Underestimate Cummins (CMI) at your own risk. Although there has been plenty of talk about how tough conditions in Europe and China's inflation fears will lead heavy machinery demand to stagnate, companies like Caterpillar (CAT), Eaton (ETN), and PACCAR (PCAR) keep reporting an inconvenient truth that business is holding up pretty nicely. Much as I admit buying a cyclical industrial like Cummins at these levels makes me nervous, it's hard to argue with the performance and the potential.
A Mostly Solid Fourth Quarter
All in all, Cummins handily surpassed analyst expectations for the quarter. Revenue rose 19% (and 6% sequentially) and beat the average Wall Street guess by almost 5%. Growth was led by a very strong result in engines, where top-line growth was 23% and external growth was 25%. Components also did well, growing 19% this quarter. Power was the laggard, though, and up just 2% while distribution revenue rose 19%.
Margins were basically fine. Gross margin did improve over last year (up 140bp), but slid (down 50bp) sequentially. Operating income followed a similar pattern - good annual growth and margin expansion (+27%, +80bp) on an adjusted basis, but a little softness sequentially (+4%, -20bp). Overall margins were hurt by incrementally lower profitability in both power gen and distribution.
Power Down, But Not Out
It's arguably a testament to Cummins' overall strength that the performance in its power business really needs to be explained. After all, the business still did grow this quarter. Still, the performance was weaker than that reported by rivals Caterpillar and Tognum.
The problem seems to be India. Cummins has a strong business selling power generators to India to supplement or compensate for inadequate utility power supplies, but sales softened this quarter and strength in markets like North American energy couldn't compensate. India's power grid isn't getting better overnight, though, so this looks every bit like just a momentary blip.
Setting A Higher Bar In Engines And Components
Cummins is cobbling some tough shoes to fill in the components space. BorgWarner (BWA) basically held its own in turbochargers, but Honeywell (HON) and Tenneco (TEN) have their work cut out in markets like turbocharging, fuel systems, and emissions.
When it comes to the engine business, conditions are still strong. There's nothing coming out of companies like Caterpillar, Joy Global (JOY), PACCAR, or Oshkosh (OSK) that really scares me about the medium/heavy truck or mining/energy sectors. Cummins did mention some weakness in Chinese construction demand, though, and that bears watching. Demand for on-the-road vehicles is still growing well in China, but plenty of investors are worried about whether Chinese's real estate bubble will pop and create some fallout.
The Bottom Line
In some respects the sort of growth that Cummins continues to deliver defies experience and common sense. Yet, that underestimates the extent to which commercial truck fleet replenishment/refreshment in North America and Europe was delayed by the credit crisis, not to mention the growth in construction and trucking in emerging markets like Brazil, India, and China.
I'm looking for Cummins to grow its revenue at a compound rate of a little more than 7% over the next five years along with further improvement in free cash flow conversion. Longer term, I'm looking for over 8% compound free cash flow growth through 2020. That's aggressive in my book, but achievable. It's also worth noting that while models usually show smooth trajectories, the reality is that there'll be at least one or two global economic slowdowns in the meantime.
Distill that all down and it means a target price more than 20% above today's price. Again, that seems bullish and ambitious given all of the worries about global deleveraging, growth, and so on, but if any company can do it, I think Cummins can. Consequently, this is still a name that I think is worth looking at as a candidate for purchase.