Dividend Growth Stock of the Month for September 2019

Caterpillar (CAT) is the world’s largest heavy-equipment manufacturer, with $55 Billion in revenue in 2018, amounting to about 16% of global market share.

CAT manufactures, sells, and services construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives all over the world.

Caterpillar’s Dividend Record

Caterpillar is a mid-yield, variable-growth dividend company.

Its dividend growth per year shows more fluctuation than we usually see. Rather than describe it in words, here is a record of CAT’s dividend’s percentage growth, per year, since 2000:

[Source: Dividend Champions spreadsheet]

We see increases from <2% on the low end (2002-03) to ~20% on the high end (2006-07, 2019).

Caterpillar operates in a cyclical business, and that is reflected in the variability of its dividend increases.

I think the company’s ability to be a Dividend Champion (25+ straight years of increases) is impressive in light of its cyclicality.

I don’t consider the dividend growth variability to be highly significant in connection with a long-term dividend growth strategy.

Caterpillar stressed its commitment to its dividend at its 2019 Investor Day conference.

It is targeting high-single-digit increases over the next four years.

What’s the Story? Caterpillar’s Business Model and Company Quality

Caterpillar could be called an infrastructure company: It does not own infrastructure, but rather it creates machines to build and maintain it.

Caterpillar’s market (and reporting) segments are as follows:

[Source of all slides in this section]

Caterpillar’s worldwide network to support these segments includes about 170 dealerships and more than 2000 branches. A little over 50% of CAT’s revenues come from outside the USA.

Strategically, Caterpillar is emphasizing expansion in its service offerings to help drive overall growth and reduce the inherent cyclicality of its business. The company estimates that over 95% of its customer contacts take place after the sale. Heavy equipment is long-lasting, but it must be maintained.

CAT’s services include product support, services in the field (inspection, troubleshooting, and repair), aftermarket parts, and a focus on digital-enabled solutions to increase customer loyalty and further strengthen its customer relationships.

Caterpillar uses the term “ME&T,” which stands for Machinery, Energy, and Transportation, to broadly refer to its services operations. The company hopes to double revenue from ME&T between 2016 ($14 B actual) and 2026 ($28 B target).

Here is how Caterpillar describes its overall investment proposition for shareholders.

Morningstar awards Caterpillar a Wide moat, based on factors such as its brand strength; extensive global dealer network; complete product lines; tight customer relationships; intellectual property engineered into its products (the company holds more than 20,000 patents); high switching costs for customers; and the growing use of technology – including interconnectedness – in its products.

Caterpillar’s Financials

I like to begin this section by seeing how Value Line rates the company’s overall financial strength. Then I go through specific financial metrics and see if I agree with their assessment.

Value Line gives Caterpillar its second-highest Financial Strength grade: A+.

The company has held that grade since 2012. Let’s look at the key financial categories and see if we agree.

Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.

The average ROE for all Dividend Champions, Challengers, and Contenders is 12%. Champions by themselves are at 10%. The following chart shows Caterpillar’s ROE 2009-2018.

[Source of all yellow-bar charts: Simply Safe Dividends]

Caterpillar’s cyclicality shows up obviously in this chart. CAT’s ROE is inconsistent from year to year.

Results like this are typical with cyclical companies. As an investor, you can either accept it or not. As I stated earlier, I think that CAT’s ability to increase its dividend every year in the face of the inherent cyclicality of its business is impressive.

Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.

A typical D/C ratio for a large, healthy company is 50%.

The normal use of D/C is to gauge risk, because it helps determine how strong the balance sheet is. All else being equal, stocks with high D/C ratios are generally riskier than those with low D/C ratios.

Caterpillar uses a lot of debt. The company does have a strong credit rating of A, but normally I would see this consistently high level of debt as a negative.

In CAT’s case, the debt level is somewhat offset by Caterpillar’s large cash position, which stands at around $8 B. So overall, I see CAT’s debt use as OK.

Operating margin is one of my favorite financial metrics. It measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.

Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range. Caterpillar’s margins are average.

At its 2019 Investor Day presentation, company executives said that they are targeting long-term operating margin improvement of 3-6 percentage points compared to the company’s 2010-16 historical baseline average of 7%-15%.

Their target is an operating margin range of 10%-21%. You can see improvement in the chart in 2017-18, the first two years of the program.

Part of this effort is a years-long program to improve operating efficiencies. The program includes reductions in both operating costs and the company’s fixed assets.

Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.

Caterpillar’s cyclicality shows up again in its EPS. The up and down years match the ones we saw with CAT’s ROE.

CFRA’s forward estimates for EPS growth are in the 5%-10% range over the next two years.

Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the money a company has available for dividends, stock buybacks, and debt repayment.

Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.

While there is some cyclicality to CAT’s cash flow, this presents a much stronger picture. The more consistent cash flow helps support CAT’s string of dividend increases.

Share Count Trend shows whether the company’s outstanding shares are increasing, decreasing, or remaining flat.

I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.

Caterpillar’s share count, while 11% lower than it was a few years ago, is basically flat over the past 4-5 years. While the company has a buyback program in place, it has not done much to reduce the outstanding shares.

In Q1 2019, CAT repurchased $1.4 billion shares of common stock, reducing its share count by about 3%.

Here is a summary of the items above:

Taking everything into account, I think that Value Line’s A+ financial rating is too generous for Caterpillar. I would give it a B.

