Just as there are some stocks out there that are cheap for good reasons, there are stocks that carry well-earned premiums, and Cummins (CMI) is one of them. While this is certainly a cyclical business, few companies in the heavy machinery space (and perhaps few cyclical companies in general) do a better job of adjusting the cost structure to capture the upside in the good times and limit the downside in the bad times.
I had hoped back in May that there’d be a pullback after the machinery sector rallied, but that never happened and now these shares are another 20%-plus higher. Not only has Cummins continued to outperform industrials in general, but also heavy machinery peers like Caterpillar (CAT), Navistar (NAV), and PACCAR (PCAR), though Deere (DE) has done even better. If I owned Cummins, I probably wouldn’t be in a hurry to sell (I might consider protective stops), but it’s tougher to make the case for buying in now, as I think the shares already price in a healthy cyclical recovery and expectations may have more downside than upside risk at this point.
Smacking Expectations, Largely On Margins
Cummins had a good quarter in the context of what I believe was the worst-ever single-quarter revenue decline in the company’s history. Revenue was about 5% better than the Street expected, but the real highlight was the core EBITDA decremental margin of 21% and the $0.60/share beat on segment profits relative to my expectations.
Revenue fell 36% this quarter, with Engines down 47%, Distribution down 21%, Components down 38%, and Power Systems down 35%. Within Engines, Cummins’ performance seemed to more or less match underlying volume trends, though with some sign of share gain in heavy-duty. The 38% decline in Components looked a little stronger than average (compared to peers), as the company continues to gain share in areas like filtration and fuel systems.
The margin performance was impressive. Gross margin declined 40bp, while EBITDA margin fell less than three points. Segment earnings fell 61%, with segment margin down about five points. All of the major segments remained positive this quarter.
The Market Is Expecting A Big Rebound In Trucks
Looking at the valuations for suppliers to the commercial vehicle market, like Cummins, it’s pretty clear that the market expects a big rebound in demand next year. Although industry orders are rebounding strongly off of very low levels, that optimism may yet be a little premature. Yes, 2021 should be significantly better than the horrible demand seen this year, but I see some risk of overinflated expectations for line-haul and intracity Class 8s, as well as medium-duty trucks. I think a lot is riding on just how strong business activity is early in 2021 and whether trucking companies feel confident in resuming fleet purchases.
I’m less bullish on the off-road market. Construction looks set for some extended weakness on weaker non-residential activity and weaker municipal/local budgets for infrastructure projects. A federal stimulus would help, but it remains to be seen if one will come. With mining, original equipment orders have been weak, and with delays in permitting new mines, it may not be until 2022 until there’s real growth again.
On an encouraging note, the recently-announced supply agreement between Cummins and Navistar largely eliminates the risk of Cummins losing that business through the majority of the decade (two emissions cycles, which likely means 2027 or beyond). Traton announced that Navistar had terminated their engine development agreement, and Cummins will remain the preferred supplier of HD and MD engines to Navistar’s North American truck and bus business.
Also on the positive side, Cummins continues to build share in the Chinese market. While the company’s share is considerably lower than in North America – 15% blended for HD/MD, versus 33% HD and 80% MD share in North America – it is going up and there’s still plenty of potential upside over the coming years.
Hydrogen Is Going To Get More Attention
Hydrogen fuel cells have long been touted as a potential alternative to gasoline and diesel engines, but for decades, the engineering challenges have rendered them little more than theoretical options. That’s starting to change, and Cummins stands as a significant potential beneficiary. While Cummins has arguably underinvested in electrification (and Cummins management believes that electrification will be slower to penetrate its core markets), it has made some meaningful investments in fuel cells.
Two trains powered by Cummins-supplied fuel cells recently completed 18-month trials in Europe and apparently the operator plans to introduce more than 40 such trains in 2022. Cummins will also be hosting a “Hydrogen Day” for analysts and investors on November 16 to discuss its portfolio and opportunities in more detail.
What interests me most about hydrogen fuel cells now is that it seems like the market is very close to economically viable “green hydrogen.” Hydrogen has traditionally been produced from natural gas or from hydrocarbon-powered electrolysis, neither of which really help the climate/carbon footprint much. Now, though, there are more efficient electrolyzers available, and the falling cost of wind energy raises the possibility that clean hydrogen could be produced at an economically-viable price.
Cummins acquired Hydrogenics back in 2019 and has leverage to various steps in the hydrogen chain, including electrolyzers, storage/delivery, and fuel cell drivetrains for commercial vehicles. Management doesn’t think that the technology is quite there yet for commercial vehicles, but given the challenges in electrifying some commercial vehicles, this is an opportunity to watch.
The good news/bad news is that I didn’t cut my near-term estimates much when COVID-19 started spreading, as I thought most of the damage would be confined to what was already going to be a cyclical down-cycle for the company anyway, and I’m not raising them much now. Basically, I haven’t seen much to change my outlook for HD/MD trucks in 2021/2022, nor for off-road applications.
So, I’m still looking for double-digit revenue growth in the three years after 2020 on the cyclical rebound. I have decided, though, to increase my long-term revenue estimates, as the company has a long history of mid single-digit long-term revenue growth, and I don’t think the advent of electrification over the next decade is going to break that trend. I’ve also modestly revised my long-term margin/FCF margin assumptions lower, as Cummins also has a very consistent track record and I need more evidence that something will fundamentally change to allow a meaningfully higher long-term FCF margin. I still expect improvement, but just more modest improvement (around a point over the next decade).
The Bottom Line
Cummins is priced like other high-quality industrials, and while it is a cyclical heavy machinery company, it is still very definitely a high-quality company. The returns now seem more on the order of mid-to-high single digits (annualized) from here, but I’d note that if you gave Cummins the sort of forward EBITDA multiple that an industrial company would get for its level of margin and ROIC, rather than valuing it like a commercial vehicle parts supplier, it would still have some meaningful upside on an EV/EBITDA.
I’m not arguing that you should do that – I’m pretty skeptical whenever analysts argue you should value a company in a given industry more like companies in a different, usually more richly-valued industry – but it is something to consider if you’re already long. For me, the cyclicality of Cummins means I’ll get another chance eventually, and right now I see a little too much risk to 2021-2022 commercial vehicle growth/demand expectations to buy in now.
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.