For a market that got very nervous very quickly about industrial companies, particularly those with sizable emerging market exposure, Cummins (CMI) is actually faring quite well. Investors seemed encouraged by the company's recent quarterly report, as well as a big (albeit not totally unexpected) win with Navistar (NAV). The question I have is whether Cummins, for all of its great qualities as a company, is still a bit too popular for investors' long-term good.
Margin Fears Eased by Q2 Numbers?
When Cummins warned about the second quarter on July 10, the stock plunged and accelerated what had been a generally downward trend since the spring. Not only were investors concerned about the relatively obvious sluggish revenue performance that management predicted, but also whether the company would be able to maintain margins in the absence of revenue momentum.
Based on second-quarter results, it looks as if Cummins is backing up its reputation as a quality company -- the numbers were disappointing relative to initial expectations, but solid relative to the company's own warning and shares have recovered meaningfully. While there was weakness in light- and medium-duty engines, the company did alright in heavy duty and, though weaker than Caterpillar (CAT), was surprisingly solid in stationary power. Best of all, however, were the margins -- operating margins did weaken, but not as badly as feared, and management guidance was fairly constructive here.
Some Good News, but Plenty of Bad News
Outside of earnings, there's still a lot of conflicting information for investors to process. News that Cummins will supply Navistar with urea-based emissions after-treatment components is a welcome, albeit not completely unexpected, development. Word that Navistar will also offer Cummins ISX15 engines on certain models is a more surprising positive, and one that backs up the value and quality proposition that Cummins offers OEMs.
It's not all good news, though. July Class 8 orders were pretty miserable, down 31% from last year and down almost one-quarter from June. At the same time, data from China continues to worsen: While reported half-year truck sales declined about 7% in the first half according to government data, individual companies have been talking about declines more on the order of 15%-30%. Along those same lines, companies that serve that market like Cummins, Caterpillar, Eaton (ETN), Volvo (VOLVY.PK), and Komatsu (KMTUY.PK) have been walking back their expectations for the full year.
It's also not just about China or the next year, either. With almost 30% emerging market exposure, Cummins could be vulnerable to that "trees don't grow to the sky" phenomenon; China, India, and Brazil are going to be major customers for years to come, but the pace of growth is going to slow if for no other reason than the rapidly increasing base (the denominator).
The Bottom Line
Navistar's failed attempt to go its own way with a new engine and different emissions treatment technology highlights just how difficult it can be to migrate away from Cummins; even Daimler, which bought Detroit Diesel years ago, continues to use Cummins in some products. That bodes well for Cummins keeping a lot of what it has, as well as winning business with the fast-growing domestic heavy equipment companies in emerging markets.
I still worry, though, that investors expect too much. Right now, the average sell-side revenue number for 2014 calls for 12% growth from 2013 (which is about 7% higher than the 2012 number). Moreover, even those analysts who are neutral on the stock seem to be more concerned about near-term momentum and sentiment than long-term growth. For a company that has already enjoyed an impressive run of performance, and one where OEMs are still often looking to substitute their own internally developed engines and components, that's a lot of optimism.
That said, I'd still be happy to own Cummins at the right price. That recent drop below $90 was very close to the "right price" and I fear I may regret not pouncing when I had the chance. With my own forward free cash flow growth estimate of about 6% (and a resulting fair value between $115 and $120), today's price is not quite enough to get me excited, but a summer malaise could once again make this an interesting -- albeit risky -- buy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.