Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

The best-performing U.S. industrial company in the S&P 500 this year:

  1. Is a onetime sprawling conglomerate and light-bulb maker that's nearing the completion of a historic breakup and just filed to shed its "too-big-to-fail" label
  2. Is a home-security provider that received one of the richest premiums in years for a major U.S. industrial company as part of its buyout by Apollo Global
  3. Is a maker of truck engines on track for its worst revenue slump since the financial crisis and a second straight year of weaker margins

If you guessed No. 3, nice work -- that's Cummins Inc. we're talking about, and it's climbed 31 percent in 2016 through last week, besting more diversified operators such as GE (No. 1) and takeover targets like ADT (No. 2). If that's surprising to you,  join the club.

Up, Up and Away
Cummins is outpacing the rest of the S&P 500 Industrials Index for its best start in years.
Source: Bloomberg

Cummins, which also makes engines for mining equipment and boats, has been trading above analysts' average 12-month price target for about two months now.  A fourth-quarter earnings miss and gloomy outlook for 2016 didn't take away any enthusiasm (in fact, the stock rose on that news; more on that later), nor did a string of not-so-great data about industrial growth and slumping North American heavy-truck orders. What is going on?

Stepped-up buybacks and a plan to return 75 percent of 2016 cash flow to shareholders have helped plump up the stock price. But the bigger reason for the gains may be that investors were afraid to miss out on an eventual industrial and commodities turnaround, says Karen Ubelhart of Bloomberg Intelligence.

Overenthusiastic
Cummins has soared past analysts' average price target this year.
Source: Bloomberg

They're betting that something has to change -- China's economy will improve, commodity prices will stabilize or the declines in truck orders will start to moderate -- and once that happens, Cummins will benefit. Or, at the very least, things won't get any worse. That's why Cummins's stock rose after it said last month that 2016 revenue would drop as much as 9 percent and Ebit margins would be lower than last year -- the outlook was about as bad as what analysts were anticipating. Hooray?

This puts investors in the position of being optimistic before there are really reasons to be optimistic. Which is all well and good; markets, after all, are naturally forward-looking. Cummins isn't overly expensive relative to the rest of the industrial sector, either. But the stock's surge in the past few months leaves little room for mistakes and that could set investors up for a disappointment.

Coming In Hot
The S&P 500 Industrials Index has climbed to its highest price since May 2015 on the backs of gains by companies including Cummins, Eaton and Paccar.
Source: Bloomberg

Take, for example, the 5.5 percent jump in Cummins's stock last Wednesday after Jim Cramer highlighted the company on CNBC as among those that should benefit from the recent rally in oil. Cummins isn’t actually as dependent on the oil industry as it is on the trucking sector, but putting that aside, it's a little early to call for a turnaround. Talks about a coordinated output freeze by OPEC went nowhere over the weekend (as Gadfly's Liam Denning had said they might) and oil prices fell Monday (Cummins, on the other hand, continued its climb).

Then there's China. Cummins has been rapidly adding market share in the country because it can offer truckers the type of engine technology needed to meet new emission standards. In the long run, this is a good thing. But Cummins needs the industry to stabilize for those share gains to pay off. There are signs that's starting to happen, but again, the strength of the momentum is unclear. And after the rush to meet emission standards, then what? 

Don't Call It a Comeback
Analysts don't project revenue or Ebitda growth for Cummins until 2018.
Source: Bloomberg

At home in North America, orders for heavy trucks have plunged and cancellation rates have climbed. The slump could work itself out by 2017 as truckers update vehicles to comply with safety and emissions regulations -- or it could just continue.  Certainly in the near term, the outlook isn't pretty and it's not unreasonable to think there might be further cuts to Cummins's guidance when it reports earnings in a few weeks.

This is all to say, optimism is a great strategy until it isn't anymore. A few bits of bad news could be painful for Cummins's shareholders. Two days after his comments helped lift Cummins's stock, CNBC's Cramer walked back a bit of his Cummins praise, saying in a post on the Street.com on Friday ``I think the business isn't that good, but people trade on the future. I don't want to own it going into earnings, but I would buy it after earnings." So don't get too comfortable with the clarity of that crystal ball.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. That's the longest stretch since 2007, according to data compiled by Bloomberg.

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net