Good morning, everyone. I'm Jerry Revich from Goldman Sachs, and I'm delighted to have with us from Atmus Filtration, Jack Kienzler, Chief Financial Officer, and we also have Todd Chirillo, Executive Director of Investor Relations in the back. Jack, Todd, thank you both for coming out.
Our pleasure. Thank you very much for having us.
Jack, as a starting point for our conversation, you know, 18 months since the IPO, can you update us on your strategic priorities today in any areas where you folks have pivoted versus 18 months ago?
Yeah, so maybe I'd just kind of recalibrate people to, you know, we really have four key pillars of our growth strategy, and those really haven't pivoted since the time of the IPO. We've really been focused on executing across those pillars, as well as, you know, obviously completing the separation from Cummins, which I'm certainly happy to update on. So those four key pillars are, first and foremost, to grow our share in our first-fit markets, particularly in the core. The second is to accelerate profitable growth in the aftermarket. The third is to transform our supply chain. And then the fourth is to build out our exposure into a number of different industrial markets. And so I've really been focused on, I would say, all four of those over the past 18 months and have been pleased with our execution against those pillars.
You know, the margin improvement has been really strong. I mean, you're up roughly four points since the time of the IPO. That's two points ahead of our estimates for those of us keeping score. Can you talk about what's played out better than the original expectations from a margin standpoint?
Yeah, absolutely. So a number of factors I would highlight. First and foremost, certainly as we emerged from the times of 2021, 2022, we've certainly been able to now catch up largely from a net price- cost perspective, and that's contributed to the margin expansion over that period of time. In addition, we've really been focused on a few key things in our supply chain in particular. So first and foremost, we previously, while under Cummins ownership, all of our distribution centers, our warehouses globally, were co-mingled with Cummins. And so a big piece of the separation has been to decouple those and pursue a more wholly owned, dedicated distribution center footprint. What that allows us to do is really focus our delivery and our inventory management in line with an aftermarket-centric business.
As a reminder, we're 80% aftermarket, 20% first-fit, which is obviously a different profile than that of Cummins. And so it's been a big focus for us. It's contributed to some of our ability to win from a top-line perspective, but it's also allowed us to control our inventory and drive some margin improvement in the business. The second piece is, honestly, getting back to basics on some of our procurement initiatives. We were probably under-focused on our supply chain from a vendor standpoint, and so really trying to bring more of our vendors under contract and enforce key partnership with them as we try to take cost out of the business. And then the last piece has just been really ramping up investment as an independent public company into driving more efficiency in our manufacturing sites.
Historically, we were a bit under-invested, I would say, from a capital standpoint in the business, in between kind of 1.5%-2% of sales, and we've ramped that up to between 2% and 3% of sales, which has allowed us to certainly focus on gaining some efficiencies, doing some automation, things of that nature, but also is positioning us to pursue more top-line growth.
Jack, Cummins is obviously a world-class business, really compounded earnings, returns, margins.
Absolutely.
Why wasn't this possible under Cummins ownership? Why was the business under-invested?
Yeah, so I think a big dynamic of it is just the size of our business relative to their broad portfolio. We're, depending on the time period, somewhere in a range of 5%-7% of their total sales. And so perhaps focused elsewhere in their portfolio as it related to investment. We're really excited about our continued partnership with Cummins and our ability to now be a world-class supplier to meet their filtration needs, while also spreading our wings, so to speak, and pursuing not only top-line growth initiatives, but also a laser focus on our own four walls from an operational improvement standpoint. So I think it's a lot of management focus and the ability to divert resources to where we believe they're most needed to meet our global customers' requirements.
So essentially, shared services was a bit of a headwind previously?
No, I think it's more just lack of focus, perhaps, on the specific vendors that supply our business versus broader Cummins. If you think about the types of materials that we procure for filtration requirements, it's a fair bit different than what Cummins is purchasing in their other components and segments. So that's just one example of where we've been able to increase our focus to drive margin improvement.
