CAT - Caterpillar: Strength To Survive Economic Weakness

2023-04-10 07:59:22 ET

Summary

• Despite an expected recession, CAT recently hit all-time highs before cooling off.
• A softer economy is not positive for this type of company, but a long-term shareholder probably has nothing to worry about.
• They've survived plenty of recessions, with their dividend intact, too, to become a dividend aristocrat.

Written by Nick Ackerman. A version of this article was originally published to members of Cash Builder Opportunities on March 26th, 2023.

Caterpillar ( CAT ) was fairly recently hitting a new 52-week high. In fact, this was an all-time high for shares of this heavy equipment maker. With an expected recession, this was certainly something that caught my attention simply because it was unexpected. At least for me, knowing that CAT is one of my more cyclical positions. That said, they've been pushing further into services, which can be a more steady and reliable way to generate revenue. With a strong track record in previous recessions and a strong balance sheet with expected continued growth in earnings, I expect CAT to be just fine through any coming recession.

Since hitting those new highs, in more recent weeks, we've now seen shares decline. We're back to trading at a fairly attractive level using a fair value based on their historical P/E trading range. Even when shares were spiking higher to start out in 2023, it wasn't necessarily grossly overvalued either.

For more patient investors that are expecting a recession later this year, we could wait to see if a better valuation materializes. Which I could certainly see that being the case too.

A longer-term investor could consider picking up an initial position or consider dollar-cost averaging. Caterpillar has survived previous recessions, and due to that services push, I believe it is even better positioned to handle the next recession. Given that, I also believe the dividend is rock solid with more growth to come.

Latest Earnings And Future Prospects

In the last quarter, CAT reported a miss on EPS but a hit on revenue. Out of the last 16 quarters of earnings, the company has only missed EPS estimates four times. In terms of revenue, the last 16 quarters showed that they missed estimates a total of six times.

That being said, they saw significant growth nonetheless, with EPS up around 28% year-over-year. 2022 was a year that marked a return to all-time profit highs.

During the 2020 pandemic, we can see that they were negatively impacted significantly in terms of profits. That took only two years to recover from despite supply chain issues and labor shortages that all companies were dealing with.

Going forward, we can see that analysts still expect earnings to grow even when considering a recession in the current year. Perhaps unsurprisingly, the company's revenue grew at a healthy clip.

CAT is separated into three main business segments ; construction industries, resources industries and energy & transportation. They also break out their earnings for the "financial products" segment.

The most profitable of these segments is the construction industry segment. It's probably the most visible or known to the public in terms of seeing their construction equipment in action on building sites. Here's a look at the latest quarterly results compared to the prior year.

However, energy & transportation are an equally large part of their total sales. It just isn't quite as profitable in terms of profits as a percent of total sales.

Construction industries provided $25.269 billion in sales for 2022 compared to $23.752 billion from energy & transportation for the full year.

The resources segment is also an important part of their business, even if it isn't as large of a contributor to the overall company. For the full year, it contributed to $12.314 billion in sales. It was also the largest increase at 26% year-over-year. Here's a highlight from the latest quarter.

Even during a recession, there will be a need for this type of equipment, so spending doesn't stop completely. That being said, it's pretty well understood that having a slower economy in a recession will significantly dent new construction.

Energy prices could fall even further, as we've been on a fairly swift downward trend, and that would mean less spending in the energy category for the company. That being said, the energy segment of their business also includes the energy transition to more renewables. They believe that this shift can contribute to their total addressable market.

However, to counteract the hit that recessions have had on the company, they've been continuing to push into services for several years now. This allows them to generate revenue and earnings even if their equipment product sales slow down.

In their last earnings call , they had to mention a remark touching on the services that help sum up their progress and potential.

As I mentioned, we generated $22 billion of services revenues in 2022, a 17% increase over 2021. Services growth in 2022 benefited from our ongoing initiatives and investments as well as price realization. We now have over 1.4 million connected assets, up from 1.2 million in 2021. We delivered over 60% of our new equipment with a customer value agreement and the launch of our new app called Cat Central to help drive growth in ecommerce sales to users. We also had the highest level of parts availability in our history. Overall, our confidence continues to increase that we'll achieve our $28 billion services target in 2026.

This gives us an idea of how services will contribute to more sticky earnings going forward. In total, they reported revenue of $59.4 billion in fiscal 2022, meaning services revenue comprised around 37% of their total revenue.

Additionally, as we mentioned, they see that the energy transition will also increase their total addressable market. It doesn't appear they have provided any hard figures on this yet, but they are clearly aware of it, so they can benefit from it.

Although the transition to renewables can be quite a hot topic to debate, if a company I have a stake in can generate additional earnings - I'm all for that! We also know that regulators continue pushing for renewables, so ignoring that could mean a lost opportunity.

We continue to believe the energy transition will support increased commodity demand, expanding our total addressable market and providing opportunities for profitable growth.

Dividend Growth Expected And Buybacks Are Strong

One thing that CAT also focuses on besides being the dominant player in their field is returning capital to shareholders. That's through both share buybacks and their dividend. They are a dividend aristocrat and have raised their dividends for 29 consecutive years. However, they are one of those companies that don't necessarily raise every single four quarters. During recessions, they will hold steady for several quarters in a row - making sure to raise at least before the end of the year to keep the consecutive growth up.

I don't so much mind this, even if it only allows them to be an aristocrat technically through this more unorthodox manner. Big oil has done this, too, to keep their streaks alive, and it still counts. It's actually quite smart to keep a balance sheet healthy.

That said, the push into services could see more consistent growth going forward as their earnings could become more stable and predictable. They've generated significant amounts of "ME&T free cash flow." This is machinery, energy & transportation free cash flow that is "operating cash flow less capital expenditures, excluding discretionary pension contributions and cash payments related to settlements with the U.S. Internal Revenue Services."

They had no trouble paying out their dividend at $5.8 billion of this free cash flow generated in the prior year. Over half of this figure was brought in during the fourth quarter alone at $3 billion.

What is interesting, though, is that they exceeded this number with share buybacks. They actually returned $6.7 billion to shareholders through 2022. Noting that they anticipate returning nearly all of this free cash flow to shareholders over time. They spent $2.4 billion on the dividend and $4.2 billion on repurchases. Combined, they returned 115% over their free cash flow. However, share buybacks can easily be turned on and off as appropriate. Share buybacks are also another contributing factor to growth for EPS per share over time.

In terms of the non-GAAP EPS payout ratio, that also shows that the dividend is easily being covered. That's enough headroom for a recession that I have no doubt they'll be able to navigate through successfully.

Conclusion

CAT may operate in a more cyclical industry by selling products to cyclical segments of the economy. That being said, their continued push into services can provide a way to "dampen the impact of cycles," as their CEO said . However, admitting they'll never truly be completely immune to these cycles. That can help stabilize earnings and continue to provide rewards to the shareholders. CAT has survived several recessions; I expect them to be fine through the next one.

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