Caterpillar: A Case for Improved Dividend Growth

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Caterpillar (NYSE: CAT) has increased its dividend 19 years in a row, which is a long dividend streak considering it is in the industrial equipment industry. Caterpillar has good, but not great past dividend growth rates.

In this article I’ll complete a dividend stock analysis and you will find out why I think their dividend growth will turn from good to great.

10 Year Stock Chart

The 10-year return has been good with the average annual return of 13.3% (11.6% from capital gains and 1.7% from dividends).

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-10-year-stock-chart-june-16-2013_large.JPG" />

Caterpillar was hit quite hard in 2008 and 2009 due to the global financial crisis, but it has recovered quite well since then.

Revenue and Earnings

Caterpillar has a fairly good revenue chart with the exception of 2009 and maybe 2010. In 2009 revenue and net income dropped significantly, but the company was able to bounce back by 2011.

<img alt="" src="http://g.fool.com/editorial/images/51147/caperpillar-revenue-net-income-chart_large.JPG" />

The revenue per share and EPS chart shows the same trend, which is to be expected.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-revenue-per-share-and-eps-chart_large.JPG" />

It took two years for Caterpillar to recover from the global financial crisis, which is a blemish on an otherwise impressive history. When the 10-year average annual increases for Caterpillar are examined it shows some impressive growth.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-10-yr-revenue-increas-table_large.JPG" />

The 10-year growth rates are all well above the 8% I typically look for.

Dividends

Caterpillar has increased their dividend for 19 consecutive years in a row with their most recent increase occurring with the dividend declared earlier this month (June 2013) when they increased the quarterly dividend by 15.4% from $0.52 to $0.60.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-dividends-chart_large.JPG" />

Dividend Growth

Caterpillar has good, but not great average annual dividend growth rates.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-dgrs-table_large.JPG" />

I like to see rates above 8%, but the three-year average annual growth rate comes in almost 3% below this. With the most recent dividend increase of 15.4% it looks like dividend growth may be improving.

Dividend Sustainability

The 10-year average annual dividend growth has been significantly lower than Earnings Per Share (EPS) growth which is a great sign as it points to a very sustainable dividend.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-eps-vs-dgr_large.JPG" />

Earnings have been higher than dividend growth so it is not surprising to see that the payout ratio has been coming down recently.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-payout-ratios_1_large.JPG" />

It looks like Caterpillar has been targeting a payout ratio of 20-30%, but because of the troubling times in 2009 it spiked up above 100%. Because of this spike up the 5 and 10 year payout ratio averages look inflated.

Estimated Future Dividend Growth

Analysts expect annual EPS growth to be 14.0% for the next 5 years. Accepting this estimate and using a payout ratio of 20-30% would result in annual dividend growth ranging from 7.9% to 17.0%. The most recent dividend increase was 15.4%, so my guess is that dividend growth will be on the higher side of this range. (Read the full analysis for more details)

Competitive Advantage & Return on Equity (ROE)

I would consider Caterpillar to have a wide moat over the competition, due to its strong brand. The Return On Equity (ROE) chart is erratic, but the majority of time it is well above 20%, which is good.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-roe-chart_large.JPG" />

The industry average for farm and construction machinery is 37.3%, which Caterpillar is currently below. That said, Caterpillar’s ROE is well above more direct competitors like CNH Global NV (NYSE: CNH), Terex Corporation (NYSE: TEX), and Komatsu Ltd. Caterpillar is below Deere & Company (NYSE: DE), but Deere & Company focuses more on farm equipment, where Caterpillar is more industrial equipment.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-industry-roe-table_large.JPG" />

Caterpillar has a very strong and well known brand, so overall I would say it has a competitive advantage, even if the ROE versus the industry is showing mixed results.

Shares Outstanding

Shares outstanding decreased from 2003 to 2008, but since then they have been growing. I’d like to see shares outstanding start to decrease.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-shares-outstanding_large.JPG" />

Valuation

Morningstar currently rates Caterpillar a 3 star stock as it is currently priced around their estimated fair value of $98. For Morningstar to rate Caterpillar as a 5 star undervalued stock the price would have to fall below their “consider buy price” of $58.80.

I calculate my own target prices and came up with $67. (Calculation details on my $67 target price here, or you can read about my valuation method here.)

Other Investment Options in the Same Industry

A lot of Caterpillar’s direct competitors don’t have a very good dividend history. CNH Global NV paid out a special dividend in 2012 of $10, but the three previous years they didn’t pay out any dividends. Komatsu Ltd. looks like it had a dividend cut in 2009 and Terex Corporation doesn’t pay out a dividend.

I had a look at the May 31, 2013 US Dividends Champions list and found Deere & Company and Parker-Hannifin Corporation (NYSE: PH) as suitable dividend growth alternatives.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-competitors-table-1_large.JPG" />

Deere & Company and Parker-Hannifin have similar dividend growth rates, but I prefer Deere & Company as it has a higher yield, lower payout ratio and higher annual estimated growth. I’d expect larger future dividend growth from Deere & Company. That said, it’s hard to compete with 57 consecutive years of dividend increases. Parker-Hannifin is tied with 5 other companies for the 3rd longest dividend streak for US companies.

Parker-Hannifin and Deere & Company are compelling dividend growth options, but Caterpillar’s yield is the highest and I’d expect dividend growth to be roughly the same as Deere & Company, and higher than Parker-Hannifin’s. When I look at them from a valuation perspective, none of them look particularly undervalued.

<img alt="" src="http://g.fool.com/editorial/images/51147/caterpillar-competitors-table-2_large.JPG" />

Caterpillar is currently priced 14% below Morningstar’s fair value, and the others all look to be trading very close to fair value. When the average yield is compared to the current yield I can see that all three companies are trading within 10% of their 5 year average yield which suggests they are fair value priced right now. I like to invest in undervalued stocks, so I’ll be hoping for a price drop before I consider investing in any of these.

Conclusion

Caterpillar has a strong well known brand that has translated into a competitive advantage. Like a lot of companies during the global financial crisis it went through tough times in 2009, but they still managed to increase their dividend and they have more than recovered. Because of the hard times in 2009 past dividend growth suffered, but I expect a strong future dividend growth, somewhere around 15% annually. If Caterpillar were to drop below my target price of $67 I would consider investing.

Caterpillar is the market share leader in an industry in which size matters, and its quality products, extensive service network, and unparalleled brand strength combine to give it solid competitive advantages. Read all about Caterpillar's strengths and weaknesses in The Motley Fool's brand new report. Just click here to access it now.


Michael Weber owns shares of Parker-Hannifin Corporation.  The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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