CAT - Caterpillar: How To Trade A Cyclical Dividend Growth Company

2023-03-08 05:54:48 ET

Summary

• CAT has a strong financial position, with healthy cash flows and manageable debt levels.
• The company enjoys a strong competitive advantage, manifested in a strong brand and significant market share.
• The Payout ratio is reasonable and sustainable, with a dividend growth track record spanning over three decades.
• Cost-averaging investment strategies can optimize cyclicality and earnings variability.

Investment Thesis

Caterpillar Inc. ( CAT ) is a multinational corporation focused on designing and manufacturing construction equipment, power generators, and other industrial products. The company has a long history and a strong brand name in the industry. It is one of the largest companies in the mining and construction equipment sector, which provides it with a competitive advantage.

From a financial perspective, CAT has a strong balance sheet, generating steady cash flows and returning value to shareholders through share buybacks and dividend payments. The company has also demonstrated an ability to navigate through challenging economic environments in the past.

However, like all companies, CAT faces risks and challenges. The company is exposed to the cyclicality of the construction and mining industries, which can impact its sales and profitability. It also faces competitive pressures from other large players in the industry.

Ultimately, whether CAT is a good investment depends on various factors, including your investment goals, risk tolerance, and overall investment portfolio. In my view, value-averaging or dollar-cost averaging can be good strategies for investing in CAT as it helps to buy more shares when the price is low and fewer shares when the price is high, which can help minimize the impact of market volatility derived from the cyclical nature of its business, and potential, improving long-term returns but allowing exposure to a quality dividend growth company while sparing investors from the tedious task of timing the market and revenue cycles. Within these lines, we issue a buy rating for CAT stock based on its strong financials, reasonable and sustainable payout ratios, consistent track record of increasing dividends during difficult times, and management's commitment to returning capital to shareholders weighed against revenue variability, cyclical nature of operations and increasing competition.

Revenue Trends

At this stage, it appears that inflation-driven Fed tightening policy may have exacerbated concerns of an economic hard landing. In 2022, shares of the construction equipment giant CAT reached an all-year low of $162 per share in September, as fears over the impact of the Fed's monetary tightening, inflation, and labor and material shortages would have on the company. Yet revenue not only showed resilience but demonstrated accelerated momentum in Q4.

CAT is known for its construction and mining equipment business, but many overlook the diversified end markets it services, the industries, and the applications in which its products are used. Diversification helps to reduce the risk of revenue and profit losses due to changes in any particular market or segment. With a portfolio of products and services spanning multiple industries and applications, CAT can better weather economic downturns or changes in demand in any area.

In Q4, CAT's sales for residential construction customers declined as rising interest rates reduced builders' profitability and slowed industry growth. Nonetheless, this decline was offset by strong mining and agriculture equipment sales. Beyond product diversification, CAT is also geographically diverse. In 2009, North America's sales decline was offset by residential demand growth in China, Oil and Gas in Russia (before sanctions), and Mining in Brazil. In 2022, we saw the same dynamics but in the opposite direction, with demand from China slowing due to COVID lockdowns Russian/Ukraine invasion, offset by a rise in demand in the US due to accommodative fiscal spending on infrastructure after the passage of the Infrastructure Investment and Jobs Act, with $1.2 trillion budget, the largest in US history.

Beyond reducing risk, Baird analyst believes expanding into the agriculture business can stimulate innovation, new product development, and growth, suggesting that CAT buy AGCO ( AGCO ) to enhance its position in agriculture. This makes sense, given that the market opportunity f rural mechanization is high and opens the door for improved access to developing markets. The company faces intense competition from Deere ( DE ) and CNH Industrial ( CNHI ), who have a solid market position in this vertical.

CAT continues to adjust its portfolio in response to competitive dynamics. In 2021, it exited Motoren Medium Speed Engine (MSE) used in Marine propulsion engines, rail locomotives, and power generation. Regardless of future changes in the company's portfolio, we see a revenue momentum across the board beyond US residential and a few pockets of lagging smaller business lines. Optimism over 2023 prospects, driven by strong demand from miners and infrastructure spending. Backlog increased by more than 30% in Q4, reaching $30.4 billion, but not all analysts are optimistic about the company's share price prospects, especially given the rapid rebound in recent months.

Last month, Baird analyst downgraded CAT to Hold from Buy, citing concerns that CAT has reached peak cycle in demand, forecasting a backlog peak in Q1 2023, contradicting management's optimism over the year's prospects as manifested in revenue outlook upgrade from $39-$66 billion to $42-$72 billion.

On the other hand, Seeking Alpha contributor Leo Nelissen brilliantly argues that Net Zero emission targets could propel a replacement cycle that could extend for decades, generating billions for CAT. Along these lines, he states:

Mining equipment demand is expected to soar for decades to come as the entire trend for green energies is now dependent on our ability to mine metals. It's truly as dramatic as it sounds. Even better, Caterpillar itself is investing in new technologies, working on major deals with the world's largest miners.

This bated breath is faced by calls of caution from investors citing recession prospects and dangers of buying into forecast optimism. For example, Juxtaposed Ideas cite increasing competition from Chinese companies capitalizing on the nation's strong technological position in emerging markets, such as EV and autonomous mining haul trucks and construction equipment.

Bulls and bears have strong points to make, but for me, I am not invested in predicting economic cycles. I believe that market trend optimization is more significant than individual chances in underlying business drivers. For this reason, I believe that value-averaging is the best market approach to investing in CAT, allowing for exposure to its dividend growth while minimizing the impact of its largely cyclical underlying business.

Summary

CAT is a well-known company in the construction equipment industry, and it has a long history of generating steady cash flows and returning value to shareholders through share buybacks and dividend payments. However, the company is also exposed to the cyclicality of the construction and mining industries, which can impact its sales and profitability.

Many investors sound the alarm over the rapid rebound in CAT's shares, fueled by what management calls a revenue momentum in Q4 that signaled a more favorable outlook for the rest of the year. While awaiting a price correction that might never come, especially if what bullish investors say about a start of a super replacement cycle is true, investors are foregoing dividends and potential continued share price rallies.

To overcome these competing dynamics, I believe that value-cost averaging is the best way to optimize your exposure to CAT rather than trying to time the market.

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