August 2, 2016 Equity Research CMI: Headwinds Continue Adjusting Estimates & Maintain Market Perform Summary: CMI continued to encounter difficult end market conditions that deteriorated through Q2 16 (main deterioration occurred in NAFTA truck, global power generation, and high horsepower engines). Management decreased its F2016E revenue view to down 8-10% from prior 5-9% yr/yr revenue drop, maintained its 11.6-12.2% EBIT margin, and decreased its F2016 expected tax rate to 27% from 28.5% (Exhibit 3). CMI does not provide explicit earnings guidance. Taken together, we estimate that the implied earnings guidance is relatively consistent with the implied guidance from Q1 16, $7.80-8.70. After CMI beat our Q2 16 expectations and maintained guidance with subdued description of end markets, we are decreasing our Q3 16E to $1.89 from $2.13 (lower revenue and margin expectations) but increasing our F2016E to $8.32 from $8.21 and F2017E to $7.92 from $7.78. We are maintaining our Market Perform rating and $123-126 valuation range. Valuation Range: $123.00 to $126.00 Our 12-18 month valuation range of $123-126 is based on an EV-to-2017E EBITDA of 8.9-9.1x and price-to-book value of 2.9-3.0x. Our valuation range implies a price-to-2017e earnings multiple of 15.5-15.9x and price-to-2017e sales multiple of 1.26-1.29x. The risks to our valuation range include further slowdown in emerging markets, delays in emissions standard implementations/enforcement. Investment Thesis: We continue to expect the company to benefit from capital redeployment to shareholders and above market growth prospects against mixed market conditions, but believe that earnings and stock performance remain dependent on duration of NAFTA truck cycle and timing of future non-nafta on-highway end market demand improvement. Market Perform Sector: Machinery Market Weight Earnings Estimates Revised Up 2015A 2016E 2017E EPS Curr. Prior Curr. Prior Q1 (Mar.) $2.14 $1.87 A NC NE Q2 (June) 2.62 2.40 A 2.16 NE Q3 (Sep.) 2.14 1.89 2.13 NE Q4 (Dec.) 2.02 2.15 2.04 NE FY $8.92 $8.32 8.21 $7.92 7.78 CY $8.92 $8.32 $7.92 FY P/EPS 13.6x 14.6x 15.3x Rev.(MM) $19,110 $17,334 $16,556 Source: Company Data, Wells Fargo Securities, LLC estimates, and Reuters NA = Not Available, NC = No Change, NE = No Estimate, NM = Not Meaningful V = Volatile, = Company is on the Priority Stock List Ticker CMI Price (08/02/2016) $121.04 52-Week Range: $79-132 Shares Outstanding: (MM) 169.0 Market Cap.: (MM) $20,455.8 S&P 500: 2,157.03 Avg. Daily Vol.: 1,806,610 Dividend/Yield: $3.95/3.3% LT Debt: (MM) $1,652.0 LT Debt/Total Cap.: 20.6% ROE: 19.0% 3-5 Yr. Est. Growth Rate: 10.0% CY 2016 Est. P/EPS-to-Growth: 1.5x Last Reporting Date: 08/02/2016 Before Open Source: Company Data, Wells Fargo Securities, LLC estimates, and Reuters Andrew Casey, Senior Analyst ( 617) 603-4265 andrew.casey@wellsfargo.com Jorge Pica, Associate Analyst ( 617) 603-4376 jorge.pica@wellsfargo.com Chris Laserinko, Associate Analyst ( 617) 603-4270 christopher.laserinko@wellsfargo.com Please see page 6 for rating definitions, important disclosures and required analyst certifications All estimates/forecasts are as of 08/02/16 unless otherwise stated. Wells Fargo Securities, LLC 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 the report and investors should consider this report as only a single factor in making their investment decision.
