Image source: Caterpillar Inc.’s website
By Callum Turcan
Caterpillar Inc. (CAT) is generally viewed as an industrial bellwether due to the company selling everything from mining excavators to forklifts to transmission systems to buyers big and small all over the globe. Management’s commitment to dividend growth has endeared Caterpillar with many income-seeking investors, but the firm’s stock price over the past year has faced volatility as a result of trade wars and a less-than-rosy outlook for the global economy. We like the free cash flow generating potential of Cat’s non-financial operations, but investors cannot lose sight of the risk inherent to the company’s ties to cyclical end markets. Its financial services operations can add to that risk as it exposes Caterpillar to potentially weakening credit profiles of cyclical customers in the event of a downturn in a given end market.
2018 in Review
Strong revenue growth and margin expansion led to material income growth at Caterpillar last year. Company-wide, Caterpillar reported over 20% annual sales growth in 2018, pushing its revenue up to $54.7 billion. Revenue growth was supported by rising demand from resource extraction industries, rising North American construction activity, and recovering demand from North America’s oil & gas industry.
Due to margin expansion (we will dig deeper into that later on) and revenue growth, Caterpillar’s operating income jumped 86% year over year in 2018 to $8.3 billion. Year-over-year net income comparisons aren’t useful due to special items relating to America’s recent tax reform, as Caterpillar’s bottom line rose eight-fold in 2018 to $6.1 billion.
In 2018, Caterpillar’s gross margin (to differentiate its core business from its financial unit, this is being measured as cost of goods sold divided by sales of machinery, energy & transportation) grew by over 185 basis points as higher prices for its products offset higher raw material and freight expenses. Gross margin expansion and effective cost control measures (specifically for R&D and SG&A expenses) helped increase Caterpillar’s 2018 GAAP operating margin (operating income dividend by total revenue) by over 530 basis points on a year-over-year basis.
Caterpillar grew its global workforce (excluding its relatively small Caterpillar Financial Services workforce) by 6% to 104,000 in 2018, with its employee count growing in North America, Asia-Pacific, and Latin America. Its employee headcount shrank in the Middle East during that period. Note that Caterpillar’s SG&A expenses rose by 10% annually in 2018 and that this is more than a one-off event. In 2017, Caterpillar grew its global workforce count by 3% which helped lead to a 14% year-over-year increase in its SG&A expenses.
That being said, Caterpillar’s SG&A expenses as a percent of total revenue dropped by almost 100 basis points in 2018 versus 2017 levels. Caterpillar’s R&D expenses on an absolute basis were roughly flat in 2018 on a year-over-year basis, enabling R&D expenses as a percent of revenue to drop by over 65 basis points during that period. These cost control measures played a key role in bolstering Caterpillar’s 2018 GAAP operating margin. As R&D expenses have been roughly flat since 2016, it is highly likely Caterpillar has been bulking up its production and corporate-level workforce through the aforementioned headcount increases.
As an aside, Caterpillar Financial Service’s workforce grew by 2% in 2017 and 1% in 2018 on an annual basis. By the end of 2018, that fully-owned subsidiary represented less than 2% of Caterpillar’s global workforce. The primary purpose of Caterpillar Financial Services is to provide credit and other financial services to Caterpillar’s customers to help facilitate sales on an ongoing basis.
Readers should keep in mind that Caterpillar is very exposed to tariffs (particularly in regards to the ongoing trade wars) and the trajectory of the global economy. The company noted this during its latest quarterly conference call (emphasis added):
“Positive price realization[s] [were] offset by higher manufacturing costs, largely due to high material and freight costs, as steel prices, tariffs and supply chain inefficiencies continue to impact our results.”
During its third quarter 2018 conference call, management forecasted that tariffs would negatively impact Caterpillar (in a direct way, there are indirect costs to consider as well) to the tune $100–200 million last year. Here is a quote from Caterpillar’s fourth quarter 2018 conference call (emphasis added):
“So if you remember the third quarter we talked about the rail and we are expecting to be at the bottom end of the $100 million range. We ended up just over $100 million. Our expectation was at this stage we don’t see a rate change in the tariffs, that’s our expectation, and obviously you’ve been – because you would just extrapolate that out based on 12 months versus five months for 2018.”
Taking that into consideration, it appears Caterpillar expects the negative full-year impact of tariffs to come in at $240 million in 2019 (extrapolating a negative $100 million effect during the last five months of 2018 across all of 2019). Whether tariff headwinds continue to exist going forward is largely a product of ongoing US-China trade talks and what direction the geopolitical winds blow.
If American tariffs were to be ramped up, management doesn’t think that, on an incremental basis, such a move would have a material impact on the firm as “quite frankly we were already hit with the earlier tariffs so we don’t think a later change will have an impact on us. It was already baked in for us.” We will see if that holds true, as that may prove to be a tad optimistic.
Dividend Safety and Cash Flow Commentary
We place a great deal of emphasis on free cash flow generation as it is the key driver of intrinsic value and dividend health for equities. Dividend payments are only sustainable over the long haul if payouts are covered by free cash flow, as taking on additional debt (to differentiate from refinancing) or issuing equity to cover those payments is largely unsustainable in the long run no matter how generous the capital markets may be for any given period of time.
