Cummins: Odd Lot “Arbitrage” Opportunity
When markets are high and richly valued, we naturally turn our attention towards special situations. Special situations rely on a corporate action to unlock value.
It’s not that Dan and I sit down and formally decide the market is high enough to warrant a change in focus. The change happens organically. High valuations reduce forward returns and make special situations relatively more attractive.
One special situation we’re watching is Cummins’ exchange offer for Atmus Filtration Technologies. The deal is conceptually similar to several we’ve posted about in the past:
August 2023 — Johnson & Johnson
May 2020 — Ecolab
February 2020 — McKesson
January 2020 — XBiotech
This exchange offer presents a chance to earn approximately 7.5% on a modest sum of money (around $26,000), resulting in a profit of approximately $1,950 over a few days. Although this trade carries some risks, it has a high likelihood of success.
Do you have a “stranded” 401k from a past job that is neglected and unmanaged? These accounts are often an excellent fit for Eagle Point Capital’s long-term investment approach. Eagle Point manages separately managed accounts for retail investors. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.
Last May, Cummins sold 19.5% of Atmus Filtration Technologies in an IPO that raised $275 million. Atmus also paid Cummins a $650 million dividend as a parting gift.
Cummins founded Atmus in 1958, 66 years ago. Since then Atmus has become a leader in filtration solutions for on-highway commercial vehicles and off-highway vehicles and equipment. Atmus’s products, branded as Fleetguard, lower emissions and reduce maintenance costs. 81% of sales are from replacement and maintenance which Atmus’s revenue relatively predictable and non-cyclical.
The purpose of this transaction is to tax-efficiently spin off Atmus and simultaneously allow Cummins to repurchase a large block of stock.
The exchange is a sign that Cummins thinks its shares are undervalued. The stock trades for 13 times earnings, which is below its long-term median of 15x. In December Cummins agreed to settle a lawsuit brought jointly by the DOJ and state of California which charged the company with installing devices to cheat emissions controls. The settlement resulted in a $2.0 billion charge to Q4 earnings.
Most investors dislike the uncertainty that pending lawsuits cast on a company, which can create a weak share price. Once the lawsuits are settled the uncertainty is lifted and investors buy back in, lifting the stock price. It’s is not a coincidence that Cummins is looking to buy back stock so soon after settling.
McKesson was in a similar situation in 2020 when opioid litigation pushed its P/E multiple down into single digits. McKesson took advantage of the opportunity and repurchased 8% of its shares for 9x earnings (about $150 per share). In 2022 McKesson formally settled the lawsuits and today the stock trades for almost $500 per share. I’m not predicting Cummins will fare that well, but the exchange is a sign that management is thinking rationally about capital allocation, which is more than I can say about most companies.
Cummins exchange offer will amount to at least a 3.5% buyback for continuing shareholders. Cummins is offering a 7.0% discount on Atmus shares to incentivize shareholders to participate. For every $100 of Cummins tendered shareholders will recieve $107.53 of Atmus stock. There is important fine print to be aware of in this deal.
First, the exchange is subject to an upper limit of 13.3965, expressed as the ratio of the price of Cummins divided by Atmus. This safeguard keeps the exchange within the target price range.
The upper limit is not currently not in effect. If it does take effect, shareholders tendering Cummins shares may receive less than $107.53 worth of Atmus shares. Cummins made a website to easily watch the indicative exchange ratio, which will be finalized after the market close on March 13th.
Second, Cummins is willing to exchange a maximum of 67,054,726 of its own shares for Atmus shares. Given the high likelihood of oversubscription (due to the appealing 7.53% return), proration is virtually guaranteed.
There is a strategy to avoid proration: tender fewer than 100 shares. According to the exchange offer detailed in Form S-4, shareholders who own "odd-lots" (less than 100 shares) of Cummins and tender all of their shares will be exempt from proration.
Shareholders who beneficially own “odd-lots” (less than 100 shares) of Cummins Common Stock and who validly tender all of their shares will not be subject to proration.
It's important to note a few risks.
First, if the exchange ratio reaches the upper limit, tendering shareholders may receive less than $107.53 worth of Atmus shares.
Second, the market price of Atmus shares might decline after the exchange but before you can sell them. If the upper limit isn't triggered, there's a 7.5% buffer against this risk.
If all goes well and the upper limit remains untriggered, investors can buy 99 shares of Cummins for approximately $25,800 and tender them all for exchange. The deadline is March 13th. Investors would receive roughly 1,256 Atmus shares valued at about $27,750 which could be sold for a profit of about $1,950.
Further Reading
Stock Spinoff Investing wrote a good piece on the exchange offer and the longer term opportunity to invest in Atmus Filtration.
Do you have a “stranded” 401k from a past job that is neglected and unmanaged? These accounts are often an excellent fit for Eagle Point Capital’s long-term investment approach. Eagle Point manages separately managed accounts for retail investors. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.
The fear of an ATMU selloff still looms. But right now this is going the opposite direction and creating an even bigger windfall for odd lot investors.
My best guess is that 62 million shares of CMI that didn't get pro-rated are in some weak hands who were just playing the tender offer. Hence the selloff. And that would also possibly explain the run-up of shares in CMI before the event.
Meanwhile, ATMU has 70% short interest and a sky-high borrow cost. And we have a couple of days before the new shares will be available. There's a short horizon here where a squeeze is possible.