my guidance, your interest. Thank you. Now let me turn it over to Chris.

Thank you, Mark. Out of consideration to others on the call, I would 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 are ready for our first question.

Okay. Our first question comes from Stephen Volkman with Jefferies. Please state your question.

Great. Good morning, guys. Thank you, Mark. I'm interested in your guidance. You kind of have my head spinning here. I apologize for that. It's a busy day. But how are you going to report the next quarter in terms of Meritor? I assume that'll be in the numbers, but you'll probably adjust out maybe the purchase accounting. I'm just trying to figure out sort of on a like-for-like basis, kind of how we're supposed to think about the next quarter.

Yeah. So what we're trying to do, and we realize it's complex for us also, there's a lot going on, Steve. So what we're trying to do is make clear how we're performing against our guidance in the Cummins business prior to the Meritor acquisition, which we lowered that guidance just to be clear, and we'll try to be clear for the reasons why. And then we'll layer on the Meritor performance. So we're trying to give projections for both, We will report all in, and then just as we've done this quarter in the earnings material, we'll break out the business pre-Meritor, Meritor separately, and the different elements so you can try and get as full a picture, and then next year we'll move to the all-in reporting. But we will continue to provide details around Meritor so that you can gain confidence that we're making progress on executing on the integration and growth of that business. going forward. So the answer is yes, it's going to look similar in Q4 to this quarter. The noise from the purchase accounting will start to go, will taper down next quarter and in subsequent quarters. But we're going to report with and without, so we're not reducing the visibility of our performance on either front. That's the main goal.

Okay. All right. Fair enough. Maybe just a quick switch then. We've seen a couple of months now of pretty amazing heavy truck orders in the United States, North America. And I'm curious kind of what you're hearing, you know, as you talk to customers and sort of the outlook longer term. I mean, you know, Are you guys starting to slot in deliveries for these big orders that we're seeing? And just kind of any color that you can give us there would be great.

Yeah, Steve. You know, we continue to see strong heavy-duty customer order interest. The conversations that I have with both end customers and OEMs are around how we're working through supply constraints that continue to exist and increase production rates. And this has just not been a typical cycle. So all of those fundamentals for the business remain strong. We project that the market will remain strong into next year because they've been using the trucks at a high rate. They've not been able to replace at the level that they want to. And as well, these new trucks that are coming out, new powertrains have improved efficiency. And as you see higher fuel prices, that's also attractive. So we continue to watch the broader economic indicators and what that may mean over time. Right now, we're continuing to work to increase production rates and see strong underlying demand.

Okay, thanks. I'll pass it on. I appreciate it.

Thanks, Steve.

Our next question comes from Jamie with Credit Suisse. Please state your question.

Hi, good morning. I guess just two questions. You know, the R&D, you know, is up considerably sequentially. And I know we're continuing to invest, but I'm wondering if we should think about that as a new run rate. Is R&D going to be structurally higher and sort of the implications for 2023? And I guess my same question is on the SG&A side. Even if we back out the $15 million that hit SG&A, you know, because of the bonus, the one-time bonus, that was also, you know, up materially. And I'm just trying to think about spend in the context of concerns on the macro, understanding your customers are still saying things are strong now, but are we taking any actions in the case the macro does weaken? Thank you.

Yeah, great. Thanks, Jamie, for that question. Good to hear from you. We have, as you noted, taken up our R&D spend in particular in the engine business. and the new power business where we have strategic investments in the fuel agnostic platforms and growing investments in electrolyzers and other key new power technologies. And so we will, you know, continue to make those investments. And as we have in the past, we're going to manage through the cycles and improve performance, underlying financial performance of the company through the up and the down cycles while still making these key strategic investments that will position us to outgrow over time. We are looking closely at our priorities for next year. We are starting to more closely manage any headcount additions so that we make sure that we're continuing to invest in key strategic areas while also managing those investments for potential downside scenario. So we are more closely scrutinizing those priorities right now.

Yep. And I would just add to that. We have lowered our admin costs like three quarters in a row. There is a tremendous focus on trying to flatten our costs out there. In particular, the increase in the SG&A was really in the selling side, which is a lot of that's tied to our aftermarket business and the power systems business, which is great. Definitely engineering on with the upward pressure, and the others are under the other type of pressure.

Okay, thank you. I appreciate it.

Our next question comes from Rob with Milius Research. Can you state your question?

Thanks, and hello, everybody. My question would be, and I'm not sure it's an easy one to answer off the cuff, but When you look at your blended pricing on engines versus the OEM pricing on trucks across your customer base, or if you wanted to specify North America, do you feel like you're caught up in that regard? Or do you have a couple hundred bips to catch up? And could you lay out the timeframe at which you would catch up if you think you are behind the OEM prices, which have a little bit more flexibility?

