Is Cummins Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what Cummins' (CMI 0.43%) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Cummins' story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much Cummins' free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Cummins' share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Cummins managing its resources well? A company's return on equity should be improving, and its debt-to-equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that Cummins' dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's look at Cummins' key statistics.

CMI Total Return Price data by YCharts.

Source: YCharts.
*Period begins at end of Q4 2009.

CMI Return on Equity data by YCharts.

Source: YCharts.
*Period begins at end of Q4 2009.

How we got here and where we're going
Cummins sure looks to be justifying its recent placement atop The Motley Fool's list of America's Best Companies -- at least from an investor standpoint. The engine maker misses out on a perfect score only because its net income has grown faster than its free cash flow. This isn't cause for concern, as Cummins' free cash flow has been higher than its net income for all of our tracking period, and even today it remains more than twice as high as reported net income. Any growth in the future would be icing on the cake. But what will it take for Cummins to earn a very rare perfect score?

As you probably know, Cummins and Westport Innovations (WPRT -0.52%) are on the vanguard of natural gas-fueled trucking. Westport made it through this analysis in far worse shape than Cummins earlier this year, as the effort to convert the world's diesel-burning transport fleets is still in its infancy. This is less of an issue for Cummins, which is really in a win-win situation in this partnership. If nat-gas engines catch on, Cummins is the undisputed manufacturing leader. If the engines remain a marginal part of the global transportation infrastructure, Cummins still holds the pole position in diesel engines, a position it's built through an impressive sustained double-digit market cap growth rate for more than six decades.

Cummins' advantage over its rivals became more pronounced recently, when truck maker Navistar International (NAV) was transformed from competitor to customer after its engines were found unable to meet EPA standards. Navistar surged today on reports of a better-than-expected turnaround pace, and its retooled engines could again push back against Cummins' dominance. That should weigh on investors' minds going forward, as Cummins may see a decline in sales and profits, as Navistar no longer needs to buy its engines out of desperation.

Navistar, however, is deepening its ties to the Cummins-Westport partnership, as its push for more nat-gas trucking relies on the Cummins-Westport engine. Navistar competitor PACCAR (PCAR 0.12%) is also using Cummins-Westport engines for its nat-gas initiative in Peterbilt and Kenworth trucks, so it appears that Cummins has this nascent segment locked down for the foreseeable future.

More important to Cummins' immediate future is the performance of its diesel-dependent engine segment, which accounts for half of revenue and which shrank by 5% in the 2012 fiscal year. Much of those sales come from heavy- and medium-duty trucks and buses, and the global market for these vehicles is projected to grow by 4.3% in 2013. It's not a great expansion, but Cummins can always beat the industry average by capturing market share from its competitors -- provided, of course, that it doesn't wind up losing share to a retooled Navistar.

Putting the pieces together
Today, Cummins has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.