On Caterpillar Inc. (NYSE: CAT) is BUY. Demand has plummeted for CAT during the coronavirus crisis, and is unlikely to recover to previous levels for at least two years. The shares offer value, with a dividend yield of 2.5% that is attractive in a low interest rate environment. Our new target price is $170.
The beta on CAT shares is about 1.05.
Due to the pandemic, Caterpillar has withdrawn its financial guidance for 2020. Management had projected EPS of $8.50-$10.00, implying a profit decline of 10%-25%. Management commented in the 3Q release that it is ‘encouraged by positive signs in certain industries and geographies.’
EARNINGS & GROWTH ANALYSIS
The Caterpillar segments. Construction Industries (approximately 38% of 3Q sales), Resource Industries (17%), Energy & Transportation (39%), and Financial Products (6%).
In Construction Industries, sales fell 21%. The decrease was due to lower sales volume, driven by the unfavorable impact of changes in dealer inventories and reduced end-user demand. Sales declined in all regions. The operating margin narrowed by 430 basis points to 9.2%.
In Resource Industries, sales declined 35% due to lower sales volume, driven by the unfavorable impact of changes in dealer inventories and lower end-user demand. This segment is driven by trends in the mining sector. Resource Industries is more volatile than the company’s other segments, with historical operating margins in the 16%-21% range. They will not be that high this year.
In the Energy & Transportation segment, sales were down 24% year-over-year, while operating profit dropped 52%. Sales weakened in all subsegments — Oil and Gas, Industrial, Transportation and Power Generation. The operating margin narrowed by 690 basis points to 11.8%. Volatile oil prices will not help this segment recover quickly.
In the Financial Products division, operating profit declined to $142 million.
But that was up from 7.85 in 2Q. Against the backdrop of challenging global manufacturing markets in 2014-2016, management took aggressive steps to cut costs. In 2017-2018, restructuring costs totaled approximately $1.65 billion and reflected the consolidation of manufacturing facilities in Europe and the U.S. In 2019, management targeted another $100-$200 million in cost savings, as well as lower short-term incentive compensation expense. In 2020, the company is reducing discretionary expenses and suspending 2020 base salary increases and short-term incentive compensation plans for many employees and all senior executives. In 2019, the full-year operating margin was 15.4%, up from 15.2% in 2019 and 13.5% in 2017. The operating margin over the past ten years has ranged from 8% to 15.4%. This looks like an 8% year.
FINANCIAL STRENGTH & DIVIDEND
Caterpillar has taken actions to improve its strong financial position by increasing liquidity.
CAT’s debt/capitalization ratio, excluding the Financial Products division, was 39% at the end of 3Q20.
CAT pays a dividend. In May 2019, the company raised its quarterly payout by 20% to $1.03, or $4.12 annually. The company has paid dividends since 1933.
MANAGEMENT & RISKS
Mr. Umpleby has worked for Caterpillar for more than 35 years. The CFO is Andrew R.J. Bonfield.
Caterpillar has a history of providing transparent results to investors.
Caterpillar management met with investors in May 2019. Key takeaways included:
The target operating margin peak is now about 17%.
The company faces a range of operational and financial risks, and its performance could be hurt by rising interest rates, unfavorable exchange-rate movements, declining commodity prices, and weakness in the construction and mining industries. The pandemic is posing a severe risk to the company’s profitability, but not its financial strength.
The company also has an underfunded pension plan.
However, we think multiples may remain under pressure given challenges from global economic conditions. Our target price is now $170, or 22-times projected 2021 earnings.