Cummins Stock: Business Under Transition (NYSE:CMI)

Company Description

Cummins Inc (NYSE:CMI) is a global leader in industrial power systems. It designs, manufactures, distributes and services diesel, natural gas, electric and hybrid powertrains and powertrain-related component products, including filtration, after-treatment, turbo-charges, fuel systems, control systems, air-handling systems, automated transmissions, axles, drivelines, brakes, suspension systems, electric power generation systems, batteries, electrified power systems, electric powertrains, hydrogen generation and fuel cell products. Last I covered CMI stock was in Nov 2020.

Products are sold to original equipment manufacturers (OEMs), distributors (both company-owned and independent) and end-users worldwide. The company operates in more than 190 territories and countries.

Cummins started out in 1919 as the Cummins Engine Company making diesel engines. Although the company did not invent the diesel engine, it has been hugely instrumental in its development. The company started its global expansion very early and by 1960 was selling products in over 98 countries. More than 50% of the company’s sales come from outside of the US. The company was first publicly listed in 1947.

The politicization of the climate change debate presented Cummins with an existential threat to its business. Cummins’ primarily supplies products which require fossil fuels to generate power. Cummins has taken a decision to pivot to be a supplier to the “green” power sector. This decision has led to a series of relatively modest acquisitions (until recently) to enable Cummins to gain access to the green power sector.

The company currently has 5 reportable operating segments:

Business Overview

Cummins until 1991 was primarily a diesel engine company. In 1991 they introduced a natural gas engine for the commercial truck and bus market. Cummins historically manufactured diesel and gas-fired engines for the heavy and medium-duty truck, bus, recreational vehicle (RV), light-duty automotive (pickups and light commercials), construction, mining, marine, rail, oil and gas, defense, and agricultural markets. Through a series of modest acquisitions over the last few years Cummins is now developing a business in supplying hybrid, hydrogen, and electric powertrains as well.

These markets are very cyclical. This can be demonstrated by looking at the long-term historical chart of Cummins’ revenues:

Although Cummins’ revenues are increasing over time the global economic cycle causes significant periodic falls.

Engines Division

The commercial vehicle market is defined by vehicle size (Gross Vehicle Weight Rating where the GVWR is equal to the weight of the vehicle plus the maximum payload) and vehicles are assigned to a specific class based on their size. The rating system goes from Class 1, which comprises light vehicles (minivans, SUVs, etc.) to Class 8 (heavy duty trucks). The key market for Cummins is the Class 8 truck segment (heavy duty trucks for long distance haulage). This Class includes vehicles with GVWR’s over 33,001 pounds.

Cummins is now the only 3^rd party engine supplier in the North American market. All remaining engines are OEM branded (the same brand as the manufacturer of the vehicle).

The Engine division has four segments (corresponding to engine sizes) under which Cummins reports its revenues:

Heavy-duty truck. Medium-duty truck and bus. Light duty auto. Off-highway.

The historical performance of these segments is shown in the following chart:

All segments within the Engine division have historically been cyclical with respect to both volumes and margins. These days margins appear to be much more stable through the cycle. Increases in regulatory standards have allowed Cummins to both increase its market share and margins, probably due to the technical superiority of its products.

Distribution Division

The Distribution division is the primary after-market sales arm for the company. The division manages the operations of wholly owned and joint venture distributors as well as relationships with a network of independent distributors who provide parts and service to the end-user customer. These full-service solutions include maintenance contracts, engineering services and integrated products where products are customized for the end-users. The division is organized into geographic regions and it operates in more than 450 locations throughout the world.

The Division’s sales come from new engines, parts, power systems and services. The historical sales split (which includes internal sales) and reported EBITDA margins is shown in the following chart:

Cummins has acquired many of their independent North American distributors over the years as a strategy to increase the use of Cummins’ parts in the after-market. This has been successful in significantly growing volumes, but it resulted in divisional margin erosion (although keep in mind that many of the sales are internal transfers which gives management some flexibility in deciding in which division the profits will be reported).

Interestingly since 2018 margins have significantly increased. Management has attributed this to the benefits of an internal restructuring, but I suspect that Cummins has been opportunistically increasing prices during the COVID induced supply chain disruption.

Components Division

The Components division supplies products which complement the Engine and Power Systems divisions. This division manufactures after-treatment systems, turbochargers, transmissions, filtration products, electronics, fuel systems, axles, drivelines, brakes and suspension systems for commercial diesel and natural gas applications.

The division is organized into 6 departments including Emission Solutions, Axles and Brakes, Turbo Technologies, Filtration, Electronics and Fuel Systems, and Automated Transmissions. The customers for this division are both internal to Cummins (including Joint-Ventures) and truck OEMs.

