For a number of reasons, the construction, mining equipment, and energy and transportation equipment company Caterpillar (CAT 0.07%) is well set for a recovery in 2021. Many investors will be tempted to buy into the stock on that basis, but the key question is whether the stock is a buy or not. Let's take a look at what's going in 2021 and try to shed some light on the answer.
Caterpillar's retail sales have bottomed
First, retail sales of Caterpillar's equipment have probably bottomed and look set to turn up in 2021. For reference, Caterpillar mainly sells through independent retailers who manage their own affairs -- I'll come to this point later -- and a look at their rolling three-month retail sales suggests that a return to growth will occur soon.
An infrastructure bill and spending on pipelines would help Caterpillar. Image source: Getty Images.
That's a good sign, as Caterpillar's sales can tend to overshoot expectations during the upswing, as they did in 2017, and it also tends to be good news for the stock, too.
Data source: Caterpillar presentations. Chart by author.
Dealer inventory is low
Second, as noted above, Caterpillar mainly sells through dealers. There's cause for optimism here based on the fact that these dealers reduced their inventory more than expected in the fourth quarter. This implies that they are likely to order more equipment from Caterpillar in due course.
During the earnings call, CEO Jim Umpleby outlined that dealers had reduced inventory by $1.1 billion in the fourth quarter compared to expectations for a reduction of $700 million. Again, that's a positive sign.
In fact, dealer inventory was reduced by $2.9 billion in 2020, and CFO Andrew Bonfield said that dealer inventory levels were at "the lower end of their normal range for months of sales" and "This dealer inventory reduction positions us well for 2021."
Management guidance
Third, although management refrained from full-year guidance due to the uncertainty created by the COVID-19 pandemic, it did guide toward an improvement in machinery, energy, and transportation free cash flow (FCF) in 2021.
Image source: Getty Images.
Caterpillar generated $3.1 billion in FCF in 2020, which was more than enough to pay out $2.2 billion in dividends. Moreover, Umpleby said that in 2021 Caterpillar would meet the FCF targets outlined on its investor day presentation in 2019. Back then, management predicted that its FCF through the cycle would be $4 billion to $8 billion, so you can likely pencil in an improvement to at least $4 billion in 2021.
There's two ways to look at this. The glass-half-full approach warms to the FCF improvement and notes that the dividend is very well covered. The glass-half-empty approach points out that Caterpillar was significantly below the low end of its forecasted FCF through the cycle in 2020.
More services revenue
Caterpillar has been trying to reduce the cyclicality of its earnings by increasing the amount of revenue it generates from services. As Umpleby pointed out, Caterpillar's services sales declined 13% in 2020 compared to a 22% decline in overall revenue. Consequently, services rose as a percentage of sales to 41% of machinery, energy, and transportation sales.
Umpleby expects services sales to grow in 2021, and that should help reduce the cyclicality of Caterpillar's revenue over the long term.
End markets improving
Management believes its end markets are improving and sales will grow in 2021. Housing in North America remains strong and that should support sales of smaller equipment, while construction activity in Asia is already recovering.
Data source: Caterpillar presentations. Chart by author.
Meanwhile, in resource industries "the improvement in mining fundamentals is expected to continue" while "metal prices are supportive of reinvestment and quoting activity continues to be robust," according to Umpleby on the earnings call. Moreover, a U.S infrastructure bill would boost aggregate and heavy construction sales.
The energy and transportation segment outlook is a mixed bag, with power generation sales seen as being supported by data center activity and transportation revenue growing with more rail activity. On the other hand, "Although we are encouraged by recent moves in oil prices, we expect oil and gas will continue to reflect conditions in that market," Umpleby said.
What it means to investors
In a nutshell, it's good news for dividend investors, because the dividend is very well covered even at the bottom of the sales cycle and management plans to increase the payout. It's probably good news for investors worried about the near term, as Caterpillar does look set for a solid recovery in 2021.
Image source: Getty Images.
However, for long-term investors there is a note of caution. The non-residential markets in the U.S. are not in great shape, and there's no guarantee that China will stimulate its economy with infrastructural spending as it has in the past. Coal mining, a challenged industry, is a major contributor to heavy mining machinery demand, and Caterpillar's oil and gas spending outlook was lackluster. Meanwhile, the fact is that Caterpillar did fail to meet its FCF targets in 2020, and its valuation is not looking particularly cheap right now.
All told, Caterpillar is in recovery mode, but it might not be as strong a recovery as in previous cycles. Cautious investors might want to wait to see if Caterpillar can start exceeding expectations before buying in.
