- Caterpillar has kept the quarterly dividend flat. This could be a precursor to difficult decisions in the quarters ahead.
- Although Caterpillar stock has gained 10% this year, investors should remain cautious due to three reasons.
- Fortunately, there is some light at the end of this tunnel.
Caterpillar (NYSE:CAT), the world’s leading maker of construction and mining equipment, has recently declared a quarterly dividend of $0.77 per share. The company has kept the dividend flat since June, 2015. This may come as a surprise to many investors since Caterpillar is one of the most reliable dividend stocks that has been growing payouts for the last 22 consecutive years and has been announcing a dividend hike in June for the last six years. Although Caterpillar can still maintain its annual dividend growth track record by announcing a hike by the end of next year, I believe the company’s decision to keep the dividend unchanged could be a precursor to difficult decisions in the quarters ahead.
Caterpillar has been hit hard by the commodities rout. The weakness in the prices of commodities over the last five years was triggered by a slowdown in China and excess supplies of most metals and energy products. The sluggish global economic growth has also not helped. Due to weak demand for equipment in its end markets, the company has seen its revenues drop from $65.87 billion in 2012 to $47 billion last year while its operating income plunged from $8.57 billion to $3.25 billion in the same period.
Caterpillar’s shares, however, have gained roughly 10% on a year-to-date basis, thanks to the recent strength in the prices of commodities and some positive signals from China. The prices of commodities, ranging from soybean to iron ore, have gained more than 21% from the bottom-level seen on January 20, as measured by the Bloomberg Commodities Index which tracks 22 different raw materials. The Chinese housing market has shown strength in property prices and sales over the last few months after the government eased lending policies.
This has sparked optimism that the worst ever commodities rout might finally be over. This has led some to believe that the world’s leading publicly listed global miners, who lost a total of $27 billion last year, could turn around soon. That could lead to an increase in demand of mining equipment and machinery, which could fuel Caterpillar’s turnaround. But I believe this is largely wishful thinking.
That’s because firstly, the prices of commodities have gained substantially from recent lows, they are still weak when compared against prior year levels. Despite the above-mentioned strength, the Bloomberg Commodity Index is still down 34% from a year earlier and is 50% below the high seen in 2011.
Secondly, the strength in the prices of some commodities is not backed by solid supply and demand fundamentals. For instance, the iron ore market remains oversupplied. That's why a number of analysts, including those from Citi, believe the red metal, which is hovering near $51 per tonne after increasing 30% from December lows, will average $49 a tonne this year and will drop to $42 in 2017. Oil prices have climbed to $50 a barrel after dropping to less than $27 a barrel in February, but oil and gas producers are not going to increase their spending levels until the rally is firmly established. For now, the exploration and production companies will continue to focus on cost-cutting measures.
Thirdly, there are growing concerns regarding the global economic slowdown in general and the strength of two of the world’s largest economies in particular. The International Monetary Fund and the World Bank have slashed this year’s economic growth outlook. The IMF currently expects global growth of just 3.2% this year down from the previous estimate of 3.4%, while the World Bank expects global economy to expand by 2.4% this year as opposed to its previous estimate of 2.9%.
In China, the housing market’s strength could begin to fade once the loose credit policy begins to moderate. This can have a negative impact on house prices and sales. The country aims to expand its GDP by almost 6.75% this year, which would be the slowest growth in more than a quarter of a century. Meanwhile, in the US, there have been growing concerns regarding moderating growth. In December, the Federal Reserve talked about increasing interest rates four times in 2016, but it was forced to abandon its plan later, which implied that the world’s largest economy wasn’t as strong as the U.S. central bank initially thought. The Fed is expected to increase rates two times in 2016, but the latest shockingly weak jobs report for the month of May has all but ruled out the possibility of a June hike.
In this environment of sluggish economic growth, I believe Caterpillar will continue to struggle with shrinking revenues and earnings. Its cash flows have already come under pressure. Historically, the company has generated enough cash flows to fully fund its capital spending and dividends. But in the previous quarter, it reported negative free cash flows of $750 million, as per my rough calculations. Perhaps this is one of the main reasons why Caterpillar kept the quarterly dividends flat. Moving forward, without any support from revenues, earnings and cash flows, the company will find it difficult to increase dividends.
Fortunately, there is some light at the end of this tunnel. Although the company will likely continue to struggle in the short run, eventually, in the long run, the commodity and economic cycle will turn. Moreover, virtually all of the mining equipment in the world will need to be replaced over the next ten years. The demand for small parts to large equipment to mining trucks will pick up. Once it does, Caterpillar will come back strongly. That’s because the company is not only the industry leader with exposure to more than 500 locations in more than 180 countries but also has been gaining market share in the downturn.
Caterpillar’s shares have climbed this year, but these gains might not last for long. Despite the strength in commodity prices and some positive indicators from China, which have fueled Caterpillar’s rally, the macro environment continues to remain weak. The company’s revenues, earnings and cash flows will remain under pressure, which will make it difficult for the company to continue growing dividends, as it has been doing for the last two decades. For these reasons, I believe investors should stay on the sidelines.