CAT - Caterpillar Is Digging Up Cash For Its Shareholders

2023-05-27 05:10:12 ET

Summary

• Caterpillar will soon have paid investors a higher dividend for 30 years.
• The company is growing rapidly and looks set to continue performing well in coming years.
• Investors can expect an 11% dividend increase in June and double-digit shareholder returns for years to come.

It's been a long while since I last analyzed Caterpillar ( CAT ) but the company has developed nicely since then, as it has for the last 100 or so years. This company has paid a quarterly dividend since 1933 and has hiked the dividend for 29 years -- soon to be 30 years.

There are of course many dividend aristocrats, but it's quite impressive that Caterpillar has managed this feat as it is operating in the pretty cyclical business of heavy construction equipment, as opposed to, say Coca-Cola ( KO ) which operates in a fairly non-cyclical industry.

You can glean some of this cyclicality from its stock chart, as CAT stock has been moving from $69 from the depths of the Covid-panic to a recent high of $265 in January of this year. In between there's been a fair amount of ups and downs. Over the last five years the stock is up by 35% before dividends, which translates into about 6.2% per year on average. Adding in a dividend yield of about 2%, we arrive at a total annual return of north of 8%. Decent, bearing in mind the numerous challenges this kind of business has had to contend with over these last few years.

Historical Dividend Growth

Caterpillar is a true dividend aristocrat, having raised its dividend through thick and thin for 29 straight years. This shows that the Board is really committed to rewarding shareholders with a steady flow of cash, as cash flows are not inherently stable in this kind of business. It should give dividend growth investors confidence that the Board is doing everything it can to look after its investors.

The cyclicality of Caterpillar's business can be seen in the chart above with its erratic payout ratio. From a low of about 30% in 2019 it reached a peak of around 72% during the pandemic era. Fortunately, we are now back down to a more manageable 35%. The low payout ratio means that the Board has plenty of room to increase the dividend, if it so wishes.

We can also see that the dividend per share has been growing nicely over the years, from $0.86 in the spring of 2019 to the current level of $1.20, an increase of 39.5% or 8.7% per year on average. An almost double-digit income increase on top of a yield of 2% should be enough to satisfy investors. It should be noted, however, that by far the biggest increase happened in the summer of 2019, when the economy was red-hot. The dividend was increased by a whopping 20% that summer.

It should also be noted that the dividend was flat for the entire calendar year of 2020. However, as the dividend was increases in the middle of 2019 and in the middle of 2021, this means that the dollar payment for 2020 was higher than 2019 and that 2021 was higher than 2020. Thus, the criteria for remaining in the dividend aristocrat club was fulfilled. Dividend nerds might have noticed that Exxon Mobil ( XOM ) used this trick, stretching it to the limit , thus barely saving its impressive dividend record.

June Dividend Hike

A good track record is definitely nice as it provides us with a certain comfort that something similar can be achieved in the future. However, it is far from certain it can be done, so we need to look a little bit closer at the growth prospects of the business.

In its latest quarterly results , released about a month ago, the company presented a pretty strong performance. Sales were up by double-digits, as was adjusted operating profit and earnings per share. It's always difficult to know whether to go by EPS or adjusted EPS. But no matter how you look at it, growth was phenomenal -- 31% or 70% depending on whether you look at EPS or adjusted EPS. True, Q1 2022 makes for an easy comparison, but still nobody can deny that things are going well. Using the adjusted number of $4.91 we are looking at a payout ratio of 24.4% -- leaving a lot of room for a hike in June.

On page 16 of the report, the company is sounding pretty bullish on the prospects for the full year. It expects strong sales and an operating profit margin in the top half of the range it communicated at its Q4 earnings presentation. This means I think we can be pretty confident it can achieve the consensus EPS estimate for 2023 of $17.82 . If that happens, it would entail an EPS growth this year of 28.8%. This would be an upper limit for a potential dividend hike. However, I do not see a need for the Board to go for such a rapid increase. It is not expected by investors and it would be wise to leave some in the tank for later years, which will probably not be as rosy as this current year.

