Good morning. My name is David, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Atmus Filtration Technologies Second Quarter 2023 Earnings Call. Today's conference is being recorded. [Operator Instructions] Thank you, Todd Chirillo, Executive Director, Investor Relations. You may begin your conference.

Thank you, David. Good morning, everyone, and welcome to the Atmus Filtration Technologies Second Quarter 2023 Earnings Call. On the call today, we have Steph Disher, Chief Executive Officer; and Jack Kienzler, Chief Financial Officer. Certain information presented today will be forward-looking and involve risks and uncertainties that could materially affect expected results. Please refer to our slides on our website for the disclosure of the risks that could affect our results and for a reconciliation of any non-GAAP measures referred to on our call. For additional information, please see our SEC filings and the Investor Relations pages available on our website at atmus.com. Now I'll turn the call over to Steph.

Thank you, Todd, and good morning. I'm excited to be here for our company's first earnings call and to provide you with an update of our second quarter 2023 results. At the end of May, we completed our initial public offering, a significant milestone for our company and the culmination of multiple years of work. The launch of Atmus provides us with a unique opportunity to grow, both in our core markets and through expansion into industrial filtration markets. Our successful IPO would not have been possible without the tireless dedication of our global employees. Every person on our team from our quality inspector at our dedicated media production facility in Korea to our safety leader in Cookeville, Tennessee, is key to our success. Our people provide premium Fleetguard products and deep industry knowledge to support the success of our customers. We have made significant progress in our first quarter as a public company and are on track with plans to separate fully from Cummins. I do want to bring to your attention that we filed in the 8-K on Tuesday, restating our first quarter 2023 financial statements and revising annual prior periods for 2020 through 2022. Jack will provide more detailed information later in our call. And of course, we want to address any questions you have. We are committed to ensuring a strong internal control environment and to communicating transparently. I would like to now turn to a summary of our strong second quarter results. I'll start with a high-level overview of our markets and the drivers of our results and then turn to our financial performance. Demand remains strong in our first-fit markets through the second quarter, and we expect this to continue through the second half with our customers reporting strong orders through the end of…

Thank you, Steph, and good morning, everybody. Before reviewing our quarterly results and full year 2023 outlook, I want to provide you with some additional details regarding the recent 8-K filing, which Steph referred to. We restated our March 31, 2023 financial statements and revised our annual financial statements for 2020, 2021 and 2022. As we closed the books in the second quarter of 2023, we identified errors within our intercompany and related party accounting practices. These errors principally included overstatements of related party receivables and related party payables and an understatement of net parent investment. When combined with other prior period errors originally considered to be immaterial, both individually and in the aggregate, the amount of the overstatement of cash provided by operating activities totaled approximately $25 million for the period. These overstatements in cash provided by operating activities were offset by an overstatement of cash used in investing activities of $3 million and cash used in financing activities of $22 million. It is important to note that these errors had no impact on revenue, net income or EBITDA for the first quarter of 2023, nor did they have an impact on the amount of the company's cash balance upon closing of the initial public offering, which was $115 million. Now let's discuss our second quarter 2023 results compared to the same period last year. As Steph mentioned, at the beginning of the call, we delivered strong financial performance. Sales were $414 million compared to $393 million from the same period last year, an increase of approximately 5%. The increased sales were driven by $32 million of pricing, which more than offset $7 million of decreased volume and $4 million of foreign exchange headwinds. Gross margin for the quarter was $114 million, an increase of $19 million compared to…

[Operator Instructions] We'll take our first question from Tami Zakaria with JPMorgan Chase.

So my first question is, it seems like volume growth was flattish in the first half. So can you help us understand what's the volume decline outlook is embedded in for the back half as you think about the full year guide? Meaning, can you quantify what kind of volume you're expecting for the back half and whether 3Q should be worse than 4Q, because I can compare step down in the fourth quarter. So any color on volume expectations would be very helpful?

