Cummins (CMI): A Blue Chip Dividend Growth Stock on the Rebound

Historically, industrial dividend growth stocks such as engine maker Cummins (CMI) have done a great job of enriching long-term investors, especially if you’ve reinvested the dividends.

 

For example, Cummins has delivered an annualized total return of 15.4% since mid-1995, nearly doubling the S&P 500’s 8.5% annual total return.

 

However, Cummins has fallen on hard times in recent years while its share price has returned over 70% since early 2016, creating potential concerns for value-focused investors.

 

Let’s take a closer look under the hood of this venerable blue chip dividend stock to see if and when its business fortunes may turn around.

 

More importantly, find out if Cummins is an attractive dividend growth stock at today’s share price or whether investors would be better off waiting for a correction before initiating or adding to their positions.

 

Business Description

Founded in 1919 in Columbus, Indiana, Cummins is the largest dedicated global industrial diesel and natural gas engine manufacturer.

 

The company’s primary markets are highway & heavy-duty vehicles, construction, and general industrial markets, where it serves customers including Chrysler, Daimler, Volvo, PACCAR, Navistar, CNH Global, Komatsu, Ford, and more.

 

Its 55,000 employees market its products in 190 countries and territories via its network of 600 company-owned and independent distributors via 7,200 dealers.

 

Roughly 60% of Cummins’ revenue is generated in North America. China (8%) and the Asia Pacific (8%) are also meaningful markets. In fact, Cummins has had a presence in China and India for 40 and 50 years, respectively.

 

Cummins operates in four segments, and its largest sales drive is its engine division:

 

Engines (35% of revenue): builds diesel and natural gas engines for: heavy-and medium-duty truck, buses, recreational vehicles, as well as light-duty automotive, agricultural, construction, mining, marine, oil and gas, rail, and governmental vehicle markets

 

Distribution (27%): distributes parts and filtration products as well as maintenance, engineering, and product integration services

 

Components (22%): provides emission solutions, including: custom engineering systems and integrated controls, oxidation catalysts, particulate filters, oxides of nitrogen reduction systems, and engineered components such as turbochargers for light-duty, mid-range, heavy-duty, and high-horsepower diesel markets. This segment also markets air and fuel filters, fuel water separators, lube and hydraulic filters, coolants, fuel additives, and other filtration systems to help customers meet regulatory emission requirements.

 

Power Generation (16%): Designs power generation systems, including controls, alternators, transfer switches, and switchgears as well as offering replacement parts and maintenance services.

 

Business Analysis

Cummins has built itself into the dominant truck and bus engine maker thanks to its expertise in meeting mandated emission requirements (the EPA has forced a 90% reduction in emissions in past decade) through things like: natural gas engines, hybrid buses, turbochargers and advanced catalytic systems.

 

This has led to dominating both the medium and heavy duty truck segment (40% market share), where it is two to three times larger than its nearest rivals, according to Morningstar.

 

The engine market has several barriers to entry that have helped Cummins build strong market share positions around the world. Extensive regulations have resulted in strict standards governing emission and noise, for example.

 

The engines Cummins’ manufactures need to comply with emission standards established by the European Union, EPA, the California Resources Board, and other agencies. Cummins spent more than $170 million on research and development in 2007 and 2008 in order to comply with 2010 EPA emissions standards in the U.S.

 

Notably, several of Cummins’ competitors opted to exit certain markets rather than pony up the cash required to remain compliant with their technologies. For example, Caterpillar exited the on-highway truck engine market in 2009, reinforcing Cummins’ technological lead.

 

Gaining entry to the engine business is very difficult. For example, PACCAR (PAC) launched its first line of engines a few years ago after spending a decade of time and more than $1 billion developing it. The finished engine even used some of Cummins’ own engine components!

 

Over the last decade, more than half of the $2-3 billion Cummins has spent on research and development has been invested in technologies that reduce emissions. When it comes to fuel-efficient technology, Cummins is the clear manufacturer of choice.

 

Beyond its engine intellectual property and economies of scale, Cummins’ moat is also formed from the way its business is operated. The company generally maintains long-term price and engine supply agreements with core customers.

 

The customer benefits from knowing Cummins’ products will be available, and OEM customers can collaborate with Cummins to jointly engineer future vehicles. In other words, switching costs are created that make it more difficult for new entrants to steal market share away from Cummins.

 

Engines are extremely important systems to keep heavy vehicles and equipment running. In most cases, it’s not worth the risk of switching suppliers for a customer to save a little bit of money.

 

Machine downtime from a faulty engine is extremely costly, reinforcing Cummins’ value as a premium engine supplier. Cummins’ vast network of dealer locations (over 7,200 across 190+ countries and territories) also means it can provide much more timely aftermarket repair services, further gaining customers’ trust.

 

It’s also worth noting the complementary nature of Cummins’ technologies and distribution channels, which should continue unlocking growth opportunities for the business.

 

For example, Cummins was able to apply its base technologies to enter the light-duty engine market in the mid-2000s. On the other end of the spectrum, Cummins recently developed a 4,000 horsepower “Hedgehog” engine that will go into the locomotive market.

