Cummins Inc. Nice Second-Quarter EPS Beat but Not Immune to Second-Half Slowdown. Equity Research Global Industrial Infrastructure Capital Goods

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1 Equity Research Global Industrial Infrastructure Capital Goods August 02, 2016 Cummins Inc. Nice Second-Quarter EPS Beat but Not Immune to Second-Half Slowdown Summary/Quick take. Cummins reported a solid EPS beat versus consensus but lowered its 2016 guidance. The guidance implies EPS in a range of $7.75 to $8.40 (midpoint $8.07) by our calculations, compared with consensus of $7.96 and our $7.75 estimate. The prior implied EPS guidance was $7.80 to $8.80 (midpoint $8.30). Cummins reported EPS of $2.40 in the second quarter, versus consensus of $2.15 and our estimate of $2.22. Sales and operating margins were moderately better than expected, and a lower tax rate contributed about $0.09. Cummins, like other industrial companies this quarter, is reporting pretty solid results, driven mostly by better-than-expected margins, which in large part are due to restructuring and material cost tailwinds. However, the outlook for capital goods has weakened. For Cummins, it is mostly weaker in NAFTA on-highway and global off-highway. During the quarter, the company bought back $120 million worth of shares and paid a dividend of $163 million on operating cash flow of $471 million. Cummins increased quarterly dividend by 25% last August. The company is targeting a cash return to shareholders of 75% of operating cash flow this year. Shareholder-friendly capital allocation strategies have helped buffer the downside for some of the larger capital good companies as well especially given the lack of yield in assets. Cummins divided yield is about 3.4%. With the potential for harder material cost comps, renewed oil market headwinds, and weak organic growth (and declines) it will probably be harder for companies to have large beats in the second half. To put this cut in perspective, first-half EPS were $4.27, implying a second-half EPS reduction of about 6% to 8% versus consensus expectations though some of this was certainly priced in. Therefore, while the downside is somewhat helped by the dividend, the macro issues, persistent weak NAFTA truck orders, and the recent run in the stock, we would expect modest downside Tuesday morning. The conference call is at 10:00 a.m. EDT. Solid beat on EBIT and EPS. Cummins reported adjusted second-quarter EPS of $2.40 that beat consensus of $2.15 and our estimate of $2.22. Revenue of $4.5 billion was basically in line with the consensus estimate and our estimate. Cummins delivered a 10% year-over-year sales decline in the quarter. The largest declines were from engine (down 28%), with lower volume in truck production in North America, and in power generation (down 16%) due to weak demand for power generation equipment and industrial engines. Components sales also saw a decline of 8%, driven by weak industry truck production, partly offset by growth in China. The distribution segment sales were up 3% year-over-year, better than consensus and our estimate driven by acquisitions, in spite of organic decline in North America and Middle East. Currency negatively affected revenues by 1%, compared with last year, as a result of the stronger U.S. dollar. Revenues in North America decreased 13%, and international sales fell 4%, with the most significant drop in the Middle East, Mexico, and Brazil. Lawrence De Maria, CFA ldemaria@williamblair.com Paris Gu pgu@williamblair.com Stock Rating: Market Perform Company Profile: Established Growth Price Target: $ Symbol: CMI (NYSE) Price: $ (52-Wk.: $80-$131) Market Value (mil.): $20,750 Long-Term EPS Growth Rate: 0% Dividend/Yield: $4.10/3.4% Fiscal Year End: December 2015A 2016E 2017E Estimates EPS Q1 $2.14 $1.87 NA Q2 $2.62 $2.22 NA Q3 $2.14 $1.86 NA Q4 $2.02 $1.80 NA FY $8.93 $7.75 $7.25 CY $7.75 $7.25 Valuation FY P/E 13.6x 15.7x 16.8x CY P/E 15.7x 16.8x Trading Data (FactSet) Shares Outstanding (mil.) 170 Float (mil.) 166 Average Daily Volume 1,879,904 Financial Data (FactSet) Book Value Per Share (MRQ) 40.6 Return on Equity (TTM) 18.5 Two-Year Price Performance Chart $150 $140 $130 $120 $110 $100 $90 $80 Jan-15 Jan-16 Sources: FactSet, William Blair & Company estimates Cummins Inc. designs, manufactures, distributes, and services engines and related technologies, including fuel systems, controls, air handling, filtration, emission solutions, and electrical power generation systems. Please refer to important disclosures on pages 4-5. Analyst certification is on page 4. William Blair or an affiliate does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as a single factor in making an investment decision.

