- Cummins will report its annual dividend hike during July, hiking 7.4% in 2021.
- Management expects revenue will have grown from FY2021 $24 billion to above $40 billion by the end of this decade.
- While a cyclical business, all financial metrics have shown strong development in the most recent decade, in combination with little debt and outpacing peers on ROIC.
- Cummins is a fair buy at this level, with potential adjustments to earnings guidance dictating stock price movements from here.
Introduction
I'm a dividend growth investor, making Cummins ( CMI ) an interesting company, not least because it is currently trading close to a 3% yield, the highest it has been since the Covid-19 market crash. Cummins is expected to announce its annual dividend hike during July, making it timely to have a look at this company.
Who Is Cummins?
Cummins is a manufacturer of powertrains and powertrain-related components covering filtration, turbochargers, fuel systems, aftertreatment, automated transmissions, fuel cell products, electric power generation systems, batteries, etc. Cummins, founded in 1919, 103 years ago, plans to reduce its total emissions by 50% by 2030 (2018 as base year) and employs 59.900 people.
Cummins provides the backbone of powertrains to anything heavy duty and secured a revenue of $24 billion for FY2021 with a GAAP net income of $2.1 billion. When publishing its FY2021 results, management guided with 6% revenue growth for FY2022.
For the FY2021, the internal business divisions ranked the following in terms of revenue. Engines at $7.6 billion in revenue, Distribution with $7.7 billion in revenue, Components with $5.9 billion in revenue, power systems with $2.6 billion in revenue and lastly, New power, with $108 million in revenue. Engines and Components derive the largest EBITDA as a percentage of revenue with 14.2% and 15.4% respectively. Followed by Power Systems with 11.2% and lastly Distribution with 9.4%. New power contributes with a negative EBITDA, and also contains the future focus on fuel cells, battery tech, etc. EBITDA performance as a whole was slightly better for FY2020, but FY2021 resulted in a total EBITDA margin of 14.6%.
Cummins pays a dividend, which it has continuously hiked, and which is regarded as both very safe and growing.
In terms of geographical revenue split, Cummins secures roughly half of its total revenue from the US, with the rest being split between India, China and rest of the world. The geographical diversification shows its beneficial nature in the sense, that when the US and India exhibited declining revenue levels from 2019 to 2020, the remaining geographical areas still grew. During the three-year period highlighted above, we've seen reliance on the US diminish slightly in terms of overall percentage of revenue. In the 10-K, it's mentioned the largest customer, PACCAR ( PCAR ), makes up 15% of total revenue. PACCAR is one of the largest manufacturers worldwide when it comes to medium- and heavy-duty trucks. No other customer makes up more than 8% of total revenue, so it's not an unreasonable concentration.
I called Cummins a backbone provider, and what I meant is, that Cummins provides machinery across different applications (Diesel, Natural gas, Propane, Hydrogen, Fuel cells, Battery systems) to a vast array of industrial equipment companies. If it needs an engine to operate, there is a fair chance that engine comes from Cummins, as also evident by the illustration above. Amongst this cohort, we have manufacturers of trucks, buses, excavators, freight trains, ships, construction site power machinery, and so on.
All of these companies, including Cummins, need to transition towards a lower emissions future. That naturally impacts the offerings of Cummins, as they need to grow their bet within hydrogen and battery tech in particular. This introduces both an opportunity and business risk for Cummins, as the verdict is still out on who will grasp the lion's share of that new market opportunity. Naturally, Cummins has great experience in powertrains in general, so I'm a firm believer in the company also being relevant in the future - more on that later - but its current revenue base will undergo a significant overhaul in the coming decade as management has to learn how to compete in a somewhat new space and also how to become profitable.
Management itself addresses it as an opportunity, where they perceive to hold an edge. From my standpoint, especially the relationships with stakeholders and partners can turn out to benefit Cummins in their pursuit towards succeeding with new powertrain technologies, as they will have the ability to test and transfer knowledge with their largest customers, also what we would typically refer to as a strategic partnership, where both companies stand to benefit from joint focus on a given challenge at hand. A recent example would be that of Cummins and Daimler Trucks ( OTC:DTRUY ) partnering on hydrogen based powertrains.
Only time will show how this unveils.
Putting The Spotlight On Cummins
The reasons why I'm focusing on Cummins are numerous. They provide equipment across a vast array of customers, there is a need for improving infrastructure across the globe, especially the mature economies who have worn down roads, bridges, harbours, all relying on heavy equipment to get the job done - but also emerging countries experience a growing urbanisation and need to secure infrastructure to match. The company is heavily exposed to traditional diesel engines, but also making strides towards a greener future. Lastly, that Cummins' stock is currently in interesting territory, more than can be said about its more famous industrial peer, Caterpillar ( CAT ).
Highlighting some of its financials, Cummins exhibits the following performance
- While cyclical, revenue for FY2012 was $17.3 billion, for FY2017 $20.4 billion and TTM $24.3 billion - showing long-term growth.
- Earnings per share is up 40% during the last decade and 37% in the most recent five years
- The five-year average EBITDA margin is 15% and Operating margin is 9.9%
- Total debt is $4.6 billion, resulting in a very healthy EBITDA/Debt ratio of 1.6
- A payout ratio of 55% when measure on a free cash flow basis for FY2021 and forward payout ratio of 41% when measured on expected free cash flow for FY2022.
- Five-year compounded annual growth rate for its dividend at 7.2%
I believe the highlights above showcase rather strong performance for a company operating within the industrial sector, where competition is strong. One of the sources of Cummins success is its close partnership status with major customers, allowing to also seek strategic partnerships for given projects and exchange of knowledge, allowing to optimise Cummins' current offerings to the greatest extent possible. This is also what makes up a substantial part of Cummins' moat, as such partnerships allow for technological leadership in powertrains.
