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Caterpillar (CAT)

Founded in 1925, Caterpillar (CAT) is the world’s largest industrial machine maker, with its hands in all major infrastructure industries. The company manufactures and sells construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. Its network of 171 mostly independently owned and operated dealers sells its products in over 190 countries and territories around the world. 

A meaningful amount of Caterpillar’s revenue is also tied to higher-margin, less volatile aftermarket parts and components; however, the company does not disclose the size of its aftermarket business.
Source: Caterpillar Investor Presentation
The company operates through four main business segments.

  • Construction Industries (42% of 2017 sales, 43% of 2017 segment profits): makes backhoes, site prep tractors, excavators, and motor graders; pipelayers, telehandlers, cold planers, asphalt pavers, compactors, road reclaimers, and wheel and track skidders.

  • Energy & Transportation (35% of 2017 sales, 38% of 2017 segment profits): offers engine-powered generators, centrifugal gas compressors, diesel-electric locomotives and components, and other rail-related products and services.

  • Resource Industries (16% of 2017 sales, 9% of 2017 segment profits): produces electric rope and hydraulic shovel, landfill and soil compactors; dragline, large wheel loader, track and rotary drills; electronics and control systems; work tool, hard rock vehicle and continuous mining systems; scoops and haulers; wheel tractor scrapers; wheel dozers products; continuous miners; and mining, off-highway, and articulated trucks.

  • Financial Products (7% of 2017 sales, 9% of 2017 segment profits): primarily offers financing for Caterpillar equipment, machinery, and engines.

In general, Caterpillar makes most of its money from the road construction and heavy construction industries, with about 50% of sales from North America.
Source: Caterpillar Investor Presentation
Note, however, that Caterpillar is gradually becoming more diversified geographically thanks to faster sales growth in Asia (specifically in construction equipment). By the end of 2017, approximately 59% of Caterpillar's revenues were coming from outside the U.S. 

Business Analysis

You typically don’t find companies with lengthy dividend growth track records in capital intensive and highly cyclical industries such as heavy equipment manufacturing.

That’s because high fixed costs and volatile revenues, which are heavily influenced by global commodity markets, make for extremely unpredictable earnings, cash flows, and margins over time. 

However, Caterpillar represents a potential exception due to its industry-leading scale and several other competitive advantages. One of the key strengths Caterpillar enjoys is the highly complex nature of the machines it builds.

For example, a single piece of heavy equipment usually costs hundreds of thousands of dollars, while mining equipment can cost millions. Buyers of such mission-critical equipment rely on highly reliable machines to help keep their production steady, because a defective device can mean production disruption and large losses.

And due to the extreme conditions in which its machines operate (temperature ranges of -40 to 125 degrees Fahrenheit), Caterpillar has spent over 100 years building up a reputation for some of the most reliable and rugged heavy equipment on earth.

A key to this reliability is Caterpillar's focus on not only producing components, but the entire machine, giving it far greater quality control over the end-to-end manufacturing process. The company also spends more than any other rival on R&D ($1.9 billion in 2017, or 4.2% of total sales) to continually improve its products, making them more competitive, reliable, and cost effective given their lower lifetime operation costs.

For example, Caterpillar was one of the first equipment makers to install data-gathering sensors in its machines (which number over 3 million worldwide), allowing clients to monitor how their equipment was operating in real time.

In the future, the company plans to connect more of these sensors to the so-called "internet of things" (IoT). IoT allows industrial clients to be able to see equipment degradation coming and better plan preventative maintenance and repair schedules to minimize costly downtime and boost profitability.

Maintenance and uptime are critical value propositions in the large equipment market, and data analytics investments should help Caterpillar deliver even better on these metrics. By becoming smarter about internal operations, dealers can services dozens more customers per day.

With faster, more relevant service, Caterpillar’s equipment and brand value will likely increase in customers’ eyes, supporting the premium pricing its brand enjoys.

Simply put, technology has the potential to transform the supplier/customer relationship over the next 5 to 10 years, and Caterpillar is investing to take advantage of this emerging opportunity.

Another major advantage Caterpillar has is its globe-spanning distribution network which consists of 171 independent distributors in 3,500 locations that employ about 150,000 contractors. 

