STOCK WATCH


Can Cummins' Success Continue?

Bob Frick

Some analysts doubt this engine maker can sustain its recent earnings growth, but maybe they have underestimated the company's ability to innovate.



Based on most analysts' opinions, the shares of engine maker Cummins are running on fumes. The company has had a remarkable run, they'll concede, but the stock, which closed at $139.98 on October 9, is expensive.

Perhaps a bit of caution is warranted, given that Cummins traded for less than $10 in March 2003. A recent Lehman Brothers report points out that Cummins' price-earnings ratio of 16 (it's now up to 18, based on the latest price and estimated 2007 earnings of $7.70 a share) is just wee bit higher than its historical peak P/E of six to seven. Of the 11 analysts who follow the Columbus, Ind., manufacturer, only three rate the stock (symbol CMI) a buy.

On the other hand, the company is growing like kudzu. And we think investors should take a hard look. One of the three bullish analysts, Charlie Rentschler of Wall Street Access, ticks off several reasons why he thinks Cummins' earnings could double in the next several years.

First, he says, "There's no other American company that's done such an incredible job of sticking its roots down into China and India." Cummins has had joint ventures in in India since the 1960s and China since the 1970s. Of the three new engine plants Cummins is building, two are in China. Many Beijing buses, part of the biggest bus company in the world, run with Cummins engines.

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Such engines are Cummins' bread and butter. The company makes diesel- and natural-gas-powered engines for trucks, buses and RVs. But it also has an important and growing business making generators for factories, offices, hospitals and the like. Generator sales are growing particularly briskly in countries where power is less than dependable. Cummins' Standby Power systems, for example, make sure a building will have power when the grid crashes.

Second, Rentschler says, "Cummins has superior technology." Case in point: Cummins is "in the vanguard" of developing car and truck diesel engines that must meet increasingly tight pollution controls.

This leads to Rentschler's third point, which is how far ahead of rivals Cummins is in getting its wares to markets. The company has already announced that it's ready for the stringent, near-zero 2010 emission standards for diesel engines, beating many other engine makers to the punch.

And passenger cars with diesel engines -- already popular in Europe -- could be the key to U.S. energy independence from OPEC, says Rentschler. In 2009, Chrysler will introduce a light pickup with a Cummins diesel engine, he says.

The analyst, by the way, is the only one of the 11 following Cummins who once worked for the company. He says he spent ten years in operations there.

What could go wrong? Well, lots of well-known, well-managed companies, such as Caterpillar (CAT) and Deere (DE), make engines. And most of Cummins' sales go to companies, such as big truck makers, who also make their own engines.

Plus the engine business is notoriously cyclical. For example, new emission standards for big truck engines in 2007 caused a spike in sales for the 2006 models and a crash in the first half of 2007. Cummins' truck-related sales dropped 40% in the first half of 2007, according to Morningstar. (Sales have already started to bounce back for all engine makers -- the things wear out, after all.)

Morningstar analyst Ben Butwin sums up the strategic case against Cummins when he writes: "The company's recent results are impressive, but we don't see any sustainable competitive advantages to keep rivals at bay."

That's a good point. Cummins' technologies for building engines that run more cleanly and producing catalytic converters used by other engine makers to help meet ever-tightening emission standards won't be on the leading edge forever. But Cummins has been so successful in recent years -- and has gained its current competitive advantages -- because it is a strong innovator.

It may well be that analysts badly underestimated Cummins' earnings in the first half of 2007 because they didn't fully appreciate the company's ability to innovate. In the first quarter, analysts on average estimated profits of 86 cents a share; Cummins posted $1.42. For the second quarter, analysts had $1.59 per share, and Cummins reported $2.13.

Analysts are looking for an 18% earnings gain, to $9.12 per share, in 2008. Rentschler says Cummins can earn $14 to $15 a share by 2011. That could mean a near-doubling of profits from 2007 levels. So although Cummins' stock is expensive and the chances of it repeating its 14-fold advance since 2003 over the next four years are zero, it's conceivable that the shares will chug along nicely, in line with earnings growth, for the foreseeable future.




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