CAT - Caterpillar: Up 29% Is This Dividend Aristocrat A Buy Now?

2024-01-10 07:30:00 ET

Summary

• Shares of Caterpillar have rocketed higher since late October.
• The industrial giant handily grew sales and adjusted profits per share in the third quarter.
• Caterpillar's interest coverage ratio through the first nine months of 2023 was robust.
• Shares of the industrial powerhouse appear to be trading at a 19% discount to fair value.
• Caterpillar's total returns through 2025 and 2033 could outperform the S&P by a sizable margin.

It's not a secret that the broader market has soared since its previous pullback last October. In that time, the S&P 500 ( SP500 ) rallied 15% from 4,100 and change to top 4,700 as of January 8. The rationale for this jump in recent months is encouraging economic data, which suggests there is a chance that a soft landing can be achieved by the Federal Reserve.

However, there are risks with markets at current levels. For one, the S&P is meaningfully overvalued. The current P/E ratio of the index is 19.6, which is well above the historical valuation multiple of 16.8. This is also not accounting for a recession, which would push the P/E ratio of the index even higher. Such a valuation also accounts for a base-case scenario of six interest rate cuts in 2024. Given that the Fed is currently telegraphing only three rate cuts in 2024, that could also pose downside risk.

This is why when I conclude building liquidity for an emergency fund in several weeks, I plan on buying Dividend Aristocrats at discounted valuations. Caterpillar (CAT) is one such business that I wouldn't mind eventually adding to my portfolio. But is the industrial still a buy after surging 29% since last October? I will dig (excavator pun intended) into Caterpillar's fundamentals and valuation to answer this question.

Caterpillar's 1.8% dividend yield admittedly doesn't jump off the page, but it is moderately above the 1.5% yield of the S&P 500. More importantly, as I will get into as the article progresses, there is plenty of room for the dividend to grow at a healthy rate moving forward.

For one, Caterpillar's 31% EPS payout ratio is below the 40% EPS payout ratio that rating agencies view as safe for industrials. Also, the company's 39% debt-to-capital ratio registers below the 50% that rating agencies like to see from industrials.

Considering Caterpillar's industry leadership and global presence, S&P unsurprisingly awards an A credit rating to the company on a stable outlook. That implies the risk of Caterpillar going to zero in the coming 30 years is just 0.66%.

With these factors in mind, the probability of the company slashing its dividend in the next average recession is just 0.5%. That's in line with the lowest dividend cut probability possible in the Zen Research Terminal shown above. In a severe recession, this risk only grows to 1.15% - - barely higher than the 1% floor for all dividend payers in the Zen Research Terminal.

What I like about Caterpillar also isn't confined to just its promising fundamentals. No, another plus is its current valuation. Using historical dividend yield and historical P/E ratio as a guide, Caterpillar could be worth $359 a share. Relative to the $292 share price (as of January 8, 2024), the industrial is priced 19% below fair value.

If Caterpillar reverts to this fair value and grows as anticipated, here are the total returns that could be in store for the next 10 years:

• 1.8% yield + 17.4% FactSet Research annual growth consensus + 2.1% annual valuation multiple expansion = 21.3% annual total return potential or a 590% 10-year cumulative total return versus the 8.6% annual total return potential of the S&P or a 128% 10-year cumulative total return

Strong Third-Quarter Results Topped Expectations

Before diving into Caterpillar's most recent operating results, it would be helpful to understand the basics of the business first. In 2022, the company generated $59.4 billion in revenue, making it the largest publicly traded industrial in the world.

Caterpillar's business is divided into four reportable segments of business. These include the construction industries, resource industries, and energy and transportation industries, which make up the company's machinery, energy and transportation category. These businesses sell a variety of products to customers, such as asphalt pavers, forestry machines, hydraulic shovels, rotary drills, and turbines. Together, these segments contributed 95.2% of Caterpillar's 2022 revenue.

The financial products business made up the remaining 4.8% of the company's revenue in 2022. This helps customers to finance and/or lease Caterpillar's equipment (figures per pages 4-6 and 61 of 156 of Caterpillar's 10-K filing ).

