Ticker: CMI
Sector: Consumer Goods
Industry: Trucks & Other Vehicles
Recommendation:
HOLD
Pricing
Closing Price $83.32 (9/15/10)
52-wk High $84.93 (9/13/10)
52-wk Low $41.51 (10/02/09)
Market Data
Market Cap $16.90B
Total Assets $8.77B
Trading Vol. 3.40M
Valuation
EPS (ttm)
P/E (ttm)
PEG
Div Yield
$1.25
22.20
0.80
1.24%
Profitability & Effectiveness (ttm)
ROA
8.77%
ROE
20.95%
Profit Margin 6.54%
Oper Margin 10.14%
Gross Margin 22.60%
Nicholas Schaefer
nasvx8@mail.missouri.edu
CUMMINS INC.
Recommendation
HOLD
Cummins is an industry leader in the design, manufacture, and
sale of diesel and natural gas engines in the United States and
worldwide. Although the recent economic downturn reduced
sales in North America and Europe, Cummins’ position in
emerging markets, such as China and India, has sustained
revenues across all four of its business segments. These
markets are expected to continue to sustain the firm in the
short-term, and propel growth in the long-term. Further,
Cummins’ excellent financial position, specifically their high
level of liquidity, has the company well positioned as the U.S.
economy begins to recover. Finally, Cummins is firmly
established as the industry leader in environmental
compliance, and therefore poised to continue its technological
development and capture increased global demand for
emissions control capability.
The fund currently holds 300 shares of Cummins, totaling
approximately 2.5 percent of the total portfolio. It is my
recommendation that the fund hold its position in Cummins,
as I feel that the security is slightly undervalued at its current
market price of $83.32 per share with a calculated intrinsic
value of $88.69. However, the fund might consider selling at
a later point due to the low margin of safety and the fact that
the relatively small difference between the estimated intrinsic
value and market value leaves little room for future
appreciation in price.
Company Profile1
Cummins Inc., founded in 1919 and headquartered in Columbus, Indiana, is a global leader in
designing, manufacturing, distributing, and servicing diesel and natural gas engines, electric
power generation systems, and engine-related component products. Component products include
filtration equipment, exhaust after-treatment technology, fuel systems, controls and air-handling
systems. Cummins serves customers through a network of more than 500 company-owned and
independent distribution locations and approximately 5,200 dealers in over 190 countries.
Cummins has four operational segments: Engine, Power Generation, Components, and
Distribution. These segments share technology, customers, strategic partners, branding, and the
Cummins distribution network to gain a competitive advantage in their respective markets.
Cummins uses its global exposure and networks to capture growth in international markets,
especially in emerging economies, such as China, India, and Brazil. More than half of the
company’s 2009 sales originated outside of the United States. Having a presence in emerging
markets stabilized growth for Cummins during the economic downturn in North America and
Europe.
Cummins also seeks to capitalize on shifts in environmental policy in the United States and
around the world. In 2009, Cummins completed work on their off-highway truck engines and
components in time to meet new 2010 EPA emission standards in North America. The company
expects their technical leadership in the design and manufacture of the key engine subsystems
necessary to meet global emissions standards to continue in the future. The firm is committed to
the research and development of future technologies that will help meet global demand for
components used to reduce carbon emissions.
2009
Net
Sales
by
Country
Other;
27%
United
States;
48%
Mexico;
2%
Canada;
3%
United
Kingdom;
4%
India;
5%
Brazil;
5%
1
Cummins
2009
10K
Report
China;
6%
Operating Segments2
Cummins has organized its operations into the following operating segments:
Engine Segment
The Cummins Engine segment manufactures and markets a broad range of diesel and natural gas
powered engines under the Cummins brand name, as well as other customer brand names.
Cummins’ engines are built for markets that include: heavy and medium-duty truck, bus,
recreational vehicle, light-duty automotive, agricultural, construction, mining, marine, oil and
gas, rail, and governmental equipment. The company offers engines with a displacement range of
1.4 to 91 liters and horsepower ranging from 31 to 3,500. Cummins also offers new parts and
service, as well as remanufactured parts and engines through their distribution network. In 2009,
the Engine segment accounted for 49 percent of total revenue.