The historical performance of this division is shown in the following chart:

The chart indicates that the bulk of the division’s revenue growth has come from the Emissions Solutions segment (because of increasing regulation) and the recently acquired Axles & Brakes business (Meritor).

Power Systems Division

The Power Systems division had been hard hit by the cyclical downturn in capital spending within the commodities sector, but volumes have recently returned. This division provides power solutions for industrial applications, standby and prime power generator sets, alternators, and other power components. The customer base is highly diversified. The division is organized into 3 segments – Power Generation, Industrial and Generator Technologies.

The historical performance of the division is shown in the following chart:

The Power Systems segment is more competitive than the auto segments due to the less strict environmental standards. This tends to nullify Cummins’ technology advantage.

New Power Division

The division was established in 2019. The division designs, manufactures, sells and services hydrogen production solutions and electrified power systems.

Revenues are relatively modest (total sales in 2022 were $176 M). The division is currently loss making and management reported at the 2022 Investor Day that it did not expect the division to break-even until 2027.

Joint Ventures

Cummins has several joint ventures, alliances, and partially owned subsidiaries. Some of these entities are consolidated into Cummins’ financial statements whilst many are not and are shown as equity investments on the Balance Sheet. These joint ventures are either manufacturing or distribution businesses and they are strategic, providing Cummins with access to developing markets with the support of a well-credentialled local partner.

The joint ventures include:

• Komatsu Cummins Chile – a distribution business which offers a full range of Cummins products in Chile and Peru.
• Beijing Foton Cummins Engine Co – a manufacturing business in China producing light and heavy-duty engines for the Chinese, Russian and Brazilian markets.
• Dongfeng Cummins Engine Co – a manufacturing business in China producing medium and heavy-duty engines for Dongfeng trucks.
• Chongqing Cummins Engine Co – a manufacturing business in China which produces engines for the industrial and stationary power markets in China.
• Dongfeng Cummins Emissions Solutions – a manufacturing business which produces diesel after-treatment products for use in Dongfeng trucks.
• Shanghai Fleetguard Filter Co – a manufacturing business in partnership with Dongfeng to produce filters and filter parts for Dongfeng trucks.
• Cummins India – an Indian listed manufacturing company producing a range of engines for the local and export markets. This is a consolidated business with minority partners.
• Eaton Cummins Automated Transmission Technologies – a consolidated company with minority shareholders which manufactures medium and heavy-duty automated transmissions for the commercial market.

The joint-venture engine manufacturing businesses are supplied with components from the Cummins Component division.

Cummins’ Strategy

The Cummins’ strategy is about using its existing business based on a mixture of hydrocarbon and electric power sources to generate strong financial returns whilst leading the sector’s transition to zero emission technologies.

The strategy is summarized by the following slide:

Cummins has created a new division through a series of acquisitions and is repositioning itself from being just a component supplier to also being a systems integrator for the “green” energy sector. Management claims that the new strategy potentially doubles the size of Cummins’ addressable market to $100B by 2030.

The key challenge for both Cummins and investors is to carefully manage the profitability of the New Power division which currently operates at a loss and is not expected to break-even until 2027. The big unknown is what will be the long-run operating margins of this division and how much investment will be required to support the establishment of a sustainable business model?

Cummins’ Historical Financial Performance

Cummins’ consolidated historical revenues and adjusted operating margins are shown in the chart below:

It should be noted that I have made several adjustments to Cummins’ reported Operating Income. The adjustments include:

• Research, Development & Engineering expenses have been eliminated from the Operating Income statement as I consider these expenses to be investments. However, I have added back an R & D depreciation expense based on a 5-year investment life.
• I have eliminated all unconsolidated Joint-Venture profits (except royalty payments).
• Prior to 2019 I treated operating leases as debt and made the corresponding adjustments to the Income statement (which is now part of the Accounting Standards).
• I have eliminated the impact of all identifiable one-off expenses.

The chart shows that Cummins has had an excellent run for the last 10 years – steadily growing revenues and managing to keep margins in a reasonably tight range.

Cummins suspended its Russian operations during 2022 and incurred $111 M of suspension costs. In 2021 CMI reported sales of $334 M in Russia.

Cummins’ Moat

My moat assessment for Cummins is shown in the following table:

This moat assessment is based on Cummins’ diesel engine business. Cummins has an excellent brand which is well respected by the customer base. Cummins potentially has a technological advantage in the on-highway segment, and this is reflected in its margins.

