In the past month, Caterpillar (CAT -0.55%) stock has soared 30%, including a 15% run from Oct. 24 to Oct. 28. A combination of factors, including the stock being too beaten down, broader market optimism, and most importantly, an incredibly strong earnings report, is the reason for the recent outperformance from Caterpillar stock.
The questions now are whether the recent climb is justified and if Caterpillar stock has more room to run.
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Overcoming economic headwinds
This earnings season, companies across all economic sectors have discussed the impacts of inflation, falling consumer demand, supply chain issues, and a strong U.S. dollar. U.S.-based companies report their results in U.S. dollars and a strong dollar relative to other currencies effectively dilutes sales made in foreign countries.
In 2021, Caterpillar made around 57% of its revenue from outside North America. The company has an incredibly complex supply chain and continues to deal with inflation challenges -- particularly higher manufacturing costs.
Yet despite all of these headwinds, Caterpillar still put up phenomenal results in its third quarter thanks to larger sales volume and its ability to raise prices. All told, Caterpillar earned $2.4 billion in operating profit for the quarter, a staggering 46% increase from Q3 2021.
Caterpillar expects its fourth-quarter revenue to be the highest of any quarter this year. Dealer inventories remain low and its order backlog is now over $30 billion, increasing by $1.6 billion in the most recent quarter. Caterpillar CEO Jim Umpleby said the following on the company's earnings call regarding expectations:
While we continue to closely monitor global macroeconomic conditions, overall demand remains healthy across our segments. We expect top line growth in the fourth quarter both year-over-year and sequentially. This expected performance reflects healthy demand and favorable price realization. We anticipate sales increases across our three primary segments as order levels and backlogs remain strong. As a reminder, dealers have been focused on supplying customer orders, and we'll look to replenish aging rental fleets over time when the supply chain situation improves.
In sum, Caterpillar's costs may be rising, inflation is ongoing, and unfavorable currency conversions are leading to lower dollar-denominated profits. But the core strength of Caterpillar's customers has been enough to drive profits and margins.
Sustained growth
In Q3, operating margin was up across all three of Caterpillar's segments -- energy and transportation, construction, and resource industries (which is mainly mining). Caterpillar's trailing-12-month revenue is down relative to years past, but thanks to a blowout Q3, its trailing-12-month net income is at an all-time high.
CAT Revenue (TTM) data by YCharts
Caterpillar's results illustrate the disconnect between the industrial economy and the consumer economy. For example, Caterpillar said that North American residential construction is weakening but residential construction only makes up around 25% of overall construction segment revenue.
Similarly, oil and gas prices have so far been lower in the second half of 2022 than in the first half. While oil and gas companies have been hesitant to boost spending since they are still recovering from the COVID-19-induced downturn in 2020, investors could see higher oil and gas industry spending even if oil and gas prices are lower, because companies need to spend money to retain the same level of production output. What's more, many producers can break even below $40 per barrel, so margins are still high at current prices. Finally, many oil and gas companies have taken advantage of the recent boom by paying down debt. Once leverage ratios and overall debt levels are at satisfactory levels, we could see increased oil and gas spending even if there's a recession or prices are lower, and Caterpillar could benefit.
A similar theme is taking place in mining, where Caterpillar said its customers remain disciplined when it comes to spending despite higher commodity prices. In sum, Caterpillar's end markets are doing well and its customers are not overspending, which is a good sign that Caterpillar could see sustained growth across its segments even if the macroeconomic picture continues to deteriorate.
A stable and growing dividend
The investment thesis for Caterpillar is rooted in the long-term growth of the global economy. As countries industrialize, they require more energy, develop new construction projects, and consume more resources. However, another key part of deciding to buy and hold Caterpillar stock is its stable and growing dividend. The company is a Dividend Aristocrat, having raised its dividend for 28 consecutive years. Caterpillar routinely generates plenty of excess free cash flow (FCF) to support the dividend. And when business is particularly good, it can also use FCF to repurchase its stock.
For Q3 2022, Caterpillar earned machinery, energy, and transportation FCF of $2.1 billion. For the quarter, Caterpillar bought back around $1.4 billion in stock and paid over $600 million in dividends.
Dividend Aristocrats like Caterpillar routinely earn FCF well in excess of their dividend obligations. A good way of gauging a company's ability to deliver FCF in excess of the dividend is to look at FCF yield relative to the dividend yield.
CAT Free Cash Flow Yield data by YCharts
In the chart above, we see that Caterpillar's FCF yield has been greater than its dividend yield for the last five years. Just as the dividend yield is calculated by dividing the dividend by the stock price, FCF yield is simply the FCF per share divided by the share price. But an easier way of thinking about FCF yield is that it's the maximum dividend yield if all of the FCF was allocated toward the dividend. In Caterpillar's case, it isn't using all of its FCF on the dividend, which leaves room for paying down debt, buying back stock, and reinvesting in the business.
A compelling long-term buy
Caterpillar stock's 30% climb over the last month may dissuade some investors from hitting the buy button, but Caterpillar's results support the strong performance. The future looks bright thanks to the overall strength of Caterpillar's customer base, which could support growing sales volumes and even future price increases. Caterpillar's strong margin and FCF give it a nice cushion in case the business does decline.
