Cummins Stock: Transforming Its Engines (NYSE:CMI)

Cummins (NYSE:CMI) is best known for its broad range of engines, and given the industry in which it operates, decarbonization is a huge challenge. However, there is opportunity at the same time as well, as there are still many years of transformation in the works to come.

The Business

Cummins is a global engine, engine components, distribution and power systems manufacturer, one with an impeccable track record. The company generated some $24 billion in sales in 2021, a number which roughly quadrupled from $6 billion and change in the year 2000, as the business still derives just over half of sales from its North American activities. Added scale resulted in better margins as well over time with EBITDA margins posted in their mid-teens.

So while this certainly still is a cyclical business, now facing the secular challenge of decarbonization, there is a consistent long term growth component to this business as well, driven by operational excellence and solid capital allocation skills. The broad range of expertise, in diesel, natural gas, propane, hydrogen, fuel cells and battery systems makes that there is always a tailor made solution around the corner, with the pace of new technology adoption driven by regulation, economics and infrastructure, among others.

This comes at a cost however, The new engines are allocated under the “new power” business as a segment which is hardly contributing revenues (let alone profits) while the core business is held back in its growth path of course.

The Base

To see where we come from we go back to 2019, a year in which Cummins generated $23.6 billion in revenues on which operating profits of $2.7 billion were reported as net earnings of nearly $2.3 billion worked down to earnings of roughly $14.50 per share. The company saw 2020 revenues fall to $19.8 billion, for obvious reasons, but limited the fall in operating earnings to $2.3 billion. Net earnings of $1.8 billion translated into earnings of roughly $12 per share that year. The company did issue a comforting outlook for 2021, seeing sales up 10% at the midpoint of the range, marking a solid recovery albeit below 2019 sales levels.

With shares trading at $180 ahead of the pandemic, valuations were non-demanding with earnings close to $15 per share, as the resulting 12-13 times earnings multiple was not that high. Shares recovered in a spectacular fashion early in 2021 as they hit a high of $275 in the spring, only to set to $200 in spring of this year, now trading at $220 per share.

Fast forwarding to February of this year, Cummins has seen a very strong 2021, a year in which revenues rose 21% to $24.0 billion, with revenue growth coming in at twice the projected growth rate at the start of the year. That was strong as earnings growth closely matched sales growth with operating earnings reported at $2.7 billion. Even as net earnings rose to $2.1 billion, below the 2019 mark, earnings per share hit a new high at $14.61 per share, on the back of share buybacks.

Net debt stood at just a billion by the end of 2021, that is based on the cash holdings and financial debt. This net debt load increases to $1.6 billion if pension liabilities are included, yet if we include $1.5 billion in investments and equity method investees, the net debt load is close to zero. With shares trading in the low $200s at the start of the year, valuations remain quite modest at 13-14 times earnings, as investors fear that these are earnings at a strong point in the cycle, while fearing the cyclicality and need to transform the business. Nonetheless, the company guided for 2022 sales to rise another 6%, and that is after a very strong 2021 already.

2022 – Active So Far

With the year only halfway over, 2022 has been quite an active year so far for Cummins and its shareholders. In February, Cummins announced the acquisition of Jacobs Vehicle Systems, a subsidiary of Altra Industrial Motion, a supplier of engine braking, cylinder deactivation and start and stop thermal management technologies. The deal involves the transfer of 600 employees, as no financial details on the revenue contribution, nor purchase price have been announced.

Just thereafter, Cummins announced a massive $3.7 billion deal for Meritor (MTOR) in a deal valued at $36.50 per share. This is a much larger deal as Cummins will further grow expertise in drivetrain and electrical powertrain solutions. The deal is really driven by the need to accelerate the transformation of the business into electronics, as Cummins furthermore sees $130 million in synergies by year three following closing of the deal.

This deal will jack up leverage quite a bit, yet in April Cummins announced a move which likely brings some liquidity down the road. This comes as the company has filed a registration statement to float its Filtration business later this year, as the question is when the IPO will happen, and what valuation will be attached to the segment. Note that his segment is part of the component business, generating some $1.5 billion a year, or about 6% of company-wide revenues.

In May, Cummins posted first quarter results which look solid with revenues up 5% to $6.4 billion, yet operating earnings were down a quarter amidst tighter expenses and continued investments into R&D and the transformation of the business. The quarterly earnings number of $2.92 per share furthermore took a beating following a write-down on the Russian operations, as otherwise earnings came in around $4 per share.

The company now see full year sales up around 8% to roughly $28 billion as EBITDA margins around 15% translates into an EBITDA number of some $4.2 billion. This reveals that a flattish net debt load will jump following the Meritor deal, but still comes in around just 1 times EBITDA. That was quite an important deal, valued at just over 10% of the enterprise value of Cummins, yet becoming instrumental to accelerate the transformation into electrical and decarbonization of the product line.

What Now?

With the company maintaining the full year sales guidance in the second quarter earnings report, earnings trend around $15 per share and trading at $220 per share, the multiple looks reasonable at 15 times earnings. Of course this is ahead of the Meritor deal which will bring real expertise and only increase leverage to about 1 times EBITDA.

So while the resulting deal impact seems reasonable and the balance sheet is still in a solid pace, it is Cummins who is actually investing large sums into the transformation with deal making, while incurring some “organic” losses as well.

After all, the New Power business generated just $42 million in second quarter revenues, yet it posted an EBITDA loss of $80 million, hence realistic losses around $100 million per quarter. With 142 million shares outstanding, that loss of that segment is actually equal to $3 per share on a pre-tax basis, quite a big number, but very necessary at the same time as well.

So without the transformation efforts, which are badly needed, Cummins is even far more profitable, posting earnings close to $18 per share. As the moves are the right moves, and still the losses of the transformation results in quite a solid earnings multiple, I like the set-up, making it a right addition to any portfolio.