Construction, mining, and oil and gas may have been among the sectors hardest hit by the COVID-19 pandemic. Still, shares of leading equipment manufacturer Caterpillar (CAT 1.16%) aren't showing any signs of slowing down. The stock has nearly doubled from its March lows and is up 18% year to date.
Either Caterpillar is doing something right that's caught investor attention, or the market is pricing in the possibility of an economic recovery. The latter isn't unwarranted considering the positive signals the company's management gave during its latest quarterly earnings release. Does that mean the stock's a buy even at its current price?
Green shoots amid despair
Caterpillar relies heavily on its global dealership network for sales. During a slowdown, dealers typically work down their inventories rather than buy fresh equipment from Caterpillar, hurting Caterpillar's top line. During the nine months ended Sept. 30, 2020, dealers had reduced inventory by $1.8 billion. Caterpillar's sales in the energy and transportation category slumped nearly 27% to $28.4 billion during the period.
Yet Caterpillar's Q3 sales were only about 1% down sequentially and flat across its three segments: construction industries, resource industries, and energy and transportation (E&T). Its operating margin also improved 2.2 percentage points sequentially to 10% in Q3. That's a positive sign as the company faced a similarly challenging business environment in both quarters in the wake of the pandemic.
Management sees signs of hope. They expect end-user demand and sales to improve in the fourth quarter and into 2021, backed by some strong end markets. Healthy housing starts and nonresidential construction activity in North America, as well as sturdy demand for construction equipment from China, are some examples. Caterpillar also expects mining orders to pick up, lifting prospects for its resource industries' division. E&T will likely be the weakest link given the low oil and gas prices and anemic demand for solar.
While this commentary from management is encouraging, there's another statistic that signals the worst might be over for Caterpillar: its retail machinery sales data. Consider that Caterpillar's total worldwide retail machinery sales slipped 20% each during the three months ended July, August, and September. In the quarter ended October, sales slid 17%, signaling a deceleration in sales declines after flattening out.
It gets even better when you factor in Caterpillar's ongoing efforts to turn challenges into opportunities. Those efforts should not only help the company preserve dividends, but also help it bounce back stronger.
How Caterpillar is handling the COVID-19 slowdown
Caterpillar got down to work soon after the pandemic broke out. As early as April, the company suspended base salary increases and incentive compensation plans for part of its workforce and trimmed discretionary spending to cut costs. Caterpillar issued bonds at low interest rates to raise cash even as it suspended its share repurchase program.
These moves boosted liquidity and left Caterpillar with enough flexibility to pursue growth opportunities, such as its decision to acquire The Weir Group's oil and gas business while the energy sector remains depressed. The $405-million cash deal should augment Caterpillar's E&T portfolio.
Explaining the rationale behind the acquisition, CEO Jim Umpleby said, "We view this as an opportunistic time to strengthen our lineup of oil and gas products and services, and importantly, we believe the transaction economics will prove attractive even if oil prices remain low."
Caterpillar has also maintained its dividends despite 2020 being an exceptionally challenging year. It last increased its quarterly dividend by 20% in May 2019, and has maintained the payout since. Caterpillar has increased its dividend for 27 straight years now and is keen to maintain its Dividend Aristocrat status. "The dividend remains a high priority through all economic cycles. All decisions concerning the dividend are made by our board of directors, but we anticipate increasing our dividend again next year," said Umpleby during Caterpillar's third-quarter earnings conference call.
In any case, Caterpillar's cash-flow position is far from its worst. In fact, its free cash flow comfortably covered its total dividend payout in the trailing twelve months. The stock currently yields a decent 2.4%.
Why you still might want to wait
Caterpillar's sales appear to have bottomed, the company is managing its costs well, its financials are stable, and dividends look safe for now. Yet as a cyclical stock, Caterpillar's fortunes ebb and flow with the economy. We need to see firm signs of an economic recovery to confirm that Caterpillar has bottomed out.
The COVID-19 pandemic rages on, and it'll still take a lot for sectors like energy and mining to regain their mojo. Caterpillar's stock price, however, is already hovering near its all-time highs, suggesting it's getting ahead of itself. In short, you might just want to watch the stock for now. Wait for a dip to pick up some shares rather than paying a premium right now.