Over the years Cummins has made substantial investments in its technology leadership as shown in the following chart:

The chart only includes expensed Technology investments made through the Income Statement. It does not include any capitalized investments or acquisitions. Cummins no longer updates their human commitment to technology but at one stage claimed that they have around 7,700 engineers working in R & D as well as another 2,700 engineers working to support their existing product range.

The typical Technology / Sales ratio in the sector is 2.8%. Cummins’ ratio is currently closer to the 75^th percentile for the sector.

I do not believe that the Cummins’ moat is wide but it may be quite deep. I am concerned that their technology edge resides with its diesel business, and it may not be readily transferable to the new power business.

Cummins’ return on investment capital suggests that its moat may be stronger than I indicate:

Cummins ROIC is excellent for a traditional manufacturing company and is closer to the sector’s 75^th percentile (18.3%).

Cummins’ Capital Structure

Cummins has been funding its acquisitions using debt and this is reflected in the increasing debt ratio shown in the following chart:

Cummins has more than doubled its traditional debt levels over the last 3 years and as a result its debt ratio is now in the sector’s highest quartile.

Cummins currently has an excellent A+/A2 credit rating but any missteps in the execution of its strategy would probably see a negative re-rating.

Cummins’ Cash-Flows

A review of Cummins’ restated cash flow statements for the last 10 years reveals the following information:

Note that I have adjusted the reported Cash Flow Statement for the impact of capitalizing the expensed Research, Development & Engineering amounts.

The data indicates that Cummins has reinvested about 65% of its restated operating cash flows back into the business (for capex, acquisitions, and research & development / engineering expenditures).

Cummins did not need the additional debt it took on to fund its business activities, but it used the debt to fund 72% of the share buybacks. Over the last 10 years, Cummins has returned $15,282 M back to shareholders in a combination of dividends and buybacks.

Although Cummins has a healthy credit rating (A+/A2), the additional debt load has increased the company’s risk profile and I suspect that as the New Power division grows and continues to make losses then the level of share buybacks will have to be reduced.

Recent Share Price Action

At the time of writing this report Cummins has significantly outperformed the S&P 500 index over the last 12 months and the share price was close to a record high. It is noted that the share price is also quite volatile.

Historical Returns

Interestingly the data does not reflect the cyclical nature of Cummins’ business. CMI stock has had an excellent run for the last 5 years and has easily outperformed the broader market’s index. However the table shows that over a 10 year horizon Cummins has under-performed relative to the market.

For me this confirms that great care must be taken when buying this stock. We must get the valuation right and we need to be disciplined about when we trade the stock.

Key Risks Facing Cummins

I think that there are two substantial risks facing Cummins.

After many years of relatively stable executive leadership Cummins now has a relatively inexperienced executive team. Tom Linebarger has retired from the CEO role after 10 years. Cummins is now entering, arguably, a very complex business environment with its least experienced team.

The other major risk for investors is that because of technology change, Cummins potentially transitions from being a global leader in low-emission diesel technology with high returns on invested capital to one of many players in the alternative fuel power train market with modest returns on invested capital.

I suspect that it is inevitable that diesel technology will be replaced by a lower emission alternative. At this stage it is unclear over what time frame this transition will happen. History would suggest that Cummins is unlikely to have the same market position in the next evolution of this market.

My Investment Thesis for Cummins

Clearly the near-term revenue forecasts for Cummins have a large degree of uncertainty due to the potential for a global economic slowdown (or even recession). At the time of writing this report the consensus revenue forecast for 2023 and 2024 is for negligible revenue growth for the Cummins base business excluding the impact of a full year of Meritor revenues.

Over the next 10 years there will be conversions from diesel to other drive-train technologies. Cummins has made some reasonable investments in the electric and hybrid drive-train markets. These markets are extremely competitive, and Cummins has been a late entry into these markets. This may mean that Cummins may not be able to maintain its revenue base as customers substitute diesel engines for electric or hybrid engines (due to competition). Nevertheless, the end-use markets are reasonably mature therefore the Cummins’ base business will probably not grow any faster than the economy. However, as Cummins substitutes diesel sales for non-diesel sales its ultimate operating margin will decline as these markets are more competitive and lower margins.

The acquired Meritor business is also reasonably mature and the historical revenue growth for Meritor since 2016 has been around 5% per year. It is noted that Meritor is a low margin business, and this is not expected to change significantly under Cummins’ leadership.

The majority of Cummins’ future revenue growth is expected to come from the New Power division. Cummins is forecasting that revenues will double from 2022 to 2023 (albeit from a low base).

