Revving up the Recovery's Engines

09/27/2010 4:10 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Right now, at this point in the economic recovery, I’d much, much rather own capital-equipment stocks than consumer stocks.

As I noted in my post on September 24th, corporate customers are buying capital goods to expand and upgrade their businesses while consumers are still keeping their wallets shut tight (see my post).

A case in point is Cummins (NYSE: CMI), a maker of diesel engines. After a slow first half to 2010, the company’s sales are showing solid increases that look as if they will extend well into 2011.

There’s no real magic here. In the Great Recession, sales of trucks and construction equipment dried up, and that crushed Cummins’ sales of diesel engines. Revenue plummeted to $10.8 billion in 2009 from $14.3 billion in 2008.

But trucks continued to get older and wear out. The sales of 2009 weren’t actually lost, but were just postponed. And now that times look a little better and corporate profits are riding at high levels, truck buyers are playing catch-up big time.

How big? In August, orders for Class 5-8 trucks leaped 21% from August 2009 and 22% from July 2010. The order backlog grew 3% from July.

And this isn’t enough to dent the historically old age of the truck fleet. Wells Fargo tracks the ratio of Class 8, the biggest trucks, sold in the last four years to the number sold in the last seven years as a way to chart the age of the truck fleet. (More sales in the last four years and the fleet is getting younger; fewer sales, and it’s aging.) The current ratio of just 47% is the lowest in the last 15 years. The truck fleet is really, really old, and there’s a lot of pent-up demand.

But that’s not all Cummins has going for it. The Environmental Protection Agency is phasing in new rules on diesel emissions that will require truck and construction-equipment operators to upgrade their equipment.

Here’s where Cummins large investment in new technology pays off: The company has been consistently among the first in its industry to get new engines certified by the EPA to market. So, for example, on September 21st, Cummins began production of the first EPA-certified engines for off-highway equipment.

Shares of Cummins aren’t cheap anymore. The stock is up 117% in the last year. But given the earnings power over the next year, it’s not yet especially expensive, either. Standard & Poor’s projects 2011 operating earnings per share will climb by 23% in 2011 to $6.53.

At around $90, the stock now trades at 16x S&P’s estimate of 2010 earnings.

I think that the multiple on the stock will move further toward the top of Cummins’ five-year range of 4.3x to 19.4x. (And I’m a little more optimistic on 2011 earnings than S&P is.)

My target price for the stock is $114 by July 2011.

Full disclosure: I don’t own shares of any stock mentioned in this post in my personal portfolio.

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