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Summary

  • Investors are not too impressed with Cummins' results despite a raise of the full year sales guidance.
  • The weaker second quarter quality of earnings might be too blame.
  • Shares trade at multiples similar to the market despite being a cyclical player, although it has a solid track record.

Investors in Cummins (NYSE:CMI) were not too impressed with the firm's second quarter results and the hike in the full year sales guidance.

I guess that investors were disappointed with the quality of the second quarter earnings, even as reported earnings were in line. Cummins' earnings were aided by "other" gains, but would otherwise have come in lower compared to last year.

Second Quarter Highlights

For the second quarter of this year, Cummins posted net sales of $4.83 billion, a 6.9% increase compared to last year. Reported sales were in line with consensus estimates.

Reported net earnings attributable to investors came in at $446 million, a 7.7% improvement on the year before. Thanks to modest share repurchases over the past year, earnings per share grew even a little faster.

On a diluted basis, earnings improved by twenty-three cents to $2.43 per share. This implied that reported earnings beat consensus estimates by five cents.

Looking Into The Quarter

CEO Tom Linebarger sees demand in the on-highway segment growing in North America amidst a growing and improving economy, as well as market share gains in medium duty truck and bus markets.

As seen above, Cummins posted nearly 7% topline sales growth while gross margins of 25.4% were down just 10 basis points on the year before. Reported operating earnings of 12.7% of sales were down by 80 basis points. This was due to higher selling, general and administrative expenses in particular.

The fact that reported earnings were up was largely thanks to a $39 million gain reported in "other" income. Without this item, earnings would have been down a tiny bit compared to last year.

In terms of segments, it was the distribution segment which showed the quickest pace of growth. Sales grew by 30% to $1.2 billion, yet growth was largely driven by acquisitions, as sales were up by just 2% excluding the impact from these deal. Reported operating margins fell by 30 basis points to 10.2% of sales.

The component business posted sales growth of 15% with revenues increasing towards $1.3 billion. Strong market conditions in North America, Europe as well as China were driving the results as operating margins improved by 230 basis points to 14.5% of sales.

The company's largest engine segment posted sales of $2.7 billion which was up by 3% compared to last year. Weakness in the power generation, as well as a weak Brazilian truck market impacted operating margins which compressed by 150 basis points to 11.3% of sales.

The power generation business, which is the smallest unit of Cummins reported a 9% drop in sales towards $743 million. Despite the aggressive fall in topline sales, margin contraction was limited to 110 basis points with earnings falling to 8.2% of sales. Weak conditions in North America as well as the Asia-Pacific and Middle-Eastern region are too blame.

Valuing Cummins

At the end of the quarter, Cummins held about $2.4 billion in cash, equivalents and marketable securities. The company has $1.7 billion in total loans outstanding as well as certain other claims.

Pensions, accrued benefits and retirement costs total about $1 billion while the company has some outstanding liabilities related to product warranties as well.

On a trailing basis, Cummins has now posted sales of $18 billion on which it net earned about $1.6 billion. With 183 million shares outstanding and share trading at about $145 per share, equity in the business is valued at roughly $26.5 billion. This values equity in Cummins at 1.5 times annual sales and 16-17 times railing earnings.

Based on the first two quarters of this year, Cummins forecasts full year revenues to be up between 8 and 11% from last year, which implies annual revenues are foreseen around $19 billion this year. Previously the company anticipated sales to grow between 6 and 10%. Operating earnings are seen between 12.75 and 13.25% of sales, resulting in operating earnings of about $2.5 billion.

Cyclical Player, With A Solid Past Performance

Over the past decade, Cummins has more than doubled its annual sales from $8.4 billion in 2004 to an anticipated $19 billion this year. The company's earnings have grown much quicker, increasing from $350 million to an anticipated $1.6 billion or so this year.

Despite these impressive results, the company remains very much a cyclical stock, posting a 25% drop in annual sales for the year of 2009, while it managed to continue to report profits even in this difficult year.

The company managed to grow the business without diluting the overall shareholder base over this time period. Recently it is more aggressive in returning cash to its investors in order to reduce the outstanding share float.

This was manifested in a new $1 billion share repurchase program which is sufficient to retire nearly 4% of the outstanding share base.

Final Takeaway

So while the headline results of the manufacturer of diesel and natural gas engines appear nice, note that revenues were aided by acquisitions while the earnings growth resulted from "other" items without being specified in the press release.

As such investors are discounting the raised sales guidance for the year, after the company previously anticipated sales to grow between 6 and 10%. Excluding the acquisitions in the distribution segments, overall sales growth would have been close to flat for the quarter.

Just two weeks ago, I last checked upon Cummins' prospects following a downgrade released by analysts at Goldman Sachs as well as after the announcement of the nearly 25% dividend hike and the $1 billion share repurchase program.

At the time I concluded that shares were not very appealing at 18 times earnings, as revenue growth was not very strong, while the company remains inherently cyclical. While the guidance for accelerating growth in2014 is impressive, it is aided by acquisitions while the quality of earnings is a bit disappointing. As such, I am a bit cautious given the at-market valuation, despite displaying some cyclicality. I do applaud the company's strong financial position, but all in all the real appeal is not visible yet at current levels.

As such I don't believe that Monday's correction does not automatically translates into a buying opportunity.

Source: Cummins - Investors Are Not Impressed With Second Quarter Earnings Quality