Cummins Inc.: Undervalued Stock With High Growth Potential

| About: Cummins Inc. (CMI)
This article is now exclusive for PRO subscribers.

Cummins Inc. (NYSE:CMI) is one of the leading companies in the designing, manufacturing and distribution of diesel and natural gas engines and engine-related components. The company serves customers around the globe through its four operating segments: engine, components, power generation and distribution. The company has finished its FY 2013 and reported its Q4 FY 2013 financial results last week beating consensus estimates. Therefore, I will determine the major performance drivers of the company along with its future outlook to assess investment opportunities in the company's stock.

Major Performance Driver- By Segment and Geography

Source: CMI Q4 Earnings Release

The first pie chart above shows that the company generated 47% of its total revenue from its engine segment during FY 2013. The remaining three segments operated by the company are also dependent upon the sales of the company's engine segment. This is because they provide complimentary products and services to the engines supplied by the company. Overall, all four of the company's segments serve the same industry. I will discuss this below as I determine the industry outlook for the company.

From the second pie chart, you can see that the company earned 52% of its total revenue during FY 2013 from the US and Canada. Therefore, while determining the industry outlook for the company, I will focus more on the industry outlook in this major revenue generating geographic region.

Before determining the future outlook of the company, with respect to the industry and geographic regions it operates in, let us analyze the historic performance of the company's major revenue driving segment: engine.

Engine Segment's Historical Performance

Source: CMI Q4 Earnings Release

The charts above show that the segment has recorded a decline in its sales and EBIT performance during FY 2013 compared to FY 2011 and FY 2012, but the company is optimistic about the recovery of its sales and EBIT during FY 2014. I will determine the viability of these forecasts for FY 2014 later on while discussing the industry outlook. Before that, let us check some metrics that contributed to the decline in the segment's performance during FY 2013.

Source: CMI 10K and Earnings Release

The table above shows that the company's engine segment generated a majority (62%) of its revenue from on-highway products sales during FY 2013. Although on-highway has recorded an increase in its contribution to the segment's total sales, it also recorded a 2% decline in its sales revenue during FY 2013. Within the on-highway market, the majority (44%) of sales were generated from heavy duty truck engine sales that declined by 9% during FY 2013 in comparison to FY 2012. Basically, the fall in sales in the heavy-duty truck market caused a major decline in the overall engine segment sales. Another major contributor to the decline in the segment's revenue is sales to industrial markets that recorded a 7% decrease in sales revenue of FY 2013 and a 16% fall in FY 2012. Sales to the industrial market generated 30% of the segment's revenue during FY 2013. I will determine the future prospects of the company in these two main markets in the industry outlook analysis below.

Industry Outlook

Source: CMI Q4 Earnings Release

You can revisit the sales mix of the company's engine segment in the pie chart above. This indicates that the sales of the company's engine segment are more dependent upon the US/Canadian markets for heavy-duty trucks. Additionally, the revenue generated from the industrial market comprises dealings in mining, marine, oil and gas and construction industries. Therefore, the prospects of these industries and markets in North America will be my main focus while determining the industry outlook for the company.

Demand for Heavy-Duty Trucks in North America

Source: CMI Q4 Earnings Release

The company expects its heavy-duty truck revenue to rise by 6% and shipments to rise by 5% during FY 2014. The table above shows that the company has forecasted an 8% rise in the market size of heavy-duty trucks in FY 2014 compared to FY 2013. Macro trends such as business growth and improvements in consumer demand and sentiment will drive strong growth opportunities for the company in North America.

The North American heavy-duty truck market has been disclosing indicators of recovery for the past several months. The class 8 truck orders exceeded the 30,000 mark for the second consecutive month in January 2014 and for the first time since 2006 according to initial data released by FTR and ACT Research. ACT reported that Class 8 orders rose 9% from December 2013 and were up 51% from the same month in 2013.These orders were beyond expectations and were regarded as a positive sign for the industry, reflecting more confidence among fleets in the economy and freight availability. Paccar Inc. (PCAR) is one of the major customers of Cummins and reported record revenues in its latest reported quarter due to the upswing in U.S. truck demand. Paccar forecasts it will sell 21,000-240,000 Class 8 trucks during its FY 2014 indicating the room for Cummins' upcoming growth.

North America Mining, Marine, Oil and Gas, and Construction Markets

The company expects its industrial revenue to remain flat during FY 2014 driven by weakness in the mining industry and partly offset by improved demand in commercial marine markets. While the mining industry is not seen recovering materially during 2014, there are positive outlooks for the oil and gas and construction industries.

The oil companies that previously operated as gas companies have now started arranging their drilling programs for the years 2014-2016. As a result, North America will begin creating growth opportunities for the oil and gas industry and its suppliers, such as Cummins during 2014.

The American Institute of Architects forecast spending on non-residential construction projects is expected to shore up to 7.2% in 2014 after logging a 5% increase during 2013. This growth will be on the back of higher construction of commercial facilities, predominantly for hotels, followed by industrial construction spending. Additionally, North America's residential housing sector is also showing signs of improvement.

2014 Guidance and My Decree

Source: CMI Q4 Earnings Release

The company has projected a 4-6% rise in its sales from its engine segment for FY 2014 and double-digit 10.5-11.5% growth in its EPS. As a whole, the company expects a 4-8% rise in its consolidated revenues for FY 2014, and its EPS is expected to increase by 12.75-13.25% as shown in the chart above. I believe the company will achieve these growth rates, as the outlook for the major revenue drivers I discussed in my analysis is quite supportive.

Despite performing above the industry average in terms of 3-year compound average revenue and net income growth, the company's stock is undervalued with a P/E ratio of 17.6 times compared to the 20.4 industry average. The company has a 3-year average compound annual revenue growth rate of 17.1% that is well above the industry average of 3.9%. The company's 3-year average compound annual net income growth is 56.6% beating the industry average of 7.6%. Therefore, investing in the company's stock is a worthwhile decision.

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

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article