Summary
- Elevated valuation: Cummins Inc.'s current valuation is elevated and may be unsustainable in the long term, indicating limited upside potential.
- Sluggish cash flow: The company's cash flow production has been sluggish, while debt has been increasing, and intangibles and goodwill represent a significant portion of its equity.
- Cummins' increasing reliance on debt to finance its growth is reflected in the decline in its ROIC levels, which have been hovering around 10% and may be unsustainable.
Introduction:
During the Q4 2022 earnings call for Cummins Inc. (CMI), several highlights were discussed. The company reported strong financial performance, with an impressive 20% increase in revenue and earnings per share of $6.66, which largely surpassed analysts' estimates. Cummins attributed its success to strong demand across its segments, particularly in the engine business.
In addition to its financial performance , Cummins emphasized its commitment to sustainability and highlighted its progress in reducing greenhouse gas emissions. The company has set a goal to be carbon-neutral by 2050 and is investing heavily in electrification to achieve this objective.
Furthermore, Cummins discussed its strategic initiatives, including investments in R&D, partnerships, and acquisitions. The company is focused on expanding its product portfolio and improving operational efficiency to stay ahead of competitors.
While Cummins acknowledged the impact of rising raw material costs on its profitability, the company believes it has taken steps to mitigate this challenge. These include pricing actions and supply chain optimization.
2022 Meritor acquisition
Cummins Inc. has completed its acquisition of Meritor , a leading supplier of drivetrain and mobility solutions for commercial vehicles. The acquisition will enable Cummins to expand its product portfolio and accelerate its electrification capabilities. The company plans to leverage Meritor's expertise in electric drivetrains to enhance its own offerings and capture a greater share of the growing market for electric commercial vehicles.
The acquisition is expected to generate significant synergies and create value for customers and shareholders alike. Cummins is committed to delivering innovative solutions that meet the evolving needs of the transportation industry. The acquisition of Meritor by Cummins had a total transaction value of around $3.7 billion, which included assumed debt and net of acquired cash. To finance the acquisition, Cummins used a combination of commercial paper, debt, and cash on its balance sheet . Despite this, the company is dedicated to preserving its strong credit ratings.
Capital Structure, Growth and Profitability
Cummins has a total invested capital amount of $18 billion, with $10 billion in equity and over $8 billion in debt. Over the past decade, the company's invested capital has increased by $9 billion, with $2 billion coming from an increase in equity (all of it as intangible assets & goodwill) and the remaining increase from debt.
While the company's debt position is not problematic, with a Net Debt/EBITDA ratio under 200%, the increase in EBITDA has not been reflected in cash flow increases. They have remained flat at $2 billion since 2013. The company's ROE has remained stable at around 20%, but ROIC levels have been hovering around 10% and deteriorating, suggesting that Cummins is exchanging equity for debt to meet return on equity requirements. While this may not pose an immediate risk, it is not sustainable in the long term, especially if EBITDA growth rates do not continue to increase and cash flow production does not match EBITDA growth rates.
Valuation:
Examining the business's valuation, the price to cash flow has reached its highest point in 10 years. This suggests that either cash flow needs to increase rapidly to bring the multiple back in line, or the market capitalization needs to correct by 15% to 20%. A 20% price correction would bring Cummins Inc. stock back to $200, the same level as one year ago. Furthermore, given that the company's growth metrics clock-in approximately 5% CAGR, it may be argued that a mid-teens P/E multiplier is too high.
Risks:
In the past decade, Cummins' stock performance has been slightly underperforming the market with a 12% CAGR return since 2013. However, in the recent 12 months, the company has shown remarkable outperformance, surpassing the S&P 500 (SP500) by nearly 30%, indicating strong momentum behind the stock. The recent acquisition of Meritor could potentially accelerate growth, and market participants seem to have taken notice. Additionally, with a potentially soft landing and an improved economic outlook, Cummins Inc. may benefit from tailwinds in the future.
Conclusions:
Given Cummins Inc.'s recent strong performance, its valuation is now high, and its cash flow production has been sluggish. Additionally, the company has been increasing its debt, and a large portion of its equity is made up of intangibles and goodwill. With these factors in mind, holding onto Cummins Inc. stock at current levels seems risky, with limited upside potential. Therefore, it may be wise to sell and reconsider investing in Cummins Inc. stock in 2024.
For further details see:
Cummins: High Valuation, Sluggish Cash Flow, Rising Debt, Sell And Revisit In 2024