A Picture’s Worth A Thousand Words
Quick follow up on our Earnings Revisions post from yesterday. In that post, we explained that:
Consensus earnings estimates for 2011 and 2012 are still greater than $95 and $108, respectively, at the same time that GDP estimates are plummeting (although still don’t face the harsh economic reality). To put these figures into perspective, analysts were forecasting a near 20% decline in earnings at the market’s trough. Today, expectations are for 22% growth in the year ahead.
We show an example of this optimism below. Cummins is a global leader in the design, manufacturing and distribution of engines and related technology. The company’s engines are found in a wide range of vehicles and equipment from emergency vehicles to 18-wheelers, berry pickers to 360-ton mining haul trucks. Management has done a tremendous job managing through the crisis. Costs have been cut relentlessly, resulting in a leaner organization with greater operating leverage. The balance sheet is rock solid. Not to mention its image as a ‘safe’ play on the secular growth of emerging market infrastructure development. It’s no wonder the street is in love with the stock.
We have a difficult time arguing any of the points above. Our concern is that the bar is set awfully high just as we stare right into a cyclical slowdown at best and more likely, something much more problematic. Note the company’s historic EBIT margins below. Margins increased from 1.4% at the start of the decade to a peak of 9.4% as the global economy marched straight up through 2006 on the back of the Chinese growth engine fueled by a credit-obsessed American consumer. Then . . . something changed. And something changed quite quickly. As economic growth screeched to a halt in 2008, margins followed, moving in a straight line back to 1.7% in Q3-09. But with ‘a little’ help from the greatest monetary and fiscal stimulus in economic history, orders reappeared and a stream-lined Cummins surprised analysts quarter after quarter, in route to a magical V-Shaped Recovery.
So what’s next? In classic fashion, consensus has basically straight-lined that v-shaped recovery over the next few years, as shown by the last piece of the chart highlighted in red and representing consensus estimates through 2011. Wall Street bulls – of which there are plenty, as none of the analysts covering the stock are brave enough to rate it less than ‘hold’ – are now projecting that the company’s margins reach record highs above 11% over the next eighteen months. Such levels would be nearly 200 basis points above the prior peak reached at the height of the credit-induced global growth bubble. Possible? Sure. Likely? Eh. Not to mention that these record margins on record sales would be achieved in a global economy in the grips of an extended deleveraging process with much of the developed world entering recession or battling depression. We can’t help but wonder, who’s buying all this stuff?
Disclosure: At the time of publication, the author did not hold a position in Cummins, although positions may change at any time.