Cummins: The Value Lies Within

| About: Cummins Inc. (CMI)

Summary

Cummins' robust balance sheet will allow for an easy transition of the capital structure.

Increasing the dividend may not be the best way to increase shareholder value.

The current share price is fair but not great – let’s take a look.

After watching the stock of Cummins Inc. (NYSE:CMI) move from a low of approximately $80 per share in January to now almost $110 per share, I decided to take a look at the security in order to determine if there was any additional upside to be had. Cummins is a company which manufactures and sells diesel and natural gas engines and related products. It also produces generators and emission solutions systems.

Just like a number of stocks I have looked at, CMI has provided excellent returns to shareholders from 2011 to 2015 with a dip coming during the year 2015 and continuing on into early 2016. There have been share buybacks and recently, an acceleration of the share buyback was unveiled. CMI has entered into an agreement with Goldman Sachs (NYSE:GS) to deliver $500 million in shares in addition to its already authorized share buyback which still has $274 million left to go. At a price of $110 per share, this could lower the share count from 177 million shares to approximately 170 million shares, representing almost a 4% reduction in the shares outstanding. The share buyback will be a key driver of value for shareholders of Cummins. (We'll come back to this later).

Similar to most companies I evaluate, I've looked at the range of Price/Earnings, dividend yield, payout ratios, and Dupont analysis on CMI. Below you will find these multiples. The earnings per share for 2016 of $8.10 (in bold) is an estimate from Value Line.

Share Price

Price/Earnings

EPS

High

Low

High

Low

Year 2016

110.40

79.90

13.63

9.86

8.10

Year 2015

148.00

85.00

16.59

9.53

8.92

Year 2014

161.00

122.60

17.61

13.41

9.14

Year 2013

141.40

103.40

17.99

13.16

7.86

Year 2012

129.50

82.20

14.90

9.46

8.69

Year 2011

121.50

79.50

13.40

8.77

9.07

Year 2010

111.90

44.80

21.64

8.67

5.17

Year 2009

51.70

18.30

20.93

7.41

2.47

Year 2008

76.00

17.70

18.63

4.34

4.08

Year 2007

71.70

28.20

19.38

7.62

3.70

Year 2006

34.80

22.20

10.21

6.51

3.41

Year 2005

23.50

15.90

8.55

5.78

2.75

Click to enlarge

Below, you will find the 2016 numbers in bold. These are estimates given the current dividend yield and assuming no increase in 2016. Both the payout ratios and yield have increased over time.

Annual Dividend

Share Price

Yield as a %

EPS

Payout Ratio %

High

Low

High

Low

Year 2016

110.40

79.90

3.90

3.53

4.88

8.10

48.15

Year 2015

148.00

85.00

3.51

2.37

4.13

8.92

39.35

Year 2014

161.00

122.60

2.81

1.75

2.29

9.14

30.74

Year 2013

141.40

103.40

2.25

1.59

2.18

7.86

28.63

Year 2012

129.50

82.20

1.80

1.39

2.19

8.69

20.71

Year 2011

121.50

79.50

1.33

1.09

1.67

9.07

14.66

Year 2010

111.90

44.80

0.88

0.79

1.96

5.17

17.02

Click to enlarge

Lastly, here is the 3-step Dupont model from 2011 to 2015.

PROFIT MARGIN

ASSET TURNOVER

FINANCIAL LEVERAGE

Net Income/Sales

Sales/AVG Total Assets

AVG Total Assets/Average SE

ROE

Year 2015

1399

19110

15449

19110

15449

7578

0.0732

1.2370

2.0388

0.1846255

Year 2014

1651

19221

15246

19221

15246

7630

0.0859

1.2607

1.9983

0.2163968

Year 2013

1483

17301

13638

17301

13638

7057

0.0857

1.2686

1.9327

0.2101608

Year 2012

1645

17334

12108

17334

12108

6217

0.0949

1.4316

1.9476

0.2645970

Year 2011

1848

18048

11035

18048

11035

5414

0.1024

1.6355

2.0384

0.3413688

Click to enlarge

Looking at the Price to Earnings P/E, it is clear the stock has traded most years between 8.5 times and 18 times earnings since 2010. As an investor, I would obviously like to purchase the security under 10 times earnings and sell when it is in excess of 15 times earnings. Year over year however, the stock price has declined as the earnings per share has started to taper off in spite of a consistent share buyback program. The management at CMI has probably realized that with declining profits (and margins), the way to deliver value is by shrinking the denominator and buying back more shares.

In fact, it may be a great idea to continue this at an accelerated pace. It may be one of the only ways to unlock the value at CMI. Having looked at the Dupont model, the profit margin has declined as of late in conjunction with the asset turnover which is also on a downtrend. ROE has declined steadily from 2011 to 2015 in spite of leverage having increased in recent years (but held constant from 2011 levels). By taking on debt to buy back shares, the shareholders equity will decrease and a higher ROE will follow.

The capital structure in the case of CMI is made up of approximately 177 million shares at $110 each, totaling approximately $19.5 billion and accounting for just under 93% of the capital structure, while the long-term debt (including the portion listed under current assets) totals approximately $1.5 billion, making up just over 7% of the capital structure. Currently, the dividend yield is 3.55% and the cost of debt is approximately 4.4% (pre-tax) and 3.21% (after tax) assuming a tax rate of 27%.

Weighing out the cost of debt and equity, it seems the cost of capital for CMI is 3.52%. Although the cost of equity and the cost of debt are similar, the potential to payout fewer dollars in dividends through the issuance of low cost long-term bonds may help the company in decreasing the payout ratio and will increase the ROE from its current 18.5%.

At CMI, there's been a clear trend - decline. Revenues have declined, the profit margin has declined, ROE has declined, share count has declined. At its current price level, shares have bounced from $80 to $110 since January, an increase of 37.5%. Although there may still be room to run, the increase since the bottom is drastically more than manufacturing companies such as John Deere (NYSE:DE), which increase almost 20% from its bottom, or a company called PACCAR (NASDAQ:PCAR), CMI's biggest customer, up about 25% since its low of $43.50. CMI seems to have over-corrected.

Looking at all the numbers, there is a clear decline in business trends for CMI. This is not a level at which I am comfortable entering into the investment. As CMI is a well run, thoroughly established company with a long track record, this is definitely an investment which I will keep on my watch list. At a price of under $90 per share, I intend to gradually enter into a position with a 4.3% dividend yield and "laugh all the way to the bank". In the coming years, I hope to see CMI undertake a large scale share buyback and take on more debt as a result of their very low cost of debt - potentially to avoid shareholder activism or a leveraged buyout.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.