Update August 17, 2016. New rules proposed by the Obama administration that would require up to a 25% reduction in carbon emissions from heavy-duty trucks over the next 10 years are good news in the long run for Cummins (CMI.) The proposed rules are 10% tougher than the rules put forward for public comment last year.
The rules mean that Cummins will eventually sell a lot more of its low emissions, high efficiency truck engines as truck makers and truck operators move to meet these standards. (The new standards won’t be implemented, in all probability if Donald Trump wins the presidential election since he has promised a big reduction in government and especially environmental regulation. They will be implemented if Hillary Clinton wins. Figure the odds on victory by either candidate into your investment analysis.)
Cummins has made developing products to meet what it sees as a global trend toward energy efficiency and emissions reductions in trucks. That approach is the leading wedge for the company’s drive to increase market share in China and in India, for example. Designing engines for lower emissions and greater fuel efficient without giving up the power to pull big loads isn’t a trivial task. Cummins has not only continued to invest in research and development–with new products such as natural gas powered engines and a plug-in hybrid coming to market now–but it has organized itself in a way that most competitors can’t match. It’s a lot easier to implement these strategies in an engine if you make all the pieces–including the turbo chargers that let more fuel efficient engines deliver needed power. Many of Cummins’ competitors buy these components–often from Cummins. (Caterpillar (CAT), for example, has decided not to invest in the R&D necessary to meet increasingly tough standards from the Environmental Protection Agency. Caterpillar, which a decade ago had a 35% share of the North American market now has an effective market share of zero.) Cummins makes them all in house and gets to design and fine-tune turbocharger and after-treatment engine systems itself.
All these are reasons to expect that–in the long run–Cummins will continue to gain market share–it owns a 40% share of the North American heavy-duty truck engine market and 73% of the market for medium-duty engines. And all this is the reason that Cummins is a member of my long-term 50 Stocks portfolio. (The shares are up 14.39%, as of the close on August 17, since I added them to this portfolio on May 3, 2013.)
But–and it’s an important “but”– in the near term, the big challenge facing Cummins and the one that will determine its near-term share price is how the company manages the current cycle downturn in the truck market. You could see the challenges clearly in the second quarter earnings reported on August 2. Revenue of $4.5 billion fell 10% year over year on lower truck sales in North America. Total units sold came in at 140,000 against 153,000 in the second quarter of 2015. On the lower revenue and unit sales, gross margin dropped to 12.6% versus 14.3% in the second quarter of 2015.
In its post earnings conference call Cummins clearly forecast that the down leg of this cycle will continue for the rest of 2016. For the full 2016 year, the company said sales will fall 8% to 10%–that’s worse than the 5% to 9% drop the company had forecast earlier. But the company also believes that it can find further cost reductions to support earnings and margins. (Cummins kept its EBIT–earnings before interest and taxes–margin forecast at 11.6% to 12.2% for 2016. Some longer term trends also work in the company’s favor in this down cycle. The growth of the company’s components business means that it’s getting a significant hunk of revenue–22%–from a business that carries higher margins than the core truck engine business. Cummins projects that component sales will fall just 6% to 9% in 2016 and that margins will be 12.75% to 13.75%. The push into international markets also helps with the company now forecasting 9% growth and 10% growth in sales in China and India, respectively. (Sales in Latin America, especially Brazil, continue to show weakness.) And finally, investing in improved production is paying off concretely on the bottom line. Warrenty expenses as a percentage of sales have fallen to the lowest level in a decade.
For the quarter Cummins reported earnings of $2.40 a share, which beat Wall Street estimates of $2.16 a share. Revenue of $4.528 billion was above Wall Street projections of $4.449 billion.
The shares are up 43.75% year to date but are ahead only 1.99% for the last 12 months. That appreciation, however, has left the shares at a price-to-equity ratio of just 15.02. That’s modest, especially when you consider that the price-to-earnings ratios of cyclical stocks rise at the bottom of the cycle as earnings and revenue growth lag. On these numbers, I’d call Cummins a relative buy right now for my long-term portfolio on the belief that this company will effectively manage the down part of the truck cycle. I added the shares to my dividend portfolio back on October 12, 2015 because the shares carried an attractive yield of near 4%. The gains in the shares have sent that dividend yield down to 3.23%, which is still very attractive in the current market, particularly since the pay off from the shares seems secure. The price gain on the shares since that October add is 13.05% as of the close on August 17.