Dividend Achievers Stock Analysis: Caterpillar

Caterpillar (CAT) is the leader in construction equipment manufacturing.  The company has a market cap of $56 billion, significantly higher than rival Deere & Company (DE) which has a market cap of $32 billion.  Caterpillar is not only a member of the Dow Jones Index, the company is also a member of theDividend Achievers Index.  Dividend Achievers are stocks that have increased their dividend payments for 10 or more consecutive years.

Caterpillar has been paying dividends since 1925.  The company has not reduced its dividend payments since 1982, giving it 32 consecutive years of dividend payments without a reduction and qualifying it for potential investment using The 8 Rules of Dividend Investing.  This article will analyze Caterpillar for dividend growth investors.

Business Overview & Current Events

Caterpillar divides its operations into 5 primary segments:  Construction Industries, Resource Industries, Energy & Transportation, Other, and Financial Products.  Each segment’s percentage of total operating profit contributed to Caterpillar in its most recent quarter is shown below to illustrate the relative importance of each segment to the company as a whole:

• Energy & Transportation: 51% of operating profit
• Construction Industries: 22% of operating profit
• Financial Products: 10% of operating profit
• Other: 10% of operating profit
• Resource Industries: 7% of operating profit

Energy & Transportation

The Energy & Transportation segment carried Caterpillar’s results in its third quarter 2014.  The segment saw sales increase by 13% and operating income by 29% versus the same period a year ago.  The company saw a rise in transportation orders as the rail industry is readying itself for changing emissions guidelines starting in 2015 in the US.  Oil & gas sales increased in the quarter due to rising North American sales.  North American oil & gas sales will likely decline over the next several quarters as the low cost of oil reduces investment  in oil & gas equipment.

Construction Industries

Caterpillar’s Construction Industries segment recorded a 2% sales loss in its most recent quarter versus the same quarter a year ago.  The segment saw strong revenue growth in the US (up 9%), but sales declined in both Latin America and the Asia/Pacific region.  US sales growth is being fueled by the continuing recovery of the construction industry in the US.  The Construction Industries segment reported a 67% increase in operating profit versus the same quarter a year ago.  The company cites lower manufacturing costs and higher prices combined with favorable currency effects as the reason for the surge in operating profit in Caterpillar’s Construction Industries segment.

Financial Products

The Financial Products segment handles the leasing and financing of Caterpillar’s equipment.  The segment grew revenue 5% in the most recent quarter.  Operating income advanced just 1% versus the same quarter a year ago.

Other

The ‘Other’ segment includes remanufacturing of engines, product support, parts distribution, paving products, forestry products, and waste products, among others.  The segment is a ‘catch-all’ for operations that do not fit neatly into Caterpillar’s other segments.  The Other segment saw revenue grow 10% and operating income increase 27% in its most recent quarter versus the same quarter a year ago.

Resource Industries

The Resource Industries segment manufactures equipment primarily for the mining industry.  The mining industry is currently in a cyclical down period.  As a result, mining industry expenditures on equipment is sinking rapidly.  The Resource Industries segment saw revenue decline 19% and operating income decline 62% in its most recent quarter versus the same quarter a year ago.

Competitive Advantage

Caterpillar’s competitive advantage comes from its industry leading size and brand name.  The Caterpillar name is synonymous with heavy equipment in the construction industry.  Caterpillar’s brand recognition has been driven by its quality manufacturing and customer care.  Caterpillar’s competitive advantage is a combination of its size, brand, and manufacturing expertise.

Growth Prospects

Caterpillar operates in several cyclical industries.  The Resource Industries segment (which serves the mining industry) is currently in a downturn.  This will affect EPS in the short-run.  Caterpillar’s long-term strategy is to avoid the cyclical effects of any one industry by diversifying across multiple industries so as not to be extremely hard hit by weakness in any one industry.   Despite its attempts at diversification, Caterpillar is still susceptible to recessions as they negatively impact investment in the energy, transportation, and construction energies which together accounted for 63% of Caterpillar’s operating income in its most recent quarter.  The image below shows Caterpillar’s EPS over the last several decades.  Notice the steep EPS declines in the mid-1990’s and during the most recent recession:

Source:  Ycharts

Despite the cyclical nature of its business, Caterpillar has managed to grow revenue per share at about 5.9% a year over the last decade, and EPS at 5.6% over the same time period.  Value Line analysts expect 4% EPS growth over the next 3 to 5 years as the company fights through a weak mining and energy market.  Caterpillar’s long-term EPS growth rate will likely be higher than 4% as the company will eventually benefit from a reversal in weakness in the energy and mining industries.

Over the past decade, Caterpillar has reduced its net share count by about 2.5% a year.   Caterpillar is currently restructuring its operations, which will likely boost margins (as we have seen in the most recent quarter).  Caterpillar will likely manage long-term margin growth of 0% to 2% a year as it realizes greater manufacturing efficiencies from a leaner supply chain and better economies of scale.  IN addition, the company should see organic revenue growth of between 2% and 4% a year over the long-run.  In total, I believe shareholders can expect EPS growth of between 4.5% and 8.5% a year over a multi-year period.  In addition, the company’s stock has a dividend yield of about 3%.  In total, shareholders can expect returns of between 7.5% and 11.5% a year from Caterpillar (not counting valuation multiple changes).

Valuation

Over the past decade, Caterpillar’s P/E has traded at a median discount of about 0.75x to the S&P 500’s P/E ratio.  If the market were to revert to its historical average P/E ratio of about 15, Caterpillar’s fair P/E ratio would be somewhere around 11.25.   The S&P 500 is currently trading at a P/E ratio of just over 20.  Caterpillar’s fair P/E ratio based on current market prices is about 15.

Caterpillar currently has a P/E ratio of 15.25.  The company is highly cyclical, however.  Average EPS over the last 5 years have been $6.65 per share.  I believe taking a 5 year average of EPS for Caterpillar is a more fair way to value the company as it takes into account the cyclical nature of Caterpillar’s EPS.  Using $6.65 a share, Caterpillar is currently trading at a P/E ratio of about 14.5, at the low end of its fair value at current market prices.  As a result, I believe Caterpillar to be fairly valued or slightly undervalued at current market prices.  Investors should not expect headwinds on total return from valuation losses.

Final Thoughts

Caterpillar is ranked in the Top 40 out of 143 businesses with 25 or more years of dividend payments without a reduction using The 8 Rules of Dividend Investing.  I believe the company is near fair value and makes a decent investment for long-term investors who can withstand its high price standard deviation of 33.3%.  I prefer rival Deere & Company to Caterpillar in the construction machinery industry.