Cummins: Sufficiently Cheap Despite Recession Fears

Summary

• Cummins is a Dividend Contender with 16 consecutive years of dividend growth. Shares currently yield 2.98%.
• Cummins has managed to do well throughout the cycle, increasing both peak and trough earnings.
• Cummins' decline from the May 2021 high has opened up a buying opportunity.

Дмитрий Ларичев/iStock via Getty Images

Cummins (NYSE:CMI) shares have declined since reaching their peak nearly a year ago and currently sit 28% off those highs. That's pushed the dividend yield up to around 3.0% and has lowered the valuation, while increasing the potential future returns.

Data by YCharts

Cummins is a leader in the design and manufacturing of diesel, natural gas, electric and hybrid power systems. It supplies the power systems for trains, heavy machinery, busses, heavy duty trucks and more. If it requires an engine, Cummins can supply it.

CMI Analyst Day Segments (CMI Analyst Day 2/23/22)

Dividend History

A lengthy dividend growth streak, while not foolproof, is one sign that the business is built to last as it's already weathered storms in the past while still growing its payout.

Cummins Dividend History (Cummins Investor Relations)

Cummins is a Dividend Contender with 16 consecutive years of dividend growth while paying the same or higher dividend every year dating back to 2000. Cummins did have a four-year hiatus in its dividend growth from 2002 through 2005, but dividend growth returned in earnest starting in 2006.

Dating back to 2000, year-over-year dividend growth has ranged from 0.0% to 50.0% with an average of 17.1% and a median of 14.2%.

Over that same period, there have been 17 rolling 5-year periods with annualized dividend growth ranging from 1.2% to 32.5% with an average of 18.2% and a median of 17.6%.

There have also been 12 rolling 10-year periods during that timeframe with annualized dividend growth ranging from 13.9% to 28.0% with an average of 21.0% and a median of 21.4%.

The rolling 1-, 3-, 5- and 10-year annualized dividend growth rates from Cummins since 2000 can be found in the following table.

Year	Annual Dividend	1 Year DGR	3 Year DGR	5 Year DGR	10 Year DGR
2000	$0.24
2001	$0.32	33.33%
2002	$0.32	0.00%
2003	$0.32	0.00%	10.06%
2004	$0.32	0.00%	0.00%
2005	$0.32	0.00%	0.00%	5.92%
2006	$0.34	6.25%	2.04%	1.22%
2007	$0.44	29.41%	11.20%	6.58%
2008	$0.62	40.91%	24.67%	14.14%
2009	$0.72	16.13%	28.42%	17.61%
2010	$0.88	22.22%	25.99%	22.42%	13.87%
2011	$1.32	50.00%	28.65%	31.17%	15.22%
2012	$1.80	36.36%	35.72%	32.55%	18.85%
2013	$2.26	25.56%	36.94%	29.52%	21.59%
2014	$2.82	24.78%	28.79%	31.40%	24.31%
2015	$3.52	24.82%	25.05%	31.95%	27.10%
2016	$4.02	14.20%	21.16%	24.95%	28.02%
2017	$4.22	4.98%	14.38%	18.58%	25.37%
2018	$4.44	5.21%	8.05%	14.46%	21.76%
2019	$4.90	10.36%	6.82%	11.68%	21.14%
2020	$5.28	7.76%	7.76%	8.45%	19.62%
2021	$5.60	6.06%	8.04%	6.85%	15.55%

Click to enlarge

Source: Author; Data Source: Cummins' Investor Relations

When implementing a dividend growth investment strategy, it's important to make sure that the dividend is well covered by profits or cash flow. A well covered dividend, i.e. lower payout ratio, allows for ample room for the dividend to remain intact and potentially still grow even in the face of temporary setbacks for the business.

CMI Dividend Payout Ratios (Cummins SEC filings)

Cummins' 10-year average net income payout ratio is 39.2% with the 5-year average coming in at 43.8%. The average free cash flow payout ratio for both periods is 42.0%. Cummins' dividend has been well covered by both net income and free cash flow over the last decade.

Quantitative Quality

As a dividend growth investor, beside a lengthy dividend growth streak, I also want to make sure that the business is performing well with the potential to continue to grow their dividend in the future. There's a number of financial metrics that I examine in order to get a feel for the business.

CMI Revenue Profits and Cash Flow (CMI SEC filings)

Cummins' revenues are up modestly over the last decade, rising 38.6% or 3.7% annualized. Gross profits have lagged behind revenue growth, increasing just 26.3% or 2.6% annualized.