When looking only at Caterpillar’s ‘Machinery, Energy & Transportation’ division, to differentiate from Caterpillar Financial Services, page 47 of its 2018 10-K and page 14 of its fourth quarter IR presentation highlights how that division generated $6.35 billion in net operating cash flow last year. That was up 16% on a year-over-year basis, enabling the firm to easily cover $1.2 billion in capital expenditures as it related to its ME&T division. Before taking its financial wing into account, $5.1 billion in free cash flow covered $2.0 billion in dividend payments, and most of its $3.8 billion in share buybacks (cash on hand was utilized to fund the rest) last year.
We recognize that Caterpillar’s adjusted ROIC (excluding goodwill) has consistently outperformed its WACC over the past few years. That indicates management allocates the firm’s capital towards quality projects, which is why we give the firm an excellent ValueCreation rating. The magnitude of those economic profits, the size of the difference between ROIC (excluding goodwill) and WACC, is quite decent earning Caterpillar an attractive Economic Castle rating.
Caterpillar has a history of continuously sanctioning share buyback programs and, at the beginning of January 2019, had $10.0 billion in share repurchasing authority under a new repurchasing plan approved back in July 2018. That is equal to 13% of its market capitalization as of this writing. Note that from 2017 to 2018, Caterpillar’s diluted outstanding share count was flat as dilutive measures (such as stock-based compensation) offset those buybacks.
Management expects Caterpillar will spend $1.4 billion on capital expenditure in 2019, specifically as it relates to ME&T-related cash outlays, which is up 15% from 2018 levels. On the flip side, pension contributions are expected to be much smaller this year due to Caterpillar already contributing large sums towards its pension programs over the past two years. From its 2018 annual report:
“Contributions to our pension and OPEB plans were $1.35 billion and $1.61 billion in 2018 and 2017, respectively. Both years included a $1.0 billion discretionary contribution to our U.S. pension plans. We expect to make approximately $315 million of contributions to our pension and OPEB plans in 2019.”
Below is an excerpt covering Caterpillar’s cash flow movements regarding its financial wing last year, keeping in mind that we are only looking at the firm’s core business when it comes to free cash flow:
“Financial Products operating cash flow was $1.52 billion in 2018, compared with $1.35 billion in 2017. Net cash used for investing activities was $2.78 billion in 2018, compared with $596 million in 2017. The change was primarily due to the impact of portfolio related activity. Net cash provided by financing activities in 2018 was $1.26 billion, compared with net cash used for financing activities of $1.82 billion in 2017. The change was primarily due to higher portfolio funding requirements and a lower dividend payment to Machinery, Energy & Transportation.”
The company exited 2018 with a company-wide current ratio of 1.4x (including $7.9 billion in cash & cash equivalent on hand) and $8.0 billion in long-term debt as it relates to its ME&T division. Its Financial Products division carried a much higher total debt load (short-term and long-term debt) of $28.5 billion at the end of 2018, most of which helped fund Caterpillar’s $31.9 billion in total receivables (long-term and short-term) in the sense that effectively the company lent money to its customers to buy its products. Note that there is a tremendous amount of noise here. For Caterpillar’s core business, it retained a marginal net debt position last year.
We give Caterpillar an adjusted Dividend Cushion ratio, which measures the firm’s ability to keep making good on its dividend payments over the coming years, of 2.5. The Dividend Cushion ratio is derived from a firm’s projected free cash flows over the next five years minus its net debt load (or plus its net cash position) as of the last fiscal year divided by its projected dividend payments over the next five years. In the adjusted measure, we also take the ability to tap capital markets and refinance debt loads into account depending on the situation at hand, which is the case with Caterpillar as we mitigate the impact its captive finance arm has on its adjusted Dividend Cushion ratio.
An adjusted ratio of 2.5 is solid and earns Caterpillar a good Dividend Safety rating, complementing its good Dividend Growth rating. Having a good Dividend Growth rating means management has a solid track record of continuously pushing through dividend increases, signaling additional growth may be ahead. Caterpillar’s core business holding a marginal net debt position at the end of 2018 makes future dividend increases far more financially viable, but dividend growth will be heavily influenced by Caterpillar’s ability to maintain and grow its free cash flow generation in the face of a softening global economic outlook. If credit markets weaken, our assessment (and its Dividend Cushion ratio) would change meaningfully.
Image shown: A visual deconstruction of Caterpillar’s Dividend Cushion Ratio
Caterpillar performed well in 2018, but the company’s stock price over the past year still faced volatility over concerns relating to weakening global economic growth expectations, something beyond its control but a risk nonetheless. Turkey just slipped into its first recession in a decade, France’s economy is limping forward after crippling protests, German economic growth is slowing down, and 2019 doesn’t look like it will offer much reprieve as economic growth expectations for the EU have recently been ratcheted down. The deceleration in China’s economic expansion may be worse than expected as a recent study notes the country overstated its annual GDP growth by 1.7% from 2008 to 2016.
Management’s focus on free cash flow, cost controls, and retaining a sizable cash balance enables Caterpillar to sport good dividend coverage with ample growth potential, but we must reiterate that the company is tied to a number of cyclical end markets. In times of cyclical downturns, management works to limit operating profit declines to less than 30% of the simultaneous decline in revenue, which speaks to experience in navigating a cyclical operating environment but also highlights the reliance on potentially volatile end markets. We aren’t interested in shares at the moment as they appear fairly valued, and global macroeconomic headwinds are increasingly notable.
As of this writing, Caterpillar trades near the midpoint of our fair value range, which is derived via our rigorous discounted cash flow analysis.
Image shown: Caterpillar is trading just above the midpoint of our fair value range as depicted by the red dot.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: Callum Turcan works as an independent contractor for Valuentum Securities.
Additional disclosure: Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.