How Will Cummins Do in a Recession?

Looking through some of the pundit discussions, we saw that Jim Cramer was commenting on Cummins Incorporated (CMI) Tuesday night.  Cramer quickly laid out some thoughts (as he normally does) stating that he thinks it's a great company, but now would not be the time to buy the stock. It also had its ex-dividend date of Wednesday, so that ship has sailed as well. With a current dividend yield of about 3.24%, this was not an insignificant opportunity. 

As with most “lightening round” discussions with Cramer, or any pundit, we have real concerns with “Sound Byte Investing” as we have come to call it at Ockham. It is fine to have a quick instinct, but the theories and stories espoused by Malcolm Gladwell in his bestselling book “Blink“ aren’t necessarily optimal for long term investing. In the coming months, we will examine this “twitter”-like mentality as it is applied to investing and the best way to benefit from the changing face of pundit advice for investors.

In this case, Cummins, Inc. has some very interesting business lines, but most are automobile related. Cummins designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and engine-related component products, including filtration and exhaust aftertreatment, fuel systems, controls and air handling systems. Interestingly, CMI is also quite diversified globally with more than 51% of Cummins’ business coming from operations outside of the United States. As they have stated, their business model is to push further into China and India through strategic partnerships, which is a wise global plan.

Problem of course with all of this is, what will they do through a recession? And with the big 3 automakers begging for more money on Capitol Hill, one must be very cautious with a company that relies so heavily on truck sales. The Dodge 2500/3500 truck line has been extremely popular, and with some very simple modifications is capable of running on alternative fuels.

As a value investment framework, Ockham Research is similar to a private equity firm in terms of our valuation methods. We are always on the lookout for value in the form of sales and cash numbers. In the case of CMI, Ockham views their current Cash Earnings as significantly below their historical average multiples of Cash Earnings, as calculated by our proprietary analysis. It is incredibly important to understand that for CMI, the current level of Cash Earnings compared to its historical levels helps identify where CMI is in relation to what the investing community was willing to pay for this level of Cash Earnings in the past.

Again, with the incredibly negative impact of recessionary spending cuts, CMI may be in a whole new ball game in terms of its historical numbers. However, with a historical high Cash Earnings per share ratio of 9.54 and a historical low Cash Earnings per share ratio of 4.18, an investor can relate where value could become optimal.

When we talk about Price to Cash Earnings numbers for CMI, we are looking specifically to see if the market is recognizing the huge disparity between CMI’s past stock price to Cash Earnings ratio to today’s levels. At a difference of 57% below the average historical Price to Cash Earnings ratio, our view would be quite positive at this point. However, as with all metrics, we need to also take other factors into account when looking at CMI (read Recession). While we view better Cash Earnings metrics as very important, if the market is slow to identify this value, or if Cash Earnings were to fall from these levels, we would become more neutral in our stance.

So bottom line? Ockham currently views Cummins as Undervalued. Now we know the doomsday folks will be quite angered by this, but we can’t help but think this is a company with great prospects for the future. No matter how you slice it, trucks make money, and if you really think we are headed for a depression, I suggest you buy a Cummins truck to load up Ma, Tom, Rose-of-Sharon, and the rest of the Joad clan to head out Californ-i-way. At least you’ll have a great engine to help you get there.

Comments

[Robert Nabloid:]

The price of Cummins stock has jumped a lot in the past few years (they've done remarkably well). I don't know if it's the best time to get in BASED on current valuation with the economy going into a big recession. What I do know is that Cummins is the leader and has a very bright future and will continue to dominate and steal market share. Their engines are meeting environmental standards way in advance while many of their competitors struggle! They are set to do VERY well based on market share in their industry. I just don't know how big the economic contraction will be based on the downturn. At the other end of this economic down turn, Cummins will do very well!

From what I remember, and correct me if I'm wrong, Cummins in the past has had to LIMIT their sales to China (and elsewhere) or they wouldn't have enough engines to satisfy the domestic markets. I also remember Cummins engines being sold out way in advance?? (My memory might be sketchy).

What I know is they are also going into natural gas and the drilling industry in a big way and taking market share. Cat got out of the trucking business altogether (for a while) and it was one of the big 3 players. (Cat, Cummins and Detroit Diesel...) Detroit Diesel's solution to the environmental standards is okay but Cat really struggled and that is one of the reasons they exited the market (I think). I'm a bit biased. I have a relative that works (diesel tech) for a Cummins service branch and I know many of the people that work in the local Cummins branch... and at the branch level they are still expanding in my market (building another building, hiring people, etc). I also know many people that work in the local Detroit Diesel branch and it doesn't seem to be as brisk or busy as Cummins, though in my market Detroit Diesel's service branch is a lot bigger in physical size and they have a larger share of the drilling market (for the time being... that looks to be changing!). (These are service/sales branch's, not the parent companies... but they may serve well as a proxy to see if the parent company is busy - but it only tells the tale from a single market... the entire picture isn't seen by me.).

Out of the three big diesel manufactures - Cummins is the one with the brightest future, IMHO.

2008 Nov 23 08:12 PM

[01123581321:]

Robert,
Very thoughtful and insightful, thanks for following up with the details of Cummins' operation. What you depict, in my opinion, demonstrates that the management of Cummins has done a superb job in sticking to both their core business strengths and still diversified in a proactive manner into other areas.

Whether the diesel business continues or must follow the downturn will be discovered relatively quickly, but these other moves by Cummins continue to strengthen our belief that it is a good long term play in this area. Again, at such depressed price levels, we think it may be the right time to move back into CMI, but again, as you allude to, the market in general may be too volatile for such a move. Really just depends at this point on each investors level of stomach acid.

Thanks.

2008 Nov 24 10:09 AM

[kotika98:]

we are in the middle of a serious recession here, and what matters is the balance sheet not the earnings! there was not a word on that in the article. funny isnt it given how many excellent companies are going down the drain because of stretched balance sheets.

(disclosure: i havent look at cummins balance sheet, it might be pristine but it is the thing anyone who wants to buy the stock must look at)

2008 Dec 30 10:53 AM