Is Caterpillar Stock a Buy?

Shares of construction giant Caterpillar (CAT -0.43%) continue to surge higher. After a strong 2020 performance, the stock has started 2021 as one of the best performers in the Dow Jones Industrial Average.

But Caterpillar isn't trading higher because its results are good. In fact, its 2020 performance was pretty terrible and included one of the company's worst quarters in history. Instead, Caterpillar's fresh all-time high is based on future performance and the expectation that the company will be a big beneficiary from a 2021 bull market, infrastructure stimulus, higher oil prices, and other post-pandemic tailwinds. Let's break down Caterpillar's 2020 performance and outlook for the years ahead to see if the company can justify its surging share price.

Image source: Caterpillar.

Business is improving

Caterpillar's full-year revenue decline of 22% and profit decline of 42% may look rough but things were a lot worse not too long ago. 

Data source: Caterpillar. YOY = year over year. 

In fact, the fourth quarter showed signs of improvement as Caterpillar's construction and resource industries continued to rebound from their pandemic lows. Caterpillar generates most of its sales through its vast dealer network. Dealers tend to ramp up inventories when they anticipate an upswing in sales. However, Caterpillar reported that dealers dramatically reduced their inventories by $1.1 billion in the fourth quarter of 2020, $400 million more than the company guided for in the third quarter. The $2.9 billion reduction in dealer inventories for the year was the largest annual decline since 2013. 

Data source: Caterpillar Inc. Chart by author.

Although Caterpillar's fourth-quarter dealer inventory guidance was way off, the company is confident that the tide is about to turn. Caterpillar is a cyclical stock whose sales are heavily dependent on market cycles. The company was on track for a multi-year upswing that was disrupted by the U.S.-China trade war in 2018 and 2019 and then the COVID-19 pandemic in 2020 and 2021. Over half of the company's sales come from outside North America, so Caterpillar benefits from emerging markets but is also vulnerable to geopolitical challenges.

Growth opportunities

With dealer inventories set to improve, the company is poised to benefit from the widespread distribution of a COVID-19 vaccine and a stimulated economy. A strong U.S. housing market and rising oil prices are helping its North American sales, while the rest of its business -- particularly in Asia, Europe, Africa, and the Middle East -- fared well throughout 2020. 

Caterpillar finalized its acquisition of Weir Group's Weir Oil and Gas division into the rebranded SPM Oil and Gas in early February. With West Texas International (WTI) crude oil prices above $60 a barrel (the highest price since late 2019), Caterpillar seems to have gotten a bargain for Weir's assets, which integrate nicely into its well services business. In sum, the stage is set for Caterpillar to begin a period of growing sales and income.

Dividend strength

Despite a challenging year, Caterpillar was able to generate ample free cash flow (FCF) to fund its $2.2 billion annual dividend obligation. This is a good sign that Caterpillar's operations, instead of debt, can support its dividend during hard times. However, the company added $2 billion in debt to its balance sheet in 2020 to bolster liquidity. As Caterpillar enters into a period of growing FCF, dividend raises are likely to follow. What's more impressive, however, is that Caterpillar has raised its annual payout for 27 consecutive years, making it a Dividend Aristocrat. Many of these dividend raises came during challenging market cycles, a testament to Caterpillar's discipline. Management has repeatedly mentioned that it is proud of Caterpillar's Dividend Aristocrat status, and plans to keep the streak going for years to come. 

Valuation concerns

Caterpillar's upbeat outlook and reliable dividend are great reasons to take a look at the stock. But unfortunately, a lot of this optimism is already priced in. Before even entering into its growth trend, shares of Caterpillar have blasted to a fresh all-time high. After easily beating the market in 2020, the stock is now up more than 150% from its pandemic low and 62% in the past year, more than four times higher than the S&P 500 and the industrial sector as a whole.

CAT data by YCharts

Not too long ago, the bull case for Caterpillar was that it was a good long-term value, had a strong balance sheet, and paid a stable and growing dividend. As sales and outlook improved, along with its share price, the buy case shifted to focus on the company's growth and international expansion. And even after passing $200 a share, Caterpillar looked expensive, but there were plenty of reasons it was still cheap.

However, Caterpillar's disappointing dealer inventory results and the fact that revenue and net income are improved but remain down signal that the company isn't out of the woods yet. It remains a great long-term buy but has yet to enter and sustain a period of growth. Investors should monitor the company's dealer inventories to identify when the uptrend begins. Additionally, Caterpillar will face easy year-over-year comps starting in the second quarter, so it's better to compare its results to 2019 numbers.

Patience is key

There's no denying that Caterpillar should post some sizable and potentially record-high results in the coming years. For now, the stock has probably gotten a little ahead of itself, so it's best to monitor its progress from the sidelines instead of diving headfirst with the crowd.