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Stock Analysis - Caterpillar Inc (CAT)

Initial Screening

Passing by construction and mining sites no matter where you are in the world, you’re bound to spot one brand in nearly all of them: Caterpillar.

In 1925 Holt Manufacturing Company and C.L. Best Tractor Company merged to create the Caterpillar Tractor Company, later restructuring itself in 1986 under the name Caterpillar Inc.

The company's business revolves around design, engineering, manufacturing, and selling machinery and engines for the construction and mining industries, supplemented by financial products and insurance and a dealer network around the world. Moreover, the company strengthens its already well-known brand with a range of branded clothing lines, functional work apparel, and toys.

Caterpillar's peer group consists of Cummins Inc (NYSE: CMI) and Deere & Company (NYSE: DE) on a national basis while Doosan Infracore (KRX: 042670) and Kubota Corp (TYO: 6326) compete beyond US borders.

Caterpillar Infographic
 

Business Model

Caterpillar is a global provider for machinery, equipment, engines, and financial products including insurance. The business model covers the full machinery value chain from the development and design of machinery, over distribution, and sales to service contracts and financing products.

Their business units cover solutions and products for the construction industry and oil/gas at 41% global revenue contribution each as well as the mining industry accounting for the remainder.

Below you can find an overview of the Caterpillar Dealer Network from Caterpillars Databook 2019

Caterpillar Global Dealer Network
 

Last year, the bulk of their sales were made in North America at 48% followed by Europe and Asia, where combined another 43% of the Sales originated. The smallest region in terms of dealerships as well as sales is Latin America accounting for roughly 8% of the global sales.

Dividend Growth and Sustainability

Caterpillar’s dividend yield as of 11/03/2020 is 2.46%, which is in line with their US-listed peers Cummins Inc (NYSE: CMI, 2.46%) and Deere & Company (NYSE: DE, 1.35%). The following section will cover some history on and judge the sustainability of Caterpillar’s dividend by examining the payout ratio as well as its growth to determine whether the construction giant makes a compelling case for dividend growth investors.

Dividend History & Growth

Since Caterpillar was formed, it has paid out a dividend, yearly in the beginning and switched to paying out quarterly in 1933. Though there were some dividend cuts and freezes in the first few decades of the company’s existence, CAT now holds status as a US Dividend Aristocrat with a dividend growth streak of 26 years.

Reflecting on the last decade, between 2010 and 2020, the dividend per common share has been increased by just under 140%, though it has to be noted that it has been over a year now since the last dividend increase.

For a dividend growth investor, I would consider keeping an eye out for the next dividend declaration before determining whether the stock will continue to be a reasonable option for your portfolio based on this recent stagnation.

Payout Ratio

Between 2010 and 2019, Caterpillar’s dividend payout ratio has been hovering steadily between 30% and 60% with outliers in 2016 and 2017, where it went well above 200% in both years.

These outliers heavily influence the 5-year-average which clocks in at 201%, but looking at the 3-year-average it’s back down to 51%. This is in line with the cyclical nature of the stock but from a payout ratio standpoint alone I would consider the dividend as safe especially in a struggling economy.

Financial Analysis

Using the Piotroski F-Score to measure Caterpillar’s current financial health, we see it secures a 5 in the 0-9 ranking. This rating is more a middle of a pack rating and below average for other companies of the industrial sector in the S&P 500 which comes in at 5.8.

My biggest pain point with CAT’s income statement is the decline in revenue and operating income since 2012. In an environment of economic growth fueling one of the longest bull markets in history, the company was not able to use this to its advantage.

From a debt perspective, the debt to equity ratio for Caterpillar is around 250.1% which I would consider very high. Adding to it the debt is currently not well covered, as the annual operating cash flows only sit at 17.8%. On the bright side at least the interest payments are covered considering a 14.4x coverage-rate by EBIT.

Investment Case

In the following section, we will dive into the company's Moat as well as Bull and Bear cases to outline which headwind the company might face while providing insight into their strategy and growth opportunities.

Moat

Caterpillar has a wide moat built on its strength of the brand, a big lock-in effect, as well as dealer networks around the world.

The brand itself is so strong that it can be found outside of industrial equipment, and whether it’s toys or clothing the brand is well recognized by all ages.

Customers of Caterpillar are locked into long service contracts so with the switching costs for equipment combined with additional training costs for companies when switching to competitors, it’s probably their customers best bet to stay put.

Furthermore, Caterpillar owns a lot of intellectual property in the form of more than 10.000 patents which is further strengthening their position as an industry leader and widens its moat.

The Bull Case

Materials are as in demand as ever and Caterpillar has stakes in mining operations around the world. Whether it’s precious metals, oil, or other stones, Caterpillars' reach goes beyond extraction support of just one specific material.

Moreover, governments around the world are looking at stimulus packages to battle an economic recession in the aftermath of COVID-19. Those packages are likely to include infrastructure projects, which could lead to an uptick in sales and revenue for Caterpillar.

The Bear Case

A third of their business derives from the equipment produced for the oil and gas industry which is in decline. Though investments may be going down in this sector, it’s one of the only sectors with stable recurring revenues in comparison to construction and mining in Q1 and Q2 2020.

Looking at the revenue, Caterpillar hasn’t managed to achieve significant growth in a bull market since the early 2010s. Supporting a sector that’s been hit hard by the lockdown and the impacts of the global pandemic have seen sales fall further and analysts expect that we won’t get back to 2019 levels until at least 2022.

While that is more or less expected and Caterpillar is operating in a very cyclical environment, the P/E ratio is very high and similar to growth stocks, making it a tough case for a value play in a time of weakness.

Partly, I would expect that valuation to be a result of a priced-in stimulus cheque for the US infrastructure to battle the aftermath of the pandemic, but that’s a long shot and it has yet to be seen how the new government will handle the pandemic and it’s long-term effects for the economy.

Conclusion

I would not buy Caterpillar at its current valuation, but it has solidified its spot on my personal watchlist. While this statement may sound very harsh it should by no means be interpreted as a sign to sell the stock.

Before considering adding the stock to my portfolio I would like to see an increased quarterly dividend supported by a positive long-term outlook and an uptrend in sales and global economic forecasts.

It’s hard for me to judge the outlook of construction and mining, as my profession is far removed from both industries, and although Caterpillar operates in a highly cyclical sector I don’t think that the current P/E valuation offers a great point in time to start a position.

For industrial machines, I would rather go with a sector always in demand and look closer at the stock of Deere & Company (NYSE: DE) operating and supporting the agriculture industry in a world of growing population and demand.

As always, I recommend potential investors browse through the documents found on Caterpillar’s investor relations page as a great start for their due diligence.

Thank you for taking a look at my stock analysis of Caterpillar Inc. I invite you to share any feedback you have to offer to help me improve future stock analysis and research!

Disclaimer

I do not hold a position in Caterpillar Inc (NYSE: CAT), but the stock will remain on my watchlist. This article expresses personal opinions and observations of someone who is not licensed to provide financial advice.

I am not receiving compensation for writing this analysis and have no business relationship with any company whose stock is mentioned in this article other than the long positions I own. Furthermore, I cannot guarantee the accuracy of the financial metrics gathered from 3rd party services like Morningstar and Yahoo Finance.

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