Machinery Discussion Increasing Expectations: After CMI beat our Q2 16 expectations and maintained guidance with subdued description of end markets, we are decreasing our Q3 16E to $1.89 from $2.13 (lower revenue and margin expectations) but increasing our F2016E to $8.32 from $8.21 and F2017E to $7.92 from $7.78 (Exhibits 1-2). Exhibit 1 Wells Fargo Securities, LLC Estimate Change Analysis in $MM, except per share data Q3 16E 2016E 2017E New Prior New Prior New Prior Revenue Growth Engines -10% -8% -7% -22% -12% -9% Power Systems -11% -5% -13% -12% 1% 4% Distribution -2% -2% -1% -3% 3% 3% Components -10% -9% -7% -5% -3% -4% Total -10% -7% -9% -9% -4% -3% EBIT Margin Engines 9.9% 12.1% 9.6% 10.2% 10.6% 9.7% Power Systems 8.3% 8.2% 8.0% 0.0% 8.3% 0.0% Distribution 6.1% 6.0% 6.1% 6.0% 5.8% 5.8% Components 10.5% 12.1% 13.3% 13.5% 12.0% 12.8% Total 11.4% 12.7% 10.5% 10.9% 10.4% 10.0% Tax Rate 27% 29% 27% 28% 29% 29% Income Attributable to Non-Controlling Interests ($16) ($12) ($70) ($58) ($79) ($63) Share Count (mm) 168.5 171.0 169.3 171.2 166.7 169.2 Earnings Per Share $1.89 $2.13 $8.32 $8.21 $7.92 $7.78 Note: Excludes any incremental restructuring actions. Exhibit 2 Engine Subsegment Wells Fargo Securities, LLC Revenue Estimate Change Analysis Q3 16E 2016E 2017E 2018E New Prior New Prior New Prior New Heavy Duty Truck -24% -25% -22% -25% -8% -9% 13% Midrange Truck and Bus -3% 7% -8% -3% -2% -4% 5% Light Duty Automotive and RVs 8% 13% 6% 11% -2% -2% 0% Off-Highway -9% -12% -9% -10% -24% 0% 3% Total Engines -10% -8% -7% -22% -12% -9% 6% CMI Decreased F2016 Revenue Guidance. Management decreased its F2016E revenue view to down 8-10% from prior 5-9% yr/yr revenue drop, maintained its 11.6-12.2% EBIT margin, and decreased its F2016 expected tax rate to 27% from 28.5% (Exhibit 3). CMI does not provide explicit earnings guidance. Taken together, we estimate that the implied earnings guidance is relatively consistent with the implied guidance from Q1 16, $7.80-8.70. The midpoint $8.25 remains above consensus F2016E $7.97, and the gap is roughly the amount that CMI outperformed consensus during Q2 16. This suggests that management is comfortable with current consensus H2 16 expectations. Inside the EBIT margin expectations, management expects decreased volume yr/yr to be partially offset by cost reduction initiatives (material cost decrease), restructuring (including UK plant consolidation in Power Systems), and reduced warranty expense (i.e., to around 2% of sales). CMI indicated it continues to expect operating cash flow to be approximately 10-15% of revenue and reiterated its intention to allocate 75% of available cash flow to share repurchase and/or dividends during F2016. In sum, CMI updated F2016 guidance with lower revenue outlook and consistent EBIT margin expectations as structural cost reduction is expected to offset lower volumes. 2
Exhibit 3 CMI 2016 Operating Guidance Analysis Revenue Yr/Yr Growth EBIT Margin Guidance Revised Expectations (1) Guidance Revised Expectations (1) from Q2 16 from Q1 16 (3) from Q2 16 from Q1 16 (3) Engines Down 9-12% (6.8%) 10-11% 9.6% Power System Down 12-14% (12.8%) 7-8% 8.0% Distribution Down 1% to Up 1% (1.3%) 5.5-6.5% 6.1% Components Down 6-9% (6.8%) 12.75-13.75% 13.3% Eliminations Total Down 8-10% Down 5-9% (9.3%) 11.6-12.2% 11.6-12.2% 10.5% Other Guidance Items from Q2 16 from Q1 16 Joint Venture Income Flat (Yr/Yr) Flat (Yr/Yr) Interest Expense ($ millions) $70 $70 $64 Tax Rate 27.0% 28.5% 26.9% Operating Cash Flow (% of Sales) 10-15% Capital Investment ($ millions) $600-650 $600-650 Global Pension Funding ($ millions) $146 $146 Note: (1) Refers to Wells Fargo Securities, LLC Expectations. (2) Excludes anticipated costs related to margin improvement activities. (3) Q1 16 Guidance did not include segment outlook due to reclassification. Exhibit 4 CMI 2016 Engine Segment Guidance Detail 2016 Guidance 2015 from Q2 16 from Q1 16 CMI Regional Truck Market Forecast NAFTA Class 8 Group 2 Production Industry Volume 200,000 210,000 291,000 % Change (Yr/Yr) (31%) (28%) NAFTA Class 6-7, Class 8 Group 1 Production Industry Volume 117,000 123,000 124,000 % Change (Yr/Yr) (6%) (1%) China Heavy & Medium Duty Truck Sales Industry Volume 820,000 720,000 751,000 % Change (Yr/Yr) 9% (4%) India Heavy & Medium Duty Production Industry Volume 370,000 350,000 318,000 % Change (Yr/Yr) 16% 10% Brazil Heavy & Medium Duty Production Industry Volume 60,000 60,000 74,000 % Change (Yr/Yr) (20%) (20%) NAFTA Market Share Expectations NAFTA Class 8 Group 2 (2) 27-30% 27-30% 33% NAFTA Class 6-7, Class 8 Group 1 (2) 72-75% 72-75% 78% China Market Share Expectations China Heavy & Medium Duty Truck ~18% ~18% ~16% China Light-duty diesel engines ~8% ~8% Note: (1) Anticipates incremental benefit from engines shipped to Nissan Titan (start of production Q4 15). (2) Anticipated share loss due to customer vertical integration. Source: Company Reports, Wells Fargo Securities, LLC. CMI Q4 15 $2.40 Dropped 8% Yr/Yr and Beat