Jack, in terms of one of the other differences versus the rest of Cummins' business is Cummins has to deliver a really effective OEM pricing point on its products. For you folks, as long as you're reasonable on aftermarket price increases, those can be passed through. Has contract structure been improving for you folks in the year and a half since you've been a standalone business? Has that approach from a pricing and contract negotiation standpoint under Cummins ownership been different versus what that process is like now?
If the pricing, as a reminder, works a little differently to whether we're talking about our first-fit piece of our business, that would be approximately 20% of the business and tends to be, as you note, more contractual in nature via long-term agreements. Generally, we're seeing price mechanisms in that space which accommodate for price- downs associated with value engineering efficiencies, so on and so forth. In the aftermarket, though, it is more flexible in nature, and we've certainly been able to realize more steady price increases, first and foremost, to offset the inflationary cost dynamics that we were facing. But the nature in the aftermarket is that it's generally sticky in nature. And so the price increases that we implemented have now remained in place. And as we've seen some moderation in different pockets of our cost base, we've been able to see some margin expansion there.
I would say nothing structural has changed per se as we've came out of Cummins. We are trying to look at our broad product portfolio and regional footprint and really figure out where are the places that we can really bring technical differentiation to drive more pricing opportunities in the business.
In terms of the ultimate margin opportunity, what's the North S tar? Donaldson has a bit of a different business mix, but I don't know if you folks internally feel like you can get your margins, excluding JV income, to their levels over time, or how do you think about what's the true north for the opportunity set?
Yeah, it's a great question and one that we continue to lead debate internally and challenge our teams on. I think coming out of the IPO, we set a goal of 200-300 basis points of margin expansion. And as you noted, we've really been able to achieve that in a relatively short time horizon. And so now we're really focused on how do we drive more top-line growth. Historically, we've had a revenue algorithm of approximately 4%-5%, and that's been comprised of about 2% market growth, 1%-2% pricing, and then 1%-2% share gains. And so if we can lift that revenue algorithm moving forward, that'll really drive some more leverage opportunities in our manufacturing space, drive more activity in our production facilities, and allow us to expand margins even more. I think about incremental margins for the business at approximately 25%.
We're really trying to continue to deliver strong incrementals and find targeted ways to invest in the business to accommodate more market share gains, which will contribute to lifting that revenue algorithm.
And for Cummins, so their joint ventures have an aggregate higher margins than the legacy business because the SG&A gets scaled with a JV partner. What's that setup like for Atmus? As we think about JV growth, is that better free cash conversion as a result, depending on what the growth profile is?
Yeah, so it probably makes sense to talk about we have two broad JVs, and it would probably make sense to talk about them separately. So the first JV is in China with our partner, Dongfeng, a large OEM in that market. And then the second is in India with a longstanding partner who's an excellent operator of that business. The strategic focus for our joint ventures has long been we bring technology and our partners bring market access, if you will. And that strategy certainly has played out for Cummins over the years and has been a nice growth trajectory for us. If I think about how the JV in China has performed, it's been a very strong manufacturing footprint and a very strong contributor to our business. Obviously, market conditions there are pretty soft at the moment.
And so it's been a consistent challenge to retain profitability amongst market share competition in declining markets. The joint venture in India has a very strong market position, a leading market position. And so our focus now is how do we continue to utilize that not only for growth in one of the highest-growing regions in the world, being India, and really capitalize on some of the tailwinds that we see for the near-term and mid-term future, things like infrastructure investment and the growth of that as a global economic power? But also how do we use that joint venture to supply our business as a strategic source of supply elsewhere around the world? As you mentioned, we do have some excess capacity in those joint ventures.
How do we continue to extract as much value, not only through our joint venture income line, but also through a strategic source of low-cost supply to the business?
From a logistics standpoint, what's reasonable in terms of what types of products would make sense to source from India and how significant could they be?
