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Caterpillar's Share Price Dip May Attract Dividend Investors

By Lee Samaha - Feb 10, 2020 at 8:48AM

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The company faces a difficult 2020, but it still looks like a good option for income-seeking investors.

Investors buy stocks for all sorts of reasons, and when it comes to a company like Caterpillar (CAT 1.95%), there will be no end of debate as to what to do with the stock. If you're worried about the possibility of earnings disappointments to come, then the stock is worth avoiding. However, a dividend-focused investor might welcome the recent stock price decline as an opportunity to buy into a stock on a 3.2% dividend yield, with a management team committed to hiking dividend payments in the future. Let's take a closer look at what's going on.

Two off-highway Caterpillar trucks.

Image source: Getty Images.

Caterpillar's gloomy guidance

There's no way to sugarcoat the deterioration in Caterpillar's end markets, and its management certainly didn't try to do so when discussing its fourth-quarter earnings. CEO James Umpleby began the earnings call by declaring, "Sales to users for all three segments were lower than our expectations," and his outlook for 2020 was not much better in tone. Here's a summary of the guidance, with added notes by the author.

Caterpillar Guidance

2020

Notes

End-user demand growth

(9%) to (4%)

Weakness in end-user demand causes Caterpillar dealers to reduce inventory.

Dealer inventory

Decline by $1 billion to $1.5 billion

According to management the inventory correction will take place largely in the first-half of 2020 so look out for some steep revenue declines in the coming quarter.

 

Adjusted profit per share

$8.50-$10

Implies a forward P/E ratio of 13.3-15.7 times earnings. Adjusted profit per share in 2019 was $11.06.

Data source: Caterpillar. Analysis by author.

Caterpillar's sales trends

Unfortunately, the negative guidance on end-user demand in 2020 is backed up by current trends in Caterpillar's retail sales. As the chart below shows, its machinery retail sales turned negative in December. Moreover, all three segments were negative, with a particularly disappointing performance from resource industries -- not least because the mining sector is supposed to be in the early innings of a multiyear capital-spending expansion.

Caterpillar retail sales growth.

Data source: Caterpillar.

Moreover, putting together management's commentary by segment creates a gloomy picture overall. In North America, state and infrastructure investment is forecast to be "stable" with residential and nonresidential construction spending set to decline. Meanwhile, China construction spending is expected to decline, with Europe slightly up.

According to Umpleby on the earnings call, for resource industries he expects "end-user demand to be roughly flat." And for energy & transportation, he says: "We expect modestly lower overall demand. In oil and gas, we expect end-user demand to weaken in North America for well servicing, recip gas compression, and drilling."

All told, it's a dismal picture and confirms the pessimism around the company's near-term prospects that became apparent in 2019. In fact, the only bright spot was Umpleby's assertion that "in mining, we expect mid-single-digit growth for end-user demand as quoting activity continues to be positive" -- a viewpoint that could be challenged with the observation that the idea of a pickup in capital spending by mining companies  appears to be getting long in the tooth.

Dividend investors might not mind

Clearly, Caterpillar's end markets are challenged in 2020, but there's a case for simply ignoring it as the typical noise that occurs when a cyclical company is in a trough year. Indeed, Caterpillar's dismal outlook leads to guidance that, at the bottom of the range, would put the stock on a one-year forward P/E ratio of 15.7, and would mean the dividend was covered more than twice by earnings. That's not bad for a company hitting a trough.

Moreover, chief financial officer Andrew Bonfield said Caterpillar would increase "the dividend by high single digits in 2020 and the next three years after that." He also expects to use the company's substantive free cash flow to buy back stock at a level similar to the $4 billion purchased in 2019.

What it all means for investors

Putting it all together, Caterpillar is undoubtedly heading for a difficult year, and it may yet disappoint on earnings, but its valuation is already largely reflective of its current position. Although not specifically stated, management seems to be planning to respond to any share price weakness by making share buybacks. Dividend investors searching for a 3.2% yield may want to do similarly and buy the stock on any significant weakness.

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