Cummins' Earnings Warning Suggests Industrials Likely Have 10%-15% Downside Risk

| About: Cummins Inc. (CMI)

There is nothing like a strong earnings warning from a major industrial company prior to earnings season to rattle the market. Cummins' (NYSE:CMI) recent earnings disclosure was far from new information to a market that has sold off fairly consistently since mid-April, but when a company takes earnings guidance down 10% in less than a couple months, it is still important.

Indeed, while the S&P 500 and its tracking exchange-traded fund SPY (NYSEARCA:SPY) have rallied over 20% from the market lows of last year -- and stocks such as Apple (NASDAQ:AAPL) are up over 30% this year alone -- Cummins' recent earnings warning suggests that the growth outlook has deteriorated significantly more than most traders and investors had expected.


Cummins' recent earnings warning should be most concerning for companies tied to the trucking industry, such as Eaton (NYSE:ETN) and Navistar (NYSE:NAV). However, the company's strong warning is also likely a sign that many leading industrial companies such as General Electric (NYSE:GE) and Caterpillar (NYSE:CAT) will face significant near-term headwinds as well, since the company's earnings warning comes after nearly two months of disappointing economic data in the U.S., Europe, and most emerging markets.

Cummins' industrial engine and equipment business are heavily levered to the trucking markets in North America, Europe, Brazil, and Asia, and the company gets around two-thirds of its revenues from outside the U.S. Cummins is the world's largest producer of diesel engines with over 200 horsepower.

If demand for new trucks and equipment is beginning to weaken significantly in North America and overseas, it is likely a strong sign that the overall trucking and transportation market has weakened significantly in the last couple months. The primary appeal of Cummins' products, industrial engines, is energy cost savings. The weakness Cummins is now seeing both in North America and abroad strongly suggests falling energy prices are likely impacting demand for new industrial products and equipment as well.

Cummins' management team has always been fairly conservative, and the fact that the company recently downgraded its outlook from 10% annual growth to zero obviously suggests that it has seen a significant and rapid deterioration in the growth outlook. Future earnings warnings are also likely. While declines in energy prices obviously affect energy producers such as Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) the most, if a strong dollar and weak growth outlook continue to put pressure on energy prices, falling oil and other commodity prices will also likely impact the cost savings companies such as Cummins and GE can offer. Falling commodity prices will likely weaken demand for new mining and industrial equipment from companies such as Caterpillar.

Even tough Cummins' engineering business is obviously significant different than the businesses of cyclical companies, such as GE and Caterpillar, Cummins' recent fourth-quarter and first-quarter earnings reports were remarkably similar to the earnings reports of many leading U.S. industrials. Cummins saw double-digit growth in its North American markets over the last year, even while new orders and sales growth deteriorated significantly in Europe and most emerging markets. The company expected strength in North America to continue to offset weakness abroad.

GE and Caterpillar both also saw significant recent sales growth in North America, and fairly limited to (in some cases) negative growth in Europe and most emerging markets. Both companies are heavily levered to demand for industrial equipment in the energy and infrastructure sectors.

Cummins is currently valued at around 9 times trailing earnings, and 7 times average current estimates for next year's likely earnings. However, earnings estimates for this year are likely to decline by 10%-15%, so the company is likely trading at around nine to 10 times this year's likely earnings -- despite the company's recent forecast for zero growth in 2012. A cyclical company that is seeing flat to negative earnings growth will likely trade at seven to eight times average estimates of next year's likely earnings, suggesting Cummins earnings are likely to be $10 a share and the stock is likely to trade around $75 a share in the near term.

To conclude, Cummins is one company, but this company's earnings warning is consistent with weakening economic data in the U.S., Europe, and most emerging markets. Companies such as GE and aviation companies like Boeing (NYSE:BA) tend to be on longer-term contracts, and these companies will likely sell off less than cyclical companies on short-term business cycles such as Cummins. Still, if the growth outlook continues to deteriorate at a moderate to significant pace, these stocks' multiples will contract. Cyclical companies on shorter-term cycles, such as Caterpillar, will likely trade at seven to eight times lowered earnings estimates for this year. Cyclical companies on longer-term cycles trade at eight to 10 times next year's lowered estimates, and today's valuations suggest many leading industrial companies are likely 10%-15% overvalued.

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