Cummins Inc.: Undervalued Stock With High Growth Potential Part II

In my previous article on Cummins Inc. (CMI), I focused on the company's ability to meet its revenue growth projections. After determining the outlook of the company's major revenue drivers with respect to relevant industry forecasts I reached the conclusion that the company will meet its 4-6% revenue growth target for FY 2014. In the article I also mentioned the company's projection of a 12.75-13.25% EBIT margin for FY 2014. One of the readers of my article demanded an analysis on the company's earnings in order to determine how the company will improve its EBIT margin from 12.5% recorded in FY 2013 to 12.75-13.25% EBIT margin projected for FY 2014 despite a revenue growth of just 4-6%. Therefore I thought of writing this article as a continuation of my previous work.

Let's begin the analysis by identifying the major EBIT and EBIT margin contributors for the company.

EBIT and EBIT Margin Analysis

Source: CMI 10K and Earnings Release

The company's engine segment is the major contributor to the company's EBIT as shown in the table above. The segment contributed 53.61% of the total EBIT before intersegment eliminations and restructuring charges earned by the company in FY 2012. The segment's contribution declined to 47.88% in FY 2013. The following table will show the pattern of growth and decline in the segment's EBIT over the past three years. The company's components segment is the second largest contributor to the company's total EBIT and is recording year-over-year increase in its contribution. The components segment's contribution to the company's total EBIT increased from 17.99% in FY 2011 to 24.24% in FY 2013.

Source: CMI 10K and Earnings Release

You can see from the table above that the company's engine segment, a major contributor to the company's EBIT, recorded a double digit decline in its EBIT in FY 2013 compared to FY 2012. In FY 2012, the segment's EBIT fell by 8.38% so there is a need to determine what will support the recovery in the company's EBIT in the coming year. This will also determine how the company will achieve its EBIT margin target set for FY 2014 as shown in the table below.

Source: CMI 10K and Earnings Release

You can see from the table above that the company has forecasted an increase in its EBIT margin for FY 2014 in all of its segments with the exception of its distribution segment. The EBIT margin of the company's engine segment recorded a year-over-year decline from 12.24% in FY 2011 to 10.4% in FY 2013. However, the company has projected a 10-110 basis point increase in its engine segment revenue for the 4-6% rise in the segment's top line and other factors that I will discuss below. The company expects a major improvement of 56-156 basis points in the power generation segment's EBIT which recorded a 3-digit basis points fall in FY 2012 and 2013. Therefore, I will determine the factors that will contribute to the EBIT margin's improvement for the company's engine segment that is the major contributor to the company's total EBIT and the power generation segment for which the highest recovery is projected by the company despite its adverse performance during the previous two fiscal years.

Engine Segment and Power Generation Segment Material Costs

Source: CMI 10K and Earnings Release

The largest expense the company incurs to reach its gross profit is the cost of sales that mainly includes the cost of materials used by the company to produce its products. The company's gross profit margin declined from 26% in FY 2012 to 25.20% in FY 2013 reflecting a fall of 80 basis points as shown in the table above. The company disclosed that favorable material costs positively impacted the company's gross profit margin in the last quarter of FY 2013 with some other items negatively contributing. Therefore, I will determine the forecasts of cost of major materials for the company's engine and power generation segment although the company did not provide specific figures of its cost of materials in its financial reports. The company manufactures and assembles strategic components used in its engines and power generation units, including blocks, heads, turbochargers, connecting rods, camshafts, crankshafts, filters, alternators and fuel systems while the rest of the parts and components are bought from external sources.

Aluminum Prices

Since most of the components of automotive engines are made from aluminum I will discuss the forecasts of aluminum alloy prices for the coming years. These aluminum components that are fixed into the engines by the manufactures include blocks, cylinders and manifolds. Fast Markets forecasts the price of aluminum will remain range bound with a slight downward trend in 2014. Any bullish move in the price will start the idle capacity of aluminum production and will eventually normalize the price. The price of aluminum rose in the previous years due to U.S. quantitative easing as the USD became devalued and signs of recovery in China became evident. The table below shows some of the statistics and forecasts for primary aluminum global supply, demand, and prices. Despite the increase in demand for aluminum the supply side will remain a bearish factor to aluminum prices.

Source: Fast Markets

Copper and Other Metal Prices

Copper is one of the main components used in electrical equipment such as power generators. Cummins uses derivatives to manage costs and risks associated with adverse movement in copper prices. This shows how the company gets materially affected from fluctuations in the price of this metal since it is a crucial metal that the company uses in its products. Analysts are expecting prices of copper to decline as they are looking at a surplus supply of $385,000 metric tons of copper in 2014. The copper mine supply is anticipated to increase in 2014 and this event along with lower Chinese demand should put downward stress on the price.

Overall Chinese demand for metals is slowing but rising supply from mines will reduce the prices of metals in 2014. Capital Economics forecasts copper, iron ore, and steel prices will drop in 2014 due to strong supply growth and restrained demand. Lead and zinc are also expected to record a drop in price as new LME warehousing rules will be applied and will "unlock stocks" and improve supply.

Conclusion

I identified some external factors regarding what will contribute to the company achieving its target of improving its EBIT margin. These include the decline in input costs incurred by the company to manufacture its products. Macro factors will cause a decline in prices of key metals the company uses and this will improve the company's gross profit margin in FY 2014. Consequently, along with the rise in the revenue of major EBIT contributing segments of the company the company's EBIT margin will get support to reach the set targets for FY 2014.

Source: Cummins Inc.: Undervalued Stock With High Growth Potential Part II

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article

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