NEW YORK (TheStreet) -- Uncontrollable macro factors have worked against Caterpillar (CAT - Get Report) 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 stock's 4.4% dividend yield (higher than 73% of all other dividend stocks in the market) and reasonable forward price-to-earnings multiple of 14.5 indicate the stock's relative attractiveness for very long-term focused dividend investors. The reasons for Caterpillar'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 Caterpillar offers compelling total return potential over the next few years and include the company in our Top 20 Dividend Stocks list.
As seen below, Caterpillar's stock was a huge winner from the late 1990s through 2010 -- a rising line means Caterpillar's total shareholder return outperformed the market. Rising commodity prices, fueled by China's rapid infrastructure build-out, were a boon for heavy equipment manufacturers' customers.
Since 2010, commodity prices have rolled over, starting with mining. U.S. 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 Caterpillar. The stock compounded at a 2.8% annualized return from 2012 to 2014, significantly trailing the market's 20.1% compound annual growth rate. Over the last year, Caterpillar 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 year-to-date:
From a product perspective, Caterpillar's breadth is unmatched -- construction and mining equipment, diesel and gas engines, industrial turbines, and locomotives are its main lines. About 85% of Caterpillar's operating income comes from its construction industries (29%) and energy and transportation (54%) segments. Construction industries sells an array of loaders and excavators and its key end markets are self-explanatory. Energy and 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, Caterpillar'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 Caterpillar at the moment, it can be easy to forget the success factors that built Caterpillar into a $50+ billion business. Caterpillar's historical success starts with its dealers. Caterpillar sells its products to dealers who sell them to end users across different markets. Caterpillar's global network of more than 175 independent dealers is second to none. To put things in better perspective, Caterpillar's largest rival, Japan's Komatsu, is about half the size of Caterpillar. Caterpillar's independent dealers have about 162,000 employees, over 40% more than Caterpillar'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 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.
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 Caterpillar'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.
Caterpillar 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 Caterpillar's estimated 2015 revenue ($49 billion). Should demand in Caterpillar's markets simultaneously recover, operating leverage could work for Caterpillar in a very large way over coming years.
Technology will play an increasingly important role in strengthening Caterpillar's dealer advantage. Caterpillar has more than three 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 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 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 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. 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-to-10 years, and Caterpillar is investing to take advantage of this emerging opportunity. Most recently, Caterpillar partnered with data analytics startup Uptake to bolster its predictive maintenance software abilities and previously tapped CalAmp for rugged wireless routersit can install on equipment to enable fluid data communication.
While these investments are small parts of Caterpillar'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.
From a safety perspective, Caterpillar's dividend payment looks very secure. Over the last 12 months, Caterpillar's dividend has consumed 49% of its GAAP earnings and less than 40% of its free cash flow. While Caterpillar is obviously a cyclical business, these payout ratios are very healthy, offering both near-term protection and opportunity for long-term dividend growth.
For companies with enough operating history, it's always a prudent exercise to observe how their businesses performed during the financial crisis. 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. Those are priorities any dividend investor can support.
Source: Simply Safe Dividends
Importantly, Caterpillar 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.
Source: Simply Safe Dividends
While payout ratios, margins, industry cyclicality, and free cash flow generation 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.
Caterpillar's balance sheet is a little tricky to analyze because the company has a financing arm to support its dealers, adding significant leverage to the balance sheet. 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 Caterpillar's financing operations is excluded, the company's debt to capital ratio drops to a healthy 35%.
Source: Simply Safe Dividends
Importantly, Caterpillar 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 (Caterpillar has produced over $1.8 billion free cash flow year-to-date 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. Caterpillar 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.
From a dividend growth perspective, Caterpillar raised its dividend by 10% to $0.77 per share this summer and has increased its dividend at a 12% annual rate over the last 10 years. 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.
Caterpillar trades at 12x last year's earnings and less than 15x forward earnings. 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), Caterpillar's multiple looks relatively attractive. Should global economies surprise to the upside over the next 1-2 years and Caterpillar see earnings recover to $7+ per share, the stock would trade at 10x earnings if it remained at today's price. When demand shows hints of recovering, the stock can move fast -- Caterpillar'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 4.4% dividend yield. A position in Caterpillar will likely increase your portfolio's volatility, so prudently sizing your position and considering averaging in are particularly important factors to think about.