1 100 120 140 160 180 200 Krause Fund Research Spring 2018 Industrials Recommendation: BUY Analysts Daniel Rosenberger [email protected]Charlie Lynch [email protected]Steve Diaz [email protected]Delun Pan [email protected]Company Overview Cummins Inc.(CMI) is a global equipment company that specializes in diesel and natural gas engines, engine-related component products, and electric power generation and has built a brand known for reliability and durability for the past 100 years. Cummins is operating in North America, Latin America, India, China, Africa, Middle East, and Asia Pacific. Cummins ended 2017 with $20.43 billion in revenues, an increase of 15.72% from 2016. In April of 2017, Cummins entered a joint venture with Eaton to build new transmission products that will further grow its already large component segment of the company. Stock Performance Highlights 52 week High 194.18 52 week Low 143.83 Beta Value 1.416 Average Daily Volume 1.71 M Share Highlights Market Capitalization 27.43B Shares Outstanding 167 b EPS (Q4 2017) $3.03 P/E Ratio 12.39 Dividend Yield 2.28% Dividend Payout Ratio 70.28% Company Performance Highlights ROA 8.48% ROE 18.77% Sales 20,428 b Financial Ratios Current Ratio 1.57 Debt to Equity 20.92% Cummins Inc. (NYSE. CMI) April 20, 2018 Current Price $160.64 Target Price $170.00-175.00 Cummins amps up its growth Increased infrastructure growth of 3.5% in the Middle East gives Cummins an opportunity to capitalize in these developing regions, specifically in power generation and heavy-duty engines. With aging truck fleets and an increase in freight demand in North America, demand for new highway trucks will increase between 220,000-250,000 trucks, or an increase of 15%-25% in 2018 with another 15% increase in 2019. As Cummins remains the global leader in turbo-technologies, we are expecting the new 50% joint venture with Eaton to develop state-of-the-are transmission technologies, increasing Cummins market share in component technologies starting in 2019. As the unemployment stays around its current state of 4.1%– 4.3%, an increase in labor costs are likely to occur, forcing market prices to increase and inflation to occur. As inflation occurs, GDP may decrease and Cummins will need to further rely on international sales to make up for possible losses in the U.S. Cummins’ has slashed supply chain risks by obtaining 80% dual-sourcing of all products, with a goal of 90% dual-sourcing in the next ten years. Systematically reducing costs and increasing order fulfillment rates. One Year Stock Performance (Yahoo finance)
Cummins Inc.(CMI) is a global equipment company that specializes in diesel and natural gas engines, engine-related component products, and electric power generation and has built a brand known for reliability and durability for the past 100 years. Cummins is operating in North America, Latin America, India, China, Africa, Middle East, and Asia Pacific. Cummins ended 2017 with $20.43 billion in revenues, an increase of 15.72% from 2016. In April of 2017, Cummins entered a joint venture with Eaton to build new transmission products that will further grow its already large component segment of the company.
Stock Performance Highlights52 week High 194.18 52 week Low 143.83 Beta Value 1.416 Average Daily Volume 1.71 M
Share Highlights Market Capitalization 27.43B Shares Outstanding 167 b EPS (Q4 2017) $3.03 P/E Ratio 12.39 Dividend Yield 2.28% Dividend Payout Ratio 70.28%
Company Performance Highlights ROA 8.48%ROE 18.77%Sales 20,428 b
Financial Ratios Current Ratio 1.57 Debt to Equity 20.92%
Cummins Inc. (NYSE. CMI)
April 20, 2018
Current Price $160.64 Target Price $170.00-175.00
Cummins amps up its growth
Increased infrastructure growth of 3.5% in the Middle Eastgives Cummins an opportunity to capitalize in these developingregions, specifically in power generation and heavy-duty engines.
With aging truck fleets and an increase in freight demand inNorth America, demand for new highway trucks will increasebetween 220,000-250,000 trucks, or an increase of 15%-25% in2018 with another 15% increase in 2019.
As Cummins remains the global leader in turbo-technologies,we are expecting the new 50% joint venture with Eaton to developstate-of-the-are transmission technologies, increasing Cumminsmarket share in component technologies starting in 2019.
As the unemployment stays around its current state of 4.1%–4.3%, an increase in labor costs are likely to occur, forcing marketprices to increase and inflation to occur. As inflation occurs, GDPmay decrease and Cummins will need to further rely oninternational sales to make up for possible losses in the U.S.
Cummins’ has slashed supply chain risks by obtaining 80%dual-sourcing of all products, with a goal of 90% dual-sourcing inthe next ten years. Systematically reducing costs and increasingorder fulfillment rates.
One Year Stock Performance (Yahoo finance)
2
We recommend a BUY rating for Cummins Inc. (CMI) to be considered by the Krause fund Portfolio. With large economic growth around the world and an increase of capital spending, Cummins has many opportunities to expand into new markets. Specifically the increase in infrastructure demand in North America, the Middle East, and South Asia. Leading the markets in turbo-technology and brand recognition of durability, we believe Cummins will increase revenues and hit a target price between $170-$175. We expect power generation and distribution to have relatively steady growth towards the future, while engine and components segments grow at a faster rate with new initiatives Cummins has been working on alongside Eaton Corp to develop new components such as Transmissions for heavy-duty and middle-duty engines. Through increased research and development and a strong backbone with influence in many countries around the world, and a strengthening economy, we anticipate continuing growth for Cummins Inc.