Distributors are the sales representatives of the company, many with decades of local expertise in what industrial clients want and need in terms of heavy machinery. Local dealers are simply more knowledge about their communities than a giant like Caterpillar could ever be, making them more effective at selling and providing a better customer experience.

Importantly, the company's dealer network is also how Caterpillar distributes its maintenance and repair parts, including through its aftermarket service contracts. 

Aftermarket parts and service contracts are usually much higher margin (and less discretionary) than original equipment sales. As a result, they create a far more stable cash flow stream that can help Caterpillar get through lean times, such as when commodity prices collapsed between 2013 and 2016.

A machine that breaks can stop an entire job, so restarting work in a few hours compared to a few days can make or break a project’s financial and operational objectives. Therefore, large dealers with a global presence and plenty of parts and technicians are a big selling point influencing a customer’s purchase decision – a rapid response rate to machine breakdowns is essential.

With machines lasting for decades in many instances, partnering with a financially healthy and proven dealer is another important consideration for customers. Lower-priced Asian competitors lack a global dealer support network and don't have the same reputation as Caterpillar, so they struggle to take share from the company.

Overall, the company’s large dealer network is a critical advantage that helps Caterpillar more easily win new orders (especially with multinational customers), resupply old sales, and maintain global market share. As the company continues expanding its base of machines that require servicing, this advantage should only strengthen. 

The combination of the firm's well-earned brand (analyst firm Interbrand says Caterpillar is the world's most valuable heavy equipment brand) and large distribution network is largely why Caterpillar enjoys number one or two market share positions in each of its product categories. Globally the company commands about 20% market share, which is roughly twice that of its nearest rival, Japan's Komatsu.

The final competitive advantage Caterpillar enjoys is the industry's best economies of scale. Specifically, the company's global reach means it can source low-cost components in bulk at the cheapest prices that still meet its strict quality standards.

During the last industrial recession, the company also embarked on a major restructuring effort focusing on streamlining its manufacturing, selling off less profitable non-core brands, and optimizing its workforce. This led to about $3.2 billion in restructuring costs between 2015 and 2017 but allowed the company to become much leaner, while improving product quality by 40%.

The end result is that Caterpillar recorded a 10% operating margin in 2017, which is nearly double the industry's average margin of about 6%. Management believes that its restructuring efforts will allow the company to achieve operating margins of about 16% in the future. Caterpillar's financial conservatism and ability to continually adapt to challenging market conditions is why the company has been able to either maintain or grow its dividend for 22 consecutive years across all sorts of economic, industry, and interest rate environments. 

Going forward, Caterpillar is likely to benefit from several long-term growth drivers, including the U.S. energy boom. For example, the U.S. Energy Information Administration projects that U.S. shale oil production will grow 30% in the coming years and then remain stable through 2040. Meanwhile, U.S. gas production is expected to grow through at least 2050. More construction equipment, generators, and transportation gear will be needed to support this production growth. 
Source: U.S. Energy Information Administration
Another long-term growth driver is the continued rise in the global population which is expected to increase from about 7.6 billion people at the end of 2017 to 8.5 billion and 9.7 billion people by 2030 and 2050, respectively. Most of the world's population growth is expected to be concentrated in emerging economies such as Asia, and by 2050 it's estimated that 66% of the world's population will live in cities.

The combination of a rising and increasingly urbanized global population means that energy consumption is also expected to grow strongly through 2040. That includes a 19% increase in fossil fuels which are projected to still account for 77% of the world's energy usage by 2040. 
Source: Caterpillar Investor Presentation
Meanwhile, construction spending is projected to increase by about $15 trillion by 2025. And overall infrastructure spending, which requires a lot of heavy, is projected to total $94 trillion between 2018 and 2040, according to analyst firm GIH. 

Caterpillar, as the world's largest heavy equipment maker, is well positioned for potentially decades of profitable growth (although the path certainly won't be linear, as we've seen in recent years). Along the way, the company's shareholder-friendly corporate culture means that dividend growth investors are likely to continue enjoying dependable, rising income over time. 

However, there are several important risks investors need to keep in mind before adding Caterpillar to their portfolios. 

