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Caterpillar Inc. (CAT) – Valuation Analysis

Caterpillar’s 4.2% Dividend Yield Looks Attractive by Simply Safe Dividends

Charles Dickens might as well have been describing the nature of highly cyclical businesses like Caterpillar when he wrote, “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.”

CAT’s experience during the Latin American debt crisis in the early 1980s provides a perfect example – the company sold 1,200 machines a year in Argentina in the late 1970s when times were good. Once the crisis struck, CAT sold a total of four machines in 1981, 1982, and 1983! Large pieces of equipment cost hundreds of thousands of dollars, if not millions, and generally last at least 10 years. When budgets tighten in a downturn, customers put off buying new equipment and flood the market with used equipment.

For dividend growth investors, higher volatility businesses are often viewed as inferior investment opportunities compared to more predictable business models. While we generally agree with this mentality (cyclicals are harder to get right and, if poorly researched, don’t jive with the “sleep well at night” investment philosophy), healthy cyclical companies trading at attractive yields with safe dividends and intact long-term growth potential can provide strong buying opportunities for yield and total return potential.

While timing the bottom of cycles is impossible and current weakness across emerging markets and commodities could prove to be prolonged, CAT has certainly caught our attention today and sits in our Top 20 Dividend Stocks list. The stock is out of favor today but has several potentially underappreciated competitive advantages that we expect to strengthen over the next five years thanks to new technologies, and CAT’s markets will eventually rebound again. We believe CAT’s reward-to-risk ratio looks favorable for long-term, buy-and-hold dividend growth investors.

As seen below, Caterpillar’s stock was a huge winner from the late 1990s through 2010 – a rising line means CAT’s total shareholder return (“TSR”) outperformed the market. Rising commodity prices, fueled especially by China’s rapid infrastructure build-out, were a boon for heavy equipment manufacturers’ customers.

Caterpillar

Since 2010, commodity prices have rolled over, starting with mining. US construction markets unexpectedly slowed down again by 2012, and the stronger dollar, rising volatility in emerging markets, and collapsing oil prices have posed even further challenges more recently.

Not surprisingly, the last few years haven’t been so kind to CAT. The stock compounded at a 2.8% annualized return from 2012-2014, significantly trailing the market’s 20.1% compound annual growth rate. Over the last year, CAT is down about 30%, again trailing the market by a wide margin.

Looking at the business today, over 60% of Caterpillar’s sales are generated outside of North America, making it especially susceptible to global trends. Courtesy of the company’s website, we can see that machine retail sales have been weakest in Asia/Pacific and Latin America regions YTD:

Caterpillar

From a product perspective, CAT’s breadth is unmatched – construction and mining equipment, diesel and gas engines, industrial turbines, and locomotives are its main lines. About 85% of CAT’s operating income comes from its Construction Industries (29%) and Energy & Transportation (54%) segments. Construction Industries sells an array of loaders and excavators and its key end markets are self-explanatory. Energy & Transportation provides engines, turbines, and locomotives to the electric power, industrial, petroleum, marine, and rail end markets. While mining is still an important end market and arguably under the most medium-term pressure, CAT’s business is more diversified than many investors might think. It should also be noted that a meaningful amount of Caterpillar’s revenue is tied to higher-margin, less volatile aftermarket parts and components; however, the company does not disclose how much revenue is aftermarket business.

With so much working against CAT at the moment, it can be easy to forget the success factors that built CAT into a $50+ billion business. If the company’s competitive advantages are still intact, the dividend is safe, current valuation multiples are reasonable, and there is reason to believe that the CAT we will see in 2020 will be meaningfully larger and more profitable than the CAT of 2015, a compelling investment opportunity might be in front of us.

CAT’s historical success starts with its dealers. CAT sells its products to dealers who sell them to end users across different markets. CAT’s global network of more than 175 independent dealers is second to none. To put things in better perspective, CAT’s largest rival, Japan’s Komatsu, is about half the size of CAT. CAT’s independent dealers have about 162,000 employees, over 40% more than CAT’s entire full-time staff. Why is a dealer network so important in the large equipment market?

A machine that breaks can stop an entire job – restarting work in a few hours compared to a few days can make or break a project’s financial and operational objectives. Therefore, large dealers with plenty of parts and technicians are a big selling point influencing a customer’s purchase decision – a rapid response rate to machine breakdowns is essential.

Efficient dealer networks also enable more aftermarket business for Caterpillar, which helps the company survive during trough years as it continuously expands its base of machines that require servicing. With machines lasting for decades in many instances, partnering with a financially healthy and proven dealer is just as important. Local dealers are also more knowledge about their communities and customers’ needs than a giant like CAT could ever be. As such, they are more effective at selling locally and provide a better customer experience. Lower-priced Asian competitors lack a global dealer support network and, therefore, struggle to take share from CAT.

