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We have, for some time now, been pressing that although the market is rising, the Dow Jones Transportation Index has lost its momentum, and has remained stagnant; therefore, clearly violating the Dow Theory and displaying bearish divergence. This has already become evident, as industrial stocks have recently slashed their forecasted profits and revenues for the next couple of years.

Cummins (CMI)

Yesterday was another such day, as the stocks of heavy machinery manufacturers slipped after market as Cummins reduced its guidance, as its sees a weakening economy ahead. The company reported that demand in North America and China for heavy duty trucks is falling. Also, a significant decline is expected in the international power generation markets in the near future. The company, in its last earnings release, made 52% and 14% of its revenues from the engine and power generation segments.

However, CMI is also taking cost management actions by implementing planned work week reductions and shutting down some of its non-core manufacturing facilities. According to the new plan, CMI has targeted to reduce its workforce by 1,000-1,500 workers by the end of this year.

What worries us is the fact that this is the second time in a passage of three months that CMI has cut its revenue guidance. The company, which had earlier expected to earn flat revenues of $18 billion this year, now expects to earn only $17 billion, thus signifying a 6% annual decline. Margins are also expected to be 13.5% rather than 14.25%-14.75%. Not only this, the company also expects a decline in this quarter from $4.4 billion to $4.1 billion. EBIT margin is now expected to be 12%, rather than sell-side expectations of 14.1%.

The stock is trading at cheap valuations. The company's forward P/E of 7x is well below its historic P/E of 13.5x. Given the EPS expectations of $9 by the end of this year, the stock is expected to be trading at $122 by the end of this year. The good news for investors is that the market is expecting that the truck market in Brazil has bottomed. CMI gets 11% of its revenues from that region. The next earnings release on October 30 will be an important catalyst. Also, truck data to be released in the first ten days of November will also give some idea about the progress of the truck market.

Paccar Inc (PCAR)

The truck manufacturer sent bearish signals to the market when it announced a slash in its production guidance for Europe and North America last month. The company cited economic weakness as the main reason.

PCAR announced that it will cut its production levels by 15%-20% in North America and Europe in this quarter on a YoY basis. The production cut for North America had already been announced by the company earlier in its earnings release in July. The slash regarding European operations did not come as a surprise, as the market already expects weak European stats for at least another couple of years.

CMI's announcement also sent PCAR's stock down by 3%. 60% of PCAR's revenues come from U.S. operations. Therefore, a weakening North American market is expected to hit the company's sales.

PCAR is renowned for surviving tough times. It very cleverly exploited Navistar's (NAV) disastrous engine policy and sent NAV's market share from 25% to 15% in Class 8 trucks. PCAR is trading at a forward P/E of 11x, which is less than one-fourth of its historic P/E of 48x. With a solid dividend yield of 1.9%, the stock is expected to go up, as the trucking environment improves in North America and Europe.

Deere (DE) and Caterpillar (CAT)

Deere, the world's largest manufacturer of tractors and harvesters, also felt the impact of CMI's announcement, as the company's stock slipped by 1%. However, it was not because of its exposure to agricultural machinery, but rather due to its operations in machinery used for construction purposes. The company makes 17% of its total revenues through its bulldozers, land movers and other heavy duty equipment used for mining. Also, the company makes more than 50% of its revenues from North America, which means that a weak economy will lead to lower sales for the future.

Caterpillar, the barometer for global mining and construction work, got a hit as well when CMI announced that it expects a decline in future mining revenues. This was the second warning in one month, when CAT itself announced in MINExpo that mining cycle is playing at its peak, and the mining CAPEX is expected to come down by 14% through 2014.

Conclusion

September's Cass Freight Index declined by 3.8% YoY. Also the Class 8 truck orders fell by 34%, according to ACT research. These declines paint a pretty ugly picture of the current situation. However, much of the expected decline has been priced in the stocks. CMI, CAT, DE and PCAR were not the only stocks that were affected. NAV, Terex (TEX), and the auto-parts manufacturers Eaton Corp (ETN) and Illinois Tool Works (IWT), also fell.

We recommend long positions in CAT, DE, PCAR and CMI for the short run, and will wait for the earnings season in order to see how the truck industry is moving, to determine long-term positions in the aforementioned stocks.

Source: 2 Major Industrial Stocks Have Cut Guidance But Remain Buys