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Top Picks 2019- Cummins CMI

Cummins (CMI) designs, manufactures, and distributes engines and related components for use in heavy-duty and medium-duty trucks, buses, construction and mining equipment, and standby power generation, explains Doug Gerlach, editor of Investor Advisory Service.

Over nearly a century, the company has earned a reputation as a leading engine manufacturer, known for the reliability and superior quality of its products. Cummins has been a beneficiary of coordinated global growth and a strong truck market. Just over half of the company’s sales come from the U.S.

See also: Top Picks 2019: McCormick & Company (MKC)

Over the past decade Cummins has benefitted from rising fuel-efficiency standards and emissions reduction regulations, which have served as a tailwind.

As a cyclical company, Cummins is dependent upon economic growth for near-term results, though the company has definite long-term growth characteristics. Given the recent strength, there is some question as to where we are in the important North American heavy-duty truck cycle.

These concerns are mitigated in part by the current backlog, which is the highest in 20 years and gives good visibility through 2019. Furthermore, management emphasizes that demand continues to be strong and broad-based globally across most of its on-highway and off-highway markets.

Warranty issues have been a nagging problem for the company, and management has worked to address these. In the second quarter, the company took a $181 million charge to address the performance of a faulty emissions control system in certain on-highway engines produced between 2010 and 2015.

Management targets warranty costs of 2% of sales over the longer term versus the 3.1% it reported in 2017 and 2.4% guidance for 2018. The increased focus on quality appears to be reflected in the performance of more recently launched engines.

See also: Top Picks 2019: Genomic Health (GHDX)

Material costs and tariffs are also a concern and a key reason why the stock is down approximately 25% from highs reached earlier this year. Cummins recently highlighted an expectation of approximately a $200 million annual headwind, split 50%-50% between materials costs and tariffs.

The company reiterated its full year guidance for sales growth of 15%-17%. Management also reduced its expectation for tariff-related expenses for this year to $80 million, down from a previous estimate of $100 million.

For 2019, the company now expects tariff-related costs of $250 million, which is $50 million higher than previous projections. Cummins expects to offset the majority of the tariff costs through pricing and improvements in its supply chain.

Accounting for the cyclicality of the business, we look to more muted growth over the next five years, targeting 7% sales growth and 10% EPS growth. Five years of 10% growth could result in EPS as high as $22.00.

The cyclical nature of the business makes it necessary to adjust historical P/E ratios. We estimate an appropriate high P/E to be 15.0x, which suggests a potential high price of $330 and a possible annual total return of 23.2% from the recent price of $130.

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