There has been a trend towards renting equipment rather than buying it, transferring the working capital burden from the end user to the dealer and/or manufacturer. Customers are increasingly using equipment globally as well, looking to utilize dealers different from the one they originally purchased the equipment at but expecting the same level of service. While these market changes will require some adaptation on Caterpillar’s part, the company’s core asset – its massive network of dealers – is still needed in all of these new use cases. We don’t view these trends as long-term risks to CAT’s business, but they could require additional near-term investment in the dealer network to help the transition, which could be fairly significant in the case of renting more equipment.

CAT is working on institutionalizing dealer best practices (e.g. a globally-aligned rental equipment model, more data sharing, and better parts logistics) across its entire network. The company believes its dealer initiatives could add anywhere from $9 billion to $18 billion to its total sales over the coming years if it can bring all of its dealers closer to median or top quartile performance. These are not numbers to sneeze at – $9 billion and $18 billion represent increases of 18% and 37%, respectively, off of CAT’s estimated 2015 revenue ($49 billion). Should demand in CAT’s markets simultaneously recover, operating leverage could work for CAT in a very large way over coming years.

Technology will play an increasingly important role in strengthening CAT’s dealer advantage. CAT has more than 3 million machines in the field, most packed with sensors and diagnostic technology throwing off data that is used to gauge the health of its equipment, help owners track their equipment, and more. Advancements in data collection and availability, coupled with improving data analytics capabilities, have made machine information increasingly valuable to solve real customer problems. For example, what if CAT’s dealers could better identify a repair need before a customer’s machine actually fails, scheduling preventative maintenance and improving the efficiency of customers’ fleets?

Accessing and intelligently using more real-time machine data can ensure that customers make more money using CAT equipment than using competitors’ equipment over the equipment’s lifetime, factoring in initial purchase price, uptime, life expectancy, maintenance costs, operating costs, and resale value. Maintenance and uptime are critical value propositions in the large equipment market, and data analytics will help CAT deliver even better on these metrics – by becoming smarter about internal operations, dealers can services dozens more customers per day. With faster, more relevant service, Caterpillar’s equipment and brand value will likely increase in customers’ eyes. Over time, it is also not hard to imagine dealers moving beyond the equipment and parts and services sales into the higher-margin, less volatile fleet management business.

Technology has the potential to transform the supplier/customer relationship over the next 5-10 years, and CAT is investing to take advantage of this emerging opportunity. Most recently, CAT partnered with data analytics startup Uptake to address some of these needs.

Regarding the partnership, CAT’s CEO said, “This relationship will combine Caterpillar’s world-class product engineering and design expertise with Uptake’s software, application and data analytics expertise. As a result, we’ll be able to transform the quintillion bytes of incoming data we see every day into useful information we feed back to our customers for on-the-spot decisions and planning purposes to further reduce owning and operating costs…We want to empower our customers with the insight necessary to shift from a reactive “repair after failure” mode to a proactive “repair before failure” stance. The end result will be more efficient operations and increased fleet availability for our customers. And the more our customers’ machines and engines stay running, the more money they make.”

Prior to the Uptake deal, CAT tapped CalAmp for ruggedized wireless routers it will install on equipment around the globe to enable fluid data communication in any environment. While these investments are small parts of CAT’s overall strategy and aren’t moving the needle today, they reinforce Caterpillar’s foresight to invest today to maintain the strength and enhance the abilities of its crown jewel (i.e. the dealer network) for decades to come.

With that said, let’s take a look at the safety and growth characteristics of CAT’s dividend.

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. CAT’s long-term dividend and fundamental data charts can all be seen here and support the following analysis.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

CAT scored a Safety Score of 47, an average ranking that suggests Caterpillar’s dividend is safer than 47% of all other dividend stocks. For a cyclical company facing headwinds, this is a respectable score for dividend safety.

Over the trailing twelve months, CAT’s dividend has consumed 49% of its unadjusted GAAP earnings and only 37% of its free cash flow. While CAT is obviously a cyclical business, these payout ratios are very healthy, offering both near-term protection and opportunity for long-term dividend growth.

Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, CAT’s payout ratios have remained pretty stable, aside from the financial crisis. The company’s consistent free cash flow generation and general conservatism allowed it to continue growing its dividend during the crisis, and its free cash flow payout ratio jumped to only 54%. The company appears to be very well managed and in a good position to continue growing its dividend, even given today’s challenging markets.

Caterpillar

Caterpillar

For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. Our Stock Analyzer tool lets us see how a company performed during the financial crisis in one click. Caterpillar’s reported sales were down 37% in fiscal year 2009 (its worst revenue drop ever), and operating margins plunged from 10.9% in fiscal year 2007 to just 1.8% in fiscal year 2009, signs of a very cyclical business. The company works very hard on improving its trough strategy, forcing each business unit to model the worst trough in their history (e.g. sales drop 80% in two years) to help the company keep meeting its three crisis goals: (1) stay profitable with strong cash flow; (2) maintain the credit rating; and (3) maintain the dividend. As conservative dividend investors, we appreciate this conservatism and thoughtful business planning.