I think as we provided in my overview comments, and I'll let Jack talk to the specifics of how it plays out into the third and fourth quarters in our guidance. Overall, I would say we're seeing a softening in the second half relative to the first. We've seen strong performance in the first quarter particularly. We saw that soften somewhat in the second quarter, particularly in the U.S. market. As we see some destocking through the channel, we expect our customers are doing that at different rates. Some had progressed that through the second quarter. We expect more of that in the third quarter and through the fourth. We do see softened economic activity impacting largely the fourth quarter I would say, and that's strongly connected to economic activity, which is a primary driver of our aftermarket, obviously. So I'll let Jack add any other specifics.

Sure. Thanks, Tami. So generally speaking, it can vary year-by-year. But over the long period of time, we generally see the second half from a seasonality perspective being softer than the first, somewhere in the range of 5% or less. Our outlook implies a little bit more of a softening than that in the second half of this year, driven by the factors that Steph just described. Usually, we've seen the third quarter be -- that decline be more pronounced in the third quarter with a little bit of recovery in the fourth quarter, but it's hard to say precisely in this period.

Got it. And if I can ask a follow-up question. Since you want to enter into industrial filtration market, can you tell us whether your current product portfolio has any product in there that can be fitted or leveraged to enter some industrial end markets relatively quickly?

We are certainly assessing our opportunities to grow into industrial filtration markets. We see this as a significant growth opportunity. So these markets are growing at twice the rate of our existing core markets, and we see the market size opportunity being 3x the size of our current market opportunities. We are primarily focused on accessing that growth opportunity through inorganic expansion and we discussed that in our remarks. We do see some possibilities of entering through organic, and we are exploring those. It really would be leveraging off our media capability. It would need some product development still though, Tami, to have finished goods that would service those markets. So that's how I would characterize it with you, but we are certainly exploring the full realm of possibilities there as to how we would fast -- could fast track organic development into those markets as well.

Next, we'll go to Jerry Revich with Goldman Sachs.

Really impressed by the margin performance. You're now running at 19% year-to-date. I'm wondering if you could just update us on how you're thinking about long-term margin targets? And obviously, you're reducing production sequentially in the guide, but it feels like the margin step down is significant. I'm wondering is that just a function of first couple of quarters, out of the gate? One thing to make sure expectations are manageable versus something that's meaningfully different back half versus first half?

Thanks for the question, Jerry. Obviously, our guidance puts full year adjusted EBITDA and it's $17.25 to $18.25. You're right, the first 2 quarters of the year have been very strong in terms of margin performance. There's a number of factors that I think have fed into that. We're very pleased with it. However, it's certainly not at a level, I would say, is sustainable at this point. So we're getting the benefits in the first half, both the first and second quarter of significant pricing actions, which were catch-up actions. And at the same time, we have seen some moderation of costs in those quarters. Plus, we've had a strong volume environment with back orders and so forth that we have caught up on largely at this point. So it was kind of a lovely mix of strong margin for that first and second quarter. As we've spoken about previously, we certainly see margin expansion opportunity in our business, and we've started to realize some of that related to the short-term actions of pricing and cost factors moderating. We are focused on expanding our margins into the future. The volume moderation in the second half certainly puts downward pressure as you discussed, and we've got a number of inefficiencies still factored into our EBITDA margins overall as we become a stand-alone company.

That's clear. And Steph, can I ask to expand on the M&A opportunity set. Can you characterize for us the size of the M&A pipeline that you folks are pursuing and just talk about your process in building that pipeline, just to give us a sense for what the opportunity set could look like from a transaction standpoint over the next 6 to 18 months?

Yes. Yes. And I don't have a specific target to talk to you about. I hope in some of these future calls, I will be able to be very, very specific about the opportunity that we're going to proceed forward with. The rigor and the process we're putting in place, I am very pleased with our progress. As I referenced, we have established a strategy team, a corporate development team. They've built a pipeline of targets. We've filtered that pipeline of targets down to those that meet our strategic criteria and our financial criteria. We're evaluating regularly -- every month, multiple targets. And as you know, we have to fish for many before we actually are going to be able to find the right opportunity for us to take that first step. We've described our acquisition strategy as a disciplined programmatic acquisition strategy, Jerry. So I see there's a smaller acquisitions that we will look to build out the synergy opportunity over time. So I'd love to be able to give you more color than that. Hopefully, that gives you a sense of the discipline and the robust establishment of team and capability we're building to really be able to set us up for a programmatic acquisition approach to industrial filtration markets.

