CMI - Cummins Is A Long-Term Buy

2023-11-18 06:16:05 ET

Summary

• Cummins is a reliable company in the industrial sector that produces both diesel and electric engines.
• The company has shown strong revenue and EPS growth over the past decade and has a consistent dividend payout.
• Cummins has opportunities for growth in electric vehicle battery production, acquisitions, and expanding the use of natural gas engines.

Introduction

One company that has been on my watchlist several times is Cummins (CMI). The industrial sector is intriguing today as there is still high uncertainty regarding the business environment. In this sector, I find Cummins interesting as it produces both the engines needed today, which use diesel, and the electric and hydrogen engines of the future.

The industrial sector tends to be volatile as demand for industrial products is cyclical. Therefore, these companies may trade for an attractive price when the economy weakens. While the short-term decline may be painful, the quality companies will endure it and will keep growing in the long run as the economic cycle turns.

Seeking Alpha's company overview shows that:

Cummins designs manufactures, distributes, and services diesel and natural gas engines, electric and hybrid powertrains, and related components worldwide. It operates through five segments: Engine, Distribution, Components, Power Systems, and New Power. The company offers diesel and natural gas-powered engines for heavy and medium-duty trucks, buses, RVs, light-duty automotive, construction, mining, marine, rail, oil and gas, defense, and agricultural markets. It also provides power generation systems, prime power generators, controls, paralleling systems, and electrified power systems with components and subsystems, including battery, fuel cell, and hydrogen production technologies.

Fundamentals

The revenues of Cummins increased by 92% over the last decade. This is mainly the result of organic growth. The company also utilizes acquisitions to expand its reach and production capacity further. In Q3, it acquired two factories from Faurecia to expand its scale. The graph also shows how cyclical the industrial segment is. You can see steep increases and declines, making the share price relatively volatile. In the medium term, as shown on Seeking Alpha, the analyst consensus expects Cummins to keep growing sales at an annual rate of ~10%.

The EPS (earnings per share) has grown much faster over the same period. EPS is up almost 150%, which equates to ~10% annual growth. The EPS grows faster than the revenues as the company has executed buyback programs and cut costs to improve the operating margin from 10% to 11% (a 10% increase). The company has to be flexible and react fast to deal with cyclicality and maintain profitability. In the future, as seen on Seeking Alpha, the analyst consensus expects Cummins to keep growing EPS at an annual rate of ~7% in the medium term.

The company is a reliable dividend payer. While the sales and EPS were volatile, the company's dividend has grown steadily. The company has not reduced the dividend for 30 years despite the cyclicality. Moreover, the company has increased the dividend yearly over the last 17 years. This is partly the result of the conservative payout ratio of 32%. It allows the company to grow the dividend even during downturns, thus providing stability for long-term investors.

In addition to dividends, the company returns capital to its shareholders via buybacks. These shares repurchase programs support EPS growth by lowering the number of shares outstanding. The company has reduced the number by 24% over the last decade. Buybacks are a highly effective tool when the share price is low, and therefore, I believe that the management should consider buying back more shares. It has stopped its buybacks in 2022, and as the share price remains attractive, it should capitalize on it.

Valuation

Cummins's P/E (price to earnings) ratio stands at 11 when using the 2023 EPS forecast. Paying 11 times EPS for a company that grows at a mid to high single-digit rate is attractive. The current valuation is almost the lowest we have seen during the last twelve months, and it is significantly lower than the P/E ratio at the end of 2022, which stood above 14. Therefore, I believe that the current valuation is a decent entry point.

The graph below from Fast Graphs also emphasizes that the valuation of Cummins is attractive. The company's average P/E ratio stands at 15.36 over the last two decades. Right now, the P/E ratio stands at 11, making it an attractive valuation. However, investors should consider that the growth rate is also slower. In my opinion, the slower growth rate doesn't justify such a low valuation. Therefore, the company is trading with a decent margin of safety.

