It looks like 2016 is proving to be a stellar year for Cummins Inc. (NYSE:CMI), with the stock gaining almost 40% year to date as of this writing. Surprisingly, the optimism doesn't quite match up with the engine maker's weak operational performance thus far -- or the challenges it faces. Investors appear to have turned hopeful after both Cummins' key customer, PACCAR (NASDAQ:PCAR), and its rival, Caterpillar Inc. (NYSE:CAT), delivered better-than-expected second-quarter numbers. However, while Caterpillar lowered its full-year guidance and extended its restructuring program, PACCAR now projects lower truck sales in the U.S.
Given the backdrop, investors might prepare to be disappointed when Cummins reports its second-quarter numbers on Aug. 2. While analysts expect its earnings per share to drop nearly 18% on 10% lower revenue, investors need to worry if Cummins fails to deliver in the following three key areas in Q2.
Cummins' engines business derives almost 70% of its sales from the U.S. and Canada and is heavily reliant on the heavy-duty truck market. If the company starts losing grip on its key market, you have every reason to be worried.
In 2015, Cummins' share in the North American heavy-duty market slipped 2 percentage points to 33%. Conditions worsened during the first quarter when Cummins' market share slumped to 29%. The company even lowered its full-year market share projections to 27%-30% from 30%-33% as key customers -- including PACCAR and Daimler -- continue to replace Cummins' engines with their own. Needless to say, if Cummins' market share drops further in Q2, it could mean trouble ahead.
Despite a challenging first quarter, Cummins maintained its operating margin above the 10% mark. Comparatively, Caterpillar reported a mid-single-digit percentage margin in both its first and second quarters.
While components was Cummins' most profitable segment in Q1, a weaker North American trucking market could hit segment profits and send the company's Q2 and full-year margins lower. Cummins last projected its 2016 margins will range between 11.6% and 12.2%, despite a 5% to 9% decline in sales. It remains to be seen whether it'll be able to reiterate and meet its guidance at a time when truck makers are turning bearish. Daimler expects its 2016 sales to be "significantly" lower than 2015, and PACCAR confirmed slower order rates in Q2.
In the Q2 report, investors must also watch for updates about Cummins' restructuring plans, as any effort to rein in costs will come in handy. Watch for trends in its selling, general, and administrative expenses: In Q1, Cummins lowered SG&A by 5% year over year. If the company can reduce costs further to boost margins, that should reinstate investors' faith in management.
Cummins derives nearly 40% of its sales from markets outside the U.S. and Canada, which isn't good news. On one hand, Caterpillar reported a substantial drop in sales from Latin America, Asia-Pacific, and the EAME regions in Q2. On the other, PACCAR projects industry truck sales in Brazil to slump almost 65% from peak levels this year. The real dampener could be off-highway markets, like oil and mining, both of which played a major role in sending Caterpillar's sales tumbling 16% in Q2.
With nearly every end market under pressure, it'll be important for Cummins to find ways to generate steady cash flow in order to meet its commitment of returning 75% of its operating cash flow to shareholders this year. Investors needn't worry much on that front, though, as the company just raised its dividend. However, dividends may grow at a slower clip in the future if Cummins' profits and free cash flows decelerate. That's something investors should keep an eye on in Cummins' upcoming earnings call.