Seeing as it is no simple task to find a company with the right mix of good management, competitive products, and attractive long-term markets, I understand why investors are slow to give up on companies that feature these attributes. All the same, it looks like the Street has already looked past this lull in Cummins' (NYSE:CMI) business. Not only is the stock up about 15% over the past year and within 10% of its all-time high, but today's valuation already presumes a pretty solid future outlook with respect to growth.
First Quarter Results Reflect The Global Slowdown
If investors hadn't already gotten the message from companies like Caterpillar (NYSE:CAT), Eaton (NYSE:ETN), Navistar (NYSE:NAV), or Volvo (Nasdaq:VOLVY), Cummins drove home that the global vehicle, industrial power, and energy markets are seeing tough times.
Cummins reported that revenue fell about 12% from the year-ago period and a further 9% from the fourth quarter, missing the Street average of estimates by a small margin. The weakness was worst in the company's largest business (engines), as revenue fell 19%, with heavy duty trucks, medium duty trucks, industrial, and stationary power sales all down by double digits (27%, 15%, 17%, and 23%, respectively). Cummins' power gen business held up better (down 4%), while components fell 7% and distribution revenue was flat.
As a company that drives significant operating leverage when revenue is strong, that leverage cuts the other way in slowdowns. To that end, gross margin fell almost two and a half points, and missed the Street average estimate by more than a point. Operating income fell more than a third, and the company missed average expectations for operating margin, but if this proves to be the bottom an operating margin above 10% (10.6%) is actually pretty encouraging.
SEE: Analyzing Operating Margins
Will Energy Become More Significant For Cummins?
Cummins has changed a lot over the past decade, and almost all for the better as the company actually gained market share in its core vehicle engines business. Looking ahead, the company has made it clear that emerging markets growth in its core engines business is a priority. I also wonder, though, whether more activity in energy is in the cards.
Investors don't seem to talk about it much, but companies like Caterpillar, Eaton, Allison (NYSE:ALSN), and Cummins have meaningful presences in the energy sector. For Cummins, it is worth close to 10% of revenue, though weakness in the North American well servicing market has certainly slowed things down.
Looking ahead, though, the company will be launching the huge new “Hedgehog” engine with an eye toward growing its addressable market in the energy sector (as well as other market sectors). I don't expect Cummins to become an energy company, but I think investors shouldn't lose sight of the opportunities Cummins has to bring its core technologies to markets like energy, rail, and general industrial.
SEE: Key Ratios For Analyzing Oil And Gas Stocks Tutorial
Trucking Is Going To Be An Up And Down Market
Some analysts and investors seemed to get lulled by the latest bull run in heavy equipment into thinking that markets like trucking/commercial vehicles, mining, and construction aren't still deeply cyclical markets. I think that thesis has been put to bed (until the next time...), but that's not to say that there isn't more growth to be had.
It's true that countries like China, Brazil, and India are going to see more trucks on their roads in the coming years. It's also true that a conversion to natural gas or other alternative fuels could lead to meaningful business for Cummins in the coming years.
All of that said, though, investors should get carried away with their growth expectations. Even if Navistar's recent efforts to develop its own engines went badly wrong (and the company came back at least partially to Cummins), others are going to try again sooner or later. Likewise, companies like Daimler and Volvo are both going to look at emerging markets like China as growth opportunities for themselves as well, to say nothing of local players like China Yuchai (NYSE:CYD). So while I do believe that Cummins will win its share of business, it's not going to win *all* of the business out there.
The Bottom Line
It's not surprising for a company searching for a cyclical bottom, but there is a wide range of analyst estimates for Cummins earnings over the next few years. That sort of spread often points to above-average volatility (for good or bad) as investors dial in their expectations.
SEE: Manage Your Clients’ Expectations
For my part, I'm looking for Cummins to grow revenue at a mid-single digit rate for the long term, with a recovery from this lull powering a low-to-mid-teens free cash flow growth rate. Were the company to find real success in new non-vehicle markets, there could certainly be some upside to the revenue figure (though perhaps at the cost of some margin). That works out to a fair value near $120. Although I usually like a wider margin of error before buying, Cummins is too popular to really hope for much more. While there is definitely a chance that the recovery in demand takes longer (and pushes down results, estimates, and the stock price in the meantime), investors should realize that this stock often snaps back quickly, so investors waiting for a pullback will need to move quickly if and when it happens.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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