Cummins’ principal customers of their heavy and medium-duty truck engines include truck
manufactures such as PACCAR, Volvo Trucks North America, Daimler Trucks North America,
Ford, and Volkswagen AG. The company’s industrial engines serve customers such as Case New
Holland, Komatsu, Hyundai, Hitachi, Ingersoll Rand, Brunswick, and Terex. The main light-duty
on-highway engine customers are Chrysler and RV manufacturers.
Power Generation Segment
Cummins’ Power Generation segment designs and manufactures most of the components that
make up power generation systems, including engines, controls, alternators, transfer switches,
and switchgear. This segment continues to be a global provider of generation systems,
components and services. The Power Generation segment consists of five business units that
include: commercial products, alternators, commercial projects, power electronics and consumer.
In 2009, the Power Generation segment accounted for 19 percent of total revenue.
This segment is continuously exploring emerging technologies including fuel cells, wind and
hybrid solutions. Cummins utilizes both internal innovation through R&D, and external
2
Cummins
2009
10K
Report
partnerships to develop cost-effective and environmentally friendly power solutions. The Power
Generation segment is quite diverse with international consumer groups in India, the Middle
East, Western Europe and East Asia.
Component Segment
The Component segment supplies products that complement the Cummins engine segment.
Products include filtration products, turbochargers, after-treatment systems, intake and exhaust
systems, and fuel systems. These products are manufactured for on and off-highway heavy-duty
and mid-range equipment, as well as industrial and passenger car applications. In 2009, the
Component segment accounted for 18 percent of total revenue.
The Component segment is organized into four main business units:
•
Filtration – offers over 14,000 products, including air, lube, fuel, hydraulic, coolant,
diesel exhaust fluid, and fuel additives. Products are sold through Cummins Distribution,
original equipment manufacturers (OEMs), and other dealers. The products are produced
and sold across 160 countries at over 30,000 distribution points
•
Turbo Technologies – designs, manufactures and markets turbochargers for light-duty,
mid-range, heavy-duty and high horsepower diesel applications. This business unit
primarily serves markets in North America, Europe and Asia.
•
Emission Solutions – designs and manufactures after-treatment and exhaust systems to
help Cummins’ customers meet increasingly stringent emissions standards. This business
unit has expanded its international manufacturing capabilities with new facilities (leases
signed in 2007) located in Beijing, China and Sao Paulo, Brazil. These facilities are in
part designed to help Cummins engines meet the new Euro IV and Euro V emissions
standards, with production beginning in 2011 and 2012, respectively.
•
Fuel Systems – designs and manufactures new and replacement fuel systems primarily
for heavy-duty on-highway diesel engine applications. Scania and Komatsu are the
primary external customers for this business unit.
Distribution Segment
The Distribution segment consists of 19 company-owned and 18 joint venture distributors that
service and distribute the full range of Cummins products and services to end-users. These
distributors are located in key markets including India, China, Japan, Australia, Europe, the
Middle East, South Africa, Brazil, North America, and Russia. Full-service solutions include
maintenance contracts, engineering services and integrated products, all with the capability to
cater to specific client needs. In 2009, the Distribution segment accounted for 14 percent of total
revenue.
Research and Development3
Cummins’ research and development program is focused on product improvement, innovation,
and cost reduction for customers. Research and development expenses, net of contract
reimbursements, were $362 million in 2009, $422 million in 2008 and $318 million in
3
Cummins
2009
10K
Report
2007. A substantial proportion of R&D has been directed at supporting compliance with 2010
EPA emissions standards: 42 percent ($151 million) in 2009, and 27 percent ($116 million) in
2008.
Sub-Industry Outlook4
Following a weak 2009, Standard & Poor’s raised its 2010 outlook for the Construction
& Farm Machinery & Heavy Trucks sub-industry to positive from neutral.5 Analysts see signs
of an improving global economy solidifying sales within the sub-industry. Part of the demand
for construction equipment is tied to residential construction and new home starts. This area has
seen weak domestic growth in 2010, but a robust global demand for new infrastructure has
helped sustain growth. The global slowdown also led to a major reduction in demand for heavy
trucks. The American Trucking Associations Index showed an 8.3 percent drop in goods
shipped by truck in 2009, the largest decline since 1982.6 However, industry experts see the
combination of a U.S. economic recovery as well as an aging truck fleet as signs that truck
purchases could pick up in the latter part of 2010 and into 2011.
