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

Value Investing Case Study 20-2. 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 is Part 2 of an update incorporating the latest results.

In Part 1, I had shown that Cummins Inc (CMI or the Group) is fundamentally strong. It is global player in the diesel engine market. Over the past decade it achieved a CAGR in revenue of 4.1 %. Despite the Covid-19 pandemic in 2020, it had achieved a ROE of 20%.

At as of 5 Nov 2021, it was trading at USD 237.07 per share that is around its historical Price to Book Value high. A high Price to Book multiple is generally associated with a growth company.

But would you consider a 4.1 % CAGR a growth trait? More importantly does it mean that CMI is a growth trap?

A growth trap is a stock that appears cheap given its growth prospects. However, the growth is illusory and instead of providing a sufficient margin of safety, it turns out to be a dud.

Join me in Part 2 of this series as I show that CMI is not a growth trap. At the current price, there is still a margin of safety to make it one of the better NYSE stocks to invest in.

Should you go and buy it? Well, read my Disclaimer.

Did Top Management Seize Opportunities?

Is there an Awesome Buying Opportunity?

Will there be Spectacular Growth in Shareholders’ Value?

How to Secure Your Investment by Minimizing Risk

Pulling it all together

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Did Top Management Seize Opportunities?

There are 12 members on the CMI Board of Directors in 2020. Except for the Chairman cum CEO, the rest of them are Independent Non-Executive Directors.

The age of the Board members ranged from 57 years to 73 years with an average of 61 years. The tenure of the Board members ranged from one who joined in 2020 to one who had served on the Board for 31 years. On average the Board members have 11 years of tenure with the Group.

The chart below summarized the profile of the Board.

Chart 1: Board Profile

Excluding the CEO, there were 19 other Executive Officers featured in the 2020 Form 10k. Their age ranged from 43 to 63 years with an average of 53 years. Their length of service with the Group ranged from 2 years to 17 years with an average of 7 years.

You can see that these Directors and Executives have long tenure with CMI.

The Directors and Executives collectively held about 1 % of the common stocks of CMI. As such I would not consider this as an owner-managed group.

2 institutional shareholders - BlackRock and Vanguard - held 17.7 % of CMI.

To align management interests with those of the shareholders, the company has an incentive plan. The Group believes that the compensation of the most senior executives should be based on CMI overall performance. Every executive’s pay is tied to the same financial metrics. A significant amount of the pay is incentive-based and is therefore at risk as illustrated below.

Chart 2: Executive Incentives

CMI uses the Return on Average Net Assets based on EBITDA for the bonus payments. For the long-term incentive plan, it is based on Return on Invested Capital and EBITDA.

Over the past 10 years, the total incentives awarded averaged USD 20.1 million per year compared to the average annual EBITDA of USD 2,867 million. The total incentives paid was equal to 0.7 % of EBITDA.

How did management perform as an operator and capital allocator? To gauge the operating performance, I compared CMI revenue growth and ROA with those of its peers. Based on this, I would rate CMI as a good operator as well as a good capital allocator. My rationale for this assessment is set out below.

Chart 3: Peer Revenue

In its 2021 Proxy Statements, CMI listed 16 companies as peers to compare the executive compensation programme. I have narrowed this down to half leaving out the car companies and those that did not have engine or power generation products.

The 8 peer companies are listed in the bottom of the Revenue and ROA charts. You can see that from both the revenue and ROA perspectives, CMI was among the better performers.

Chart 4: Peer ROA

Table 1 summarized the results.

Table 1: Summary of Peer Comparisons

In terms of asset allocation, the Group generated USD 23.5 billion in cash flow from operations during the period from 2010 to 2020. Of this:

USD 6.0 billion was paid out as dividends while another USD 7.4 billion was spend on share buyback. CMI generated USD 18.3 billion of net income during this period. Thus, the total amount spent on dividends and share buyback was equal to a pay-out ratio of 0.73.

USD 7.5 billion was spent on CAPEX with another USD 1.7 billion on net acquisitions (amount paid less the sale of businesses and/or PPE). In total about half of the PAT was spent to maintain and grow the facilities.

The balance went to working capital and/or to increase the cash position.

During this period, there was also an increase in the debt by USD 3.9 billion. This is about 1/6 of the cash flow from operations.

Looking at this as a whole, I would conclude that this was a good capital allocation plan. A large portion that was not spend on CAPEX and acquisitions was returned to shareholders.

In Part 1, I had shown that the Group did not overpay for the acquisitions of the US and Canadian distributors. This is another illustration of the capital allocation capability of management.

CMI Deployment of cash flow from operation

Chart 5: Capital Allocation

Is there an Awesome Buying Opportunity?

I generally use two approaches in assessing the intrinsic value ie Asset-based and Earnings-based.

