The Long and Short
Rising sales, strong margins, low net leverage favor Cummins
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Cummins has rebounded impressively from its low point during the pandemic with both the top line and EBITDA set to exceed the highs posted in fiscal 2018. With sales expected to increase in the low- to mid-20% range for the year and the EBITDA margin likely to approach 16%, Cummins’ (A2/A+) 10-year bonds have value as one of the widest ‘A’ credits in the transportation and manufacturing sector. A sizeable cash position and net leverage below half a turn helps, too. The CMI 1.5% 2030 issue offers 10 bp g-spread of pick up over lower-rated Caterpillar Inc. (CAT – A2/A) bonds, despite having a stronger credit profile, even after excluding debt associated with CAT’s financing unit.
Exhibit 1. Transportation and manufacturing ‘A’ 7-year to 10-year curve
Source: Bloomberg TRACE; Amherst Pierpont Securities
Second Quarter Results Exceed Expectations
CMI’s second quarter 2021 results saw strong growth as revenues were up 59% from the year-ago period, with North America posting a 74% increase while international revenues were up 42%. Management noted that results were fueled by robust demand across all global markets, after being negatively impacted by the pandemic. Freight activity in North America has continued to grow which has led to elevated rates in both spot and contract pricing. While the increased pricing has led to growth in fleet profitability, CMI also witnessed strong backlog in truck orders. Additionally, iron ore copper and thermal coal prices remained high which helps to support a positive outlook for mining.
Despite supply chain disruptions that led to higher costs coupled with higher compensation, CMI was able to expand its EBITDA margin by 160 bp year-over-year (to 15.9%). While this is not the highest second quarter on record for CMI with respect to the EBITDA margin, as the company posted an EBITDA margin of 17.0% in 2Q19, we note that CMI’s quarterly EBITDA margin year-to-date is outpacing 2018. Furthermore, guidance for the full year has the EBITDA margin in the 15.5%-16% range, meaning that if CMI were to achieve the upper end of that range, it will achieve a record annual EBITDA margin even as the company expects supply chain disruptions to negatively impact the second half of 2021.
Exhibit 2. CMI Quarterly EBITDA Margin (1Q18-2Q21)
Source: CMI Company Reports; Amherst Pierpont Securities
Balance Sheet Strong Entering and Exiting the Pandemic
CMI has maintained a very conservative balance sheet which was very beneficial entering into the pandemic. We note that CMI entered the pandemic with roughly $1.5 billion of cash on hand and finished 2020 with a cash balance of $3.9 billion. While CMI tapped the market for $2 billion in August 2020 to shore up liquidity (similar to peers), proceeds were largely used to repay CP. That said, leverage continues to remain low as we note that total debt/EBITDA is roughly 1.2x. Factoring in the company’s strong cash balance which now stands at $2.9 billion, net leverage is approximately 0.4x. This compares favorably to peers such as CAT, whose total leverage and net leverage are 1.5x and 1.0x, respectively (after excluding debt associated with the financing unit). Furthermore, CMI’s balance sheet benefits from strong free cash flow generation as cash flow/sales was roughly 11.8% on a LTM basis. This is up from 10.5% posted in 2019 and 7% in 2018.
Could Moody’s Upgrade?
Moody’s affirmed CMI’s ratings and stable outlook when it tapped the market in August of last year. At that time, the agency noted that the ratings could be upgraded over time should the company sustain an EBITDA margin of 15% and debt/EBITDA of 1.0x. Furthermore, Moody’s wanted to see annual free cash flow of approximately $1.5 billion. We note that CMI has achieved two of the three parameters and should CMI achieve the high end of the EBITDA margin range that it has guided to, EBITDA could approach $3.9 billion. We note that absent any further debt reduction, leverage could end the year close to 1.0x, while falling below 1.0x in fiscal 2022. If CMI would like to hit 1.0x total leverage at year-end 2021, it would need to repay roughly $500 million of debt.
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