Cummins: Why The Stock Could Fall 20% From Here (NYSE:CMI)

COVID, COVID, COVID

Few industries benefitted from the COVID-19 pandemic the way trucking did. As the world closed down and slowly re-opened, people turned to e-commerce in droves. These goods, which in pre-pandemic times were delivered by rail until the so-called “last mile” of delivery, more often than not found themselves snarled in a supply chain unprepared to handle what was being pushed through it. As rail providers struggled and ports became backlogged, the highly fragmented trucking industry experienced a COVID boom that few other industries did.

Enter Cummins, Inc (NYSE:CMI). As the leading manufacturer of Class 8 engines and powertrains, Cummins booked historic levels of growth as the economy began its gradual reopening. Trucking is a notoriously brutal and cyclical industry, and we contend that the end of the COVID tailwind for Cummins has arrived.

Changing Winds

The last few years have been good to Cummins. The company is expected to post top-line sales of $27 billion in 2022, a 14% increase over 2021. EBITDA is expected to be close to $4 billion, a little more than 12% over the prior year.

Analysts also expect that the business will continue to grow in 2023, with an expected top-line growth rate of almost 12%. The estimates for 2024 show the company’s top line shrinking, but by less than 1%–hardly cause for alarm, especially in an industry so easily rocked by economic uncertainty.

These estimates seem, in our view, to be a bit rosy. But before we dive into that, let’s take a look at just how cyclical these swings can be.

If you look at most businesses’ sales over time, you see patterns in how sales ebb and flow with the greater economic cycle. Some businesses are less susceptible to having their fortunes tilted one way or another by broader economic influences, while others are not so lucky. Cummins, which commands more than 80% of the Class 8 engine market, belongs firmly in the latter class.

Prior to 2020, Cummins quarterly sales when compared on a year-over-year basis fluctuated with a fair degree of reliability. Rarely in the past 10 years (again, aside from 2020), was there much in the way of wild moves–typically a quarter with sales up from the previous year would be followed with a quarter of sales down from the previous year. For the past ten years, the business has rarely sustained multiple quarters of year-over-year growth.

This is something to be expected. Cummins’s business is, after all, the first step in the order process of a long and volatile supply chain–the medium and heavy-duty truck market. We believe that the above chart serves as the initial evidence for our case that businesses like Cummins over-earned during the pandemic; that an industry with low barriers to entry and sudden high demand pulled forward years worth of orders into a single cycle. This is initially evident to us by the heavy surge in revenue of the past five quarters (the two down quarters at the start of 2022 were actually up on a relative basis but down when compared to the stratospheric quarters the year prior).

We believe that, despite analyst estimates for 2023, this cycle will be ending within the next one to two quarters.

Put Yourself In The Customer’s Shoes

There are a few points we’d like to make about Cummins’s particular customer base.

First, the U.S. trucking industry is incredibly fragmented. And you may say, “well, yes, I already knew that,” but perhaps it isn’t well understood exactly how fragmented it is. According to The Economist, the overall domestic American trucking industry is about $800 billion per year–similar to the airline industry.

They estimate that there are around 900,000 American trucking companies, and that 96% of them own fewer than 20 trucks, while the largest trucking companies make up less than 10% of the market’s overall revenue.

This is staggering. To fully wrap your mind around it, imagine if the airline industry had 100,000 participants, each owning only a few planes. Imagine if players like Delta (DAL) and Southwest (LUV) made up less than 10% of revenues. Can you imagine the nightmares Boeing (BA) would face having to manufacture for such an unstable customer base?

That is exactly the problem facing Cummins. And with these particular macro conditions and with this customer base, there seems to be very little for Cummins in the way of good answers.

Consider:

1. It’s bad enough that every sale Cummins makes is another company’s capital expense–exactly the sort of expense that get slashed and delayed in times of economic hardship. As they reign in spending, customers will look to extend fleet life for as long as possible.
2. The vast majority of Cummins’s end customers are very small businesses. Not only are they very CAPEX sensitive, but their very survival in an economic downturn is a serious question.

Cancel Anytime

There is yet another wrinkle in the analyst’s estimates of Cummins’s future sales over the next twelve months which we think is under-appreciated. Unlike the airline industry, in which orders are placed years in advance and companies like Boeing have leverage to write protection clauses into purchase agreements should a deal fall through, truck sales are typically not considered firm outside of a few month’s lead time.

Take a look at what Cummins had to say in its last 10-K:

We have supply agreements with some truck and off-highway equipment OEMs, however most of our business is transacted through open purchase orders. These open orders are historically subject to month-to-month releases and are subject to cancellation on reasonable notice without cancellation charges and therefore are not considered firm.