GDP (Strength in the Economy) GDP is used as a relatively strong indicator of the Industrial sector due to its sensitivity to the industry. With the large investments that we see in the sector, clients are more prone to purchase these goods while GDP is increasing. As the chart below reflects, the industrials sector has had a steady growth over the past three years, from about $487 in 2014 to $615 in 2018. The Lighter blue line represents the Industrial sector, while the dark blue represents the S&P 500. The extreme similarity between the S&P 500 and the Industrials sector proves a high correlation, and helps analysts determine, on a more specific time line, the adjustments that will be seen by the Industrial sectors.
S&P 500 Industrials Growth (3 yr.)
S&P Dow Jones Indices (11)
GDP Estimates within 6 Months With fourth quarter 2017 GDP beating estimates and coming in at 2.9% after ending 2016 at 1.8%. This GDP growth does not fully explain the high increase in the stock market as we saw from September into the beginning of January. Those increases were the market reacting to the new tax law that was introduced by the Trump administration. Within the first six months we are expecting to see an increase of GDP to 3.1% due to increased spending by companies taking advantage of new tax laws.
Trading Economics (14)
Global Real GDP We believe that the GDP will continue to grow and will reach a range of 3.3%‐3.7%. We are expecting the new tax bill to raise GDP with an increase in consumer spending and stronger business investments. We are also expecting manufacturers to benefit from stronger exports as the global economy continues to rise in the future. Global GDP – Real GDP Because a large part of Cummins revenues comes from overseas, roughly 46%, it is important that we recognize the Global GDP and factor this into our forecasts. Global real GDP is currently sitting at 3.7%, with a general consensus that this rate will not change drastically within the next year, staying consistent at 3.7%. Interest Rates Interest rates today are extremely important to the economy because of companies needing to borrow capital for their investments. Currently, the 10‐year Interest rate
Executive Summary
Economic Outlook
3
is sitting at 2.83% which is the rate most companies base their borrowing ability on. The fed recently increased the short term rates from 1.25%‐1.50% to a range of 1.5%‐1.75%, the first rate hike of three or possibly four that we will see this year. Infrastructure, capital expenditures, agriculture, and transportation sectors all rely on borrowing capital to finance various projects. If interest rates continue to grow, companies will not borrow as much capital to invest and we could quite possibly see a decrease in Industrial manufacturing, which in turn could lower GDP.
Historical 10‐yr Treasury Rates
U.S. Department of Treasury (15)
Exchange Rates Exchange rates in today’s market are extremely important due to the increasing globalization of companies, specifically the increase in Industrial companies around the world. A few interest rates we are going to be focusing on are the Japanese Yen, the Euro, and the U.S. Dollar. Currently, the Japanese yen is trading at $107.34 per US Dollar and the Euro is trading at $0.81 per US Dollar. Generally, when companies are generating revenues overseas, they will keep the revenue in the respective companies. However, when companies due end up bringing revenues back, companies run the risk of possible profit loss based on the current exchange rates of that particular country. In the case of Cummins, with locations in 190 different countries it is imperative that exchange rates are acknowledged and are taken into account when moving across country lines.
Tax Rates This year marks a big year in economic history with the new tax bill that was introduced by President Trump’s administration. This bill decreased companies tax rates from the 35% rate we have had since 1986 and decreased this rate to 21%. Following the decrease in the tax rate, we see an increase in foreign tax benefits that we receive from ‐6.4% to about ‐1%. This is due to the United States having a tax rate that is more in line with a majority of other
countries we trade with. We anticipate seeing a decrease in the amount of deferred taxes that companies keep on their balance sheets moving forward. With this new tax rate, we will see higher net income reported for companies and increase their balance sheet.
Unemployment Unemployment is at an all‐time low of 4.1%, since 2001, and has been at this level since October 2017. With unemployment low, this can cause some issues in terms of labor costs for companies. With Unemployment staying low, the ability to find employees also decreases which means labor costs will increase in order to keep your company in competition with others. As labor costs increase, companies will need to increase their product prices to cover the increase in labor. We already see a small increase in hourly earnings from the past quarter, increasing from 2.6% to 2.7%.
U.S. Department of Treasury (15)
We are expecting a small increase in unemployment over the next year to 4.4%. We expect the number of people in the work force to increase with people who are currently not in the work force but who see the stagnant rate and are compelled back in. As the number of people within the work force increases, we are also expecting GDP to rise with the increase in goods and services being produced. Capacity Utilization Capacity utilization denotes the amount of production a country or organization has versus the amount of production they could potentially reach without changing their production costs. The United States is currently at a capacity rate of 77.66% and has been fluctuating between 67% and about 81% for the past 10 years. A higher capacity utilization is a sign of a healthy economy with companies who are investing in machinery and other resources to help with the demand of the product all while not increasing production costs. A healthy TCU is anything above 70%. If companies continue to spend money on capital, we expect to see a small increase in TCU rates to between 78% and 79% keeping the United States in a healthy state.
4
FRED Economic Data(13)
FRED Economic Data(13)
Industry Overview The industrial machinery sector holds a large spectrum of sub‐industries. Cummins operates under the heavy machinery sector and, for our purposes we will be analyzing three specific sub‐industries within the sector: construction machinery, mining and resource equipment, and energy and transportation machinery. However, these sub‐industries tend to have similar characteristics when considering key drivers, trends and environments. Companies within these sub‐sectors, including Cummins, are extremely sensitive to the global economy and its health largely in part to their global positioning and historical correlation with markets. In order to sell their products effectively, companies use independent dealers to distribute and sell their products. Lastly, due to consolidation, many of these companies have a large presence in many different sub‐industries and therefore may be hard to compare.
