The Power Play: Cummins’ Path To More Than 10% Annual Returns (NYSE:CMI)

Introduction

I am knee-deep into industrial stocks, as more than 50% of my dividend growth portfolio consists of stocks from that sector. While more than half of this exposure consists of anti-cyclical defense contractor exposure, I own two cyclical machinery giants: Deere & Company (DE) and Caterpillar (CAT).

I often make the case that if I didn’t own these, I would be a buyer of Cummins Inc. (NYSE:CMI), which is the star of this article.

Like Deere and Caterpillar, Cummins is a cyclical machinery producer with one major difference, which is its position in the supply chain.

As a producer focused on engines and related products and services, the company caters to a wide range of customers across a number of key industries that include railroads, maritime shipping, on-road transportation, mining, agriculture, and construction.

As we can see, the company’s customers include some of the world’s largest producers of trucks, mining equipment, heavy-duty trucks, and industrial applications that require external power.

I’m not only bringing this up to show that CMI has certain benefits thanks to its position further up the supply chain but also because its earnings tell us a lot about the health of various industries.

My most recent article on the company was written on November 15, when I went with the title “Cummins: The A-Rated Dividend Stock Keeps Shining.”

Since then, shares are up 12%, beating the 11% return of the S&P 500 by slightly more than 100 basis points.

As Cummins just released its earnings, it’s time we take a closer look at the company, which reported great quarterly numbers.

However, it also hinted at demand normalization, which, in combination with weakness in cyclical economic indicators, could hint at new buying opportunities down the road.

So, let’s get to it!

Strength Amid Weakness

In the fourth quarter of 2023, the company reported revenues of $8.5 billion, which marks a 10% increase compared to the previous year.

However, the EBITDA for this quarter was a net loss of $878 million, largely due to a one-time charge of $2.04 billion to settle U.S. regulatory claims.

Cummins Inc. has reached an agreement in principle to resolve U.S. regulatory claims regarding its emissions certification and compliance process for certain engines primarily used in pick-up truck applications.

[…] Cummins expects to record a charge of approximately $2.04 billion in the fourth quarter of 2023 to resolve these and other related matters involving approximately one million pick-up truck applications in the United States. Of this amount, approximately $1.93 billion relates to payments that are expected to be made in the first half of 2024. – Cummins

In light of these regulatory claims, the company strengthened its emissions compliance program in 2023 to ensure its products comply with increasingly stringent regulations worldwide.

This included the establishment of the Product Compliance and Regulatory Affairs organization aimed at enhancing safety and promoting a cleaner environment through regulatory compliance and product innovation.

Additionally, costs associated with voluntary retirement and separation of separation, as well as the planned separation of Atmus Filtration Technologies (ATMU), further impacted the financial performance.

However, despite these challenges, the company’s sales in North America grew by 8%, driven by improved pricing across various end markets and stronger demand for power generation products.

Internationally, revenues increased by 13%, primarily due to strong global demand, particularly in the data center sector.

On a full-year basis, we continue to find good results, as the segment performance breakdown showed significant achievements across the board.

• The Components segment reported record revenues of $13.4 billion, marking a 38% increase over the prior year.
• The Engine segment achieved record revenues of $11.7 billion, up 7% from the previous year.
• The Distribution segment saw revenues climb by 15% to a record $10.2 billion.
• The Power Systems segment also recorded a milestone, with revenues reaching $5.7 billion, representing a 13% increase over the prior year.
• The Accelera segment reported a net loss at the EBITDA level, with revenues reaching $354 million in 2023. However, as this segment is still minor and focused on long-term growth, we can somewhat ignore the EBITDA loss.

What’s interesting about these numbers is the fact that the market environment has soured last year.

As we can see in the chart below, leading economic surveys like the New York/Philadelphia Federal Reserve manufacturing surveys point to lower demand in industrial sectors.

So far, this has dragged down retail sales of heavy-duty trucks, which is one of the indicators I use to track the health of one of the company’s biggest markets.

This brings me to the outlook.

What’s Next?

Looking ahead to the four quarters of this current year, the company anticipates moderation in several key markets, especially in the U.S. truck market, which perfectly aligns with the chart above.

The good news is that despite these challenges, the company is confident in its ability to navigate economic cycles and improve cycle-over-cycle performance.

It also plans to spin off its remaining ownership in Atmus through an exchange offer as part of its portfolio repositioning strategy.

To give you some numbers, the company also provided detailed guidance for 2024, forecasting a 2% to 5% decline in total company revenue compared to 2023, which makes sense in light of economic challenges.

