Is Cummins one of the better NYSE stocks? (Part 1 of 2)

Value Investing Case Study 20-1. I first covered Cummins in Sep 2021 for ValueWalk based on the financials till Jun 2021. Since then, Cummins had released it Q3 2021 results. This post is an update incorporating the latest results.

As of 5 Nov 2021, Cummins Inc (CMI or the Group) was trading at USD 237.07 per share compared to its Book Value of USD 56.51 per share (as of 3 Oct 2021). This is equal to a Price to Book Value of 4.2.

As can be seen from the chart below, this Price to Book Value multiple is about the past 10 years peak.

Chart 1: CMI Price to Book Value

You would be tempted to think that there is no margin of safety to invest at this price. But Price to Book Value multiple can be a misleading valuation metric. This is especially if you have a situation where there was an aggressive share buyback programme.

From 2010 to 2020, the Group spent about USD 7.4 billion to buy back 57.9 million of its shares. This is a considerable sum when compared with its 2010 Book Value of USD 4.7 billion. So, what is the real Book Value of CMI given that it has 143 million shares outstanding today?

Join me in this 2-parter as I analyse and show that there is still a buying opportunity. This had led me to conclude that CMI is still one of the better NYSE stocks to invest in.

Should you go and buy it? Read my Disclaimer.

Is there Anything Special about the Group’s Expertise?

Is there Concern about how it Uses its Funds?

Is the Current Performance Outstanding?

Tracing the Group’s Rich and Unique History

Is there a Great Future?

Pulling it all together

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Is there Anything Special about the Group’s Expertise?

The Group is an American multinational corporation. It designs, manufactures, distributes and services a wide range of engine related products. These included diesel, natural gas, electric and hybrid powertrain and powertrain related components.

The company was founded in 1919 as the Cummins Engine Company by J. Irwin Miller, William G. Irwin, and Clessie Cummins, a local mechanic. The company name was changed to its present form in 2001.

In its initial days, the Group focused on developing the diesel engine invented 20 years earlier. The Cummins N Series engines became the industry leader in the post-World War 2 road building boom in the United States. More than half the heavy-duty truck market used Cummins engines in the 1950s.

Since then, the Group has expanded its product range and today is organized into 5 operating segments:

Engine. This segment manufactures and markets a broad range of diesel and gas-power engines. The engines are made under the Cummins brand name and certain OEM names. They are used in trucks, buses and pick-up and light commercial vehicles. CMI also serves the non-automotive market such as those for stand-by, mobile and distributed power generation.

Distribution. This is the Group primary sales, service and support channel. This is organized and managed globally as 8 geographic regions.

Components. This segment supplies products which complement the Engine and Power Systems segments. It has emissions solutions, turbo technologies, filtration, electronics & fuels systems and automated transmissions.

Power Systems. This was established in 2016 by combining the previous Power Generation segment with the high horsepower engine business. The product lines today are power generation, industrial and generator technologies. The segment competes with engine manufacturers and generator set assemblers.

New Power that was set up in 2018. It focuses on hydrogen production solutions and electrified power systems including sub-systems such as fuel cell technologies.

The Group serves its customers through a network of 500 distributors. Some are wholly owned while others are joint ventures and independent distributors. They are all located in about 190 countries and territories. In 2020, the US accounted for about 54 % of the Group revenue.

Is there Concern about how it Uses its Funds?

As of 3 Oct 2021, the Group had a Total Capital Employed (TCE) of USD 13.27 billion. Shareholder’s fund accounted for 61 % of the TCE with the balance from minority interests and debt (including leases).

About 66 % of the TCE was deployed for the operations. About 19 % of the TCE was in cash compared to the electrical equipment industry average of 5 % (Source: Damodaran Jan 2021).

Table 1: Sources and Uses of Funds

CMI had a book debt to TCE ratio of 32 % compared to the US electrical equipment industry average of 49 % (Industry source: Damodaran Jan 2021).

Chart 2: Capital Structure

But looking at the debt ratio for the Group can be misleading as the Debt Equity ratio had climbed from 0.16 in 2010 to 0.52 in 2020. However, when you look at the net debt (debt less cash), the picture is that the Group is still very low geared. Refer to the chart below.