For the low end of the estimate, I would look at history for guidance. In 2021, it hiked the dividend by 7.8%. This must be regarded as a cautious raise, as it was still during the pandemic and the Board was probably more cautious than it needs to be now. We could imagine a $0.10 increase to $1.30, which would entail an 8.3% increase. In line with its lowest increase in recent history and a number which would further lower its payout ratio. I do think, though, that the Board doesn't feel the need to be so cautious at this time. If they are really as optimistic about the future as management was just a month ago, it should show us by offering something more. If we assume that EPS will come in at $17.82 and we want to have a payout ratio equal to the lowest level in recent years -- 30% -- we land at a quarterly dividend of $1.33. This is conservative, but would still mean an increase of 11%. This is a fair middle ground, rewarding shareholders handsomely on the one hand, yet on the other hand keeping the payout ratio at a conservative level. My prediction is therefore a new quarterly dividend of $1.33 .

Risk Factors

Caterpillar has to be prepared for a lot of uncertainty in its kind of business. One of the most important risk factors is the business cycle. The company needs to plan both production levels, procurement, shipping contracts and staffing levels according to how it deems the economic activity to develop in coming quarters. This is no easy task, and if it invests heavily in production capacity at the top of the cycle, the company will be marred with high fixed costs for many years to come. Although management is bullish now, a global recession during the next year or two is certainly a risk and will definitely impact Caterpillar's earnings in a negative way. Another risk is currency risk. The U.S. dollar has been rising for at least a decade now, compared to most other currencies. This means that earnings abroad are dampened when converted to U.S. dollars. If the dollar strengthens further, this will drag earnings down when reported in U.S. dollars. Competition is certainly a risk, both from domestic and international operators. It is not too difficult to switch to other brands if Caterpillar charges uncompetitive prices for its products. This puts a limit as to how much the company can hike prices in order to compensate for inflation.

Current Valuation

Although the company is doing well, investors might not do well if they pay too much to get on board. Therefore, I always look at some key valuation metrics, both on its own and compared to some key competitors. I have chosen domestic competitor Deere ( DE ) and international competitor Komatsu ( OTCPK:KMTUY ) as a peer group.

Source: Seeking Alpha

The first thing that hits me is that maybe Warren Buffett is right -- the Japanese stock looks quite cheap. It wins both the Price/Sales category and the Price/Earnings category. As for the dividend yield, it lands in the middle. But remember, Japanese companies have for decades been known to offer puny yields. Now we are talking competitive income here.

Caterpillar ends up in the middle when we compare Price/Sales whereas it loses the Price/Earnings competition. However, we are looking at a 12.8x multiple here so I would consider it a minor loss. When it comes to the dividend, however, Caterpillar is a pretty clear winner with its 2.3% yield.

I would say all of these companies look pretty enticing and perhaps especially Caterpillar with its fair valuation, comparatively high yield, strong global position and good growth prospects. Speaking of growth prospects, analysts expect the company to produce long-term EPS growth of 15.3% . If we add that to the 2.3% yield, and we assume no change to the fairly low earnings multiple, we arrive at an expected total annual shareholder return of 17.6%. We are not talking a tech darling here, we are talking excavators and tractors with an undemanding multiple and global brand. Frankly speaking, at these levels this looks like a really good buy for long-term dividend growth investors.

Conclusion

Caterpillar has been delivering cash to shareholders on a quarterly basis since 1933. Its dividend growth record will soon extend into 30 years. The business is doing well and I conservatively expect the Board to hike the dividend by 11% this June. The valuation is undemanding and growth prospects are more than fine. Long-term dividend growth investors should use the recent pullback to buy shares in this global leader. Not only will you get a decent yield, you can also expect the dividend to grow by double digits for many years to come.

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