I do give CAT credit for its strategic focus on improving its margins, cost structure, and services business (which helps smooth out some of its inherent cyclicality); and also, for its healthy cash position.

Caterpillar’s Stock Valuation

I use four different approaches, then average them out.

Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.

The basic valuation estimate uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a basic “fair value” reference line.

In the following chart, the fair-value reference line is orange, the black line is CAT’s actual price, and I circled CAT’s current P/E ratio.

Since the black price line is below the orange fair-value reference line, Caterpillar is undervalued by this first method.

To calculate the degree of undervaluation, we make a ratio out of the P/Es.

Calculating Valuation Ratio from FASTGraphs
Actual P/E ratio / Reference P/E ratio
9.8 / 15 = 0.65

That suggests that Caterpillar is undervalued by 35%.

We calculate the stock’s fair price by dividing the actual price by the valuation ratio. We get $114 / 0.65 = $175 for a fair price.

That’s a wide disparity from CAT’s actual price. In the next steps, we’ll see whether that makes sense or is misleading.

I believe it is a good idea to keep the uncertainty of valuation in mind as an investor. We’re not measuring a physical trait like length or width. We are making a value judgement.

Different methods and models will come up with different results. That’s why I average four models.

Step 2: FASTGraphs Normalized. The second valuation step is to compare Caterpillar’s current P/E to its own long-term average P/E.

This step paints a similar picture to the first step and again suggests that CAT is significantly undervalued.

CAT’s 5-year average P/E is 16.9 (circled). The blue fair-price reference line is drawn using that P/E. Again the black price line is below the blue reference line.

Using the same calculation methods as above, we get the following results for CAT’s valuation.

• Valuation ratio: 9.8 / 16.9 = 0.58
• Fair price: $114 / 0.58 = $197

This suggests that Caterpillar is selling at even a larger discount than the first method.

Step 3: Morningstar Star Rating. Morningstar takes yet a different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.

In a nutshell, the DCF model is based on the idea that a company is worth all of its future cash flows, discounted back to the present to reflect the time value of money.

Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they have an admirably comprehensive and conservative process.

Morningstar gives Caterpillar 4 out of 5 stars, meaning that they consider the stock to be undervalued. Here is a historical graph of their fair value estimates (black line) compared to the stock’s price (dotted).

Currently, they calculate a fair price of $169, which represents a valuation ratio of 0.68 and a discount of 32%. Normally, I would expect Morningstar to give such a wide variation five stars, but they also believe that there is a high degree of uncertainty to valuing Caterpillar.

Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield. This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued.

This chart shows Caterpillar’s current yield (green dot) compared to its 5-year average yield.

[Source: Simply Safe Dividends]

CAT’s 5-year average yield is 3.1%, while its current yield is 3.6%. When the current yield is higher than the historical average, that suggests that the stock is undervalued.

As with the other methods, we can make a valuation ratio out of these numbers.

Calculating Valuation Ratio from Yield Comparison
Historical yield / Current yield
3.1% / 3.6% = 0.86

That suggests undervaluation of 14%, which in turn suggests a fair price of $133.

Valuation Summary:

The bottom line on my valuation is that Caterpillar is 33% undervalued, with a fair price of $169. That has to be considered a very good deal if you like the company.

For comparison, CFRA’s current estimate of CAT’s fair value is $147.

Miscellaneous Factors

Beta

Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:

• They present fewer occasions to react emotionally to rapid price changes like price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.

Caterpillar’s 5-year beta is 0.58, which means its volatility has been, on average, well less than the market’s. This is a positive factor.

Analyst’s Recommendations

In their most recent report on Caterpillar, Thomson Reuters gathered the recommendations of 28 analysts covering the stock. Their mean recommendation just edges into the “buy” range.

This is a slightly positive factor.

What’s the Bottom Line on Caterpillar?

Here are CAT’s positives:

• Good dividend yield (3.6%) combined with a 26-year streak of increases, including 19% increase this year.
• “Very Safe” dividend safety grade of 93/100 from Simply Safe Dividends.
• Global leader in heavy equipment. Worldwide dealership network, strong customer relationships, and robust services infrastructure.
• Strengthening service business, with target to double revenue from services in a decade.
• Program to improve operating margins is off to good start in its first two years.
• Investment-grade credit rating from S&P, high Safety rating from Value Line, Wide Moat rating from Morningstar.
• Shares are 33% undervalued.

And here are CAT’s negatives:

• Operates in highly cyclical industries.
• Capital structure dependent on high debt levels, although that is somewhat offset by large cash position.
• Unproven yet whether higher operating margins will be sustainable through full business cycles.

In my opinion, Caterpillar presents a solid dividend growth opportunity. The company’s ability to be a Dividend Champion in a cyclical business is impressive. The company’s significant undervaluation presents an attractive entry point.

Here are other recent discussions of CAT on Daily Trade Alert.

The 9 Best Stocks to Own on U.S.-China Trade Optimism (James Brumley, April 2019)
Stocks We Are Considering for the Income Builder Portfolio in 2019 (Mike Nadel, January 2019)
Bill Gates’ Dividend Portfolio (Brian Bollinger, August 2018)
Stocks of the Month for August 2018 (Rick Pendergraft, August 2018)

Remember that this is not a recommendation to buy, hold, or sell Caterpillar. Always do your own due diligence. Think not only about the company’s quality, dividend outlook, and business prospects, but also about how and whether it fits your personal financial goals.

— Dave Van Knapp

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