Yeah, so generally speaking, historically, as you think about the emissions dynamics around the world, we've tended to develop emissions-leading products and more advanced filtration technologies for our markets, such as North America, Europe, what have you. And then we've leveraged those products into these joint ventures for use in those local markets, China, India. And what we're seeing is one of the beauties of our business is the long aftermarket tail that we have. And so we'll introduce a product in the first fit and in some cases still be realizing revenue on that product 30 years down the road. So it can certainly use the joint ventures for the source of that product.
But also we've seen really strong capabilities, in particular in India, around some of things like air intake systems and other applications that we don't necessarily have or have invested in other areas of the world. So there's some niche technology components that we feel they can really contribute to the organization.
And with your global footprint within the context of the tariff conversation, it could be a source of opportunity, it could be a source of risk. In the scenario where countries where you source from, if they are hit with tariffs, contractually, would you be able to pass them through to your customers? Can you talk about in that hypothetical scenario how that would work? And at the same time, this dynamic of sourcing globally, to what extent can that potentially be an opportunity?
Yeah, so it probably makes sense to take a step back and just talk about our manufacturing strategy. We are really and have been over a long period of time in region for region. And so what I mean by that is largely in China for China, in some important locations like Australia, for example, for the broader Asia-Pacific region, South Africa and France, for example, for the EMEA region. And then in North America, we have two manufacturing locations here in the United States, and then we have a production facility in Mexico. That production facility in Mexico is largely aftermarket in nature and serves the business globally, but obviously serves the North American market.
And so we're, I think like everybody, is taking a very close look at what impacts tariffs could have and how we would adjust as a business to the extent that they're put in at different levels. So how would we address it? I think first and foremost, looking at flexibility in the supply chain. That could be from a logistics standpoint, changing shipping routes and supplying different countries out of different distribution centers or manufacturing locations. Secondly, certainly looking at where does it make sense to manufacture product. But obviously, you have to look at the total landed cost and cost equation when you are evaluating that and also the short-term, long-term trade-offs. And so you don't want to make a big shift for a short-term dynamic, right?
And then lastly, and probably most importantly, looking at the role that pricing can play as we think about passing through incremental costs through to the end users. So that could look like a number of different mechanisms, and we're investigating all of the different abilities to do so. Again, largely as I think about the tariffs, Mexico is probably the biggest area of impact. And being aftermarket, it does present a little bit more flexibility for us as it relates to pricing action.
Got it. And so it sounds like just maybe to put a finer point on that, you're not anticipating much pushback in that scenario from your larger aftermarket truck manufacturer customers if you were to push through a significant price increase?
I think it's hard to say at this moment. I think it's a dynamic that is affecting ourselves, all of our competitors, our customers, their suppliers, right? So I think certainly what you'll see is a trickle-down effect from tariffs should they be put in place and eventually those largely make it to the end user.
Are you folks thinking about stocking inventories or your customers thinking about stocking inventories?
We have not taken any actions on that to date. We're, again, evaluating the broader landscape and looking at all possibilities to mitigate the exposures to our business and most importantly, continue to deliver for our customers as and where they need our product.
And to shift gears, another opportunity that you folks have spoken about is potential to gain share from folks that had viewed Cummins as a competitor. Can you talk about how those efforts are going? Do the folks at Caterpillar still view you folks as consistent with a hedgehog?
Yeah, so I think, as I mentioned, the first pillar of our strategic growth plan is to grow share in first-fit in our core markets. And so there's really, I would say, three ways in which we're envisioning doing that. The first is a concept that we call winning with the winners. And so we have very key longstanding relationships with many of the key OEMs in our core markets. Certainly, Cummins is our largest customer, and we're excited about continuing to serve them as a key supplier and win with them, but also with the likes of PACCAR, the TRATON GROUP, so on and so forth. And so how do we do that? It's a couple of ways. One is to continue to innovate internally and bring technically differentiated solutions that help them meet their needs.
