Buying Companies with Great Products – Cummins (CMI) – Part II

Summary

• In Part I, we screened out FOXF and GTX and did a deeper analysis of SNA
• In Part II below, we’ll analyze Cummins, Inc (CMI)

Cummins (CMI)

Overview

Cummins Inc. primarily designs, manufactures, distributes, and services diesel and natural gas engines, as well as components like turbochargers. Although it’s a different kind of industrial from Snap-On, CMI’s fortunes will mostly rise and fall with the worldwide sale of trucks, which is probably peaking for this cycle.

Let’s get into it.

Key Stats, Metrics, and Financials

CMI’s valuation stats are mostly at the low end of their 10-year range, though its Book metrics are more in line with history:

Returns on Invested Capital, Assets, and Equity are up since hitting a low in 2017:

Cummins’ balance sheet isn’t as strong as SNA’s, though. Its Quick Ratio has dipped below 1, with a big increase in short-term debt:

This warrants a closer look.

Quality

Let’s check out some other Quality metrics, like Piotroski F and Altman Z scores:

The company’s Piotroski score was recently only a 6, but improved 2 points in the most recent quarter due to improvements in its gross margin and a slight uptick in its current ratio. I wouldn’t rate a Current Ratio improvement from 1.54 to 1.57 as very significant, however, and it’s still very low.

The Gross Margin improvement does seem real, and back to more historical levels.

Let’s look at its Altman Z score, which measures bankruptcy risk.

The Altman Z Score of 4.08 for manufacturers in the TTM is in the green range, though the company’s score has been mostly been declining since 2012. (Ignore the blue MRQ value at the end — we’re going to remove it as some of the metrics used in calculating Altman compare items on the income statement to the balance sheet, which doesn’t work for a single quarter.)

So, all this seems OK, but not stellar.

I took a glance at the most recent 10-Q to see what all the short term debt is. It turns out it’s $709M in commercial paper — a short-term loan to finance its operations with an average interest rate of 2.6%. This isn’t all that unusual, but I’m not sure I like it. Hold that thought, though.

Cummins is also a dividend payer, with a trailing yield of 2.84%. But its dividend growth has really flattened lately:

It’s definitely troubling when a dividend grower is forced to pull back, but I’d rather they pull back than finance dividends with debt!

CMI’s payout ratio is just under 30%, which is reasonable. I’m glad they didn’t continue to grow the payout unsustainably, but I don’t like that they had to slow their dividend growth, either.

CMI’s owner earnings has recently begun growing again, mostly due to an uptick in revenue growth that has passed to the bottom line.

With $2B in owner earnings, though, why does the company need to reduce its dividend growth and use commercial paper to finance itself?

Financial Engineering

Well, it turns out that CMI’s TTM dividend payout was $751M, which is just about equivalent to its commercial paper loan of $709M.

It looks like it’s financing its dividend with a short term loan. In some ways, this seems crazy. If you need the cash to invest in your business, why are you borrowing money just to give it to shareholders? At 2.6%, it costs them (and by extension, shareholders) $18M a year to keep that up.

At the same time, the company is spending a lot to buy back shares:

So, Cummins is borrowing money at 2.6% to buy shares in a company (itself) that has a forward expected dividend yield of 2.74%. I guess this is a form of financial arbitrage, but this stops being a good deal if the company’s price goes up much more (which will drop its yield to less than 2.6%), which it will inevitably do if the company keeps buying back a billion dollars of its equity.

Dividends and buybacks are a way to return cash to shareholders. You do more of that when you have lots of cash kicking around and not enough good projects to invest in. Borrowing, even at a low rate, to return even more cash, just seems like dumb financial engineering.

Here’s a summary of what’s going on with the business from their latest earnings call:

In summary, we are maintaining our revenue outlook for the year with improved truck markets in North America, offsetting lower demand in power generation markets, while increasing our EBITDA guidance range by 50 basis points, due to lower material costs and strong operational performance. During the quarter, we’ve returned 68% of operating cash flow or $279 million to shareholders in the form of dividends and share repurchases, consistent with our plan to return 75% of operating cash flow to shareholders for the year.

Tom Linebarger, Chairman and CEO, 1Q2019 earnings call

So, the growth outlook isn’t great but improving COGS will help margins and cash flow continue to grow. They’re returning a lot of cash to shareholders, but borrowing quite a bit to do it, which doesn’t make sense to me.

Cummins DCF Valuation

Let’s take a quick look at the current valuation using a DCF:

I used $2.11B as the start value, which is its TTM Owner Earnings. I used 4.24% as the growth, which is what its median revenue CAGR has been over recent 3-year periods. I used the same 8% discount rate as SNA.

At these levels, it looks like CMI is significantly undervalued.

Conclusion

Like Snap-On, this is going to be a cyclical stock, and its current level of cash return will be hard to maintain if revenues start taking a hit, and if credit markets dry up.

But, even without the intense focus on returning cash to shareholders, its core business is generating a lot of cash. Further problems with China and global recessions will hurt the company, which will probably take out its stock price even more. I’ll probably put this on my “buy during the next recession” watch list.

Disclosure: I do not own any stocks discussed in this article.