The Worst Appears To Be Over For This Quality Dividend Growth Stock

Even blue chip dividend stocks can fall on hard times, especially when they operate in highly cyclical industries that depend on volatile commodity prices.

Such was the case with Caterpillar (CAT), which despite an impressive track record of growing its dividend at an average rate of 11% over the past 20 years, was forced to freeze its pay increases for eight consecutive quarters during the worst industry downturn in decades.

However, now it appears as if the worst is over, so let’s take another look at Caterpillar to see how its fundamentals have held up during this most recent industrial recession and if today could be a reasonable time to consider adding the stock to a diversified dividend growth portfolio.

Business Overview
Founded in 1925 in Peoria, Illinois, Caterpillar is the world’s largest industrial machine maker, with its hands in all major infrastructure industries.

The company manufactures and sells construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.

A meaningful amount of Caterpillar’s revenue is also tied to higher-margin, less volatile aftermarket parts and components; however, the company does not disclose the size of its aftermarket business.

Source: Caterpillar Investor Presentation

The company operates through four main business segments.

Construction Industries (40% of 2016 sales, 47% of 2016 segment profits): makes backhoes, site prep tractors; excavators; and motor graders, pipelayers, telehandlers, cold planers, asphalt pavers, compactors, road reclaimers, and wheel and track skidders and feller bunchers.

Resource Industries (15% of 2016 sales, -30% of 2016 segment profits): produces electric rope and hydraulic shovel, landfill and soil compactors, dragline, large wheel loader, track and rotary drills, electronics and control systems, work tool, hard rock vehicle and continuous mining systems, scoops and haulers, wheel tractor scrapers, wheel dozers products;continuous miners; and mining, off-highway, and articulated trucks.

Energy & Transportation (37% of 2016 sales, 63% of 2016 segment profits): offers reciprocating engine powered generators set, centrifugal gas compressors, diesel-electric locomotives and components, and other rail-related products and services.

Financial Products (8% of 2016 sales, 20% of 2016 segment profits): primarily offers financing for Caterpillar equipment, machinery, and engines, as well as dealers; property.

In general, Caterpillar makes most of its money from the road construction and heavy construction industries, with about 50% of sales from North America.

Business Analysis
You typically don’t find companies with lengthy dividend growth track records in capital intensive and highly cyclical industries.

That’s because high fixed costs and volatile revenues, which are heavily influenced by global commodity markets, make for extremely unpredictable earnings, cash flows, margins, and returns on capital over time.

Source: Simply Safe Dividends

However, just because an industry is volatile doesn’t mean that select, best-in-breed industry leaders can’t make great dividend growth stocks. That’s because the capital intensive nature of the industry also makes Caterpillar’s moat very wide.

Specifically, the company has numerous competitive advantages that allow it to maintain strong pricing power for those products that are ordered (even if the volume decreases during an industrial recession).

This is because the products Caterpillar manufactures are typically very complex and increasingly high-tech, and the end consumer is most concerned with highly reliable and rugged products (that can operate in extreme climates where temperatures vary from -40F to 120F) from a brand they know and trust.

The company’s large global distributor network (Caterpillar sells its products to dealers who sell them to end users across different markets) is also a major competitive advantage.

Caterpillar’s network consists of about 150,000 global independent contractors who have strong local relationships with end users. To put this in perspective, Caterpillar’s largest rival, Japan’s Komatsu, is about half the size.

Why is a large dealer network so important for Caterpillar in the heavy 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 Caterpillar 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 Caterpillar.

Overall, the company’s large dealer network is a critical advantage that helps Caterpillar more easily win new orders, resupply old sales, and maintain global market share.

Even during long industry downturns, including the slump from 2013 to 2016 when global commodities crashed (which hurt miners and energy producers), Caterpillar’s giant scale and access to vast resources allowed it to not only survive but make vital changes that ensure its long-term market dominance will continue.

For example, Caterpillar has undergone major restructuring in the past four years that includes vast cost cutting, non-core asset sales, and maximizing low cost global sourcing for inputs, while actually improving the quality and reliability of its products.

