CUMMINS INC. Recommendation HOLD. Ticker: CMI Sector: Consumer Goods Industry: Trucks & Other Vehicles

Transcription

1 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) $1.25 P/E (ttm) PEG 0.80 Div Yield 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 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 $ 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.

2 Company Profile 1 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 Net Sales by Country Other; 27% Mexico; 2% Canada; 3% United Kingdom; 4% India; 5% Brazil; 5% China; 6% United States; 48% 1 Cummins K Report

3 Operating Segments 2 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 K Report

4 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.

5 Research and Development 3 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 K Report

6 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 Sub-Industry Outlook 4 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 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 Financial Performance 7 On July 30, 2010 Cummins announced its second quarter results for 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 Cummins K Report 7 Cummins 2 nd Quarter Q Report

7 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

8 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

9 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 Growth 1011 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 K Report 12 named to dow jones sustainabilityindexes again for ?reflink=MW_news_stmp

10 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 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 13 nuid=4&langid=1033&

11 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 Growth 1516 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 The company experienced a high influx of demand due to the 2010 EPA emission standards taking effect in January This high level of demand was quickly met with decreased sales in the first quarter of 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 exiting highway truck enginesnavistar pact set 15 Morningstar 16 Cummins K Report

12 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% (10.59% %) = 16.14% Utilizing the CAPM formula above, a discount rate of 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 percent is the average growth rate of the S&P 500 index since 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 CO html

13 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 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 $70.95 $74.81 $79.23 $84.31 $ $74.30 $78.64 $83.64 $89.45 $ $78.07 $82.98 $88.69 $95.41 $ $82.34 $87.95 $94.55 $ $ $87.22 $93.71 $ $ $ Morningstar inflation rates/

14 Appendix A Valuation Calculations

15 Appendix B Cummins Consolidated Financial Statements Cummins K Report

16

17