Financial Performance7
On July 30, 2010 Cummins announced its second quarter results for 2010. The company
significantly improved performance quarter-over-quarter and year-over-year in a number of
metrics. Revenue in the second quarter totaled $3.208 billion, up 29 percent from the preceding
quarter while net income rose to $246 million from $149 million. The following table and chart
highlight Cummins’ quarterly financial trends.
4
Morningstar
5
http://www.spoutlookonline.com
6
Cummins
2009
10K
Report
7
Cummins
2nd
Quarter
2010
10Q
Report
Cummins Quarterly Financial Results
Due to the uniqueness of each firm’s operations, a direct comparison between competitors in this
industry is somewhat difficult. With a market capitalization of $16.9 billion, Cummins is
relatively large and has price/earnings, price/book, and price/sales ratios near the industry
average but far above its nearest competition. In addition, its margins and return on equity are
significantly higher than all comparison groups, with the exception of Oshkosh. Oshkosh’s high
debt/equity has allowed it to maintain a higher return on equity. Cummins’ extraordinarily low
debt ratio stands out among its peers and is below 10 percent of the industry average.
Competitor and Industry Comparison
Financial Ratio Comparison
CMI = Cummins, Inc.
VOLVY = Volvo Corporation
NAV = Navistar International Corporation
OSK = Oshkosh Corporation
Stock Performance
Over the last year, Cummins stock has realized substantial gains. This security outperformed
industry competitors, Volvo, Navistar, and Oshkosh in the preceding 5 months. Leading into this
period, its performance was middling when compared to its peers. Cummins stock performed
similarly when compared to the S&P 500 and the commercial vehicle and truck industry index.8
TTM Stock Performance (CMI vs VOLVY, NAV & OSK)
TTM Stock Performance (CMI vs S&P500 & Construction/Farm Equipment Index)
8
Bigcharts.com
Professional analysts are generally moderately positive regarding Cummins’ future prospects,
placing, on average, an outperform recommendation on the stock. Competitors NAV, and OSK
have, on average, buy, and hold recommendations, respectively. Morningstar classifies
Cummins as a large-growth style stock.9
Morningstar Compiled Analyst Opinions
Morningstar Classification - Cummins
Positive Forces For Growth1011
Environmental Compliance Capabilities
Cummins operates within a highly regulated industry and has invested significantly in new
products and technologies designed to lower exhaust emissions. As an illustration of their
commitment to sustainability, Cummins was named to the Dow Jones World Sustainability
Index for the sixth consecutive year. This index represents the top 10 percent of the world’s
largest 2,500 companies in economic, environmental and social leadership.12
Cummins’ engine products are subject to extensive regulatory requirements that directly or
indirectly impose standards governing emissions and noise. All of Cummins’ current products
comply with standards set by the Environmental Protection Agency (EPA) and other state and
international regulatory agencies. Cummins’ ability to comply with these and future emission
standards is an essential component in maintaining market share in regulated markets.
9
Morningstar
10
Morningstar
11
Cummins
2009
10K
Report
12
http://www.marketwatch.com/story/cummins‐named‐to‐dow‐jones‐sustainability‐
indexes‐again‐for‐2010‐2010‐09‐10?reflink=MW_news_stmp
On January 1, 2010, the current United States on-highway emissions standards came into effect.
Fourth quarter revenue in 2009 was positively affected by this immediate increased demand for
emissions compliant engines. Internationally, emissions standards in Europe, Japan, Mexico,
Australia, Brazil, India and China are becoming more stringent. Cummins believes that their
experience in meeting U.S. emissions standards will leave the company well positioned to take
advantage of these markets as demand for emissions control capability grows.13
Global Footprint/Business Partnerships
The Cummins business model is centered on capturing an increased global demand, especially
in emerging counties. Cummins has strengthened its position in India and China in particular,
where the company has operated since 1962 and 1975 respectively. Cummins employs over
10,000 people in India and over 7,000 people in China, both in Cummins-owned and joint
venture businesses. Sales in India and China in 2009 were $1.3 billion and $1.7 billion
respectively. Cummins forecasts 2010 sales to total $1.8 billion in India, and $2.6 billion in
China. Cummins’ global market share provides for a geographic balance, which has proven to
be extremely valuable during the economic downturn in North America and Europe.