Opportunities

The first opportunity is an electric vehicle (EV) battery production joint venture. The company produces engines that use electricity and even hydrogen, and it now goes into another part of the value chain. The joint venture with Daimler Truck and Bus, PACCAR, and EV Energy to accelerate and localize battery cell production in the United States presents a significant growth opportunity. The venture aims to manufacture battery cells for electric commercial vehicles and industrial applications, contributing to the clean technology sector and creating jobs.

"We see this partnership as an opportunity to share investment with two long-standing partners while advancing a key technology solution for our customers and industry and collectively accelerate the energy transition in the United States."

(Jennifer Rumsey - Chair & Chief Executive Officer, Q3 2023 Conference call)

Moreover, the acquisition of Faurecia commercial vehicle manufacturing plants serves as an opportunity to increase scale. Cumpurchasesition of two Faurecia commercial vehicle manufacturing plants in Indiana and the Netherlands in October is positioned as a strategic move to meet the current and future demand for low-emission products, enhancing the Cummins Emission Solutions business.

"This acquisition is a natural addition to the Cummins Emission Solutions business and will help ensure we meet current and future demand for low-emission products."

(Jennifer Rumsey - Chair & Chief Executive Officer, Q3 2023 Conference call)

Expanding the applications of natural gas engines is also beneficial for future growth. Collaborations with Freightliner and Knight Transportation to offer the new X15 natural gas engine for heavy-duty trucks, particularly in North America, demonstrate Cummins' commitment to sustainable solutions. The introduction of the X15 N, the first natural gas engine designed specifically for heavy-duty on-highway truck applications, is positioned for success in 2024. This is crucial as natural gas is expected to remain a leading energy source in America.

"The X15 N, which will launch in North America in 2024, is the first natural gas engine to be designed specifically for the heavy-duty on-highway truck application."

(Jennifer Rumsey - Chair & Chief Executive Officer, Q3 2023 Conference call)

Risks

Softening aftermarket and off-highway markets may pose a risk. Cummins acknowledges a softening in aftermarket demand, which, combined with weaker demand in some off-highway markets, mainly industrial, may contribute to lower revenues and profitability. This reflects a potential challenge in maintaining growth momentum. That is a medium-term risk, as higher rates make it harder to finance purchases.

"We see signs of softening aftermarket demand and weaker demand in some industrial parts."

(Mark Smith - Chief Financial Officer, Q3 2023 Conference call)

Another risk is the supply chain constraints that persist. The ongoing industry supply constraints impacting North American truck production are a meaningful risk factor. Cummins identifies inventory management efforts and truck component shortages as challenges that may affect OEM production rates, potentially limiting growth in its crucial trucks business.

"While orders remain relatively strong, inventory management, truck component shortages, limiting our OEM production rates, and fewer working days are all contributing to our view for the quarter."

(Jennifer Rumsey - Chair & Chief Executive Officer, Q3 2023 Conference call)

Lastly, the company has to deal with a continued weak outlook in China. Despite some recovery, Cummins mentions a continued weak outlook in China. Factors such as a tepid economy, weaker overall activity, and slow recovery in the China truck market pose challenges for growth in this region. We have seen President Xi of China visiting the U.S. this week to seek increased cooperation. China is in a challenging situation that may affect the world economy.

"Despite the slow pace of recovery in the China truck market, we continue to see strong performance for the 15-liter natural gas engine."

(Jennifer Rumsey - Chair & Chief Executive Officer, Q3 2023 Conference call)

Conclusions

Cummins looks like a solid, promising company following Q3 2023. The company offers solid fundamentals across the board, with top-line growth leading to EPS growth, allowing it to pay a growing dividend. Moreover, the company is poised to maintain the dividend even during a more challenging business environment as it maintains a conservative payout ratio.

The company has several growth opportunities around electric vehicles and hydrogen, making it ready for the next generation of engines. It also expands the usage of natural, which is the current tech for low-emission heavy trucks. While there are risks, especially from softening markets in the U.S. and China, these are cyclical risks. Therefore, I believe that at the current valuation, the shares of Cummins are a BUY.

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