Cummins: This Dividend Stock Is On Sale

Summary

• Sales are expected to grow 10% to 14% during 2018, an increase from the original forecast.
• I project 11% upside potential based on a discounted cash flow model.
• Wall Street has a price target of $170, which represents 18% upside potential in the stock.

I consider now a good time to buy Cummins' (NYSE:CMI) stock for the following reasons:

1. All operating trends in 2017 were good, which included 17% sales growth and record free cash flow. This trajectory is expected to continue into 2018, and Cummins recently upped its forecast based on first-quarter results.
2. The 3.00% dividend is well supported by free cash flow and likely to continue growing.
3. Cummins is valued attractively based on multiple approaches including a discounted cash flow model, historical valuation multiples, and a comparables analysis.

Financial Snapshot

Cummins rebounded in 2017 and produced strong results. Revenues were up 17%, including 15% in North American sales and a 19% increase in international sales. Excluding charges totaling $777 million from tax reform, net income also increased to $1.8 billion ($10.62/share). The balance sheet is also in a very good shape. $2.3 billion in debt for a company that produces more than $20 billion in revenue and consistent free cash flow is very reasonable.

Data Source: Cummins' SEC Filings

After a strong first quarter, Cummins upgraded its 2018 sales guidance. According to its latest earnings release:

"Based on the current forecast, Cummins expects full year 2018 revenues to be up 10% to 14 %, compared to prior guidance of up 4% to 8%. EBITDA is projected to be in the range of 15.4% to 15.8% of sales, down from 15.8% to 16.2% of sales. Excluding the impact of the first quarter charge for the product campaign, full year EBITDA is expected to be in the range of 16.2% to 16.6% percent."

Dividend Analysis

One of the main reasons to own Cummins' stock is the dividend, which currently has an annual yield of 3.00%. The company has a long dividend history, which goes back to the 1980s. Growth has been particularly impressive in the recent 5 years, which has seen the payment more than double ($0.50/share to $1.08/share). I consider this dividend as very safe and likely to continue growing in the coming years. This is because of the projected sales growth and the fact that the dividend coverage ratio has been 50% or below for the last 5 years. This ratio has been negative so far this year, but I don't consider that a big deal because it's just one quarter and should level off for the remainder of the year.

Discounted Cash Flow Model: 11% Upside Potential

Based on free cash flow, I view the stock as undervalued. This model assumes that Cummins produces $1.4 billion in free cash flow during 2018. This is basically the average annual free cash flow over the last 5 years. I've also assumed a 3% growth rate, which is on the conservative spectrum from various sources.

• Risk-Free Rate - I used the yield on a 30-year Treasury bond.
• Equity Risk Premium - This figure is calculated every month by Aswath Damodaran, a Stern Business School Professor.
• Required Rate of Return - Calculated by multiplying the Equity Risk Premium by Beta and then adding the Risk-Free Rate.
• Value of Equity = CF1/(r - g).
• CF1 = 2018's estimated free cash flow of $1.4 billion.
• "r" is the required rate of return, and "g" is the long-term growth rate.

Historical Valuation Multiples

Based on historical valuation multiples, Cummins looks attractively valued across the board (Data sources: Yahoo Finance & Reuters):

• Forward P/E of 10.7x (5-year average of 14.6x)
• Forward PEG of 0.75x (5-year average of 1.7x)
• Price/Sales of 1.2x (5-year average of 1.3x)

EV/FCF is also reasonable and within its historical range. I generally like to see this ratio be below 20x, so 18.11x is good.

CMI EV to Free Cash Flow (Annual) data by YCharts

Comparables Analysis

Relative to peers, Cummins trades at a discount based on all major valuation multiples. I especially like a 35% discount on EV/FCF and a 48% discount based on PEG ratio.

• Enterprise Value, Forward P/E, Price Sales, PEG, and Yield provided by Yahoo Finance
• LT Growth Rate derived from Forward P/E and PEG Ratio
• EV/FCF provided by YCharts

Conclusion

Cummins' future currently looks bright. 2017 was a great year, and 2018 looks to be even better. The best part is the stock trades at a discount across multiple valuation approaches. I especially like the company's consistent free cash flow, which I don't believe investors are currently giving enough value to. This opinion is based off my discounted cash flow model and an EV/FCF multiple that's significantly lower than peers. My analysis here is consistent with Wall Street's expectations. According to MarketWatch, the average target price is $170, which represents 18% upside potential. Now looks like the time to pick up this stock.

Analyst’s 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.