After failing to increase its dividend in June like it has in past years and continuing to report double-digit declines in sales and earnings this week, Caterpillar has many dividend investors wondering about the safety of its current payout.
Caterpillar’s revenue has declined from $66 billion in 2012 to a projected $40 billion in 2016. The company’s retail sales have now fallen for more than 40 consecutive months.
None of this is new news from when I wrote my initial thesis on Caterpillar last fall. However, the macro situation does not appear to be getting any better.
In fact, billionaire hedge fund manager David Einhorn is now short Caterpillar. He expects the company’s stock to be more than cut in half over the next two years as the commodity supercycle continues to come to an end.
Despite the doom and gloom, the market reacted favorable to Caterpillar’s second quarter earnings report on Tuesday, July 26.
Caterpillar’s stock has surged more than 7% since Monday despite reporting a 16% drop in revenue and a 22% decline in adjusted earnings per share for the second quarter.
Most likely, investors are happy that Caterpillar’s outlook didn’t get materially worse – perhaps the current downturn in commodity markets is nearing a bottom and not as bad as Einhorn believes.
Regardless, most of Caterpillar’s key end markets are still feeling pain. Falling oil prices, depressed mining markets, and oversupplied construction equipment are all hurting volumes and pricing.
As a result, management slightly lowered Caterpillar’s full-year guidance.
Last quarter, management expected sales between $40 billion and $42 billion for 2016.
Today, Caterpillar sees sales coming in closer to $40 billion. Management cited additional uncertainty caused by the Brexit vote, unrest in Turkey, the U.S. election, the recent retreat in crude oil prices, and several other factors.
Earnings per share are expected to come in at $2.75 in 2016 and $3.55 if Caterpillar’s $700 million of restructuring costs are excluded.
As revenue continues to drop, Caterpillar is making every move it can to preserve profits. The company expects to take out over $2 billion in costs this year with its restructuring actions.
Combining office functions, laying people off, taking out manufacturing floor space, and reducing material costs are the primary drivers that will help Caterpillar increase its cost reductions from $1.1 billion year-to-date to more than $2 billion by the end of the year.
On the earnings call, management emphasized that maintaining Caterpillar’s “credit rating and the dividend are very high priorities.”
However, having lived through the financial crisis, we all know that sometimes there is only so much a company can do to protect its dividend.
This is particularly true for cyclical businesses with high financial leverage. Caterpillar is a meaningful position in our Top 20 Dividend Stocks and Conservative Retirees dividend portfolios, so I am keeping a particularly close eye on its dividend safety.
My goal is to never own a company that cuts its dividend, and the three portfolios in our monthly dividend newsletter have so far been successful with a combined 64 dividend increases and zero dividend cuts since their inception.
I believe there are a number of warning signs given by companies before they cut their dividends.
High payout ratios, stretched balance sheets, deterioration sales and earnings growth, weak free cash flow generation, and high business model volatility are a number of key indicators.
Let’s take a closer look at where Caterpillar is today to evaluate the safety of its dividend.
Dividend Safety Analysis: Caterpillar
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Caterpillar’s dividend and fundamental data charts can all be seen by clicking here.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. A score of 50 is average, 75 or higher is considered excellent, and 25 or lower is considered weak.
Caterpillar’s Dividend Safety Score is 35, which indicates that the company’s dividend payment is less secure than the average dividend-paying stock in the market but is not at extremely risky levels (yet).
Most companies that cut their dividends have Dividend Safety Scores below 25 prior to announcing their dividend cut.
For example, Kinder Morgan, ConocoPhillips, BHP Billiton, and Potash all scored below 20 for Dividend Safety before their dividend reductions were announced.
Let’s take a closer look at the drivers behind Caterpillar’s sub-par Dividend Safety Score.
Caterpillar currently pays annual dividends of $3.08 per share, which is close to twice the amount of dividends it paid in 2008 of $1.56 per share.
The company’s management team targets trough earnings per share between $2.50 and $3.50.