Two, there's a little bit of indirect benefit as you think about further consolidation in the market on the back of some of the upcoming emissions regulations. And so as Cummins has demonstrated the ability to take share, we are an indirect beneficiary of that as well from a market share gain perspective. The second piece of it is, as you note, focusing on customers who we haven't really pursued historically. That may be because of competitive dynamics with Cummins. It may be because we just didn't have the resources in-house to pursue them from a sales perspective, an application engineering perspective, so on and so forth. And so what I would say is the dialogue has been really good. We're trying to get our name out there and cultivate those relationships.
Certainly, wouldn't envision gaining 100% share with anyone overnight, but it's a long cycle in the first-fit markets, and so generally, it can take three to four years to cultivate these relationships, and we're pleased with the initial traction on it.
And on that note, EPA 27, we're a significant architecture change. You folks are picking up a good bit of content. What about your OEM share? How's that going? Are you able to maintain the position that you have or grow it?
Yeah, we've largely been able to maintain and then grow in pockets. So if you think about emissions regulations, we only really have one direct product that addresses emissions directly. That would be crankcase ventilation. But what we have seen is with more complicated powertrain architectures, the need for more advanced filtration content, and that has driven the content expansion opportunities from a revenue standpoint for us. Certainly looking forward to that emissions change and the share gains that that will bring along with it. We're also trying to continue to look at our product portfolio. How do we increase things like service intervals, which are really key for our end users, and continue to manage this balance of serving our first fit customers and also serving our end users in the aftermarket?
You mentioned the content increases that essentially help meet all the pressures from the regulation. Are you displacing others, or is that just pure content gains?
Yeah, so anytime in the first fit in particular, you generally need a catalyst, if you will, to gain share. If you think about filtration content on the back of an overall powertrain, it's a relatively small piece in the grand scheme of things. And so you don't often see our first fit customers willing to make a change on a component absent a catalyst for that. So the most obvious catalyst, particularly in the on-highway markets, has been emissions regulation changes. And so we've certainly seen that present market share opportunities for this upcoming emission cycle. And yeah, we've been able to capitalize on that.
Very interesting, and so I know at the high end, your content can be as high as $350 per engine. What is it in total moving from and to with OEMs?
Yeah, so generally speaking, I think it's very product-dependent, vehicle-dependent, so I think that approximation of $350 is about right for where we've been. And again, to put that into perspective on a broader powertrain, that's, call it, $40,000 for an approximation, the very small piece of the equation. And again, we talk about our product as sort of a low-cost insurance policy for our customers. In terms of actual share gains, it's really hard to give you a content expansion. It's really hard to give you a precise figure because it depends so much, but excited about how that can contribute to our overall revenue algorithm. As you recall, I mentioned that 2% share gain that we've been able to deliver, and content expansion is really embedded in that historically, and we expect that to continue going forward.
Got it. But it's fair to think about it as a meaningful step change.
On things like crankcase ventilation, yes. And then it depends on the other mechanisms you're talking about.
And then it's interesting, right, because to comply and receive the benefit of the required warranties, customers are going to have to use authorized filtration parts. Can you talk about where your market share is for five-year-old trucks versus new trucks? It sounds like that could be a significant opportunity, that part of the regulation for you.
Yeah, so generally speaking, I would say that we and others, to the extent they're on first fit, would see a very high attach rate, as we call it, when you're on a first fit product. And that's largely driven by the warranty dynamics and also driven by IP in certain instances. And so we would expect that to continue. And if the warranty period extends, then conventional wisdom would be that you would be able to extend with that. I think a bigger piece of it is really the strength that we have in the OE channel. About 65% of our revenues come from the OE distributor channel. And we would say we're relatively underpenetrated in the independent distributor channel, which we can talk more about.
