Cummins Cannot Cool Cash Flow Concern

| About: Cummins Inc. (CMI)

Cummins (NYSE: CMI) perhaps tried to mitigate the impact of its bad news Tuesday, but the market homed in on the core of the company's trouble. Cummins started its press release of July 10 with a statement about the raising of its dividend, which it said reflected confidence in the company's long-term prospects and its financial position. While it's true that a dividend hike is a way of communicating a confident outlook, the market values a company based on its future cash flows. Those came into question Tuesday, when Cummins significantly lowered its forecast for 2012. Thus the stock fell 8.9% shortly after the release hit the wire, despite the company's best effort to stave a decline.

I discussed my expectations for the industrial sector in a recent article entitled, 5 Industrials to Consider Selling. The five industrial sector securities highlighted in that report were General Electric (NYSE: GE), Caterpillar (NYSE: CAT), Emerson Electric (NYSE: EMR) and Honeywell (NYSE: HON). In retrospect, I might have included Cummins as well. I included the Industrial Select Sector SPDR (NYSE: XLI) though, on my view that the entire industrial sector should come under pressure. Cummins supported that argument this week with its news, because it attributed its issues to some of the same culprits we discussed.

Cummins said its disappointment was due to weakness in some markets due to slowing global economic growth. Most troubling to the broader market, Cummins said its U.S. order trends for trucks and power generation softened. Furthermore, where it previously expected improvement in Brazil, India and China, it was finding slowing growth. The relative appreciation of the U.S. dollar also worked against the company this past quarter.

The company pledged to manage costs and to stay focused on the funding of its critical growth programs. It continues to seek operating margin improvement. And of course, it raised its quarterly dividend by 25% to 50 cents. At the close of trading Tuesday, that would peg the company's dividend yield at 2.3%. It was a noble effort, but investors could not help but question if this would be the beginning of something more, the start of a negative trend.

I've been warning for months now that Europe would infect us, as 20% of our exports are sold into the critical region. And I said Europe would infect even the emerging market BRIC nations, as global ties remained important against domestic development therein. Cummins' result only raises my concern about the rest of the industrial sector, a good portion of which will have a similar message to share this quarter and moving forward.

Cummins said its revenue would more likely match those of 2011, rather than the 10% increase it had previously expected. Analysts had forecast revenue of $19.84 billion based on Yahoo Finance data, which would mark 9.9% growth over CMI's top line of $18.05 billion in 2011. Also, Cummins' second-quarter revenue was estimated by the company Tuesday to come in at $4.45 billion, against the average analysts' estimate of $5.07 billion.

Earnings estimates will now be revised downward, as unlike the stock price, those tend to adjust less than instantaneously. If the company earns what it did last year on a per share basis, at $9.07, then its P/E ratio is 9.6X. Analysts' five-year growth outlook was about 10.6% before this news broke. Assuming it drifts down to 10% now, then the company trades at a PEG ratio of roughly 1.0, based on these assumptions. That means the market price adjusting mechanism is well-oiled.

At this point, with the risk of a "second shoe" falling, something that often happens despite management confidence, I could not recommend the purchase of CMI. I'm not sure I would hold it either, but the PEG ratio we calculated here would justify it. Diversified portfolios might be better served looking to aerospace and defense or to stick with industrials serving energy and agriculture long term (not short term though), like Deere (NYSE: DE), for their industrial sector exposure. Iran remains on the horizon, and Boeing (NYSE: BA) continues to receive good news, most recently indirectly from Alcoa's (NYSE: AA) data. That said, eventually, aerospace would be impacted as well. While my view for agriculture remains favorable, I expect it would likewise suffer more immediately before recovering later.

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