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Why Cummins Is Struggling to Reassure Nervous Investors

By Dan Caplinger - May 3, 2018 at 9:51AM

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Even a big guidance boost from the engine maker didn't prevent the stock from falling.

Industrial companies like Cummins (CMI -0.01%) are seeing some new challenges during the current earnings season. On one hand, an upturn in the business cycle for the industrial sector has helped to drive greater demand for the products that Cummins and its peers make, and that's led companies to boost their near-term guidance. Yet some longer-term concerns have investors nervous about whether Cummins will be able to sustain the progress it's made in recent years. In that light, even strong backward-looking results aren't always enough to convince skeptics about future success.

Coming into Tuesday's first-quarter financial report, Cummins investors wanted to see continued growth from the engine-maker, and what the company said was generally favorable compared to those expectations. Yet the response from shareholders showed that Cummins still has to overcome fears about its future beyond the current year, and investors need to be ready for a potential disconnect between the stock price and Cummins' fundamental business prospects.

Red Cummins 6.7 liter turbo diesel engine.

Image source: Cummins.

How Cummins fared to start 2018

Cummins' first-quarter results continued a streak of impressive gains. Revenue was higher by 21% to come in at $5.57 billion, which was well above the 13% growth that those following the stock had expected. As we've seen in recent quarters, accounting adjustments sent GAAP net income down for the quarter, but after making allowances for product campaign costs and discrete tax charges, adjusted earnings of $3.30 per share pushed well beyond the consensus forecast among investors for $2.93 per share.

Geographically, Cummins' diversity showed consistent performance across the globe. Sales picked up 22% in the North American market, while international revenue was higher by 20%. Cummins cited especially strong growth in Europe, Latin America, China, and India in pushing its top line higher.

Cummins' business segments also all fared well. Components led the way higher with a 30% jump in sales, and pre-tax operating earnings were higher by about 5% on higher commercial truck production in North America and the introduction of new products in India. Power systems enjoyed a 22% boost to the segment top line, and segment profit climbed by two-thirds thanks to a rebound in mining and oil and gas activity. The key engine segment posted 21% sales growth and a nearly 5% rise in pre-tax operating earnings due to increased global demand in trucks and construction. Only the distribution segment saw a slight drop in segment profit, and even there, sales climbed 13%.

Can Cummins keep revving up?

CEO Tom Linebarger succinctly summed the quarter. "Improving demand in a number of the Company's core markets," Linebarger said, "combined with our strong global market share and the success of new products aimed at lowering emissions, resulted in sales growth."

Due to those tailwinds, Cummins boosted its sales guidance for 2018. The company now sees revenue rising 10% to 14%, up from its previous guidance for 4% to 8% gains. Costs from the product campaign will hurt pre-tax operating margin slightly, but better-than-expected performance so far in the year minimized the downward impact.

Yet the cause for the campaign raised red flags for some market participants. Cummins said that the move is "part of a proactive plan to address the performance of an aftertreatment component in certain on-highway products produced between 2010 and 2015 in North America." The engine-maker has been dealing with regulators about emissions issues, and the fear that those issues could become more of a money pit for Cummins in the long run seemed to be the primary cause of concern. That comes despite the fact that Cummins has worked with Westport Fuel Systems to gain near-zero emissions certification for its ISX12N engine.

Cummins investors weren't comfortable with the potential regulatory obstacles despite the generally favorable financial performance, and the stock posted losses of at least 4% on both Tuesday and Wednesday following the Tuesday morning report. Until the engine-maker's future gets a little bit clearer, it's entirely possible that shareholders will keep downplaying the huge success that Cummins has seen and instead focus on worst-case scenarios that could come down the road.

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