This means that, while Cummins and the analysts can attempt to forecast demand, they cannot do so with any reasonable degree of certainty. It’s a testament to the underlying fragmentation of the customer base that not even cancellation charges can be written into orders.

The bottom line here is that should conditions within the U.S. trucking industry–again, a fragmented industry with hundreds of thousands of micro-sized players–shift dramatically, Cummins would be likely to feel the impact without much in the way of warning.

So, Are Warning Bells Ringing?

The little that we can glean doesn’t seem to be good. Data from various sources all seem to point to a broader slowdown in demand for trucking services in line with the consumer softness that has been reported this earning’s season by retailers.

Consider, for example, the inventory levels of three large retailers–Walmart (WMT), Target (TGT), and Nike (NKE).

Rising inventory levels are generally a leading indicator for trucking demand, as companies rely on prior sales forecasts to schedule shipping. As those forecasts change and inventory builds or declines, replenishment schedules adjust accordingly.

Here we see while the inventory levels for Walmart and Target have begun to moderate somewhat, they remain historically elevated, up 14% and 12.5%, respectively. Nike’s inventory levels remain stubbornly high. So long as major retailers and manufacturers have to sit on higher and higher levels of inventory, the fewer goods they will need moved while they deplete the currently held stock.

This is not the only issue. The American Trucking Association has posted two sequential decreasing months of total tonnage shipped over American roads–down 1.2% in October and down 2.5% in November of 2022.

This trend doesn’t appear to have reversed. Factoring firm TCI Capital releases near real-time data on load rates and capacity for the trucking spot market. The data from recent weeks paints a picture of continued near-term weakness.

Spot Market Loads are non-contract loads that trucking companies can assign drivers to immediately. As we can see, in December 2022 spot market load volume declined by 57% year over year, while spot market capacity (available drivers) increased by 13%–not ideal. And while spot market loads increased by 5.2% from November 2022 to December 2022, it’s hard to count that as a win since December is the prime holiday season month where retailers should be consistently replenishing stock. A mere 5% bump is indicative of a weak holiday season, in our opinion.

All of these factors point to a multi-month slowdown in the domestic trucking industry–a slowdown which, we think, will impact Cummins’s near-term earnings and potentially create significant headwinds for (or render impossible) 2023’s growth projections.

Will Cummins Weather The Storm?

We do not believe that Cummins is being priced appropriately by the market to reflect the risks outlined above. The stock currently trades at 12.4x forward earnings. This is down significantly from the pandemic high of mid-2020 when the stock changed hands at close to 26x earnings, but it still remains above the pre-covid average of between 8.5x to 10x forward earnings.

This estimate may seem low for bulls, and we understand that sentiment, especially given the stock’s long valuation slide over the last two years. However, we believe that the risk inherent in this business–the lack of safety mechanisms to protect Cummins from order cancellations and the fragile nature of the end customer base–demand a lower multiple. This low multiple helps to compensate investors for the risk of owning a company whose revenue stream could materially erode with little to no warning.

A slump in trucking demand could hurt top-line revenue as well, and hard. As demand has spiked over the last few years, Cummins produced more trucks than it would have in a regular business cycle. Pulling forward these sales could make Cummins a victim of its own success by creating a glut of used-trucks on the market as the smallest players in the industry succumb to economic pressures.

Subsequent demand by the next crop of new, small trucking companies as the business cycle recovers could then be absorbed in greater part by the used-truck market, the effect of which could have a chilling, rippling effect on Cummins. This has the potential to create a multi-year issue for Cummins as it grapples with an abundance of used, serviceable product in the marketplace.

The stock currently trades at $242. Using next year’s estimated earnings and a 10x target multiple, we set a target price of $197 on the stock. We remind readers that should Cummins guide lower on their forecasts in the coming months, that the target price would fall commensurately.

The Bottom Line

In the last three years Cummins has beaten the broader market, returning more than 40% vs. the S&P 500’s (SPY) 20%.

We believe that this outperformance is set to come to an end.

1. Cummins serves a fragmented and highly economically susceptible customer base.
2. The spot load market and overall tonnages have decreased over the last several months as inventories remain elevated.
3. Cummins lacks the ability to accurately forecast customer demand more than one quarter out, at best.
4. By pulling sales forward during the pandemic, the stage could be set for a difficult next business cycle.

It’s also worth pointing out that company insiders have sold tens of millions of dollars worth of shares over the past 12 months, with no insider purchases since before February of 2022.

For these reasons, we believe the ceiling is currently in on the stock. It seems to us that the stock is priced to perfection, and that the risk is elevated to the downside from here.

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