Cummins (CMI) reported a double-digit sales decline during the second quarter of 2016 and expects full-year revenue to slump about 10%.
Lower truck production in North America and dismal global demand for off-highway vehicles and power generation equipment are weighing on the company.
As the company’s key end markets continue reeling, investors are beginning to wonder how safe Cummins’ dividend payment is.
After all, cyclical industrial businesses are not often the best place to find safe dividends.
Before analyzing Cummins’ dividend, let’s quickly review the business itself. My full thesis on the company can be seen here.
Cummins has been in business for nearly 100 years and recorded total sales of $19.1 billion in 2015. The company manufactures and services diesel and natural gas engines (35% of revenue), electric power generation systems (16%), and engine-related components (22% – e.g. fuel systems, controls, filtration, emission solutions).
Cummins also owns distributors (27%) that provide aftermarket services and support to 7,200 dealer locations.
Some of the company’s representative customers are Chrysler, Daimler, Volvo, Navistar, Komatsu, and Ford.
By geography, North America accounts for 60% of revenue. Europe & the Middle East (14%), Asia Pacific (8%), and China (7%) are also important regions.
Cummins has proven to be a durable business with leading market share positions over the years for several reasons.
The company invests heavily in research and development to ensure its engines comply with extensive regulatory requirements for emission and noise.
In addition to its technology edge, Cummins maintains long-term engine supply agreements with key customers to ensure stable pricing and well-engineered vehicles. New entrants would struggle to crack these sticky relationships.
Customers like Cummins for its technology quality and reliability. The company’s global distribution network has a presence in more than 190 countries, ensuring that appropriate support is in place to service customers’ engines and maximize uptime. Smaller players cannot offer such a comprehensive support network.
Let’s take a closer look at the dividend to see if Cummins can continue making payments despite the downturn in many of its markets.
Cummins’ Dividend Safety
My goal is to never be found holding a company that cuts its dividend. While this is perhaps a lofty objective, I believe that a number of warning signs are given off before a company actually reduces its dividend.
The most likely companies to cut their dividends usually have some combination of high payout ratios, weak free cash flow generation, declining sales and earnings, overleveraged balance sheets, and no proven commitment to paying and growing dividends over time.
Tracking these key metrics is time-consuming, which is why I created a Dividend Safety Score to help me keep tabs on all of these factors for companies I am interested in.
Our Dividend Safety Score analyzes 25+ years of dividend data and 10+ years of fundamental data to answer the question, “Is the current dividend payment safe?”
We look at factors such as current and historical EPS and free cash flow payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more. Cummins’ most important dividend and fundamental data can be seen by clicking here.
A Dividend Safety Score of 50 is average, 75 or higher is considered excellent, and 25 or lower is considered weak.
Most companies that end up cutting their dividends score below 25 prior to announcing their dividend reduction.
Kinder Morgan, Potash, BHP Billiton, and ConocoPhillips all scored below 20 for Dividend Safety before announcing their dividend cuts.
Investors in Cummins can find some relief in knowing that the company has a strong Dividend Safety Score of 82.
Cummins’ payout ratios over the last 12 months remain very healthy, even for a cyclical business. The company’s earnings per share and free cash flow per share payout ratios sit at 53% and 44%, respectively.
Even if Cummins’ free cash flow was cut in half from here, it would still cover the dividend.
Looking further back, we can see that Cummins has historically maintained a relatively low and stable payout ratio, highlighting the company’s consistent earnings generation and conservative capital allocation.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
Of course, Cummins’ business is sensitive to the economy, which is generally not good for dividend safety. The company’s sales fell 25% in fiscal year 2009, and CMI’s stock plunged nearly 60% in 2008, underperforming the S&P 500 by 20%.
The company’s performance during the next recession will likely be a little stronger. Cummins has been acquiring its distributors over the last few years, improving its mix of aftermarket parts and services. Distributors now account for close to 30% of total revenue and should see steadier demand trends throughout a full business cycle.
Source: Simply Safe Dividends
Despite the steep drop in revenue during the last recession, Cummins’ strong cost controls and working capital management preserved free cash flow, which is used to pay out dividends.
As seen below, free cash flow per share edged down just 4% in 2008 and actually increased 76% in 2009 to $4.23 per share, which more than covers the company’s current dividend of $4.10 per share.
