Why We're Optimistic About Caterpillar's Dividend Prospects

| About: Caterpillar Inc. (CAT)


Caterpillar’s dividend prospects have been called into question due to its falling profitability.

We think its new strategy, plus the scope for improved performance in US construction and global resources markets, have the potential to positively catalyse its bottom line as well as.

Future dividend growth could surprise on the upside and become a further positive share price catalyst in the long run.

Whenever any company experiences a difficult period where sales and profitability are coming under pressure, there is always concern regarding its payment of dividends. As a result, it is completely understandable that investors are becoming increasingly pessimistic regarding Caterpillar's (NYSE: CAT) shareholder payouts, since its EPS in the fourth quarter of 2015 fell from $1.23 in Q4 2014 to a loss of $0.15 per share.

Undoubtedly, a loss-making company will not be able to sustain dividends at any level in the long run. With Caterpillar yielding 4.8% after its share price fall of 20% in the last year, there is real fear among many investors that it will go from being an appealing dividend play to a dividend has-been. However, we think that is wide of the mark.

For starters, we're backing Caterpillar's strategy to turn its financial performance around. It underwent a major restructuring in the fourth quarter of 2015 and when the costs from doing this are removed, its EPS for the quarter stood at $0.74 versus an adjusted figure of $1.35 from Q4 2014. Sure, that's still a fall of 45% but crucially, Caterpillar remained profitable once restructuring charges are adjusted for.

We think that Caterpillar's restructuring has the potential to not only secure dividends and their long-term growth, but to also positively catalyze the company's profitability and share price, too. For example, Caterpillar is reducing the size of its workforce and is also closing multiple production facilities as it aims to achieve cost savings of $1.5bn per annum over the medium term.

Such changes are set to have a positive impact on the company's bottom line, with EPS due to rise by 5.4% in 2016 and by a further 0.8% next year. Although those growth rates are hardly index-beating, they show that Caterpillar is on the right track towards improving its financial progress and we believe that will positively catalyze investor sentiment in the company's shares.

In addition, we think that Caterpillar's focus on the US construction industry is set to reinvigorate its bottom line and push its share price higher. With the chances of further interest rate rises being relatively low due to the lackluster GDP figures coming out of China, we think that having a bias towards the US economy and towards construction (which historically has responded positively to a loose monetary policy) could cause an increase in Caterpillar's medium term outlook.

And with the energy and resources sectors unlikely to continue to endure their recent troubles in the long run due to the potential for more stable commodity prices, we're optimistic about Caterpillar's ability to not only come back from its present challenges, but to also strengthen its position relative to its peers as a result of the company's sound strategy. This potential for improved performance from its two key divisions is set to deliver improved dividends and a higher share price in our view.

With dividends being covered just 1.16 times in 2015, many investors may be concerned about Caterpillar's ability to not only grow shareholder payouts moving forward, but to even maintain them. For us, the key lies in the changes being made by the company, as well as the fact that if restructuring charges are excluded, Caterpillar's dividend coverage ratio rises to a much healthier 1.54 for 2015.

This indicates that even if profit does disappoint in the short run, there is still scope for dividends to increase by around 10% per annum and we believe this growth could act as a positive catalyst on the company's share price and on investor sentiment. That's especially the case since interest rate rises are unlikely to be substantial in the medium term, meaning that companies offering strong dividend growth (such as Caterpillar) could gain in popularity moving forward.

With Caterpillar trading on an EV/EBITDA ratio of just 9.6, we think there is major upside potential and that the company's share price will be positively catalyzed by improving margins (owing to its new strategy), improved performance from the US construction industry and global energy and resources markets, as well as double-digit dividend growth due to a significant amount of headroom which presently exists when making dividend payments.

Therefore, although a yield of 4.8% may sound too good to be true while the S&P 500 yields 2.3%, we think that buyers of Caterpillar's stock right now will enjoy highly appealing dividend increases in the long run, as well as index-beating capital gains, too.

Disclaimer: This article is in no way a recommendation to buy or sell any stock mentioned, nor should it be considered financial advice. These are only the author's personal opinions and you should do your own research.

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.

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