2 Margins. Adjusted segment operating margins came in at 13.1%, above consensus of 12.7% and our estimate of 12.8%. Engine EBIT margin was 10.3%, better than the 10.1% Street expectation, and power generation margin was 9.8%, above the 6.8% consensus. Components EBIT of 14.9% was also higher than consensus of 14.4%. Distribution EBIT margin was 5.6%, missing the consensus of 6.9%. Engine EBIT decremental margins were roughly 22% according to our calculations. Overall decrementals were about 27%. We await more color on the call. Capital allocation. During the quarter, the company bought back $120 million worth of shares and paid a dividend of $163 million on operating cash flow of $471 million. Cummins increased quarterly dividend by 25% last August. Cummins reduces 2016 guidance. The guidance now calls for sales to be down 8% to 10% from prior range of 5% to 9%. Cummins maintains EBIT margins of 11.6% to 12.2%. The new revenue guidance implies sales of $17.2 billion to $17.6 billion, which compares with the consensus estimate of $17.5 billion and our $17.7 billion forecast. Depending on the tax rate and buyback, we believe guidance implies an EPS range of about $7.70 to $8.40. This compares with consensus of $7.96 and our $7.75 estimate. A variance table is included on the following page. 2 Lawrence De Maria, CFA

3 Cummins Variance Table ($ in millions, except per share data) Actual Cons. WB Variance vs. Change vs. 2Q 16 2Q 16E 2Q 16E WB 2Q 16E (%) 2Q 15A 2Q 15A (% ) Revenue Engine 2,002 2,442 2,442 (18.0%) 2,797 (28.4%) Power Generation % % Components 1,279 1,259 1,332 (3.9%) 1,397 (8.4%) Distribution 1,544 1,483 1, % 1, % Eliminations (1,218) (1,374) (1,475) NM (1,421) NM Total Revenue $4,528 $4,491 $4, % $5,015 (9.7%) Gross profit 1,197 1,127 1, % 1,332 (10.1%) % margin 26.4% 25.1% 25.6% 83 bps 26.6% -12 bps SG&A % 537 (2.4%) % of sales 11.6% 11.2% 11.3% 26 bps 10.7% 86 bps % growth (2.4%) (6.7%) (5.4%) 293 bps 0.4% -279 bps R&D % 166 (6.6%) % of sales 3.4% 3.8% 3.3% 13 bps 3.3% 11 bps % growth (6.6%) 2.4% (10.9%) 432 bps (7.3%) 64 bps Equity, royalty and interest income % 94 (6.4%) Adjusted EBIT Engine (16.2%) 341 (39.6%) Power Generation % % Components (2.0%) 223 (14.8%) Distribution (15.0%) 113 (23.0%) Corporate and Eliminations 18 (15) (15) 220.0% (13) (238.5%) Adjusted EBIT $591 $571 $ % $721 (18.0%) Incremental/(Decremental) Margin Engine (17.0%) (26.8%) (26.9%) 988 bps 25.0% -4,198 bps Power Generation 19.0% (13.8%) (18.0%) 3,699 bps (18.2%) 3,715 bps Components (28.0%) (30.4%) (44.4%) 1,648 bps 59.4% -8,734 bps Distribution (53.1%) (83.3%) (184.2%) 13,111 bps (5.0%) -4,802 bps Incremental/(Decremental) Margin (26.7%) (28.6%) (27.7%) 101 bps 35.6% -6,225 bps EBIT Margin Engine 10.3% 10.1% 10.1% 23 bps 12.2% -190 bps Power Generation 9.8% 6.8% 7.0% 278 bps 7.6% 214 bps Components 14.9% 14.4% 14.6% 29 bps 16.0% -111 bps Distribution 5.6% 6.9% 6.9% -123 bps 7.6% -192 bps Total EBIT Margin 13.1% 12.7% 12.8% 23 bps 14.4% -132 bps Tax rate 25.7% 28.0% 28.5% -2.8% 29.5% (3.8%) Diluted shares (0.7%) 180 (5.9%) Diluted EPS, Excluding Special Items $2.40 $2.15 $ % $2.62 (8.4%) Sources: Cummins, FactSet and William Blair & Company L.L.C. Estimates Cummins Guidance Comparison ($ in billions) Old New Prior Prior Guidance Guidance Consensus WB Est. Revenue ($bn) $17.4bn - $18.2bn $17.2bn - $17.6bn $17.5bn $17.7bn % change Down 5-9% Down 8-10% -8.3% -7.6% EBIT Margin 11.6% % 11.6% % 11.7% 11.3% Implied EPS (a) $7.8 - $8.8 $7.7 - $8.4 $7.96 $7.75 (a) Makes assumptions on tax rate, diluted shares outstanding and below -the-line items. Estimated range subject to change pending conference call. Sources: Cummins, FactSet and William Blair & Company L.L.C. Estimates 3 Lawrence De Maria, CFA

