Summary
- Cummins exhibits long-term growth in revenue, net income, free cashflow, and dividends. They also repurchase shares and have a high ROIC relative to their WACC.
- Unlevered DCF with conservative assumptions show buy rating and 15% upside with mildly optimistic assumptions.
- CMI is more than a diesel engine manufacturer. This segment comprises less than a third of its net sales. They have several product lines in many high growth markets.
Thesis
Cummins (CMI) has outstanding financials, valuation, industry growth, and market and product line diversification. These factors lead to a "Buy" rating at the current price for investors holding for ten years, despite some risk in customer base and peer performance the past year.
Business
Cummins Inc. designs, manufactures, distributes, and services diesel, natural gas, electric and hybrid powertrains and components. They have exposure to many other markets such has hydrogen production, fuel cell products, electric power generation systems, turbochargers, transmissions, and control systems. Their five operating segments consist of Engine, Distribution, Components, Power Systems and New Power. CMI is often sought after as a diesel engine provider, but it is clear they are much more than this. In fact, diesel engines only account for less than a third of their net sales.
The Engine segment consists of diesel and natural gas-powered engines for trucks, bus, RV, construction, mining, marine, rail, oil and gas, defense, and agricultural markets.
The Distribution segment is the primary sales, and service support channel. This includes customer service segments such as in-shop support, field service, and aftermarket parts.
The Components segment includes products such as aftertreatment and emission solutions, turbocharger technology, transmissions, filtration, electronics, and fuel systems for diesel and natural gas applications.
The power systems contain four subsegments: Power Generation, Industrial, and generator technologies and the New Power Segment. Power Generation includes power generators for many applications using natural gas, diesel, or biogas fuel. Industrials include high horsepower engines for mining, rail, defense, oil and gas and marine applications. Generator technologies include A/C generator/alternator products for internal combustion, and the New Power Segment revolves around products using hydrogen and electrified power solutions.
Overall, CMI has its hands in many different products and markets besides diesel technology. These markets help diversify and hedge against risk in the diesel industry, but also provide growth opportunities in other industries.
Customers, Peers, And Industry Outlook
CMI is customer top heavy with PACCAR ( PCAR ) representing 15% of net sales in 2021. Other major customers include Navistar, Daimler, and Stellantis ( STLA ). These four customers represent 33% of consolidated net sales. However, these customers represented 37% of net sales in 2019, so CMI is doing a better job at diversifying its customer base. From a peer and competition standpoint, profitability , momentum , and peer grades look great. Valuation grades look subpar, but I will counterargue with a deeper analysis. The lackluster growth grades are being addressed through the different markets in diesel, hydrogen, and natural gas, along with the vast product line CMI has. The industries CMI are in have great growth prospects as well. The diesel engine market has a CAGR is around 6.8%, with hydrogen engines at 8.7% and Natural Gas at 7.4%. Overall, their industry outlook seems a lot better than people give credit towards.
Something to note is CMI included a graph in their 10-k of performance versus peers and the S&P 500, showing they lagged behind in 2021. CMI is a very cyclical company but seems to match the market in the long run.
However, this may provide an opportunity for investors to jump in at a cheap price. We know the outlook for their industry is bright and even analysts are predicting this by looking at eps estimates. CMI has matched analysts estimated pretty well, so the analysts must be giving the credit they deserve. I think we could follow their future prediction with relative confidence.
Financials
CMI has six key things I look for when judging the performance of a company. They have top line revenue growth over the last ten years with an average of 7.5% YoY. They also have Net income growth of 6% YoY the last ten years, and a whopping 18% the last five. They consistently repurchase shares at (-2.7%) rate YoY, generating value for the shareholder and have more than tripled their annual dividend since 2012. They also boast a good ROIC of 18% average over the last ten years, and never dipped below 10%. We have calculated WACC in a later segment to be around 9.11%. Though WACC changes over time, their ROIC has been significantly higher on most years. This tells me management is efficient at investing capital. Their Free cash flow has dipped the last two years but has increased overall the last ten. This is important to see in a cyclical stock such as CMI.
Valuation
A fair value of $232 per share was calculated by a 10-year Unlevered Discounted Cash Flow ("DCF") analysis using CAPM with a 2.5% terminal growth rate ("TGR") and a 10% weighted average cost of capital ("WACC") discount. Note that CMI's WACC was actually calculated to be 9.11%, but I decided to discount by 10% to match the market. A worst-case, best-case, and normal-case scenario were averaged to arrive at the fair value. Revenue and EBIT projections were used from average results of (11) analysts for 2022 and (11) analysts for 2023 from Financial Modeling Prep (Red Text). Personal projections were used thereafter, with the following conservative assumptions in the tan boxes.
CMI DCF Assumption (Author) CMI Fair Value (Author)
The results show around a 3% upside with extremely conservative assumptions at the $232 price. This does not include their 2.70% dividend or the consistent share buybacks, which should add more upside. A very conservative best-case scenario exhibits almost a 15% upside at a $270 price. This valuation would indicate a "Buy" rating. For more information on the steps and calculations in the spreadsheet, I attached the following equation sheet ( Mitchell_s_Reference_Sheet.pdf ), which follows a standard unlevered free cash flow DCF approach.
Risks And Catalysts
CMI has a few risks to make note of. Although they are improving on their customer base, it still is a little top heavy. Fortunately, it is with relatively large and safe companies with PACCAR and Stellantis, but detrimental impacts to these companies could wipe a third of their customer base. Another risk is how inferior diesel technology becomes. Though it still has great outlook over the next ten years, despite the hype around EV market, there is still a risk this becomes inferior as other technologies improve. CMI understands this risk and has done a fantastic job researching and joining other markets with a vast product line. Any major changes to these, would result in a re-analysis of the company and possibly a change in thesis.
Conclusion
CMI has a lot of great things going for it. Their revenue, net income, free cash flow, and dividend have shown great growth over the last ten years. Furthermore, their ROIC has been good in respect to their WACC, indicating management has efficiently invested capital. They further reward the shareholder through share buybacks, and a conservative DCF indicated they are undervalued. They have done a fantastic job diversifying their product line for different markets to hedge against diesel inferiority through natural gas and hydrogen engine markets. They are often looked at as a diesel engine manufacturer, but this only constitutes less than a third of their net sales and the markets and products they have entered have great industry CAGR and outlook. There are some risks with customer base and diesel industry outlook, but this also may provide a great time to enter as analysts are expecting them to grow in the next year alone, not to mention the long term. CMI is a great company and is a "Buy" at the current price.
For further details see:
Cummins: An Undervalued Dividend Growth Stock