CUMMINS INC quarterly report, Q2 FY2017

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Cummins Inc. — Q2 2017 Form 10-Q

Business context and reporting period. Cummins designs, manufactures, distributes and services engines, components and power systems globally. The quarter ended July 2, 2017; comparisons are with the quarter ended July 3, 2016. Financial amounts below are in U.S. dollars.

Financial performance

  • Q2 revenue: $5.078 billion, up 12% year over year. All four segments grew sales.
  • Q2 earnings: Operating income was $595 million, up 5%; net income attributable to Cummins was $424 million, up 4%. Diluted EPS was $2.53 versus $2.40.
  • Margins: Gross margin was 24.6%, down from 26.4%; operating margin was approximately 11.7%, versus 12.5%. Higher volume, lower material costs and improved Distribution margins were offset by higher warranty costs and variable compensation.
  • First-half results: Revenue was $9.667 billion, up 10%; operating income was $1.141 billion, up 10%; net income attributable to Cummins was $820 million, up 13%; diluted EPS was $4.88 versus $4.26. Gross margin was 24.6%, compared with 25.5%.
  • Cash flow: First-half operating cash flow was $826 million, up from $738 million. Capital expenditures and internal-use software investments totaled $222 million. Cash and cash equivalents rose to $1.293 billion from $1.120 billion at year-end.
  • Liquidity and debt: Cash, cash equivalents and marketable securities totaled $1.467 billion. Total debt was $1.797 billion, down from $1.856 billion at December 31, 2016; debt was 18.7% of total capital, versus 20.6%. Working capital was $3.708 billion and the current ratio was 1.76. Available capacity under the revolving facility was approximately $1.616 billion.
  • Shareholder returns: First-half dividends paid were $343 million; Cummins repurchased $120 million of stock. In July, the board raised the quarterly dividend 5.4%, from $1.025 to $1.08 per share.

Material changes and segment trends

  • Engine: Q2 sales rose 15% and EBIT rose 34% to $277 million; higher North American truck and global off-highway demand contributed. First-half EBIT rose 26% to $506 million.
  • Distribution: Q2 sales increased 12% to $1.722 billion and EBIT rose 10% to $96 million. Growth reflected organic sales and acquired North American distributors.
  • Components: Q2 sales increased 14% to $1.454 billion, while EBIT was flat at $190 million; EBIT margin fell to 13.1% from 14.9%. Higher sales were offset by costs and expenses, including warranty costs.
  • Power Systems: Q2 sales rose 10% to $1.017 billion, but EBIT fell 32% to $61 million and margin declined to 6.0% from 9.8%. Industrial growth was offset by weaker power-generation sales, higher warranty costs, unfavorable mix and material costs.
  • First-half equity, royalty and interest income from investees increased to $206 million from $160 million, supporting earnings. Foreign-currency translation generated a first-half gain of $182 million, compared with a $270 million loss in the prior-year period.

Outlook, risks and unusual items

  • Management expects the 2017 effective tax rate to be approximately 26%, excluding one-time items; full-year capital expenditures are projected at $500 million–$530 million. Management expects 2017 pension cost of approximately $83 million and an additional $50 million of defined-benefit contributions for the remainder of the year.
  • The filing provides directional market commentary, but no specific full-year revenue or EPS guidance. Positive trends cited include strong North American pickup and medium-duty truck demand, strong off-highway demand in China and India, and potential improvement in global mining. Challenges include soft power-generation and marine markets, weak Brazil conditions and currency pressure.
  • Warranty liability was $1.521 billion at period-end, including deferred extended-warranty revenue. Warranty expense and estimate changes weighed on margins. The emissions-related field campaign accrual was $159 million; the company said the campaign would take time to complete and final costs could differ from the accrual. It did not then expect EPA or CARB fines or penalties.
  • After quarter-end, on July 31, 2017, Cummins closed its $600 million purchase of a 50% interest in the Eaton Cummins Automated Transmission Technologies venture. Cummins expects to consolidate it in Components and did not expect a significant effect on 2017 consolidated results.
  • Other disclosed risks include market downturns, customer and supplier risks, currency and political conditions, emissions regulation, recalls, litigation, commodity costs, pension-asset performance and cybersecurity. Management said disclosure controls were effective and reported no material change in internal controls during the quarter.

Most important facts for investors to verify

  • Whether sales growth translates into restored gross margin, given Q2 and first-half margin contraction and higher warranty costs.
  • Whether Power Systems’ EBIT and margins recover, and whether Components can convert sales growth into improved profitability.
  • The ultimate cost and timing of the $159 million emissions campaign accrual, including the outcome of the related customer cost-allocation litigation.
  • The effect of the Eaton transmission venture’s consolidation, purchase accounting and $600 million cash-and-short-term-debt funding on future results and leverage.
  • Whether operating cash flow, working capital and liquidity remain adequate as demand, capital spending, dividends, buybacks and pension contributions evolve.
  • Progress and quantified financial effects of adopting new accounting standards, particularly revenue recognition in 2018 and lease accounting in 2019.