Cummins Inc. Equity Valuation and Analysis

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Cummins Inc. does not distinguish raw materials from work-in-progress because of the constant movement of resources from different locations. They also recognize their inventories using either the lower of cost or the net realizable value. Inventory management is a huge component of Cummins Inc. key accounting policies. Choice of accounting policy for valuing inventory can have a significant influence on the assets of the balance sheet. Cummins Inc. values 78% of its domestic inventory using FIFO and the remaining 22%, comprised mostly of heavy-duty, high-horsepower engines and parts are valued using LIFO. Components of Engine Segment (As % of Engine Sales) 10% 32% 27% Heavy-Duty Medium-Duty Light-Duty Industrial Stationary-Power 14% 17% Cummins Inc. reported sales of $2.1 billion in their Heavy-Duty truck engine segment, which accounted for approximately 22% of overall net sales. When reporting cost of good sold, Cummins Inc. has chosen to use the LIFO method of accounting for inventory in this heavy-Duty engine segment. By using the LIFO method, cost of goods sold in the Heavy-Duty truck engine segment is overstated in a rising price environment. Since this segment makes up almost - 24 -
22% of sales outstanding, this reduces income taxes payable significantly through understating gross margin, and ultimately reducing net earnings. Accounting Flexibility Cummins Inc.’ management team has many different ways that it can account for its key accounting policies. Managers in diversified machinery have a choice of how to classify inventory. Cummins Inc. uses a combination of FIFO and LIFO, although FIFO comprises for a majority (78%) of the inventory. If a situation arises where management needs to increase their expenses and lower their tax base, they could switch to using predominantly LIFO. However, this is a stringent transition process that the I.R.S. would have to approve. Although FIFO is more indicative of actual inventory levels, switching to LIFO would reduce the value created from employing FIFO for tax purposes. Additionally, auditors would question the switch and raise issues about the underlying motive for pursuing FIFO, a more transparent inventory policy. Caterpillar uses an accounting strategy that is almost the complete opposite of Cummins Inc. Caterpillar is considerably larger than Cummins Inc. with total assets of $47 Billion compared to that of Cummins Inc. with total assets of $6.9 Billion. Because Caterpillar is such a large and well-established firm, we believe that they use LIFO in order to reduce their tax base. Cummins Inc., a smaller company with more growth potential, uses FIFO to boost earnings and portray as much economic growth as possible. Cummins Inc. discloses the excess of FIFO over LIFO to be 69 million in 2005, and an average of 65 million for the period of 2003-2005. With gross margin being overstated, we can assume that at an income tax rate of 35%, Cummings is distorting income taxes payable by approximately 24 million. This helps create value by reducing the taxes paid to the Internal Revenue Service. Management is allowed to use LIFO for tax purposes and Cummins employs LIFO to reduce taxable income and the associated income taxes payable. - 25 -
Page 1 and 2: Cummins Inc. Equity Valuation and A
Page 3 and 4: Investment Recommendation: Overvalu
Page 5 and 6: industry. With few buyers and many
Page 7 and 8: to different structured firms, so w
Page 9 and 10: Cummins Inc. is classified as a mem
Page 11 and 12: Industry Structure and Profitabilit
Page 13 and 14: Another key factor that plays into
Page 15 and 16: The threat of substitute products i
Page 17 and 18: Strategies for Creating a Competiti
Page 19 and 20: Cummins has the potential to attrac
Page 21 and 22: accounting policies recognized by C
Page 23: Warranty Provisions in Relation to
Page 27 and 28: can result in the plan being over o
Page 29 and 30: inventories, it is a proper account
Page 31 and 32: We can also look at the expense man
Page 33 and 34: Net Sales/ Net Accounts Receivable
Page 35 and 36: Net Sales/ Warranty Liabilities 45.
Page 37 and 38: lower than Caterpillars. Changes in
Page 39 and 40: Pension Expense/SG&A 0.15 0.10 0.05
Page 41 and 42: transferred to different accounts t
Page 43 and 44: efficiency ratios go down steadily
Page 45 and 46: The Accounts Receivable Turnover 8.
Page 47 and 48: management’s inability to accurat
Page 49 and 50: In summation, all measures of profi
Page 51 and 52: The operating expense ratio compare
Page 53 and 54: able to grow their earnings by an a
Page 55 and 56: Return on Assets 12.00% 10.00% 8.00
Page 57 and 58: illion in 2006. Net income increase
Page 59 and 60: Cummins is well-positioned to repay
Page 61 and 62: Debt Service Margin 6.00 5.00 4.00
Page 63 and 64: dividend policy and choose to retai
Page 65 and 66: The PP&E turnover is a measurement
Page 67 and 68: SGR & IGR Analysis IGR & SGR 25.00%
Page 69 and 70: 2005 to 2006 to forecast a more rat
Page 71 and 72: to support this assumption is that
Page 73 and 74: CUMMINS INC. AND CONSOLIDATED SUBSI
Page 75 and 76:
Balance Sheet By forecasting the ba
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CUMMINS INC. AND CONSOLIDATED SUBSI
Page 79 and 80:
Cash flows from operation activitie
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Valuation Analysis There are a vari
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Trailing Price to Earnings (2006) T
Page 85 and 86:
Price Earnings Growth Due to a nega
Page 87 and 88:
taking the average of a historical
Page 89 and 90:
they will not be able to issue debt
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Sensitivity Analysis g Observed Pri
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Analyst Recommendation Through a ca
Page 95 and 96:
Value Weighted Cost of Equity 72 Mo
Page 97 and 98:
Residual Income (RI) 1 2 3 4 5 6 7
Page 99 and 100:
AEG 1 2 3 4 5 6 7 8 9 10 Termina 20
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Cummins Inc. Equity Valuation and Analysis

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