Yeah, Rob, this is how I would describe it. Since the start of 2021, what we've seen is supply challenges and inflation that has driven cost and inefficiency into our business. For 2022, we are expecting a 400 basis point improvement in price compared to a 230 basis point impact on cost. So we are ahead for the year when you think about that price-cost balance, and we're also working to make improvements in operating efficiency, and we continue to have work to do to get back to where we were at the start of 2021. And we're able to price more rapidly into our aftermarket business, but of course, where we've got high backlog in the power systems business or long-term contracts, right, that takes time to flow through as we negotiate with customers, and that we have metal market and other contractual agreements that that also flow through over time, but not immediately.

And just to confirm, one of the reasons why we're ahead on price and material cost this year is, in fact, we bore a lot of those costs in the second half of 2020.

Please tell them, Mark. Yep, yep. Okay. Sorry. Got it. Got it. And then could you give a general comment on just supply chain? Do you feel like we've peaked out on risk? China may be doing lockdowns again. So, you know, if you take that answer globally, how does the risk of upside-downside on cost and supply chain feel to you? And I'll stop there.

Thanks. So on the supply chain side, we continue to see improvement, and we also still have issues. So at this point, electronic components continues to be our biggest risk. and disruptor. But as you said, there continue to be these dynamic lockdowns in China, congestion in certain ports that is more on the East Coast, more in Europe. And so we continue to see some supply chain disruption. So from where I sit, quarter over quarter, it's been improving and we've been taking build rates up and able to drive some operational improvement and those issues are not completely gone. And so that is in part influencing this continued expectation that we'll see improvement going into Q4 and into next year.

Got it. Thank you. Thanks, Rob.

Our next question comes from David with Evercore. Please state your question.

David, are you there?

Yes, I am. Sorry about that. Just so I can understand exactly the fourth quarter, sort of what you're adding back to 3Q, can you tell us what is your implied EBITDA margin for the fourth quarter, just so I can level set?

Fifteen and a half ex meritor.

So 15 and a half for the fourth quarter.

Compared to fifth quarter, yeah. Mm-hmm.

Then when I think about China, obviously it's a big driver in the EBITDA margins, just given a lot of the truck business comes in as JV income. I know the consolidated aspect of construction activity there for your business. But obviously truck, looking forward, how should we think about what you're seeing in China just from what you normally would see around Chinese New Year, obviously with the Congress they just had there, stimulus, a lot of things going on. I'm just curious. I thought Beijing photon in particular was a little weaker than I would have thought. But I'm just curious what you're seeing on the truck side in particular.

No significant momentum at all there right now, Dave. So that's certainly not part of the improvement from Q3 to Q4.

Yeah. And as you noted, I mean, you know, they just had the Congress elected to the third term. We typically see some seasonality in that market. It's difficult to predict at this point. So as Mark said, we're not projecting improvement through the end of the year.

And when it comes to the PowerGen business, within that you obviously have some of the mining. Can you give us a little perspective, an early look at 23, how you're thinking about that business, just given the recent results were pretty healthy?

Yeah, like the U.S. truck market, the power systems markets continue to remain strong. There's a large back order there, so we're projecting strength going into next year.

Thank you very much. Thanks, David. Thanks, David.

Our next question comes from Jerry with Goldman Sachs. Please state your question.

Yes, hi. Good morning, everyone. Morning, Jerry. I'm wondering – Hey, Mark. I'm wondering if you folks can talk about, as we head into 23, you've got a number of tailwinds in terms of electrolyzer production ramping up, the e-axles ramping up at Meritor, and maybe some medium-duty engine production ramping based on your recent wins. Looking at the new product contribution, 23 versus 22, can you just outline for us the magnitude of

tailwind you know it feels like the electrolyzer opportunity is tracking ahead of expectations but maybe I can get you to expand on that if you don't mind what I would say is yeah we've got line of sight into improving demand in new power business I would expect this point in time without getting into specific numbers both growth in battery electric systems and electrolyzer sales like next year's I think the momentum is going to continue in new power And then, yes, we've got strong customer demand on the e-axle side. Again, I don't think that's going to be a dramatic change relative to a $27 billion company, but demand is strong. I've got clearest visibility into the new power side right now.

Yeah, and on the electrolyzers, you know, I talked about some of the investment in production capacity. So, you know, we're in the early stages of building up that production capacity, building up the backlog. It's going to be lumpy at this point, and it's going to grow, as Mark said, over time. And we still feel really good, in fact. the Inflation Reduction Act and the climate provisions around that are strengthening the hydrogen outlook in the U.S.

Super. And can I ask the initial customer response on the Meritor integration? Can you talk about what those conversations have been like, particularly as it pertains to selling e-axles and conventional axles to traditional Cummins customers that haven't been Meritor customers. And if you could touch on within the Meritor margin guidance, what's the inventory step up that's embedded that's depressing results looks like by at least two points. But I'm wondering if you could outline that relative to the full year guidance, slide 14 for Meritor. Thanks.