Key Risks

First, it can't be stressed enough how cyclical heavy equipment sales and earnings can be. Caterpillar's end markets are extremely sensitive to commodity prices and the health of both local and global economies, which can result in extraordinary boom and bust cycles. 

For example, in the late 1970's Argentina's economy was flourishing as high commodity prices drove very strong growth in mining and resource extraction. Caterpillar went from selling 1,200 mining machines per year in the late 1970's to a total of four machines in 1981, 1982, and 1983 when Argentina experienced a debt crisis that devastated its economy. 

Large pieces of equipment cost hundreds of thousands of dollars, if not millions, and generally last at least 10 years. When budgets tighten in a downturn, customers put off buying new equipment and flood the market with used equipment. If this goes on long enough, Caterpillar's dividend could become less secure, especially if management stretched the company's balance sheet before the unexpected downturn.

While Caterpillar’s strong focus on reliable, durable, and high-tech equipment has been a big success in Western markets, in emerging economies the company has struggled to win similar market share. End users in those nations often focus more on the upfront cost of machines and less on the long-term operating costs, which could hinder the company’sinternational growth efforts over the long term.

China, which has represented a major growth market for Caterpillar in recent years, also comes with its own risks. For one thing, the recent trade dispute between the U.S. and China might end up harming Caterpillar's market share in that country since it could face steep tariffs on its equipment. 

In addition, be aware that China's recent strong growth has been partially driven by that nation's response to the 2008-2009 global financial crisis. Specifically, China's instituted a massive stimulus plan focused on the manufacturing and construction industries. In 2017, nearly 20% of China's GDP came from construction (compared to about 6% in the U.S.). 

While great for construction equipment makers like Caterpillar, the risk is that China has massively overbuilt its infrastructure needs for the sake of boosting short-term economic growth. Low capacity utilization is threatening the solvency of many of its heavy manufacturing industries, which have been kept afloat by large, cheap loans from state-owned banks. If China's construction boom cools off, Caterpillar could face some growth challenges. 

Investors also need to realize that Caterpillar's individual segments, such as Resource Industries, are heavily tied to just a few key commodities. This includes coal mining which accounted for 30% of that segment's sales in 2017 and 5% of company-wide revenue. 

Coal is in a secular decline due to several factors, including a global effort to lower emissions. For example, the U.S. and much of the world are shifting from coal to gas-fired power plants, which emit 50% less CO2. 

Furthermore, the same U.S. energy boom that provides a long-term growth runway has also pushed natural gas prices much lower than the price of coal (per energy unit equivalent). In other words, coal will likely serve as a growth headwind, partially offsetting rising sales in other business units. 

Besides volatile commodity prices, Caterpillar's short-term results can also be affected by fluctuations in foreign currency exchange rates. As the company’s sales increasingly come from overseas markets, Caterpillar will become more and more exposed to this. A strengthening U.S. dollar increases the cost of its products in foreign countries and hurts reported earnings growth domestically (when local currencies are converted to U.S. dollars for accounting purposes).

Finally, investors should be aware that Caterpillar has used record low interest rates over the past few years to take on a lot of debt. Today the company's total debt stands at nearly $35 billion and its debt/EBITDA ratio is 4.3, much higher than the industry average of 3.0. Thanks to a strong credit rating ("A" per S&P), the company's average interest rate is just 3.4%, and Caterpillar's cash flow should have no problem servicing its debt. 

However, in a rising interest rate environment, Caterpillar is likely to face rising refinancing costs in the future. Management will have to prioritize deleveraging the balance sheet, which could result in somewhat slower dividend growth despite the company's growing earnings.

Closing Thoughts on Caterpillar

When it comes to heavy machinery makers, they don’t get much better than Caterpillar. The company’s long operating history, entrenched products, substantial dealer network, and conservative management have helped Caterpillar maintain its dividend throughout the industry's best and worst conditions over the last few decades.

That being said, as a highly cyclical company, Caterpillar may not be the most appropriate selection for a very conservative retirement portfolio. Investors considering the stock need to have a stomach for some price volatility, maintain a well-diversified portfolio, and keep tabs on the industry's health. The best time to buy a company like Caterpillar is usually when investors are pessimistic about short-term demand trends. 

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