Cummins Provides A 13% Upside To Investors

Aug.26.14 | About: Cummins Inc. (CMI)


Cummins' latest quarter brought double-digit growth in top line due to the healthy domestic market..

Improvement in international markets should help improve sales further.

Warranty cost control will bring better bottom-line figure in the future.

Multiple-based valuation gives a 13.6% upside potential.

Cummins Inc (NYSE:CMI) share value has gone up by 16% in one year. The company has emerged stronger than ever following an internal 10-year reinvention and is on way to profit from future emission standards. The outcome has been visible in the company's quarterly result. This is why many analysts, including me, have raised their price target for the firm.

In this article, I will take investors through the performance of Cummins' most recent quarter. After that I will discuss and quantify the future upside potential of the company.

Second Quarter

In its latest period, Cummins delivered a revenue figure of $4.8 billion. This was 7% higher than what the company reported during the second quarter of 2013. The raise was due to an increase in demand in on-highway markets, and the acquisition of distributors in North America. The distribution network is becoming extremely lucrative for Cummins as the acquisitions helped the company raise the distribution segment's revenue by 30% in the latest period.

The company is experiencing favorable operating climate in the home market as the economy improves. The reinvention has helped it expand in the recovering market. This could be witnessed from the growing market share of Cummins in medium-duty truck and bus markets.

However, revenues from international markets declined 1% due to lower revenues in Mexico, Brazil and India; however, partially offset by a better performance in China. I believe that the problems being faced in Mexico and Brazil are temporary. Mexico is one of the hottest markets at present. Mexico's aging trucks with an average vehicle age of 17.4 years is also another reason worth considering. The age implies that a significant replacement of the old trucks needs to be done. Future economic growth and improved credit availability are also expected to support growth in heavy commercial vehicle "HCV" demand over the next one year, taking the market to a new peak in 2015. Similar is the case with Brazil market which should improve too.

For the domestic market, Cummins' market share is 38% year-to-date. The market size is expected to increase by 15% this year. Moreover, shipments to the heavy-duty truck market exceeded 23,000 units in the second quarter, increasing by 11% from 2013 levels. The company's main advantage lies in the medium-truck market where it holds a domestic market share of 73%. This market share is 10% higher than what the company had in 2013. Cummins delivered almost 20,000 engines in the second quarter, 28% up as compared to the previous year. The market is expected to grow further by 9% for the year. This will help the company in generating more sales and increasing its market share further.

Moving forward, gross margin fell for the period by 10 bps as higher volumes, lower material and commodity costs, and improved distribution segment sales were offset by negative foreign currency and higher warranty costs. Nonetheless, these events weren't material and thus the overall profitability of the company sustained.

Higher compensation expense and costs related to acquisition brought a slight dent on the non-operating costs, as they also rose as a percentage of sales. The net result was earnings per share of $2.43, a 10.5% increase since the same quarter in the previous year. Overall, the company's top-line growth was healthy and should continue to do so by the improving environment in international markets as well as through the progress the company is already making in its domestic market.

Talking about the costs, I expect the warranty expense to fall in the future. Warranty expense was the main driver of the lower EBIT margin in the engines segment for Cummins during the past quarter. While the new products of Cummins are performing well and product failure rate is low, warranty costs on 2013 engines are higher due to higher average cost per repair. The higher average cost is driven by greater complexity in the engine systems, especially with the addition of on-board diagnostics.

It will take several quarters for the warranty rates to reflect the improvements the company is making to its engines. It's important to note that the warranty costs per engine on 2013 engines are still well below the cost of 2010 engines. This progress reaffirms my belief that Cummins will be able to reduce these costs even further the next year.

By using multiple-based valuation, I can quantify the upside potential Cummins has to offer on its stock. Based on the above model, Cummins offer an upside potential of 13.7% to the investors.

Bottom Line

Cummins is also working hard to increase shareholders value by following an aggressive share repurchases policy and increasing its dividend payouts. The company has committed to distribute 50% of its full-year operating cash flow to the investors through dividends and share repurchases. Recently, Cummins' directors approved a share repurchase program of $1 billion after the completion of the current $1 billion program. Besides, the company has also announced a 25% increase in dividend to 78 cents.

Healthy operations have allowed Cummins to raise its full-year revenue guidance to the range of 8-11% from the previous forecast of 6-10%. As markets continue to grow and improve, the company should see further increase in its top line. As for the costs, better warranty cost structure will bring in higher earnings figure for the next year. That being said, Cummins is a good investment to consider. It holds a buy rating.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.