Caterpillar: Don't Dig In Just Yet

| About: Caterpillar Inc. (CAT)

Summary

When interest rates are still low, Caterpillar’s near 4% dividend yield looks good and is attracting investors.

However, the stock's fundamentals are middling, and its outlook is negative.

Dividend investors wishing to buy the stock should wait for a market correction that brings the stock down at least 10%, or about $70 per share.

Weak First Quarter, Strong Stock Price

Caterpillar Inc. (NYSE:CAT) is having an interesting year. In April, the company reported first quarter revenues that were 25% below their level from a year earlier while its earnings were a penny short of expectations.

Despite this, Caterpillar's stock is up by over 16% in the year-to-date, which is better than the returns of the Dow Jones Industrial Average and S&P500 during the same period. The catalyst for the good stock performance of the stock may be that less bad news is good news. Specifically, the rate of decline in its monthly machinery sales appears to be bottoming out and a mild recovery in China are adding wind to Caterpillar's sales.

Of course, there is the matter of Brexit, which is expected to hit the company hard, particularly as the company has 20 manufacturing facilities and 10,000 employees situated in the United Kingdom.

Dividend and Outlook. One overlooked factor in Caterpillar's ascension is its attractive dividend yield. At nearly 4%, the stock provides investors who put $10,000 in Caterpillar with around $400 a year in passive income. Given that Caterpillar is a component of the Dow Jones Industrial Average and is widely regarded as 'blue chip' stock despite its poor performance over the past few years, it is likely that its high dividend yield, in addition to the expectation that the worst is over, are buoying the stock.

In our view, despite its attractive dividend - the company has raised its dividend by 10% or more over the past three years - Caterpillar is a mixed bag and investors should proceed with caution. Here's why:

First, while Caterpillar has the capacity to continue paying dividends, its financial strength metrics are decidedly middling. After years of paying out dividends and buying back shares, Caterpillar's Working Capital and Debt-to-Equity ratios are now decidedly pedestrian at 1.29-to-1.00 and 0.99-to-1.00, respectively.

What these two numbers are telling us is that Caterpillar has gotten to the point where it will need much better operating results to rebuild it liquid resources. Barring this, at some point over the next 3 to 5 years, it will have to resort to borrowing or drawing down on retained earnings to finance its returns to shareholders.

Indeed, Caterpillar's operating profit dove by 71% from $1.7 Billion to $494 million in the first quarter, mainly because its sales had dipped and the resulting contribution to profits was far less than previously. In fact, if Caterpillar management hadn't reduced its variable manufacturing and period costs by $474 million, its operations would have only broken even in the first quarter.

Nonetheless, Caterpillar generated just enough cash from its operations to fund its dividend for the period and while it does carry approximately $38 Billion in debt, its net interest expense was just $281 million in the first quarter - little changed from the previous year. It should also be noted that much of the debt that Caterpillar carries relates to the equipment it leases to customers. If we net out its financial debt from both its current and long-term trade receivables, the company's net debt position is just $7.5 Billion, which is means that its actual Long-Term Debt-to-Equity ratio is at just 0.48-to-1.00 - well below the average for its industry.

Second, Caterpillar's dividends and stock buybacks may be masking its problems. At around 4%, Caterpillar's dividend is the third-highest among all of the Dow's components. This makes it attractive to shareholders and creates a positive loop where investors buying the stock because of the dividend are also wind up boosting the stock price.

Meanwhile, its stock buybacks have reduced its share count by around 9% over the last 5 years - while wise investors will compare net income rather than earnings-per-share to get around these buybacks and note that Caterpillar's net income has diminished for three straight years, the reality is that earnings are often reported on a per-share basis and compared against analyst estimates rather than past performance. Because of this, reducing the number of shares could enable Caterpillar to beat earnings estimates (which are partially based on the guidance it provides), potentially driving the stock higher.

The reality, however, is that despite its financial engineering, Caterpillar's shares remain expensive: the company is trading at 41 times its trailing earnings and 22 times its forward earnings estimates. Both these measures are higher than that of both the Dow and S&P500, making Caterpillar a candidate for price retrenchment if the markets turn volatile for an extended period.

Third, Caterpillar's prospects just aren't all that good. By the company's own admission, its business outlook is mixed and in its last earnings report, it lowered the midpoint of its 2016 sales projection by around 2%. This is consistent with the consensus estimate that projects a 24% decline in the current year's revenues and slight revenue contraction each year over the next 5 years.

Given Caterpillar's global footprint and sensitivity to economic activity, this negative outlook shouldn't be surprising - but investors looking for alternatives merely have to turn to Caterpillar's peers, which on aggregate are expected to see revenue growth of over 10% a year over the next half-decade.

Meanwhile, Brexit could make its prospects worse - about a quarter of Caterpillar's revenues are from the EMEA (Europe, Middle East & Africa) region and the United Kingdom is an important manufacturing hub for its equipment sales to this area. The imposition of tariffs on its equipment exports to Europe from the UK post-Brexit, as well as a weaker Sterling could further curtail its already flagging revenues. Brexit is a large enough concern to Caterpillar that its UK Country director released a statement in the aftermath of the leave triumph.

Conclusion

All things considered, Caterpillar is probably a stock to buy only during market retrenchments that drive the stock down by 10% from its current level down to about $70 per share. Incidentally, this would further boost its dividend yield to about 4.4%.

We are very skeptical that Caterpillar has turned the corner, particularly as this is based on just a couple of months' worth of data and the company itself sees further weakness ahead. Moreover, the fallout from Brexit has only begun to be felt - Caterpillar could very well see a significant negative hit from EU-imposed tariffs and a weaker Sterling in the coming years.

Given such a scenario, and the fact that Caterpillar's stock is within striking distance of its 52-week high, it seems ripe for the kind of pullback that could damage investors' capital and erode the returns from its high dividend. Caterpillar investors must proceed with caution.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.