Caterpillar: Money making insect

Nowadays, there is not many people who did not hear about Caterpillar’s (ticker CAT) excavators and bulldozers. The company which increased its dividend for the 25 years despite the fact that it operates in a highly cyclical industry, where regular dividend growth is a rarity. Caterpillar’s management has repeatedly fulfilled its shareholder commitment despite the inevitable ups and downs of this business over the years. Currently, the dividend yield has returned to 3.1%. This makes me look closely at this stock.

Recent financial results and future outlook

Caterpillar was founded in 1925. Its main area is heavy engineering, especially machines such as bulldozers, excavators and various mining machinery. The production of diesel and gas engines as well as gas turbines is also important part of business. As at 5 February 2020, Caterpillar has a market capitalization of $ 76 billion, generates annual revenue of $ 55 billion and employs around 104,000 people worldwide.

It is important to first take a look at the just released fourth quarter results as this says a lot about the way Caterpillar is handling the current business environment. Let’s start by mentioning that sales had a big slump. Total sales fell by 8% to $13.1 billion. This is roughly $400 million below expectations and the result of weakness in all segments. Total sales volume contracted and caused a $1.0 billion tailwind compared to the prior-year quarter when sales were at $14.3 billion. Moreover, unlike in the third quarter, the company did not manage to take some pressure off of falling volumes by raising prices. Adding to that, unfavorable currency translations came in at a net loss of $103 million in sales. Only financial product revenues did slightly better and added $46 million to total sales. In other words, without having to mention any other details, we are dealing with an increasing case of declining end-user demand.

The good news is that earnings per share were up 3% despite a weak operating result. Not only that, but adjusted EPS reached $2.63. That’s up 3% compared to the prior-year quarter and way higher than expectations of $2.37. One of the reasons the company managed to avoid a three quarter contraction streak is the fact that buybacks continue to reduce the number of outstanding shares – hence supporting profit per share. In 2019, Caterpillar returned $6.2 billion to shareholders. The company increased its dividend by 20% and reduced the number of shares outstanding by 9%. Total free cash flow came in at $5.3 billion.

Despite the relatively positive dividend news, we cannot ignore the weak end of 2019 since it is crucial for future outlook. As estimated by Caterpillar, a “best case” scenario would mean that earnings per share would fall by 9.6%. These expectations are based on lower sales due to lower end-user demand. The company’s current outlook for the future perfectly illustrates the current economic situation, mainly due to the fact that coronavirus in China continues to raise concerns about further economic slowdown.

Coronavirus is currently the major factor causing fall of price per share. Personally, I do not dare to estimate the total impact of virus. However, it is important to learn from the past, where we can see that the stock suffered a similar cyclical drop in 2015/2016 and after that significantly raised again. Last but not least, I’m hugely optimistic based upon orders from the marine segment and then possible military contracts as there is no Tesla bulldozer or heavy equipment of like type which significantly reduces competition for Caterpillar. In other words, Caterpillar is company which does not have to worry much about their market share. Therefore, I believe  Caterpillar should be a good choice in long term despite the current challenges. Before conclusion, let’s look at the stock performance during the last recession.

Recession performance

Caterpillar is certainly not immune to recessions, as the slowdown in the global economy is usually accompanied by lower commodity prices and decrease in construction work. During the last major recession, these factors hit the Caterpillar (though only for a while), as you can see below:

  • 2007 earnings per share $ 5.32
  • 2008 earnings per share $ 5.71 (up 7%)
  • 2009 earnings per share $ 1.43 (down 75%)
  • 2010 earnings per share $ 4.15 (up 190%)

The figures above illustrates that Caterpillar was affected by the crisis. However the market recovered relatively quickly. In 2011, earnings per share were the same as before the recession. The next recession is unlikely to be as devastating for Caterpillar as the last one, but it is almost certain that if this happens, earnings per share will drop significantly again. For the sake of completeness, also look at the dividend payments. Is is nice to see that dividend was regularly increased despite the crisis.

  • 2007 dividend $ 1.32 (year-end yield 2.58%)
  • 2008 dividend $ 1.56 (year-end yield 4.83%)
  • 2009 dividend $ 1.68 (year-end yield 3.90%)
  • 2010 dividend $ 1.72 (year-end yield 2.37%)

Last but not least, let’s see how it would turn out if we invested in the stock at the worst possible moment before the big crisis on 12 May 2008, when the stock was at its peak at 83.7USD per share. For illustration purposes, let’s assume that we bought 11.95 shares for $ 1,000.

Source: Authors work based on data from Seekingalpha.com

As you can see above, even in such an unfortunate investment, we would have been profitable at the end of 2010 due to juicy dividend payments. By the end of 2019, our return of investment would be almost 100% which means 2 111 $ on our account including dividends assuming original investment was 1000 $.

Conclusion

Caterpillar is a stock I follow closely as well as JNJ. I am definetely ready to buy as soon as market goes down. We’ll see how the situation around coronavirus develops. Further spread of the virus might put the stock under pressure and possibly create an opportunity to buy. Because of the above considerations, I believe that Caterpillar is a good investment in long run. Company is supported by a 25-year dividend growth and currently offers attractive yield over 3%. Moreover low payout ratio of around one third of earnings for 2019 is great for further expansion in the coming years. I would like to avoid valuation analyzes again. Let’s conclude with reports from December 2019 and January 2020 from JP Morgan and Daiwa Securities, which estimate the target price of the shares at $ 178 and $ 165.

Sources: seekingalpha.com, suredividend.com, finviz.com

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