Tuesday, Cummins Inc. (CMI) provided an earnings surprise in its earnings release for the second quarter. CMI reported a profit of $464 million, which was 4.2% above market expectations. Revenues were in line with the $4.45M estimate. This figure was provided in the recently announced guidance, in which the outlook was slashed in accordance with softening demand from emerging markets. Another highlight of the release was the current gross margins of the company, which are at all time highs.
Press Release & July 10 Announcement
The reported revenues, even though in line with estimates, fell on a YoY basis. Same is the case for profits, which declined by 8.6% YoY. The company maintained the outlook that it had announced on July 10, i.e. $18 billion, with no growth YoY. The expected EBITDA margin for the year is between 14.25%-14.75%, revised after the previous guidance of 14.5%-15%. It was also lower than this quarter's EBITDA margin of 14.9%. The gross profits rose from 25.9% to 27.2%
On July 10, CMI decided to cut its future revenue figure in light of slower than expected growth in emerging economies like China, Brazil and India, which account for 35% of the company's current revenues. Earlier, the company had expected a 10% growth YoY leading to an amount near $20 billion, with $5.1 billion coming this quarter. However, after the revision, the annual and this quarter's revenues shrunk to $18 billion and $4.45 billion respectively.
The company operates in four segments, namely engine, components, power generation and international distribution segments. The engine segment manufactures natural gas and diesel engines. The components segment makes components for engine repair, which cater to the aftermarket. The power generation segment makes components for power generation systems, like switchgears. The distribution segment provides engine spare parts and service solutions.
Before discussing the percentage contribution of each segment, we have briefly touched upon the end markets for the company's products. Following shows the geographical representation of the company's revenues:
The chart shows that the company relies heavily on emerging markets for its sales.
China has clearly not grown at the rate expected by the market. The company's revenue from China fell by 25% YoY this quarter. CMI expects it to fall by 13%, revising it from an earlier figure of an 8% decline only. Sales of excavators, from which the company's engines derive their demand, also fell by 35% in China.
The Chinese GDP expanded by only 7.6% last quarter, less than the 8.1% in the previous quarter. Also, the exports' growth rates for the first half of the year declined to 9% from 24% in the last year's first half. The Chinese economy needs incremental investment to grow. Leaders are required to pace up the implementation of their expansionary policies, which can help get back the momentum at which the economy was running a couple of years back. However, the IMF is positive after the recent interest rate cuts by the government, and has given a growth rate forecast of 8% for the next quarter.
The Brazilian government is also working hard to pick the economic growth rate that has been damaged by last year's tightening of the monetary policy, done to achieve a growth-inflation balance. According to the IMF, Brazil's economy is expected to grow at 2.5% this year and 4% next year. For future growth, exports have to be triggered and consumption and investment have to be appropriately balanced. The FIFA 2014 World Cup and the 2016 Olympics will surely trigger the economy in the near future.
However, the North American truck market came as a savior, as the sales of heavy duty trucks rose by 16% YoY. Although, the company has still lowered its heavy and medium truck production forecasts for North America, China, India and Brazil.
Following shows the segment-wise revenue bifurcation of the company: (Click to enlarge)
Following shows the segment-wise performance of the company: (Click to enlarge)
Following shows the company's guidance for the year 2012:
The following points will help explain why margins for three of the four segments fell, and in which areas the segments saw growth, which was offset by the decline in other regions:
'Engines' gets 57% of its revenues from engines for light, medium and heavy trucks. It witnessed improved light, medium and heavy truck demand, and an improving construction market in North America, from where it gets 55% of its total revenue. However, this was offset by the slow Chinese construction market, and the slow Brazilian trucks market, as Chinese and Brazilian sales account for 20% of the total division's revenue.
With regards to 'components', CMI is the world's leading supplier of filtration and coolant products. Increased North American demand was offset by the falling European auto market, and the hobbling Chinese market.
In 'power generation', CMI has leading market shares in multiple geographies. Higher North American demand was offset by soft demands from Latin America, China and Europe. However, energy shortfalls will continue to be a problem in emerging economies.
'Distribution' is the only segment that saw a positive YoY growth for sales. This happened because of the strong service and parts market in North America, offset by the declining power generation business in Middle East, and weak demand in the North American oil & gas market. The sales of this division are the least cyclical, as compared to the other three.
The following shows the estimate versus actual figures for gross margins over eight straight quarters, and the overall trend of the margins. (Click to enlarge)
This quarter's margins were at record levels, which became possible since the company has been actively working to improve productivity and quality. CMI recently won the Supplier Quality Award from PACCAR (PCAR) for its brilliant performance in 2011.
The company has no debt-related problems. The gross margins are rising and the operating margins are stable. The end markets, even though showing stagnant or slow growth, are expected to recover in future. Also, the company has enough resources to survive through recession. The stock is currently trading at a P/E ratio of 9x. However, historically it has traded at a multiple of 13.5x, and having an annual earnings growth of 12.75%, using 2013 earnings, the stock is expected to be trading near $135.