Yeah, we're obviously in the early days of integrating the Meritor business. Excited to have that as part of us starting to have conversations with customers at a strategic level. And it's a positive for them that we have added Meritor to our portfolio and can talk about how we're serving them both in the core businesses, the new power business going forward. Early days and those conversations are both on operational and supply as well as the strategic opportunities that we have.

Yeah, a lot of focus on demand and delivery right now, as there is in other parts of our business, Jerry. So we aren't short of demand. We need to keep raising those production rates.

And, Jerry, on your question on the inventory step-up, and there's a good reconciliation in the earnings deck, which talks through the complicated picture that is Meritor for this quarter. It's about $32 million was the impact in the third quarter of that inventory step-up.

Any in the fourth, Chris?

Just a small bit. Most of that inventory burns off quickly, as you would expect, Jerry.

Super. Thank you.

Our next question comes from Tammy with J.P. Morgan. Please state your question.

Hi. Good morning. Thank you for taking my questions. I have a couple of modeling questions. Hi. So my first question is, I saw in your presentation that Meritor's a GAAP EBITDA rate, I think you said was 4.5%. And so can you help us with what it would have been on a non-GAAP basis? Because as we think about incorporating Meritor in our model, let's say for next year, what non-GAAP EBITDA rate should we be using? And do you expect that rate to improve over the next few years as we better integrate that business?

Yeah, so let me try to unpack that a little bit. So the U.S. GAAP results essentially for Meritorious itself was essentially break-even in the second quarter. And as Jen mentioned, our guidance for the full year for 2022 is about 4.5%. So that implies the U.S. GAAP, when you take out, you know, including the purchase accounting in Q2 and a little bit in Q3, implies an EBITDA of about 9% in the quarter. in the fourth quarter. And that was up from, if you take out some of the noise in the third quarter, that was approximately 7.3% operating EBITDA. So we're seeing a step up there. And then we would continue to, as we go toward the future, continue to drive improvement there, both through the synergies we gain, as well as other improvements in the business. So that gives you some view of kind of

trajectory there and happy to talk through more separately if you like but also the performance in the short run of course is going to be dependent on the market and we'll give you all of those elements both in the q4 and as we get to next year i realize it's messy and appreciate everyone's patience as we've tried to work out the best disclosures to give you all this information we'll continue to err on the side of sharing more and not less to make it as clear as possible

Got it. That's super helpful. And another quick one from me. From a modeling perspective, the bonus that you gave to employees this quarter, as we lap it next year, we should be treating it as one-off for now, right?

Yes. It won't be present even in the fourth quarter results, and that's one of the factors why Our EBITDA margins will – not the only factor, but one of the factors why our margins will be better in the fourth quarter.

Okay, awesome. Great. Thank you so much.

Thanks, Tammy.

Thank you. Our next question comes from Stephen with UBS. Please cite your question.

Thanks. Good morning. So lots of puts and takes, but just to kind of summarize at a high level, is the overall message that basically your power gen business is a bit better than you're expecting, China is a bit worse, and the China drag is just kind of a bit bigger than you have the benefit from power gen, and you have slightly higher investments in new power. I mean, is that sort of the key summary of it, of the core business, And then you gave the 15.5% margin implied for Q4. Is there any bridge you can give us from Q3 EBITDA to Q4? I know you just mentioned, obviously, the $56 million of employee costs. Is there any other sort of just direct bridge you can give us to help go from Q3 to Q4?

Yes. There are really three core elements to that bridge, Steve. The bonus we've mentioned. Little bit of improvement in pricing from Q3 to Q4. And then we did have some operational challenges concentrated in one or two areas, and we expect those to improve. And those three elements are the key drivers of the margin rebound. No improvement in China baiting. No significant increase in expenses expected in the fourth quarter.

Okay. And would you agree with sort of the summary I gave of kind of what the main puts and takes of the core business were?

Yeah. And the only other thing is we continue to incur these mark-to-market losses so we didn't call them out. At some point that will stabilize and rebound. Those were present in the third quarter but at a lower rate than in the second quarter. So that's noise in the other income line.

Okay. That's very helpful. And then just in terms of the heavy-duty truck market in North America, I'm curious how much visibility you have to the second half of 2023 at this point. You talked earlier about, you know, the order strength. I guess I'm just curious how far into 2023 the OEMs have given you their work plans and the confidence you have there relative to the first half. Thank you.

Yeah, I mean, we are, of course, talking about outlook and forecast with our OEM customers and staying close to them on that. At this point, we've got about a nine-month backlog based on strong orders in September and October, and we'll continue to stay close to them to watch how that outlook evolves in the second half of the year.

