Caterpillar (CAT -0.55%) may still be stuck in the mining malaise, but the market is willing to give the company the benefit of the doubt. The stock has gained 15% year to date and 19% over the past year, as of this writing, despite the challenges that the company continues to face.
When will Caterpillar find its way out of the mining slowdown pit? Source: Caterpillar
While Caterpillar's road to recovery could still be a long one, and some even believe that much of the optimism is already baked into its share price, there are strong reasons to believe that the stock deserves to head higher from here. Here are three of them.
How diversity is helping Caterpillar
A sluggish mining industry may have put tremendous pressure on Caterpillar's resource industries (mining equipment) division, but resource industries is neither the company's largest nor its most profitable business. While construction equipment continues to be Caterpillar's core area of expertise, energy and transportation, or E&T has emerged as the most resilient and profitable among all its businesses. For perspective, E&T contributed 40% and 54% to Caterpillar's total machinery sales and operating profits, respectively, in 2013.
Considering that Caterpillar's E&T business serves several key industries -- including oil and gas, power generation, transportation (marine and rail), and industrial -- it isn't as prone to cyclical volatility as its construction business. Moreover, each of these industries represents enormous growth opportunities. The graph below, from the U.S. Energy Information Administration, shows the projected global energy demand through 2040. It's a perfect platform for Caterpillar's natural gas and dual-fuel engines business to grow.
Source: Caterpillar presentation; Data source: EIA – International Annual Energy Outlook, July 25, 2013.
The point I'm trying to drive home is a simple one: Caterpillar's story goes well beyond mining, and its diversity should ensure good growth in the years to come.
Growing leaner and stronger
There's no denying that Caterpillar is a financially solid company. Consider this: In 2013 -- a year that will go down in the company's history as one of its most challenging years -- Caterpillar generated free cash flow worth 1.5 times its net income. Few companies can back up their entire net income with cash flow, even in good times.
So how did Caterpillar pull it off? Stringent cost control and efficient inventory management played key roles. Sensing weak end markets, Caterpillar wisely scaled back production last year and shifted focus to its inventory-at-hand instead. As a result, it could reduce its inventory by a whopping $2.9 billion through the year, thus freeing up lots of cash.
At the same time, Caterpillar initiated several restructuring mov;les, helping it slash its manufacturing, operating, and research and development costs by roughly $1.2 billion in 2013. The company isn't done yet: It reduced those costs by another $0.5 billion during the first half this year.
If you're worried about Caterpillar's total debt-to-equity ratio of 131%, you must also know that the company sports an interest coverage ratio of 14x, meaning that its current operating profits can cover its interest expenses 14 times over. For the record, that's very healthy.
Long story short, if Caterpillar can maintain such healthy financials in turbulent times, there's no reason why it can't churn out bigger surprises when business conditions improve.
Rewarding shareholders
While increasing its dividend regularly, Caterpillar has also fervently repurchased shares over the past decade. The chart below reveals that the company's share count dipped 8% over the time frame even as its dividend grew roughly 240%.
CAT Shares Outstanding data by YCharts
The trend will likely continue. If 2013 was an excellent year in terms of shareholder returns -- Caterpillar increased its dividend by 15% and repurchased shares worth $2 billion – 2014 is turning out to be an incredible year. After repurchasing shares worth $1.7 billion during just the first quarter, the company is buying back another $2.5 billion worth of shares this quarter. To top that, Caterpillar raised its dividend by 17% this past June.
The best part is that Caterpillar is still paying out just about 40% of its earnings as dividends, which means there's room for more. And if you think higher dividends will come at the cost of the company's organic growth, Caterpillar is actually looking at a number that's "significantly north of $4 billion a year to spend on growth" over the next five years. In case you're wondering, the company spent $4 billion on capital expenditure and R&D in 2013.
Simply put, Caterpillar should be able to generate much higher cash flows in the years to come that can support its ambitious growth as well as shareholder return plans.
Foolish takeaway
Every cyclical company has its share of ups and downs, but the one that can keep its head above water in downturns is also capable of beating the market in an upturn. Caterpillar is a perfect example, which is why every dip in its share price can be safely considered an opportunity, especially if you are a long-term investor.
