Cummins: Beware Of The Value Trap Ahead Of Rough Times

| About: Cummins Inc. (CMI)

Shares of diesel engine manufacturer Cummins Inc. (CMI) fell 9% in yesterday's trading session, with the company surprising the broader equity markets in the afternoon after it lowered its full year outlook.

Guidance Cut

Halfway during the trading session, Cummins took the market by surprise. The company said that a strong dollar, coupled with softer demand in critical emerging markets, was impacting demand. CEO Linebarger noted that orders in the US for the company's trucks and power generation business had softened, and growth in China, India and Brazil came in lower than expected.

For 2012, Cummins expects full year revenues to be flat compared to 2011. Earlier this year, Cummins expected full year revenue growth of 10% vs. 2011's annual revenues of $18.0 billion. Second quarter revenue is now expected to come in at $4.45 billion, while analysts have been looking for quarterly revenues of $5.1 billion.

To soften the pain for shareholders, Cummins' board announced a 25% hike in its quarterly dividend to $0.50 per share. This provides investors with an annual dividend yield of roughly 2.3%. Strong operational cash flows and a lower debt position allow the company to pay structurally higher dividends, according to the company.

Industrial Sector

Cummins' warning signals put a drag on the entire industrial sector yesterday. Shares of Caterpillar (CAT) fell 3.5%, Joy Global (JOY) fell 5.5%, Deere (DE) fell 2.4%, Honeywell (HON) fell 2.7% and General Electric (GE) fell 2.2%. The profit warning of Cummins impacted the entire equity markets as well. The S&P 500 traded flat around lunch time, but ended the day down 11 points to 1,342 points. Markets were also impacted by news stories coming from the eurozone indicating that the German Constitutional Court might delay the approval of the eurozone's bailout fund.

Investment Thesis

Shares of Cummins have fallen by roughly a third to $87 per share after peaking at $130 in March of this year. Year to date, the shares trade roughly flat, after Cummins has been a long-term outperformer. Shares returned 65% over the last five years and shares have ten-folded over the last decade.

While the shares appear obviously cheap at 9 times annual earnings after a 33% drop in its share price, the company operates in a cyclical business. Revenues for 2013 could easily drop in case the global economy continues to slow down, and margin compression is to be anticipated. Beware of the "double-whammy" of lower revenues combined with margin compression.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.