Cummins - Dividends & Buybacks Supported by Reliable Cash Flow

• The engine maker is undervalued based on almost every metric as well as based on our conservative discounted cash flow model.
• The company has started making the necessary moves to ensure a successful future by expanding its capabilities including through acquisitions and investing in R&D.
• The reliable cash flow is being used to pay a hefty dividend, buy back shares, and adapt to the major technological and regulatory changes impacting its businesses.

A year to date slide of almost 20% has brought Cummins (CMI) shares into value territory.  While the heavy-duty diesel and natural gas engine maker faces many headwinds, the company is also making the necessary moves to adapt to changes in its industry.  In its 2017 Analyst Day Presentation, the company, headquartered in Columbus, Indiana, stated that it plans to invest $500 million over the next three years in partners, internal development and manufacturing capabilities.  This commitment shows that management recognizes the need to expand capabilities and adapt to remain relevant in the long term.  Exactly how it has started on this path will be discussed in the sections that follow.

Segment & Product Mix

Cummins has four operating segments consisting of Engine, Distribution, Components, and Power Systems.  Per the image below, the Engine segment provides the biggest share of total revenue, 34%.

Source: Q2 Presentation

The Engine segment manufactures diesel and natural gas engines for heavy and medium-duty trucks, busses, and light duty automotive as well as for construction, mining, defense, and agricultural markets.  The main customers for the heavy-duty truck engines include PACCAR (PCAR), Navistar (NAV), and Daimler (DDAIF).  The industrial engines are sold to manufactures of construction, agricultural and marine equipment including Hyundai (HYMTF), Xuzhou Construction Machinery, Komatsu (KMTUY), and John Deere (DE).  Customers for the light duty engines include Fiat Chrysler (FCAU) and Nissan (NSANY).  The company faces a host of competition in the engine segment including Daimler, Caterpillar (CAT), Volvo (VLVLY), Ford (F) and Paccar. 

The distribution segment accounted for 26% of revenues.  In addition to distribution, this segment also incorporates servicing Cummins’ products.  World-wide servicing and distribution is handled for all of Cummins’ products:  parts, engines, and power generation.  

The Components segment supplies products to complement the Engine and Power Systems segments.  This includes after treatment systems, turbochargers, transmissions, filtration products, fuel systems.  This segment also involves a joint venture formed in 2017 with a company we previously covered, Eaton (ETN).  The Eaton Cummins Automated Transmission Technologies joint venture is focused on medium-duty and heavy-duty automated transmissions for the commercial vehicle market. 

The power systems segment accounted for 16% of Q2 revenue and is split into three product lines including power generation, industrial, and generator technologies.  The power generation product line is for the diesel and gas power generators used in data centers, health care, and other consumer and commercial applications.  The industrial product line consists of diesel and natural gas high-horsepower engines used in equipment for mining, rail, defense, oil and gas, and commercial marine applications.  Finally, the generator technologies product line consists of A/C generator and alternator products for generator set assemblers within the company and externally.

Industry Outlook

When talking about the industries Cummins serves, the main one is trucking.  The largest customer, PACCAR accounted for 14% of sales in 2017.  Cummins has long term supply arrangements with PACCAR for the heavy-duty ISX 15 liter engine as well as other engines.  No other customer accounts for more than 10% of sales.  To give one an idea of the size of the sector, according to the Bureau of Labor Statistics or BLS, there were over 870,000 heavy and tractor-trailer truck drivers in 2017 in the United States alone.  The occupational outlook handbook’s projected change in employment for tractor-trailer truck drivers from 2016 to 2026 is 6% which is about as fast as average.  The expected growth rate for diesel service technicians and mechanics over the same period is slightly better with a forecasted growth rate of 9%.

One of the obvious headwinds is for Cummins is the environmental concerns and associated mandates countries are starting to impose on gasoline and diesel powered engines.  So far these mandates mostly only apply to cars and not medium duty or heavy duty trucks but that will change even with diesel engines likely be around for years to come.  Even Germany, where the diesel engine was invented by Rudolf Diesel, has placed restrictions on diesel vehicles including trucks from using certain roads.  The shift away from diesel engines is already well on its way in Europe with cities banning or restricting diesel vehicles and France, Norway, and Britain planning to do away with them entirely.