Key Industry Drivers
GDP Growth Heavy machinery has a high dependency on stable market conditions. Consistent growth levels and a stable economic environment, including consistent GDP growth, increases product demand because consumers can more accurately predict if they’ll be able to commit to the large capital expenditures. For example, total industrial production has closely tracked real GDP in recent years and we can expect this trend to continue looking forward.
Commodity Prices Companies in the sector are highly sensitive to changes in certain commodity prices, specifically steel. Commodity prices are relatively stable throughout time, however with recent import tariffs plans by President Trump, we see large changes in steel prices within the next year. As of now, there is an announced 25% tariff on steel and a 10% tariff on aluminum imports, which would result in an anywhere from a 6‐20% decrease in EPS estimates for companies in the industrial machinery sector, according to analysts at J.P. Morgan. However, from our perspective, we see the 25% tariff as a worst case scenario and recommend that these tariffs be met with a high level of skepticism until future advancements in tariff talks be made.
Within the next year, we see steel prices continuing to increase but at a slower rate. This will inhibit growth within the industry in the short term, however if the recent easing
50
55
60
65
70
75
80
85
90
95
100Feb‐08
Oct‐08
Jun‐09
Feb‐10
Oct‐10
Jun‐11
Feb‐12
Oct‐12
Jun‐13
Feb‐14
Oct‐14
Jun‐15
Feb‐16
Oct‐16
Jun‐17
Feb‐18
Total Capacity Utilization
78.2
78.6
78.3
78.5
78
78.1
78.2
78.3
78.4
78.5
78.6
78.7
Q2/2018 Q3/2018 Q4/2018 Q1/2019
Total Capactiy Utilization Forecast
‐5.0
0.0
5.0
10.0
2010 2011 2012 2013 2014 2015 2016 2017
Percent Change
Real GDP vs Total Industrials Prod.
Real GDP Total Industrials Production
Sector Analysis
5
of trade war talks is any sign, we could see this recent run up in prices reverse.
Capital Spending Sales volume in the industrials sector is heavily reliant on capital expenditures. Customers, both individuals and corporations, rely on favorable capital markets in order to make heavy machinery purchases. Recent years have been a great environment for capital spending. With equity markets at all‐time highs and interest rates at extreme lows, we saw many companies take advantage and capital spending flourish. Looking ahead, with fed rate hikes scheduled to take place, upwards pressure on interest rates are causing a final boost in capital spending levels. We see this cycle in capital expenditure growth coming to an end in 2018 and decrease in later years as the effects of increase interest rates reduce capital spending. Industry Trends Increased Order Volume Order volume within the industry has increased dramatically in 2018 and will serve as strong support for continued revenue growth in the upcoming year.
Purchasing Managers Index (PMI) The PMI index is a monthly measure of five seasonally adjusted diffusion indexes. Each measure is evenly weighted and are comprised of new orders, production, employment, supplier deliveries, and inventories. A measurement over 50 indicates improving conditions.
Through 2017 and further into 2018, PMI has been considerably strong with an increase in new orders and production along with low unemployment. New orders are set to settle before the end of 2018 as capital spending slows, however production and supplier deliveries will remain high as orders become fulfilled.
New Orders New orders are a key statistic to understanding the current demand environment. The Durable Goods report for
Manufacturers’ is a figure used to see new orders in the last month. In 2018, we’ve seen strong increases in new orders with a 7.4% increase in new, nondefense capital goods orders (5).
Order Backlog Order backlog is an indicator for expected future revenues. Simply put, it’s the accumulation of unshipped orders. In 2018, we’ve seen a strong trend of increasing backlog among manufacturing firms. Based on the Institute for Supply Management’s Backlog Index, March and February registered 59.8% (50% indicates normal). (7)
Date % Higher % Same % Lower Index
18‐Mar 32.1 55.4 12.5 59.8
18‐Feb 31.8 56 12.2 59.8
18‐Jan 27.8 56.8 15.4 56.2
17‐Dec 25.6 58.6 15.9 54.9
On average, 30 percent of manufacturing firms reported higher order backlog. However, Cummins reported not having backlog due to open‐door contracts with its clients. We see these increases in backlog as an effect of the current stable economic environment. As noted before, the capital spending trend in the last 12 months has pushed order volume and created a healthy amount of order backlog for the coming year and even further into 2019.
Competitive Environment The heavy machinery industry as a whole is moderately fragmented. We see competition in this sector vary heavily between companies depending on geography and even individual orders. Therefore, comparing companies can become quite difficult when they compete in different regions of the globe.
As with any industry, price competition is to be expected, however, the machinery industry also competes based on the depth of their product offerings, such as their ability to fulfill the customer’s wants and their compatibility with the customer’s facilities or needs. When considering larger sales to other companies or governments, product compatibility is the key determinant in whose product gets bought. Companies that can adapt their products or diversify their product line in order to fit multiple customer’s pre‐existing factory footprints have a large competitive advantage over others. We see this with Cummins vast array of products throughout each segment of the company.
35
40
45
50
55
60
65
ISM Purchasing Managers Index
6
Industrial Automation Research and development in the heavy machinery sector has had a specific focus to create and improve automation within the construction and mining industries. Companies push the idea that the automation of processes will reduce labor costs, improve consistency in product quality, reduce waste, and make available real‐time feedback and diagnostics for job efficiency.
Currently, the industry’s level of automation is constricted. Applications involving autonomous use are limited to repetitive tasks and the types of technology used are similar to that of self‐driving vehicles, such as GPS and a mix of RADAR and LiDAR sensors. The mining industry is one of the biggest benefiters of such technology. Bulldozing, hauling materials, and remote operation in underground environments are key examples of modern‐day applications.
