Why This Stock Will Drive Your Portfolio to Outperform

Neha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Cummins (NYSE: CMI) ran off the road last month with missed earnings estimates, and sell ratings on its stock are piling up.  Is that reason enough to get the stock out of your eyesight?  Not unless you have weighed its pros and cons well. Let’s do it together.  

Strengths

In top form: Cummins was among the top 200 in 2011 Fortune 500 rankings. It also claimed a spot in the Dow Jones Sustainability World Index (which names the top 10% of the world’s largest 2500 companies judged on various parameters) for seven consecutive years.

In right hands: Cummins’ research and development commitment is spot-on. Consider the way it held its cool in the mad run-up to meet 2010 emission standards. So while peer Navistar (NYSE: NAV) battled spiraling repair and warranty claims last year for engines it built in 2010, Cummins’ warranty costs hit a 15-year low at the same time. More recently, Cummins’ ISX15 engine became the first to get certified by the EPA for 2013 emission standards and greenhouse gas rules effective 2014. Its generator set has already received EPA Tier 4 certification 3 years before deadline. No wonder then, that Cummins enjoys such excellent reputation and brand loyalty.   

In great company: Cummins believes in team work, evident from its enviable global tie-ins. A 50:50 joint venture with India’s leading auto company Tata Motors (NYSE: TTM), ventures with Komatsu in Japan, and those with Dongfeng and Chongqing in China are to name a few. Back home, a tie-up with natural-gas engine technology expert Westport Innovations (NASDAQ: WPRT) stands out. The Venture with Tata has taken Cummins to the top spot in India’s trucking market, while the one with Westport is reaching new heights -- it is the biggest revenue and profit generator for Westport today. Cummins’ customer list is equally delectable. Paccar (NASDAQ: PCAR), Ford, Daimler, Volvo, MAN, Chrysler – you name it and Cummins has it.

In sync: Cummins has kept its chin up even in trying times – its gross and net profit margins were 28% and 10%, respectively, for the past twelve months – indicating management efficiency. Shareholders have been rewarded as well – return on equity was 31% for the past year, and dividends have been raised by more than 125% since 2009, currently yielding 2%. Regular share buybacks and a dividend re-investment option act as cherries on the cake.

In safe position: Cummins’ financial standing is even more impressive. Given its total debt-to-equity ratio of 12%, interest coverage ratio of a whopping 72 times, the fact that it was free cash flow positive by over $500 million for the past three years, and cash equivalents of over $1 billion (as on Sept. 30), things can't seem to get any better. Furthermore, the scope to increase dividends and comfortably assume more debt for growth plans is huge.

Weaknesses

At the mercy of: How would it feel when you run out of necessities and find your grocer shut? No food, no work. Cummins might find itself in a similar fix were its single supplier, which alone provides for 60% to 70% of its total product parts requirement, delays shipments or falls out.

In a risky room: Now imagine you are the grocer and one customer who took care of more than 10% of your sales decides to move away. Similarly, Paccar alone contributes 12% to Cummins’ sales being its largest customer. If circumstances compel Paccar to scale back production, Cummins’ top line could take a huge hit. We got a sense of this in the last quarter.

In troubled waters: Cummins gets 60% of its sales from outside the U.S. That should be a strength right? The problem arises when global economies start melting. In its last quarter, Cummins’ revenue from North America improved 2% while that from international markets slumped 21%. Europe accounts for 15% sales, which is a concern. Further, having presence in 190 countries further means you need to handle as many regulations, standards, market sentiments, economic situations, and so on. Not many know how market uncertainties have almost sealed the fate of a diesel engine platform that Cummins started developing in 2006. The probability of its closure is high, which could cost the company more than $200 million on impairment.

Opportunities

In gassed-up mode: Natural gas is one of the biggest opportunities for Cummins. The conversion is already accelerating, what with natural-gas fuel stations coming up in a big way. Production of Cummins-Westport’s advanced heavy-duty ISX12 G engines will kick off next year, and customers are already lining up. Another heavy-duty engine is ready for launch next year, which should be able to tap cheaper LNG opportunities.

In the right field: Stricter emission standards have become a norm across global markets, which by itself is a huge opportunity for a company that is an expert in making updated and compliant products. I already gave two examples earlier. Cummins can particularly take advantage of Navistar’s lost market share to expand its own.

Threats

On its toes: If stricter standards are an opportunity, they add costs too. 42% of Cummins’ total research and development in 2009 went towards meeting 2010 EPA standards, and 17% of R&D spending last year was for 2013 EPA standards compliance. Complications multiply when standards differ across different markets, as is generally the case. Any mess-up could mar reputation and turn the tide in favor of peers who are proactive. Recall Navistar’s case.

On alert: Cummins is heavily dependent on India and China – the two accounted for 43% of revenue last year. Both economies are grappling with several issues. If Fool colleague Travis Hoium’s fears of things getting worse in China come true, Cummins could be in trouble. High inflation and slow growth continue to plague India -- Tata Motors was even compelled to cut production some months back – and political uncertainty remains high as the nation stares at general elections 2014.

On soft ground: Cummins’ business is directly related to the health of the American trucking industry, which is responsible for 50% of its engines sales. Truck tonnage and freight growth remain feverish, and industry experts aren’t expecting a turnaround soon.

Under watch: For a global company like Cummins, local manufacturers in respective markets are major competitors. Navistar might not be a big threat right now, but Caterpillar and Volvo are taking leaps with advanced engines and other products.

Foolish wrap-up

Cummins’ muted full-year outlook might have caught you off-guard, but any long-term investor would have thrown his fears out of the window. Good margins, rock-solid balance sheet, decent dividends, excellent management, and great opportunities – perfect to award Cummins a spot in your portfolio, even at current price. Click here to add Cummins to your stock watchlist.


Neha Chamaria has no positions in the stocks mentioned above. The Motley Fool owns shares of Cummins and Westport Innovations. Motley Fool newsletter services recommend Cummins, PACCAR Inc, 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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