Friday, July 31, 2015

Recent Purchase of Caterpillar (CAT)

I continue to remain aggressive hunting down the best deals on high-quality stocks I can possibly find and deploying capital when those sales present themselves.
It appears another sale presented itself. So I deployed some capital. What else would you expect, right?
The stock I’m going to discuss today is available at one of the best values that’s been offered on it over the last few years. It also sports the highest yield it’s possibly ever had outside the financial crisis. It’s a cyclical stock, but I see a long-term opportunity here.
I purchased 15 shares of Caterpillar Inc. (CAT) on 7/9/15 for $81.53 per share.

Overview

Caterpillar Inc. is the world’s largest manufacturer of heavy construction and mining equipment, and also manufactures diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.
The company operates in the following five primary segments: Energy & Transportation (39% of fiscal year 2014 sales), Construction Industries (35%), Resource Industries (16%), Financial Products (6%), and All Other (3%).
Approximately 62% of FY 2014 revenue was generated outside the United States.
They have a network of 177 dealers – 129 of which are located outside the US. These dealers, which are mostly independently owned and operated, serve more than 180 countries and 3,500 outlets.

Fundamentals

I’ve long been somewhat lukewarm on Caterpillar due to the cyclical nature of the business and my opinion that Deere & Company (DE) is a slightly superior business. However, CAT and DE don’t compete across all their product lines; DE obviously concentrates on farm equipment, while CAT offers me more exposure to the construction, energy, and resource industries. In addition, CAT is far more global. So I view them as complementary holdings, and I like the idea of owning both as relatively small positions.
As a cyclical business, the fundamentals will vary depending on what time frame you’re looking at. I always like to look at the last 10 years of any company’s financials so as to smooth out any short-term fluctuations or cyclical peaks and troughs, but this isn’t always completely accurate. Nonetheless, I think it gives us the best apples-to-apples comparison possible.
Over the last decade, CAT’s growth has been mediocre. Not horrible, but not great. Recent weakness in its mining business has possibly clouded the long-term potential here.
Revenue is up from $36.339 billion to $55.184 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 4.75%.
Earnings per share grew from $4.04 to $5.88 over the last decade, which is a CAGR of 4.26%.
Not all that impressive, but, again, the time frame matters for cyclical businesses. Looking at the 10-year growth of EPS from fiscal years 2003 to 2012, for instance, would show a compound annual growth rate over 20%.
S&P Capital IQ anticipates that EPS will compound at a 7% annual rate over the next three years, which I think would be more than acceptable for a business like this with the current trends in some of its major operating segments. It’s quite possible that an uptick in housing construction due to pent-up demand from the financial crisis could offset some of the weakness in mining. Some recent reports have shown that housing construction is back to pre-recession numbers.
The company repurchased approximately 11% of its outstanding shares over the last decade, which has helped buoy results and will likely continue to do so. Management authorized in January 2014 a new stock buyback plan, which allows them to repurchase up to $10 billion of the common stock – that’s about 1/5 of the entire company’s current market cap. That plan expires at the end of 2018.
In addition, the company has a robust backlog of $16.5 billion as of the end of Q1 2015. That’s down slightly from the end of 2014.
What I think is really wonderful about this business, though, is the dividend growth track record they’ve managed to build, especially factoring in the cyclical nature of demand on most of its products.
After all, it’s sustainable and growing dividend income I’m after as a dividend growth investor, and even better when that comes attached with a very attractive yield. Well, check, check, and check.
They’ve increased their dividend for the past 22 consecutive years.
And over the last decade, the company has increased that dividend at an annual rate of 12.8%. In fact, they just announced a 10% dividend increase in June, which gave me some confidence to go ahead and initiate a position here. If management is confident enough in operations to raise its dividend by 10%, then I’m confident enough to buy shares here.
That most recent dividend increase combined with weakness in the stock price – it’s down more than 10% on the year – has led to a sky-high yield of 3.78%. That’s pretty much unheard of for CAT.
The payout ratio is 49.4%, which is factoring in a recently increased dividend and weakness in earnings over the last couple years. The dividend appears extremely healthy here.
Overall, the dividend metrics are really appealing to me. You get a management team that obviously places a priority on increasing the dividend, a high yield, a double-digit long-term growth rate, and a moderate payout ratio. Not much to really dislike there across the board.
The company does maintain a leveraged balance sheet, though it looks worse than it really is due to the financing operations. Caterpillar obviously manufactures very large and very expensive machinery, and so the company offers retail and wholesale financing to its customers and dealers.
The long-term debt/equity ratio is 1.65, though approximately 2/3 of its long-term debt is related to financing. The interest coverage ratio is healthy at just below 13. They have more than $7 billion in cash and short-term investments on the balance sheet.
Profitability is strong, but it has been declining over the last couple years. This appears primarily due to the aforementioned headwinds. Over the last five years, the company has averaged net margin of 7.33% and return on equity of 29.90%. I see some room for improvement here, but nothing particularly worrisome.

