The Dow Jones Industrial average is the second oldest market index. Although still one of the most often consulted barometers of the condition of the stock market, it is now really more of an industrial index by designation only, as the components within it comprise a much broader swath of domestic business fields. Today, Caterpillar (CAT - Free Caterpillar Stock Report) stands out as a true industrial company still harbored in the Dow 30.
With significant exposure to economic cycles, Caterpillar’s results are often steered by the end markets it serves, for better or worse. In the U.S., the blue chip’s first-quarter sales grew 9%, year over year, as the domestic construction industry grew at a decent clip. Furthermore, second-quarter results will likely be supported by housing starts that, in April, were at the highest level in seven years. Elsewhere, the Energy & Transportation segment’s sales have been resilient, although management has suggested that this strength is unlikely to persist due to headwinds associated with lower oil prices.
However, sluggishness in every other major geographic region is more than offsetting these positives. Construction activity abroad is particularly weak. In all, the top line regressed 4% last quarter, as we can deduce from the Quarterly Sales box. Moreover, as pressure mounts from the oil-related portion of CAT’s business, near-term sales will probably be hampered further. Also problematic is pronounced mining industry softness due to persistently low commodity prices of late.
But that’s not all. Foreign exchange rates are a universal concern among multinational corporations this year. As indicated in the Blurb, 62% of sales were derived from beyond domestic borders in 2014. Far-flung operations present headwinds where the euro and Japanese yen have weakened relative to the dollar. Maintaining market share can be a challenge in this environment since the strong dollar allows overseas rivals to be more competitive.
Surprisingly, although revenues fell, earnings actually rose in the first quarter. Substantially reduced restructuring costs in the period coincided with seasonally soft expenses, allowing an expansion of profit margins. March-period share net of $1.86 was well above Wall Street’s consensus and topped the prior-year tally by a double-digit percentage. Yet by scanning across the Quarterly Earnings box, it seems unlikely that the company will repeat this feat in any period for the remainder of the year.
As its end markets struggle to gain traction, this blue-chip stock has been underperforming the broader market. We can ascertain this from the Total Return box, which provides dividend-adjusted returns of the individual equity compared alongside amalgamated market performance. While CAT has not bested this average in the one-, three-, or five-year span, perhaps most startling is that while the Value Line Arithmetic Index has exhibited a total return of 58.8% over the last three years, CAT shareholders have seen the value of their holding erode by 9.7%.
Shifting our attention to the Array, we can see that annual performance has been inconsistent. Still, the dividend has been raised with regularity of late. In 2014, the distributions made up 40% of net profit, telling us there is room for expansion. (Generally speaking, an annual payout below 50% is a good sign that there is ample opportunity for the dividend to grow.) With sufficient clearance, profit growth may not necessarily be a required precursor to dividend growth. That may be an important consideration due to the high probability of earnings retreating in 2015.
We are not factoring a dividend raise into our estimates this year. Based on an assumption of a static quarterly payout and shrinking earnings, the dividend to net profit ratio would escalate to over 50%. If, on the other hand, the company does decide to raise its distribution, we suspect it would favor the August payout as the time to do so, using historical distributions in the Quarterly Dividends Paid box as a reference. Any hike would likely be slight, and we would encourage a conservative approach by considering a raise as a bonus rather than a sure thing. Meanwhile, the yield (as seen in the Top Label) is substantial, about 50% greater than the median of all dividend payers in the Value Line universe.
There is seemingly no sufficient catalyst for strong stock performance in the near term. If commodity prices bounce back from this prolonged slump, CAT stands to benefit. Still, it is better to buy into an equity with cyclical exposure when those factors begin to trend in a positive direction. To us, it seems too early to predict that transformation in many of CAT’s end markets. Considering the battle against persistent headwinds, the dividend alone is not enough to substantiate this equity as a top investment selection. The neutral Timeliness rank (found in the Ranks section) confirms that this issue does not stand out for relative near-term price performance. Growth and momentum investors should stay on the sidelines.
In the final paragraph of the Comment, our analyst Dominic B. Silva writes, “The stock is trading at a P/E multiple that is well above the level we project by 2018-2020.” With this, we can glean the correlation between price-to-earnings multiple and long-term capital appreciation potential. Earnings are projected to rise in the 3- to 5-year span, which makes sense considering that various stimulus efforts going on abroad will take some time to materialize into better-performing economies, much like what has been the case in the U.S. over the last several years. However, multiple compression is apt dampen stock returns. Indeed, the company’s relative P/E ratio, though lower than the market average, is quite high compared to its historical norms, as we can see in the Array. Therefore, buy-and-hold investors may also be better suited elsewhere, at the recent valuation.