CMI’s stock has declined more than 20% over the past six months. Investors are concerned about the slowdown in China, softness in off-highway machinery markets caused by slumping commodity prices, and potentially peaking demand in the North American truck market. CMI serves a variety of cyclical markets around the world, and many of them have faced challenges in recent years. Investors are becoming increasingly impatient and uneasy wondering when the next leg of growth will occur. For long-term dividend growth investors willing to stomach some volatility, CMI’s 3.6% dividend yield is appealing given the dividend’s safety and growth potential.
CMI makes and services diesel and natural gas engines (44% of sales), electric power generation systems (12%), and engine-related component products (23%). The company also owns a number of distributors (21%) that provide aftermarket services and support the dealer network. Its main 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. International sales account for about 40% of CMI’s total revenue. CMI has been around for nearly 100 years and specializes in manufacturing the cleanest, most fuel-efficient and regulatory-compliant engines for many different types of vehicles and end markets.
The following pie chart highlights the Engine segment’s end market mix. The truck and bus market accounts for a little over half of its total sales.
The engine market has numerous barriers to entry that have allowed CMI to build dominant market share positions across many of the regions it serves. Extensive regulatory requirements in developed markets (and increasingly developing markets as well) have imposed ever-stricter standards governing emission and noise. CMI’s products must comply with emission standards that the European Union, EPA, the California Resources Board, and other regulatory agencies have established for heavy-duty on-highway diesel and gas engines and off-highway engines. In order to comply with 2010 EPA emissions standards in the US, CMI invested over $170 million in R&D in 2007 and 2008.
The large investment required to remain compliant further solidified CMI’s market position as several competitors preferred to exit certain markets rather than invest to meet requirements. Caterpillar was the most notable peer that decided to exit the on-highway truck engine market in 2009 to focus on off-highway heavy-duty trucks, reinforcing the technological lead CMI has built in the on-highway engine market. (See our analysis of Caterpillar’s dividend here). Looking even further back, over half of the $2-3 billion CMI spent on R&D in the last 10 years has been invested in emission reduction technologies. With fuel representing a significant cost for many of CMI’s customers, CMI’s continual investments in fuel-efficient technology maintain its status as the premium engine vendor of choice.
The following chart is a bit dated, coming from CMI’s 2013 Analyst Day, but it highlights the company’s strong on-highway market share across the globe. CMI’s scale allows it to provide the best value proposition for its customers, keeping costs low through bulk purchases of materials and lean six sigma operations while having the significant capital necessary to establish production facilities and invest in R&D.
While CMI’s extensive engine knowhow and technology investments have played a substantial part in its growth, its contracts with customers and dealer network play equally important roles in maintaining its dominant position.
As seen below, CMI’s total shareholder return (“TSR”) significantly outpaced the market’s return over the last 15 years, represented by a rising line. Since 2012, however, CMI has underperformed, including a decline of more than 20% over the past six months.
Essentially, investors are growing increasingly worried that all of CMI’s end markets will take another leg down next year. CMI’s off-highway markets have already been weak for a couple of years, but its on-highway truck engine business has been very solid, enough to offset other headwinds thus far. However, many believe the truck cycle is peaking, including Volvo. Unlike in the past, when major emissions regulations kicked in and helped CMI significantly outgrow the market due to its superior technology, CMI seemingly lacks major catalysts to separate itself from near-term cycles.
Our crystal ball is no better than yours, and trying to time market cycles is often a futile effort. What we can do, however, is analyze how the company is prepared for the next downturn and what the market might already be pricing in given CMI’s current valuation.
In 2009, CMI’s earnings plunged 44%. By segment EBIT, Engine fell 53% (industrial was down 40%; on-highway fell 16%), Power Generation dropped 56%, Components was down 44%, and Distribution was more stable at -3%. Heading into the recession, CMI’s mix was a bit different than today.