Chart 3: Debt Equity ratio

Given its history, you would think that a significant portion of the Group net assets would be tied up in either the Engine or Power Systems segment. The chart below shows how the Group net assets were deployed in 2020.

The Components segment took up the biggest share with 31 % followed next by the Distribution segment with 26 %.

However, in 2010 the Engine segment accounted for 42 % of the net assets. This meant there was some significant change in the business direction since then.

Chart 4: Segment Net Assets

Is the Current Performance Outstanding?

For the YTD 3 Oct 2021, the Group achieved revenue of USD 18.2 billion and net income of USD 1.76 billion. For the same period last year, the Group achieved revenue of USD 14.0 billion with USD 1.30 billion net income. These were equal to a revenue growth of 30 % and a net income growth of 36 %.

The Group attributed the revenue growth to higher demand in all operating segments and all geographic regions. These were due to an improved economic environment and fewer effects from the Covid-19 pandemic.

Revenue growth partly contributed to the growth in net income. Increased gross margins was another reason for the net income growth. Higher equity, royalty and interest income from the investees primarily in China was another reason.

The Q3 YTD results are in line with the long-term trend as can be seen from the Performance Index chart. There were jumps in revenue (greater than 10 %) in 2011, 2014, 2017 and 2018. At the same time there were significant changes in PAT in 2017 and 2018.

Except for 2014, the improved revenue in 2011, 2017 and 2018 were due to an increase in demand for all the segment products. But a large part of the increase in 2014 were due to CMI acquisitions of its North American distributors.

The drop in PAT in 2017 despite an increase in revenue was due mostly to a one off USD 777 million tax adjustments.

The rebound in PAT in 2018 was partly due to increase sales and gross profit margins and without the 2017 tax impact.

Chart 5: Performance Index

While revenue and profits showed an uptrend, gross profitability did not show any long-term improvement. This was because revenue growth was driven by growth in Total Assets as shown below. Gross profitability is defined as gross profit margins divided by Total Assets.

Chart 6: Drivers of Revenue Growth

Over the period from 2010 to 2020, the Group achieved an average ROE of 23%. While the ROE in 2020 was about the same as that in 2010, a DuPont analysis showed that Asset Turnover had declined while Leverage had increased.

I had earlier pointed out the shift in the allocation of net assets from the Engine segment to the Distribution and Components segments. You would have thought that this was because of declining returns from the Engine segment. The chart below does not support this view.

As the New Power segment was only formed 3 years ago, I have compared the segment performance over the past 3 years. In terms of EBITDA/TCE, the Engine segment delivered the best results. Overall, the Group achieved an average of 37 % return over the past 3 years.

Table 2: Segment Performance

Note

a) Return = EBITDA/Net Asset. The is the average annual return for the 3 years.

Tracing the Group’s Rich and Unique History

Over the period from 2010 to 2020, CMI revenue grew at a CAGR of 4.1 %. The bulk of the growth came from the US as can be seen from the chart. Revenue in the US grew at a CAGR of 8.3 % from 2010 to 2020 compared to 0.8 % for the International segment.

Chart 7: Regional Revenue

In terms of business segment, we have the following CAGR in revenue from 2010 to 2020

Engine - (1.1%)

Distribution - 11.9 %

Components - 7.9 %

Power Systems - (0.5%)

You can see the growth in the Distribution and Components segments in contrast with the decline in the Engine and Power Systems. Note that the New Power segment was established in 2017 and as such there is no significant revenue contribution in 2020.

Chart 8: Segment Revenue

Engine and Power Systems

There was a reorganization in 2016. The Power generation segment was combined with the high horsepower engine business to form the Power System segment.

In other words, the pre-2016 figures for the Power System segment as shown referred to only the Power generation business. However, the post 2016 revenue referred to the combined figures.

Chart 9: Segment EBITDA

In the early part of the decade the Engine and Power Systems together accounted for about 2/3 of the Group revenue. Over the past three years, this has dropped to about 2/5.