However, despite the overall decline in revenue, Cummins projects an EBITDA margin range of 14.4% to 15.4% of sales, indicating a continued focus on maintaining profitability amid market challenges.

In 2023, the EBITDA margin was 15.3%.

Digging a bit deeper, Cummins anticipates a challenging outlook for North American heavy-duty truck production in 2024, projecting a decline of 10% to 15% compared to the previous year.

This forecast reflects expectations of softer demand in the second half of the year, following a slight decrease from peak production levels in the first half of 2023.

In China, Cummins projects a 3% increase in total revenue, including joint ventures.

The company anticipates a mixed outlook for the truck market in this nation, with heavy-duty and medium-duty truck demand expected to decline by 5% to up 10%.

Despite the challenging market conditions, Cummins used its earnings call to express confidence in its natural gas engine offerings, particularly the 15-liter engine, which achieved a significant market share in the heavy-duty segment in 2023.

In India, heavy & medium truck sales growth is expected to be flat to up 5%, with most tailwinds coming from power generation demand.

Furthermore, Cummins anticipates continued growth in its Accelera business for the fiscal year 2024, with sales expected to range from $450 million to $500 million.

Although this segment is small and not profitable, it shows the company’s confidence in its ability to capitalize on the increasing demand for clean energy solutions, particularly electrolyzers and electrified components.

To summarize this part and using the visualization below, 2024 could be the first year of lower sales and EBITDA since the start of the current upswing after the pandemic.

So, what does all of this mean for shareholders?

Shareholder Returns & Valuation

In terms of capital allocation, the company remains focused on organic investments, dividend growth, and debt reduction, the three pillars that have provided investors with fantastic returns.

Since 2003, CMI has returned more than 20% per year!

Going back to February 2014, CMI has returned 8.3% per year.

Over the past five years, the company has returned 56% of operating cash flow to shareholders through share repurchases and dividends.

CMI currently yields 2.7%, which is based on a $1.68 per quarter per share dividend.

Its most recent hike was 7% on July 12, 2023, which is roughly in line with its five-year dividend CAGR of 7.9%.

The dividend has been hiked for 18 consecutive years and is protected by a payout ratio in the low 30% range.

So, what about its valuation?

Despite the threat of weakness in 2024, the stock is far from expensive.

Using the data in the chart below:

• 2024 is expected to see a 4% decline in earnings per share.
• 2025 is expected to see a recovery with 12% EPS growth, potentially followed by 10% growth in 2026.
• CMI is currently trading at a blended P/E ratio of 12.7x, which is below its normalized P/E ratio of 15.4x.
• A return to its normalized valuation by incorporation of its dividend and expected EPS growth could result in 15% annual returns and a fair price target of $363, which is 45% above the current price and 38% above the average consensus price target of $263.

The reason why the consensus price target isn’t higher is uncertainty.

Although there’s a high likelihood that EPS will rebound in 2025, it is currently tough to say how bad 2024 could be.

4% EPS contraction is currently the consensus. It could get worse unless economic growth indicators show some serious upside momentum in the months ahead.

In other words, I believe the company’s 4Q23 results perfectly go with what I said in my prior article:

Although I believe that this is possible, I can by no means promise a return like this. We could easily see a prolonged manufacturing recession, which would require EPS expectations downgrades.

Hence, while I like the long-term risk/reward, investors need to be very careful, as we could see 10% to 20% more downside if the ISM index does not bottom in the next two quarters. So, please take that into account when researching CMI.

That said, I am still sticking to a Buy rating as the company is not even close to being undervalued.

However, if I were in the market for CMI (I’m not because of the aforementioned elevated exposure to machinery stocks), I would start small and mainly try to accumulate shares on weakness.

Given economic headwinds, I would not bet against a temporary 15% to 20% stock price decline before the stock returns 10% to 15% per year, supported by potentially rebounding economic growth, elevated emerging market demand, and a rapidly increasing renewable energy segment.

Takeaway

In essence, Cummins remains a compelling investment choice despite facing headwinds in the industrial sector.

The company’s resilience amid economic challenges, supported by its strategic initiatives and diversified revenue streams, underpins its long-term growth potential.

While short-term uncertainties may cloud the outlook, Cummins’ track record of robust shareholder returns and prudent capital allocation provides some confidence.

Investors should approach with caution, mindful of potential near-term volatility, yet recognize the opportunity for accumulation on market dips.

In navigating the cyclical nature of the industry, patience and a focus on fundamentals will likely yield highly favorable returns over time.