 

Through continuous innovation and growth of its distribution and dealer networks, Cummins can continue maintaining its market share and expanding into adjacent markets for long-term growth.

 

Despite Cummins’ numerous strengths, industrial companies are generally cyclical. Cummins is no exception.

 

In the last four years, a major slowdown in demand for new trucks and a weak global economy have resulted in negative growth in its top and bottom line, as well as declining margins.

 

 

Unfortunately, due to ongoing weakness in demand for heavy and medium duty trucks in the U.S. and Brazil, this trend has shown no signs of reversing. Cummins’ sales have declined year-over-year for five consecutive quarters.

 

 

In fact, all of the company’s divisions see falling sales for the full year to one extent or another. Here’s a look at Cummins’ most recent guidance for 2016:

 

 

Cummins’ margins have deteriorated to the point where its profitability is now beneath that of most other industrial companies.

 

Company	Operating Margin	Net Margin	FCF Margin	Return On Assets	Return On Equity	Return On Invested Capital
Cummins	9.3%	6.6%	8.5%	7.6%	16.0%	13.3%
Industry Average	12.6%	8.8%	NA	4.6%	15.0%	NA

Source: Morningstar

 

However, despite the cyclical downturn in sales and earnings, management has still been able to generate stronger than average returns on capital, thanks to its disciplined approach to cost management. This has allowed Cummins to maintain an enviable free cash flow margin despite the challenges facing its industry.

 

Unfortunately, the trucking industry, which has been facing a shortage of drivers that has driven up wages, cutting into profits, and created a glut of trucks, might not turnaround for a while.

 

According to CEO Tom Linebarger, “There is no sign of a pickup out there right now. I think what you have a situation is, for many, many months, we’re still producing more than orders are coming in, and that hasn’t changed.”

 

According to ACT Research, a leading industry analyst firm, engine sales for Class 8 trucks aren’t likely to pick up until 2018 at the earliest.

 

With low commodity prices causing low demand from Cummins’ off road business, which serves the energy and mining industry, it looks like sales, earnings, and cash flows are likely to continue trending downward in the coming year or two.

 

While a weak macro backdrop doesn’t impair Cummins’ competitive advantages or long-term earnings power, it could keep a lid on the stock in the near term.

 

Key Risks

Like all multi-global corporations, Cummins faces the threat of a strong dollar. Negative currency effects create a growth headwind as it attempts to gain market share overseas.

 

A major cause of the strong dollar is the U.S. economy showing signs of faster growth, allowing for rising interest rates that increase demand for dollars as foreign investors seek to partake in higher-yielding U.S. investments.

 

However, more concerning for Cummins investors is the increasing competition it could be facing. This is because Volkswagen is has recently taken a 17% stake in competitor Navistar (NAV) as it attempts to appease global regulators after its recent emission scandal by investing in low emissions vehicles.

 

Additionally, a major customer, PACCAR, has announced its entrance into the Class 8 engine market.

 

Up until now, Cummins has benefited from the fact that increasing regulatory pressure to cut truck emissions has resulted in increasing design costs that potential rivals, such as Caterpillar (CAT), which used to have 35% of the market, chose to forgo by conceding the market to Cummins.

 

However, now well-capitalized rivals could start to eat away at its market share and reduce its pricing power if their own emission offerings prove a worthy rival to Cummins’ technologies.

 

In addition, while China represents the company’s second largest (and fastest growing) market, in the most recent quarter Cummins’ market share in China (through a joint venture with two Chinese companies) fell from 17.9% to 16.5%.

 

This just goes to show that, despite 40 years of operating experience in China, sales success isn’t guaranteed because of the large amount of competition Cummins is facing in the Middle Kingdom from home grown companies.

 

We can’t forget the longer-term risks either. In the medium term, Cummins’ natural gas and hybrid bus engines could be a good growth catalyst.

 

However, companies such as Tesla (TSLA) and Mercedes have announced that they are working on electric semi-trucks.

 

While the technology to create sufficiently long-haul EV semis is probably still a few decades away, investors need to keep in mind that electric trucks could potentially impact Cummins’ business model.

 

That’s because EV engines are far more reliable, longer-lasting, and have very few moving parts. This makes for far less frequent maintenance requirements and would reduce demand for most of the equipment Cummins has spent the last century perfecting.

 

Dividend Safety Analysis: Cummins

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. You can see that almost all companies cutting their dividends scored below 40 for Dividend Safety at the time of their announcements, and companies with lower Dividend Safety Scores generally experienced larger dividend cuts.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been (including analysis of every dividend cut in the chart above), and how to use them for your portfolio. You can review this analysis and learn more about Dividend Safety Scores by clicking here.

 

Cummins has a Dividend Safety Score of 79, which means that despite the challenging industry conditions, the dividend remains safe and dependable.

 

Part of this is due to the company’s moderate payout ratios, which mean that even with declining sales, earnings and cash flow, the dividend is well covered and at low risk of needing to be cut.

