Cummins Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended October 2, 2016; comparisons are to the periods ended September 27, 2015. Dollar amounts are in millions unless stated otherwise.
Business context
Cummins designs, manufactures, distributes and services engines, components and power-generation systems globally. Its reportable segments are Engine, Distribution, Components and Power Systems. In 2016, Power Generation and high-horsepower engines were combined into Power Systems; the company also revised its allocation of certain shared costs among segments, without changing consolidated results.
Key financial results
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Net sales | $4,187 | $4,620 | $13,006 | $14,344 |
| Gross margin | $1,079; 25.8% | $1,208; 26.1% | $3,332; 25.6% | $3,735; 26.0% |
| Operating income | $384 | $557 | $1,421 | $1,828 |
| Net income attributable to Cummins | $289 | $380 | $1,016 | $1,238 |
| Diluted EPS | $1.72 | $2.14 | $5.99 | $6.90 |
| Operating cash flow | Not separately provided for the quarter | Not separately provided for the quarter | $1,310 | $1,131 |
- Quarterly sales fell 9%, operating income fell 31%, and Cummins-attributable net income fell 24% year over year. Nine-month sales declined 9% and attributable net income declined 18%.
- Gross margin percentage decreased 0.3 percentage point in Q3 and 0.4 point year to date. Lower volumes and unfavorable mix weighed on margins; lower material and commodity costs provided partial offsets. Quarterly results also included a $99 loss-contingency accrual; the nine-month accrual was $138.
- Operating cash flow increased $179 year over year for the first nine months, reflecting lower working-capital outflows and higher deferred taxes, partly offset by lower net income, translation and hedging effects, and restructuring payments.
- Cash and cash equivalents were $1,251 at October 2, 2016, and marketable securities were $250, for total cash and securities of $1,501. Working capital was $3,486 and the current ratio was 1.81, down from 2.09 at December 31, 2015.
- Total debt was $1,949, versus $1,639 at year-end 2015; debt to total capital rose to 21.2% from 17.5%. Debt included $273 of commercial paper. Long-term debt, including current maturities, was $1,628.
- Investing cash use was $590 and financing cash use was $1,041 for the nine months. The company repurchased $745 of shares and paid $505 in dividends. Capital expenditures and internal-use software spending totaled $354.
Material changes and segment performance
Management attributed weaker consolidated sales mainly to reduced demand across global on-highway, power-generation and industrial markets, together with unfavorable foreign-exchange effects. U.S. and Canada revenue declined 13% in Q3; international revenue declined 3%. For the first nine months, those declines were 12% and 5%, respectively. The company reported improved Distribution sales from prior North American distributor acquisitions, partly offsetting organic-market weakness.
- Engine: Q3 segment sales declined 12% and EBIT declined 59%, to $89; the $99 contingency charge was recorded in this segment. Heavy-duty truck weakness was pronounced.
- Distribution: Q3 sales declined 3% and EBIT declined 22%, to $96, reflecting weaker organic demand and currency effects, partly offset by acquired distributor sales.
- Components: Q3 sales declined 8% and EBIT declined 5%, to $148.
- Power Systems: Q3 sales declined 13% and EBIT declined 20%, to $59, amid lower power-generation and industrial demand.
For the nine months, diluted EPS included an estimated $0.18 benefit from lower weighted-average share count, primarily due to repurchases. Foreign-currency translation reduced other comprehensive income by $299 year to date.
Outlook, risks and unusual items
- Management expected strong North American pickup-truck demand but declining heavy- and medium-duty truck production, weaker North American construction, continued weakness in power generation, Brazil, oil and gas, commercial marine and global mining, and continuing foreign-currency volatility.
- The company intended to realize approximately $160 of annualized savings from 2015 restructuring actions and said further facility closures or restructuring could result in additional charges. It planned 2016 capital spending of $550–$600.
- Management expected a 2016 effective tax rate of approximately 25.5%, excluding one-time items. It expected 2016 net periodic pension cost of approximately $42 and stated anticipated pension contributions of $146 to U.S. and U.K. plans and $44 to German plans.
- Emissions-related contingency: Cummins recorded a cumulative $138 accrual in 2016 for its expected participation in an expanded voluntary campaign involving engines installed in certain customer vehicles with third-party aftertreatment systems. The campaign remained subject to final cost uncertainty and pending cost-allocation litigation with the OEM customer. Cummins did not then expect EPA or CARB fines or penalties.
- Other disclosed exposures included ordinary-course litigation and environmental matters, supplier minimum-purchase commitments with approximately $108 in potential penalties if purchases stopped, and guarantees. The company said it did not anticipate supplier penalties and did not believe ordinary-course lawsuits were material individually or in aggregate, while noting outcomes could still adversely affect results.
- After quarter-end, Cummins acquired the remaining 50% of Cummins Pacific, LLC for stated consideration of $97, including $17 cash and $66 to eliminate debt; the remaining $14 was payable subject to adjustments. It expected to recognize a $13 gain in Q4 2016.
Investor verification priorities
- Track the final scope, approval, cost and payment timing of the emissions campaign, and the outcome of cost-allocation litigation with the OEM.
- Assess whether demand, foreign exchange and segment profitability follow the weak-market outlook described by management, particularly in heavy-duty trucks, power generation and industrial end markets.
- Reconcile debt and liquidity movements, including commercial-paper usage, buybacks, dividends and the effect of international cash balances and potential repatriation taxes.
- Monitor delivery of restructuring savings, planned capital spending and pension contributions, and whether further restructuring charges arise.
- Confirm the final purchase-price adjustments and Q4 gain from the Cummins Pacific acquisition.