In the future, we see automation as a major competitive advantage in the industry. The benefits of eliminating human error for customers and at the same time reduce expensive labor costs for jobs such as crane or other large machinery operators is a major need among the heavy machinery consumer base.
Construction Demand in North America For companies in the heavy machinery industry, construction products sold in North America make up a considerable amount of revenue every year. Estimates for this area see a 5% growth in 2018 and we believe through the demand of residential and non‐building construction that these estimate are within reason, however we meet them with some skepticism.
Non‐Building Construction Non‐building construction, such as roads, bridges, and other infrastructure have a somewhat positive outlook in 2018 and the potential for a large upside. Government transition from the FASTLANE initiative into the Infrastructure for Rebuilding America, or INFRA, program has sparked the building of new highways and the construction of multiple bridges. However, unless considerable legislation on a proposed “Rebuild America’s Infrastructure” plan takes place in mid‐2018, we believe reelections are pushing any large infrastructure bill far in 2019. Assuming this, infrastructure should only grow at moderately normal rates, or 3‐4%.
Industry Metrics The following section shows comparable metrics within the heavy machinery industry. Among Cummins Inc.
competitors include, Caterpillar, Komatsu, Hitachi, and Volvo.
Gross Margin Competitive pricing has had quite an influence on gross margins within the industry. Typically, gross margin is a proper gauge on the performance of a company within its industry. A company’s ability to control its operating costs, as well as its capability to demand a premium from customers are key advantages within any industry.
Cummins does not have a large stake in Gross Margins compared to its competitors, with Cat, Komatsu, and Hitachi achieving higher gross margins. However, Cummins continues to achieve growth Year‐over‐year. We are expecting to see an increase to 25.85% gross margins in 2017 hold steady for future years.
Operating Cash Flow/Sales Ratio Operating cash flow/sales shows us the capability of a company to translate value to shareholders through day to day activities. This metric is key to understanding the financial stability for a machinery company. The larger the operating cash flow, the less concern over a company’s ability to access external financing, pay down debt, or as before, provide dividends to shareholders.
Cummins produces around 11.15% operating cash in 2017, with Kamatsu leading the way at 14.21%, Cummins falls fourth in line compared to its competitors. With the changes in tax rates, Cummins, along with the rest of the industry, stands to improve their operating cash flows/sales ratio in 2018 by a noticeable margin.
26.40%24.92%
28.65%
25.66%
23.95%
25.92% 25.66%
20.00%
22.00%
24.00%
26.00%
28.00%
30.00%
CAT CMI KomatsuHitachiAB Volvo AverageMedian
Gross Margin
12.54%11.15%
14.21%
8.86%
11.23% 11.60% 11.23%
0.00%
5.00%
10.00%
15.00%
CAT CMI Komatsu Hitachi AB Volvo Average Median
Operating Cashflows/Sales
7
R&D Expense/Sales Research and development (R&D) expense/sales is a metric that demands attention. The machinery industry has a high dependence on its ability to use future technology to improve efficiency of its machines and add new value. A company’s ability to effectively fund their research and development department supports a positive future outlook due to its ability to create sustainable advantages.
Although Caterpillar has an enormous lead in R&D expenses, Cummins has shown great strength in the new technology that has come out of this department. Being able alter emissions from their products and continue to stay ahead of the game in many components that coincide with engines Cummins manufacturers, the research and development department should be recognized for the large impact, and small expenses that are created.
Porter’s Five Forces
Threat of New Entrants: Low As a whole, barriers to entry of heavy machinery industrials are high. The amount of capital needed to manufacture the large pieces of machinery alone is enough to keep many new possible entrants out. Once you consider the hurdles of various government regulation and policy, name brand loyalty, patents, proprietary knowledge, and the cost of switching facilities to accommodate the manufacturing of new products, it is easy to understand how difficult it is to enter the industry.
Threat of Substitution: Moderate The large companies within the industry have enough differentiation between products so that each have diverse offerings or unique service terms. As said previously, substitutes from new entrants is unlikely due to the high capital requirements. However, substitution due to existing competitors is still an ongoing concern for firms and likely to exist for a long time.
Power of Suppliers: Low Supplier bargaining power is solely based on material or product scarcity, competitor demand, supplier size, and switching costs. In the heavy machinery industry, companies source materials from various suppliers around the world. The likelihood of a single supplier having the ability to pressure the large players within the heavy machinery industry is extremely low. For every input in the machines they create, there are multiple suppliers able to do provide them the necessary amount of materials.
Power of Buyers: Low Buying power for the customers of large heavy machinery is low due to the imbalance between companies that sell heavy machinery and the number of customers. This is even more severe as we consider the larger firms within the industry. The number of firms that can provide large orders and produce the specific product requested in the industry heavily disfavors customers.
Competitive Rivalry: High Despite the low number of competitors in the heavy machinery industry, competition among the few comparable firms is intense. Companies in the industry are heavily invested in international markets. Due to this, firms more likely find themselves having to compete against other firms in their respect domestic markets. Despite this disadvantage, companies can still create competitive advantages in the industry, through supply chain management or effective R&D.
Company Overview Cummins Inc. is a global equipment company that specialize in manufacturing and servicing diesel and natural gas engines, engine‐related components, and electric‐powered generation systems. Established in 1919, Cummins is headquartered in Columbus, Indiana but has distribution and manufacturing centers in 190 countries while employing 58,600 people. Cummins has built a reputation known throughout the world of strong and reliable engines with even more reliable service facilities. Cummins has 46% of total revenues being generated outside of the United States. Specifically looking at revenues, we can break down Cummins into four distinct segments: Engine, components, power generation technology, and distribution.
