Cummins Drop Highlights Potential Opportunity

By Tom Gibbs - July 12, 2012 | Tickers: CAT, CMI, DE, JOY, PCAR | 0 Comments

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Cummins (NYSE: CMI) has had a heck of an experience over the past five years.  With revenues tied very closely to global GDP levels, the diesel and natural gas engine manufacturer’s revenues were crushed by nearly 25% in 2009 after double-digit top line increases in the prior year.  Following the bottoming out in the mid-recessionary climate, Cummins has made a huge resurgence – growing revenues by an average of 30% per year in 2010 and 2011 and passing along ~670% investment gains to patient investors when stock prices recently neared $130/share. 

The manufacturer has not enjoyed such a rosy second quarter of 2012 thus far, however.  Continued worries over the European economic crisis and a slowdown in key emerging nations including Brazil, China, and India, Cummins stock has taken a 33+% hit from this year’s highs.  The issuance of the corporation’s 2012 guidance update on July 10^th did not help matters, either.  With expectations of 2012 revenues being about on par with 2011’s $18 billion, Cummins has essentially rescinded the original 10% annual growth projections that it issued earlier this year. 

Cummins’ update echoes a continued uncertainty regarding the mid-term expectations of the industrial sector.  Shares of Deere & Co. (NYSE: DE), Caterpillar (NYSE: CAT), and Joy Global (NYSE: JOY) took 2.5%, 4.5%, and 5.5% hits, respectively, from the news as it resonated throughout the market.  The remainder of 2012 and the 2013 operating periods for all of these firms continues to hang in question as the combination of lower revenues and margin compression is a very real scenario should the industrial economy continue to stagnate. 

Drivers and Reactions

Although Cummins did report very solid Q1 results – 16% revenue and 36% EPS increases compared to Q1 2011 – the July 10^th was not a completely unexpected announcement.  Class 8 truck orders, for example, have been on a secular decline since this past January, and last month’s orders were a full 23% lower than June 2011 levels.  In addition to softer demand for trucks and power generation equipment in the United States, Cummins’ highest volume market with key customers like PACCAR (NASDAQ: PCAR), the relatively strong dollar has also dampened recent earnings.  Operating in more than 190 countries and territories, Cummins is a model example of a truly global corporation, and the prospects of emerging markets’ currencies continuing their deprecation to the dollar is expected to be one of the lingering effects on the corporation’s profitability.

Despite the pessimism and the market’s huge negative reaction to the news – Cummins closed down 10% on July 10^th and traded down by as much as 3% on the 11^th – many analysts are still rather bullish on the stock’s long term performance.  Between Jefferies & Co., Sterne Agee, and Credit Suisse, newly cut price targets still range from $100-$136/share, an ample premium to current prices around $85/share. 

With current valuations implying a near 50% discount from the stock’s past five year average P/E around 16x, there is no doubt that Cummins is a bargain on the surface.  Several key factors hint that although there are still some short-term uncertainties, over the long-run Cummins is less of a value trap than the current market activity suggests.

• Strong Freight Economy: Despite the U.S. freight economy experiencing a significant dip during the recession, the trucking industry has very strong long-term prospects.  In 2011, trucking activity comprised 67% of tonnage and 81% of revenue generated in the freight transportation industry, and over the next ten years trucking’s share of tonnage and freight revenues will increase to 70% and 82%, respectively.  The increased penetration of trucking will occur while total freight tonnage grows by 21% and total revenues in the freight transportation industry grow by nearly 60% over the same time period.

• More Stringent Emissions Control Standards: One of the true long-term growth opportunities for Cummins, a whole schedule of emission changes every year throughout the mid 2010s implies sustained demand. 

• Products with Confidence: Navistar posted operating losses in the past two quarters due to higher cost of goods sold, which were driven in part by disproportionately large warranty costs in relation to revenues.  Cummins can easily gain additional market share points going forward as customers continue to strengthen their confidence in the corporation’s products.  Cummins’ warranty costs as a percentage of revenues have, after all, recently reached a fifteen year low.

• Strong Balance Sheet and Cash Flow Generation: Although updated revenues for Q2 are meaningfully below original analyst estimates for the quarter, Cummins did reaffirm that the full year’s top line would be on par with 2011’s reported figure.   With stagnant revenues and a rather strong free cash flow conversion rate for 2011, it will be rather difficult for the corporation to generate a comparably robust FCF for 2012, but the newly upped dividend does tend to reinforce the confidence Cummins has in its cash generation abilities. 

Cummings does appear to be a pretty compelling opportunity at current market valuations, but there is always a very real risk of purchasing into bad news.  With Q2 revenue guidance ($4.45 billion) implying H1 2012 revenues being 5% higher than the comparable period in 2011, there will be a meaningful top line contraction during the latter half of the year, which can cause many unknowns to arise.  Shares could very well become even cheaper before they tend to rise back towards 11-12x P/E (with an estimated $9/share, on the low end, in earnings this year) in the mid-term. 

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