Shares of engine-maker Cummins Inc. (NYSE:CMI) are up 40% this year on hopes for stronger sales related to the Navistar (NYSE:NAV) deal. While the deal will be a positive for revenue growth in 2014, a sluggish global economy may not support lofty expectations. Combine weakness in the macro environment with the possibility of rising labor costs around contract negotiations and investors may want to take some of their profits.
Flat sales growth is the good news
Much of the sentiment around the recent share price surge is due to a deal announced with Navistar earlier this month. Navistar plans to add the Cummins 6.7 liter engine in its international DuraStar medium-duty trucks as well as its CE Series school buses. Production for the medium-duty trucks is set to begin in December with school bus production set to begin in January 2014.
Revenue for the second quarter increased just 1.6% over the year ago comparable with North America jumping 7% against a drop of 4% in international revenue. Average selling price was down almost 10% as a mix to less-expensive smaller engines was only partially offset by an increase of 3.4% in volume sales. The company generates 60% of sales from its engine segment and 40% from power generation.
Management was able to increase its 2013 guidance, largely related to revenue from the Navistar deal, to flat growth for the year. The shares jumped almost 6% in the two days around the earnings announcement as investors had expected close to a 5% drop in sales for the year.
Labor could be an issue going into next year
A little more than a third (34%) of the 46,000 worldwide employees are represented by collective bargaining agreements, many of which will need to be renegotiated in 2014-2015. One of these groups, the Teamsters Local 519 in Knoxville, is currently on strike and preparing to renegotiate in 2014. The Cummins Crosspoint facility is the exclusive distributor of the company's products in the five-state territory of Illinois, Indiana, Kentucky, Tennessee and West Virginia.
Selling, general and administrative expenses make up the majority of operating costs, averaging almost 11% of sales and topping $1.9 billion last year. While overall growth has been week, the unions may look on the new Navistar deal as a sign that profits will be better and could ask for higher concessions. Whatever the ultimate outcome of labor talks, the shares could be volatile around negotiations.
A price premium and tough expectations
The shares trade for 17.9 times trailing earnings, well above their five-year average of 14.1 times but a slight discount to the industry average of 18.9 times earnings. The price-to-book valuation is much higher at 3.8 times compared to a five-year average of 3.0 times and an industry average of 2.9 times book value.
Contrary to the premium paid for the shares, operations are less profitable that industry peers. The operating margin of 11% is under the 14% industry average and the company earns just $0.08 for every dollar of sales.
Free cash flow almost halved in 2012, dropping $636 million in 2012 to $755 million on a $541 million decrease in cash from operations and an increase of $95 million in capital expenditures.
Analyst estimates are for $8.18 a share in earnings for 2013, increasing 21% to $9.86 for fiscal 2014. The strong earnings expectations are counter to flat sales growth this year and consensus for 9.5% sales growth to $19 billion in 2014.
Sales growth has averaged just 7.5% over the last four years and has been flat or down over the last two. In the current 2% GDP growth environment for the U.S. and a European economy that is just beginning to dig itself out of recession, I doubt that the company will make 9.5% sales growth next year. Even if the company were to meet expectations for top-line growth, it would have to manage a net margin of 9.6% to meet bottom-line expectations. While net margin has been strong over the last two years, averaging 9.8% for 2011-2012, the company's longer-term average is closer to 7.8% net of sales.
Modeling a growth in sales of 7% to $18.5 billion and a net margin of 8.5% yields $8.48 per share for 2014 earnings. This puts the shares flat at $135 over the next year assuming a price multiple around 16 times earnings.
Combine a global economy that will not support high expectations with possible margin weakness from higher labor costs and the shares just do not merit their current valuation. Long-term investors may want to take some profit off the table or hedge weakness by selling calls against their position. Selling the January 2015 calls with a strike of $135 protects you from a 12% drop while you still get to collect the quarterly dividend on the shares.