Fitch Affirms Cummins at 'A'; Outlook Stable
KEY RATING DRIVERS
The ratings for CMI incorporate the company's solid balance sheet, low leverage and consistently positive free cash flow (FCF) that enable CMI to cope with cyclicality in its heavy - and medium-duty truck, off-road equipment, and power generation markets. Other rating strengths include proven technological capabilities, competitive positions in CMI's core engine and power generation markets, and a global distribution network.
Fitch views vertical integration by CMI's truck engine customers in North America as a key risk, including the long - term impact of Navistar's recent alliance agreement with VW Truck & Bus. The immediate impact of the alliance is likely to be limited but could increase over time. CMI's strong product line and its expansion in other product and geographic markets mitigate the impact of reduced market share, even as the pace of decline in CMI's market share of heavy duty truck engines has accelerated during the past 1 - 2 years, partly reflecting the current industry downturn for heavy duty trucks. CMI's current market share is in the high-20% range compared to the high-30% range previously. While CMI could regain some share when the heavy duty truck market recovers, the long-term negative trend remains a concern. CMI's share of the medium duty truck market in North America is materially higher than heavy duty engines but is subject to similar concerns.
The impact from the loss of market share is partly offset by CMI's expansion in emerging regions, particularly through joint ventures and new product introductions in China that have benefited from trends toward stricter emissions standards, demand for better fuel efficiency and more technology content. New product introductions by CMI's joint ventures and components business in China have supported revenue despite slowing economic growth in the region. Weak economic conditions in Brazil however, which is an important market, appear unlikely to improve soon.
During the past year, CMI has become more focused on generating higher growth and returns to shareholders through acquisitions and share repurchases. The company would be willing to consider debt-funded acquisitions and higher leverage, including an increase in debt/EBITDA to a range of 1.5x - 2.0x, or possibly higher in certain instances. While this adjustment to the company's strategy represents a rating concern, Fitch believes such an increase in leverage would be temporary and that CMI would use FCF to reduce debt or could adjust its cash deployment to free up funds, including, if necessary, a temporary reduction to its long-term plan to return 50% of operating cash flow to shareholders.
CMI plans to return roughly 75% of operating cash flow to shareholders in 2016. It repurchased $900 million of shares in 2015 and will likely repurchase a similar amount in 2016. Acquisitions have not been significant but Fitch believes large transactions are possible in the future.
At July 3, 2016 CMI's leverage remained at low levels, including debt/EBITDA of 0.8x and funds from operations (FFO) adjusted leverage of 1.4x. CMI's leverage would be lower when considering the impact of earnings from manufacturing and distributor joint ventures which are excluded from Fitch's calculation of EBITDA, although the impact has been reduced by the acquisition over several years of CMI's North American distributors.
Fitch estimates FCF after dividends for all of 2016 will increase to $600 million - $650 million compared to $589 million in 2015. The increase reflects expectations for lower capital expenditures, improved working capital, and lower pension contributions, partly offset by lower profitability and higher dividends. Dividends have increased materially in the past 2 - 3 years as part of CMI's plan to increase returns to shareholders. In the absence of a recovery in CMI's end-markets, Fitch estimates FCF could decline in 2017 but should remain solidly positive. As a result, FCF metrics could be slightly weaker than CMI's historical ranges including FFO adjusted debt of approximately 1.6x at the end of 2016, compared to 1.4 at the end of 2015, and FCF slightly below 20%. However, Fitch would expect these metrics to be strong over the long term after CMI's end-markets recover.
CMI's financial results are pressured by difficult conditions in several of CMI's key end markets including heavy duty trucks in North America, global mining, oil and gas, construction, and emerging markets including Brazil and China. The market for medium duty trucks is typically more stable than heavy duty trucks but could also be down slightly. Fitch expects CMI's sales growth in 2016 could decline by high single digits and EBITDA margins could fall to around 13% or lower compared to 13.5% in 2015, excluding restructuring and special charges. In late 2015, CMI recognized $90 million of restructuring charges across all of its segments to reduce excess capacity and controls costs.
CMI's acquisition activity in the past three years has been centered on purchasing the remaining equity in most of its U. S. and Canadian distributors at a cumulative cost of $783 million. These acquisitions were largely completed in 2015; the final distributor acquisition is planned in the fourth quarter of 2016. Full ownership of the distributors enables CMI to streamline operations and customer support. It also provides an opportunity to capture distribution aftermarket revenue from parts, filtration and service which tend to be more stable than CMI's original equipment business.
Joint venture income from unconsolidated ventures, primarily related to the engine and distribution segments, generated approximately 15% of segment profit in the first half of 2016. Income from distribution joint ventures has shifted to CMI's distribution segment due to its acquisitions of partly owned distributors over the past three years. Income from manufacturing joint ventures is concentrated in China where CMI has a market share of just under 15%. The market in China is highly competitive, however, and pricing is challenging. Truck demand is currently strong but can change quickly. China should be a source of long-term demand, but there are risks related to government constraints on participation by foreign companies.
Fitch's key assumptions within the rating case for the issuer include:
--North America heavy duty truck production declines by more than 25% in 2016 following a cyclical peak in 2015;
--Lower market share for CMI's engines in North America due to vertical integration by heavy duty truck OEMs;
--CMI gains additional market share in China over the long term, including consolidated and joint venture revenue;
--During 2016, CMI pays approximately 75% of operating cash flow as dividends and share repurchases;
--FCF of approximately $600 million-$650 million in 2016;
--Segment EBITDA margins decline by approximately 50-75 basis points in 2016.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Market share in the North America heavy duty Class 8 truck market deteriorates as a result of customer in-sourcing or competitive pressure, without offsetting gains in other markets;
--CMI loses competitiveness as a result of ineffective new product development;
--Cash deployment for share repurchases or other discretionary spending contributes to consistently higher leverage, including mid-cycle debt/EBITDA consistently above 1.25x;
--Lower FCF resulting in FCF/total adjusted debt declining to the mid-teens over the long term compared to levels near 20% or higher historically.
Fitch believes a positive rating action is unlikely given cyclicality in CMI's end markets and the company's willingness to incur additional debt and higher leverage, at least temporarily, to fund future acquisitions.
Liquidity at July 3, 2016 included cash and marketable securities of $1.3 billion. At the end of 2015, 74% of CMI's cash was held outside the U. S., much of which would incur taxes if repatriated. Liquidity is also provided by a $1.75 billion five-year revolver which matures in 2020, most of which was available at July 3, 2016. The facility backs a commercial paper program put in place by CMI in early 2016. Liquidity was offset by $200 million of commercial paper, $38 million of current maturities of long-term debt and $19 million of loans payable. Debt maturities are well distributed, with no significant maturities scheduled before 2023. CMI's debt totaled $1.8 billion at July 3, 2016.
CMI expects to contribute $146 million to pension plans in 2016, compared to $190 million of total contributions in 2015. The plans in both the U. S. and U. K. are overfunded which minimizes the likelihood of large future contributions and supports FCF.
FULL LIST OF RATING ACTIONS
Fitch has affirmed CMI's long-term ratings as follows:
--IDR at 'A';
--Senior unsecured credit facility at 'A';
--Senior unsecured debt at 'A'.
--Short-Term IDR 'F1';
--Commercial Paper 'F1'.
The Rating Outlook is Stable.