Next, we'll go to Joe O'Dea with Wells Fargo.

I wanted to circle back on aftermarket. And if you could kind of parse it by what you're seeing on the destock side and then what you're anticipating on the slower economic activity side, and so just any color on what you've seen from a cadence perspective on the destock? Whether kind of the right thinking is that -- you saw it in 2Q, maybe it's a little bit steeper headwind in 3Q, and then that eases in 4Q. And then regarding the softer economic activity, the degree to -- what you're actually hearing and seeing from customers as opposed to sort of what you're anticipating just based on what you see on the macro?

Yes. Maybe I'll take it at a go and Steph, obviously, can weigh in here, too. So Joe, I think it's a little difficult to -- an aftermarket as you're aware, to parse out the specific driver. I think all of our broader customers have approached this year from an inventory management standpoint a little bit differently. And so you're seeing destocking occur at different times with different customers. And so we did see some of that in Q2, as Steph alluded to and expect some more of that here over the back half as everyone rightsizes their inventory relative to their expectations. In terms of the overall economic activity. I would say we are seeing some slowdown there. You can look at a number of different inputs, whether it's great indices or truck tonnage to point to a slowdown in that activity. Perhaps it isn't as pronounced as we all thought a quarter ago. And so we're keeping a close eye on how that unfolds and we'll continue to monitor what happens in the aftermarket.

Got it. And then a question on R&D. I think that was up 20% sequentially in year-over-year. Not sure how much of that is tied to stand-alone or how much is tied to maybe some initiatives underway, but if you could you could touch on anything that contributed to that by sort of specific programs or any organic efforts toward industrial?

Yes, absolutely. So generally speaking, we think about R&D as a percent of sales right in that 2.5%, call it, in the 2% to 3% of sales range, and that's kind of where we've been pretty consistently. We do have some lumpiness, if you will, in terms of prototype recoveries, in particular, as we work with our customers to develop new products. The timing of reimbursement for that can be -- can cause some differences quarter-on-quarter. But overall, we continue to invest from an R&D perspective and are excited about what the team can do, not only in our core markets as they bring new solutions forward for our customers, but also through the evaluation of these industrial markets and what capabilities can we leverage into those new markets.

Next, we'll go to Rob Mason with Baird.

It's good to see the benefits of your pricing initiatives flow through that's pretty visible. I was curious what your outlook for the full year includes with respect to price as we go forward? And just also around your pricing initiatives, the stickiness of that price that you've put through as you think about the balance of the year and if some of these costs do continue to come down like freight, input costs, et cetera?

Yes. No. Thanks, Rob. Good to talk to you. So let me just give an overview on where I see we are in the sort of price cost story. So largely through now the second quarter, we've caught up on price cost, I would say, as you've reflected in terms of our margin performance. We obviously had the lag through previous periods of performance. So I'd say largely we're caught up now. And we are seeing inflationary pressures and commodity prices moderate. So I do expect pricing in our outlook and what's contained in our guidance to return much more to historical trends is where I would guide you to. Of course, if we do see costs escalate further, we will adjust for that. You will see the lag that we have experienced in the past, but we would adjust for those. I'm not expecting any issues of stickiness. We really have been able to successfully pass price into the market, as you've seen and demonstrated and so, I wouldn't flag any issues there at this point.

Just as a follow-up, it looks like your kind of onetime separation cost the outlook for the year suggests those could increase sequentially as we go through the second half of the year. Could you just update us on where you think you are in terms of your ability to move off from some of the TSAs? And you also mentioned some inclusion of inefficiencies in the outlook as well. Just -- is there any way to frame up what those inefficiencies amount to quantitatively right now?

