CMI - Cummins: Powering Its Engines

2023-06-19 07:14:50 ET

Summary

• Cummins continues to see a solid operating performance as it makes a gradual transition to electronic and emission-reduced engines.
• While the company still has a long way to go in its transition, initial signs are encouraging.
• I like Cummins here amidst quite a few moving parts, a reasonable valuation multiple, and a proactive stance to the transition.

In the summer of last year, I believed that Cummins ( CMI ) was transforming its business in a sensible way. I called the company a secular growth play in a cyclical industry, which furthermore had to electrify and decarbonize its solutions, something which the company gladly took very seriously.

Doing just fine and trading at not-too-demanding valuations, the company looked like a decent part for many portfolios, a conclusion which I still underwrite today.

An Overview

Cummins is a global manufacturer of engines, engine components, distribution, and power systems. The company generated $24 billion in sales in 2021, a number which quadrupled from $6 billion in 2000. Increased scale over time made EBITDA margins have improved to the mid-teens.

Besides the cyclical component, Cummins faces challenges and opportunities from decarbonization as well, as the company claims that a broad range of expertise in diesel, natural gas, propane, hydrogen, fuel cells, and battery systems makes that there is always a tailor-made solution in the portfolio. After all, regulation, economics, and actual infrastructure determine the speed of adoption and transformation in each segment.

The company has placed all these new engines in the ¨new power¨ business, a segment hardly contributing to any revenues (not to mention profits), although that topline sales traction is seen in this area.

Total revenues for 2021 rose 21% to $24.0 billion, on the back of the easy comparables during the pandemic, being roughly on par with the 2019 results. Operating earnings were posted at $2.7 billion, with net earnings of $2.1 billion coming in just shy of $15 per share.

Net debt of a billion, is very modest, even if this number increases to $1.5 billion if we factor in some pension liabilities, offset largely by similar-sized investments in other businesses and equity method investees. Trading at $200 at the start of 2022, valuations were modest at 13–14 times earnings, as investors recognized that the business was finding itself at a strong point in the cycle, facing a transition challenge as well.

The company has seen a very active 2022, as the company announced the acquisition of Jacobs Vehicle Systems, a subsidiary of Altra Industrial Motion. This was followed by a $3.7 billion deal to acquire Meritor, to thereby growing expertise in drivetrain and electrical powertrain solutions. To offset part of the increase in net debt, the company announced its intention to float its filtration business, something which was set to happen in 2023.

After a solid start of the year and the Meritor deal, the company saw 2022 sales at $28 billion, with EBITDA margins in the mid-teens suggesting a roughly $4.2 billion EBITDA number. This number should be roughly equal to the net debt load post the Meritor deal. Trading at $220 last summer, the valuation looked reasonable at 15 times earnings with leverage equal to reported EBITDA.

Moreover, the business was seeing some losses due to the transition, which over time should become the core business of course. The New Power business generated second-quarter sales for 2022 of $42 million, and an EBITDA loss of $80 million. With realistic losses reported around $100 million a quarter, I pegged the losses of these activities at $3 per share on a pre-tax basis, a huge number. If these can become a profit center, the future looked good in my eyes.

Holding Steady

Since the summer of last year, shares have held up rather well. In fact, shares rallied to the $250 mark towards the end of 2022, although they had fallen to the $200 mark in May of this year amidst concerns on the outlook for the business, as a general market rally pushed shares up to $235 at the moment of writing.

In February of this year, the company posted 2022 sales which were in line with the guidance. Full-year sales rose from $24.0 billion to $28.1 billion as operating earnings rose in a modest fashion from $2.7 billion to $2.9 billion, as net earnings were rather flattish at $2.2 billion amidst higher interest expenses and taxes. Amidst a modest reduction in the share base, the earnings power improved to just over $15 per share. Moreover, the 2023 guidance was solid with sales seen up another 12-17% on the back of the Meritor deal, with EBITDA margins seen around 15% of sales.

For the year, the New Power business generated a mere $176 million in external sales, posting EBITDA losses of $340 million in the process, although that fourth quarter external sales already came in at $70 million.

First quarter sales rose in a pronounced manner to $8.5 billion, as first-quarter earnings of $5.55 per share were particularly strong as well, allowing the business to know operate with net debt just in excess of $5 billion, for leverage ratios around 1 time. The New Power business - now labeled Accelera - posted an $85 million revenue number, now accompanied by an EBITDA loss of $94 million. On the back of the strong quarter, the company now sees 15-20% revenue growth for the year, with EBITDA margins now seen at 15.0-15.7%.

In May, the company has seen quite some events. The company has seen the IPO of Filtration business Atmus Filtration Technologies ( ATMU ) . At the offer price, the business was valued at an enterprise valuation of around $2.2 billion, as Cummins still holds a vast majority stake in the business. This deal is relatively small, with Cummins supporting a near $40 billion enterprise valuation at prevailing levels. Some of the IPO proceeds benefiting Cummins were immediately used to acquire two of Faurecia´s commercial vehicles plants in an EUR 142 million deal.

With earnings power now trending around $20 per share, the valuation remains non-demanding, all while the company has outlined a solid guidance for 2023 and leverage remains firmly in control. Amidst all this, I am still upbeat on Cummins here, believing it is not spectacular, but a decent addition to most portfolios.

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