3 Reasons Not To Get Long On Caterpillar Stock

  • Auctions of Caterpillar equipment in Australia illustrates how dire the industry has become. No recovery in coal related industries on the horizon.
  • Caterpillar has the cash flows to keep rewarding shareholders but its EBITDA is sliding faster than revenue.
  • Taking on debt in a rising interest rate environment could mean much lower valuations for this stock.

Caterpillar (NYSE:CAT) is almost a dividend aristocrat (25 years of increasing dividends), so I don't see this stock cutting its dividend in the near term. Caterpillar has typically been a company that has ploughed most of its operating profits into share buybacks since 2011 in an effort to keep the stock elevated, but I don't know whether it will be enough. Revenue topped out in 2012 at $65.87 billion and has been on the slide ever since, with the worst drop coming in October. Furthermore EPS topped out in the same year at $8.48, but the main reason why this company has been able to satisfy shareholders with rising dividends and buybacks throughout this downward cycle is that it has kept its cash position elevated. Its cash and cash equivalents balance rose from $3.05 billion to $7.34 billion in 2014. Moreover I don't understand why the announcement a few months ago about the pending 10,000 job losses didn't affect the share price more. The company also reported lower revenue guidance for 2015 ( down $1 billion to $48 billion), and 2016 to be another 5% lower than 2015. If this indeed happens, it will be the first time in 90 years that revenues will have decreased for 4 consecutive years. Yet Caterpillar stock still has a stubborn p/e ratio of almost 15, whereas in 2011, the company's p/e ratio was under 14 and it had nearly 40% more profits. This company has set itself too much as a strict commodity play. Here are 3 reasons why I would stay out.

Firstly you have the Chinese economy where a turnaround doesn't seem likely especially after the country devalued its currency a few months ago. If these devaluations continue, they will only add to Caterpillar's pain in the Asian Pacific region. China consumes the most commodities in the world by far, so when this economy slows down, all companies mining coal or copper get adversely affected. To really get a clear picture of how the Chinese economy is unraveling, we have to go to Australia, which has been one of the principal countries supplying raw materials to China. In Australia presently, you have vast amounts of mining equipment being sold at auction for pennies on the dollar. If the serious declines in construction, taking place in Asia and South America at present, spread into North America and Europe, then Caterpillar's valuations at the moment are outrageous. Furthermore when you combine the downturn in the commodities space with the seemingly abundant supply of second hand machinery (which are driving down the price), it seems obvious that Caterpillar's sales will continue to fall in the near term.

Secondly we have to look at this company's dividend which may not be a risk in the near term but long term could hurt this stock's capital gain potential. First we have to look at the pay out ratio which is up around 60%, but realistically this figure is around 80% when you include restructuring costs, which is definitely on the high side. Bulls will say that the dividend will continue to be safe because of the company's large cash balance and continuing cost cutting efforts. The company expects capex to be 50% lower by the end of this year than in 2012 and to keep on getting smaller until 2018. Its current debt to equity ratio is 1.59 which again is healthy considering the pullback the stock has had. Nevertheless dividend investors are ignoring earnings growth which is a vital metric when evaluating the safety of a dividend. Why take a chance on a dividend stock with negative earnings growth? Caterpillar has set itself up to be a pure play on a commodity revival which at the moment doesn't seem likely. It has ample liquidity with almost $5 billion of industrial segment cash but if sales keep falling, I can't see the company continuing to rewards shareholders with share buybacks and increasing dividends over time. Investors should note that reducing buybacks would decrease the company's EPS figures which again would be taken bearishly by the street.

As investors we get paid to predict the future and while Caterpillar's balance sheet at the moment may look pretty sound, there are still some underlying negative trends that you should be aware of. Firstly its cash flows are dropping faster than its revenue. Sales decreased by 16% from 2012 to 2014 whereas its EBIDTA dropped by 20%+ ($12.3 billion to $9.3 billion in 2014). Furthermore the company didn't borrow to issue its share buybacks last quarter but sooner or later if sales keep dropping, it will have to borrow funds to keep shareholders happy. This is where this company could run up against serious problems. Its asset value has deteriorated significantly since 2012 (see chart) so any hike in liabilities would put pressure on its balance sheet especially if interest rates were to rise.

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To sum up, I believe Caterpillar will keep paying its dividend over time, but it will come under pressure if commodity prices continue to fall. I would ignore this industrial and pick a strong dividend player in the energy space or mining space as both industries are present are closely correlated. Despite the downturn, there are plenty of stocks in these sectors that have positive earnings growth and production growth also. Caterpillar doesn't seem to have catalysts that can spark growth which is why its future is a play on the mining and energy sectors.

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  • I do not have any business relationship with the companies mentioned in this post.
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