Adapting & Expanding Capabilities

Cummins management is aware of the inherent challenges it will face to remain relevant in the long term.  However, the company has shown the ability to expand capabilities and enter emerging growth areas.  One way to ensure the company adapts successfully is to diversify its operations and expand its capabilities.  One way to this is via acquisitions.  To this end, Cummins announced the acquisition of Efficient Drivetrains, Inc. in July.   The Silicon Valley based company produces hybrid and fully electric power solutions for commercial markets.  When announcing the acquisition, Cummins noted that it was part of its ongoing strategic efforts to build capabilities in electric storage.   Previous acquisitions in this area include UK-based Johnson Matthey Battery Systems and North American-based Brammo.  While the diesel engine is not going away any time soon, Cummins needs to continue to diversify its operations to ensure it is involved in the emerging technologies that will shape the future of the industry.

Cummins has had reliable cash flow for years now which is what gives it the dry powder to fund further acquisitions.  Diesel fuel and engines are still very important to the U.S. economy with most of the products we use every day being transported by trucks and trains with diesel engines in addition to construction and farming equipment.  Per the U.S. Energy Information Administration, diesel fuel accounted for 21% of the petroleum consumed by the U.S. transportation sector in 2017.  The EIA’s page on the uses of fuel also mentions another customer served by Cummins, the U.S. military, which uses diesel fuel in tanks and trucks because diesel fuel is less flammable and explosive than other fuels and diesel engines are less likely to stall.  A host of industries also rely on diesel generators for backup or emergency electricity including hospitals, utilities, data centers and other large buildings.  Cummins’ generators cover the full spectrum of commercial, industrial, and residential applications.  All of this means that the shift away from diesel will be gradual.

Cummins is also the main supplier of natural gas engines.  Per the U.S. Department of Transportation’s Commercial Truck Fuel Efficiency Study, two of Cummins’ engines represented over 90% of the medium and heavy-duty natural gas engine market for trucks.  The report mentions that one manufacturer, by which they are referring to Cummins, has a virtual monopoly on the US market for heavy duty natural gas engines.  However, the positives related to this seem limited as the report concludes that the much greater storage requirements for natural gas compared to the smaller volume required for gasoline or diesel combined with the relatively low volume of sales means that natural gas vehicles will always be more expensive than conventionally fueled vehicles.  The other part of the equation of course is that natural gas can be much cheaper depending on the swings in the price of oil.  As long as oil prices remain low, there will be subdued interest in natural gas engines.

For its own part, Cummins thinks diesel engines will be the best solution for many markets for decades to come.  Per its Sep 25, 2017 news release, it noted that its engines powered 33% of the heavy duty truck market and nearly 80% of the medium duty truck market.  In the release the company highlighted its clean-diesel technology, electrified powertrain solutions and its digital and data & analytics capabilities.  One area of research that we would like to highlight from the news release is the concept urban hauler electric vehicle, AEOS.  With AEOS, Cummins introduced a battery pack that gives the truck a range of 100 miles or 300 miles if two additional battery packs are used.  The concept truck could have its range extended to 600 miles with the use of Cummins B4.5 or B6.7 engines.  The release states that these engine options offer 50% fuel savings compared to today’s diesel hybrids with zero emissions.

Source:  Cummins News Article

Diversification & Financials

We already mentioned that Cummins’ has some diversification with its power generation and engine segment.  The company is also expanding its capabilities via acquisitions and R&D investments.  Another way to consider diversification is by looking at the regions from which revenue is generated.  The pie chart below shows that the U.S. and Canada are by far Cummins most important markets accounting for 59% of revenue.  However, this still means a substantial portion of revenues, 41%, is derived from international sales.