While those restructuring costs have resulted in substantial decreases in reported earnings, the company’s free cash flow has risen nicely to $4.3 billion, good for a healthy double-digit margin.

Caterpillar Trailing 12-Month Profitability

Sources: Morningstar, Gurufocus

And that’s after spending $2 billion in 2016 on R&D, including cutting edge Internet of Things (IoT) and automation integration into its products that will help its customers achieve greater cost efficiency in the future.

In other words, while Caterpillar has spent the industry downturn cutting costs to the bone, it’s also been planning for the future by focusing on improving quality and making its machines’ capabilities aligned with the market’s emerging trends.

Better yet, because Caterpillar is an industry leader in automated mining technology, the company is appears to be well positioned to maintain and gain market share in an industry where maximizing productivity and thus lowering production costs per ton is the primary concern.

Meanwhile, Caterpillar’s integration into the Internet of Things, via fast developing 5G technology, will allow end users to maximize the utility of their machines and thus reduce cost overruns to help maximize profits.

Caterpillar 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.

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 Caterpillar’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 Caterpillar’s equipment than competitors’ gear 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 investments should help Caterpillar 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, supporting the premium pricing its brand enjoys.

Simply put, technology has the potential to transform the supplier/customer relationship over the next 5 to 10 years, and Caterpillar is investing to take advantage of this emerging opportunity.

Best of all, Caterpillar is set to benefit in the coming decades from growth in infrastructure needs as the world’s population increases and the world urbanizes, requiring trillions of dollars in new infrastructure and construction spending.

In addition, because so much of this population growth will be in fast-developing emerging markets, energy use, including from traditional fossil fuels, is still expected to grow strongly despite the rise of renewable alternatives, supporting demand for much of Caterpillar’s product portfolio.

The bottom line is that Caterpillar is an industry leader with a strong technological advantage. The company’s well-earned reputation for quality and reliability, along with its globe-spanning distribution network, mean that it’s likely to continue winning market share while being able to command premium prices and expand its margins over time. The end result is strong free cash flow growth and steady dividend increases.

Key Risks
There are four important risks to keep in mind before investing in Caterpillar.

First, never forget that it operates in highly cyclical industries, such as construction, mining, and energy extraction.

As a result, Caterpillar’s sales, earnings, and cash flow are highly sensitive to the global economy and commodity prices. While the company’s long-term growth catalysts are strong, in the short to medium-term a lot of the company’s fundamentals are outside management’s control.

Caterpillar’s performance 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, Caterpillar 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.

If this goes on long enough, the dividend’s safety could become impaired.

Next, as the company’s sales increasingly come from overseas, Caterpillar will become more and more exposed to foreign exchange risk.

Specifically, a strong U.S. dollar would increase the cost of its products in foreign countries, as well as hurt reported earnings and cash flow growth domestically (when local currencies are converted to U.S. dollars for accounting purposes).

In addition, while Caterpillar’s strong focus on reliable, durable, and high-tech equipment has been a big success in western markets, in emerging economies the company has struggled to win similar market share because end users in those nations often focus more on the upfront cost of machines and less on the long-term operating costs. This could hinder the company’s long-term, international growth efforts.

Finally, due to the highly capital intensive nature of the business, Caterpillar holds a lot of debt, which in coming years will need to be refinanced in a rising interest rate environment. This means interest costs are likely to rise and could further create headwinds for the growth of its bottom line and dividend.

Caterpillar’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

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

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

Caterpillar has a Dividend Safety Score of 63, indicating a relatively safe dividend and improvement compared to last year thanks to the company’s cost cuts and a return to growth in several key end markets.

Caterpillar has one of the most consistent growth records of any cyclical stock. This consistency is courtesy of management’s record of generating strong free cash flow even in times of severe economic and industry distress (Caterpillar was still free cash flow positive during the great recession), helping covering the dividend even if earnings do not.

