The fundamentals for Caterpillar (CAT) are mixed. On the positive side we have the core business of the Company; on the negative we have the financial business.
Core Business Fundamentals
As regards the future:
- Caterpillar derives much of its demand from mining and infrastructure companies; the engine division has strong demand from Energy, Power Generation and Marine Industry too. Both mining and infrastructure are particularly powerful up-trends, caused by demand in emerging markets, most notably China and India. This is offset by demand reduction in the construction industry, where weakness is expected to continue.
- Caterpillar products are highly dependent on credit availability. Several potential buyers have damaged and over-leveraged balance sheets.
- As a result of the financial crisis, a deferral in replacement cycle can be expected. There are no visible catalysts for a significant reversal during 2009 into much of 2010.
- Natural resources by nature are finite. The cost of discovering and developing new mines is increasing, and the depletion rate of aging resources is accelerating. As new mines are developed to satisfy rising demand, the marginal cost of production increases. In such a situation, prices must rise. The demand to discover and develop new mines creates a market for Caterpillar products.
- Natural resource owners typically have backward sloping supply curves during periods when marginal cost of new fields is causing a shift in the supply curve. Producer assets are safe underground and when prices are low relative to future expectations, the incentive to monetize commodities is also low. Thus supply falls despite rising prices and this drives prices up further; in fact the spread between spot and future prices creates an arbitrage opportunity which puts an upward trend on spot rates. As prices rise, profitability of the entire sector rises; the old low marginal cost fields are highly profitable offset in part by the increased cost of developing new fields. Strength in profitability of the resource sector will typically lead to stronger demand and margins for Caterpillar.
- The massive liquidity and stimulus packages by governments the world over should result in inflation down the road. Inflation expectations typically result in firm commodity prices. This expectation will likely be quickly offset by rapid reduction in leverage and liquidity once a recovery takes hold firmly. Strength in profitability of the resource sector will typically lead to stronger demand and margins for Caterpillar.
- As risk aversion abates, capital outflows is likely to result in a weaker dollar. The dollar may also weaken as a result of challenges to its status as the world’s reserve currency; though this will take time. A weak dollar results in firm commodity prices.
Overall, I believe the long term prospects are strong; however, I do not believe that annual growth rates of 12.73% achieved over the 16 years ended 31 December can continue ad infinitum. I expect nominal growth rates to range from 6% to 8% made up of real growth of 3% to 4% (in line with global GDP growth rates) and inflation rates ranging between 3% and 4%.
At the end of the quarter ended 31 March 2009, total debt net of long term investments and cash was at $16.6 billion. This is 2.62X shareholders equity ($6.3 billion) at the end of the quarter. While I do acknowledge debt is important for this capital intensive business; I remain of the view that this is too much debt. I would feel much happier if the business was de-risked by reducing total debt net of long term investments and cash to just under $10 billion for a Debt to Debt plus Equity ratio of 30%. As it happens, reduction of finance receivables of just over $9 billion from the $16.6 million would bring leverage well below my comfort zone. Yet, the finance receivable worries me; I would be much happier if the financial services business were spun off or disposed to leave behind a powerful industrial company. Despite this reservation, I find Caterpillar trading at compelling valuations.
Delivering and Returning Shareholder Value
Over the last 16 years ended 31 December 2008, Caterpillar has grown earnings at an astounding 12.73% annualized. During this period, dividends have growth by a mind boggling 20.68% annualized. The annual share price appreciation has grown at 15.32% annualized; the annualized return is over 10% annualized using the $32.49 average share price for 2009. During the same period, the shares outstanding have been reduced significantly through buybacks net of dilution on account of new capital and employee awards; effectively 25.8% of the shares outstanding have been bought back over 16 years. The company has returned value to shareholders in three ways (a) dividends, (b) buy backs and (c) share price appreciation. Responsible shareholder value return makes these shares attractive to the broadest investor audience and this has a great impact on share prices and value recognition.
Returning shareholder value through buybacks is powerful. It has several advantages over and above dividends. For departing shareholders, demand for shares by the company allows for stronger relative share values, which provides a better capital gain or smaller capital loss on exit. Buybacks are also very tax effective for continuing shareholders; the share count reducing means that the continuing shareholder owns a larger percentage of the company following a buyback; in effect the continuing shareholder has succeeded in securing a higher percentage ownership without a tax burden. Compare this to the dividend re-investment option where there would be a significant tax cost associated with dividend income, which leaves less dollars available for investment. Buybacks also allow employees to be compensated through stock grants and option awards without any threat of dilution. Finally, buybacks can easily be suspended during difficult economic times without having an adverse impact on share prices compared with the reaction on suspending a dividend. Why then not simply return shareholder value using only buybacks?
There are a few very significant reasons; firstly a buyback program is not regarded as a dividend by investors. Thus income investors tend to shun shares which reward shareholders only through share buybacks; this lack of investor interest has a significant impact of market value of shares.
Secondly, companies are not very good at handling share buyback programs. For example, in the case of Caterpillar, the most significant buying occurred during 2005-2008; a time during which share valuations were strong. Today quite correctly, there is a need to conserve resources and so buybacks are suspended. Finally, an investor in Caterpillar invests to profit from their magnificent machines; when Caterpillar buys its own shares, it is in effect speculating in its shares. I would trust Warren Buffett with a buyback program because his business is investing; but for a normal Company the focus is returning shareholder value not investing activity.
