Evaluating Caterpillar's Dividend Growth Potential

| About: Caterpillar Inc. (CAT)


Do your best to avoid backward-looking analysis.

The future is the most important time horizon for dividend growth investors.

Caterpillar has a Dividend Cushion ratio of 1. Let's find out what that means.

History has revealed that the best-performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. This makes a lot of sense, as the strongest dividend growers are often the strongest generators of increasing cash flow. Caterpillar (NYSE:CAT) is one such gem. Let's evaluate its dividend growth prospects in this article.

But first, let's start with framing this analysis for readers. Most dividend assessments tend to be backward-looking--meaning the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30 or more years isn't much to write home about.

Imagine, for example, giving your grandson $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.

Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?

With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative Valuentum Dividend Cushion methodology.

For those that may not be familiar with our boutique research firm, we generate a discounted cash-flow analysis for all firms in our coverage. We use these future forecasts of free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future.

The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based and driven from items taken directly off the financial statements.

Let's take a look at Caterpillar's investment highlights and then its dividend report to see how all of the analysis comes together.

Caterpillar's Investment Highlights

• Caterpillar's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. Results are not immune to geopolitical risks, however.

• Caterpillar makes construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company also owns Caterpillar Financial Services (Cat Financial). Operations are tied to cyclical end markets.

• Caterpillar has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 7.7% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 64.5%.

• Cat's dealer network is a significant competitive advantage. The company's reach is phenomenal, with about 50 dealers in the US and over 140 outside of the US (serving 180+ countries). We like the firm's proficiency in lowering costs, improving cash flows and continued execution of lean manufacturing initiatives.

• Near-term trends aren't favorable. Industry surveys indicate that total mining capital expenditures will fall another 20% in 2014 from 2013 levels, which were ~10% below 2012 spending. Mining equipment sales remain tied to expectations of commodity prices.

Caterpillar's Dividend Report

Caterpillar's dividend yield is nice, offering a ~2.6% annual payout at current price levels. The bottom right of the table below reveals our expectations for Caterpillar's future pace of dividend growth (~8%-12% per annum). The table also includes Cat's recent shifting of dividends into 2012 due to concerns about changing tax laws, and the annualized forecast of dividends for this year. Please have a look.

Image Source: Valuentum

Let's now dig into Caterpillar's qualitative ratings for dividend safety, dividend growth potential and risk of capital loss. The Dividend Cushion ratio not only informs our opinion of the safety of the dividend but also its capacity for future growth.

Dividend Safety / Cushion / 1

We assess the safety of a firm's dividend by adding the company's net cash to our forecast of its free cash flows over the next five years. We then divide that sum by the total expected dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. Caterpillar scores a 1 on our Dividend Cushion™, which means its dividend coverage with future free cash flow (after considering its balance sheet and future expected dividend growth) is at parity. This isn't necessarily a bad thing, but we'd like to see more cushion in Cat's financials.

Dividend Growth Potential - GOOD

We judge the future potential growth of the dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion™, and management's willingness to consistently raise the dividend, as measured by the firm's dividend track record. Caterpillar registers an GOOD rating on our scale, and we think the firm's annual dividend will be $4.02 per share within the next several years (by the end of fiscal 2018).

We assign the quantitative dividend growth rates to firms on the basis of their qualitative Dividend Growth rating. The scale we use as guidance to assign future dividend growth rates is shown below.

Dividend Growth Potential Scale

Excellent: 8% or higher
Good: 4%-8%
Poor: 2%-4%
Very Poor: 0%-2%

Because Caterpillar has GOOD dividend growth potential, we think its dividend will grow at a rate of 8%-12% per (slightly higher than the high end of the 'GOOD' range). But why the boost? In addition to the Dividend Cushion ratio, we also evaluate recent growth rates in the dividend and/or the dividend payout ratio to fine-tune the trajectory of the forecasts. In Caterpillar's case, because the board recently raised its dividend significantly this year, we include slightly higher growth for 2015 and 2016 to capture the board's inclination to raise the dividend at a pace that's above the earnings growth rate (at least in the near term). This is why 2015 and 2016 growth rates are higher than the long-term trend calling for 8%.

Though the science and math is the Dividend Cushion, in this example, there is some art in forecasting dividends payments, especially for a cyclical entity such as Cat. For those interested in dividend growth forecasts for other companies, we have dividend growth forecasts for every company in our 1,000+ firm coverage universe that pays a meaningful dividend.

Risk of Capital Loss - MEDIUM

Though the dividend certainly can impact a company's share price, we assess the risk of capital loss within the valuation context. If the stock is undervalued (based on our DCF process), we think the risk of failing to recoup one's original capital investment (excluding dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (excluding dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's original investment (excluding dividends) is HIGH. Caterpillar registers a score of MEDIUM on our scale. Though we generally prefer firms that are underpriced, or have a LOW risk of capital loss, in this market environment, very few dividend growth firms are in this situation.

Wrapping It Up

We like Caterpillar's dividend growth potential, though the cyclicality of its operations is a key risk, pressuring the Dividend Cushion ratio to a degree. Cat's board has recently stepped up its efforts in providing investors a higher yield as well, and this is a distinct positive for income investors. We don't currently include the company in the Dividend Growth portfolio (we can't hold every great dividend growth idea; only the best of the best), but the firm's dividend growth potential is noteworthy. Thanks for reading!

The following provides the definitions of the terms you may have read in the dividend report (image) above. Thank you for reading!

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.