This Engine Giant Could Soon Swing into High Gear

By Neha Chamaria - August 3, 2012 | Tickers: CMI, NAV, PCAR, TTM | 0 Comments

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Cummins’ (NYSE: CMI) shares shot up post results. Was it just the earnings beat, or was it something in the earnings call that ignited the spark? The engine maker’s Street-crushing second-quarter numbers didn’t really surprise me, as expectations weren’t too high after the company cut its full-year revenue forecast some days back.

But there’s something that could, if things go in Cummins’ favor, prove to be a big impetus to the company and its stock. And its weak outlook still proves the company’s mettle. How? Read along to know.

Home is the best
A 4% slide in Cummins’ second-quarter top line from the year-ago period was in stark contrast to its first quarter when revenue climbed 16%. This wasn’t unexpected though, as most of the emerging markets have slowed down in recent months; and Cummins derives more than half its revenue from international markets.

It was a stronger North American truck market that saved Cummins from a huge blow to its top line. This market accounts for more than 50% of the company’s engine division (which is also its largest) sales.  In fact, strength in the U.S. markets, particularly in the trucking and construction segments, is acting as a savior for most companies in a situation where markets like China and Brazil are slowing down. For instance, truck maker PACCAR's (NASDAQ: PCAR) second-quarter sales were up nearly 13%, riding on the back of higher demand from the U.S. Similarly, most of the 8% sales growth in Caterpillar's largest division, construction industries, came from North America, which helped lift its total second-quarter revenue by 22%. 

As I expected, one of Cummins’ most important tie-ins -- a 50:50 joint venture with India’s biggest truck maker, Tata Motors (NYSE: TTM) — failed to deliver unlike previous quarters. Production volumes were 35% lower from last year as major players in the nation, including Tata, cut back production because of tepid demand. Outlook continues to be bleak, with Cummins’ expecting truck industry sales in India to slip by 8% for the full year.

The spark
So what was the bright spot in the numbers? Interestingly, despite lower revenue, Cummins’ gross margins hit a record high of 27.2% during the second quarter, up from 25.9% a year ago. An extremely encouraging sign, improving gross margins indicate excellent management efficiency. One factor that played a key role in boosting margins, and which also places Cummins in better stead particularly when compared to peer Navistar International (NYSE: NAV) was low warranty costs.

The contrasting story of the two companies is really interesting. It all started with the U.S. Environmental Protection Agency emission standards, adherence to which required both companies to invest significant effort and money to upgrade their engines launched in 2010. Nothing seemed amiss when Navistar suddenly reported a surge in its warranty claims pertaining to the 2010 engines during its first quarter, inking its books with red. Ironically, at around the same time, Cummins’ warranty costs hit a 15-year low.

The saga continues…
Navistar’s worries multiplied, also because the EPA’s decision on its new engine technology was pending for long. Meanwhile, rumors that Navistar could opt for Cummins’ engines surfaced last month, sending shares of both companies north. But what followed was the last thing Navistar could have wished for. The EPA didn’t certify its ambitious technology, forcing Navistar to abandon its plans and go for the same technology other industry players had already adopted.

Ironically, Navistar has been Cummins’ customer for long, and the current situation might only compel it to buy more of Cummins’ engines till it gets its act together. Although Cummins’ management declined to comment on whether it would bid to supply Navistar with relevant components, it acknowledged Navistar as its long-standing customer with the following words during the earnings call: “we've been partners or customers for a long time and have maintained discussions, relationships even despite the competition.” So are the two probably discussing how Cummins can be a salve to Navistar’s wounds? And did this play a role in pushing Cummins’ shares up? Can’t say no for sure.

For Cummins, all this means huge potential to gain market share as customers lose confidence in Navistar’s offerings. Cummins engines, made in collaboration with Westport Innovations are anyway emerging as hot favorites in the industry. As an example, even before it goes into full production, Cummins-Westport advanced heavy-duty ISX12 G engines have already found takers. PACCAR -- Cummins’ oldest and largest customer -- will fit its ‘next-generation’ trucks launched recently with these engines. Navistar too is powering more trucks with Cummins-Westport engines as announced earlier this year.

The Foolish bottom line
Cummins’ mute full-year outlook shouldn’t really be a worry, because in these trying times even if the company earns anywhere near to what it did last year — which was a record year — it will deserve a pat on the back.

I had told you some days back what a compelling buy Cummins appears to be, not just for the next few quarters, but for the long run. It’s a fundamentally solid company with a business line that is looking beyond the present. If you’re looking for a value bet, Cummins is for you.

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