Consensus. CMI continued to encounter difficult end market conditions that deteriorated through Q2 16 (main deterioration occurred in North American Free Trade Agreement (NAFTA) truck, global power generation and high horsepower engines). Negative mix shifts were further compounded by a $39 million contingency charge that represented an approximate $0.16 drag on earnings. Despite this, CMI offset the volume decline through cost reduction initiatives, and gross margin improved yr/yr partly due to lower warranty costs. Even though the company is clearly encountering weak market conditions, Q2 16 EPS of $2.40 dropped less than expected and outperformed consensus Q2 16E EPS of $2.16. Vs. Q2 15: Q2 16 EPS of $2.40 dropped 8% yr/yr on 10% revenue decline yr/yr (negative 9% organic and negative 1% currency) and 130bps EBIT margin compression to 13.1% on 27% decremental margins (excontingency charge 13.8% EBIT margin on 19% decremental). Earnings dropped $0.22 yr/yr on: negative $0.51 EBIT (including approximate $0.16 contingency headwind) and positive $0.29 other items. Vs. Our Expectations: Adjusted Q2 16 EPS of $2.40 beat our Q2 16E of $2.16 by $0.24 on: positive $0.13 pretax ($0.12 EBIT all driven by Eliminations that offset approximate $0.16 contingency loss headwind), $0.09 tax, and $0.02 lower share count (Exhibits 5-6). In sum, company realized an earnings decline yr/yr but beat expectations. 3
Machinery Exhibit 5 CMI Q2 16 Yr/Yr Earnings Growth Analysis Revenue Yr/Yr Growth, Margin, and Tax Rate Incremental Yr/Yr Earnings Variance Analysis Reported Expectation Reported vs.q2 15 (1) Relative to Expectation Prior EPS $2.62 $2.16 Heavy Duty Truck -29% -35% Medium-duty Truck and Bus -11% -9% Light-duty Automotive and RV 11% 15% Off-Highway -9% -10% Stationary Power 0% 0% Total Engines -14% -15% Power Systems -16% -16% Distribution -2% -2% Components -8% -6% Eliminations -6% -4% Total Sales -10% -13% Gross Profit (Including Product Coverage) 25.5% 24.4% ($0.63) $0.36 SG&A 10.5% 10.5% $0.05 ($0.27) R & D and Other 3.3% 3.3% $0.20 $0.12 Operating Profit (1) 11.4% 10.6% ($0.38) $0.21 Net (Income) Expense from JVs and Alliances ($0.02) ($0.01) Interest Expense $0.00 $0.01 Other, net ($0.10) ($0.08) Pretax Income 13% 12.4% ($0.50) $0.13 Income Tax Rate (1) 26% 29% $0.12 $0.09 Post-Tax Contribution ($0.38) $0.22 Noncontrolling Interest $0.02 ($0.02) Share Count 169 171.5 $0.14 $0.04 Post-Tax Contribution ($0.22) $0.24 Q2 16 $2.40 $2.40 Note: (1) Q2 16 includes $0.16 contingency expense adjustment. Exhibit 6 CMI Q2 16 Yr/Yr Operating Segment Earnings Growth Contribution Analysis Revenue and EBIT Margin Change Analysis Incremental Yr/Yr Segment EBIT Contribution Analysis Revenue Yr/Yr Growth EBIT Margin Incremental Margin Reported vs. Q2 15 (1) Relative to Expectation Reported Expected Reported Expected Q2 15 (yr/yr) Engines (1) -14% -15% 10.3% 11.8% 12.0% 22% ($0.28) ($0.11) Power Systems -16% -16% 9.8% 7.9% 11.6% 21% ($0.15) $0.07 Distribution -2% -2% 5.6% 5.6% 7.6% -53% ($0.10) $0.02 Components -8% -6% 14.9% 14.2% 16.0% 28% ($0.13) $0.02 Eliminations $0.15 $0.12 Total (1) -9.7% -12.8% 13.1% 12.8% 14.4% 27% ($0.51) $0.12 Note: (1) Q2 16 includes $0.16 contingency expense adjustment. Valuation and Risks: CMI has realized further compression in end market demand, and we continue to expect the company to partially offset the impact of decreased end market demand on earnings through incremental restructuring/headcount reduction, capital redeployment to shareholders. On modestly higher expectations and net debt (Q2 16 $3.50 net debt per share and 5.3% net debt to total capital), we are maintaining our Market Perform and our $123-126 valuation range (Exhibit 7). Exhibit 7 CMI Valuation Range Multiple Analysis Valuation Range Historical Multiple Ranges (1) $123-126 Average Max Min EV-to-2017E EBITDA (2,3) 8.9-9.1x 5.5x 8.8x 3.3x Price-to-Q2 16 Book Value 2.9-3.0x 1.8x 4.7x 0.7x Price-to-2017E Earnings (3) 15.5-15.9x 12.0x 130.7x (90.4x) Price-to-2017E Sales 1.26-1.29x 0.3x 1.11x 0.15x Note: (1) Based on ten years of trading data. (2) EBITDA includes joint venture income. (3) EBITDA and EPS excluding restructuring charges. Source: Company reports, Factset, Wells Fargo Securities, LLC estimates There are risks to our thesis, as highlighted in the following points: Currently, CMI is encountering weak market conditions in NAFTA, Brazil, China and Europe and currency headwinds due to the $US strengthening relative to developing market currencies. Looking forward, we expect CMI to realize incremental earnings pressure related to declines in NAFTA on-highway and offhighway demand and limited to no improvement in markets that have realized sharp declines during 2015 4
