Cummins Inc. — Q3 2017 Form 10-Q
Reporting period: Third quarter ended October 1, 2017; comparisons are with the quarter ended October 2, 2016. Nine-month figures cover the periods ended on those dates. Amounts are in U.S. dollars.
Business context and financial performance
Cummins designs, manufactures, distributes and services engines, components and power-generation products worldwide. Its reportable segments are Engine, Distribution, Components and Power Systems.
- Q3 revenue: $5.285 billion, up 26% year over year. Nine-month revenue: $14.952 billion, up 15%.
- Q3 profitability: Gross margin was $1.339 billion (25.3% of sales, versus 25.8%); operating income was $629 million; net income attributable to Cummins was $453 million; diluted EPS was $2.71, up from $1.72.
- Nine-month profitability: Gross margin was $3.716 billion (24.9% of sales, versus 25.6%); operating income was $1.770 billion; net income attributable to Cummins was $1.273 billion; diluted EPS was $7.60, versus $5.99.
- Cash flow: Nine-month operating cash flow was $1.471 billion, compared with $1.314 billion. Investing activities used $786 million and financing activities used $600 million. Cash and cash equivalents ended at $1.290 billion.
- Liquidity and debt: Cash, cash equivalents and marketable securities totaled $1.444 billion. Current ratio was 1.57, versus 1.78 at year-end 2016. Total debt was $2.255 billion, up from $1.856 billion; debt to total capital was 20.8%, versus 20.6%. Available revolving credit capacity was approximately $2.236 billion.
- Shareholder returns: Cummins repurchased $391 million of stock and paid $522 million in dividends in the first nine months. The quarterly dividend was increased 5.4% to $1.08 per share.
Material changes and segment performance
- Growth reflected stronger demand across all segments, notably North American on-highway markets, construction and industrial markets, and demand in China. Management also cited acquisitions of North American distributors as contributing to Distribution sales.
- Q3 segment sales and EBIT were: Engine $2.336 billion and $229 million; Distribution $1.753 billion and $91 million; Components $1.533 billion and $217 million; Power Systems $1.056 billion and $81 million. Segment sales include intersegment amounts.
- Gross-margin dollars increased, but margin as a percentage of sales declined. Higher volumes, improved leverage and lower material costs were partly offset by higher warranty costs and variable compensation. Warranty costs affected gross margin by $105 million in Q3 and $234 million year to date.
- Net income growth also benefited from the absence of the prior-year loss-contingency accrual ($99 million in Q3 2016; $138 million for the first nine months of 2016) and higher income from investees. Higher SG&A, research and development expenses, and the effective tax rate were offsets.
Outlook, unusual items and risks
- Management expected strong North American heavy-duty and medium-duty truck, pickup, construction, and China truck and off-highway demand; global mining demand might continue improving. Power-generation markets could remain soft, while Brazil’s weak economy and weak marine markets were cited as challenges.
- Management expected a 2017 effective tax rate of approximately 26%, excluding one-time items, and capital expenditures of $500–$530 million. No consolidated revenue or earnings forecast was provided in the supplied filing text.
- Cummins paid $600 million for a 50% interest in the Eaton Cummins Automated Transmission Technologies venture, consolidated in Components because of a tie-breaking board vote. It reported $69 million of venture revenue and a $5 million net loss in Q3; management did not expect a significant consolidated impact in 2017.
- A $29 million Q3 charge was recorded for campaigns addressing emissions issues in certain pre-2013 engine systems. Additional engine systems from model years 2010–2015 were under review; the potential impact was not yet estimable and could be material. The company said it did not currently expect related EPA or CARB fines or penalties.
- Other contingencies include an ongoing dispute and campaign involving third-party aftertreatment systems, with a remaining $148 million accrual, as well as product, environmental, tax and other litigation. Management said final outcomes could differ from recorded estimates and potentially affect results, financial condition or cash flows.
- After quarter-end, Cummins agreed to acquire Brammo battery assets for approximately $70 million, with a potential additional earnout of up to $100 million; closing was expected in Q4 2017.
- Key broader risks include market downturns, customer and supplier concentration or distress, commodity and currency movements, emissions regulation and product recalls, litigation, and pension-asset and discount-rate volatility.
Important facts for investors to verify
- Whether the strong truck, construction, China and mining demand trends continued, and whether softer power-generation, marine and Brazil markets worsened.
- The scope, cost and timing of the emissions campaigns, including the unresolved review of additional engine systems and the third-party aftertreatment dispute.
- Warranty expense and reserve development, including the $1.643 billion reported warranty-related balance and the assumptions behind future campaign costs.
- Cash conversion and working-capital trends: receivables and inventories rose from year-end, while the current ratio declined.
- The Eaton venture’s subsequent contribution to sales, earnings and cash flow, and the closing terms and eventual earnout for the Brammo transaction.