What I didn't highlight in the bullets above, is the fact that Cummins' net income hasn't shown the same growth as the revenue. That is from an accounting perspective, but if we look at the development within free cash flow, the development is rather consistent - improving long-term.
Again, we are dealing with a cyclical company, but as is evident, free cash flow is growing over the long-term. Cummins has a fairly consistent CAPEX budget, resulting in growing cash from operations as the business expands.
Currently, Cummins is expected to grow revenue to $25.9 billion for FY2022 and $27.7 billion for FY2023. Naturally, there is uncertainty tied to these numbers, and the pace will be unknown for now, but historically Cummins has been able to grow its business, and I would expect for them to continue doing so. If Cummins managed to achieve the current expectations, it would represent a 7.9% and 6.7% revenue growth rate, respectively.
One of the key metrics I always pay attention to is the company's ability to create returns on invested capital, and I've already shown Cummins' recent performance, but that is of course better displayed in a comparison with competitors or peers.
Not many companies are very similar to Cummins, but here I've listed a group of companies who to some extent cross into one or more of the business areas of Cummins. As can be seen, Cummins is leading the pack, with the same being the case if we look at return on equity, with the exception of Caterpillar doing better. The reason I'm keeping an eye on the ROIC, is that in essence, it illustrates management's ability to secure profits from their investments, naturally, I'm on the lookout for top performers on an industry basis.
Growing revenue and growing cash flows have also made Cummins a shareholder friendly company. As mentioned, Cummins is expected to hike its dividend during this month, while also having repurchased its own shares for a number of years, having reduced its float by 15% in the past five years and 25% in the past ten years.
Looking To The Future
During the section concerning company introduction, I mentioned their need to assert themselves as a leader of electrification of powertrains, including hydrogen or other emergent technologies. Management's own perspective is that Cummins is the only company in possession of a broad enough portfolio of technological capabilities to capture the change coming their way. Naturally, management has an interest in portraying one's company as a success, so I would receive such a statement with a bit of scepticism. Management laid it all out in the recent analyst day 2022 , and for prospective investors, I suggest going through the material as it gives great insights as to how management expects the situation to unfold.
I previously talked about Cummins consistent growth when observing revenue development on a decade long time horizon. Similarly, looking ahead, and management is expecting Cummins to continue its historical growth. The existing revenue base business is expected to add $9 to $11 billion in revenue before we reach 2030, while the new power division is expected to grow immensely. Here, management is also providing a range, as there is significant uncertainty tied to such an outlook. Breakeven is expected to be reached by 2027, again emphasising that such a target could change, in fact it would only be natural if it changes as this involves adoption of a new portfolio of technologies and products. Seeing that timeline extend a year or two, isn't something that would cause me to flinch.
Valuation
Cummins is a stable business going back more than a hundred years. Its financial profile is good, and the outlook appears promising, although Cummins should be recognised as a mature business.
Historically, Cummins has traded at a higher level than currently, at least when measured on a price to earnings ratio. This metric is meaningful given Cummins' status as a mature business, with a stable capex budget, meaning there are few surprises when trying to forecast its financial profile, growing more or less in pace with global GDP.
On a forward basis, the price to earnings ratio comes in at 11.4, immediately suggesting the stock is currently undervalued compared to its long-term mean valuation. Given Cummins' stability, there appears to be little reason to suggest the valuation should be significantly lower than its long-term average, especially considering the company being in possession of a reasonable roadmap to continued growth.
Similarly, when observing the current valuation from a P/FCF standpoint, the 3Y mean is 16.8 and 5Y mean 17 compared to the forward P/FCF at 14.4. Price to book is 3.3 compared to the 3Y mean of 3.8 and 5Y mean of 3.6.
With the current information available, Cummins' appears to be in the buy range. Naturally, if management is forced to slash forward guidance significantly, it would reduce the "E" in the price to earnings ratio, elevating the current price to earnings ratio. Given the current state of the global economy, where we are all pending whether we enter into a recession, small or big, a margin of safety in the valuation is recommendable.
Going back to the financial crisis, the most recent deep recession, Cummins managed to stay profitable, so I would encourage prospective investors to focus on the long- and opposed to short-term. In this instance, it means that Cummins should be expected to bounce back, even if earnings will suffer in the short-term.
Another heuristic one can use when considering a mature company, is the idea of dividend yield theory. That the yield reverses to its mean once deviating from it. Evidently, the dividend yield mean in recent years is well below the current level, but observing the stock over five years or longer, and the yield is actually trading quite close to its mean.
Conclusion
As stated, I believe its recommendable to maintain a margin of safety in the valuation when going long today, given the state of the global economy, where it's reasonable to expect companies facing the need to consider revising guidance. While I perceive Cummins' to be in the buy range considering the current valuation, I've personally decided to establish a position, which I plan to build over time in order to reach a full position. Simply due to the fact that I perceive Cummins to be a fair buy at this level, but not a strong buy as I believe there could be more downside ahead of us. This will rest on potential need for adjustment for the earnings guidance in the upcoming quarterly results.
Cummins is about to announce its annual dividend hike, while having a very manageable payout ratio. Already trading with its highest dividend yield since the Covid-19 market crash, the forward dividend will most likely be rather attractive at above 3% once the hike is announced. Management expects the company to increase its revenue from FY2021 $24 billion to $41 to $46 billion by the end of this decade. As such, there is still plenty of growth left in Cummins, underlining there is little reason to suspect Cummins doesn't remain a growing business, although we must remember its cyclical nature.
For further details see:
A Look At Cummins Before The Upcoming Dividend Hike