(i.e., Brazil, China, Russia, etc.). If markets are stronger than we expect and recent currency trends reverse, then CMI F2016 through F2017 earnings could have upside risk. If the markets experience weaker demand for an extended period of time, then our F2016 through F2017 earnings expectations could have downside risk. CMI continues to encounter market share losses in its NAFTA Class 6-8 truck exposure due to vertical integration. If share losses accelerate due to unexpected customer actions, then our estimates could have downside risk. CMI announced initiatives that it expects will reduce annualized cost by $300 million, driven by $160 million restructuring benefit, approximate $75 million raw material cost reduction, and about $65 million from lower warranty accrual. If the company fails to realize its cost savings benefit, our estimates could be too high. We believe that CMI maintains a relatively strong balance sheet that could be used to support further share repurchase and/or acceleration in acquisition activity. We are not including any substantial benefit from an acceleration of capital deployment. If CMI is more aggressive in utilizing its balance sheet to drive growth, we would have to reassess our expectations. We expect the company to augment global growth with incremental content driven by regional emissions regulation changes for both on and off-highway markets. If emissions regulation implementation timing is delayed, then our expectations could have downside risk. CMI, like other equipment manufacturers, may encounter negative margin impacts from higher commodity costs and incremental labor and incentive costs as production is increased. We anticipate that the company will be able to offset these with either volume or pricing. Company Description: (CMI), based in Columbus, Indiana, is a leading worldwide designer, manufacturer and distributor of diesel and natural gas engines, electric power generation systems and engine-related components, including filtration and emissions solutions, fuel systems, controls and air handling systems. 5
Machinery Required Disclosures Additional Information Available Upon Request I certify that: 1) All views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers discussed; and 2) No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this research report. Wells Fargo Securities, LLC maintains a market in the common stock of 6
Wells Fargo Securities, LLC or its affiliates intends to seek or expects to receive compensation for investment banking services in the next three months from Wells Fargo Securities, LLC and/or its affiliates, have beneficial ownership of 1% or more of any class of the common stock of currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided noninvestment banking securities-related services to Wells Fargo Securities, LLC received compensation for products or services other than investment banking services from in the past 12 months. Wells Fargo Securities, LLC or its affiliates has a significant financial interest in CMI: The risks to our valuation range include further slowdown in emerging markets, delays in emissions standard implementations/enforcement. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm, which includes, but is not limited to investment banking revenue. STOCK RATING 1=Outperform: The stock appears attractively valued, and we believe the stock's total return will exceed that of the market over the next 12 months. BUY 2=Market Perform: The stock appears appropriately valued, and we believe the stock's total return will be in line with the market over the next 12 months. HOLD 3=Underperform: The stock appears overvalued, and we believe the stock's total return will be below the market over the next 12 months. SELL SECTOR RATING O=Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. M=Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. U=Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. VOLATILITY RATING V = A stock is defined as volatile if the stock price has fluctuated by +/-20% or greater in at least 8 of the past 24 months or if the analyst expects significant volatility. All IPO stocks are automatically rated volatile within the first 24 months of trading. As of: August 2, 2016 42% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Outperform. 56% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Market Perform. 3% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Underperform. Wells Fargo Securities, LLC has provided investment banking services for 37% of its Equity Research Outperform-rated companies. Wells Fargo Securities, LLC has provided investment banking services for 27% of its Equity Research Market Perform-rated companies. Wells Fargo Securities, LLC has provided investment banking services for 3% of its Equity Research Underperform-rated companies. Important Disclosure for International Clients EEA The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ( WFSIL ). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 ( the Act ), the content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. Australia Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to Australian recipients by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. 7
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