11.39%
3.68% 3.91%
1.60%
4.81% 5.08%3.91%
0.00%
5.00%
10.00%
15.00%
CAT CMI Komatsu Hitachi AB Volvo Average Median
R&D Expense/Sales
Company Analysis
8
Financial Summary Cummins generated a 2017 revenue of $23.32 Billion, a 15.7% growth from FY 2016. Q4 2017 EPS showed a surprising 35% increase from Q4 2016. In 2017, we saw an increase in the engine segment of about 15% primarily due to the increase in infrastructure spending in North America and other global markets. Sales in the Components segment soared to $1.6 Billion, an increase of 32% over the last year, topping the revenue segment of 2017. Management forecasted a 50% plow back of net income for 2017 and paid shareholders $701 Million, or $4.21/Share outstanding.
2018 heavy‐duty truck sales are expecting to reach upwards of 220,000‐250,000 units sold in North America according to Cummins partner, Paccar. With this in mind, we believe that Cummins has an advantage over its competitors with many different engine styles to choose from. Open supply contracts with various venders allows Cummins to keep a Gross Margin around 25% and allows for flexibility with the suppliers and a consistent expense we can infer year over year.
Business Segments Engine Segment Cummins is very well known and respected for the engines that they provide to their clients. Providing heavy and medium‐duty trucks, busses, recreational vehicles, light‐duty automotive, construction, marine, and agricultural vehicles. Cummins also produces a vast array of engines within each category ranging from small 48 horsepower 2.8 liter engine, to a 715 horsepower 91 liter engine. Cummins catalog of products allows them to reach new markets or clients without needing to alter their product line and accrue extra expense.
The development of new technology has given Cummins the ability to alter their engines capabilities to abide by the EPA’s emission standards while continuing to provide the strength and reliability recognized by the brand. Cummins has seen a large increase in their engine product line as companies have been replacing existing machines, and countries overseas have been growing at tremendous rates through construction and modernization. Guidance predicts this trend to stay strong through 2018 as companies continue to utilize the new tax laws and increase or replace their PP&E.
Power Generation Cummins designs and manufactures power generation systems, with most of the components built in‐house. Components including engines, controls, transfer switches, and switch gears that allow Cummins to improve cost of goods sold and maintain strong consistency in their products. Representing 16% of total sales, revenue is generated through organizations such as hospitals, data centers, and construction sites all around the globe by offering an uninterrupted secondary power supply. Cummins has seen a large increase again in the emerging markets outside of North America were continues power infrastructure is still lacking. We look forward to seeing power generation continue to grow as developing countries make the transition into the tertiary markets.
Power supply options range from residential emergency generators, such as the Quite Connect RS13A which is smaller than an A/C Unit. Ending with industrial generators, such as the diesel Generator QST30 series engine developed for a continuous power supply. Similar to the engine segment Cummins has a broad range of options for clients to be able to choose the product that best suits their needs.
Component Segment The component segment was responsible for 31.10% of total revenues in 2017 and offers an array of products that Cummins clients find very useful. Cummins manufactures filters, alternators, fuel systems, intake and exhaust systems, and is the largest global supplier of Turbochargers for commercial use1. This segment also develops necessary add‐ins that engine and power generation needs not only to run more efficiently, but to add leverage to the specialized equipment.
The largest component is the development of emissions solutions that are then applied to all Cummins products that excrete emissions into the atmosphere. This constantly changing technology keeps Cummins one step ahead of its competitors in this segment.
Distribution Segment Cummins consists of 34 company owned and 8 joint venture distribution centers that sell and service the full range of Cummins’ products. Distribution is responsible for 30.15% of total revenues in 2017, services include rebuilds, specific customer
9
modifications, and engineering services. Distribution is also responsible for keeping dealers up to date with new technology, training, and technical support.
Service centers are spread out around the globe to enhance clients experience with Cummins products with its 7,400 dealers in more than 190 countries. Distribution centers are in relatively close proximity to competitors in various locations and are constantly competing with firms such as Caterpillar, Kamatsu, and Volvo to keep current clients and build rapport with new clients. This segment is a key contributor to maximizing the Cummins brand perception and thus increasing its intangible asset moat.
Revenue Break down in 2017 (4)
Major Clients
Cummins has developed relationships with thousands of businesses throughout the world and will continue to create those long‐standing relationships. Currently, PACCAR is the largest consumer of Cummins’ products. Attributing 14% of Cummins total revenue in 2017, PACCAR has been the leading consumer client for close to 12 years, with Cummins providing them with products for 73 years (4). Specifically with PACCAR, Cummins have long‐term supply contracts for particular specifications of engine models but not necessarily the number of finished products.
Clients other than PACCAR that are notable are Fiat Chrysler who have contracted Cummins for their Ram Trucks. Daimler, a premium car manufacturer, currently have contracts for heavy and middle‐duty engines, while Navistar has contracts with Cummins for heavy‐duty engines. All contracts that Cummins has with businesses are considered open‐purchase contracts. Stipulating that any orders not able to be filled can be subject to cancelation with reasonable notice. This can quite possibly have negative effects in future earnings reports if the industrial economy has
negative results. If infrastructure spending decreases and businesses pull back on capital expenditures, we could see Cummins in distress for contracts to fill.
Production Similar to most companies, Cummins makes an effort to source their materials at the lowest costs, which means manufacturing them in‐house. Cummins management team has acted accordingly and has developed strategies to produce a majority of necessary items for Cummins products in‐house including cylinder blocks, connecting rods, camshafts, turbochargers, and more. For materials that are outsourced, Cummins uses long‐term contracts to ensure quality materials at a fixed costs despite the possibility of economic change. This gives Cummins a competitive advantage over its competitors when commodity prices rise due to demand and Cummins is able to purchase those materials at a predetermined rate.