A critical component of Cummins’ success is the company’s ability to effectively partner with
other strong companies in the marketplace. At the start of 2010, Cummins had 56 joint ventures
in 18 countries. Some of these partnerships include deals with Komatsu, Scania, Tata,
Dongfeng Motors, Foton Motors and Brunswick-Mercury Marine. Cummins also has an
ownership stake in 85 percent of their global distribution network, providing a steady profit
stream for the company.
Strong Company Liquidity
Despite the global economic downturn, Cummins maintains a solid financial position. Strong
fourth quarter sales allowed the company to finish 2009 with minimal debt and sizable cash and
securities balances. As of December 31, 2009, the company reported $930 million in cash and
equivalents and $190 million in marketable securities. Further, Cummins has $1.07 billion
available under their revolving credit facility and $154 million available under short-term
receivables. Cummins’ existing long-term debt does not require significant cash outflows in the
near term, with principal payments ranging from $17 to $67 million over the next five years.
The increased ability to remain liquid was driven by proper inventory management,
controls on capital and discretionary spending, and lower repurchases of common stock.
Cummins believes that their liquidity will provide for financial flexibility to fund working
capital, capital expenditures, dividend payments, or stock repurchases in the future. The
following table highlights Cummins’ financial position in 2009.
In-House Manufacturing
Cummins has a significant competitive advantage over its competition thanks to in-house
manufacturing of nearly all its engine components. This keeps the company cost structure low.
Morningstar estimates that Cummins has had a 10 percent cost advantage over rival Navistar
13http://www.cummins.com/cmi/content.jsp?dataId=3058&newsInfo=true&siteId=1&me
nuId=4&langId=1033&
NAV during the past three years. As the economy rebounds, this could prove to be a dramatic
cost advantage within the industry.
Caterpillar Exiting On-Highway Market
In 2009, Caterpillar announced their exit from the on-highway truck engine market to focus on
off-highway heavy-duty trucks. Although the on-highway market represented only six percent
of Caterpillar engine sales, the move positively affects Cummins and their position within the
market. The move is thought to be related to Caterpillar’s lack of commitment to meet 2010
EPA emissions standards. Caterpillar is a key competitor of Cummins in the on- highway
truck engine market, and their exit reiterates Cummins’ superior technological lead in
emissions standards and fuel economy. Since 1998, Cummins has steadily gained market share
in on-highway medium and heavy-duty truck engine production.14
Negative Forces For Growth1516
Fluctuations In Demand
During the global recession, Cummins experienced decreasing sales due to the volatility of
demand within the industry. Sales in 2009 totaled $10.8 billion, down from record levels in
2008 ($14.3 billion). The increased volatility in demand can be seen in Cummins’ fourth quarter
numbers in 2009. The company experienced a high influx of demand due to the 2010 EPA
emission standards taking effect in January 2010. This high level of demand was quickly met
with decreased sales in the first quarter of 2010. Sales in the first quarter of 2010 totaled $2.478
billion, down 27 percent from Q409 sales of $3.4 billion. The cyclical demand seen within the
market compounds the already weak U.S. economy.
Uncertain Economic Environment
Since the beginning of the 2008 recession, Cummins reduced its global workforce by 15 percent,
froze merit pay, instituted salary cuts for officers and directors, and reduced expenses in every
category across every part of the company. These actions have come in response to industrywide cutbacks by trucking, construction and other industries dependant upon heavy-duty
engines. The weak U.S. economy and housing market forced many large carriers to take
portions of their fleets out of service, and smaller carriers to shut down all together. Analysts
believe that the renewed use of these once off- duty fleets could delay the purchase of new
equipment.
Additionally, a number of companies in the global automotive industry continue to experience
financial difficulties. In North America, Ford Motor Company, General Motors Corporation,
and Chrysler Group, LLC all narrowly averted financial collapse. Despite a recent recovery, all
of these firms have experienced declining markets in the long-term. Automakers in Europe and
Japan have also experienced difficulties related to a weak global economy and tight credit
markets.
