Modeling and assigning a fair value to Cummins (NYSE:CMI) is not a particularly easy task. It's hard to find a better company in the transportation components sector, not to mention the wider industrial sector as a whole. Through all of the cyclical ups and downs of the commercial vehicle market(s), Cummins almost always generates double-digit returns on invested capital and has managed to stay in the green with free cash flow.
So quality and ability to execute are not problems. What is the problem is estimating fair future growth rates. It seems hard to imagine that Cummins can match its trailing revenue growth rate of 12%, but countries like Brazil, China, and India are still seeing trucking operators building their fleets, while the move to natural gas could fuel demand not only for LNG/CNG engines, but also compression facilities and more equipment for the energy sector. Although I think the Street may be a little too optimistic on the free cash flow margin leverage Cummins can deliver, I'm increasingly thinking this is a good stock to own for the longer term.
Making The Best Of A Tough Environment
The global commercial vehicle market is still seeing some pretty stiff headwinds, but Cummins nevertheless managed to pull some top-line growth out of this quarter. With that, Cummins beat on the top line, more or less held the line on margins, and delivered a solid operating beat for the quarter.
SEE: Investors Already Thinking Recovery For Cummins
Revenue rose 2% as reported (and 15% on a sequential basis). The company's largest business segment, engines, saw revenue decline 7% as a 3% improvement in volume was offset by a 10% decline in price (largely due to mix). Vehicle engine revenue rose 5%, while industrial and stationary declined 11% and 37%, respectively. Power generation was down 11%, while components rose 8% and distribution revenue rose 20%.
Despite the higher volume in the engine business, gross margin declined more than one and a half points due in large part to a mix shift to smaller, lower horsepower engines. Cummins kept a lid on SG&A and R&D spending, though, and limited the operating income decline to 5% (and a one-point decline in operating margin).
SEE: A Look At Corporate Profit Margins
On the call, management wasn't terribly bullish. The North American Class 8 truck market is still pretty weak, though the inclusion of revenue from Navistar (NYSE:NAV) is helping. Likewise, the North American energy market may have bottomed, but it's not reversing quickly (and Cummins generates a meaningful amount of revenue from the engines that power frac units). Outside the U.S., management sees conditions in China as flat, India as worsening, and only Latin America showing many signs of improvement.
What Will Natural Gas Do For The Business?
One of the bigger long-term uncertainties is the impact that natural gas will have on Cummins' business. I'm not talking just about the companies joint venture with Westport (Nasdaq:WPRT) for natural-gas powered engines. Although I could see this JV gaining share from existing non-Cummins diesel engines (including Caterpillar (NYSE:CAT) and Daimler's Detroit Diesel), I don't necessarily see that as the major delta.
What could change is the demand for equipment that will feed natural gas engines. If natural gas-fueled engines catch on, there will be a need for more compression systems across the country, and Cummins products can power those. Likewise, more natural gas demand will likely lead to more natural gas exploration/production, and more demand for Cummins' products in the field.
The Bottom Line
Between excellent R&D capabilities in diesel engines, growing emphasis on emissions control and fuel efficiency, and potential in non-vehicle markets, it's not hard to be bullish about the prospects for Cummins. The key question is just how much bullishness is reasonable.
Generally speaking, growth slows as companies get larger. To that end, I don't believe Cummins can reproduce the 12% annual revenue growth of the past decade. Likewise, given that Cummins hasn't exceeded an 8% free cash flow margin in recent (10 years) history, I think analysts projecting double-digit future free cash flow margins are getting a little ahead of themselves.
Still, if there's an industrial company that can outperform, Cummins (with its strong international exposure and North American market share) is the one I'd pick. I've increased my long-term base case revenue growth estimate to 6%, and that points to a fair value of almost $135 today. Go to 8.5% revenue growth and the target jumps to to $158, while a target of 10% growth leads to a $173 target.
I would not invest in Cummins on the basis of thinking that 10% annual revenue growth and 18% annual free cash flow growth is likely. Likewise, I wouldn't rule out the risk that the big burst of demand in markets like China won't be repeated. Still, on a risk/reward basis, I think Cummins' past performance suggests that this company is a good name to pick if you believe that global heavy vehicle demand still has worthwhile growth potential over the next decade.
Disclosure – At the time of writing, the author had no positions in any companies mentioned.
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