Cummins has established a great network of suppliers through its globalization efforts and breaking its way through into new markets. By building relationships with new supply companies, Cummins has been able to create dual sourcing advantages for materials. This allows Cummins to evaluate the market and obtain the best price for the materials needed, all while mitigating risk if one source is unable to provide materials in a timely manner. This creates competitive advantage towards Cummins competitors when markets are tight and clients are looking for products rather quickly. Cummins is able to keep up with demand and develop or increase customer loyalty to the Cummins brand.
Catalysts of Growth Increase in Capital Expenditures As we see the United States GDP continuing to grow and companies take advantage of new tax laws, we are expecting to see an increase in capital expenditure spending. With an estimated increase in freight demand in North America of between 220,000‐250,000 truck units, or a 15%‐25% increase from 2017, Cummins will see an increase in its engine and components segments(2). Something to note about this growth is that this is cyclical growth. Although we will expect even more truck growth in 2019, some of this current year’s growth is due to aging truck fleets, while the latter shows an increase in freight transport in North America.
10
Increase in Middle Eastern Infrastructure With the current economic boom in the Middle East, specifically Saudi Arabia, there is definite room for Cummins to continue growth in this region. Currently, Infrastructure and transport spending has seen an increase of about 39% in 2017. Other nations around the area are seeing increases in their infrastructure spending. With Cummins having a headquarters in Dubai, there won’t need to be time to integrate themselves into the market. Being localized within the market as well will decrease the possibility of competitors attempting to push Cummins out. Reaching market share in the Middle East will have a high positive affect on the company’s earnings.
Valuation Summary We have arrived at a Buy recommendation for Cummins Inc. with the help of various valuation techniques to help us obtain a target price of $170‐$175. The models we developed are the discounted cash flow model (DCF), economic profit model (EP), dividend discount model (DDM), and using comparison data with relative firms in the industry. These models are created to show how different components of the industry come together to tell a similar story of how Cummins will continue to grow. We believe that the models that fit best to tell our story are the DCF and EP Models. These models are representing financial accounts that are developing the revenues of Cummins. Using DCF and EP models, are able to further dissect the revenues and come to a future stock price we are have confidence behind.
Forecasting Revenues Cummins is broken up into four different segments including engine manufacturing, power generation, components, and distribution. All four of these segments have created a total revenue of around $23.3 Billion in 2017, which we believe will continue to grow in the upcoming years. Within Cummins, we see a lot of Intersegment sales that occur, especially between component and engine segments. In forecasting revenues we also forecasted Intersegment sales and then subtracted to get real revenue growth. We have decided to break revenues down into segment growth to give a more accurate representation of Cummins and their individual segments.
Engine Segment The engine segment is responsible for 28.57% of total revenues in 2017. We are expecting Cummins to grow their engine segment by 7.00% in 2018, and slowly decrease their yearly growth to a consistent state of 4.0% in 2025 and thereafter. This boost in revenue comes from the increased demand in freight transportation as well as aging truck fleets that we have addressed earlier. This revenue growth also stems from sales in the generation segment, using regular gasoline engines to power the systems. Cummins also has 35% of market share in North America as of 2016, and continuing growth of overseas developing markets (9).
Distribution Segment The distribution segment comprises about 30.15% of total revenue on the Cummins balance sheet. With the large presence that Cummins has around the United States as well as overseas, customers have easy access to services and upgrades that Cummins offers. We are expecting a Slight increase in distribution in 2018 at 15% while slowly decreasing in overall revenue finally becoming stagnant at 4% in 2026. While having distribution centers in over 190 countries, Cummins is able to control the distribution and aftermarket materials. With increased sales within the next few years, more clients will be in need of service adjustments or new components to keep their Cummins equipment up to spec. Having this control allows Cummins to increase their brand recognition around the globe and strengthen their intangible assets which will grow Cummins as a whole.
Component Segment The component segment brings in about 22.88% of total revenues in 2017. Components including turbo‐technologies, filtration systems, and fuel systems. All necessary for Cummins engines to perform at peak reliability. We are estimating an increase of 16% of sales in 2018 with a similar decrease in revenues as we gave to distribution. Ending with a continued value estimate of 4% growth. We see similar growth in the component segment relating back to the globalization aspect of the industry. We also expect to see an increase in components due a joint venture with Eaton Corp to produce medium and heavy‐duty engine transmissions. With the purchase of more engines of construction and heavy‐duty trucks, comes the need for more integrative systems that Cummins provides to its customers.
Valuation Analysis
11
Power Generation The power generation segment accounts for 15.63% of total revenues in 2017. Hitting mainly emerging markets with little consistency in terms of electrical power, Cummins provides state‐of‐the‐art stand by power generators that offer uninterrupted capabilities. We expect to see a 16 % increase in sales in 2018 while Cummins pushes to offer its products during reconstruction and power mobility needs.
Forecasting Cost of Goods Sold (COGS) We forecasted out Cost of Goods Sold based off of an average growth rate over 10 years based off of products and services revenues. We found an average of 73.238% as our cost of goods sold. During our research on Cummins and the changes they were making with their cost‐reduction initiative, we decided to lower the cost of goods sold by a small margin to 72.80% This change may seem small but as we will see when we work the sensitivity analysis, our price is rather sensitive to cost of goods sold rate we have derived. Going along with the cost‐reduction initiative, while Cummins is constantly adjusting the firm, the cost of goods sold amount may be altered slightly through the next few years as Cummins develops new methods of producing materials that are currently being out‐sourced. Cummins has a goal of 90% of materials made in‐house, they are currently at 80%, with only 11% more to go, and we will see a decrease in this value in the future.
