Investors looking to own shares of blue-chip companies often turn to the Dow Jones Industrial Average, a popular gauge of the broader stock market. This index is composed of 30 large-cap stocks from a variety of sectors and industries.
Most of the companies in the index are well-known among investors. All of these companies also pay a dividend, such as Caterpillar Inc. (CAT, Financial), one of the most undervalued stocks in the Dow Jones Industrial Average.
Caterpillar has been persistently undervalued throughout 2019. The stock offers a compelling expected total return as well as an attractive dividend yield.
Recent news leads to undervaluation
Caterpillar is the world’s leading manufacturer of construction and mining equipment. The company generates $45 billion in annual sales. One of its major sources of revenue is China, a highly important market. With the U.S. and China exchanging increases in tariffs on goods coming from the other country, the escalating trade war has the potential to impact its financial results. As a result, the stock is down 2% year to date while the S&P 500 has increased nearly 14%.
Caterpillar reported first-quarter financial results on March 24. Earnings per share totaled $3.25, a company record. Of that, 31 cents came from a discrete tax benefit that was related to U.S. tax reform. Excluding this, adjusted earnings still managed to beat estimates by 8 cents. Revenue grew 4.7% to $13.5 billion, which was $110 million above the average analysts’ estimate.
The resource industries segment was the primary driver of growth during the quarter. This segment had an 18% increase in sales due to strong demand from the commodities market. The higher level of demand for non-residential construction activities also contributed to growth. Overall, higher sales volumes and favorable price realization more than made up for increased material and freight costs. Segment profits were up 52%.
The construction industries segment grew 3.5% as higher demand for road construction in North America was partially offset by decreased construction activity in Latin America, a negative impact from currency translation in Asia Pacific and a slight decline in sales in the Europe, Africa and Middle East region. The company said segment profit decreased slightly due to higher material, labor and freight costs.
Revenue for the energy and transportation segment was flat from the prior-year quarter. Oil and gas sales dropped due to the timing of turbine deliveries in the U.S. Transportation sales were down due to currency exchange, while the industrial business was virtually unchanged from the prior year. Power generation was the lone business within this segment to grow and that was because of a higher number of diesel engine applications. Higher input costs were a 4% drag on energy and transportation’s profit.
Caterpillar’s retail new business volumes declined 7% to $2.35 billion due to volume declines in North America and Asia Pacific. The company also bought back $750 million worth of its own stock during the quarter.
The company raised its earnings per share guidance for the year to a range of $12.06 to $13.06 from $11.75 to $12.75. Because the upward revision was almost entirely due to a non-recurring discrete tax benefit, we will use the previous midpoint for earnings of $12.25 per share. Achieving this midpoint would represent an increase of nearly 10% from 2018.
Caterpillar operates in a very cyclical industry. When the economies of the world are performing well, its products and services are in high demand. During a recession, industrial companies often produce poor results as spending on projects usually is paused. For example, consider Caterpillar’s performance before, during and after the last recession:
- 2007 adjusted earnings per share: $5.32
- 2008 adjusted earnings per share: $5.71
- 2009 adjusted earnings per share: $1.43
- 2010 adjusted earnings per share: $4.15
- 2011 adjusted earnings per share: $7.81
- 2012 adjusted earnings per share: $9.36
Caterpillar’s adjusted earnings per share grew 7.3% in 2008 before plummeting 75% in 2009. It took the company several years to make a new high for earnings per share. Investors interested in Caterpillar need to be aware the company will likely suffer a steep decline in profits during the next recession, which will likely cause the share price to drop significantly. It should also be noted that the company continued to increase its dividend in the last recession even as earnings declined.
To help adjust for the impact of a possible recession over the next five years, we target a 5% annual growth rate for earnings per share through 2024.
Valuation and expected returns
Despite operating in a cyclical sector, Caterpillar has managed to increase its dividend for the past 25 years. This makes it a member of the Dividend Aristocrat index, which is composed of companies with at least 25 years of dividend growth.
Caterpillar has increased its dividend:
- By an average of 4% per year for the past five years.
- By an average of 7% per year for the past 10 years.
Given the nature of the industry, these low growth rates are not terribly surprising. However, Caterpillar gave investors a nearly 20% dividend increase for the upcoming August payment. This is the largest increase in the company's history.
Each share of Caterpillar should produce $3.78 in dividends per share. This equates to a 3% yield at current prices, which is well above the average yield of 1.9% for the S&P 500.
Using expected dividends per share for the year, Caterpillar’s dividend payout ratio is 31%. Even if earnings were to drop suddenly, the payout ratio is low enough that the dividend is likely to be safe.
Many investors prefer using free cash flow to assess the safety of the company’s dividend. In the first quarter, Caterpillar produced $1.12 billion in cash from operating activities and spent $550 million on capital expenditures for free cash flow of $570 million. The company distributed $494 million in dividends for a free cash flow payout ratio of 87%.
Expanding the time horizon, the payout ratio is significantly less. Last year, Caterpillar generated $6.15 billion of cash from operating activities and spent $1.28 billion on capital expenditures for free cash flow of $4.87 billion. The company distributed $1.95 billion of common share dividends during the same time period for a free cash flow payout ratio of 40%.
Caterpillar’s dividend appears very safe using either earnings per share or free cash flow over a longer term.
Shares of Caterpillar trade at $124 currently. Using our expected earnings per share for 2019 of $12.25, the stock has a price-earnings ratio of 10.1. This is less than half of the valuation of the S&P 500. We feel a combination of the cyclical nature of the business and escalation of a trade war with China have caused shares of the company to trade with a low valuation.
We have a 2024 target price-earnings ratio of 15 for the stock, slightly below its 10-year historical average of 16.9. If the stock were to achieve this target by 2024, the valuation would be an 8.2% tailwind to annual returns over this period.
Total annual returns over the next five years would consist of the following:
- 5%Ă‚ earnings per share growth.
- 3% dividend yield.
- 8.2% multiple expansion.
We expect Caterpillar to offer shareholders an annual return of over 16% through 2024.
An attractive Dow stock
The ongoing trade war with China has negatively impacted shares of Caterpillar so far in 2019. Regardless, the company expects earnings per share to grow nearly 10% this year. It even gave shareholders a record dividend increase.
Caterpillar is an excellent combination of growth, yield and multiple expansion. Investors willing to look past the headline noise of a trade war are likely to be rewarded with this high-quality Dow stock over the next five years.
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