 

In fact, over the past 12 months Cummins’ free cash flow (FCF) payout ratio has come in at a low 44%, allowing management to continue growing the dividend despite deteriorating industry conditions.

 

 

Cummins’ business model is also a free cash flow machine, further solidifying its dividend. Free cash flow supports sustainable dividend growth, and you can see that Cummins has generated positive free cash flow in each year over the last decade.

 

 

The third reason for confidence in Cummins’ dividend is the firm’s pristine balance sheet. For cyclical companies, the balance sheet can make or break them if they overextended themselves at the peak of their markets.

 

Management, recognizing the cyclical nature of this industry, has wisely chosen to keep debt to a minimum, resulting in very strong current, and interest coverage ratios.

 

 

Similarly, when we compare Cummins against other industrial rivals, we can see that management has been excessively cautious with leverage, which is a great thing.

 

Cummins’ excellent credit rating means it can borrow cheaply, and in a worst case scenario use debt to make up for any potential cash flow deficiencies in maintaining its dividend; a strategy we’ve seen from numerous energy blue chip dividend stocks in recent years.

 

Company	Debt / EBITDA	EBITDA / Interest	Debt / Capital	Current Ratio	S&P Credit Rating
Cummins	0.88	32.25	17%	1.81	A+
Industry Average	3.60	NA	46%	1.77	NA

Source: Morningstar

 

Best of all, management remains committed to maintaining and continuing to grow the dividend, with CFO Pat Ward recently telling analysts that Cummins plans to continue returning 75% of operating cash flow to shareholders in buybacks and dividends.

 

This signals that Cummins has a very dividend-friendly management culture that will probably avoid a payout cut unless absolutely necessary.

 

Overall, Cummins’ dividend is very safe almost regardless of where its cyclical markets go over the coming quarters. The company’s healthy payout ratio, continued free cash flow generation, and strong balance sheet provide plenty of flexibility.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Cummins has a Dividend Growth Score of 67, meaning that investors can expect slightly above average dividend growth, relative to the S&P 500’s historical 6.1% dividend growth rate.

 

Cummins is no dividend aristocrat, having only raised its dividend for 11 straight years. However, that does still make it a dividend achiever.

 

As you can see, the low payout ratios allowed Cummins to compound its dividend at a double-digit rate for the last two decades. Management last raised Cummins’ dividend by 5% in July 2016.

 

 

Of course, in the next year the likely deterioration of sales, earnings, and cash flow will mean that Cummins won’t be able to continue its recent frantic pace of payout growth.

 

However, even if the trucking industry doesn’t recover until 2018 the company should be able to manage 5% to 7% dividend growth in the next two years.

 

And if things improve after that, as analysts expect they will (4% long-term revenue growth is projected), along with ongoing cost cutting should allow for long-term net income growth of 5% to 6%.

 

Combined with the company’s consistent track record of buybacks, that should boost overall long-term EPS growth to 6% to 8% and allow for dividend growth in the range of 7% to 9%.

 

Valuation

While Cummins’ P/E multiple is still below the market’s 26.1, shares have soared more than 70% in the past year.

 

This has resulted in Cummins trading meaningfully above its 13-year median P/E ratio, due in part to the cyclical nature of the industry (earnings are volatile, making cyclicals look expensive on a P/E basis when earnings are temporarily depressed).

 

P/E	13-Year Median P/E	Yield	13-Year Median Yield
21.3	14.8	2.8%	1.6%

Source: Gurufocus

 

However, even if we look a few years out to 2019 when earnings are expected to be higher and closer to “normalized” levels for this cyclical company, CMI’s stock trades at a P/E multiple of 16.4 (based on 2019 earnings estimates).

 

While the dividend yield is still appealing, especially compared to its historic level, it’s hard to make a really compelling valuation case for the stock today.

 

I don’t think Cummins’ valuation is at an excessive level where shareholders such as me should consider selling their stock, but new investors considering the business might be better off waiting to initiate a position.

 

A price closer to $120 or below (versus $147 today) would result in a more reasonable forward P/E multiple of 15 and a dividend yield of 3.4%.

 

Investor sentiment can change quickly for cyclical companies (CMI’s stock plunged 40% in seven months in 2015), so it’s worth being alert for these types of opportunities.

 

Closing Thoughts on Cummins

Cummins is a solid blue chip dividend growth stock with an excellent record of rewarding income investors with secure and growing payouts, as well as market-beating long-term total returns.

 

However, the last year’s rally in Cummins’ stock does not seem justified by current fundamentals. We don’t yet know if Cummins’ worst days are behind it, and but the market’s expectations don’t leave much room for a surprise slip in profits.

 

If you like the company’s long-term prospects, it might make more sense to put CMI’s stock on a watch list and wait for the next market correction, which could bring shares closer to the $120 target I identified above.

 

For now, as a long-term investor, I plan to continue riding out the inevitable and unpredictable ups and downs with Cummins in our Top 20 Dividend Stocks portfolio, believing in the company’s long-term outlook for better growth ahead.