Asset Value (AV) is broken down into several components - NTA and Book value.

Earning Value is broken down into the Non-Operating Asset component, Earning Power Value (EPV), and the Earning Value with growth.

For the Earning Value with growth, I had two scenarios - Conservative and Optimistic. The Conservative one was based on a single stage Free Cash Flow to the Firm model with 4 % growth rate. The growth rate was set to be equal to the long-term US GDP growth rate. Coincidentally, CMI revenue from 2010 to 2020 grew at 4.1 % CAGR.

For the Optimistic Earning Value with growth, I used a 2-stage Free Cash Flow to the Firm model. I assumed 10 years high growth rate of 7.4 %. This was CMI revenue growth rate from 2017 to 2019. The terminal growth rate was assumed to be 4 %.

The other key assumptions in my valuation were:

I used the average 2017 to 2019 values as the bases. This is to exclude the impact of the Covid-19 pandemic.

The cost of capital was derived based on the CAPM. I assumed a 1.9 % risk-free rate and the Beta was built-up based on the US electrical equipment sector Beta. The values for the various parameter were taken from Damodaran Jan 2021 dataset.

The results of the valuation are tabulated as well as charted below.

Chart 6: Valuation

As can be seen from the Chart 6:

The Earning Value is greater than the Asset Value.

Over the past 5 years, the highest market price was below the Optimistic Earning Value with growth.

Table 2: Valuation metrics

Note

a) This comprises cash and the investment in associates and joint ventures.

In a normal competitive environment, I would expect the EPV to be about the same as the Asset Value. According to Professor Bruce Greenwald, you can gain insights into a company’s competitive position by comparing the AV with the EPV.

EPV > AV

For CMI, its EPV is 2.4 times its Book Value. You would have concluded that this was because CMI had some sustainable competitive advantages. But before we draw any conclusion, we have to remember that there were substantial share buybacks.

Over the period from 2010 to 2020, CMI spend USD 7.358 billion to buy back 57.9 million of its shares. This share buyback had reduced its Book Value as well as impacted its value per share. For an apple-to-apple comparison, we should adjust for the buybacks.

I assumed that if there were no buybacks, all the money spent on buybacks would be accounted for as retained earnings. The adjusted Book Value then = USD 8.082 b + USD 7.358 b = USD 15.440 b.

At the same time, if there were no buybacks, the number of shares outstanding = 143.0 m + 57.9 m = 200.9 m

The adjusted Book Value = 15.440 X 1,000 / 200.9 = USD 77 per share

Making the same adjustments for the EPV, the adjusted EPV = USD 134 per share. Note that I assumed that the money spent on buybacks were accounted as additional non-operating assets with zero income.

The result is that the adjusted EPV is 74 % higher than the adjusted Book Value. This is significant and suggest that CMI must have some sustained competitive advantages.

CMI has substantial patents and trademarks relating to the products the Group manufactures.

It has long standing customer relationships.

It owns and/or controls its distributors.

From a numerical perspective, the competitive advantage has translated to an average 23 % ROE over the past decade. This is about triple its cost of equity.

Earning Value with growth

The current price is above the Book Value and EPV. Thus, the margin of safety would have to come from a valuation assuming growth.

My valuation shows that:

There is 1% margin of safety under the Conservative scenario.

There is 31 % margin of safety under the Optimistic scenario.

The above analysis showed that CMI is a buying opportunity only if growth under the Optimistic scenario can be justified.

There should not be any concern about the 4 % terminal growth rate. Apart from being the same as the long-term US GDP growth rate, CMI had achieved this growth rate from 2010 to 2020. This included the 2020 pandemic year. The US average business cycle is about 5 years so you can say that CMI had achieved the 4 % over 2 business cycles.

CMI had achieved higher growth rates in the past few years. From 2016 to 2017 CMI revenue grew at 17 %. From 2017 to 2018, the revenue grew at another 16%. These are significantly larger than the 7.4 % assumed for the high growth phase.

The growth for the high growth phase is actually single digit growth. Normally a growth stock is one with double digit growth during the high growth phase. This implied that I did not modeled CMI as a growth stock.

There are of course some concerns about the growth assumptions:

I had used the historical reinvestment rates of 23.9 % in my model. This is much lower than the reinvestment rate derived from the fundamental equation of growth = return X reinvestment rate. The Free Cash Flow would be lower if I had used the fundamental reinvestment rate. This is turn will result in a lower valuation.

The global growth in diesel engines, power generators or even auto powertrains were projected to be around 4 % to 5 % CAGR. This must mean that CMI would gain market share with the 7.4 % growth rate.

There is potentially higher growth in the electric powertrain products. But there is a possibility that it would be at the expense of the diesel powertrain products. I am assuming that the despite the cannibalization, the Group would have overall growth.

