CMI - Cummins: Driving Profits Across Generational Portfolio Updates

2023-10-12 13:21:44 ET

Summary

• Cummins' shares are trading at a 12.9x TTM P/E and offer a 3.0% dividend yield, making them attractive after a market pullback.
• The company has shown continued revenue growth, with total revenues of $8.6 billion in the latest quarter, up 31.2%.
• Cummins is making strategic shifts into new energy transportation, including acquisitions and partnerships in the electric vehicle and hydrogen powered engines.

Shares of Cummins ( CMI ) are back on my buy list after the latest pullback in the market environment trading at 12.9x TTM P/E and yielding a 3.0% dividend. Since I last wrote about the company during COVID the shares are up 88.8% compared to the market return of 67.40%. The company continues to grow revenues and looks to be making the right shifts into new energy transportation as this article will discuss.

Latest Quarterly Results

Cummins latest quarterly results show continued growth in the business with total revenues of $8.6 billion in the quarter for a growth rate of 31.2%. For the six-month YTD period, total revenues were $17.1 billion which is an increase of 31.8% compared to the prior year six-month period. GAAP net Income for the quarter was $720 million and diluted EPS of $5.05 (+2.2%) but YTD GAAP diluted EPS of $10.60 shows more impressive growth (+34.9%). The latest quarter brings diluted EPS to $17.86 leaving Cummins trading at a 12.8x TTM P/E.

The high jump in revenues is partially due to the 2022 acquisition of Meritor Inc., which supplies drivetrain, mobility, braking and electric powertrain components, for about $3.7 billion. The company continues to adjust its product portfolio and recently also spun off their filtration business, Atmus Filtration Technologies ( ATMU ), in a $1.8 billion market debut back in May 2023. Cummins continued to own around 83% of Atmus Filtration's shares after the IPO.

Moving down the income statement, SG&A expenses were $873 million in the quarter which was up 40.4% compared to the prior year quarter and up 31.4% YTD again being driven by the acquisition and consolidation Meritor. Total operating profit was up 7.5% for the quarter and 31.0% YTD with EBITDA margins at 15.1% of sales in the latest quarter. Management maintained their full year outlook with sales up 15% - 20% and EBITDA at 15.0% - 15.7%.

Further to the above-mentioned acquisitions/divestitures, Cummins continues to shift the capital budget towards new energy products in the electric vehicle and hydrogen power through Accelera™ by Cummins, the zero-emissions business segment of Cummins. In recent months, the company has announced a number of new projects that will help drive the company into the next generation.

• A new 21-gigawatt hour battery plant , with JV partners Daimler Truck Group and PACCAR each owning 30% and joint control of the venture. EVE Energy will serve as the technology partner in the JV with 10% ownership. EVE Energy is a global leader in the manufacture of LFP battery cells for the vehicle industry and is publicly traded on the Shenzhen stock exchange.
• North America's first green hydrogen-powered passenger train. The train, the Coradia iLint, is manufactured by Alstom, the global green and smart mobility leader. The green hydrogen used in Alstom's Coradia iLint train is produced by an Accelera HySTAT®-100-10 electrolyzer, which is owned and operated in Quebec by project partner Harnois Énergies.
• The next generation of electric school buses with partner Blue Bird with a next-gen battery that has a capacity of 196kWh 25% increase from the previous model and can now travel up to 130 miles on a single charge.

Profitable and Growing

Cummins' scale and position in the industry have allowed it to achieve an average return on equity and return on invested capital of 23.7% and 17.8%, respectively, over the past decade. This level of profitability is well above my rule of thumb of 15% ROE and 9% ROIC, allowing me to be confident that, in my opinion, the company is able to maintain and continue to increase its intrinsic value over a business cycle.