Worse still, operating profits have shown just a 17.4% increase or 1.8% annualized, although operating cash flow is up 47.3% or 4.4% annualized during that time. Free cash flow showed the most improvement across the five metrics growing 94.7% or 7.7% annualized.

The rolling 5-year CAGRs for Cummins' revenue, gross and operating profits, and operating and free cash flow can be found in the following chart.

CMI 5 Year Financial CAGR (CMI SEC filings)

I want to see stable or rising margins over time as the business is able to get further entrenched in its competitive positioning. I prefer to see free cash flow margins greater than 10%; however, that's more dependent on the industry.

CMI Margins (CMI SEC filings)

Cummins' gross margins have been stable with a 10-year average of 24.6% and a 5-year average of 25.1%. Its free cash flow margin has averages of 7.6% and 8.4%, respectively, which doesn't quite hit the 10% threshold that I prefer to see.

In addition to the margins that Cummins earns, I also want to see how profitable it is in terms of its assets and capital base. The free cash flow return on invested capital [FCF ROIC] is my preferred method of tracking how efficient the business is at generating cash compared to its capital.

CMI Free Cash Flow Returns (CMI SEC Filings)

Once again, I prefer to see 10% or greater levels for FCF ROIC, which Cummins has surpassed each year over the last decade. Cummins has averaged a 15.6% FCF ROIC over the last decade with a 17.2% 5-year average.

To understand how Cummins uses its free cash flow, I calculate three variations of the metric, defined below:

1. Free Cash Flow, FCF: Operating cash flow less capital expenditures
2. Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
3. Free Cash Flow after Dividend and Buyback, FCFaDB: FCFaD less net cash used to repurchase shares

CMI Free Cash Flows (CMI SEC filings)

During the last decade Cummins has generated a cumulative total of $15.5 B in FCF. As we saw earlier, Cummins has paid and grown its dividend every year, sending back a total of $6.3 B to shareholders which puts the 10-year FCFaD at a healthy $9.1 B.

Cummins has also used a net total of $7.7 B to repurchase shares during that time. That puts the 10-year FCFaDB at $1.5 B.

Of the $14.0 B that Cummins has used on share buybacks and dividends during the last decade, roughly 45% has been used on dividends with the remaining going towards buybacks. Share repurchases can be a great way to return additional cash to shareholders.

CMI Shares Outstanding (CMI SEC filings)

With the $7.7 B in net cash spent on buybacks, Cummins has been steadily reducing the share count year after year. In total, the share count is down 23.1% from FY 2012 through FY 2021 which works out to a 2.9% annual decrease.

My intention when I purchase shares in a company is to own them for a period measured in years, if not decades. As such, I want to make sure the balance sheet looks good and that the business is not excessively leveraged and potentially jeopardizing my equity investment.

CMI Debt to Capitalization (CMI SEC filings)

I generally want to see stable debt-to-capitalization ratios over time with significant changes being more closely examined. Cummins' debt-to-capitalization ratio has averaged 23% over the last decade and 29% for the last 5 years.

Additionally, I track the net debt levels versus several income/profit/cash flow metrics to get a better idea of the debt constraints. In essence, the net debt ratios let you know how quickly the business could de-lever should the interest rate environment significantly change as it has recently.

CMI Debt Ratios (CMI SEC filings)

Prior to FY 2016, Cummins carried a negative net debt position, i.e. more cash than total debt. Since then, Cummins' net debt ratios have been rising signifying more debt on the balance sheet. The 5-year average net debt-to-EBITDA, -operating income, and -free cash flow ratios are 0.3x, 0.4x, and 0.6x, respectively. Cummins' debt levels are not a concern for me at this time.

Valuation

In order to determine potential attractive levels to purchase shares at, I employ several valuation methods. The methods that I used are the minimum acceptable rate of return [MARR] analysis, dividend yield theory, and a reverse discounted cash flow analysis.

A MARR analysis entails estimating the future earnings and dividends that a business will be able to produce. You then determine what you believe a fair and conservative terminal multiple would be for those future earnings in order to determine the future market value. If the expected return is greater than your threshold for investment, then you can feel free to invest in the business.

Analysts expect Cummins to report FY 2022 EPS of $17.31 and FY 2023 EPS of $20.07. They also expect that Cummins will be able to grow EPS 8.6% annually over the next 5 years. I then assumed that EPS growth would slow to just 5.0% annually for the following 5 years. Dividends are assumed to target a 37.5% payout ratio.