If Caterpillar’s earnings guidance for 2016 is accurate ($3.55 per share), its profits would sit at the high end of management’s targeted trough earnings range.
At that level, Caterpillar’s dividend payout ratio would be approximately 88% – a risky level for most businesses, especially a cyclical company such as Cat.
When a company pays out most or all of its cash flow as a dividend, it is potentially jeopardizing its future.
Funds for reinvestment opportunities can be reduced, competitive advantages can be eroded, and the company could run into a cash crunch if its access to debt and equity markets is cut off.
The latter reason is why many firms reduced their dividend payouts during the financial crisis when credit markets froze and cash became an invaluable commodity to have.
However, some companies with high payout ratios and a strong commitment to paying uninterrupted dividends possess strengths which help them continue paying dividends through hard times.
Select companies can choose to use cash on hand and/or take on debt to temporarily bridge any cash flow deficits caused by their dividend payments during periods of depressed business conditions.
Caterpillar is one of these businesses if push comes to shove.
Caterpillar paid out approximately $1.8 billion in dividends last fiscal year. While the company’s cash flow could continue declining over the next year or two, pushing its payout ratio over 100%, Caterpillar is fortunate to have nearly $6.8 billion in cash on hand.
Put another way, Caterpillar could use only its cash on hand to pay its current dividend for nearly four years before it would run out of money (assuming it did not need to make any debt repayments and continued generating positive free cash flow over that time).
The company’s business model and strong cost controls also enable it to continue generating free cash flow in virtually every economic environment, which reduces its need to dip deeper into cash reserves or tap debt markets during times of distress.
As seen below, Caterpillar recorded positive free cash flow of $2.82 per share in fiscal year 2008 and continued to generate excellent cash flow the last few years despite weakness across its key end markets.
Should the company need to raise cash, it shouldn’t have many problems either. Moody’s lowered Caterpillar’s outlook to negative in April 2016 but continues to give the company an investment-grade rating.
Furthermore, Caterpillar’s Machinery, Energy & Transportation business has a debt-to-capital ratio of 39%, which sits somewhat below my preferred threshold of 50%.
The company does finance a lot of its equipment to end customers, which could get it into serious trouble if these businesses cannot make their payments.
However, Cat Financial’s portfolio continues performing very well. Past dues were 2.93% during the second quarter of 2016, which is slightly lower than the 2.97% rate recorded in the second quarter of 2015 and lower than historical averages.
Caterpillar also maintains three credit facilities with $2.75 billion available. The majority of its credit availability expires in 2018 and 2020, providing the company with a nice backstop through at least the next several years.
Equally important, the company’s management team has been extremely committed to the dividend for over 80 years.
Caterpillar has paid a quarterly dividend every year since 1933 and increased its dividend for 22 consecutive years. In three years, the company will likely join the Dividend Aristocrats list, barring another major shock to the global economy.
Simply put, the company’s management is very determined to continue paying dividends and will seemingly pull every lever possible before making a cut.
As long as current macro conditions stabilize and Caterpillar’s cost reduction activities do not hurt its competitiveness, I believe the dividend should be safe.
However, if David Einhorn’s short thesis plays out and commodities move lower for longer, Caterpillar could find itself in a situation down the road where its dividend could legitimately be at risk.
For now, I view this as a low probability event but will keep my eye on macro developments. Caterpillar’s management team is obviously feeling cautious as well, choosing to forego the usual dividend increase in June.
Closing Thoughts on Caterpillar’s Dividend
I believe Caterpillar’s dividend is safe for at least the next year or two if current macro conditions do not improve or even experience a moderate decline.
However, the company’s margin of safety is admittedly low if commodity markets take another leg down, which is certainly a possibility (sales plunged nearly 40% in 2009 to $32.4 billion).
I wouldn’t mind rotating into a blue chip dividend stock with a safer, faster-growing dividend payment – especially if Caterpillar’s stock continues to rally higher.
However, there is not a great sense of urgency today given Caterpillar’s operational strength, continued free cash flow generation, and generally healthy credit position.