As seen below, CMI’s most volatile segment, Power Generation, accounted for 18% of sales and 26% of EBIT in 2007. This business has struggled over the past few years and is less than 10% of sales and 7% of EBIT today – in other words, it won’t hurt overall earnings nearly as much as it did in 2008-09. CMI’s industrial engine business saw sales plunge 40% in 2009 compared to a 16% drop in on-highway engine sales. Once again, we see that industrial mix has shrunk from 18% in 2007 to 12% today. Perhaps most importantly, Distribution revenue has grown from just 12% of revenue in 2007 to 27% of net sales in 2014 (driven by acquisitions), removing some of CMI’s cyclicality because this business contains a good amount of aftermarket support.
While it’s hard to estimate the impact a recession would have on CMI’s business, we think its mix is healthier than it was during the financial crisis and would be surprised if earnings fell by 40% again. Looking at consensus earnings estimates for 2016, which already bake in some pessimism about CMI’s growth prospects, we can see expectations are for CMI to report close to $11 in earnings per share. If we cut that estimate by 40%, CMI would report about $6.50 in earnings instead. Slapping on a 10x multiple, which is what CMI briefly traded at the bottom of the market in 2009, yields a $65 price target and represents a total return of -35%. At 12x trough earnings, the stock would trade at $78 for a total return of -25%. If markets don’t simultaneously tank but instead demonstrate stability or modest growth, CMI trades at less than 11x forward earnings. We also believe CMI could generate $15 in earnings per share within five years. If the stock were to trade at 13x earnings, it would increase to nearly $200. Despite global uncertainty, we think the odds are in the favor of the long-term focused dividend growth investor. With most investors fixated on the truck market possibly peaking, let’s look at some of its data.
The following data was provided by IBIS World and shows historical and forecasted growth in the truck and bus market (52% of CMI’s engine sales). Growth has been very volatile over the last 15 years. The industry’s 2015 revenue of $31 billion is a bit on the high side relative to history but is flat compared to 2005’s level. Growth has been reasonable since 2012 as well, never exceeding 7% in any given year. While a pullback is possible, the market could also continue growing or remain stable as global transportation demand moves higher. For whatever it’s worth, IBIS World forecasts the truck market to grow 1-2% per year over the next five years.
Ups and downs in CMI’s markets are nothing new but can create great buying opportunities for patient investors. Over longer periods of time, we believe each of CMI’s markets will grow in size. Beyond market gyrations, investors should continue watching CMI’s cost-conscious OEM customers, who have historically outsourced certain types of engine production to CMI but might look to vertically integrate more in the future to save money. CMI’s long-term contracts with its customers, the high level of emissions regulations, importance of a big dealer network, and the costly and lengthy time required to develop an engine (Paccar spent 10 years and $1 billion, incorporating CMI’s components) reduce the likelihood of this becoming an issue, but it would be a material development as CMI’s top eight customers account for more than 35% of its total revenue.
The other long-term risk we are watching is CMI’s market share and profitability in emerging markets, such as China. Many of these markets require lower price points and have less emphasis on engine performance. So far, CMI has significantly outgrown the engine market in China, and we expect tighter emissions over time could further consolidate CMI’s position given its superior technology, scale, and long-term presence in the market.
Altogether, we think the market is pricing in a reasonable decline in CMI’s business already, barring a global recession. While uncertainty in many global economies may push out the recovery and expansion of power generation, industrial, and truck engines, we think CMI will continue gaining market share and be well prepared for an eventual pickup in demand.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. CMI’s long-term dividend and fundamental data charts can all be seen here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
CMI recorded an excellent Safety Score of 98, suggesting its current dividend payment is one of the safest available in the market. The company’s moderate payout ratios, very healthy balance sheet, and wide moat support the favorable ranking despite the business’s cyclicality.
Over the trailing twelve months, CMI’s dividend has consumed 35% of its GAAP earnings and 43% of its free cash flow. CMI is a cyclical business, but its payout ratios provide plenty of protection in case the truck market rolls over – a 50% drop in earnings, similar to the decline experienced during the financial crisis, would boost CMI’s EPS payout ratio to a reasonable 70% level.
Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, CMI’s payout ratios have generally remained at or below 30% for most of its history.
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. Our Stock Analyzer tool lets us see how a company performed during the financial crisis in one click. CMI’s reported sales were fell 25% in fiscal year 2009, and its earnings dropped over 40%, reflecting the high operating leverage in CMI’s business model (i.e. fewer engines to spread its fixed manufacturing costs over).
