Cummins (CMI) is enjoying the last few quarters of this heavy-duty truck-driven cyclical peak, but management is already preparing for a downturn in 2020 that will almost certainly lead to one year (maybe two) of negative comps in revenue, EBITDA, and free cash flow. Ex-North America demand and other businesses like Power could help soften the blow, but cyclicality is just part of the story and something that long-term investors need to accept.
I think valuation on Cummins is pretty reasonable today, and I don’t see it as particularly over-valued or under-valued. Certainly there is a risk that end-market demand will correct to a “weaker for longer” cycle than currently expected, but my bigger concern is just how markets tend to treat cyclical stocks; Wall Street is obsessed with growth and Cummins shares may well lag when the reality of the cycle starts showing up in the numbers, even though everybody knows it’s a cyclical company that goes through its ups and downs and still manages to generate strong cash flows and ROICs across the cycle.
Getting Strapped In For The Downswing
There’s no question that the heavy duty truck cycle in North America is rolling over. While production levels remain robust, orders are plunging. May orders for Class 8 trucks fell 70% year over year, with the lowest monthly volume in about two years. Medium-duty trucks fared a little better, but orders were still down 21% year over year.
This is just how it goes in this business, and nothing that Cummins hasn’t been through before. The company’s market share (the % of Class 8 trucks with Cummins engines) has pretty much stabilized in the mid-30%’s, with Navistar (NAV) and PACCAR (PCAR) using more Cummins engines (roughly 80% and 60% share, respectively), while Daimler (OTCPK:DMLRY) and Volvo (OTCPK:VOLVY) make much greater use of vertical integration and in-sourcing (Cummins has a little less than 20% share w/ Daimler and less than 10% share with Volvo).
With trucking spot rates on the way down, due somewhat to slowing demand but also to increasing supply, I expect that the decline in production rates that will likely start in Q4’19 could last through 2021, even though I think spot trucking rates could find a floor this fall and start expanding again sometime around mid-2020. There will still be plenty of truck capacity to absorb, though, which is why I think the correction in Cummins’ engine business could persist through 2021.
In the meantime, Cummins should get some help from China. Cummins has low double-digit share in China’s Class 8 market, and the business should be boosted by new emissions regulations (NS VI), though Cummins recently guided to a longer implementation cycle (four years instead of two). Emissions-driven actions in India could also be a modest boost.
Still, I think Cummins’ core business is in okay shape. With North American heavy truck engine sales accounting for about 10% of overall revenue, there’s a bit of a “tail wagging the dog” factor with the market’s focus on this business, though to be fair the total revenue impact is more than 10% given that there are meaningful component sales tied to engines. Still, it’s a part of Cummins’ business, not the whole, and I think it is noteworthy that management has also been guiding toward less pressure from vertical integration. With truck OEMs seeing expanding research demands in areas like safety, automation, and other systems, devoting resources to internally-developed engines isn’t quite as appealing as it might have been a few years ago.
Time To Power Up?
Cummins’ Power Systems business has certainly slowed of late, with growth decelerating from 9% in Q4’18 to just barely positive in Q1’19 (and down 10% qoq), on weakening demand in oil/gas and mining. Weaker industrial demand is definitely a threat as oil/gas service companies are pulling in the reins on pressure pumping (which is also showing up in Kirby’s (KEX) DES business) and the mining cycle matures, and utility and back-up power demand is likewise not particularly strong.
Still, Cummins has some growth plans worth considering. Management recently provided an outlook at a sell-side conference for outgrowing its power end-markets by 4% to 5% a year on increased penetration of its high-HP engines in markets like oil/gas, rail, and power gen. Relative to Caterpillar (CAT) and GE (GE), rail is arguably an overlooked market for Cummins, and the company recently signed a contract with Amtrak for locomotive engines.
I also believe Cummins could look outside the business for growth opportunities. Volkswagen (OTCPK:VWAGY) is shopping its MAN Energy Solutions business, and I believe Cummins could be a buyer. MAN is primarily a manufacturer of high-HP engines, with about half of its revenue coming from marine markets (2-stroke and 4-stroke engines). Another third or so of the business is in power generation applications. I’m not sure analysts would be excited about Cummins entering the marine engine market, but MAN would upgrade Cummins’ high-HP capabilities and further diversify the company away from North American trucks.
No Urgency In EVs
The EV debate around Cummins seems to have quieted for now, as investors accept the idea that while there will be some (relatively) near-term threats in areas like medium-duty trucks, the ramp-up of electrical commercial trucks will take a long time and is likely a multi-decade process for Cummins’ core long-haul trucking end-markets. I expect this to be a volatile factor in the stock price, with analysts and investors periodically freaking out and then calming down about it as companies announce various pilot commercial truck EV programs.
I also expect Cummins to continue to invest in and develop its EV systems opportunities. Cummins isn’t going to be a battery maker, but it is working on battery management systems, pack development, and so on, as well as power electronics, motors, generators, powertrain components, and so on. I have some minor concerns that Cummins hasn’t done more in the area of commercial-grade traction motors, but given the limited near-term market, there’s plenty of here.
I expect Cummins to see some revenue shrinkage over the next three years (on a CAGR basis), but I expect growth to re-accelerate on a five-year and 10-year basis. Likewise, I expect EBITDA and EBITDA margins to come under pressure in 2020/2021 before re-accelerating. If Cummins can generate mid-single-digit long-term FCF growth, I think the shares are priced for a high single-digit return today. Using my margin-driven EV/revenue approach, I think fair value for Cummins is in the $160’s to the low/mid-$170’s; the higher end of the range is based on Cummins’ likely 2019 EBITDA margin, while the lower end is driven by looking ahead to what EBITDA margins are likely to be over the next 18-24 months.
The Bottom Line
Investors seem to forget that Cummins is cyclical, and I think there could be opportunities to pick up shares at better valuations during the upcoming downturn. Cummins isn’t a bad stock now, but buying ahead of a cyclical downturn is a tough way to find alpha, particularly when the valuation doesn’t look particularly distressed.
Disclosure: I/we 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.