- The payout ratio is close to 60% and the company is expected to increase the dividend in the Summer. This metric needs to be watched
- US construction is growing and Caterpillar is benefiting. This trend needs to continue.
- Oil prices will move Caterpillar stock meaningfully as the "Energy & Transporation" is the company's biggest industry.
Caterpillar (NYSE:CAT) will announce its 2015 fourth quarter fiscal earnings before market open on the 28th of January. The consensus EPS forecast is $0.71 which is a whopping $0.64 short of the reported figure in Q4-2015. Caterpillar is guiding just under $48 billion in revenue for the year which means the expected top line figure is around $12 billion which again will be over $2.2 billion short of what was reported in the same period last year.
In my opinion, Caterpillar is living off its dividend aristocrat status (currently paying out a dividend of over 5%) because 2016 guidance is also weak (guiding 5% lower revenues). Furthermore, when you include the carnage that the energy and mining sectors have endured, it is strange to see that Caterpillar stock is still trading at a premium with a high price to book ratio of 2.2 or book value per share of around $27.
Does a company with a market cap of $35 billion deserve such a valuation? I don't think so considering that most companies in these divisions have had their balance sheet decimated over the last 18 months with the exception of some downstream companies or big integrated companies like Exxon Mobil (NYSE:XOM) which is almost 10 times the market cap of Caterpillar. The majority of investors invested in Caterpillar at the moment are dividend investors. If you are one of them, here are some things you should be looking out for.
Firstly the dividend is not expected to be raised until July of this year and Caterpillar currently pays $3.12 or a current 5.05% yield based on the current stock price of $60.99. It will be interesting to see if the pace of buybacks continue at the company as buybacks have been instrumental in my view in keeping Caterpillar stock price elevated over the past few years. $1.5 billion worth of stock was bought last quarter and more than $8 billion in shares have been bought back by management over the past 3 years.
We need to look at Caterpillar's cash flow statement to see if the company's excellent dividend growth rate can be maintained. The company's trailing twelve-month free cash flow metric is $3.54 billion and falling. With a float of 582 million shares, the dividend is currently costing the company $1.79 billion annually and rising despite the large buybacks in recent years. Free cash flow fell to $780 million last quarter - well below the $1.2 billion figure printed in Q3-2014 meaning the payout ratio has now spiked to almost 60%.
To keep on paying this dividend, Caterpillar had to drastically cut its work force over the last 12 months (culling of 8,000 employees - see chart) as restructuring costs ($800 million for 2015 predicted). Lower sales are finally taking its toll on the company.
Source: Company Website
Ongoing restructuring efforts are predicted to enable Caterpillar save $1.5 billion per annum which will definitely help the bottom line and cash flow figures. Therefore, if the pay-out ratio can return to mid 50's from these measures, dividend growth rates should continue at least in the near term (13% presently over 3 years which mean the present dividend would get hiked to $0.87 in the Summer).
The second area I would watch closely is the construction industry, specifically in North America. Last quarter North America reported top line revenue in this division of $1.82 billion which was just 5% lower than Q3-2014. North America and specifically the US definitely are experiencing growth in residential and commercial building construction.
We saw the growth in commercial when some US banks announced their own set of earnings last week and Caterpillar desperately needs this trend to continue. Why? Well, its energy and transportation division is getting hammered at the moment due to lower oil prices. The division brought in $4.2 billion for the company last quarter which was 25% lower than the same quarter of 2014. I'm expecting it will be lower for Q4 especially when you see how the price of crude behaved in the final quarter of 2015 (dropped around $11 a barrel).
Analysts are predicting an EPS of $3.51 on revenues of $43.4 billion for 2016 which still makes its forward price to earnings ratio of 17+, too high for me at this moment in time. If consensus goes to plan and the Caterpillar stock reverts back to its 5 year price to earnings average of 14.5, the stock should drop to $50 a share. Would I be a buyer at that point? It depends on how its restructuring efforts would be going at that time.
Caterpillar needs to keep EPS elevated as much as it can. Restructuring efforts will take time but sooner or later, the company's net earnings should find a floor if the commodity rout continues. On Friday last we saw how Caterpillar stock is a play on rising oil prices. Oil spiked to $32 a barrel and Caterpillar stock also rallied over 2%.
To sum up, Caterpillar revenues has been in a downward spiral for the past 4 years and 2016 looks like it will be number 5. Nevertheless, it still is generating enough cash flow to justify paying out its high dividend despite the serious decline in its net earnings. The price of oil and the construction industry are the 2 shining lights that could turn around Caterpillar stock in the near term as every other sector and region are presently experiencing double digit declines.