Caterpillar (New York stock market :CAT) is one of the first stocks I bought for my dividend (growth) portfolio.
The company has several distinguishing characteristics, such as a robust machinery business with a wide competitive moat, impressive pricing power, substantial free cash flow that is consistently used to fuel dividend growth, and profit from secular tailwinds such as the current surge in commodity demand driven by the electric vehicle industry and the energy transition.
In January I writing that Caterpillar is one of the best places to bet on net zero, as it will benefit hugely from much-needed investment in mining equipment. However, I also wrote that economic challenges will provide us with better buying opportunities.
Needless to say, I’m always trying to buy (a lot) more as I’m very optimistic about the long term. Given the economic development, I think the market will give us another opportunity in 2023.
Since then, the stock has fallen 16%. Shares are now 21% below their 52-week high.
It is therefore time to assess the risk/reward ratio based on new developments, my economic outlook and the company’s ability to generate value. After all, investors should only buy stocks on weakness when they are backed by a strong long-term bull case. Anything else would be long term wealth destruction.
So let’s go !
Markets sense economic weakness
Earlier this month, I tweeted that the market was beginning to price in a recession. On April 4, investors sold a wide range of cyclical stocks, including Caterpillar.
This is part of a larger trend indicating industrial underperformance. The chart below highlights this, as it shows the ratio of industrial stocks to the S&P 500. At the start of this year, industrial stocks were strong, despite economic weakness. Now, investors are betting on significant economic weakness.
Essentially we are now in a situation where the market is telling us the macro figures will be much worse in the coming months – or something like that.
Last month, Caterpillar CEO Jim Umpleby said construction demand was strong.
As reported by Bloomberg:
“The feedback we’re getting from our construction customers in North America is pretty good,” Umpleby said in an interview at ConExpo in Las Vegas, North America’s largest construction convention. “They see projects coming either from an infrastructure perspective or from one government-funded party another, but they feel pretty good about what they see.”
[…] He added that those customers are seeing a lot of activity for so-called “big dirt jobs,” such as new battery and chip factories.
He wasn’t wrong. I get these comments from several industry insiders. Especially in North America, construction demand is holding up fairly well, especially in light of supply chain relocation, another secular trend that is benefiting Caterpillar.
This is what the company said in its 4Q22 earnings call:
[…] it was another strong quarter as demand remained strong for our products and services. Sales increased by 20% compared to the fourth quarter of 2021, better than expected. Supply chain improvements enabled larger than expected shipments, particularly in construction industries, and supported an increase in dealer inventories. We achieved double-digit revenue increases in each of our three core segments and saw sales growth in North America, Latin America and EAME, while Asia-Pacific was at almost stable.
Although we continue to closely monitor global macroeconomic conditions, overall demand remains healthy across all of our segments, and we expect 2023 to be better than 2022, both in terms of revenue and earnings.
That said, cracks are starting to appear.
In February, US construction numbers began to weaken. Year-on-year construction value is slightly negative at -0.1%. Year-over-year growth fell to 5.2%. Don’t get me wrong, 5.2% is a lot. It’s the trend that counts.
In private residential construction, there has been a sharp drop in single-family construction. In non-residential construction, we see significant weakness in retail trade. Manufacturing is doing quite well, driven by the aforementioned benefits of supply chain relocation.
The main architectural billing index fell to 48.0 in February. Although this is slightly below the neutral line of 50.0, it indicates another month of expected contraction.
Another indicator that continued its downward trend into contraction territory is the ISM manufacturing index. This index stood at 46.3 in March, led by weak new orders.
While it’s hard to estimate how bad things could get, I think cyclical stocks could see more declines.
While a recession is obviously not a bullish move, it does lead to fantastic buying opportunities. To visualize this, I made the table below.
- The top part: The upper part of the chart below displays the Caterpillar stock price.
- Lower part: The lower part shows the ISM index we just talked about (black line) and the total sale since the all-time high of Caterpillar.
Note the correlation between the CAT stock price and the ISM index. This makes sense, because the ISM index is forward-looking. Once investors see weakness, they start selling cyclical stocks like Caterpillar to price in higher demand risks.
Also note that I highlighted this year’s performance. CAT’s stock price performance has been strong at the start of this year, ignoring economic weakness. Now, investors face greater weakness and the need to lower their expectations regardless of the benefits of secular growth.
While this may indicate between 10% and 20% further decline in stock price, this is ideal for investors (like me) who like to buy high quality stocks at bargain prices.
High shareholder value and valuation benefits
Caterpillar has a fantastic Seeking Alpha Dividend Dashboard. The company scores high in all categories, with top ratings for dividend growth and regularity.
Despite a number of recessions, CAT has increased its dividend for 29 consecutive years, making it a dividend aristocrat. Its current yield is 2.3%, supported by a conservative payout ratio of 34%. Over the past five years, the average annual dividend increase has been 8.7%.
Here are the latest hikes:
- June 2022: 8.1%
- June 2021: 7.8%
- July 2019: 19.8%
Although we have already briefly discussed the low payout ratio, CAT is benefiting from a number of tailwinds allowing it to increase its dividend.
- The company is on track to generate $7.0 billion in free cash flow this year, followed by an expected increase to $8.2 billion in 2024. This implies a free cash flow yield of 6 .5% in 2023. This figure could be 7.6% in 2024. This figure is boosted by a declining CapEx/revenue ratio, thanks to strong post-pandemic sales. This accelerates free cash flow.
- CAT has net debt of $28.3 billion in 2023E, or 2.4x 2023E EBITDA.
The company’s balance sheet is rated A. It allows the company to distribute almost all of its free cash flow to shareholders, as the company reiterated at its Evercore ISI industry conference. discussion last month.
Thus, over the past ten years, the company has repurchased 21% of its shares, adding to earnings per share growth.
During this period, the company has deleveraged its balance sheet, meaning that redemptions and dividend growth have been very sustainable. Given the free cash flow outlook, we can assume this remains the case – even if a potential recession leads to negative outlook adjustments.
That said, the company is trading at 11.8x 2023E EBITDA. This is based on its market capitalization of $108 billion, its net debt of $28.3 billion in 2023E and its pension liabilities of $4.2 billion.
My base case is that CAT is undervalued by about 25%. This would put CAT at $258. The current consensus estimate is $247.
However, economic challenges could end up reducing the company’s prospects. I do not claim that CAT will achieve this goal in the months or quarters to come.
I think the stock could drop to $180, which would translate into a very attractive risk/reward ratio. If the stock falls to this level, the implied dividend yield would be 2.7%, which would be a lot.
To take with
Caterpillar is in a delicate situation. The company is benefiting from secular tailwinds like the transition to electric vehicles, supply chain relocation and the fact that general construction spending is still high.
However, cracks are beginning to appear. Economic conditions are weakening rapidly, causing recession fears to trigger weakness in cyclical stocks.
Although CAT shares are attractively valued, I expect a potential move to $180 per share as investors de-risk their portfolios.
Although this hurts my CAT position, I look forward to adding more shares during the fixes. After all, CAT continues to prove that it is a fantastic dividend growth stock with a very healthy balance sheet, moderate CapEx (vs. sales) and (related) free cash flow. long term up.
I expect redemptions and dividend growth to continue and I think investors will have the option to buy at (or near) $180.
Looking ahead, the next major event is the company’s 1Q23 earnings call, which I expect to tell more about changing demand dynamics. I believe management will confirm my expectations.