The Stuff of Nightmares

 | Oct 30, 2013 | 11:30 AM EDT
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The third-quarter earnings report Cummins (CMI) released before the market open on Tuesday is the stuff of Wall Street nightmares. Not because the company reported such terrible results, or because it slashed guidance -- or even because the stock plunged.

It's because the bad news was so unexpected. And that sets loose the possibility in which the global and/or U.S. economy is slowing more than expected. In that scenario, Wall Street will get blind-sided as companies begin to report much lower-than-expected earnings and revenue just when the U.S. stock market is at a peak.

Given the recent government shutdown/debt ceiling crisis, it's not an unreasonable fear , especially since we don't know what the effect of these events has been on the economy. The very "reasonableness" of this fear just makes the nightmare all the scarier.

At the company's analysts' day on Sept. 16, management was reassuring. Even in what is a challenging global economy, they said they would be able to generate solid growth from its introduction of new products and from gains in market share.

But just a month later, Cummins missed on earnings -- reporting $1.90 a share instead of the $2.11 Wall Street had projected -- and on revenue -- reporting revenue of $4.27 billion vs. projections of $4.38 billion. They also lowered guidance for the full year -- revenue will fall 3% for the year against previous guidance for flat revenue for the year.

What happened? Unfortunately, it doesn't look like there's an easy answer. There was no supply chain glitch and no volcano destroyed a supplier. No senior manager is now living a life of ease in Brazil on company money.

We can pull out a few causes that aren't too scary. Exchange rates hurt more than expected in the quarter. India hit what in the conference call Cummins called a "tipping point" and sales dropped sharply.

But a good part of the miss simply looks like business across multiple units was softer than expected. And that's what's disturbing to the market.

The miss came on lower revenue and profits in the power generation unit, which was not totally unexpected since this business has lagged for quarters. But this also happened in engines, a core company unit that had been doing well. The North American heavy truck market was softer than expected in the quarter -- the company shipped 20,000 heavy-duty truck engines in North America in the third quarter, a decrease of 6% from the second quarter. Cummins now expects engine unit revenue for 2013 to be 8% lower than last year.

Of course, it's possible that Cummins, normally a very well managed and conservative company, simply got its forecast wrong. Maybe the company was simply too optimistic and this miss isn't so much a sign that the economy is unexpectedly deteriorating as it is an indicator that Cummins isn't as immune from a weak economy as it thought way back in September.

That explanation is certainly more reassuring for the market as a whole than the alternative -- that the economy took a bigger hit than anyone expected in September.



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