14
http://www.marketwatch.com/story/caterpillar‐exiting‐highway‐truck‐engines‐
navistar‐pact‐set
15
Morningstar
16
Cummins
2009
10K
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Because many of Cummins’ suppliers supply these and other automakers, the difficult auto
industry conditions have also adversely affected the Cummins supply base. Further disruption in
the auto industry could lead to the bankruptcy of vital suppliers, supply chain interruptions, or
commercial disputes. Chrysler is a key customer for the Cummins on-highway engine products.
According to Morningstar, Chrysler now accounts for only three percent of Cummins’ annual
revenue, down from 10 percent prior to bankruptcy. Chrysler’s financial stability should be
closely monitored in the future.
A number of economists now warn of the possibility of a “Double-Dip” recession, which would
further complicate Cummins’ position and negatively impact growth if such a downturn were to
materialize.17
Unionized Workforce
Unionized labor accounts for approximately 40 percent of Cummins’ workforce, which allows
trade unions to exert significant pressure on company management. While the firm has been
able to reduce labor costs during the recent recession, several union contracts are set to expire
over the next few years and previous cost-cutting efforts may leave these organizations less
willing to negotiate.
Backward Integration
Cummins has seen several of its major customers, including PACCAR and Navistar, make
successful attempts at backward integration. The continued slow growth of the global economy
may lead others to produce their own engines and components in-house in an attempt to control
supply chains and reduce costs.
Valuation
To approximate Cummins’ intrinsic value, the discounted cash flow model was used.
RNVS = 3.74% + 1.81 (10.59% - 3.74%) = 16.14%
Utilizing the CAPM formula above, a discount rate of 16.14 percent was calculated. The risk
free rate of 3.74 percent is the mean annual interest rate of US treasury bills going back to
1928,18 while the market return rate of 10.59 percent is the average growth rate of the S&P 500
index since 1871.19 While these numbers may fluctuate in the short-term, S&P 500 and Treasury
bill rates are currently depressed, these averages will likely be maintained in the long-run. The
Beta of 1.81 represents the average of estimates from Bloomberg, Reuters, Yahoo Finance, and
Google Finance.
Net income, depreciation, and amortization figures were gathered from the 2009 Cummins 10k
annual report. Average increase in working capital and average capital expenditures represent the
17
http://online.wsj.com/article/BT‐CO‐20100908‐716641.html
18
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
19
http://www.moneychimp.com/features/market_cagr.htm
mean of these figures for the previous 5 years listed in the 10k. These averages appear
representative, as there are no outliers within the data.
Both Morningstar and Yahoo Finance forecast a 12 percent growth rate for Cummins over the
next 5 years, which is in-line with the general analyst consensus.2021 These projections were
utilized in the initial five-year period, with the growth rate lowered by 1.6 percent in each
subsequent year until reaching a second stage growth rate of 3.42 percent, the historic mean rate
of inflation in the US.22 As a large firm, the growth rate of Cummins’ free cash flow should
eventually decrease to the rate of inflation as its potential for future growth is diminished due to
the maturation of developing markets.
The discounted cash flow Model reports an intrinsic value of $88.69 per share. The table below
summarizes
the
sensitivity
of
this
calculation
to
changes
in
the
discount
rate
and
estimated
first
and
second
stage
growth
rates.
At the end of the trading day, Wednesday, September 15,
2010, Cummins was priced at $83.32 per share. Based on this model, Cummins is slightly
undervalued at its current price.
Cummins Intrinsic Value Per Share – Sensitivity Analysis
Discount
Rate
Growth
Rates
-2
-1
0
+1
+2
+2
$70.95
$74.30
$78.07
$82.34
$87.22
+1
$74.81
$78.64
$82.98
$87.95
$93.71
0
$79.23
$83.64
$88.69
$94.55
$101.44
-1
$84.31
$89.45
$95.41
$102.42
$110.80
20
Morningstar
21
http://finance.yahoo.com/q/ae?s=CMI+Analyst+Estimates
22
http://www.usinflationcalculator.com/inflation/historical‐inflation‐rates/
-2
$90.23
$96.30
$103.43
$111.95
$122.36
Appendix A – Valuation Calculations
Appendix B – Cummins Consolidated Financial Statements23
23
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2009
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