In fact, thanks to the end of the global industrial recession, Caterpillar’s FCF payout ratio over the past 12 months has come in at a conservative 42%, thanks to management paring back on capital spending and stepping up aggressive cost cutting, both which sent FCF up significantly.

Equally important for long-term dividend security is a strong balance sheet, which management has stated is a top priority (as is the dividend).

At first glance, Caterpillar’s giant debt pile may seem frightening. For a cyclical and highly capital intensive company, it’s important that management hasn’t overextended the company with leverage.

But we also need to remember that Caterpillar is great at generating strong FCF even during industry recessions, so we need to keep things in perspective.

For example, when we compare Caterpillar to its peers, we find a slightly above average leverage ratio (Debt/EBITDA), but much lower debt/capital and a current ratio (short-term assets/short-term liabilities) that is nearly quadruple the industry’s average.

In addition, the interest coverage ratio is nearly double that of its peers, which is why Caterpillar still enjoys a very strong investment-grade credit rating.

Sources: Morningstar, Simply Safe Dividends, Fast Graphs, CSImarketing.com

That allows it to continue borrowing very cheaply (average interest rate is just 1.3%), giving management more financial flexibility to continue growing the business while still maintaining a safe dividend.

Caterpillar’s Dividend Growth
Caterpillar has a strong historical record of generating double-digit payout growth over decades, including several industry business cycles.

Caterpillar’s impressive ability to continue being free cash flow positive even during the worst economic and industry downturns of the past 50 years means that investors can generally expect dividend growth to continue at a moderate pace.

However, be aware that because Caterpillar’s business model is so volatile, estimating dividend growth is very challenging, especially during any short to medium-term period.

Analysts do expect that continued global economic growth and a recovery in commodity prices should allow Caterpillar to grow its EPS at about 10% annually over the next decade.

This, along with a relatively safe payout ratio over the trailing 12-month period means that Caterpillar should be capable of high single-digit dividend growth, if those rosy economic and industry assumptions prove true.

However, remember that in a volatile industry such as this, any long-term growth forecast is a an educated guesstimate and needs to be taken with a grain of salt.

Valuation
Since the U.S. presidential election, Caterpillar’s shares are up more than 60%, beating the market by about 45%. However, CAT’s share price has far outpaced the fundamental improvements in the company’s business, making the stock appear somewhat overvalued.

For example, CAT’s forward P/E ratio is 18.5, which is higher than the S&P 500’s and the stock’s historical 16.0 average.

CAT’s dividend yield of 2.3% is below its five-year average near 3% and at a three-year low.

Given the highly cyclical nature of the stock, Caterpillar isn’t a good choice for those looking to live off dividends in retirement, especially after this volatile stock has experienced such a strong run up.

Over the long-term, Caterpillar’s business can presumably grow somewhat faster than global GDP thanks to the operating leverage in its business and continued share repurchases.

Given analysts expectations and assuming long-term earnings growth in the high single-digits, Caterpillar’s stock could generate 8.3% to 10.3% annual total returns (2.3% dividend yield plus 6% to 8% annual earnings growth).

However, keep in mind that the unpredictable nature of its business model means that those returns, if they happen, could very well be lumpy. Plenty of dividend aristocrats and dividend kings offer similar or better total return potential with far less uncertainty.

Conclusion
When it comes to heavy machinery makers, they don’t get much better than Caterpillar. The company’s long operating history, entrenched products, substantial dealer network, and conservative management have helped the company maintain its dividend during tough economic and industry times.

With the worst of the current downturn potentially over, Caterpillar’s investors can likely expect improving fundamentals and a strengthening balance sheet, as well as faster dividend growth in the future, at least compared to the last few years.

That being said, as a highly cyclical company, Caterpillar may not be the most appropriate selection for a very conservative retirement portfolio. The strong rally of the last few months means that many of the fundamental positives are probably baked into the current share price (and then some).

Caterpillar is better off on a watch list for now, and investors seeking current income with less price volatility can review some of the best high dividend stocks here instead.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends