Tramino
A recent surge in truck orders has done wonders for heavy machinery companies exposed to that sector, with the shares of Allison (ALSN), Cummins (NYSE:CMI), and PACCAR (PCAR) up about 15% to 25% since late September as September Class 8 truck orders set an all-time record and October orders came in strong as well. At the same time, component availability is improving, breaking up production logjams, cost inflation is flattening out, and pricing actions are contributing more significantly.
What happens next is the big question. I’ve been expecting Cummins to do well into the first half of 2023, but I’m concerned that higher interest rates, weaker economic conditions, and a worsening freight market will drive weaker demand. I like the long-term outlook for Cummins, particularly after the Meritor deal and with the company’s growing exposure to decarbonization, but I don’t see such a compelling prospective return relative to the cyclical risk.
Mixed Trends In The Quarter
It’s challenging to evaluate the third quarter results from Cummins relative to sell-side expectations, as it seems that some sell-side analysts included Meritor in their estimates, while others did not, and it makes a difference when it comes to whether or not Cummins beat/missed results. In any case, I’d call the earnings no worse than “good enough”, when constructive guidance.
Revenue rose 11% year over year as reported, excluding Meritor, and the business was up slightly on a sequential basis. Engine revenue rose 8% yoy and was basically flat sequentially, with the company seeing good growth in the North American highway market with weaker demand in China trucking and construction markets. Distribution revenue rose 14% yoy and declined about 1% qoq. Components revenue rose 10% yoy and 1% qoq, with stronger results in the turbo, filtration, and transmission business (the JV with Eaton (ETN)). Power Systems revenue rose 16% yoy and 12% qoq on stronger industrial and oil/gas demand, and New Power revenue rose 96% yoy and 7% qoq.
Gross margin improved 100bp yoy and declined 150bp to 26.2%, while adjusted EBITDA rose 7% yoy and fell 15% qoq, with margin down 40bp yoy and 250bp qoq to 14.0%.
Relative to other heavy vehicle suppliers like Allison and Dana (DAN), I’d say Cummins’ performance was fine, though perhaps not exceptional. Allison reported 25% year-over-year growth in its third quarter, while Dana saw 15% overall growth and 17.5% growth in its commercial/off-highway operations.
Relative to the last third quarter before the pandemic, Cummins’ revenue was about 14% higher, while Allison’s revenue was 6% higher and Dana’s revenue was 17% higher (with 22% higher revenue in the commercial/off-highway businesses). Looking at margins, Cummins has seen about 330bp of EBITDA margin erosion, while Allison has seen closer to six points of erosion and Dana has seen about four points of EBITDA margin erosion.
A Tricky Cyclical Turn Is Just Up Ahead
It’s never all that easy to predict the cyclical turns in the heavy machinery space, but this next cyclical turn is going to be more challenging than most given cross-currents in demand, production/shipment, and margins.
On the demand side, truck orders have been red-hot here of late, with September Class 8 orders up 96% yoy and October orders up 83%. It’s worth noting, though, that those order tallies are inflated by a late opening of truck OEM order books for 2023. Trucking company balance sheets are strong now after an uncommonly strong boom cycle, but rates have started to roll over and I expect trucking orders will start declining. At the same time, though, there are still meaningful backlogs going into 2023 due to supply/component shortages in 2022 that curtailed production, so there’s still a backlog to work off ahead of those slowing orders.
If that weren’t complicated enough, there’s also the reality that Cummins operates a global business with significant contributions from Asia and Europe. European truck registrations were up in August, but nobody seems to have too much confidence that demand is going to remain strong in Europe given the impact of higher rates and disruptions from Russia’s war in Ukraine. Meanwhile, China has been exceptionally weak this year (management is expecting a 55% sales decline for 2022) due in large part to COVID disruptions, and that demand will rebound … but it could be in the second half of 2023 or in 2024.
Margins, too, are no simpler. Like other suppliers, Cummins is seeing input cost inflation easing, and the company should be set to benefit from some pricing leverage. More important, and I would argue less appreciated/understood on the Street, is the potential impact of more regular production schedules as component availability continues to improve. Production disruptions caused by OEMs significantly altering their orders on short notice in response to their ability to source components played have played havoc with many suppliers, and I’ve seen several suppliers attribute more gross margin pressure to these inefficiencies than input cost inflation.
Will The IRA Accelerate New Power Adoption?
Amidst all this chaos in the conventional Cummins business is the longer-term question about how quickly customers (and OEMs) will adopt new lower-emission power technologies. The Inflation Reduction Act provides meaningful subsidies for green hydrogen and clean heavy-duty vehicles, with up to $3/kg in available subsidies for green hydrogen and 30% sticker price tax credits for clean vehicles.
All of this should help drive cost parity with conventional diesel at a faster pace, but there are still a lot of complicated aspects to the story. For instance, converting to battery powertrains makes sense for many municipal medium/heavy-duty applications (like waste collection), but it’s much harder to make the case for batteries for long-haul trucks given the significant weight of batteries. On the other hand, fuel cells could make a great deal more sense in long-haul trucking, but could prove too expensive for municipal use. On top of all that, bridge technologies like natural gas-powered ICE powertrains could still see meaningful use.
What I like about Cummins is that management is structuring the business in such a way that the company is relatively agnostic to however the market evolves. The company clearly has a strong presence in conventional diesel engines, and those are going to be in the majority of new-builds through 2035. At the same time, the company has solutions for bridge options like natural gas powertrains, as well as solutions for full battery-electric or fuel cell powertrains, and I expect the company’s green hydrogen electrolyzers to see broad demand outside of transportation as industrial customers look for greener power-gen options.
The Outlook
I expect FY’23 to still be a healthy year for Cummins as OEMs deliver out of their backlogs and these strong initial 2023 orders, but I do expect a contraction in 2024. Beyond that, I expect a long-term core revenue growth rate in the neighborhood of 4% to 5%, with some upside if the company’s non-transportation green energy business exceeds my expectations.
For margins, I expect significant year to year volatility as the company goes through its cycles, but I expect a general upward trend as the company continues a slower march toward the higher single-digits over time, driving FCF growth modestly ahead of revenue growth.
The Bottom Line
Given the significant cyclicality of the business, discounted cash flow is tricky to use for valuation, as underestimating the depth and duration of cycles can meaningfully throw off near-term cash flow assumptions. That said, those year-to-year variations do smooth out over time, and I think these shares are priced for a high single-digit long-term total annualized return. At the same time, I think the shares are modestly undervalued on a near-term margin-driven EV/revenue basis, with a fair value in the high-$260’s.
I have a great deal of respect for Cummins management, and the shares have performed well over the long term – a 15-year annualized return of almost 11% that is comfortably above the average returns of the supplier and heavy machinery sectors. At this point, though, the valuation is so-so in my view, and there are a lot of quality industrial names that offer larger potential returns and wider margins of safety. If you’re more bullish on trucking and the global economy in general for 2023, this is a name to consider, but it’s more of a watchlist name for me right now.
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