Notwithstanding these concerns, the 31 % margin of safety should provide some room for error.

Will there be Spectacular Growth in Shareholders’ Value?

If you have been following my blog, you will know that a high-quality company is one that has a good chance of increasing shareholders’ value.

I looked at the following metrics to assess shareholders' value creation.

Compare the growth in shareholders’ funds assuming no payment of dividend or share buyback with the cost of equity.

Compare the return as measured by EBIT(1-t) / TCE with the WACC.

Compare the shareholder gain with the cost of equity. The shareholder gain is the capital gain and dividends received if he bought one share at the end of 2010 and held onto it till the end of 2020.

The results of such comparisons are tabulated below

Table 3: Shareholders Value Creation

Table 4: Shareholders Gain

As can be seen from all the 3 metrics, the returns exceeded the respective cost of funds. Thus, shareholders value was created.

Share buyback

CMI had an aggressive share buyback programme. Share buybacks would add to shareholders value if it was carried out at prices less than the intrinsic value.

To assess this correctly, there is a need to computed the intrinsic value for each year. However, I just did a back-of-envelop analysis by comparing the buyback price with the Book Value.

This is because there is link between the intrinsic value and the Book Value and I used the 2020 linkage as the basis.

In 2020, the Earning value with growth based on a Conservative scenario = USD 239.59 per share. The Book Value was USD 56.51 per share. We then have the link between intrinsic value and Book Value as 239.59 / 56.51 = 4.2

If the 2020 buyback price to Book Value was less than 4.2, I would conclude that the buyback was undertaken at a price that was less than the intrinsic value. By assuming that this 4.2 ratio held from 2010 to 2020, I now have the basis to compare the historical share buyback prices with the “intrinsic value”.

The table below shows the buyback price to Book Value of the respective years. You can see that the buybacks were all undertaken at prices less than the intrinsic value

Table 5: Share Buyback

This is of course a back-of-envelope analysis, but it does point to the Group not overpaying for the shares.

Case Notes

According to Investopedia, shareholder value is based on the firm's ability to sustain and grow profits over time. Increasing shareholders value increases the total amount in the equity section of the balance sheet.

A company’s shareholders value depends on strategic decisions made by the company. This includes the ability to make wise investments and generate a healthy return on invested capital.

"To maximize shareholder value, there are three main strategies for driving profitability." Corporate Finance Institute

Revenue growth

Increasing operating margin.

Increasing capital efficiency.

There are then 2 ways to assess whether shareholders value have been created. The first is to consider how shareholders value have increased over time as carried out in this case study. The other way is to look at the various drivers of profitability.

As you can see, there are several ways to analyze companies and they require making choices about the methods. If you are a newbie and are not sure what to do, you can seek third party assistance.

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.

How to Secure Your Investment by Minimizing Risk

I considered 2 risks when investing - privatization risk and business risk.

Privatization risk arises when a party undertakes to buy up all the shares to take the company private. You are then forced to sell at a price that may be lower than the intrinsic value. This is quite common in the ASEAN share market when the controlling shareholder takes advantage of the low market price.

I have not come across this in the US market so far. I would dismiss this risk for CMI as there is no major controlling shareholder to consider such a privatization exercise. Besides the current market price is above the Book Value and EPV to render this as unlikely.

The main investment risk then relates to business risk. From a big picture perspective, the risks are:

The failure to build up a significant market share in the powertrain business. This would be a failure of its vertical integration strategy.

The failure to build a significant share of the alternative fuel engine market so as to replace the diesel products. The company has recognized the green and alternative energy trends. It had taken steps to acquire the necessary expertise. The unknow is whether this alternative energy products would be championed by some new player. This is like what is happening to the electric vehicle sector by Tesla. Or whether the current industry players would be able to transform themselves and remain relevant.

The valuation assumed that CMI can managed both risks so that it will continue to grow. While there will be product and technology changes, I have assumed that CMI would not go the way of Kodak or Nokia with the advent of new technologies.

Pulling it all together

In Part 1, I have shown that CMI is financially sound with a good growth and profitability track record.

In Part 2, I have shown that management is both a good operator as well as a good capital allocator. The Group has a track record of creating shareholders value. And they have taken steps to change the business direction to be in line with the energy trends. All these reinforces the point the CMI is a good company.

Now whether it is a good investment depends on whether there is a sufficient margin of safety. In CMI case, the margin of safety comes from assuming that it can deliver the high growth rates over the next 10 years.

The plus point is that the high growth rates assumed in my valuation is actually single digits growth rates. And they are just a few % points above the US long term GDP growth rates. The numbers are not some mind-boggling growth rates.

I would conclude that there is an investment opportunity here and that CMI is one of the better NYSE stocks to invest in.

End of Part 2 of 2

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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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