While the Engine segment has managed to grew its EBITDA over the past decade, I could not say the same about the Power Systems segment. Refer to the Segment EBITDA chart.

You can see that there has been a significant change in the business of the Group. This is reflected in the way the Group described its business in its Form 10k.

In 2010 CMI described its business as “…diesel and natural gas engines, electric power generation systems and engine-related component products…”

In 2020 CMI business was described as “…diesel, natural gas, electric and hybrid powertrains and powertrain-related components…”

Components

A powertrain is an assembly of every component that thrusts the vehicle into motion. It includes engine, transmission, driveshaft, axles, and differential. A powertrain system is one of the main components of a vehicle. It would appear that to serve the powertrain market, CMI would have to rely on its Engine and Components segments.

I would conclude that CMI business direction has changed. The change was more than just different energy sources ie from diesel and natural gas to electric and hybrid. It has also broadened CMIs product mix from engine to powertrain.

In line with this change in business direction, CMI acquired the following.

2012 - USD 176 m for Hilite (after treatment technologies).

2016 - USD 86 m for 45 % of Wuxi Cummins Turbo Technologies.

2017 - USD 62 m and 600 m respectively for 100% of Brammo Inc (low voltage battery) and 50 % of Eaton Cummins Automate Transmission Technologies.

2018 - USD 51 m for 100 % of Efficient Drivetrains Inc.

2019- USD 235 m for 81 % of Hydrogenics Corp (fuel cell and hydrogen production technologies)

These acquisitions explain the growth of the Components segment.

Acquisition of US Distributors

In 2013 CMI announced that it would acquire all its partially owned US and Canadian distributors over the next 3 to 5 years. CMI actually spent about USD 428 million between 2012 and 2016 to acquire 15 distributors.

I estimated that during the pre-acquisition period for North America, the Distribution segment earned an average EBIT of USD 90 million per year. Post-acquisition (2017 to 2020), the average EBIT for North America was about USD 325 million per year. The estimates were based on the North American revenue X segment EBIT margin.

This back-of-envelop calculation showed that the Group gained about USD 235 million per year from the acquisitions. The amount spend was equal to about 2 years payback. No doubt the post-acquisition performance was also due to organic growth. But it illustrated that it was a beneficial exercise.

Organic growth

Because of these acquisitions, to assess CMI organic growth, it is more realistic to look at the period from 2017 to 2019. This would exclude the effect of the pandemic as per the table below.

Table 3: Segment Revenue Growth

Based on the Notes in its Financial Statements, the revenue due to acquisitions consolidated in 2018 and 2019 were not significant. In other words, the growth rates shown in the table can be considered as organic growth.

Case Notes

Capital expenditures or CAPEX are investments that companies make to grow or maintain their business. Unlike operating expenses, which recur yearly, capital expenditures are less predictable.

Aside from analysing a company's investment in its fixed assets, the CAPEX metric is used in several ratios for company analysis.

The cash-flow-to-CAPEX ratio relates to a company's ability to acquire long-term assets using free cash flow.

CAPEX is also used in calculating free cash flow.

CAPEX can be segregated into growth CAPEX and maintenance CAPEX.

Growth CAPEX is undertaken by a company to expand existing operations or further growth prospects. It focuses on activities such as the acquisition of fixed assets, and building expansion.

Maintenance CAPEX refers to capital expenditure that is necessary to continue operating in its current form.

Companies rarely break down growth and maintenance expenditures in their financial statements. You have to use rough estimates when separating the two expenditures. There are 2 methods used to distinguish them.

The first and simplest involves deducting the depreciation from the capital expenditure to get the growth CAPEX. The depreciation acts as the maintenance CAPEX.

The other method involves first determining the growth CAPEX. This is done by using the average CAPEX to sales ratio multiplied by the change in sales. Then subtract this growth CAPEX from the total CAPEX to get the maintenance CAPEX.

Some companies also grow their capacities and capabilities via acquisitions. As such I consider acquisitions as part of the CAPEX.