4 IMPORTANT DISCLOSURES William Blair or an affiliate is a market maker in the security of Cummins Inc. William Blair or an affiliate expects to receive or intends to seek compensation for investment banking services from Cummins Inc. within the next three months. Additional information is available upon request. This report is available in electronic form to registered users via R*Docs at or Please contact us at or consult williamblair.com/research-and-insights/equity-research/coverage.aspx for all disclosures. Lawrence De Maria attests that 1) all of the views expressed in this research report accurately reflect his/her personal views about any and all of the securities and companies covered by this report, and 2) no part of his/her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed by him/her in this report. We seek to update our research as appropriate, but various regulations may prohibit us from doing so. Other than certain periodical industry reports, the majority of reports are published at irregular intervals as deemed appropriate by the analyst.. In addition, the analyst has not received compensation from any subject company in the past 12 months. DOW JONES: 18, S&P 500: 2, NASDAQ: 5, Cummins Inc. (CMI) Jul 19, Jul 21,2016 Previous Clos e: $ $160 $150 Date: 9/17/2013 tg_price: Date: 2/5/2015 tg_price: Date: 10/27/2015 tg_price: Date: 7/28/2015 Date: 2/4/2016 tg_price: tg_price: $140 $130 $120 $110 Date: 4/17/2014 tg_price: Date: 4/29/2014 tg_price: Date: 10/28/2014 tg_price: Date: 9/25/2015 rec_name: M tg_price: Date: 5/3/2016 tg_price: $100 $90 $80 Jan-14 Jan-15 Jan-16 Source: FactSet and William Blair Legend: I = = Analyst = No Recommendation Change, tg _price = Price Target Current Rating Distribution (as of 07/31/16) Coverage Universe Percent Inv. Banking Relationships* Percent Outperform (Buy) 63 Outperform (Buy) 8 Market Perform (Hold) 36 Market Perform (Hold) 3 Underperform (Sell) 1 Underperform (Sell) 0 *Percentage of companies in each rating category that are investment banking clients, defined as companies for which William Blair has received compensation for investment banking services within the past 12 months. The compensation of the research analyst is based on a variety of factors, including performance of his or her stock recommendations; contributions to all of the firm s departments, including asset management, corporate finance, institutional sales, and retail brokerage; firm profitability; and competitive factors. OTHER IMPORTANT DISCLOSURES Stock ratings, price targets, and valuation methodologies: William Blair & Company, L.L.C. uses a three-point system to rate stocks. Individual ratings and price targets (where used) reflect the expected performance of the stock relative to the broader market (generally the S&P 500, unless otherwise indicated) over the next 12 months. The assessment of expected performance is a function of near-, intermediate-, and long-term company fundamentals, industry outlook, confidence in earnings estimates, valuation (and our valuation methodology), and other factors. Outperform (O) stock expected to outperform the broader market over the next 12 months; Market Perform (M) stock expected to perform approximately in line with the broader market over the next 12 months; Underperform (U) stock expected to underperform the broader market over the next 12 months; not rated (NR) the stock is not currently rated. The valuation methodologies used to determine price targets (where 4 Lawrence De Maria, CFA

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