What that allows us to do, that strength from a position with the OE dealer network, allows us to capture a high share amongst the first-generation, second-generation fleet owners. We would certainly expect that to continue. It's a big piece of our go-to-market strategy, and we want to continue to hold that position of strength with the OE dealer network.
Jack, can we shift gears and talk about industrial filtration opportunities? Your updated views on the M&A landscape, if you don't mind. What's the target market size? What are you seeing in terms of deal flow, size of companies? Can you calibrate us, please?
Absolutely. Yeah, so the fourth pillar of our strategy, as I mentioned, is to expand into industrial markets, and really, we see those as growing at about twice the rate of our core markets and being about three times the size in terms of total addressable market. It's really a compelling growth avenue for us. We're thinking about it largely across three verticals: industrial water, industrial air, and then industrial liquids excluding water. So think like bulk fuel filtration, for example, hydraulics, that type of thing. Obviously, we have not stepped out in terms of an M&A opportunity just yet, but we continue to view inorganic expansion as the primary way that we'll get into these markets. We do have some ability to leverage our current technology into these markets, and we did and have launched some organic products into those markets.
But we still largely view it as an inorganic strategy so that we can acquire customer relationships and channel paths into these markets. We've been pleased with the strategic advancements that we've made. We've been doing a lot of work to build the pipeline, sharpen our pencil on what it is that we're specifically looking for and what the right entry points would be that would allow us to realize synergies and carve out a piece of the market. So excited about where we can go there. Obviously, we're taking a disciplined approach to it, and so it's not been an overnight thing. And we're also thinking about it through what I would describe as a programmatic lens. And so we don't view necessarily a transformative deal here out of the gates, but rather a more programmatic approach as we look to build out an industrial arm over time.
In terms of not having done a deal so far, how much of that is valuation versus the wrong type of assets coming to market? Can you talk a little bit about that?
Yeah, so I would say it's not really been as much of a valuation dynamic as really us taking a close look and trying to ensure that we have the ability to scale the business either on its own or through an add-on acquisition strategy. When you're deploying M&A in a programmatic way, inherently, the businesses you're looking at are a fair bit smaller than ourselves. And so one of the big questions that we take is, do we have the ability to scale this? Is the product something that is able to command a compelling niche in the market that we can then bring our global scale to and our manufacturing ability to help it grow? And so we've looked at a lot of different transactions. And really, the reason we've passed thus far is more that strategic and ability to scale more so than valuation.
What is the range of valuation that you're seeing?
Depends on the vertical that I talked about. I would say the water assets have tended to command a bit of a higher multiple, at least in what we've seen, and things like industrial air may be a little bit lower, but I think you're looking in kind of the mid to low teens, is how I would describe it.
In your mind, is there justification for water-based assets to have a higher multiple?
I think certainly it's a broad landscape, first and foremost. So industrial water, it sounds like one market, but there's many different underlying markets there, whether you're talking municipal or industrial. And then even within that, whether you're a full treatment train provider or a component supplier into that. And so we're really intrigued by that market amongst others, not just industrial water. And I think it's very asset-specific as it relates to the ability to command certain multiples. Depends on the margin profile, depends on the aftermarket nature.
And in terms of just the general asset size that you're seeing, super fragmented market, what's the range of company sizes that you're looking at?
Yeah, so generally speaking, we're talking companies with revenues in the range of, call it $40 million-$80 million, to give you a rough range. Obviously, it's not completely bound by those upper and lower bounds, but that's the size of the company. And again, the real question is, can we take those, scale them, add some synergy realization to them to help create value over time?
And then you announced a $150 million repurchase authorization. Can you talk about how you're thinking about deploying capital in that direction versus M&A? Are we going to see, hey, look, if the cash balance gets above a certain level, then we'll step up buyback, and we want to give ourselves option value on M&A first, or can we do both at the same time?
