Shares of Cummins Inc. (CMI) have experienced a decent appreciation of 21.8% since July, when they touched the 52-week low of $82.20. Should investors ride on the recent recovery trend? In this article, I will elaborate on the stock value analysis that could potentially help in formulating your investment decision.
Cummins' valuations are attractive based on the company's solid financial performance relative to its peers' (see comparable analysis table below). Analysts on average predict the company's revenue, EBITDA, and EPS 2-year CAGRs to be -0.1%, 6.3%, and -2.6%, respectively, for the current and next fiscal years. The growth estimates are largely worse than the averages of 3.9%, 6.5%, and 7.3%, respectively, for a peer group consisting of Cummins' primary competitors. However, the firm's EBITDA margin is forecasted to expand by 2.1% over the same period, considerably higher than the peer average of just 0.8%. On the profit side, all of Cummins' profitability and capital return measures are above the par, indicating a solid margin performance. The company carries a low level of debt as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Cummins' trailing free cash flow margin of 4.6% is markedly higher than the peer average of only 1.8%. The company's interest coverage ratio, current ratio and quick ratio are in line with the group averages, reflecting a healthy solvency condition and a fairly liquid balance sheet.
To summarize the financial comparisons, Cummins' relatively weak growth prospects would be the primary drag on the stock's valuations. However, given the company's solid profitability and cash flow generating capability, I would expect the stock to trade fairly in line with the peer-average level. Nevertheless, the current stock valuations at 7.1x forward EV/EBITDA, 11.4x forward P/E, and 0.93x PEG represent an average valuation discount of 8.0% to the peer-average trading multiples, suggesting that the stock is now priced slightly below the fair value.
Both Cummins' trailing EV/EBITDA and P/E multiples are currently near their 3-year lows (see charts below). In addition, the stock's forward P/E multiple is trading at a 13.4% discount to the same multiple of the S&P 500 Index (see chart below), despite the fact that Cummins' estimated long-term earnings growth rate of 12.3% is considerably higher than the average estimate of 7.9% for the S&P 500 companies.
Based on the peer-average PEG of 1.0x and Cummins' long-term estimated earnings growth rate at 12.3%, I believe the stock should reasonably command a forward P/E multiple range between 12.0x and 13.0x. Assuming that the analysts' estimated fiscal 2014 EPS of $10.50 can be sustained, these assumptions would imply a 1-year target stock value range between $126.00 and $136.50. By using a cost of equity at 12.4% (details are discussed below), one can calculate the present value of the stock price range to be between $112.10 and $121.44, representing an average of 16.8% upside from the current market price.
Alternatively, I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2014 (see DCF chart below). To account for the financial projection risk, a company-specific risk premium of 2.5% is applied in the cost of equity calculation. To be conservative, a normalized risk free rate of 2.3% is used instead of the current depressed 10-year US Treasury yield.
Based on a WACC of 11.6% and a terminal growth rate of 3.0%, the DCF model yields a share price of $114.44, which supports my conclusion in the relative value analysis.
What would be the upside catalyst for Cummins? I tend to agree with the view from Piper Jaffray's recent research note, wrote by Alexander E. Potter (according to Thomson One, Equity Research):
"Truck maker Navistar recently altered its strategy to begin using CMI components - or in some cases entire CMI engines - in the company's trucks. In total we think this new NAV-related business will increase CMI's 2013 revenue by $400m-$800m, with an EPS impact perhaps exceeding $0.50. Consensus estimates currently call for 3.5% revenue growth in 2013, but after backing out this incremental NAV business (which didn't exist in 2012), consensus implies top-line growth of -1% to +1%. We think investors are likely to view this as beatable, especially given improving truck markets in Brazil, China and North America."
On top of the favorable valuations, the stock also offers a 2.0% forward dividend yield. Over the past 5 fiscal years, the dividend per share had been raised by a significant 5-year CAGR of 32.1% from $0.33 in fiscal 2006 to $1.33 in fiscal 2011 (see chart below).
From a technical perspective, there has been a solid technical price support range between $80.00 and $90.00 since 2011, which somewhat limits the price downside (see chart below).
Bottom line, as more indicators suggest a stabilizing macroeconomic environment, investors should consider building up positions in some quality cyclical stocks. In the light of the tempting valuation level and the healthy fundamentals, Cummins should be one such candidate.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all financial data in the article and the DCF chart (except for the highlighted assumptions) are sourced from Capital IQ.