Source: Q2 Presentation

Transitioning to a look at financials it is easy to see why Cummins would show up on the stock screens of value investors.  The company has been a reliable cash generator for years.  Unlike the major auto manufactures that burned through cash during the recession, Cummins’ cash from operations has exceeded capital expenditures since 1998 and the company has had positive net income since 2002. This reliable cash flow is what has allowed Cummins’ to buy back shares and pay an attractive dividend with the current yield of 3.14%.  The graph below highlights the simultaneous substantial reduction in shares since 2006 and dividend increase.

Source:  2017 Analyst Day Presentation

The company has also kept debt and manageable levels with the long term debt to equity ratio currently standing at 0.21%.  The current ratio is also at a stable 1.60.  Another way to confirm the company’s ability to generate excess cash is to take a look at the growth in retained earnings over the last 10 years.  The retained earnings balance shows how much cash was left over after the company paid for all of its operating expenses, acquisitions, and dividends.

Valuation

One thing we want to touch on again before getting into the discounted cash model is the consistency in financial results for Cummins over the years.  Specifically, the company has had positive net income and generated positive free cash flow for over a decade.  The table below shows the free cash flow figures for the last 10 years.

Source: barchart

One note from the table above is that acquisitions are not included when calculating free cash flow.  We provided the acquisitions row in the table to highlight even these were covered by cash from operations for the last 10 years.  This type of reliability in generating free cash flow is by no means common in the industrial sector.

Our discounted cash flow model will cover a five year time frame.  The current quote for Cummins is $144.90.  The model will assume a forward PE of 15 which is slightly above average for the last five years.  According to Reuters the PE range for the last five years was 11.22 to 17.82 with the current PE more towards the lower end of that range coming in at 13.14.  The model will assume the average analyst estimate for the annual EPS growth rate for the next five years of 11.7% which was taken from finviz.  Since this estimate appears very optimistic we will also consider a model with a growth rate of 4.2% which was the actual EPS annual growth rate over the past five years.  The model assumes that the dividend will grow at the same rate as earnings which seems reasonable given the historical dividend growth rate provided in a previous image.  To keep the model conservative no share buybacks were assumed.  This is important to remember given that the company has a consistent track record of repurchasing its shares as discussed in the previous section.  Using the very achievable annual EPS growth rate of 4.2%, and a discount rate of 10%, the model shows that Cummins is trading at 96% of fair value.  If we use the optimistic 11.7% annual EPS growth rate suggested by analysts, then Cummins is currently trading at 69% of fair value.  We predict the actual growth rate to come in somewhere between the two figures.  The model indicates now is a good time to initiate a position given that Cummins is trading below fair value even when using the low future annual EPS growth rate of 4.2% while assuming no share buybacks.  Investors are also paid to wait for a rebound in the case of the engine maker thanks to its 3.14% dividend yield.  The table below summarizes some financial ratios to show how they relate to the sector averages.

	CMI	Sector
PE	12.6	17.54
Price to Sales	1.04	9.78
Price to Book	3.25	5.45
Price to Cash Flow	9.38	11.2
Dividend Yield	3.14	2.5
Payout Ratio	37.33	27.96
Return on Assets	10.73	6.64
Return on Investment	16.45	11.21
Return on Equity	25.82	13.31

Source: Reuters

Cummins comes out ahead on every metric in the table compared to the sector averages with the exception of the payout ratio.  Note, that Cummins still has a very comfortable payout ratio especially considering the reliability in cash flows discussed previously.  We also want to highlight the impressive return on assets, return on investment, and return on equities figures with the later exceeding 25%.

Final Thoughts

We think Cummins is a bargain and investors should take advantage of the recent pullback in the shares to initiate a position.  Our main concern when we started our research into Cummins was the long term outlook for diesel engines.  This is not a business for the very distant future given the environmental concerns and emissions regulations highlighted in the article.  However, diesel engines are very likely to be around for several more decades allowing Cummins to continue to use its reliable cash flow to expand its capabilities beyond its core diesel engine and generator businesses.  Recent acquisitions and the R&D efforts highlighted above show that management is moving in the right direction to adapt to the changes facing its industry.  The financial metrics themselves are outstanding.  The company is a cash cow that pays a hefty dividend and is buying back shares at an impressive clip.  All of these factors make us rate Cummins a buy and we recommend investors take advantage of the current weakness in the shares.