Is Caterpillar A Good Choice For A Buy And Hold Investor?

Summary

• I like companies that are solidly grounded in the developed economies yet have the presence and scale to take advantage of emerging markets.
• We live in a world desperate for new infrastructure and CAT is well positioned to take advantage of this trend.
• A healthy and growing dividend at an attractive entry point.

When I look at an investment, I am looking at the company from the standpoint of wanting to purchase a great company at an attractive entry point that is paying a quality dividend that they will be able to grow over time. I am not as interested in timing the market as much as buying and holding forever knowing that every quarter I am going to get paid and I will be able to sleep well at night. With that said, is Caterpillar (NYSE:CAT) the kind of company that I would want to hold in my portfolio?

Company overview

Source: Investor Presentation

2018 was a great year for Caterpillar returning record adjusted profits per share of $11.22 vs. $6.88 in the previous year. Sales revenues rose by 20% in the year and the company finished with a strong cash position of $7.9 billion. During the year, the company used their strong cash flows to repurchase $3.8 billion in shares while increasing their dividend by more than 11.5% rewarding shareholders. Looking ahead, the company is forecasting increases in sales in 2019 to power a per share profit increase of between 5-14% supporting future dividend increases and more share buybacks as free cash flow continues to accelerate.

When I am looking for an investment

What intrigues me most about CAT is that they are a global company and a bellwether indicator of the worldwide economy. Divided into 3 main divisions, Construction Industries, Resource Industries and Energy & Transportation, the company reflects what is going on within the industrial sector. Also important is their global reach with manufacturing facilities and distributors around the world. Their operations segments are divided globally as North America, Latin America, Europe Africa Middle East EAME and Asia Pacific.

The reason I like to look for companies with global reach is that the mature economies of North America and Europe are growing at a much different pace than the Emerging market economies of Asia and Latin America. These economies also operate under different social license allowing them to proceed with major infrastructure projects that are either already built or might not necessarily get built in North America or Europe where resistance to infrastructure development is facing different challenges.

For that reason, I look at North America and Europe as offering stability to companies but look to Emerging markets as the growth engine that will drive future profitability supporting shareholder value and future dividend increases.

Caterpillar is a worldwide power

Caterpillar maintains a leading presence worldwide in the construction industry. With its headquarters in Deerfield, Illinois, they serve customers around the globe. Their manufacturing, marketing, logistics, services, research and development (R&D) and related facilities, along with dealer locations, total more than 500 locations worldwide.

This presence is important because it allows them to be key players in the markets they serve. For instance in China, where trade tensions are threatening many US business relationships, CAT operates 7 manufacturing facilities, a re-manufacturing facility plus parts and components facilities. This on the ground presence allows them to avoid tariffs while integrating within the local business opportunity base.

The same is true in other key Asian markets like India where CAT has been since the 1930s and employs more than 10,000 people at various manufacturing and distribution centers integrating within this rapidly growing economy.

Source:Caterpillar 2017 Enterprise Strategy

We live in a world desperate for new infrastructure

According to Global Infrastructure Hub, there is a disconnect happening between the infrastructure investment needed and the infrastructure projects that are being built. Based on their calculations, we are currently spending $500 billion less on infrastructure per year than we should and that figure will increase to $1 trillion per year by 2040 with the greatest demand coming in the energy, rail and road construction sectors, all key sectors to Caterpillar and their shareholders.

Source: Global Infrastructure Outlook - A G20 INITIATIVE

Also of note in this report is where the need for additional infrastructure spending is coming from and where the need is greatest. According to the report, the Americas will need to spend close to $20 trillion on new infrastructure between now and 2040 but are only on pace to spend $14 trillion leaving more than $6 trillion in catch up on spending. However, the greatest amount of infrastructure spending is currently taking place in Asia where $51 trillion of infrastructure is needed and the region is on track to spend $46 trillion of that. As a shareholder, that puts even greater impetus on Caterpillar to get their strategy right and on the government to build bridges, not walls in what definitely needs to be a more global economy for business.

