Caterpillar: Collecting A 10% Yield For Agreeing To A 15% Gain

About: Caterpillar Inc. (CAT)
by: Eli Inkrot

In previous commentary I highlighted the idea that Caterpillar could be a better investment when it looks more “expensive."

This article focuses on creating a very large cash flow from the security.

In the end it comes down to your individual goals, but it can be helpful to be aware of your options regardless.

In a previous article I detailed why Caterpillar (NYSE:CAT) could be a better investment at times when it looks more "expensive." The idea was simple: while we're trained to think "low P/E = good, high P/E = bad" there can be a bit more to the story than that.

Caterpillar tends to be cyclical, with both its earnings and share price bouncing about greatly through a business cycle. During the times of lower share prices, the dividend yield is higher and the "bounce back" opportunity quickly enhances. At least historically, times when shares looked more "expensive" - with a higher P/E ratio and payout ratio - have also tended to be reasonable times to invest.

Today Caterpillar appears to be in one of those situations. This isn't a blanket recommendation. Instead it's recognizing what has occurred. Earnings are down significantly in the last few years, with the share price now 40% lower than it was less than two years ago. In turn, the dividend yield is much higher and should earnings recover in the future shares have a lower "investment bar" to jump over in order to provide reasonable returns.

The long-term investor could be content thinking about starting or adding to a partnership position, with the anticipation of cyclical but ultimately improving prospects ahead. Indeed, this sort of thing tends to work out quite well in the aggregate.

Caterpillar currently pays a $0.77 quarterly dividend which equates to $3.08 on an annul basis, good for a yield of about 4.7%. This by itself offers a strong starting point on the income front.

Of course it's also possible that you would like to generate an even higher cash flow. This approach is certainly not for everyone, but I think that it's prudent to at least be aware of what options are available to you. You could both own shares and sell a covered call to increase your immediate cash flow. Let's look at some examples to get a better feel for the process.

At the time of writing, the January 20th 2017 call with a $72.50 strike price had a bid of about $3.75. We'll call it $3.50 to account for transaction costs and fluctuations. I have no affinity for this expiration date, but it does provide a close annual comparison.

If you were to buy 100 shares today it would cost ~$6,600. In the next year you might expect to collect $308 or more in dividend payments, plus whatever happens to the share price. Alternatively, you could make an agreement to sell your shares at a price of $72.50. In exchange for making this agreement you would receive ~$350 as an upfront premium, which is a bit more than your expected dividend payments for the whole year. (Keep in mind the option premium potentially "doubles" your yield, but may be taxed at a different rate than dividends or long-term capital gains.)

Now one of two things happens: either the option is exercised or it is not. If the option is not exercised, as would likely be the case if the share price were under $72.50, nothing changes. You still keep your shares and collect the dividend payments. In addition, you also received ~$350 in upfront premium that is yours to keep, bringing your total yield up to 10%. While selling the covered call does not prevent from loss, in this scenario it is clearly favorable to holding shares only.

The second possibility is that the option is exercised as would be the case if the share price were above $72.50. In this instance you would receive proceeds of $7,250 (less transaction fees and taxes) to go along with the ~$350 upfront premium. In addition you might receive dividend payments along the way. In this scenario your total gain would be between 15% and 20%, with 5% of that coming upfront regardless.

In this case the risk relates to having to sell your shares should the share price increase above the strike price. If the share price went to $80 per share you would have been better off sitting on your hands and forgetting about the option.

Of course you're not forced to agree to sell at given price. Here's a look at various call options available based on the same January 2017 expiration date:

Note that the "net" premium uses the most recent bid less $0.25 for transaction costs and fluctuations. Naturally the amount that others are willing to pay for your agreement decreases as the share price increases.

Here's a look at that same information in a different format:

The second column - premium yield - shows you what current amount of income you can derive from agreeing to sell your shares at the strike price within the next year. The "capped gain" shows you the maximum gain that you would receive should the option be exercised, including the strike price and premium received. Finally, the "gain with dividends" column illustrates the maximum gain that you could receive if you received the strike price, premium and dividends along the way.

This table ought to be interesting for those who own or would like to own shares of Caterpillar. I'm not recommending that you sell a call option and thus agree to sell your shares. Instead, this is merely a means to present a subset of what is out there. In the example above I used the $72.50 strike price, which had a "net" premium of around $3.50. You can see the 15% to 20% capped gain that I described earlier.

Should shares "only" increase say 5%, selling this call option would have been the preferred outcome. Alternatively, if shares increase 30% you would have capped your gain well below this. It all comes down to your expectations and being happy with either outcome.

To this point, you can make agreements to sell your shares at much higher or lower shares prices. Agreeing to sell at higher share prices decreases the amount of premium income you could receive, but also decreases the probability that your shares will be called away. Alternatively, agreeing to sell at lower prices increases the current cash flow, but can cap your potential gains much quicker. The idea is to figure out your investing goal and find a balance (if at all) that could be appropriate.

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.