Cummins has been an extremely reliable free cash flow generator for more than a decade, strengthening the safety profile of its dividend.
Source: Simply Safe Dividends
Dividend safety can be severely impacted by a company’s balance sheet, especially for cyclical companies such as Cummins.
Dividend payments can be jeopardized if an unexpected downturn in demand hits and a company has too much debt relative to its depressed cash flows. Businesses will always make their debt payments before issuing dividends.
Cummins’ balance sheet is in great shape. The company has $1.28 billion in cash compared to $1.65 billion in total book debt.
No major long-term debt is due until 2023, which gives the company plenty of flexibility to continue reinvesting in its business and returning cash to shareholders even if macro conditions remain soft.
With a long-term debt to capital ratio below 20% and strong credit ratings, Cummins should have easy access to credit markets as well if it ever desired to borrow more money.
Source: Simply Safe Dividends
As a sign of financial strength, Cummins increased its dividend in July by 5.1% despite weak quarterly results.
Management is very committed to the dividend. Cummins has paid uninterrupted dividends since 1993 and increased its dividend every year since 2006.
Shareholders have enjoyed a rising yield on cost and strong double-digit dividend growth rates over the last 20 years, making Cummins one of the fastest income growers in the market.
Source: Simply Safe Dividends
Incremental dividend growth will remain more modest until macro headwinds have subsided, but income investors can sleep well knowing that Cummins’ dividend payments are very safe.
Closing Thoughts on Cummins’ Dividend
Cyclical companies should always be approached with an extra level of caution. While some of their dividend payments are safe, their stock prices can be whipped around with little notice as end market conditions and market sentiment rapidly change.
Despite its higher stock price volatility, Cummins is well positioned to continue paying its dividend even if market conditions worsen.
The company maintains reasonable payout ratios, generates excellent free cash flow, is increasing its mix of stable aftermarket business, has a healthy balance sheet, and has demonstrated its commitment to the dividend for nearly 25 years.
For conservative income investors able to stomach the ups and downs of Cummins’ end markets, the stock’s 3.2% yield could be appealing.
Some of the companies I will be analyzing for dividend safety next include General Motors, Big Oil (Exxon, Chevron, BP, Shell, Total), Compass Minerals, and Southern.
If there are any other stocks that would be interesting to review for Dividend Safety, leave a comment below with the ticker.
You analyzed FLO earlier this year. It has dropped in price precipitiously this past week apparently as a result of a probe in to how workers are classified and somewhat weaker than expected earnings. The safety and growth ratings are still very strong. Is this an opportunity to buy a solid company now yielding over 4%?
Hi Gonzaga1,
Please see my response to Bill below.
Thanks,
Brian
Will Googl ever pay a dividen?
Hi Rick,
I doubt GOOGL will start paying dividends anytime soon. There are so many different growth areas the company is investing in. Until its business really matures (if it ever does), I would be surprised if a dividend was initialized.
Brian
I bought FLO on the price drop so I’d also be interested in your thoughts
Hi Bill & Gonzaga1,
Here is the response I recently sent to another member who asked about FLO:
In my view, FLO’s weakness today is not being driven by its Dividend Safety but instead by increased concerns over how the company is treating its delivery drivers (as independent contracts rather than employees). The U.S. Department of labor announced on Tuesday that it would be conducting a compliance review of FLO’s business (see the Wall Street Journal article here). This is why the market is selling off FLO today.
Here’s why I think the dividend is still safe. First, Flowers business continues generating excellent cash flow and has very reasonable payout ratios for how stable its business is (people are still eating bread and baked goods).
Year-to-date, Flowers has generated $55.3 million in free cash flow compared to $33.4 million in dividend payments, representing a healthy 60% Free Cash Flow payout ratio. Based on management’s revised 2016 guidance, FLO expects full-year adjusted earnings per share to be about $0.92 compared to its annual dividend payments of $0.64 per share (70% EPS payout ratio). The company’s dividend is easily covered by underlying earnings and cash flow, and fundamentals are not deteriorating.