For the expected terminal multiple, I like to see how investors have typically valued Cummins in the past. Over the last decade, Cummins' shares have usually trade between roughly 10x and 20x TTM EPS. For the MARR analysis, I'll examine terminal multiples spanning that range.

Data by YCharts

The following table shows the potential internal rates of return that Cummins could generate provided the assumptions laid out above are reasonable forecasts of how the future plays out. Returns assume that shares are purchased around $194.93, Monday's closing price, and that dividends target a 37.5% payout ratio.

	IRR
P/E Level	5 Year	10 Year
20	25.6%	16.0%
15	18.5%	13.0%
12.5	14.2%	11.2%
10	9.2%	9.0%
7.5	3.2%	6.4%

Click to enlarge

Source: Author

Additionally, I use the MARR analysis framework to determine at what price I could purchase shares in order to generate the returns that I desire from my investments. My standard hurdle rate is a 10% IRR, and for Cummins I'll also examine 8% and 12% return levels.

	Purchase Price Targets
	10% Return Target		12% Return Target		8% Return Target
P/E Level	5 Year	10 Year	5 Year	10 Year	5 Year	10 Year
20	$354	$312	$327	$267	$384	$367
15	$273	$248	$252	$213	$295	$290
12.5	$232	$215	$214	$185	$251	$251
10	$191	$183	$177	$158	$206	$212
7.5	$150	$150	$139	$131	$162	$174

Click to enlarge

Source: Author

Dividend yield theory is a valuation method based on the idea that investors, collectively, will value a business around a normalized dividend yield. For Cummins, I'll use the 5-year average yield as a proxy for the fair value.

Cummins Dividend Yield Theory (CMI Investor Relations and Yahoo Finance)

Cummins' shares currently offer a forward dividend yield of 2.98% compared to the 5-year average forward yield of 2.78%.

A reverse discounted cash flow analysis can be used to reverse engineer what the current market price implies about investors' expectation for the future growth, margins, and cash flows for the business. For Cummins, I used a simplified DCF model based on revenue growth, an initial free cash flow margin of 7.5% that improves to 9.0% during the forecast period.

Under those assumptions, Cummins needs to grow revenues 3.2% annually during the forecast period in order to generate the free cash flows necessary to support the current market valuation at a 10% hurdle rate. Reducing the hurdle rate to 8% lowers the required revenue growth to just 1.5% annually through the forecast period.

Conclusion

Cummins is an interesting company poised to capitalize on the further electrification of heavy machinery and trucks. It's one of those picks and shovels type of businesses for a lot of industries that helps it to weather the various storms.

CMI Analyst Day Cycle (CMI Analysts Day 2/23/22)

Source

While Cummins will still be subjected to the movements of the bigger economic picture, they've done a solid job raising the bar throughout the cycle.

Dividend yield theory suggests a fair value range for Cummins between $190 and $232. Meanwhile, the MARR analysis assuming a 10x to 12.5x terminal P/E ratio puts the fair value between $191 and $132 assuming a target of 10% IRRs. The reverse discounted cash flow analysis also shows that Cummins is likely cheap at current levels with a low hurdle to reach 10%+ returns.

Recession and inflation fears have pushed Cummins' valuation down. While warranted for the short term, this could be the buying opportunity for those that are able to take a longer term view of the business. The question really boils down to will a recession be a permanent impairment to the underlying business or just a temporary setback? In Cummins' case, I believe it will be temporary.

Cummins appears to believe so as well as it is projecting to have $41 to $46 B in FY 2030 revenues. While that's quite speculative to be forecasting out 8 years, it clearly believes the opportunity is there to grow its core business as well as with additional acquisitions and what it considers new power, which includes the electric adoption. That would represent a 70%+ increase from FY 2021's sales.

CMI Analyst Day Targets (CMI Analyst Day 2/23/22)

Similarly, Q1 results were overall quite strong with sales up 5% compared to the same period in 2021. Management is also confident enough to raise their full year revenue guidance due to stronger than expected demand and they have been able to push along price increases to help combat their own cost increases. Overall, it was a solid start to the fiscal year for Cummins in spite of the headwinds related to the Russia-Ukraine conflict as well as the continuing COVID-19 measures being undertaken in China.

I would be interested in adding shares of Cummins to my portfolio around current levels once cash is freed up within my account. The market price well could have more downside ahead if the fears of recession prove out; however, I believe that Cummins is sufficiently cheap despite those potential headwinds.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in CMI over 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.

I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.