High quality companies are able to generate cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio. As seen below, CMI has generated healthy free cash flow each of the past 10 years:
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well. For cyclical companies like CMI, the balance sheet can make or break a business if it overextended itself at the peak of its markets.
As seen below, CMI’s long-term debt to capital ratio has remained very conservative over the past decade. Given the cyclical nature of CMI’s industry, we have no problem with this.
Looking more closely at CMI’s balance sheet, we can see that the company is in a very healthy position. CMI has more cash on hand ($1.8 billion) than debt ($1.6 billion), and its free cash flow generation ($1.5 billion last year) provides plenty of capital allocation flexibility. We would not be surprised if the company announced a substantial share repurchase plan at its upcoming Investor Day in November.
Altogether, CMI’s dividend is very safe regardless of how its cyclical markets turn in the coming quarters. The company’s sub-45% payout ratios provide a nice cushion, the balance sheet is very flexible, the industry has high barriers to entry, and CMI’s markets will grow over the long-term.
Dividend Growth Score
Our 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.
CMI’s Growth Score is 88, meaning its dividend’s growth potential ranks higher than 88% of all other dividend stocks we monitor.
In August, CMI hiked its quarterly dividend by 25% and has now raised its dividend by 457% since the beginning 2010. As seen below, CMI’s total dividends paid have increased at more than 20% per year over every time period from 2005 to 2014. While CMI is not a dividend aristocrat, it has maintained or grown its dividend for the last 25+ years despite the cyclical nature of its markets. With safe payout ratios, a very healthy balance sheet, and large markets to continue penetrating, we believe CMI can grow its dividend at a double-digit annual clip for a long time to come.
CMI trades at less than 11x 2015 estimate earnings, possibly reflecting the market’s expectations for earnings estimates to fall as the North American truck market slows, international markets soften further, and foreign exchange headwinds intensify. During the financial crisis, CMI traded down to around $20 per share in late February 2009 before sharply rebounding to $110 by the end of 2010. At its lowest point, CMI traded around 10x its actual 2009 GAAP diluted earnings per share, which plunged 44% from the prior year (including a material restructuring charge).
If we cut 2016 estimate earnings by 40%, CMI would earn about $6.50 per share next year. If the stock plunges again to 10x trough earnings, it would trade in the mid $60s and offer an incredibly high (and safe) dividend yield of more than 6%, assuming no incremental raises. We think CMI’s earnings would likely decline much less than the 45% drop witnessed in 2009 because its mix of less cyclical distribution revenue is twice what it was in 2007, and the company’s exposure to highly cyclical power generation and industrial engine markets is much lower.
Regardless, if the truck cycle rolls over and other markets continue declining, we would be surprised if CMI lost more than 40% of its current value. While that is no small paper loss, it is an extremely pessimistic and unlikely scenario, in our opinion. We view the chances of recessionary conditions spreading across all of CMI’s markets simultaneously as very low, and we expect the company’s markets to all be larger in five years than they are today. We believe it is more likely that CMI generates $15+ in earnings per share within five years. If CMI trades at just 13x earnings, it would push the stock close to $200, representing nearly 100% upside and presenting a favorable valuation skew for long-term investors.
The stock’s dividend yield is 3.6%, good for a Yield Score of 65. This means that CMI’s dividend yield is higher than 65% of all other dividend-paying stocks, making it one of the more attractive dividend growth stocks. With safe payout ratios, net cash on the balance sheet, and consistent free cash flow generation, we believe the stock trades at a reasonable price for long-term dividend growth investors despite fears of a pullback in North American truck markets and China.
CMI is a cyclical dividend growth stock. Investors are worried about its markets rolling over, particularly in China and the truck market in North America. This is creating opportunity for long-term focused investors to begin building a position in the stock today, maintaining an awareness that the cyclical nature of CMI could cause it to fall further and offer even better buying opportunities. Timing market cycles is impossible, but the stock’s price appears to offer an attractive payoff ratio, CMI’s markets will continue growing over long-term periods, and we believe CMI’s competitive advantages will remain intact, ensuring it captures a meaningful part of that growth.[/mepr-rule]
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