While FLO doesn’t maintain much cash on its balance sheet, the company is in a great position to borrow money if the Dep’t of Labor hits the company with a fine. FLO has over $500 million available it could borrow from its credit facility if it is ultimately forced to pay its delivery drivers a sizable fee. However, this is still a largely unknown event with, in my view, a less than 50/50 chance of ever materializing. The market just doesn’t like the additional uncertainty caused by the Dep’t of Labor’s new investigation. This is a tough judgment call because it’s really hard to know the probability of the Dep’t of Labor ruling against FLO and the magnitude of payments the company would have to make.
Management is also very conservative and knows that many retirees depend on FLO for dividend income. Cutting the dividend would be the last thing they would ever want to do. Unless there is an unprecedented labor fee FLO is forced to pay its drivers (e.g. $500+ million), it’s hard for me to imagine a scenario where the dividend is jeopardized.
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Here is what I noted in the “Risks” section from my thesis in March 2016 about the labor risk:
“Another risk facing Flowers is the 18 lawsuits that have cropped up in recent years challenging the company’s classification of its distributors as independent contractors rather than employees. Many food companies including Flowers’ main competitors and companies in other industries use independent distributor business models, so this isn’t a risk that is unique to the company.
Classifying its independent distributors as contractors rather than employees saves these companies from having to pay overtime wages, Social Security and Medicare taxes, and unemployment.
In the company’s 10-K, Flowers states that, “Given the stage of the complaints and the claims and issues presented, the company cannot reasonably estimate at this time the possible loss or range of loss, if any, that may arise from the unresolved lawsuits.”
The company has classified its distributors as independent contractors since the 1980s and could face substantial changes to retroactively compensate these workers as employees, as well as major costs to buy back distribution routes and trucks from its contractors (independent distributors own the distribution rights in a specific geographic market). However, the notes receivables that Flowers took to finance the independent distributor’s purchase of the route and truck from Flowers would substantially offset the cost of buying back the routes and trucks.
Lawsuits notoriously take a long time to be resolved, but it’s hard to know how things could play out. In 2015, FedEx was forced to pay $228 million to its 2,300 delivery drivers working in California as they were deemed to be improperly labeled as independent contractors from 2000 to 2007. The case took 10 years to resolve but turned out to be very costly.
At the end of the day, we view the lawsuits to be a low probability, medium severity type of event that will likely offer little clarity for a number of years. While it’s easy for contractors to join class action lawsuits against the company (little effort is required but there could be a financial reward), that does not increase the legitimacy of the cases against Flowers. It’s also worth repeating that virtually every major play in the industry faces the same independent contractor classification issues, not just Flowers.
We are willing to give management the benefit of the doubt and believe that the company also has plenty of financial firepower to make it through any potentially adverse rulings, however unlikely they might be.”
Thanks for the Cummins review. Reassuring to know you are still comfortable with it.
Thanks for the great review SSD! Have looked at CMI, ETN, etc. in my hunt for a new company during the boom. They hit all the metrics of our stock screener, which is what brought them on our radar in the first place. But this is a great analysis that is going to provide us some key information as we dissect them further. FLO is also on the radar and it seems you have addressed their dividend safety in other comments. I’ll be honest, I was a little worried about what your conclusion was going to be at the beginning of the article; however, I’m glad the ultimate result was that you feel CMI’s dividend is safe based on all things considered. I’m keeping my eye out for a dip here and will pounce when needed.
Take care!
Bert
Hi Bert! Thanks for reading, and I’m glad you enjoyed my review. I’ve held CMI for just over a year now and have pretty much broken even on the investment so far. It can be hard to hold these cyclical companies through the ups and downs (CMI has traded between $84 and $137 per share since I’ve participated), but at least CMI’s dividend safety continues to look good.
Enjoy the rest of your weekend,
Brian
Thanks for the excellent analysis on Cummins. I like the company a lot and sure their dividend is safe.
The scary thing is its 3 dollars off it’s 52 week high. It was trading in January at $86 and today it is at $127.
Like you mention above, CMI has a very high beta of 1.5 and if the market unwinds a bit you could see a big opportunity in this name.
This is added to my watch list.
Thanks for writing this Brian.
Cheers Steve.
Any recent or up-coming reviews on defense contractors…LMT, RTN, etc.?
Hi Danny,
Both LMT and RTN score 99’s for Dividend Safety, indicating that they have some of the safest dividend payments in the market. You can learn more about our Dividend Safety Scores and view their real-time track record here: http://www.simplysafedividends.com/dividend-safety-scores/
Thanks,
Brian