On the growth side, book value per share has grown from $23.61 in 2010 to $79.69 in its latest quarter, which, when combined with the dividends paid out from equity, has averaged growth of 18.7% annually and further supports the ROE average. This book value growth is slightly lower than average ROE not due to poor performance at the company, but rather the mathematical effect of Cummins repurchasing their shares at much higher values than the price-to-book value as calculated from the financials. Let's analyze the potential for increased dividends more through looking at the cash flows.

Cash Flow Analysis

Cummins' does a great job of generating cash and in recent years has been using this free cash flow to pay down debt as well as meaningfully increasing the dividend as mentioned earlier. To get an idea of the sustainability of dividends and share repurchases, we can take a look at what percent of cash flow from operations is available to be returned to shareholders after making the necessary capital expenditures. As can be seen below, capital expenditures and acquisitions only used up on average 34% and 32%, respectively, of cash flow from operations over the past decade. This leaves approximately 34% to be returned to investors in the form of dividends and share repurchases.

With average cash flow from operations of $2.4 billion over the past five years, this 55% would imply free cash flow to shareholders of $830 million for around a 2.6% free cash flow yield at the current $32.3 billion market capitalization. Part of this low cash flow yield is driven by the large 2022 acquisition of Meritor, which if we adjust for, would raise the free cash flow yield to a better 4.1% covering the 3% dividend nicely and leaving room for additional share repurchases.

Getting a Sense of Valuation

Cummins' 12.9x TTM P/E ratio can also be expressed as a 7.8% earnings yield, but I also always like to examine the relationship between average ROE and price-to-book value in what I call the Investors' Adjusted ROE, especially for cyclical companies. It examines the average ROE over a business cycle and adjusts that ROE for the price investors are currently paying for the company's book value or equity per share. Cummins has a great ROE, but potential returns for investors depend on the multiple paid for the book value of equity in the public stock market.

With Cummins earning an average ROE of 23.7% since 2010 and shares currently trading at a price-to-book value of 2.9x when the price is $230.05, this would yield an investors' Adjusted ROE of 8.2% for an investors' equity at that purchase price, if history repeats itself. This no growth yield is slightly below the 9% that I like to see, but adding 3% to conservatively represent the company growing alongside GDP could increase this potential total return beyond my 9% target. Below is a table outlining the potential earnings yield estimates from this investors' adjusted ROE figure as well as the cash flow and earnings yields discussed.

How About The Debt?

Financial leverage at Cummins has seen a notable rise since the beginning of the decade, moving from lows of 1.9x in 2012 to 2.79x in the latest quarter. The latest jump is mainly due to debt raised in 2022 for the acquisition of Meritor Inc., which supplies drivetrain, mobility, braking and electric powertrain components, for about $3.7 billion. In the latest quarters, the company already looks to be paying down leverage.

Cummins also does a great job returning cash to shareholders in the form of dividends and share repurchases. Since its 2010 fiscal year, the company has bought back on average 2.7% of its outstanding shares each year, as can be seen in the graph above. Adding these share repurchases on top of the current 3.0% yield would imply a total shareholder yield of 5.7%.

Despite the rising financial leverage, the interest coverage ratio remains a healthy 9.1x in the TTM period. However, manufacturing companies can lease a large portion of their facilities, and with large leases being part of the business, it is crucial to look at a coverage ratio of both lease and interest payments as they compare to operating income before lease payments. With $514 million of lease assets on the balance sheet as of the latest quarter, Cummins has $135 million of current operating lease liabilities due in the next year. Looking at such a coverage ratio of lease and interest payments for Cummins, lowers the coverage ratio a bit but it still comes to a decent 6.8x, as can be seen in the below table.

Takeaway for Investors

Cummins is a nicely profitable company navigating the changing engine and powertrain landscape well in my opinion. The company is currently digesting its largest acquisition in over a decade so financial leverage is a bit tighter than normal and interest expenses are elevated. I will look for the company to continue bringing the leverage ratio back down as it drives through the proposed synergies in the acquisition. At 12.9x TTM P/E I am getting interest in Cummins' shares once again.

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