At face value, Caterpillar's stock looks way too expensive. Its P/E ratio is over 32, and its price-to-sales ratio is around 2.5, the highest levels for the company in three years and above the market average for industrial stocks. But Caterpillar has an ace up its sleeve that makes its valuation cheap even at these levels, and worth adding to your portfolio right now.
Dividend raises are on the way
In 2020, Caterpillar raised its annual dividend for the 27th consecutive year, extending the streak that placed it on the short list of Dividend Aristocrats. It suspended share buybacks, but plans to increase its quarterly payouts to shareholders again in 2021.
Becoming a Dividend Aristocrat is an impressive feat for any company, let alone a cyclical business like Caterpillar. Consistently raising a dividend even during times of declining revenue and earnings (like in 2020) sends a strong signal to investors about a company's faith in its business despite the environment it operates in. And Caterpillar's dividend, which at current share prices yields 2.1%, remains a key reason to own the stock over the long term.
Caterpillar's valuation looks lofty based on its 2020 performance, but it's actually reasonable because the company is poised to enter into a period of growing sales and net income. Dealer inventory is a leading indicator that supports this theory.
Caterpillar sells the majority of its machinery and engines through a global network of independent dealers. Dealers tend to ramp up their inventories to capture higher end-user sales when demand is high, and let them get more depleted when economic activity slows.
After falling sharply during the Great Recession, dealer inventories increased from 2010 to 2012, when Caterpillar reported its highest-ever annual revenue. The cycle then shifted and inventories decreased from 2013 to 2016, then were flat in 2017. Inventories rose in 2018, but Caterpillar was hit hard by the U.S.-China trade war, which stymied its progress. This lasted into 2019, during which the company reported only moderate increases in dealer inventories. The final figures aren't in yet, but dealer inventories are believed to have fallen by $2.5 billion in 2020 (their highest decline since 2013) due to impacts from the COVID-19 pandemic.
In sum, Caterpillar was poised to enter a multiyear uptrend in 2018 that was hindered first by the U.S.-China trade war and then by the pandemic. During the company's third-quarter conference call, CFO Andrew Bonfield noted that "with dealer inventory coming down by $2.5 billion, we'll start 2021 well-positioned for changes in market demand." In other words, dealers will need to increase their inventories (which will, in turn, drive Caterpillar's sales) if the economy rebounds in 2021.
2012 remains the highest-revenue year in Caterpillar's history. But since then, the company hasn't experienced a normal market cycle. Given that the company is arguably better-positioned to capture growth now than ever before, the premise that the next three to four years could be a favorable business cycle makes its stock price attractive even at these record highs.
Strong balance sheet
Having a strong balance sheet is of paramount importance for a cyclical company like Caterpillar because it ensures the company can run its business, make investments, and pay dividends even during tough times.
As of the end of Q3, Caterpillar had $9.36 billion in long-term debt due within a year and $9.32 billion in cash on its balance sheet, meaning it has plenty of cash to cover its upcoming debt payments. In the third quarter, it paid interest of $136 million on $38.13 billion, which is an annual interest rate of just 1.4%. That investment-grade balance sheet gives the company access to cheap debt, but it hasn't abused the privilege. Its total net long-term debt position and its financial leverage have remained at reasonable levels for years, and have stayed strong throughout the pandemic.
The total package
Caterpillar's consistently strong balance sheet and growing dividend are two good reasons to own the stock over the long term. With the economy reopening, a COVID-19 vaccine on the way, and the Federal Reserve planning to keep the fed funds rate near zero until at least 2023, the stage is set for Caterpillar to enjoy a period of rising sales and net income. And when measured against the financial numbers we can expect to see, the stock looks a whole lot more like a good investment.