Looking at Q4 results

Source: Investor Presentation

Sales and revenues for Q4 were up 11% to $14.342 billion, an increase of $1.446 billion compared with Q4 of 2017. The increase was related to higher sales volume and increased demand across all regions and in the three primary segments. Improved pricing especially in Construction Industries, also contributed. The increase was partially offset by unfavorable currency impacts due to a stronger U.S. dollar.

The greatest growth came from the Resource Industries sector where overall growth came in at 21%. If there was any concerns it was in the Asian and Latin American Construction Industries where a slowing Chinese economy and trade tensions might be starting to impact growth. This was offset by strong growth in North America where sales increased by 17% on the back of increasing demand.

The forecast for 2019 is positive as continued growth is projected across all sectors and improving prices are expected to add to the bottom line. The main concerns are macro as tariffs continue to impact costs and uncertainty in the price of oil and gas has the ability to slow investments in this sector. I also have concerns that an increasing deficit brought on by tax reforms combined with political tensions in the US will impact the government's ability to get things done and invest in needed infrastructure projects. Although politicians continue to talk about infrastructure spending, there still seems to be a lack of follow-through. This may further accelerate the trend towards under-investment in infrastructure.

Caterpillar | Quarterly Financial Results

A healthy and growing dividend

As an early retiree, I depend on dividends to fund my lifestyle and they are an important part of my dividend growth strategy. With a current yield of 2.6%, Caterpillar comes in on the low side of where I like my companies to pay out. Typically, I look for dividend stocks that are paying in the 3-5% range which is where CAT historically sits but has fallen behind due to the rapid growth in share price. In addition, after increasing the dividend by more than 11% in 2018 and with a payout ratio of less than 30%, I believe that there is room to continue increasing the dividend in 2019 as the company continues to reward shareholders. It would be nice to see them bring the dividend back within their historical range above 3% and not allow it to fall back further.

Also important to shareholders is the company's aggressive share buyback program which saw them buy back $3.8 billion in the year including $750 million in stock buybacks in Q3 and Q4. With these buybacks, the company is reducing share count in a meaningful way which should drive higher earnings per share and share price. As a primarily buy and hold dividend investor, this has less of an impact on myself as I would prefer more aggressive dividend increases. However, as a cyclical company, the strategy makes sense as it protects them from the longer-term commitments associated with dividends as the market works through various cycles.

From a valuation standpoint, the company is currently trading with a P/E ratio of 12.8 which for a company of this caliber is low compared to the average P/E for the DJIA of 16 and peers like Deere (DE) at 22 and Cummins (CMI) at 18.

Looking forward

Looking forward, I see Caterpillar continuing to invest in new technology in order to streamline the business and build efficiencies into their existing product offerings. The continued development of AI and the ability to adopt innovations like 3D printing will go hand in hand with investments to digitize their system. After significant restructuring over the past couple of years, 2019 sees them in a better place financially to move forward.

With a strong cash position, I see them continuing to increase the dividend balanced with continued stock buybacks. I believe that the under-investment in new infrastructure will drive future sales in North America while worldwide I see a leveling European market, continued uncertainty in South America along with short-term challenges in Asia to be replaced by continued if not slower growth. I would not be surprised to see India challenge China as the economic engine in this area. Their existing footprint in the fastest growing parts of the world set them up for future success.

As a dividend investor, I am adding more shares but would like to see them place greater emphasis on their dividend by boosting their payout ratio and allowing the dividend to catch up with the growth of the company. If you are a more active investor, this might be a good time to jump in as the valuation is attractive and the company's greater emphasis on buybacks should boost the share price. I also believe that the current political climate will stabilize and the US will once again embrace the opportunities globalization presents to push America's great companies forward instead of holding them back with their current restrictive trade policies.

Analyst’s Disclosure: I am/we are long CAT. 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.