There are two answers to the headline on this article, and together, they significantly contribute to the investment case for Caterpillar (CAT -0.90%). The first answer is $24,300 -- that's what you would have by buying and holding the stock. But you would have $32,200 if you had reinvested the dividends.
The difference is a testament to the power of compounding with a stock that has an excellent record of growing dividends. Here's why Caterpillar is worth a look for income-seeking investors.
Caterpillar's dividend history
Not only has the company paid a cash dividend every year since its formation in 1933, but it has also raised its payout yearly for the last 29 consecutive years. That fact might surprise some readers; after all, Caterpillar's mix of construction, mining, energy, and transportation machinery serves highly cyclical markets.
As you can see below, revenue and free cash flow (FCF) tend to oscillate over time, and its FCF has barely covered its dividend at points in the past. That said, there's plenty of reason to believe Caterpillar will grow its payout in the future, and the stock also has upside potential.
Data by YCharts. TTM = trailing 12 months.
Caterpillar improves its margin and cash flow
Management knows its revenue and earnings are cyclical. Indeed, this is implicitly recognized in the financial framework it outlines to investors. During the company's investor day presentation in 2019, management laid out its plan to improve its performance through the cycle.
In plain English, it's a recognition that there's little Caterpillar can do about its end markets. Still, management can try to improve its profit margin and cash-flow generation during the ups and downs. As such, there were two key takeaways from its projections:
- Caterpillar expects its future adjusted operating margin to be 10% to 21% compared to 7% to 15% in the 2010-2016 time frame.
- FCF for its machine, energy, and transportation (ME&T) segment is expected to be $4 billion to $8 billion compared to the $3 billion to $6 billion it generated in the 2010-2016 cycle.
Some of management's plans to achieve these aims involve structural cost reductions. That includes lowering its manufacturing footprint, and increasing its services revenue from $14 billion in 2016 to $28 billion in 2026.
Services revenue tends to be more sticky in a downturn (certainly more than high-ticket heavy machinery), and increasing it as a share of revenue will reduce cyclicality in Caterpillar's business. In addition, a key part of the services' plan involves using digital technology (apps, e-commerce, and the like) to enable customers and dealers to order spare parts and inventory more easily.
The good news is that the plan appears to be working. Only in the traumatic year of 2020 did Caterpillar pull below the low end of the $4 billion to $8 billion FCF range.
Data source: Caterpillar presentations.
In addition, Caterpillar appears to be making good progress toward the target of $26 billion in services revenue in 2026.
Data source: Caterpillar presentations.
Moreover, considering that the cash dividend payout comes to $2.4 billion, the targeted FCF range implies the company's dividend will easily be covered in the future, and there's potential for significant improvement in the payout.
The growth potential
However, the case for Caterpillar isn't just based on self-help operational improvements. There's also potential for a long-term commodity cycle to catalyze sales of its mining and oil & gas equipment -- the so-called "commodity super-cycle argument."
While typical commodity cycles tend to last a few years, the super-cycle argument holds that structural demand factors are in place (population growth, increase in middle classes in the developing world, growing demand for commodities to support the electrification of everything trend, etc.) that will lead to a rise in demand. Meanwhile, the increasing difficulty of acquiring mining permits due to regulatory and environmental concerns will constrain supply.
The result is a long-term increase in prices, and construction and resource equipment should benefit from higher infrastructure spending.
Image source: Getty Images.
As such, investing in Caterpillar isn't just about buying a reliable company that can grow dividends through the economic cycle; it's also an investment in the commodity super-cycle argument (if you believe in it) and an investment in a company that's reducing the volatility of its earnings and cash flow through the cycle.
The history of Caterpillar's dividends contributing to total returns and the likelihood of good dividend appreciation in the future make the stock interesting for long-term investors looking for passive income.
