Cummins: $2.1 Billion Later

| About: Cummins Inc. (CMI)

Summary

Druckenmiller believes that it's silly to borrow money to buy back stock.

Cummins technically bought back shares with debt, but it made a lot of sense.

Due to a slow global economy, there probably wasn't that many opportunities to expand.

When the stock was trading at 10x P/E, the management had an excellent opportunity to create long-term value in the absence of growth.

Paying a dividend would not have allowed shareholders to capture the long-term value associated with the cancelled shares.

Stanley Druckenmiller is one of the best hedge fund manager's in the world. When he talks, people listen. He once said:

If you're running a business for the long term, the last thing you should be doing is borrowing money to buy back stock.

Today I'll explain why this does not apply to Cummins (NYSE:CMI).

I talked about Cummins earlier when the shares were in the dumps in January. I stood by the management's decision to repurchase shares in the $80s, shares have since risen to $113.

Let's first understand the rationale behind Stanley Druckenmiller's statement. Usually if you are running your company for the long-term, then you should be growing. Share repurchase is merely financial engineering that doesn't improve the company's overall value. When you take on debt to repurchase shares, you are forgoing growth opportunity while increasing the fixed costs of the business (i.e. interest expense). While Cummins didn't take on more debt to finance the buybacks, the fact that it didn't choose to retain the cash on the balance sheet (i.e. canceling out the debt) makes the two scenarios very similar.

Why Cummins Made The Right Decision

First I want to say that what Druckenmiller is right in general (he's a macro focused investor); however, exceptions exist on a case by case basis, and Cummins' situation most certainly fits the bill.

Since 2014, the company has spent $2.1 billion in share repurchases. Why does this make financial sense? As mentioned earlier, a company typically seeks to grow over the long-term. Does Cummins have room to grow? Absolutely. Wards Auto reported that Cummins share of North American truck engines was just 37% and Cummins' international opportunity is essentially limitless. So why is the company repurchasing shares instead of investing in growth to create value over the long-term?

Expansion opportunities come and go. The manufacturing industry is highly competitive, it's not a "build it and they will come" type of business (like Starbucks). Due to weakness in the global economy, it was unlikely that Cummins could find good opportunities. In fact, the company took a $211 million impairment in 2015 to reflect the under-utilization of light-duty diesel assets. I think we can all agree when I say that it does not make any sense for Cummins to open a new plant just for the sake of growth. Furthermore, the company is still making the necessary capital investments ($744 million in FY 2015) to sustain existing operation, so the management isn't starving the business of capital.

One thing I've touched on before in previous articles is Cummins' massive cash flow. Even though the macro environment was tough in the first quarter, the company still generated $153 million of cash flow. What would be the best way to spend that cash? We ruled out unnecessary capital projects since the demand just isn't there, so the company can either do nothing (debt isn't a revolver so it can't be repaid immediately), pay dividends, or repurchase shares.

If the management let the cash sit on the balance sheet, they'll have to try to generate a return that beats the cost of debt. Not only is money management not their core competency, in today's low interest environment, it'll be tough to find good investments. So we are left with dividends or buybacks. Out of the two options, buying back shares was a much better choice. A dividend distribution only benefits the recipient once whereas buybacks capture the present value of all future cash flows associated with the shares. The distinction is subtle, but when your stock is trading at below 10x P/E, the company gets to eliminate the future cash flows associated with the shares at a very low cost, and all the savings will be passed on to the remaining shareholders.

Where Cummins Stands Today

Cummins' stock is no longer as cheap as before, as it's currently trading at 15x TTM P/E. As shares have appreciated significantly, it's unlikely that the management would continue to repurchase shares nor does it make financial sense to do so. From a valuation standpoint, I would say that the current valuation accurate reflects near-term headwinds that the company will face (slow global economy) while also taking the company's strong free cash flow ($1.25 billion in 2015) into account. There is no question that the company will continue to produce healthy cash flows as it has done so in the first quarter, so even if the stock falls in the future, the management will have the dry powder available to take advantage of market's short-sightedness.

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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.