Modeling and assigning a fair value to Cummins (NYSE:CMI) is not a particularly easy task. It's hard to find a better company in the transportation components sector, not to mention the wider industrial sector as a whole. Through all of the cyclical ups and downs of the commercial vehicle market(s), Cummins almost always generates double-digit returns on invested capital and has managed to stay in the green with free cash flow. So quality and ability to execute are not problems. What is the problem is estimating fair future growth rates. It seems hard to imagine that Cummins can match its trailing revenue growth rate of 12%, but countries like Brazil, China, and India are still seeing trucking operators building their fleets, while the move to natural gas could fuel demand not only for LNG/CNG engines, but also compression facilities and more equipment for the energy sector. Although I think the Street may be a little too optimistic on the free cash flow margin leverage Cummins can deliver, I'm increasingly thinking this is a good stock to own for the longer term. Making The Best Of A Tough EnvironmentThe global commercial vehicle market is still seeing some pretty stiff headwinds, but Cummins nevertheless managed to pull some top-line growth out of this quarter. With that, Cummins beat on the top line, more or less held the line on margins, and delivered a solid operating beat for the quarter.SEE: Investors Already Thinking Recovery For Cummins Revenue rose 2% as reported (and 15% on a sequential basis). The company's largest business segment, engines, saw revenue decline 7% as a 3% improvement in volume was offset by a 10% decline in price (largely due to mix). Vehicle engine revenue rose 5%, while industrial and stationary declined 11% and 37%, respectively. Power generation was down 11%, while components rose 8% and distribution revenue rose 20%. Despite the higher volume in the engine business, gross margin declined more than one and a half points due in large part to a mix shift to smaller, lower horsepower engines. Cummins kept a lid on SG&A and R&D spending, though, and limited the operating income decline to 5% (and a one-point decline in operating margin).SEE: A Look At Corporate Profit Margins Navistar Helping, But The Big Recovery Isn't Coming Right AwayOn the call, management wasn't terribly bullish. The North American Class 8 truck market is still pretty weak, though the inclusion of revenue from Navistar (NYSE:NAV) is helping. Likewise, the North American energy market may have bottomed, but it's not reversing quickly (and Cummins generates a meaningful amount of revenue from the engines that power frac units). Outside the U.S., management sees conditions in China as flat, India as worsening, and only Latin America showing many signs of improvement. What Will Natural Gas Do For The Business?One of the bigger long-term uncertainties is the impact that natural gas will have on Cummins' business. I'm not talking just about the companies joint venture with Westport (Nasdaq:WPRT) for natural-gas powered engines. Although I could see this JV gaining share from existing non-Cummins diesel engines (including Caterpillar (NYSE:CAT) and Daimler's Detroit Diesel), I don't necessarily see that as the major delta. What could change is the demand for equipment that will feed natural gas engines. If natural gas-fueled engines catch on, there will be a need for more compression systems across the country, and Cummins products can power those. Likewise, more natural gas demand will likely lead to more natural gas exploration/production, and more demand for Cummins' products in the field. The Bottom LineBetween excellent R&D capabilities in diesel engines, growing emphasis on emissions control and fuel efficiency, and potential in non-vehicle markets, it's not hard to be bullish about the prospects for Cummins. The key question is just how much bullishness is reasonable. Generally speaking, growth slows as companies get larger. To that end, I don't believe Cummins can reproduce the 12% annual revenue growth of the past decade. Likewise, given that Cummins hasn't exceeded an 8% free cash flow margin in recent (10 years) history, I think analysts projecting double-digit future free cash flow margins are getting a little ahead of themselves. Still, if there's an industrial company that can outperform, Cummins (with its strong international exposure and North American market share) is the one I'd pick. I've increased my long-term base case revenue growth estimate to 6%, and that points to a fair value of almost $135 today. Go to 8.5% revenue growth and the target jumps to to $158, while a target of 10% growth leads to a $173 target. I would not invest in Cummins on the basis of thinking that 10% annual revenue growth and 18% annual free cash flow growth is likely. Likewise, I wouldn't rule out the risk that the big burst of demand in markets like China won't be repeated. Still, on a risk/reward basis, I think Cummins' past performance suggests that this company is a good name to pick if you believe that global heavy vehicle demand still has worthwhile growth potential over the next decade. Disclosure – At the time of writing, the author had no positions in any companies mentioned.

Related Articles
  1. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  3. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  4. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  5. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  6. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  7. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  8. Stock Analysis

    Top 3 Stocks for the Coming Holiday Season

    If you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
  9. Investing News

    Could a Rate Hike Send Stocks Higher?

    A rate hike would certainly alter the investment scene, but would it be for the better or worse?
  10. Investing News

    Corporate Bonds or Stocks: Which is Better Now?

    With market volatility high, you may think it is time to run for corporate bonds instead of stocks. Before you do take a deeper look into which is better.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!