Perfect. Thank you. Thanks, Steve.

Our next question comes from Matt with Cohen. Please state your question.

Good morning. Thank you. Can you guys talk about the rationale behind doing a one-time bonus rather than further pay increases? Is it that just you didn't want to lock into pay increases ahead of a possible moderation of labor costs overall in the economy? Or did something change?

specific happened in the quarter that made it necessary to do the bonus in order to not have you know a lot of attrition yeah really was more the latter so of course we're always looking at you know at pay and and what's happening with the market as it relates to labor to labor costs but really we felt very strongly that given the tremendous effort of our employees over the last 18 months to deliver revenue at the level we did and work through all of the supply chain challenges and continue to commit to deliver key strategic growth initiatives. And given the environment where they are experiencing higher inflation, the impact to them and the labor market is tighter. We felt that this one time recognition was very appropriate to show appreciation to mitigate attrition and really motivate people to be connected to delivering and continuing to deliver for the company.

But it makes sense. And then just a bigger picture question, you're expecting strong demand in mining and oil and gas for the rest of the year. Does it look like this momentum should continue into 2023? And on the mining side, does it look like this demand is being driven by equipment replacement? I know we had an equipment replacement cycle threatening to happen for the last decade, and it's been false starts. Does it look to you guys like this time it could be a multi-year replacement cycle on the mining side?

Yeah, we do see that demand continuing in the next year. Of course, in oil and gas with the energy challenges, there's a lot of demand to invest there. And we'll have to continue to monitor those economic indicators over time. But right now in both of those markets, we continue to see strong demand holding into 2023.

Yeah, we're pretty much sold out for this year. There are some regional factors, increased coal production in India. There's some local factors as well as the overall security and availability of energy across borders.

Thanks very much. Thanks, Matt. Thank you.

Our next question comes from Noah with Hassenheimer. Please state your question.

All right. Thanks for taking the questions. Just sticking with off-highway first, you mentioned that it was really, you know, the engine sales to some of the construction customers in North America, that growth being driven by CapEx from rental companies and pricing. Have you started to see any benefits kicking in from IAJA yet? Is that sort of a demand tailwind for 23 years? or potentially beyond?

Yeah, I mean, the Inflation Reduction Act is going to drive investment in infrastructure to support some of these cleaner energy technologies. So we expect over time we'll see increased electrolyzer demand, as I alluded to earlier, and that could also provide benefit to underlying construction demand in the U.S. It's It's early, right, to actually see the specific impact of that, but certainly it should provide a positive benefit.

Sorry, I know we've had a lot of legislation out of Washington. I was talking about the IIJA, the infrastructure bill.

Sorry, did I respond on the wrong one?

Yeah, well, it's nice to have multiple shots on goal. But, yeah, just wondering if you can talk through kind of any impact from the infrastructure bill so far.

Yeah, so thanks, Noah. I think the infrastructure bill is similar, actually having a very similar outcome, whereas obviously IRA is driving more into the new power space. We are seeing some good momentum in that space, and, you know, we benefit that, whether through the rental companies or some of the other construction equipment in North America has remained strong through this year and is carrying forward that momentum as those, you know, we continue to build out, and there's a lot of work to be done, as you know. So that is certainly helping us.

Okay, great. And then, you know, I know a couple of folks have asked about Meritor, you know, impact going forward for next year. So I know we won't be precise here, but just for everybody's modeling, as we think about, you know, components, margin, I mean, you analyze, you know, this year, 7.5% EBITDA margin, add some synergies capture and some growth. It's still going to be a margin headwind in components of probably a couple hundred bits, right, as we look at the 23.

Is that a good starting point? On a percentage basis, it's clearly going to be dilutive in the early part of the ownership, and the goal is to keep working that up over time.

And any early color on the cadence of the synergies capture that you can give us?

No, I mean, we're working on that. We've got teams dedicated to that, working on that every day. We still feel confident about the numbers we gave earlier of $130 million pre-tax by year three. And I will say we're finding some other synergies as well in taxes and other things that are not included there. But it's a lot of work still ahead of us, a lot of good progress to start. And, of course, integrating the employees, it's a lot of work, but we're off to a good start. I will say, you know, that business is also very busy with demand and supply challenges, just as we are in our course. We very much appreciate the hard work of the employees who are listening to us, driving synergies and improvement in their operations. You know, they're all very busy, and we appreciate that.

Okay.

Thanks so much for the call.

Thanks, Noah. Thank you.

That was our final question, and that concludes the Q&A session of this call. I'll turn it back over to Chris for closing remarks.

Thank you, everyone, much everyone for joining. As always, we will be available this afternoon to answer any questions that you may have from the investor relations perspective and appreciate your attendance today. Thank you.

Thank you. This concludes today's conference call. We thank you for your participation. You may disconnect your lines at this time and have a great day.