Can Caterpillar Continue Its Remarkable Dividend Growth Track Record?

  • Caterpillar has been growing dividends for the last 22 years and enjoys a sustainable competitive advantage.
  • However, Caterpillar is facing insurmountable headwinds, the likes of which it has never seen before.
  • Barring any global economic revival, the company could be forced to rethink its payout strategy within the next couple of years.

Caterpillar (NYSE:CAT) is one of the most reliable dividend payers. With a quarterly dividend of $.77, the company offers a generous yield of 3.9% at the current price level. That’s higher than the S&P-500 average yield of 2.1% and peer average of 2.47%, according to data from Thomson Reuters. But more importantly, Caterpillar is from the rare group of companies that have been consistently growing dividends for more than two decades.

Generally speaking, when it comes to dividend investing, one of the safest companies are those that have been growing payouts for the last 25 years. The so called “dividend champions”, such as Walmart (NYSE:WMT), Chevron (NYSE:CVX), Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), 3M (NYSE:MMM) and Coca Cola (NYSE:KO), enjoy sustainable competitive advantage which allows them to earn reliable cash flows every year and reward shareholders with higher dividends, even during down cycles. Technically, Caterpillar is not a dividend champion since it hasn’t grown payouts for 25 years on the trot, but 22 years of growth is still a remarkable record.

Caterpillar’s sustainable competitive advantage is underpinned by its powerful brand, an enviable product portfolio, manufacturing scale and a strong dealer network spread in 131 countries. To call Caterpillar the world’s leading construction and mining equipment manufacturer is actually an understatement. Caterpillar is either the industry leader or the second largest player in virtually every product market that it serves. It alone commands a little less than one-fifth of the global construction equipment space. With a market cap of $46.14 billion, Caterpillar is more than twice as large as its nearest competitor, the Tokyo based Komatsu valued at $18 billion.

However, Caterpillar is facing insurmountable headwinds, the likes of which it has never seen before. Caterpillar was one of the biggest beneficiaries of the boom in the mining, construction and energy markets that lifted the demand for heavy machinery. However, most, if not all, of that increase was led by China which was urbanizing at a rapid pace. When China slowed, the demand for commodities like iron-ore, coal and copper came crashing down.

The slowdown in the other major global economies, particularly Brazil, Russia and Europe, made things worse. That was followed by a slump in oil prices, thanks to a supply glut, which hit the demand of Caterpillar’s oil drilling and well-servicing products. Its woes were further exacerbated by strengthening dollar. The rise of the greenback against other currencies negatively impacts Caterpillar’s international sales, which are reported in US dollars, and makes its products relatively more expensive for foreign buyers.

Caterpillar’s top and bottom-line has been shrinking over the last three years. The company’s revenues have fallen from $65.88 billion in 2012 to $47.01 billion last year. During this period, its operating expenses have largely remained flat, but profits have plunged from $5.6 billion to $2.1 billion. And it doesn’t look like things will get any better, at least in 2016.  The company expects revenues of ~$42 billion for the current year, a drop of more than 10% from last year. This could mark the fourth consecutive revenue drop for Caterpillar – that’s something which has never happened in the company’s 100 year history. This signifies the severity of the current downturn.

Moreover, with weaker than expected global economic growth and excess supply of equipment in all of Caterpillar’s end markets, the current year could actually turn out to be worse than expected. The International Monetary Fund’s recent warning has heightened concerns around the state of global economy. Last week, IMF reduced the growth outlook for the current year by 0.2 percentage points to 3.2%.

It is clear that China’s economic slowdown, the impact of weak commodity prices on emerging markets and sluggish recovery of developed countries following the global financial crisis is making a bigger dent on the demand of goods and services than IMF initially expected. And that’s bad for Caterpillar. For a turnaround, the company is relying on an economic revival which would lead to a rebound in mining and construction activity.

Fortunately, Caterpillar does have a very strong balance sheet. Its debt-capital ratio clocked in at 39.1% last year, up from $37.4% a year earlier. However, the leverage metric is still significantly below the top end of the company’s target of 45%. Moreover, despite shrinking revenues, Caterpillar still generates enough cash flows to fully fund its entire capital budget and dividends. Last year, for instance, the company generated $6.67 billion in operating cash flows but spent $3.26 billion as capital expenditure (ME&T capex including expenditure on equipment leased to others) and $1.76 billion as cash dividends.

Due to an under-levered balance sheet and strong cash flow profile, I believe there is no significant threat to the company’s dividend in the short term. But with slumping sales, Caterpillar can’t continue rewarding shareholders this way. Eventually, in the long-run, the cash flows will buckle, forcing the company to revise its payout policy.

For instance, according to my rough and conservative estimates, if Caterpillar continues to reduce capex by 5% each year but increases the dividend by 5% (actual cash dividend increase was 8.4% last year) while operating cash flows drop by 8% (actual drop was 17.2% last year), then the company will be unable to fully fund the dividend and capital spending from operating cash flows after 2019.  This means it could be forced to alter its dividend strategy over the next couple of years.

Conclusion

Caterpillar comes with a remarkable dividend growth track record, a sustainable competitive advantage and a decent balance sheet, but it is still at the mercy of the construction, mining and energy markets. The poor state of the global economy could force Caterpillar to revise its dividend growth strategy. I believe that if you are looking for a stock that has grown dividends for decades and is positioned to continue moving this way in the future, then you should avoid Caterpillar.

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