Yeah, absolutely. So in terms of capital allocation strategy and priorities, first and foremost, it's growth. And so what do I mean by that? Certainly, I mean organic investment in the business to accommodate top-line growth in our core in particular. I mentioned lifting what had been historically a bit of underinvestment in the business to more of a 2%-3% CapEx range as a percentage of sales. And then the other piece of the growth is really M&A, right? And so how do we, again, lift our historical revenue algorithm organically and inorganically into some of these industrial markets? Certainly, we feel like we have really strong balance sheet capacity at the moment, finishing the third quarter at about 1.2 times net debt to EBITDA. And the free cash flow generation of the business has allowed us to really create optionality.
The second priority, I would say, is cash returns to shareholders. You saw us announce really two components of that strategy. A dividend and then also a share repurchase program, $150 million share repurchase program. We executed 10 million of that inside of the third quarter. At a minimum, I would think about that as really offsetting dilution. To your point, you can never quite time M&A exactly. It creates a little bit of optionality for us to flex that up to the extent we're not gaining or seeing the compelling M&A opportunities in the market. The third piece, and I'll talk about how we think about net debt to EBITDA as well, but the third piece is just thinking about our debt profile. I wouldn't anticipate anything other than contractual amortization of our Term Loan A in the near term.
And so right now, I mentioned we're at 1.2 times net debt to EBITDA. We think two times is about right for this business in a steady state including M&A moving forward. And so I think, again, a hallmark of the business is the cash flow generation. And it really creates that flexibility for us to pursue all of the above when it relates to capital allocation.
In terms of the path from 1.2 to 2, what we hear from most companies is they would only lever up for M&A as opposed to buyback. Does that apply to you as well?
I think that's very fair. Yeah.
Is there a lower bound on net debt to EBITDA?
No, not necessarily. I just think we have the luxury of generating a lot of cash. And so we intend to put that cash to work as it relates to, again, growth first and foremost. But if those larger opportunities don't present themselves, then we'll look to ramp up the cash, the share repurchase activity.
Jack, let's shift gears and talk about new regulations outside of the U.S. We spoke about EPA 27. What's the incremental content opportunity for you folks coming up in Brazil, India, Europe? Is there a step up for your products?
Yeah, so I think, again, I've talked about this kind of global nature of our business and what that's allowed us to do is develop content applicable to emissions-leading regions of the world, such as North America, and then leverage that investment across other regions as those regulations catch up. And so we've seen that over the years as we leverage product, as I mentioned, into our joint ventures in China and India, but also through our organic businesses in Brazil, Europe, and elsewhere. And I would anticipate that continuing. As you think about the content expansion, it's a very similar story, frankly, to the U.S., as I mentioned. So largely included in our historical 2% market share gains that we've seen.
And in terms of the specific requirements, we mentioned some crankcase ventilation business on EPA 27. What about the standards that will be implemented elsewhere?
I think it looks largely similar in terms of that being the most directly correlated to emissions regulations. But also, again, we see continued desire to extend things like service intervals, and all of that requires more advanced filtration content. And anytime we can leverage our technical capabilities, it really helps us gain share not only in the aftermarket, but also in first fit. And so we'll continue to focus on our two primary products, which would be fuel filtration and crankcase ventilation, where we believe we have market-leading positions, and continue to try to cultivate new relationships and grow the business.
And lastly, from a cost structure standpoint, in total, given essentially supply chain performance improving, is there an opportunity for material costs, including shipping, to potentially be a tailwind for you folks?
Yeah, I think it depends. Certainly, looking at a lot of different components, I would think about we'll keep an eye on steel, for example, as our largest commodity. That had looked unfavorable, and now the trend has been a little bit more favorable. Certainly, I think inputs like labor and whatnot will continue to be a headwind. And so we'll keep a close eye on it as we think about 2025.
Super. Jack, Todd, thank you.
Absolutely. Thank you, Jerry. And thank you, everyone, for your interest.