Caterpillar's (NYSE:CAT) sales and earnings are cyclical -- they always have been and probably always will be. In other words, they go up in tandem with the economy and then down with it. That hasn't been a great quality to have in 2020 as the economy has hit a rough patch, but the reality is Caterpillar is firmly on a path to recovery. Does this make the stock worth buying for 2021?

The investment thesis behind the stock is simple. It's usually a good idea to buy a cyclical stock when it's starting its upswing phase, and that's where Caterpillar is right now. The rationale is that the stock usually starts from a place where investor expectations are low, and then it climbs a wall of worry as the recovery takes shape. In addition, as its revenue growth gathers momentum, analysts are often left scrambling to upgrade forecasts, so you could buy in while others are still waiting to hear what analysts have to say.

Mining machinery outside

Image source: Getty Images.

The chart below shows that significant price appreciation occurred after  revenue troughs formed at the start of 2010 and 2017.

CAT Chart

Data by YCharts

Is an upswing underway?

If you want to get in just before an upswing, the question then is how can you determine when the trough is ready to turn. The answer comes from digging into the details of the company's retail sales. Caterpillar generates most of its sales through independent dealers, and if these dealers' retail sales are rising, they will inevitably order more from Caterpillar.

The chart below shows that Caterpillar's retail sales appear to have bottomed and look like they will turn positive in 2021, just as they did in 2017.

Aside from its importance to the investment case for those looking to play a cyclical recovery, a bottoming of Caterpillar's sales, earnings, and free cash flow would be a major plus for dividend investors. The reason being that Caterpillar is a company that aims to return "substantially all" of its free cash flow to investors, and if 2020 will indeed mark a trough, then the bottom of its free cash flow generation will easily cover its current dividend payout of around $2.3 billion. The stock's current dividend yield is 2.3%. All told, Caterpillar's dividend is safe. 

Caterpillar retail sales.

Data source: Caterpillar presentations.

Caterpillar's dividend

As such, Caterpillar is worth buying for dividend investors. The dividend is well covered by free cash flow, and management is planning to reduce the cyclicality of its earnings by expanding its services revenue, which tends to hold up better than equipment sales in a slowdown as customers will still be using machinery, but might hold off purchasing new equipment.

In this way, the company's free cash flow bottom through the cycle will grow higher over time. Caterpillar's overall sales were $53.8 billion in 2019 with $18 billion coming from services, but management plans to generate $28 billion worth of sales from services in 2026.

That said, there are two key reasons Caterpillar might not be a great cyclical play right now. First, the stock has risen a lot recently and investors have already priced a lot of the recovery in. Second, there's reason to believe that Caterpillar's recovery won't be as strong as it has been in previous cycles.

Valuation and recovery

The chart below of enterprise value (market cap plus net debt) to earnings before interest, taxation, depreciation, and amortization (EBITDA) shows that Caterpillar's valuation is already quite high. Moreover, a decline in earnings in the fourth quarter is expected to lead to an EV/EBITDA multiple of nearly 21 at the end of the year.

CAT Revenue (TTM) Chart

Data by YCharts

Turning to the issue of the strength of the recovery, it helps to break out Caterpillar's machinery earnings by end market. In this way, investors can see how Caterpillar's earnings tend to swing up and down with the cycle.

Segment Earnings  First Three Quarters 2020

2019

2018

2017

2016

Construction industries

$1,743 million

$3,931 million

$4,174 million

$3,255 million

$1,639 million

Resource industries

$623 million

$1,629 million

$1,603 million

$698 million

($1,045 million)

Energy and transportation

$1,718 million

$3,910 million

$3,938 million

$2,856 million

$2,187 million

Data source: Caterpillar presentations.

The unanswered questions are mainly regarding its resources (mining and aggregates) and energy and transportation segments. While coal mining is far from the only market that the resource industries segment sells into, it is a key market and there's no way to sugarcoat the fact that coal production is falling in Caterpillar's key U.S. market.

In addition, oil rig counts are a useful proxy for oil and gas spending (the energy and transportation segment) and there's no guarantee that conditions will significantly improve as they did in 2010 and 2017. Finally, locomotive sales (energy and transportation) could be challenged as railroads continue to focus on initiatives designed to reduce their asset base.

All told, Caterpillar's sales appear to have bottomed, that's the good news, but it's far from clear that the upswing will be as strong as it was in previous recoveries. 

US Oil Rig Count Chart

Data by YCharts

Is it a stock to buy?

Investors focused on dividends can feel safe buying the stock, but for other investors, Caterpillar's current valuation looks a little rich given the caution around some of its end markets. Investors should keep a close eye on capital spending in the mining and oil and gas industries, as well as hope for a boost in infrastructure spending. Until clear evidence emerges, then most investors will want to put Caterpillar on the watch list rather than the buy list right now.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.