Cummins Getting A Lot Of Benefit Of The Doubt

| About: Cummins Inc. (CMI)
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With the stock up almost 40% from its October 2012 lows and less than 10% from its 52-week high, it seems safe to say that investors are feeling pretty good about Cummins' (NYSE:CMI) recovery prospects. Though I have little doubt that anything is changing in regards to the company's top-notch quality, I do wonder if investors are too quick to assume that emerging market growth is just going to go back to where it was. I would love to accumulate these shares at attractive prices, but today's valuation already assumes a pretty optimistic scenario.

Q4 Earnings Show A Tough Environment, But Ongoing Improvement

Given prior reports from companies, including Honeywell (NYSE:HON), Eaton (NYSE:ETN), Volvo (OTCPK:VOLVY), and Caterpillar (NYSE:CAT), there was no reason to expect a great quarter from Cummins. While Cummins did indeed see significant contraction this quarter, I think there's an upside to this downturn.

Revenue fell 13% this quarter, which was meaningfully better than expected as Cummins beat the average estimate by about 5%. Engine revenue fell 18% this quarter, with heavy duty engines down 30% - more than offsetting the 15% growth in light duty engine sales and the slight (4%) decline in medium-duty. Power gen and components were also weak, down 17% and 14%, respectively, while the distribution business saw 9% growth.

Where Cummins really impressed me was on the margins - this may not mark the low point for this cycle, but Cummins has managed to maintain significantly better margins on the way down than in prior cycles. Gross margin fell about a half-point from last year, while operating income dropped 30%. Segment EBIT was down 19%, though, with segment margins down only about one point.

Management Still In The Bunker

While investors seem to be of the opinion that the worst of the global truck market is in sight, Cummins management is still being cautious with business and guidance.

To that end, the Street seemed to shrug off their guidance that revenue in 2013 would be flat at best compared to 2012 and down as much as 5% (against an average expectation of 3% growth). More positively, management pointed to an EBIT margin of 13% to 14%, which would make for a very strong trough result. Investors should also note that the company cut its inventory by $300 million on a sequential basis.

I can see why management is being cautious. None of the major comparables/peers - Caterpillar, Eaton, Honeywell, Illinois Tool Works (NYSE:ITW), Volvo - have been eager to stretch their necks out and call for a quick turnaround in 2013, though most seem to think we'll see signs of progress later in the year. To that end, while Brazil has been looking stronger of late, heavy duty truck orders in China have still looked a little sketchy.

One of the big potential unknowns for 2013 would seem to be the company's business with Navistar (NYSE:NAV). Navistar will be using Cummins 15-liter engines and Cummins SCR technology in its 11-liter and 13-liter engines starting this year. That could be worth several hundreds of millions of dollars to Cummins, but there's a catch - how much of Navistar's share gains will come from customers like Daimler or Volvo where Cummins has relatively lower share and how much will come from bigger Cummins customers?

Will Emerging Market Growth Just Go Back To Where It Was?

Cummins' management has remained pretty consistent and patient in their view that the company still has ample opportunity to benefit from emerging market growth. By virtue of its many joint ventures around the world and strong share in markets like India (where it is a major supplier to Tata (NYSE:TTM)), that seems reasonable, but I'd be careful about just extrapolating past results into the future.

It's true that Chinese OEMs are gaining a better reputation around the world and becoming increasingly viable players (particularly in other emerging markets). And many of these emerging Chinese exporters use Cummins engines and hydraulics/components from other top-tier American suppliers like Parker-Hannifin (NYSE:PH), Eaton, and Honeywell. By the same token, domestic manufacturers like China Yuchai (NYSE:CYD) are working hard to close the gap with imports and are often willing to take lower prices in the hopes of building long-term relationships.

There are also some inherent challenges and risks to the nature of the company's joint ventures. In India, for instance, a lot of the company's market growth has been eaten back by adverse currency moves. A better example comes from China where Cummins' JV partner Dongfeng has formed a partnership with Volvo to build trucks and engines. While this agreement doesn't replace the Cummins-Dongfeng tie-up and it will likely be years before it's a real threat, I think it's hard to make the argument that this arrangement helps Cummins (unless they struggle to develop effective/efficient engines and must eventually turn to Cummins).

Last and not least, don't forget the law of large(r) numbers. It's true that more and more cargo is moving around China, India, and Brazil and that that cargo requires trucks to carry it. Eventually, though, the big buying surge is going to abate and these markets are likely to settle into the predictably unpredictable cyclicality that we see in North America and Europe. I do think we're a fair distance from that point, but it concerns me that very few analysts publicly discuss the reality that China, India, and Brazil are not just bottomless pits of heavy industrial equipment demand.

Growth Is The Big Unknown

Cummins runs a highly focused business, and management seems to have no particular inclinations to change that through large M&A deals. That would ordinarily simplify the process of projecting Cummins' growth rate, but the markets Cummins serve are so deeply cyclical that all you can really do is come up with scenarios and weigh them against present valuation.

For instance, management has talked about a goal of $30 billion in revenue and 15% operating margins, but when the company hits those targets, it has pretty dramatic implications for value. If it takes almost 10 years, Cummins would be looking at a revenue growth rate of around 5% (against a trailing 10-year rate of 12%) and possibly a free cash flow growth rate of 14%. That works out to a target of about $119.

Assume that Cummins gets there in 2020, though, and the growth rates increase to about 7% and 16%, respectively, and the target increases to $135. Get even more aggressive, say a target date of 2018, and the growth rates work out to almost 9% and 17% and the fair value goes north of $154 per share.

The Bottom Line

I like the Cummins business a lot and that leads me to be a little more careful about projecting strong growth rates just to validate a decision to buy the stock at these levels. As a result, I'm most inclined to go with a fair value estimate in the $120's - splitting the difference between the first two growth scenarios. Even there I may be underestimating the company's ability to improve its free cash flow generation, but I would also observe that this is still a cyclical business and one that still has a relatively lackluster record of translating revenue into free cash flow.

If you're strongly bullish on the prospects for a near-term improvement in emerging markets and/or improving North American truck orders, it's certainly possible to make the argument for buying these shares today. I think investors have overshot with this recent upswing in the markets, though, and I will hold out in the hopes of getting these shares at a better price a little later.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.