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Cummins Cannot Outrun Expectations
It is both to Cummins' (NYSE:CMI) credit and misfortune that the company has trained analysts and investors to expect a lot. This manufacturer of heavy-duty engines and power generation systems had handily surpassed earnings estimates in three of the last four quarters, analysts had been steadily raising estimates and target prices, and institutional investors had pushed the stock up more than 100% in the past year.
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So when the company delivered a quarter that many industrial CEOs could only dream about, Wall Street's reaction was little more than "what else ya got?" delivered with a shrug.
A Cap to a Strong Year
For the fourth quarter, Cummins reported that revenue rose 22% to over $4 billion. Engine revenue is still more than 50% of the total, and this segment grew 15% despite ongoing weakness in the U.S. market. As it has in recent periods, Cummins more than made up for an iffy North American on-the-road market with strong performances overseas and in industrial segments like mining and agriculture - no surprise, really, given the strong results from the likes of Caterpillar (NYSE:CAT), Deere (NYSE:DE), Komatsu (Nasdaq:KMTUY) or Joy Global (Nasdaq:JOYG).
Elsewhere, power gen revenue jumped 50% (to over $900 million), while component revenue rose 25%.
As Cummins continues to pull out of the recession, strong revenue is translating into incremental operating leverage. Operating income rose 41% this quarter and the operating margin expanded by almost two full points. Although margins in the components business did slip, better performance in engines and significantly better results in power gen more than made up for it. (For more, see Zooming In On Net Operating Income.)
No Potholes in the Road Yet
Although Cummins had a really good 2010, that was despite a tough market in North America for both heavy-duty and medium-duty truck engines. Here, though, is where the company's diversification has really paid off, as the torrid pace of industrial expansion, resource exploitation, and construction outside the United States really saved the company's bacon.
Looking out into 2011, there doesn't seem to be an obvious reason to believe the end is nigh. Eaton's (NYSE:ETN) CEO recently talked about his concerns regarding supply chain shortages in the face of a major rebound in North American commercial truck sales. On top of that, companies with mining exposure ranging from Caterpillar to Joy Global to Sandvik are all pointing toward more activity and order strength. With that in mind, it would seem that a good situation is likely to get better, though no investor should sleep on the risk that government attempts to moderate growth in Brazil, China, Turkey, and other emerging markets could take down growth and impact Cummins' sales. (For related reading, see Cummins Propels Forward.)
The Bottom Line
Cummins is a good example of the sort of stock that is the bane of value investors. In most operational respects, Cummins is a fantastic company - great overseas exposure, good margins, good returns on capital and assets. On the other hand, the company's free cash flow generation has never been as good as it would seem it should be, and this is a cyclical business.
So what's a value investor to do? Is it prudent to model never-before-seen levels of free cash flow margin? And when should an investor assume that the double-digit revenue growth tapers off (and does it go negative in four or five years)? Obviously those are key factors to consider, but also perfect examples of why modeling and stock valuation is never as scientific or objective as some like to pretend.
On balance, it just does not seem reasonable to say the Cummins shares are "cheap". They may not be all that expensive either, though, if an investor is willing to believe that the company could achieve nearly $22 billion in annual sales in 2015. So long as the global economy, and especially the industrial sector, continues to recover it seems dangerous to bet against a top-flight supplier to that recovery. (For more, see Analysts Redline Cummins.)
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So when the company delivered a quarter that many industrial CEOs could only dream about, Wall Street's reaction was little more than "what else ya got?" delivered with a shrug.
A Cap to a Strong Year
For the fourth quarter, Cummins reported that revenue rose 22% to over $4 billion. Engine revenue is still more than 50% of the total, and this segment grew 15% despite ongoing weakness in the U.S. market. As it has in recent periods, Cummins more than made up for an iffy North American on-the-road market with strong performances overseas and in industrial segments like mining and agriculture - no surprise, really, given the strong results from the likes of Caterpillar (NYSE:CAT), Deere (NYSE:DE), Komatsu (Nasdaq:KMTUY) or Joy Global (Nasdaq:JOYG).
Elsewhere, power gen revenue jumped 50% (to over $900 million), while component revenue rose 25%.
As Cummins continues to pull out of the recession, strong revenue is translating into incremental operating leverage. Operating income rose 41% this quarter and the operating margin expanded by almost two full points. Although margins in the components business did slip, better performance in engines and significantly better results in power gen more than made up for it. (For more, see Zooming In On Net Operating Income.)
Although Cummins had a really good 2010, that was despite a tough market in North America for both heavy-duty and medium-duty truck engines. Here, though, is where the company's diversification has really paid off, as the torrid pace of industrial expansion, resource exploitation, and construction outside the United States really saved the company's bacon.
Looking out into 2011, there doesn't seem to be an obvious reason to believe the end is nigh. Eaton's (NYSE:ETN) CEO recently talked about his concerns regarding supply chain shortages in the face of a major rebound in North American commercial truck sales. On top of that, companies with mining exposure ranging from Caterpillar to Joy Global to Sandvik are all pointing toward more activity and order strength. With that in mind, it would seem that a good situation is likely to get better, though no investor should sleep on the risk that government attempts to moderate growth in Brazil, China, Turkey, and other emerging markets could take down growth and impact Cummins' sales. (For related reading, see Cummins Propels Forward.)
The Bottom Line
Cummins is a good example of the sort of stock that is the bane of value investors. In most operational respects, Cummins is a fantastic company - great overseas exposure, good margins, good returns on capital and assets. On the other hand, the company's free cash flow generation has never been as good as it would seem it should be, and this is a cyclical business.
So what's a value investor to do? Is it prudent to model never-before-seen levels of free cash flow margin? And when should an investor assume that the double-digit revenue growth tapers off (and does it go negative in four or five years)? Obviously those are key factors to consider, but also perfect examples of why modeling and stock valuation is never as scientific or objective as some like to pretend.
On balance, it just does not seem reasonable to say the Cummins shares are "cheap". They may not be all that expensive either, though, if an investor is willing to believe that the company could achieve nearly $22 billion in annual sales in 2015. So long as the global economy, and especially the industrial sector, continues to recover it seems dangerous to bet against a top-flight supplier to that recovery. (For more, see Analysts Redline Cummins.)
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by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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