Cummins has high aspirations for its New Power division and is projecting revenues of between $6 B to $13 B by 2030 depending upon the uptake of ZEV conversions. I think that there are significant risks associated with this forecast but for this scenario I have assumed that Cummins does achieve $6 B of revenues for the New Power Division. At this stage it is not clear what the ultimate margin will be in this division (Cummins has projected it to breakeven by 2027). I have assumed that the operating margins for this division will be the sector’s current average of 11.6%.

Cummins will continue to invest in diesel and natural gas combustion engines for the medium and heavy-duty markets which are unlikely to be disrupted over the medium term because of the negative impact on payloads experienced by electric / hybrid drivetrains. Over the longer term I expect that this advantage will be eliminated as the alternative drive technologies evolve (this will have a negative impact on capital productivity). Over time I would expect that Cummins’ level of investment will decline (as you would expect in a declining industry) and this will slow the rate of decline in the company’s ROIC.

In summary my scenario inputs for each division are:

Note that the sales growth estimates are for the years from 2025 to 2028 and the mature margins are EBITDA margins without the allocation of R & D expenses at the divisional level (I have treated R & D as an investment and I have applied an amortization charge at the corporate level).

Valuation Assumptions

In summary, this should enable Cummins to achieve:

• Consensus revenues for 2023 and 2024 followed by revenue growth of 5% ± 2% in years 2 to 8 before growth begins to decline to GDP (4%) for years 9 and 10.
• Adjusted Operating Margins (which have been adjusted for the impact of operating lease expenses and the capitalization of Research and Development) will decline over time to 11.3% ± 0.5%) into perpetuity.
• Capital productivity (as represented by Δ Sales / Net Capital) will decline from the current level of 2.3 and settle at 1.6 ± 0.25 (between the median and the 75^th percentile of companies in the Sector).
• The current Return on Invested Operating Capital (around 21%) will decline over time before settling at 11% ± 1% in perpetuity which is the sector’s median level.
• I have used the Capital Asset Pricing Model (CAPM) to estimate the current cost of capital to be 9.92% and I expect that the mature cost of capital will be 9.9% ± 0.3% (this reflects the higher uncertainty associated with Cummins’ future revenues).
• I have used an average tax rate of 22%.
• Market value of equity investments – I have estimated a market value for Cummins’ unconsolidated equity investments using the current Sector’s median Price to Book ratio (established from my Sector screen) of 3.11. It is noted that I would normally discount the value of any Chinese investments thus reflecting the risks and uncertainties associated with investing in China but in this instance the impact on the valuation is not material.
• Market value of minority shareholders – I have used the same Price to Book ratio to adjust the value of the minority shareholders’ stake in Cummins.
• I have used the December 2022 total number of common shares (141.5 M).
• I have valued the Management Options at $229 M using a Black-Scholes model.
• I have applied a one-off discount to Cummins’ valuation of $258 M which reflects the current value of the Hydrogenics Corp’s PUT / CALL option.

Discounted Cash Flow Valuation

A Free Cash Flow to the Firm approach is used with a 3-stage model (high growth, declining growth, and maturity). The model only seeks to value the cash flows of the operating assets. The valuation has been performed in $USD.

The model estimates Cummins’ Enterprise Value is $39,699 M and the Equity Value is $28,507 M. This equates to a mid-point value per share of around $202.

I also developed a Monte Carlo simulation for the valuation based on the range of inputs for the valuation. The output of the simulation is developed after 100,000 iterations.

The Monte Carlo simulation can be used to help understand the major sources of sensitivity in the valuation. The valuation distribution is mainly influenced by the sales growth (24%) and the operating margin (21%).

The simulation indicates that at a discount rate of 9.9% – the valuation for Cummins is between $174 and $235 per share with a typical value around $201.

This would indicate that Cummins is currently Expensive.

Final Recommendation

For each company that I value I also assess what role this company could potentially play in my portfolio. The cornerstone of my portfolio is what I term “Tier 1” companies. These are the companies that I hold for the long term and where I invest most of my cash.

My high-level Tier 1 investment assessment for Cummins is:

In the past Cummins has ticked many of these boxes (excepting sector tail winds) but the situation is changing because of the changes to emission regulations. There is a high probability that Cummins’ future business (over the medium to long term) is going to be dramatically different to its historical business.

This level of uncertainty prevents me from categorizing Cummins as a Tier 1 company.

Nevertheless, I think that Cummins is highly investable. The company has a strong position in the diesel market and the company has been well managed. As the company is currently trading above my valuation and equity markets are becoming more volatile, I think that the company is a Sell.

If there was a significant market pullback, I would recommend that Cummins could potentially be an excellent trading opportunity.