- Caterpillar's R&D budget remains elevated. This will ensure that the company hits the ground running when commodity prices rise.
- Land prices have to come down in the US which will boost construction. Chinese house prices have risen now for 6 months straight, which should aid investments in the sector.
- A long term put option at the $60 strike price will still earn more in income that annual dividends in 2016.
Caterpillar (NYSE:CAT) is currently trading at $67.31 which is, basically flat for the year. The stock is down almost 40% since the oil rout started but recent moves in the price of crude (now almost $33 a share) may mean that a firm bottom has been printed in the oil markets. Many investors have vacated the energy sector due to elevated volatility, dividend risk and extreme share price, but Caterpillar's dividend remains secure which is why its share price hasn't capitulated considering over $3 billion has been wiped off its bottom line since 2012. The dividend will be raised again this year which will probably bring the annual payout to around $3.18 per share. The current float is 582 million shares meaning dividend payouts would come to $1.85 billion which looks safe as Caterpillar delivered free cash flows of $3.41 billion in 2015.
Caterpillar recently revised its 2016 revenue outlook downward (to around $42 billion) which probably is a smart play considering its initial 2015 top line guidance (around $50 billion) was well above the $47 billion sales the company ended up with. What does this mean for dividend investors? Well, we need to see operating expenses fall faster to offset the projected decline in earnings. For example operating costs only fell 15% last quarter compared to a 22% decline in top line sales. This needs to balance itself out and with prudence. Why? As Caterpillar continues to get smaller, it is imperative that the cuts happen at the right place to ensure that the company can participate when commodity prices begin to rally once more. Therefore, the next step in their cost-cutting initiatives, which is to close five plants, is crucial and will mean a further loss of 670 jobs (10,000 job losses in total projected through 2018). This will buy the company more time to keep its cash flows elevated which will keep the company from taking on further debt. Furthermore, Caterpillar has other growth triggers in its favor.
Firstly, you have the construction industries both in the US and China which are critical to Caterpillar's sales going forward. The construction division in North America was the last pillar to drop but I don't see this division being down for long as there are huge shortages of new houses in the US in particular. Lot prices are just too expensive for builders to build standard new homes on, which is why millennials are being squeezed out of the market at the moment. A gradual decline in land prices in the US would be bullish for Caterpillar in that more construction equipment would be needed. I believe this will happen soon enough as the real estate market starts to slowly run out of buyers.
China is in a different position compared to the US as it has much higher interest rates and I'm predicting that this country also will see long-term growth in its real estate sector despite probable short-term declines. The Chinese government is now allowing a family to own multiple properties which should keep demand elevated. Furthermore, recent yuan devaluations should mean more disposable income for many Chinese. Where will this income go? Well, with its stock market being highly volatile over the last few months, real estate looks an attractive option especially when you consider that house prices have now been rising for the last 6 months.
An investment in Caterpillar is an investment in a market leader which is currently commanding a 19% share of the construction market which is far higher any other competitor. Apart from this, the capital it ploughs into R&D every year (around 4% of revenues), which came in at $2.17 billion last year, really makes this company stand out in this sector. When construction, mining and energy companies finally return to the market and aggressively buy products once again, I believe Caterpillar will be their first port of call due to its annual multi-billion dollar research and development. These investments, despite having earnings and cash flow declines in the near term, alone are a testament to the company's long-term vision.
So how do we play an investment in Caterpillar stock going forward? Well, the chart shows that Caterpillar stock bottomed on the 28th of January at around $58 a share. If you still are wary of downside risk, you could sell the $60-January-2017 put for $580 which is 332 days to expiration. What does this trade give you? As long as you are willing to buy Caterpillar at $60 next January, you will receive an upfront payment of $580 now. You either get assigned or not. If you are not assigned, you keep the entire premium ($580) which is almost a 10% return on investment (as you would have had to park $6,000 in the event 100 shares were "put" to you at expiration). On the other hand, if you are assigned, you are now long 100 shares of stock at $60 a share. However, your break even is $54.2 which equates to an earnings multiple of just under 15 (based off 2016 projections) which is the company's 5-year average. The 12 month out "put" option will give you more income than the dividends in 2016 plus if you are exercised, you will be getting the stock at a much cheaper price than it is today. An excellent defensive trading strategy.
To sum up, Caterpillar stock still looks favorable at current price levels mainly due to its financials and a strong dividend. The dividend is secure and will be raised again this year. Although mining and energy divisions are weak, Caterpillar's construction divisions should return to growth soon due to real estate being in demand especially in the US. Caterpillar stock has rallied hard since late January so, selling a long term put option may be the best strategy here.