Qualitative Aspects

Ever drive or walk by a construction site and not see Caterpillar’s familiar yellow machines working?
Probably not.
And that’s because the company sports the leading share of the world’s construction machinery market at approximately 19%. The heavy equipment the company manufactures and sells is necessary for its customers to get jobs done.
Caterpillar operates a global brand with a strong manufacturing and dealer network that offers its customers sales, financing, and support across the world. It’s in that massive dealer network that Caterpillar has an incredible competitive advantage. Knowing that there will be minimal downtime due to the quality and reputation of the products combined with the availability of support and service means Caterpillar is far ahead of most competition – CAT has had almost 100 years to build this network out.
The manufacturing footprint also stretches the globe, which affords the company economies of scale and logistics advantages.
Although they’ve faced intense competition in China, the company’s competitive position in global terms remains strong, from what I can see. There’s still a huge opportunity that exists due to the building out of infrastructure and housing that’s necessary in many countries, like India. And while the pricing for many commodities, including oil and iron ore, remain weak, which reduces demand for some of their equipment, the company’s diversification across geographies and product type insulates them somewhat.

Risks

The company is heavily exposed to a number of cyclical industries, making its very business model highly cyclical.
Since the company is extremely global with most of its sales occurring abroad, it faces currency risks.
Its global dominance has been challenged in China, as the company trails market leader Komatsu Ltd. (KMTUY).
Caterpillar also faces acquisition and integration risks. Poorly timed acquisition of Bucyrus International, Inc. in 2011 and the write-down of assets related to ERA Mining Machinery Limited highlight this risk.
Any slowdown in the global economy could adversely affect the company due to its exposure to economically sensitive industries.

Valuation

The stock is currently offered for a P/E ratio of 13.07. It’s tough to use that as an extremely accurate measuring stick due to the cyclical nature of operations, but I do find that reasonably appealing when looking out over the last decade or so for this stock. For perspective, the five-year average P/E ratio is 18.2.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term dividend growth rate. I think that growth rate is fair when looking at the long-term track record for underlying operational growth and dividend growth, as well as the moderate payout ratio and potential for growth moving forward. Both the long-term and short-term numbers for dividend growth seem to indicate I’m including a margin of safety there. The DDM analysis gives me a fair value of $93.72.
The stock appears undervalued by just about any metric you want to look at. However, I think a dearth of near-term catalysts compounded by aforementioned headwinds means this is a very long-term play (my favorite kind, of course).

Conclusion

There isn’t any other company in the world quite like CAT. Their scale, diversification, network, and brand are all unrivaled.
However, 2015 will likely be a tough year for the company. Now, Q1 results were quite solid – EPS of $1.81 per share was a 25.7% improvement over Q1 2014’s $1.44. And FY 2015 guidance was slightly improved to $4.70. All in all, though, the short-term picture isn’t that bright.
But that’s exactly when you buy a high-quality company. You don’t buy when the roses are red and violets are blue; you buy when the sky is gray and everyone thinks it’s falling. Well, that’s kind of where CAT is at right now. Shares are down almost 25% over the last year, which is substantial for the size of the company we’re talking about here. I like buying quality merchandise when it’s marked down, and I certainly appreciate a 25% cheaper price on the stock.
It also helps to know that Bill Gates, through the Bill & Melinda Gates Foundation Trust, owns almost 2% of Caterpillar. Notably, he also has a substantial stake in DE through his private holding company, Cascade Investment, LLC.
We’ve got a yield near 4% with double-digit dividend growth and more than two consecutive decades of dividend raises. And the stock appears to carry a margin of safety here, assuming they can increase the dividend in the upper single digits for the foreseeable future and beyond. At the very least, it’s fairly valued, even considering the headwinds.
This purchase adds $46.20 to my annual dividend income, based on the current $0.77 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates CAT as a 3/5 star valuation, with a fair value estimate of $79.00.
S&P Capital IQ rates CAT as a 3/5 star “hold”, with a fair value calculation of $85.00.
I’ll update my Freedom Fund in early August to reflect this recent purchase.
Full Disclosure: Long DE and CAT.
Shareholder in CAT? Any thoughts on the company? Do you think the current price represents an opportunity? 
Thanks for reading.

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