Cummins Inc. — Q2 2016 Form 10-Q
Reporting period: Three and six months ended July 3, 2016; comparisons are with the three and six months ended June 28, 2015. Amounts are in millions except per-share data.
Business context
Cummins designs, manufactures, distributes and services engines and related components, power generation systems and associated products worldwide. Its reportable segments are Engine, Distribution, Components and Power Systems. In Q2 2016, Power Generation and high-horsepower engines were combined into the new Power Systems segment; prior-period segment results were recast for the reorganization. A revised shared-cost allocation method affected 2016 segment results but not consolidated results.
Financial performance
| Metric | Q2 2016 | Q2 2015 | First half 2016 | First half 2015 |
|---|---|---|---|---|
| Net sales | $4,528 | $5,015 | $8,819 | $9,724 |
| Gross margin | $1,197 | $1,332 | $2,253 | $2,527 |
| Gross margin as % of sales | 26.4% | 26.6% | 25.5% | 26.0% |
| Operating income | $567 | $723 | $1,037 | $1,271 |
| Net income attributable to Cummins | $406 | $471 | $727 | $858 |
| Diluted EPS | $2.40 | $2.62 | $4.26 | $4.76 |
Quarterly sales fell 10% and first-half sales fell 9%. Management attributed the declines mainly to lower demand across on-highway, power generation and industrial markets, unfavorable product mix and foreign currency effects. Lower volumes and mix reduced gross margin dollars; lower material and commodity costs, lower warranty expense and Distribution growth partly offset the pressure. The first-half effective tax rate was 26.9%, versus 28.1% a year earlier; management expects approximately 27.0% for full-year 2016, excluding one-time items.
Segment EBIT declined year over year in Q2: Engine $206 (down 26%), Distribution $87 (down 23%), Components $190 (down 15%) and Power Systems $90 (down 29%). Power Systems had the largest first-half EBIT decline, down 40% to $136. Engine results included a $39 accrual for an emissions-related loss contingency.
Cash flow, balance sheet and capital allocation
- First-half operating cash flow was $734, up from $569. Management cited more favorable working-capital movements, partly offset by lower net income, currency/hedging effects and restructuring payments.
- First-half investing cash outflow was $391, including $189 of capital expenditures and $27 for internal-use software. The company plans $600–$650 of 2016 capital spending.
- First-half financing cash outflow was $892, including $695 of share repurchases and $333 of common dividends. Cash and cash equivalents declined $666 to $1,045, including a $117 adverse currency impact. Cash, cash equivalents and marketable securities totaled $1,280.
- At July 3, working capital was $3,480 and the current ratio was 1.84, compared with $4,144 and 2.09 at year-end 2015. Receivables were $3,023 and inventories were $2,778.
- Total debt was $1,871, up from $1,639 at year-end; debt-to-capital rose to 20.6% from 17.5%, reflecting repurchases and higher debt, including commercial paper. Commercial paper outstanding was $200; long-term debt was $1,614. The $1.75 billion revolving facility had $1.55 billion available after commercial paper borrowings, plus $171 of other available credit capacity.
- The Board raised the quarterly dividend 5.1%, from $0.975 to $1.025 per share, in July 2016. The company repurchased 6.7 million shares for $695 in the first half.
Outlook, commentary and risks
- Management expected strong North American pickup demand, improving demand in India and approximately $160 of annualized savings from the 2015 restructuring actions.
- Challenges identified for the remainder of 2016 included declining North American heavy-duty truck production, weak power generation, Brazil, foreign-currency volatility, weak oil and gas demand and continued weakness in global mining markets. Further facility closures or restructuring could result in additional charges. The filing provides no specific full-year revenue or earnings forecast.
- The 2015 restructuring reduced the workforce by about 1,900 employees and generated a $90 charge. Substantially all terminations were complete; $42 of related cash payments had been made in the first half.
- An emissions-testing issue involving certain third-party aftertreatment systems led to a voluntary campaign proposal. Cummins recorded a $60 charge in 2015 and an additional $39 accrual in Q2 2016. Campaign execution and cost-sharing arrangements remained in progress; final costs could differ. The company did not then expect EPA or CARB fines or penalties.
- Other disclosed exposures include product, environmental, tax and other litigation; supplier minimum-purchase commitments with approximately $124 of potential penalties if purchases ceased; and $40 of guarantees’ maximum potential loss, of which $15 was accrued. Management stated it did not anticipate supplier penalties and did not consider pending lawsuits material individually or in aggregate, while noting outcomes could adversely affect results.
- Foreign-currency translation reduced comprehensive income by $213 in Q2 and $270 in the first half. Key risks include cyclical market demand, customer and supplier conditions, emissions regulation, currency movements, litigation, product liability, pension assumptions and geopolitical and economic conditions.
Important facts for investors to verify
- Whether demand and volumes in heavy-duty trucks, power generation, oil and gas, mining and Brazil continued to weaken or stabilized after the quarter.
- The ultimate cost, timing, regulatory approval and customer cost-sharing for the emissions campaign, and whether any additional accruals, fines or penalties arose.
- Whether projected restructuring savings of about $160 annually were achieved and whether further facility actions created charges.
- Cash generation, working-capital trends, debt and liquidity after substantial repurchases and dividends; also the impact of foreign-currency movements.
- How the revised segment structure and cost-allocation methodology affect interpretation of segment trends and comparability.