Dividends are dangerous too. When a company targets a payout ratio of say 50%; during tough times, suspending dividends might be the outcome. And this is not good for share values.
It is for this reason I believe a combination of dividends and buybacks is the most effective mechanism for returning shareholder value. Suppose a company returns value through dividends with a payout of 25%; it is likely that such a dividend will be sustainable even in a bad year. The company could return a further 25% payout through a buyback program; in a rough year such a program could easily be suspended with a smaller negative impact on share values.
For Caterpillar, the dividend payout over the 16 year period ended 31 December 2008 has averaged 31.36% of EPS (median payout 26.86%). After considering share buybacks, the adjusted payout has averaged 53% (median adjusted payout 50%). In my view the company has done well. The times might still require a cut to the dividend; but if it had returned value solely through dividends, the cut would have come long ago. My gripe on buybacks is simple; the company bought when values were high and that has harmed continuing shareholders.
Suppose Caterpillar has maintained a target adjusted payout of 50%, with 26.86% being paid out via dividends and 23.44% being paid back via buybacks. Suppose Caterpillar had bought shares throughout the year regardless of the management’s perception of values; then shares bought back during 1994 to 2008 inclusive would have been 232 million instead of 210 million shares as it currently stands. In my view, targeting an annual payout and the systematically paying a stable dividend together with a systematic repurchase program is the best way to go.
In terms of growth, over the sixteen years between 1993 and 2008, CAT’s performance has been formidable; Estimated Free Cash Flow has grown at over 6.95% annualized while EPS has grown at near 12.73% annualized. Earnings growth after considering the impact of the buybacks net of dilution during this period has been lower at 10.64%; when I say earnings growth I mean earnings in total for the company, regardless of the number of shareholders. This compares with GDP growth during this period of 4.5% (2% real growth plus 2.5% inflation) during the same period. This is a great achievement by any standards; it reflects well on both the product quality and management at CAT.
Going ahead can we expect more of the same? Overall, I believe the long term prospects are strong; however, I do not believe that annual growth rates of 12.73% achieved over the 16 years ended 31 December can continue ad infinitum. I expect nominal growth rates to range from 6% to 8% made up of real growth of 3% to 4% (in line with global GDP growth rates) and inflation rates ranging between 3% and 4%. With the financial crisis, we can expect some slow-down in long term growth expectations in the US and OECD Countries with perhaps a slower degree of slowdown in the emerging markets in the near future.
I have assumed a long term growth expectation of 7% made up of 3.5% real global GDP growth and 3.5% global inflation. I believe these rates to be achievable and conservative; particularly as CAT is aggressively entering emerging markets. Valuing the FCF in perpetuity [(FCF*1.07)/(11%-7%)] at a target long term annualized rate of return of 11%, gives a value of near $69. Valuing 2008 EPS on the same basis gives a value of near $152. Going with the Gordon's Growth Model, which values dividend on the same basis, we get a value of near $43. The problem with all three is that 2008 numbers are used; why not use 2009 numbers instead?
Using 2009 numbers we get values of $41, $52 and $44 respectively. We could now argue that 2009 numbers are estimates only; besides, they might not reflect a reasonable starting point for the exercise of valuation. Why not use the six year cycle averages and use the averages expected to prevail at end 2009? Using the six year average EPS expected at end 2009 of $1.21, we arrive at a value of $112; we get $74 if we use six year average free cash flow. A Gordon’s Growth Model using six year average EPS and a 50% payout ratio results in value of $56.
For multiple based valuations, I have used the six year cycle EPS, multiplied by the median six year PE (PE 6) to arrive at $58 as a reasonable price target. In order to eliminate the impact of the high valuations during the 16 year period of extraordinary growth, I have also come up with a target price of $50 using six year cycle EPS, multiplied by the bottom quartile six year PE.
In my view $36 is a good entry point for an investor in perpetuity; this is based on Gordon's Growth Model with a dividend cut to $1.36 for 2009 with future dividend growth at 7% and a required investor return of 11% annually. For a person with a shorter holding period, an exit target of $58 over 12 months is not unrealistic. With no immediate catalysts in sight, CAT might take longer to produce results and it does carry risks of a double dip recession; yet I believe the valuation is compelling and the dividend will provide some reward for the risk undertaken.
The Estimated Free Cash Flow is simply the Diluted EPS (Excluding Items) Plus Depreciation Less Capex. The EPS is the diluted number excluding items. The annual average price is the average daily closing price for each year.
The six year average EPS is an attempt to smooth earnings over an economic cycle; during this period we have had the Asian Contagion of 1997, the IT bubble and now the bursting of the US property and debt bubbles. With these cyclical forces at work, it is senseless to look at the long term potential of a business based on a single quarter or year. The PE measure is a traditional PE (Price/EPS); except that it is calculated on the annual average price. The PE 6 measure is the annual average price divided by the six year average EPS.
If anyone is interested in the detailed numbers, leave me a message telling me where to send it.
Disclosure: Long CAT