Cummins Stock: Too Cheap to Ignore? (NYSE: CMI)
I was very excited to write this article for one major reason: we are dealing with a dividend growth opportunity that is actually cheap with a good risk/reward ratio. My most recent Cummins Inc. (CMI) the article was written in July 2021, which means it’s time for me to cover the stock again. At the time, I wrote that the company was facing potential headwinds:
Unfortunately, the biggest risk facing investors is a further deterioration in economic expectations. This could happen if the pandemic slows key economic hubs again (i.e. through new lockdowns) or if China is unable to continue its post-pandemic growth streak.
Currently, the stock is down almost 23% year over year with a dividend yield approaching 3%. Considering economic cycles and Cummins’ cyclical share price in addition to the company’s ability to generate shareholder value, I am extremely pleased to see that the valuation has fallen. We are looking for a great opportunity for dividend growth investors who are not afraid of dividend paying industrial stocks. In this article, I will give you the details!
Cummins Stock – Seasonal Behavior and Valuation
Normally I do this at the end of each article. However today, I start with that because it is the reason which pushed me to write this article.
With a market capitalization of $27.6 billion, Cummins is one of the world’s leading producers of engines, components, timing and fuel systems. It sells most of its annual revenue of $24.0 billion in North America ($13.4 billion), Europe ($3.3 billion) and Asia-Pacific (3. $2 billion).
The company’s products include engines and related solutions for tractors, buses, trucks, heavy construction machinery, trains and even ships. While high-performance diesel engines are the company’s daily bread, it is investing in next-generation power sources like hydrogen. To date, Cummins has invested approximately $1.0 billion in new energy through research and development, mergers and acquisitions, and internal CapEx. Yet in 2021, new electricity accounted for just $100 million in revenue, or less than 0.5% of total sales.
So, for now, we’re stuck with a relatively simple business model: high-quality engines. There’s more than I’ll explain in this article, but for now, that’s what we need to know.
What you’re looking at below is an overview of Cummins withdrawals since the 1970s. When the company was less mature (before 2000), it regularly sold nearly 60%. This is still the case for some machine companies, but it no longer applies to CMI. What CMI does is drop 25% on a very regular basis with bigger drops towards 40% when economic expectations drop more than usual. In 2015, for example, the stock entered a manufacturing recession. Currently, the stock is down due to slowing economic growth, problems in Russia, high inflation and fears that the Federal Reserve could trigger a recession.
In Russia, the company has an agreement with the truck manufacturer Kamaz, which is 47% owned by the Russian government (indirectly). So the ongoing war adds a whole new layer of uncertainty to an already low stock.
Based on this background, I want to present the chart below – the cornerstone of this article. Below, I compare the year-over-year performance of CMI’s stock price to the Empire State Manufacturing Index. Conducted by the New York Fed, it is a survey similar to the ISM index which displays economic expectations.
Needless to say, the correlation is beautiful – and it makes sense given CMI’s cyclical business model.
Growth expectations peaked in the second half of 2021. Right now, the CMI is pricing in a significant decline in economic growth, which is good because a lot has already been priced in according to the chart.
In terms of valuation, we are now dealing with a market capitalization of $27.6 billion and near-zero net debt – hence the company has a fortress balance sheet. Technically speaking, the company has $1.5 billion in net debt in 4Q21, but free cash flow expectations are high (I’ll get to that in this post) and the company has high working capital. As a result, analysts expect net debt to decline to just $100 million in 2022. Analysts also expect EBITDA of $4.0 billion in fiscal 2022, giving us an enterprise value of $27.7 billion and an EBITDA multiple of 6.9x. Next year’s EBITDA is expected to be $4.4 billion, which would reduce the valuation to 6.3x EBITDA. Yet, for reasons of slowing growth expectations, I will refrain from using higher EBITDA estimates.
Using this valuation, we get an attractive valuation close to the lower end of the (cyclical) valuation range.
CMI shareholder value
I haven’t finished explaining why CMI is attractively valued. I just wanted to use a different section for free cash flow.
In general, the machinery industry is competitive. There are many players in the market and it is difficult to establish reliable long-term relationships with suppliers. It is in general, and it does not apply to CMI. The company, founded in 1919, is well established and able to operate with high margins and free cash flow.
In this case, free cash flow, or FCF, is net income adjusted for non-cash items and capital expenditures. This is money the company can spend on buyouts, dividends, debt reduction and the like.
It turns out that the company, which supplies almost all trucks and related companies (see preview below), is really good at generating free cash flow.
Cummins manages an annual CapEx budget of nearly $790 million. That’s not expected to change much, although greater investment in new technology is slowly pushing that figure to $800 million. This means that higher economic growth allows higher operating cash flow to lead to higher free cash flow, as shown in the chart below.
In 2021, free cash flow was close to $1.5 billion. This year, it is expected to be $2.2 billion. Next year, analysts are looking for $2.4 billion, including $2.6 billion in 2024. While all of this is subject to extreme economic uncertainty, it gives you an idea of what analysts expect. that CMI is capable when economic growth is accommodating. Right now, it also helps that commodity prices are high, which is supporting demand for off-road engines.
Using the market cap of $27.6 billion, we get an implied FCF yield of 8.0%. Right now, the company’s dividend yield is 2.8%, which means there’s LOTS of room to increase the yield – even if the FCF isn’t rising anymore. It won’t happen, but it’s an example of the amount of FCF the company generates. Therefore, I was able to give the company near-zero net debt this year in my EV/EBITDA valuation because the total FCF after dividends is sufficient to turn net debt into net cash very soon.
The chart below shows that the business tends to be cheap when (implied) free cash flow approaches 7.5%. This is currently the case, although the FCF is falling a bit due to slowing economic growth.
Additionally, the ratio between the CMI and the S&P 500 (lower half of the chart below) is at its lowest in several years. Usually these lows are buying opportunities. The upper part of the chart shows the total return (i.e. including dividends) for the last 10 years. Unfortunately, Cummins hasn’t been able to beat the S&P 500 since the Great Financial Crisis. The same goes for peers like Caterpillar (CAT), which I own.
It is not a problem if investors are buying because of dividend growth. Since 2014, annual dividend growth has averaged 10.4% according to Seeking Alpha. Additionally, the yield spread on the S&P 500 is 160 basis points (chart below). This is one of the highest in recent years and another indicator that makes “valuation” more attractive. Additionally, the company has repurchased approximately 13% of its outstanding shares since 2017.
I have loved Cummins for many years. It’s a terrific long-term investment with near double-digit annual dividend growth, a strong balance sheet and long-term relationships with all major machine manufacturers. Although Cummins is slowly moving forward with investing in hydrogen and related technologies, it remains heavily dependent on demand for diesel (and related) engines for the time being. Thus, cyclical growth dominates secular growth.
This explains why the stock is currently in steep decline. Slowing economic growth expectations and lingering uncertainties about Ukraine are impacting the stock, which is bad news for people who expect to make a quick buck from the stock. Still, this is great news for long-term investors looking to initiate a position or add to an existing position.
Although the stock could drop another 10% if we are about to enter a manufacturing recession, I think we are at attractive prices that warrant stock purchases. If you are not long yet, I would start by buying a small position. The EV/EBITDA is attractive without factoring in strong future growth. The same goes for the company’s implied free cash flow yield of 8%.
Once investors take into account that CMI is highly cyclical and the risks that come with it, I think we are dealing with an attractive opportunity to buy quality dividend growth with a yield close to 3%.
(Disagree? Let me know in the comments!