Shares in truck engine manufacturer Cummins (NYSE:CMI) have continued their strong run this year with the stock up around 9.5% year to date. Moreover, the indications from the industry are that North American conditions improved over the quarter, and key customers like Navistar (NYSE:NAV) and Paccar (NASDAQ:PCAR) are also seeing improvements. With that said, what are the risks and rewards of buying Cummins stock today?
North American demand improving
Cummins reports out of four separate segments, with engine and components (mainly trucking) being the most important by far. A breakout of its earnings before interest, or EBIT, demonstrates what really matters.
Moreover, the U.S. contributed 48% of sales, and its key customers include Paccar (around 12% of sales in 2013) for heavy- and medium-duty truck engines. Navistar and Volvo are key customers in heavy duty, and Daimler, Navistar, MAN, and Ford use Cummins engines in the medium-duty market. North America matters a lot to Cummins, not least because the company reaffirmed that it's aiming for 38% share of the heavy-duty market and 70% of the mid-range market.
The good news is that, according to research from Bloomberg, most of the companies exposed to the heavy truck industry upgraded their forecasts for heavy duty North American production in the first quarter.
Paccar's estimates are not included in the figures, but it's management recently forecast U.S. and Canadian Class 8 truck sales (roughly equivalent to Cummins's figures in the table) to be 220,000-240,000, and sees that "the market will progressively improve as we go through the year".
The North America industry backdrop looks good for Cummins, but for Navistar it's almost a godsend. The latter is battling to reduce structural costs, and recover market share lost in the aftermath of its failure to develop a gas recirculation technology engine. Turnaround stories are nearly always helped by better end market conditions, and the company is worth looking at closely.
International markets mixed for Cummins
Observant readers will note that Cummin's North American numbers for heavy-duty trucks are in the graph above, but a look at its updated guidance reveals positive and negative trends in its key markets.
|Production Units||2013 Actual||Previous Estimate for 2014||Current Estimate||Trend|
|Heavy Duty NAFTA||218||236||244||Better|
|Medium Duty NAFTA||112||120||122||Better|
|Heavy & Medium Duty China||1061||988||1061||Better|
|Heavy & Medium Duty India||226||226||226||Flat|
|Heavy & Medium Duty Brazil||190||190||152||Worse|
Conditions in North America are clearly improving, and on balance, it's a net positive for Cummins's international markets. In fact, the company now expects revenue to rise by 6%-10% for the full year versus a previous forecast of 4%-8%.
However, there is a note of caution around its international markets. Conditions in Brazil have deteriorated considerably over the last few months, and although Cummins kept its full year forecast for India unchanged, it also said that India truck demand fell 7% in the quarter. Another sign that India's economy is in trouble came from Cummins's updated expectation that power generation revenue in India will decline 15% in the full year versus a previous forecast of flat growth.
Moreover, the upgrade to China's production forecast is more about demand getting stronger ahead of a move to a tighter emissions standard, than it is about underlying economic strength. Indeed, Cummins' CEO, Tom Linebarger, spoke to the emissions issue on the conference call:
With the deadline for sales of NS3-compliant vehicles now set it would be logical to assume the demand for NS3 vehicles will remain strong for the remainder of this year. But with OEMs already having shifted a significant proportion of production to NS4 vehicles, it's not yet clear how overall industry demand and OEM production will play out in the second half of the year.
In other words, don't be surprised to see some volatility around how demand pans out in China this year, and given that the country contributed $720million (including joint ventures) to Cummins's revenue in the first quarter, its contribution is significant. For ease of comparison, total revenue for Cummins was $4.4 billion.
The bottom line
All told, conditions are getting better in North America for the trucking industry, and for the near term at least, Cummins, Navistar, and Paccar are likely to receive a lift. On the other hand, there is an amount of uncertainty in China, and conditions appear to have weakened in other emerging markets.
Much depends on what economic growth in China will look like in the second half of the year, and on how truck sales and production adjust to the push and pull of tighter emission standards. Foolish investors might want to be a little cautious with the stock, specially after such a great run.