Cummins: Regulations, The Economy And Aging Fleets Offer Upside

| About: Cummins Inc. (CMI)

In trucker lingo, clean-and-green means wide open roadways. For Cummins Inc. (NYSE:CMI), clean-and-green is a better description for how the government wants its engines to perform.

Those regulations, along with truck operators, appetite for more fuel efficient fleets, have forced Cummins to bump up research and development spending.

Investors hope those investments will soon pay off as operators - hungry to squeeze profits from fuel costs - replace aging equipment.

So far, R&D investments haven't translated into big bucks.

Cummins revenue has faltered against tough comparisons as the global truck market has shrunk. Sluggishness in China and Europe has resulted in lackluster medium and heavy duty truck sales, offsetting friendlier markets like Brazil.

But it's the United States that can truly move Cummins higher over the coming two years.

Despite its global reach, roughly 50% of Cummins business still comes from North America. And signs are starting to suggest an improving economy in the United States could spark a broader recovery in the trucking industry, supporting new truck demand.

So far, truck order growth has been hit-and-miss and driven predominately by replacing older, less fuel efficient fleets.

Generally, the industry has kept a lid on capital spending amid uncertainty surrounding GDP growth and new hours-of-service regulations set to kick in July 1st.

Those new hours-of-service rules reduce the maximum number of hours drivers can operate each week by as much as 12%.

If the rules go through as planned, pressure rises for operators to fill the capacity gap, especially since hours of service regulations are likely to add to - rather than solve -the trucker shortage.

It will also pave the way for truckers to open wallets and replace more of their fleet, rather than just "critical care" rigs.

This modernization is likely near a tipping point given the average truck is 6.6 years old - the high end of the typical refresh cycle. A bump in the form of confidence may be all that's necessary to jumpstart spending.

New heavy duty truck sales improved in April.

According to industry researcher ACT Research, Class 8 heavy duty truck orders increased 36% year-over-year in April to 23,200 units. That marked the second highest total in the past 16 months and a 7th consecutive month of more than 20,000 units ordered.

Those orders are likely to benefit from thinning cancellation rates. ACT reported cancellations dropped to the lowest level since Q3 2010 last month.

The low cancellation rate suggests truck sales growth is currently dominated by replacement orders. If so, there's plenty of room for the industry to expand capacity if the economy turns higher.

Operators would also benefit from an additional incentive. Cummins' more fuel efficient engines could add millions to large fleet operators' bottom line.

In mid March, Cummins revealed its latest line up of engines at the Mid America Trucking Show.

This included heavy duty engines capable of delivering 2% better fuel economy than 2012 models.

The company also claims its SmartTorque2 engine offers greater torque in the top gears, allowing drivers to operate at lower revolutions per minute ("RPMs"). That change could result in a 3-6% jump in fuel economy when paired with an Eaton (NYSE:ETN) transmission.

Outisde of big rigs, Cummins can also benefit from improving sales of trucks tied to construction spending.

In April, automakers reported pickup sales grew three times faster than the overall vehicle market.

This rebound comes as new home construction grew 29% from a year ago. Sales of the Dodge Ram pickup were up 49% in April from last year -- good news for Cummins which supplies Turbo Diesel engines for certain models.

If Cummins engine unit volume climbs thanks to higher rig and pickup sales the company could see operating margins improve. The company has been restructuring operations to reduce costs and reported record gross margins in 2012. In the most recent quarter, selling, administrative and research and development costs dropped $30 million from a year ago. All in, Cummins expects to produce EBIT of 11-12% of sales, up from 10.8% in 2012.

Cummins appears bullish on the remainder of 2013.

During the company's last conference call, Chairman and CEO N. Thomas Linebarger said "we do expect that the first quarter marks a low point for revenues this year, and we expect to see sequential improvement in revenues, driven most significantly by on-highway markets in North America, in which we have strong market share for engines and components, and by the construction market in North America."

The company's CFO, Patrick Ward, added, "we do expect sequential improvement in revenues beginning in the second quarter. And we think that will help provide a platform for improved margin performance, too, for the company throughout the remaining 3 quarters of the year."

Mr Ward also added, "it was encouraging to see that the performance both at gross margin level and in EBIT margin level improved month after month. So we started off the quarter close to 10%. We finished off the quarter close to 13%. So that made me feel good that we've got momentum going into the second quarter that can carry us forward toward this guidance."

Overall, tight truck capacity and growing tighter following regulations should put a floor underneath freight shipping spot rates. Improving trucker pricing power, a historically old current fleet and economic incentives tied to better fuel costs should boost engine sales through next year. If so, those higher unit volumes will help more money drop to earnings and support dividend growth.

As for timing, now has been a good time to pick up shares. According to data from the Seasonal Investor database, shares have moved higher in 8 of the past 10 years from June through August 31st.

Source: Seasonal Investor

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Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CMI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.