As you can see, fundamental analysis requires you to make choices and assumptions. This requires you to have a comprehensive company analysis. At the same time you need the business experience to identify the opportunities for improvements.

If you do not have a business background, you may find this a bit challenging. If you face such a situation, one way is to rely on third-party analysis and valuation.

There are several financial advisers who provide such analyses.

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Is there a Great Future?

The earlier analyses point to 2 shifts in CMI business direction:

Expanding its distribution arm.

Changing its product focus. It moved away from engines and power systems to powertrains, powertrain components and new power.

This is not to suggest that the diesel engine is in any immediate danger of being disrupted. There is still room for steady growth.

The global diesel engine market reached a value of US$ 207 Billion in 2020. Looking forward, IMARC Group expects the market to grow at a CAGR of 4.2% during 2021-2026.

Global demand for diesel engines is expected to increase 4.2% per year through 2023 to $244 billion. It is accelerating from sluggish gains recorded between 2013 and 2018. Freedonia

At the same time, the generator industry is still a growth sector. Various market research companies project global growth over the next 5 to 10 years at greater than 5 % CAGR. Refer to the Generac post.

However, the market for powertrain in general does not seem brighter although the electric niche seemed to fare better.

The automotive powertrain systems market is anticipated to register a CAGR of over 5% during the forecast period, 2020-2025. Mordor Intelligence. This is not a concentrated industry as illustrated below.

Chart 10: Powertrain Market Concentration

The demand for automotive powertrain will have a CAGR of 5.2% during the 2017 to 2026 assessment period. Fact.MR

The global automotive powertrain market is projected to exceed over USD 650 billion in the coming year. The automotive powertrain market is estimated to grow at a CAGR of over 5% in near future. Grand View Research

When it comes the electric powertrain, we have more aggressive growth rates;

The global electric powertrain market size was valued at USD 71.86 billion in 2020. It is expected to grow at a CAGR of 33.5% from 2021 to 2028. Grand View Research.

The global electric powertrain market is projected to be valued at USD 191.4 billion by 2027 from an estimated USD 62.9 billion in 2019, growing at a CAGR of 14.9%. Market and Markets.

At the same time, there are challenges in the powertrain component market. In 2019 McKinsey & Co suggested that there are shifts in the powertrain component markets. Refer to its article “Reboost: A comprehensive view on the changing powertrain component market and how suppliers can succeed”.

In the past the same two powertrain types - gasoline and diesel - had characterized the industry for over a century. Today, there is a broad powertrain mix as the industry pushes toward more environmentally friendly and efficient transportation. This push was prompted mostly by government mandates.

As the powertrain portfolio diversifies and includes an increasing number of hybrid and electric varieties, the powertrain component landscape is becoming more complex and dynamic.

McKinsey had 4 key messages:

Electric-mobility is at a tipping point.

The mix of powertrain technologies underlies several forces and will vary by region.

Powertrain content will see dramatic change.

Suppliers are refining their strategies in response to a shifting component market.

They recommended the following:

Develop a tangible vision and clear strategy.

Assess performance focus areas granularly, but steer them globally.

Allocate resources through an “old- versus new-world” lens.

Prioritize a culture of performance and accountability.

My take is that CMI has recognized the changes in the market and has positioned itself to take advantage of the trends. But it is not without its challenges.

Pulling it all together

The analysis has shown that the Group is fundamentally strong.

It has a very low net Debt-Equity ratio.

It had achieved an average 23 % ROE from 2010 to 2020.

It had been able to achieve a revenue CAGR of 4.1 % from 2010 to 2020. This is taking into account the 2020 pandemic year. Excluding 2020, it achieved a CAGR of 6.6 % from 2010 to 2019.

The Group had changed its business direction to take into account the market trends.

Now while it a good company, whether it is a good investment will depend on comparing its market price with its intrinsic value. Only then can we conclusive state that it is one of the better NYSE companies to invest in.

Join me in Part 2 of this series as I value CMI.

End of Part 1 of 2

Part 2 of 2 was published on 28 Nov 2021

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Disclaimer & Disclosure

I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.

I may have equity interests in some of the companies featured.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.

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