Research and Development We felt that sharing our take on the R&D process might be beneficial considering the average R&D cost is about 4% and we have forecasted R&D to be about 6%. Cummins recently invested in a joint venture with Eaton to develop new transmission equipment that will be used with engines that Cummins manufactures. We are expecting that Cummins will be increasing R&D due to this new market that they are breaking into. Joining transmissions with the engine can take some time and will increase the expenses. However, we do believe that this will be a great advantage to Cummins and will allow for most of the vehicles they will service to have most of the mechanism be part of the Cummins brand. The investment will be worth it and will increase Cummins’ bottom line in the long run.
Weighted Average Cost of Capital (WACC) We arrived at a Cummins Weighted Average Cost of Capital of 9.18% using the firm’s market value of equity of 89.81% with a market value of debt of 10.09%. The summation of both equity and debt rates are provided below.
Market value of Equity To derive Cummins cost of equity, we used a risk free rate of 3.062%, an Expected market return of 4.80%, and a raw equity beta of 1.416, calculated by averaging a two year weekly, 3 year weekly, 3 year monthly, 5 year weekly, and 5 year monthly. After taking out outliers, we averaged the Raw Beta values and created a beta that we felt represented the market well. Using the capital asset pricing model, we derived our market value of equity of 9.86%.
Market value cost of debt Cummins cost of debt was found using a twenty‐eight year maturity bond outstanding Cummins has. Taking that rate of 4.016% and multiplying it by the one minus the current marginal tax rate of 21.60%. We came to a final market value of debt as 3.15%.
Valuation Models Discounted Cash Flow & Economic Profit Model As we look at our valuation analysis, we feel that the Discounted Cash flow Model and Economic Profit model provided the most accurate estimates of the intrinsic value of Cummins Stock. Both of our models calculated an intrinsic value of $169.71, and after an adjustment up to April 16th we came to an adjusted stock price of $172.54. We feel this is an accurate stock price based on our assumptions of revenue, expenses, as well as certain balance sheet items that had a large sensitivity to the stock price. Using management guidance and historical data, we feel that Cummins should be classified as a BUY at its current levels.
Dividend Discount Model (DDM) Looking at our Dividend Discount Model (DDM) we do not believe that this model is the most accurate in estimating the intrinsic value of Cummins. The DDM yielded an intrinsic value of 149.08, which we feel is very low compared to the stock price right now and where we believe the company is going. We feel that the market may not see the value and growth potential that Cummins is heading into. The market may not be taking into account the growing infrastructure, aging technologies, and rising GDP rate that will push Cummins into higher growth. Although Cummins does pay out a modest dividend yield, of around 48% of net income, the future growth we see in Cummins is far greater than the slow growth in Dividend payouts.
Relative Valuation Model Finally, we believe that the Relative Valuation Model is not accurate when estimating the intrinsic value of Cummins
12
due to the calculations it presented. We used both the Price‐to‐Earnings (P/E) ratio and the Price‐to‐Earnings‐Growth (PEG) ratio. Both of these outputs were either very high or very low compared to the current stock price of Cummins. The P/E ratio gave a relative value of $238.56‐$241.32 after excluding the outliers in the data analysis. With our current stock price sitting at 162.39, we believe this value is not an accurate representation of future growth for Cummins. Moving on to the PEG ratio, we see a relatively large stock price of $241.31. Again, this price does not match current market trends and is not an accurate representation of future change for Cummins.
Sensitivity Analysis CV growth of NOPLAT vs. CV ROIC In comparing these two metrics, we wanted to look at how changing the CV of NOPLAT would affect our overall stock price. If we should see an increase in either our expenses or our revenue, we wanted to be able to predict the end result of future stock growth. Our sensitivity analysis yielded a stock price between $164.63 and $182.17. This analysis is detailed in the table below.
Accounts Receivable vs. Inventory Growth In comparing these two metrics, we wanted to analyze the effect of accounts receivable will have on Cummins stock price as this variable can change over time if companies decide to increase their deferred expenses, Cummins could see an increase in growth with this variable. Our sensitivity analysis yielded a stock price between $174.22 and $170.86. This analysis is detailed in the table below.
Risk-free Rate vs. Loans Payable In comparing these two metrics, we wanted to analyze the effect the risk‐free rate would have on Cummins stock price. We wanted to test this variable specifically due to the rising yield curve and the effect that a rising risk‐free rate will have. Our sensitivity analysis yielded a stock price between $159.82 and $188.16. This analysis is detailed in the table below.
Beta vs. Long-term Debt In comparing these two metrics, we wanted to analyze the effect that Beta has on our stock price. If the perceived risk increases and our sensitivity to the stock market increases, we want to see how this will affect our overall stock price. Our sensitivity analysis yielded a stock price between $155.35 and $194.04. This analysis is detailed in the table below.
Cost of Goods Sold vs. Research and Development In comparing these two metrics, we wanted to see how sensitive our stock price would be if there was a sudden drastic change in Cost of Goods Sold. With cost of goods sold being a highly sensitive value in general, the increase or decrease in commodities could change our overall stock price. Our sensitivity analysis yielded a stock price between $145.54 and $214.65. This analysis is detailed in the table below.