Caterpillar's revenue shot up by 12% in the third quarter ended September 30 to $16.8 billion. For context, that was $240 million ahead of the analyst consensus. What factors made these impressive results possible for the industrial?

First, construction industries revenue rose by 12% to $7 billion during the third quarter. This was due to improved price realization throughout the business and favorable currency translation in Europe and the Middle East.

Next, energy and transportation industries revenue was up by 11% to $6.9 billion for the third quarter. This was the result of better price realization and growing sales volumes (e.g., growth in large reciprocating engines and rail services).

Third, resource industries revenue increased by 9% over the year-ago period to $3.4 billion in the third quarter. Lower sales volumes were more than countered by improved price realization during the quarter.

Fourth, Caterpillar's financial products revenue surged by 20% to $979 million for the third quarter. This was due to higher interest rates throughout the markets where the company has operations. As a note, these figures don't add up perfectly because of rounding and $1.5 billion in corporate items and eliminations in the third quarter (details sourced from page 30 of 81 of Caterpillar's 10-Q filing ).

Caterpillar's adjusted profit per share soared 40% higher year-over-year to $5.52 during the third quarter. That was $0.73 above the analyst consensus. A bigger revenue base and a 430 basis point expansion in adjusted operating profit margin to 20.8% led adjusted profit per share growth to exceed revenue growth for the quarter.

In the years to come, Caterpillar looks like it can continue to deliver solid growth to shareholders. This is because the company's backlog of $28.1 billion is approximately 44% of trailing 12 month revenue according to CFO Andrew Bonfield's remarks in the Q3 2023 earnings call . That's well above the typical backlog in the 30% range in recent years. Additionally, the company's more stable service revenue is gradually becoming a higher proportion of total revenue as well.

Moving to solvency, Caterpillar is a financially sound business. The company's interest coverage ratio through the first nine months of 2023 was 25.5.

Free Cash Flow Can Keep Dividend Growth Chugging Along

In June, Caterpillar extended its dividend growth streak to 29 consecutive years with an 8.3% raise in its quarterly dividend per share to $1.30 . I would anticipate that similar dividend growth can continue in the years to come.

That's because Caterpillar generated $6.6 billion in free cash flow through the first three quarters of 2023. Against the $1.9 billion in dividends paid, that is a free cash flow payout ratio of just 28.6% (info according to page 10 of 81 of Caterpillar's 10-Q filing).

Risks To Consider

Caterpillar is a fundamentally great business. But I believe that the risk profiles of even the best businesses must be evaluated before considering taking ownership positions.

Caterpillar is a top-notch cyclical, so it comes with the risks that would be expected from a cyclical. When its customers are doing well, it tends to do very well. In the last 20 years, the company's earnings have grown 14 years per FAST Graphs. That's arguably solid for a cyclical. But in environments that are challenging to customers (e.g., the Great Recession, the 2015 and 2016 downturn in energy, and the COVID-19 pandemic), declines in earnings are often sharp. That can lead to significant stock volatility, which some investors may find unappealing.

The majority of Caterpillar's revenue is derived from outside the United States. That exposes the company to risks, such as unfavorable foreign currency translation, trade wars, and regulations that vary by market.

Lastly, Caterpillar's continued success will hinge upon it being able to design and sell products that appeal to customers. If the company can't keep delivering, it could lose market share to competitors. That could weigh on Caterpillar's growth prospects.

Summary: A Dividend Aristocrat With Market-Beating Potential

Caterpillar isn't just a business that could outpace the S&P over the long haul. That's because the company's blended P/E ratio of 13.9 remains below its normal P/E ratio of 17.4. If Caterpillar returned to this P/E ratio and grew as analysts expect, it could generate 35% cumulative total returns through 2025. That would be 4X the 8% cumulative total returns that are projected from the SPDR S&P 500 ETF Trust (SPY) during that time. This is why I am initiating a buy rating on shares of Caterpillar.

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