Cummins Disappoints the Greedy so I'm Buying on the Drop

07/29/2014 3:50 pm EST


Jim Jubak

Founder and Editor,

After this truck engine company raised its forecast for fiscal 2014 revenue without raising its forecast for profit margins, many greedy traders and investors dropped the stock, but MoneyShow's Jim Jubak sees this as an opportunity and is adding shares as of today, July 29.

As a kid, whenever I used to gripe that my ice cream cone wasn’t big enough or a present wasn’t special enough, my grandmother used to retort, “What do you want? Egg in your beer?” That never made a whole lot of sense to me but I did get the general idea that when you have a good thing (beer), asking for another good thing (an egg) is selfish and spoiled. (The most likely origin of the phrase dates from World War II when beer and eggs were both rare in the European Theatre. Why my grandmother—who, to the best of my knowledge, wasn’t ever a GI—used the phrase, is a puzzle to me).

And that’s exactly what I’d retort to those traders and investors who have dropped shares of Cummins (CMI) 3.5% in the last two days. Before the open on Monday, July 28, Cummins reported second quarter earnings (after adjusting for one-time gains) of $2.34 a share (versus the Wall Street consensus of $2.38). Revenue climbed 6.9% year over year to $4.84 billion, just slightly above the Wall Street estimate of $4.83 billion.

The company’s big sin, however—judging from analyst comments after the report—was that the company raised its forecast for fiscal 2014 revenue to $18.7 billion to $19.2 billion without raising its forecast for profit margins. Growth will accelerate to 8%-11% for the year from an earlier forecast of 6%-10%. This is the second quarter in a row where Cummins has raised its revenue forecast for the year without forecasting increased margins. And that—especially given the company’s forecast for a pickup in truck demand in the North American market—left analysts and some traders disappointed.

Cummins is a member of my long-term Jubak Picks 50 portfolio. On the increase in revenue guidance and the drop in share price, I’m adding the shares to my 12-18 month Jubak Picks portfolio as well, with a target price of $175 a share. The shares trade at just 16.2 times forecast 2014 earnings per share and show a PEG ratio (PE to growth rate ratio) of 1.25.

Cummins’s forecast for an improving North American truck market, and its guidance for higher revenue in 2014 than previously, argue that these shares are a good choice for playing higher growth in the US economy in the second half of the year. With Cummins, you get the dominant maker of diesel truck engines in the United States and a component business that sells to, pretty much, every other engine maker. That last is especially important at the moment since it's the components unit that’s the company’s margins star. In the quarter, margins in the component business climbed to 14.5%, above the company’s forecast of 12.75%-13.75%.

I think the problem of static margins—even as revenue forecasts increase—will work itself out over the next six to 12 months. Cummins, which is always among the lead innovators in its industry, introduced a large number of new engines in 2013. That drove up warranty costs—as new products often will—but those costs will come down over time, as is the typical pattern after new product introductions.

With heavy-duty truck sales forecast to increase by 14% year over year and with North American truck shipments forecast to climb 26% year over year, I think margin expansion will come. And, in the meantime, 8% to 11% revenue growth is nothing to pass up in a slow-growth global economy.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I managed, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund shut its doors at the end of May and my personal portfolio is now in cash. I anticipate putting those funds to work in the market over the next few months and when I do I’ll disclose my positions here.

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