Historically, industrial dividend growth stocks such as engine maker Cummins (CMI) have done a great job of enriching long-term investors, especially if you’ve reinvested the dividends.

For example, Cummins has delivered an annualized total return of 15.4% since mid-1995, nearly doubling the S&P 500’s 8.5% annual total return.

However, Cummins has fallen on hard times in recent years while its share price has returned over 70% since early 2016, creating potential concerns for value-focused investors.

Let’s take a closer look under the hood of this venerable blue chip dividend stock to see if and when its business fortunes may turn around.

More importantly, find out if Cummins is an attractive dividend growth stock at today’s share price or whether investors would be better off waiting for a correction before initiating or adding to their positions.

Business Description

Founded in 1919 in Columbus, Indiana, Cummins is the largest dedicated global industrial diesel and natural gas engine manufacturer.

The company’s primary markets are highway & heavy-duty vehicles, construction, and general industrial markets, where it serves customers including Chrysler, Daimler, Volvo, PACCAR, Navistar, CNH Global, Komatsu, Ford, and more.

Its 55,000 employees market its products in 190 countries and territories via its network of 600 company-owned and independent distributors via 7,200 dealers.

Roughly 60% of Cummins’ revenue is generated in North America. China (8%) and the Asia Pacific (8%) are also meaningful markets. In fact, Cummins has had a presence in China and India for 40 and 50 years, respectively.

Cummins operates in four segments, and its largest sales drive is its engine division:

Engines (35% of revenue): builds diesel and natural gas engines for: heavy-and medium-duty truck, buses, recreational vehicles, as well as light-duty automotive, agricultural, construction, mining, marine, oil and gas, rail, and governmental vehicle markets

Distribution (27%): distributes parts and filtration products as well as maintenance, engineering, and product integration services

Components (22%): provides emission solutions, including: custom engineering systems and integrated controls, oxidation catalysts, particulate filters, oxides of nitrogen reduction systems, and engineered components such as turbochargers for light-duty, mid-range, heavy-duty, and high-horsepower diesel markets. This segment also markets air and fuel filters, fuel water separators, lube and hydraulic filters, coolants, fuel additives, and other filtration systems to help customers meet regulatory emission requirements.

Power Generation (16%): Designs power generation systems, including controls, alternators, transfer switches, and switchgears as well as offering replacement parts and maintenance services.

Business Analysis

Cummins has built itself into the dominant truck and bus engine maker thanks to its expertise in meeting mandated emission requirements (the EPA has forced a 90% reduction in emissions in past decade) through things like: natural gas engines, hybrid buses, turbochargers and advanced catalytic systems.

This has led to dominating both the medium and heavy duty truck segment (40% market share), where it is two to three times larger than its nearest rivals, according to Morningstar.

The engine market has several barriers to entry that have helped Cummins build strong market share positions around the world. Extensive regulations have resulted in strict standards governing emission and noise, for example.

The engines Cummins’ manufactures need to comply with emission standards established by the European Union, EPA, the California Resources Board, and other agencies. Cummins spent more than $170 million on research and development in 2007 and 2008 in order to comply with 2010 EPA emissions standards in the U.S.

Notably, several of Cummins’ competitors opted to exit certain markets rather than pony up the cash required to remain compliant with their technologies. For example, Caterpillar exited the on-highway truck engine market in 2009, reinforcing Cummins’ technological lead.

Gaining entry to the engine business is very difficult. For example, PACCAR (PAC) launched its first line of engines a few years ago after spending a decade of time and more than $1 billion developing it. The finished engine even used some of Cummins’ own engine components!

Over the last decade, more than half of the $2-3 billion Cummins has spent on research and development has been invested in technologies that reduce emissions. When it comes to fuel-efficient technology, Cummins is the clear manufacturer of choice.

Beyond its engine intellectual property and economies of scale, Cummins’ moat is also formed from the way its business is operated. The company generally maintains long-term price and engine supply agreements with core customers.

The customer benefits from knowing Cummins’ products will be available, and OEM customers can collaborate with Cummins to jointly engineer future vehicles. In other words, switching costs are created that make it more difficult for new entrants to steal market share away from Cummins.

Engines are extremely important systems to keep heavy vehicles and equipment running. In most cases, it’s not worth the risk of switching suppliers for a customer to save a little bit of money.

Machine downtime from a faulty engine is extremely costly, reinforcing Cummins’ value as a premium engine supplier. Cummins’ vast network of dealer locations (over 7,200 across 190+ countries and territories) also means it can provide much more timely aftermarket repair services, further gaining customers’ trust.

It’s also worth noting the complementary nature of Cummins’ technologies and distribution channels, which should continue unlocking growth opportunities for the business.

For example, Cummins was able to apply its base technologies to enter the light-duty engine market in the mid-2000s. On the other end of the spectrum, Cummins recently developed a 4,000 horsepower “Hedgehog” engine that will go into the locomotive market.

Through continuous innovation and growth of its distribution and dealer networks, Cummins can continue maintaining its market share and expanding into adjacent markets for long-term growth.

Despite Cummins’ numerous strengths, industrial companies are generally cyclical. Cummins is no exception.

In the last four years, a major slowdown in demand for new trucks and a weak global economy have resulted in negative growth in its top and bottom line, as well as declining margins.

Cummins

Source: Cummins Investor Presentation

Cummins CMI Dividend

Source: Simply Safe Dividends

Unfortunately, due to ongoing weakness in demand for heavy and medium duty trucks in the U.S. and Brazil, this trend has shown no signs of reversing. Cummins’ sales have declined year-over-year for five consecutive quarters.

Cummins CMI Dividend

Source: Simply Safe Dividends

In fact, all of the company’s divisions see falling sales for the full year to one extent or another. Here’s a look at Cummins’ most recent guidance for 2016:

Cummins CMI Dividend

Cummins’ margins have deteriorated to the point where its profitability is now beneath that of most other industrial companies.

Company Operating Margin Net Margin FCF Margin Return On Assets Return On Equity Return On Invested Capital
Cummins 9.3% 6.6% 8.5% 7.6% 16.0% 13.3%
Industry Average 12.6% 8.8% NA 4.6% 15.0% NA

Source: Morningstar

However, despite the cyclical downturn in sales and earnings, management has still been able to generate stronger than average returns on capital, thanks to its disciplined approach to cost management. This has allowed Cummins to maintain an enviable free cash flow margin despite the challenges facing its industry.

Unfortunately, the trucking industry, which has been facing

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