It seems strange to advocate for a highly cyclical company as a dividend candidate, but Caterpillar (CAT 3.03%) has a strong track record of growing its dividend over the last few decades. Moreover, management intends to reduce the cyclicality of its earnings and cash flow by increasing its services revenue. It all adds up to making Caterpillar a genuine dividend-paying option for investors. Here's why. 

Caterpillar's cyclical earnings and cash flow

The industrial company's current dividend payout comes to around $2.44 billion, and generates a near 2% dividend yield for income-seeking investors. Moreover, it's a dividend that management plans to increase in the coming years, backed by improving profit margins and cash flow. 

To understand why, you have to go back to the investor day presentation in 2019, where management laid out its medium-term plan. The key to the plan was to raise Caterpillar's operating margin and free-cash-flow profile through the cycle, mainly by focusing on growing its services revenue from $14 billion in 2016 to $28 billion in 2026. 

Why growing services sales matters

The company's equipment sales are cyclical and always will be due to their exposure to construction, mining, transportation, and energy markets. As such, Caterpillar's equipment sales will fluctuate with the ups and downs of its end markets -- potential and existing customers tend to hold back on large ticket purchases of new equipment during a slowdown. Moreover, given that Caterpillar is a manufacturer with high fixed costs, its margins will also fluctuate.

However, growing services revenue helps to reduce the volatility in earnings and cash flow because customers will still need to service equipment even in a downturn. In a nutshell, management plans to generate machine, energy, and transportation (ME&T) free cash flow (FCF) in the range of $4 billion to $8 billion through the cycle, compared to $3 billion to $6 billion in the previous cycle. Using ME&T makes sense for industrial companies because it removes the distortions caused by the financial services arm on cash flow.

Did Caterpillar meet its targets?

The chart below shows how Caterpillar has performed, historically and since the investor day in 2019. As you can see, Caterpillar has met the aim of $4 billion to $8 billion, with the exception of 2020. While it's never good news to see a company fail to meet its targets, it's somewhat understandable given the demand destruction caused by the pandemic. Nonetheless, it's worth noting that Caterpillar's ME&T FCF covered its dividend even then. 

Caterpilar Cash Flow Chart

Data source: Caterpillar presentations.

Caterpillar's FCF generation is supported by the ongoing expansion of its services sales, and here the company looks on track to hit its aim of $28 billion in sales by 2026.

Caterpillar services revenue chart

Data source: Caterpillar presentations.

How to think about Caterpillar stock 

All told, the expansion of services sales underpins its ME&T FCF generation, and if you are looking for a decent yield play, then Caterpillar fits the bill. For example, even at the trough of the range (ME&T FCF of $4 billion), the current dividend will be covered by 1.6 times -- there's ample room for dividend expansion in the coming years. 

If you are wondering about valuation, then the midpoint of Caterpillar's ME&T FCF range of $4 billion to $8 billion is $6 billion. At the current market cap of $120 billion that implies an FCF to market cap yield of 5% through the cycle. That's a decent yield compared to the current 3.9% yield on the 10-year U.S. Treasury note. 

That said, the prospect of Caterpillar significantly growing long-term earnings somewhat depends on the economy, and the commodity cycle in particular. As such, Caterpillar offers investors a combination of a dividend play and upside potential from a commodity supercycle driving its resources equipment (its construction equipment also has exposure to energy spending) higher. That might suit many investors.