Yes. So let me give an overview of how we're tracking overall. It's a significant separation from Cummins, and I'll give some more color to that to give you a sense of it and then I'll ask Jeff to add anything that he thinks I'm missing. But just overall, there are certain elements, certain functions that we are heavily entangled with Cummins, and we've called those out a few times, but I would describe those predominantly as warehousing and transportation, HR and IT. And we are tracking very well in terms of our separation plans and the individual projects. I would just broadly describe those as being on track. I spoke to a couple of those features in my highlights. We've established 2 of our warehouses and distribution centers. So we are very much on track with where we expected to be at the end of the second quarter. I think the challenge in terms of just where those inefficiencies might lie that we're just guarding against is just unanticipated elements of IT, perhaps that we need to keep on longer, for example. That's what I would characterize it as. And a good example, I feel like we've adequately integrated this, but as we stand up our own cybersecurity capability, we do need to keep coverage of Cummins' cyber security for the whole period, wherever we're using any of Cummins' allocations, right? So we can't really turn that piece off right until we get to the end of our 2-year journey, if you like, at the end of 2024. But we're on track right now. We've been managing it very well and we'll wind down the TSAs as we turn off the activities in the services.

Yes. And just to add a little bit here, Rob. So I think -- as you think about the cadence of the onetime costs, as you alluded to, we are expecting to remain at this level, it's not a touch elevated as we move through the back half of the year. As a reminder, we had about $4 million of these onetime costs in our first quarter of 2023 and then $9 million here in the second quarter. Our guidance is $30 million to $35 million for the full year. And so we do expect to continue to incur these costs as we separate facilities from Cummins, systems from Cummins so on and so forth. And just for color, roughly 1/3 of those -- that $30 million to $35 million should be incurred in our cost of sales with the balance down in SG&A primarily.

Next, we'll go to Andrew Obin with Bank of America.

Just a follow-up on the destock commentary. I think there are a lot of dynamics here. I think one of your competitors would really have to do with specifically what one of their customers was doing. But are you seeing destock at the distributor level? Or are you seeing destock at the OEM customer level? Where is the destock that you're talking about?

Yes. And so Andrew, I'll focus largely on the North America market with my comments. It is the majority of our aftermarket, just to give you a sense. And so I'll focus on North America. Look, what I would say, it is varying by OE actually. That's the color I would give you. And some of our customers were really all the way through the dealer and distributor channel, and it's moderated back to normal levels of inventory through the chain and we think we're most of the way through the destocking. In others, we're kind of still in the distributor or a dealer level, and then in others, again, it's up at the OE level. So it is varying actually. We're seeing some [indiscernible] moving through that faster than others. We expect it to play out. Almost that variation is helping us as this moderates through, is how I would describe it. we're expecting that destocking to play out over the remainder of quarter 3 and 4.

Got you. And just a follow-up question on inflation. I think industry is starting to talk about disinflation or maybe some talking about deflation. I think you guys are talking about better price from your supply chain. But I think historically, the industry would give back pricing in a deflationary environment. Have you adjusted the -- just remind us, if you have adjusted your contract structure going forward, to sort of to mitigate that? Or should we look at sort of legacy patterns where inputs go down first and then you guys have to give back some price. Can you just talk about structurally, what do contracts look like?

Yes. So I'll talk at a high level just to the differences between our first-fit business and aftermarket as it relates to pricing. So it's roughly 80%-20%, so 80% aftermarket, 20% first-fit. Our first-fit contracts are very much based on our contractual arrangement. Many of those have risen full causes integrated into them. And you've seen that flow through in our previous period results. In terms of the aftermarket, we passed price increases to the aftermarket and -- roughly on a twice a year basis, but it varies by region. At the moment, we are not seeing deflationary pressures, I would say. Certainly, we're seeing a lower inflationary environment. We have only really caught up, I would say, in those markets to the previous rising and escalating cost environment. So I certainly don't -- I'm not looking at a deflationary piece in our forward pricing outlook.

But generally, in aftermarket, the point is that pricing should be a lot more stable than in the OE channel?

Exactly.

There are no further questions at this time. Todd Chirillo rule, I'll turn the call back over to you for any additional or closing remarks.

Great. Thank you. That concludes our teleconference for the day. Thank you for participating and your continued interest. As always, the Investor Relations team will be available for questions after the call.

This concludes today's conference call. You may now disconnect.