What happened
Shares in machinery equipment company Caterpillar (CAT 0.96%) fell 14.3% in the first half of 2020 according to data provided by S&P Global Market Intelligence. The move comes as a consequence of a significant deterioration in its end market prospects.
It hasn't been an easy year for the company. Caterpillar started the year with its retail sales growth in negative territory. However, there were hopes for a cyclical bounce in the industrial economy that would aid its construction machinery sales. Meanwhile, an ongoing recovery in mining commodity and energy prices was seen as supporting a long-cycle recovery in Caterpillar's sales of mining and oil and gas equipment.
Caterpillar needs global construction activity to improve. Image source: Getty Images.
Unfortunately, the COVID-19 pandemic has put paid to all these hopes, and Caterpillar has now endured six straight months of retail sales declines. As a result Caterpillar is no longer giving earnings guidance for 2020, and management has backed off the previous targets it set for 2020.
Here's how chief executive officer Jim Umpleby put it on the first quarter earnings call: "Depending upon how the pandemic unfolds, while we expect our margins and free cash flows to be better than our historical performance of 2010 to 2016, it will be challenging for us to achieve the margin and cash flow targets communicated during our 2019 Investor Day."
So what
The deterioration in near-term prospects is obviously a disappointment, as is management's backing off of its previous targets. However, these developments need to be put into context.
First, it would have been very hard for management to envisage something like the COVID-19 pandemic in its planning.
Second, in the Investor Day presentations, management maintained that the business had been restructured so that free cash flow would bottom at $4 billion though the economic cycle. Therefore, even if Caterpillar isn't quite able to hit that free cash flow target, the $2.3 billion dividend payout still looks easily sustainable. In addition, the market is expecting a significant improvement in sales and earnings next year.
Now what
Ultimately, Caterpillar's fortunes will be decided by the shape of the global industrial recovery and in particular the recovery in construction and infrastructure spending, as well as capital spending in the mining and energy sectors. In the near term, it's clearly a difficult environment, but Wall Street analysts have sales recovering in 2021, and the stock's 3.2% dividend yield will attract income-seeking investors.
