Buffett Might Buy this Stock, Should You?

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Nowadays, many transportation stocks are being ignored by investors. This does not come as a surprise given that the transportation stocks normally do not perform well in recessionary times, as low economic activity leads to lesser transportation of goods across the country. Despite such a challenging economic environment, Cummins (NYSE: CMI), the truck engine manufacturer, has recently been receiving a lot of attention. In such recessionary times, why is Cummins an investor darling?

The Investment Case 

Investment banking firm Baird called Cummins a Top Idea for 2013. Even some people are predicting that Berkshire Hathaway is expected to make an acquisition in the $20 billion enterprise valuation range in 2013, and Cummins seems to be a hot candidate for this coveted spot. Cummins remains well-positioned to deliver solid profitability even in a somewhat challenging macro-economic environment.

The North American heavy duty truck market seems to be in a bottoming process and could see some recovery over the course of 2013, with Cummins poised to see some incremental revenue and earnings from the rollout of its heavy duty engines and emissions after-treatment components into Navistar’s (NYSE: NAV) North American vehicles.

In addition, while the international markets remain uncertain, the downside risk from these regions could be dampened given significant corrections in 2012, and some markets, such as Brazilian trucking, could see some recovery given more accommodative economic policies. The company’s solid product line in the natural gas segment will continue to help the company benefit from the shale gas boom.

The Business Drivers

Cummins ranks among the premier global independent suppliers of engines for on- and off-highway applications, along with related technologies such as turbochargers and emissions after-treatment systems. Cummins’s strong reputation for quality and innovation has heavily contributed to its success in the marketplace, and it helps the company to generate strong profitability and cash flow, which can be deployed into a combination of investments in the business and cash returns to its shareholders.

Cummins’s extensive joint venture strategy, whereby it partners with locally-based companies in geographies such as China and India, gives the company a competitive advantage by being partnered with local players who have experience and leading positions in their local markets. In this way, the company is poised to benefit from the potential growth in the emerging markets.

The company has also been running partnerships in North America. Two of its most important partnerships include:

1)      Partnership with Navistar: Cummins had been providing engines to Navistar for decades until about two years ago, when Navistar’s disastrous emissions strategy made Cummins’ engines incompatible with Navistar trucks. I am talking about the time when Navistar’s ex-CEO Dan Ustian’s decided single-handedly that Navistar would go for a new type of engine (known as Exhaustive Gas Recirculation (EGR)) rather than the engine (Selective Catalytic Reduction (SCR)) approved by the Environment Protection Agency (EPA).

This engine strategy failed miserably and as a result, Navistar had to pay massive warranty charges and non-conformance penalties. However, after realizing what a big mistake he had made, Ustian approached Cummins for the rescue. Now, Cummins is producing 15-litre engines and SCR after-treatment for Navistar’s 13-L engines. In this way, Cummins will be able to enhance its already massive market share (40% YTD) in the U.S. engine strategy. I have covered this in detail in one of my earlier posts.

2)      Partnership with Westport Innovations (NASDAQ: WPRT): Cummins is currently running a joint venture with Westport, the natural gas engine technology provider. CWI (the name of the joint venture) will help Cummins to benefit from the rising demand of gas-driven trucks in the U.S. The bears believe that demand for gas-driven vehicles will not rise in another decade or so, given the lack of natural gas fueling infrastructure and the potential turnaround in the natural gas prices (that will diminish the economic benefits of switching from diesel to natural gas).

In this scenario, I have two answers:

i)        Firstly, many companies are actively working to develop an extensive natural gas fueling infrastructure. In this context, Clean Energy Fuel Corp (NASDAQ: CLNE) is developing 150 fueling stations nation-wide.

ii)       Secondly, even if the natural gas adoption rate does not reach a desirable level, Cummins has the option of exiting from this partnership in 2021. The CWI JV is scheduled to terminate in 2021 with a buyout option at 1.3 times EBIT in 2019. In case of a buyout, Cummins will enjoy the terminal value of the project.

 Upside/Downside Scenarios

An upside could be driven by faster-than-expected growth in emerging markets, for instance, a return to 2010-levels of GDP growth and stronger-than-expected truck markets in North America. In this scenario, I would expect shares to trade at a multiple of 14. This means a price target of $143 at a 2013 EPS of $10.20.

A downside could be driven by worse-than-expected macroeconomic activity contributing to declining revenue and significant margin declines, although not to prior trough levels given operating improvements and efficiency gains in the intervening years. In this scenario, a lower 10x multiple could lead a price of $65 at a 2013 EPS of $6.50.

Valuation Analysis

Cummins currently trades at a forward multiple of 12.5 times earnings. This is well below the 5-year average P/E of 13.9. The current multiple is slightly above the Machinery group average of 12.2, but represents a discount to the 13.0 multiple for the S&P 500. Given Cummins’s leading market position in its end markets, strong long-term growth prospects, and financial strength, I do not think a discount vs. the broader market is warranted.

AnalystX has no position in any stocks mentioned. The Motley Fool recommends Clean Energy Fuels, Cummins, and Westport Innovations. The Motley Fool owns shares of Clean Energy Fuels, Cummins, and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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