13
Dividend Yield vs. SG&A Expense In comparing these two metrics, we wanted to see how our price would differ if the dividend yield were to change based on the earnings received per share. Cummins has been very gracious with the amount of EPS they are giving as dividends and we could see an increase in dividend yield as the company continues to grow. Our sensitivity analysis yielded a stock price between $126.11 and $218.97. This analysis is detailed in the table below.
14
Important Disclaimer
This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students’ skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report.
7). “Institute for Supply Management | Established in 1915.” ISM ‐ ISM Report ‐ March 2018 Manufacturing ISM® Report On Business®, 2 Apr. 2018, www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm?SSO=1#backlogOrders.
8). ISM Purchasing Managers Index, YCharts, March 2018,https://ycharts.com/indicators/purchasing_managers_index
9). Millers, Jon. “Eaton and Cummins Inc. Announce Joint Venture.” Cummins Inc., 1 Aug. 2017, www.cummins.com/news/2017/08/01/eaton‐and‐cummins‐inc‐announce‐joint‐venture.
13). Staff, AMEinfo. “Middle East Infrastructure Projects Get Massive Boost.” AMEInfo, AMEInfo, 24 May 2017, ameinfo.com/construction‐real‐estate/infrastructure/middle‐east‐infrastructure‐projects‐get‐massive‐boost/.
14). “United States GDP Growth Rate 1947‐2018 | Data | Chart | Calendar.” United States GDP Growth Rate | 1947‐2018 | Data | Chart | Calendar, 2018, tradingeconomics.com/united‐states/gdp‐growth.
15). “U.S. Department of the Treasury.” US Department of the Treasury, 2017, www.treasury.gov/resource‐center/data‐chart‐center/interest‐rates/Pages/Historic‐LongTerm‐Rate‐Data‐Visualization.aspx.
Present Value of Operating Lease Obligations (2017) Present Value of Operating Lease Obligations (2016) Present Value of Operating Lease Obligations (2015)
Operating Operating Operating
Fiscal Years Ending Dec. 31 Leases Fiscal Years Ending Dec. 31 Leases Fiscal Years Ending 0.35 Leases
2018 140 2017 141 2016 163
2019 108 2018 101 2017 137
2020 80 2019 81 2018 105
2021 60 2020 59 2019 90
2022 44 2021 44 2020 43
Thereafter 70 Thereafter 93 Thereafter 110
Total Minimum Payments 502 Total Minimum Payments 519 Total Minimum Payments 648
Cummins (CMI)Weighted Average Cost of Capital (WACC) Estimation
Cost of EquityRisk Free Rate 3.062%Expected Market Return 4.80%Equity Beta of CMI 1.416Cost of Equity 9.86%
Cost of DebtPre Tax cost of Debt 4.016%Marginal Tax Rate 21.60%Cost of debt 3.15%
Market Value of EqutiyPrice Per Share $166.67Total Shares Outstanding 165Market Value of Equity 27500.55
Market Value of DebtCurrent Maturities of LT Debt 50Loans Payable ‐ Short Term 680.89Long Term Debt 4572017 Present Value of Operating Leases 447.5337Market Value of Debt 1635.78
Capital Structure of Cummins INC. Market Value Percentage of totalMV of Equity 27500.55 94%MV of Debt 1635.776232 6%Total 29136.32623 100%
Weighted Average Cost of Capital (WACC) Capital Structure Percentage Cost TotalEquity 94.39% 9.86% 9.31%Debt 5.61% 3.15% 0.18%WACC 9.48%
value of EP 25206Add beginning Cost of Capital 3686Value of Operating Assets 28892Add Excess Cash 38Add: Marketable Securities 202Add: Long Term Investments 1115Add: Nonconsolidated Equity Investe 327Less: Debt 1636Less: PV of Operating Leases 140Less: ESOP 117Less: Pension Obligations 336Less: Postretirment benefits 276
Value of Equity 28069Shares Outstanding 166Intrinsic Value of Stock 169.41$
Adjusted Stock Price $ 172.25
Cummins (CMI)Dividend Discount Model (DDM) or Fundamental P/E Valuation Model
Present Value of Operating Lease Obligations (2017) Present Value of Operating Lease Obligations (2016) Present Value of Operating Lease Obligations (2015)
Shares Outstanding (beginning of the year) 165,683,334 166,180,040 166,677,309 167,174,824 167,672,561 168,170,502 168,288,627 168,286,920 168,285,367 168,283,953Plus: Shares Issued Through ESOP 500,000 500,000 500,000 500,000 500,000 120,000 0 0 0 0Less: Shares Repurchased in Treasury 3,294 2,731 2,486 2,263 2,060 1,875 1,706 1,553 1,414 1,287 Shares Outstanding (end of the year) 166,180,040 166,677,309 167,174,824 167,672,561 168,170,502 168,288,627 168,286,920 168,285,367 168,283,953 168,282,666
166 167 167 168 168 168 168 168 168 168
VALUATION OF OPTIONS GRANTED IN ESOP
Ticker Symbol CMICurrent Stock Price $166.67Risk Free Rate 3.06%Current Dividend Yield 2.28%Annualized St. Dev. of Stock Returns 38.80%
Average Average B‐S ValueRange of Number Exercise Remaining Option of OptionsOutstanding Options of Shares Price Life (yrs) Price GrantedRange 1 466,693 119.78 5.00 68.65$ 32,039,636$ Range 2 420,369 123.88 5.00 66.93$ 28,136,151$ Range 3 404,494 120.41 5.00 68.38$ 27,661,150$ Range 4 411,239 120.84 6.00 70.37$ 28,939,994$ Total 1,702,795 121.20$ 5.24 83.68$ 116,776,930$
