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Morningstar | Cummins Prepares for an Electrified Future While Continuing to Advance Diesel Technology. See Updated Analyst Note from 08 Jul 2019

After taking a fresh look at Cummins, we are raising our fair value estimate to $176 from $159. The change is primarily due to an increase in our midcycle operating margin estimate, which we have raised to 11.8% from 10.4%, based on our assumption that customers will eagerly adopt more fuel-efficient, next-generation engines. Cummins is currently the leading manufacturer of on-highway class 8 truck engines, with 38% market share in North America. It also provides diesel engines to manufacturers of off-highway equipment and locomotives in addition to manufacturing its own diesel-powered generators. Cummins’ ability to continuously advance diesel technology to address both customer needs and government mandates has allowed the firm to grow revenue, which have increased sevenfold in the past 30 years, as well as increase its market share of class 8 engines despite aggressive insourcing efforts from truck manufacturers.

Our research suggests that Cummins’ end users appreciate the availability of third-party engines for a variety of reasons. For the initial truck purchase, Cummins provides additional bargaining power for fleets, which is decidedly negative for the truck manufacturers, who lose both the initial vehicle content and the aftermarket engine parts revenue.

Customers’ demand for Cummins’ engines is sufficiently robust that it effectively forces truck manufacturers to offer a third-party alternative, which is not in their best financial interest. We believe this demand stems from both brand affinity and the need for fleets to cost-effectively maintain a single type of engine across different truck platforms. The increased complexity of diesel engines in the past decade, including exhaust after-treatment systems, has elevated maintenance expenditures and the scope of technical documentation. We believe these factors will encourage a large percentage of fleets to seek a single source of engines across truck platforms for the foreseeable future.

Despite Cummins’ healthy research and development spending, technological disruption remains a long-term threat to its core business. In the first half of 2019, several electric heavy-duty truck new entrants, including Tesla, Xos, and Nikola, announced thousands of pre-orders of their electric class 8 trucks. Concurrently, major incumbent truck manufacturers have also released prototypes of their battery-electric and hydrogen fuel cell vehicles. Despite the bold pronouncements, major milestones for production of electric trucks continue to slip. Most notable of these pushbacks occurred in Tesla’s first-quarter earnings announcement, where it mentioned production of its electric truck, Semi, will commence in 2020 instead of the previously planned 2019 release.

Cummins has a delicate balancing act, as it must continually advance diesel technology while hedging its bets by investing in alternative powertrain technology. Despite its track record of skillfully addressing competitive threats, it is unlikely to escape the impact of the widespread adoption of commercial electric powertrains that is likely to occur in 10 to 20 years. For commercial customers, the appeal of electric powertrains stems from significantly lower operational costs, where both routine maintenance items and major repairs are largely eliminated. The downside for an internal combustion engine manufacturer who wishes to transition to making electric powertrains is that the low-maintenance model will crush lucrative aftermarket revenue streams.

We believe the battle between internal combustion technologies and electric powertrains coming in the next two decades will initially benefit Cummins. Specifically, diesel ecosystem participants, including petroleum companies and truck manufacturers, have vested interests in Cummins’ success. As with previous disruptions caused by government mandates, Cummins will likely capture a larger share of vehicle content. Given that a typical on-highway diesel engine costs less than one-tenth its lifetime fuel consumption expenditures, increasingly astute customers are likely to invest in more efficient engines to achieve a lower total cost of vehicle ownership. Because Cummins has been able to increase fuel economy 2% to 3% for each new generation of engine it releases, sophisticated fleets are generally willing to replace trucks long before catastrophic engine failures occur. Advancements are likely to continue for several decades because the thermal efficiency of on-highway diesel engines is generally under 40%, leaving significant room for future improvements.