Cummins Inc. (CMI), is an industrial giant with a strong competitive advantage.
The company designs, manufactures, distributes, and services diesel and natural gas engines, electric and hybrid powertrains, and related components worldwide.
It operates through five segments: Engine, Distribution, Components, Power Systems, and New Power.
Cummins is trading at a low forward multiple, but we remain neutral in the short-term because we believe we may be able to get a better entry point. (See Cummins stock charts on TipRanks)
Measuring Its Competitive Advantage
We can measure Cummins’ competitive advantage by comparing its earnings power value to the value of reproducing the business. Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.
Cummins’ average EBIT margin over the past five years was 10.4%. Using its revenue for the last 12 months, its adjusted EBIT is as follows:
$23.2 billion x 0.104 = $2.41 billion
Using a marginal tax rate of 22%, the after tax adjusted EBIT is $1.88 billion.
Cummins’ weighted average cost of capital is 6.8%. The earnings power value is $27.65 billion ($1.88 billion divided by 0.068).
Finally, its total asset value is $22.61 billion. As a result, Cummins has a competitive advantage because its earnings power value is greater than the reproduction value of the business.
Growth Catalysts, Risks
Cummins is currently trading at 15.3 times earnings and approximately 11.5 times forward earnings.
Since the company is cyclical, it’s more sensitive to business cycles. As a result, its P/E ratio tends to mostly hover between 10 to 20. However, Cummins does generate a lot of free cash flow which it regularly uses for dividends and buybacks.
The company’s share count continues to decrease every year as a result of the buybacks. This means that earnings per share will increase even if earnings stay flat. The increased EPS leads to a higher share price even if the P/E ratio stays in the same historical range.
In fact, Cummins’ EPS remained relatively flat from 2011 to 2016 despite seeing earnings decline over that same period. The stock mostly trended up during that time period nonetheless, although it did so with a lot of volatility. This demonstrates the impact that share buybacks can have.
Another growth catalyst for Cummins is its participation in developing new technology that uses green energy. In particular, the company is focusing on hydrogen energy. It’s already powering some trains in Europe with its fuel cells, in addition to other applications, ranging from grocery trucks to the first PEM electrolyzer in the United States.
However, like many manufacturers these days, Cummins is vulnerable to supply chain disruptions that lead to uncertainties about the company’s operations.
On top of that, increased costs of raw materials may impact the company’s margins if it’s not able to pass on the expense. In addition, there is always the cyclical risk that is associated with the industry.
Wall Street’s Take
Turning to Wall Street, Cummins has a Moderate Buy consensus rating, based on four Buys and five Holds assigned in the past three months. The average Cummins price target of $278.67 implies 27.1% upside potential.
Cummins is undoubtedly an industry leader, with a measurable competitive advantage.
However, given the cyclical nature of the industry, a stock like Cummins produces the best returns after a cyclical sell-off. The stock has been on a downward trend for months now, and it’s possible that we are nearing a bottom.
Unless you can stomach a lot of volatility, it’s better to wait for momentum to pick up towards the upside before entering industrial stocks.
Disclosure: At the time of publication, Stock Bros Research did not have a position in any of the securities mentioned in this article.
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