- Cummins reported much higher than expected earnings and sales as its business is benefiting from a steep increase in truck demand.
- The company significantly raised its guidance and is in a great spot to further hike dividends and buybacks.
- Unfortunately, the valuation is a bit lofty, which means that I would advise (new) investors to buy/add on weakness.
I have covered Cummins (NYSE:CMI) a lot on this website in the past as the company is known as a reliable dividend growth stock with a massive footprint in the (diesel) engine industry. This cyclical company has made it to a new all-time high earlier this year as the company benefits from a rapid increase in transportation demand on top of the expected recovery that comes with falling COVID cases and gradual reopenings across the globe. As a result, the company easily beat sales and earnings estimates and raised its guidance. Right now, however, valuation is the biggest issue facing the company as economic sentiment indicators indicate a less favorable risk/reward. My advice, therefore, is to wait for more weakness before either initiating a position or buying more.
Here's What Happened in 1Q21
Let's start with the most important numbers - as I always like to do shortly after an earnings release. Thanks to the overview provided by Seeking Alpha, one needs a few seconds to figure out that GAAP EPS came in much higher than expected. This was made possible because total sales came in $740 million higher than expected. On a year-on-year basis, the company reported a 21.6% increase in total sales, which is absolutely stunning given that the easy gains come in Q2 (as Q2/20 saw massive lockdowns). In other words, an earnings beat is significant proof of the company's perfect execution rather than having had the benefit of a very weak comparable quarter.
The biggest winner (in %-terms) was new power, which reported a 250% sales increase but also a $51 million loss in EBITDA as adoption of new technology takes time and is not profitable on a small scale. Regardless, while this segment is neglectable for now, the company's products like battery solutions and electric busses will make sure that investors aren't stuck with a company focussed on old technologies in the future.
The three core segments (engines, distribution, and components) all reported positive sales growth with components reporting more than 40% sales growth. This segment benefited from both higher demand in North America and China and higher EBITDA margins as higher volumes met lower product coverage costs.
Engines benefited from higher on-highway revenues due to higher truck demand and higher off-highway demand due to a recovery in global construction markets. In this case, on-highway sales were up 15%. Off-highway sales were up 9%.
On top of that, the company, again, generated strong free cash flow. In this case, operating cash flow of $339 million turned into $252 million in free cash flow as capital expenditures slightly increased to $87 million. The company also increased dividend payments by $2 million to $197 million and repurchased shares worth $418 million. As free cash flow is lower than shareholder payout, the company used its $3.4 billion cash position to finance this gap, which is fine as I expect the company to use the next few quarters to start rebuilding cash through internal cash generation (FCF).
The Outlook Was Raised
I already gave it away at the start of the article, but sales growth has been upgraded by a lot. The company roughly doubled its expected growth rates as it expects sales to advance between 20% and 24%. The EBITDA margin has been raised slightly. I would not be surprised if EBITDA expectations were to remain unchanged for the remainder of the year given the input inflation the company has to deal with and global supply chain challenges.
With that said, I have some issues with regard to valuation.
The single biggest problem I have with Cummins right now is the fact that economic expectations are close to a multi-decade high. Even though the leading ISM manufacturing index has come down a bit, we are seeing that business expectations are very high. That is, without a doubt, good news for the company and its shareholders. It means that growth is here to stay for a while. Unfortunately, it means that the risk/reward for new investors is somewhat unfavorable as 'the market' knows that business expectations are low. If I were to make Cummins a top 5 position in my portfolio, I would buy it once this index bottoms after a sell-off and economic downturn. I am not saying that Cummins is poised to fall, but the risk/reward for a trade isn't that good. If you want to buy this company long-term, I think you should expect somewhat subdued returns over the next few years. That's OK, but it's a risk that needs to be discussed - I think.
Source: Author's Spreadsheets (Raw Data: ISM, Philly & NY Federal Reserve)
With that in mind, the company is expected to generate $3.9 billion in EBITDA in 2022. Also, and this is a big deal, the company could technically reduce net debt to minus $142 million. I doubt that will happen as I expect accelerating buybacks and more dividends, but for the sake of valuation, I am using negative net debt instead of a lower number of shares outstanding.
Based on these numbers and a $37.6 billion market cap, the company is trading at 9.6x 2022 EBITDA. This is towards the upper bound of the historical valuation range. Some might make the case that a higher valuation is justified as the company is focusing on next-gen engines like electric engines and hydrogen. However, the company remains extremely cyclical and as I do not see accelerating free cash flow, I think 9.6x EBITDA is not a valuation you want to use to initiate a large position.
Here is what I would do.
Calling a stock unattractively valued is always a risk as it may send the wrong message. If you are a long-term investor, I wouldn't sell a Cummins share - maybe ever. The company has a fantastic track record and is one of my favorite companies in the business. If I hadn't bought Deere (DE) and Caterpillar (CAT), I would have added Cummins a few months ago. However, I am not adding the stock now as I believe that other stocks may have a better risk/reward. I think new investors should initiate a position once Cummins drops 8-10%. That's also where I would add to my position if I were a long-term investor.
The just-released results show how well-positioned this company is to benefit from economic upswing, and I do not doubt that this will change anytime soon.
(Dis)agree? Let me know in the comments!
This article was written by
Leo Nelissen is an analyst focusing on major economic developments related to supply chains, infrastructure, and commodities. He is a contributing author for iREIT on Alpha team, Leo aims to provide insightful analysis and actionable investment ideas, with a particular emphasis on dividend growth opportunities.
Analyst’s Disclosure: I am/we are long DE, CAT. 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. Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.
Analyst’s Disclosure: I am/we are long DE, CAT. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.