CAT - Caterpillar: Exemplary Financials Consistent Dividend

2023-03-08 23:38:27 ET

Summary

• Caterpillar is a global leader in the heavy machinery industry demonstrating the best-in-class profitability metrics with management championing in cost efficiency.
• The company is a dividend aristocrat with an A+ dividend consistency grade from Seeking Alpha Quant.
• My valuation estimates indicate an upside potential of about 11%.

Investment thesis

Caterpillar ( CAT ) has consistently delivered impressive profitability which translated into a robust return on equity, even during the last recession due to Covid-19. The company has a long dividends payout history which indicates a firm commitment to creating shareholders value. This predictability in dividends together with my valuation calculations which indicate an 11% upside potential make CAT stock a compelling investment opportunity for value investors.

Company information

CAT is the world's leader in the manufacturing of heavy equipment with over 13% market share, according to Morningstar . The company's history traces back almost one century, it was founded in 1925. CAT is a component of two major indexes: Dow Jones Industrial Average and the S&P 500.

The company has four reportable segments: Construction Industries, Resource Industries, Energy & Transportation, and Caterpillar Financial Services.

The company pays dividends with a vibrant payout history tracing back to 1933. CAT has a decent "B" overall dividend grade from Seeking Alpha Quant .

Financials

The company announced its latest quarterly results on January 31, 2023 . Despite missing consensus expectations on EPS, I believe that 4Q results were solid. Caterpillar's sales grew more than 20% year-over-year thanks to stronger pricing and increased demand for the company's products.

Sales increased across all three major segments

In Construction Industries, revenue rose 19% YoY, due to favorable pricing and higher sales volumes in both Americas. Segment profit increased 87% from around $800 million to approximately $1.5 billion.

In Resource Industries, revenue rose 26% YoY, also due to favorable pricing and higher sales volumes. Increased sales were partially offset by increased material costs, freight, and higher manufacturing costs. Segment profit increased 110% from around $290 million to approximately $600 million.

In Energy & Transportation segment, revenue rose 19% YoY. Sales increased across all four subsegments. In Oil and Gas subsegment, there was an increase in turbines and turbine-related services, reciprocating engines, and aftermarket parts. In Power Generation major growth drivers were an increase in reciprocating engines and turbine and turbine-related services. The Industrial subsegment faced increased sales across all regions. And Transportation subsegment rose thanks to increases in marine applications, reciprocating engine aftermarket parts and rail services. Segment profit increased 72% from around $685 million to approximately $1.2 billion.

Performance for the full FY 2022 in comparison to FY 2021 was also very strong delivering a 17% revenue increase and adjusted operating profit outpacing the topline with a 31% growth. The company's balance sheet is strong at the FY 2022 year-end with $6 billion cash balance and sound liquidity ratios.

I consider Caterpillar's leverage elevated, but it is at the company's historical average level, so I believe that management is balancing risks well.

The company operates in a cyclical business, so its topline is heavily dependent on the global economy's health and demand is driven by the intensity of customers' capital projects. So, to deliver a solid bottom line and cash flows, management should keep an eye on the costs. Looking back at the company's financial performance in the last 10 years, I can conclude that management has been very strong in managing costs. Both gross and operating margins expanded in the last decade without any significant shrinkages even during the Covid-19 recession.

The management is looking forward to FY 2023 positively, with ambitious plans to continue expanding the operating margin, which is subject to increases in revenue. Consensus estimates forecast CAT revenue at about $63 billion, so we can expect an adjusted operating margin of about 18%.

Valuation

Caterpillar has been very consistent in paying and increasing dividends during the last decades. So, to value the stock I think the dividend discount model [DDM] is the best option. Here I need three assumptions, which I can measure reasonably. First, for the required rate of return, I prefer to use WACC, which is currently estimated by GuruFocus at around 8%. Second, for the current dividend, I use the FY2024 dividend consensus estimate , which is at $5.26 per share. Finally, for dividend growth, I prefer to be conservative, so I take 3Y Dividend Growth CAGR and round it down to 6%.

Incorporating all assumptions together, I arrived at a fair price of the stock of $263, which indicates an 11% upside potential from current levels.

To challenge my calculations, I usually cross-check them with valuation multiples. CAT is a market leader with great profitability metrics , so it is not surprising that multiples are much wider than the sector median demonstrates. Here I would like to emphasize your attention to the fact that currently, the stock is trading below Caterpillar's historical 5-year average multiples, which for me, points to undervaluation as well.

From the price-to-FCF ratio perspective, we can also see that currently, the stock is trading far behind recent highs for this metric. Last year the stock has been trading, on average, well above 30, while the current ratio is in the mid-twenties.

In summary, DDM calculations together with historical valuation ratios analysis suggest that CAT stock is undervalued.

Risks to consider

While Caterpillar represents a good investment opportunity with upside potential and safe dividends, investors face risks as well.

First of all, demand for the company's products and services depends heavily on the global economy. A sharp downturn in the economy will adversely affect Caterpillar's sales and profitability.

Second, from the operating costs side, the company's earnings are vulnerable to fluctuations in commodity prices. In the manufacturing process, Caterpillar utilizes steel as well as other raw materials.

Third, a significant portion of sales are generated from the construction industry, so the company's earnings are heavily dependent on new project demand, building permits, and the overall health of the construction industry.

Takeaway

To conclude, I am very positive about Caterpillar stock because of its exemplary financial performance together with dividend consistency. Being an industry leader, Caterpillar is well-positioned to continue generating strong returns for its investors in the years ahead. The stock is a buy for long-term investors seeking both steady growth and stable dividend income.

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