Caterpillar

Importantly, CAT continued throwing off nice amounts of free cash flow during the crisis and has generated free cash flow each of the past 10 years. For a cyclical company, this is no small feat! Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio.

Caterpillar

While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well. This is especially true for cyclical companies, which can face life-threatening refinancing risks during periods of cyclical lows if they mistimed the market with their balance sheets and expansion plans.

CAT’s balance sheet is a little tricky to analyze because the company has a financing arm to support its dealers. This adds significant leverage to the balance sheet, but the debt is backed by equipment in the field.

As seen below, including the company’s debt from financing operations, Caterpillar’s long-term debt to capital ratio has remained quite steady over the last decade and suggests the company’s current leverage is in similar or slightly better shape than it was entering the financial crisis. If the debt from CAT’s financing operations is excluded, the company’s debt to capital ratio drops to a healthy 35%.

Caterpillar

Importantly, CAT also has nearly $8 billion in cash on hand today compared to just $2.7 billion at the end of 2008 and $1.1 billion at the end of 2007. With the company continuing to generate free cash flow even in rough markets (CAT has produced over $1.8 billion free cash flow YTD and generated cash during the financial crisis) and on pace to pay out around $1.7 billion in dividends for the full year, the dividend looks to be in very good shape from our perspective.

The credit metrics below include CAT’s debt from financing operations, so the numbers are on the conservative side. Even so, the company’s debt appears to be well covered, and it’s great to see so much cash on the balance sheet. CAT was even able to successfully issue 50-year bonds last year at a 4.8% yield, another sign of its perceived financial strength by the market.

Caterpillar

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios.

CAT’s Growth Score is 58, meaning its dividend’s growth potential ranks slightly above the average dividend stock’s growth potential (a score of 50 is “average”). The company’s relatively low payout ratios, consistent cash flow generation, and balance sheet health should allow it to continue growing its dividend despite challenging near-term market trends.

While market trends are currently challenging, Caterpillar’s efforts to take out costs, improve revenue generation at its dealers, and harness technology to unlock to revenue opportunities should help stabilize profits in the near-term while providing better growth potential as cyclical markets eventually recover.

CAT has increased its dividend for more than 20 consecutive years and most recently raised its dividend by 10% to $0.77 per share. The company’s dividend has increased at a 12% annual rate over the last 10 years and 13% over the last three years.

Caterpillar

Valuation

CAT’s dividend yield is 4.2%, a Yield Score of 73 in our database – this means that CAT’s current dividend yield is higher than 73% of other dividend stocks in the market. Given the safety and above-average growth characteristics of CAT’s dividend, today’s yield is very appealing.

CAT also trades at 12x last year’s earnings and less than 15x forward earnings estimates. With fundamentals looking closer to a bottom than a top (sales are expected to hit $49 billion in fiscal year 2015, down from about $66 billion three years ago), CAT’s multiple looks relatively attractive. Should global economies surprise to the upside over the next 1-2 years and CAT see earnings recover to $7+ per share, the stock would trade at about 10x earnings if it remained at today’s price. When demand shows hints of recovering, the stock can move fast – CAT’s shares surged more than 60% in 2010.

Unless the world enters another recession, Caterpillar’s value looks interesting today for long-term dividend growth investors and also provides nice current income with a 4.2% dividend yield. A position in CAT will likely increase your portfolio’s volatility, so prudently sizing your position and considering averaging in are particularly important factors to think about.

Conclusion

Uncontrollable macro factors have worked against CAT over the past three years, causing the stock to significantly underperform the market. While the business is cyclical, the company’s hefty cash pile on hand, consistent free cash flow generation, and moderate payout ratios create strong cushion for the dividend and appear to offer double-digit dividend growth potential when its markets eventually rebound. Timing the bottom of the current down cycle is impossible, but the stocks 4.2% dividend yield (higher than 73% of all other dividend stocks in the market) and reasonable forward P/E multiple of 14.5 indicate the stock’s relative attractiveness for very long-term focused dividend investors. The reasons for CAT’s success over its 85+ years of being in business continue to hold true today with its dealer network, and the company is quickly integrating new technologies that will widen its moat. For these reasons, we believe CAT offers compelling total return potential over the next few years and include the company in our Top 20 Dividend Stocks list.

About Simply Safe Dividends

Simply Safe Dividends provides easy-to-use stock analysis software for dividend investors. Our dividend data and tools help dividend investors save time and make better investment decisions. From our Top 20 Dividend Stocks list and four hand-picked dividend portfolio to our stock screener and fundamental charts, we have everything a dividend investor needs to save time, make better stock picking decisions, and reduce risk. Over 2,700 dividend stocks and 25+ years of data are inside.