Caterpillar: An Industrial Machine Maker with an Impressive Dividend Growth History

Founded in 1925 with a product line consisting of just five tractors, Caterpillar (CAT) has grown to become the world’s largest industrial machine maker, with its hands in all major infrastructure industries.

The company primarily sells construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.

Caterpillar operates through four business segments: 

In addition to sales of heavy equipment, approximately 33% of Caterpillar’s revenue is tied to higher-margin aftermarket parts and services. Geographically, about 60% of the firm's revenue is generated outside of America.

Caterpillar has paid a quarterly dividend since 1933 and is a dividend aristocrat with 26 consecutive years of dividend increases.

Few companies boast lengthy dividend growth track records in capital-intensive and cyclical industries such as heavy equipment manufacturing. 

After all, high fixed costs and volatile revenues, which are driven by construction and commodity cycles, make for unpredictable cash flow any single year.

However, Caterpillar has proven to be an exception over the decades thanks to its industry-leading scale and several other advantages, beginning with the 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 over a million. Equipment buyers need to have their pricey machines working as best as possible to reduce costly downtime.

Since its founding in 1925, Caterpillar has invested heavily in research and development (nearly $2 billion annually in recent years) to develop a reputation for building some of the most reliable and rugged equipment on earth.

But more importantly, Caterpillar has developed the most extensive sales and service network in its industry with independent dealers and branches in more than 190 countries.

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's entrenched position.

Simply put, Caterpillar's large dealer network is a critical advantage that helps the firm more easily win new orders (especially with multinational customers), resupply old sales, and maintain a leading position in almost all of the markets it competes in.

With over 4 million pieces of Caterpillar equipment in use worldwide, the company's services business accounts for over 30% of firm-wide revenue and is expected to be a key growth driver going forward. In fact, management aspires to double services' revenue from $14 billion in 2016 to $28 billion in 2026. For context, Caterpillar's 2019 revenue totaled $53.8 billion.

Caterpillar expects to connect more of its machinery to the cloud (nearly 1 million of its assets are already connected) to bolster the capabilities and growth of its services business. These advancements can help clients see equipment degradation coming and better plan preventative maintenance to minimize downtime.

Not only do services carry higher margins compared to original equipment sales, but they also provide a far more stable cash flow stream since maintenance work is less discretionary in nature.

Combined with substantial restructuring activities completed in recent years, which included reducing Caterpillar's manufacturing footprint by nearly 30% since 2014, the company's profitability is expected to remain stronger in the future.

For example, Caterpillar's operating margin historically ranged between 7% and 15% throughout a cycle, but management now expects margins to hover between 10% and 21%. 

This gave management the confidence to boost Caterpillar's dividend by 20% in 2019 with high single-digit annual dividend growth targeted through 2023. Even with a higher dividend, Caterpillar believes its free cash flow payout ratio will only reach about 60% during a low sales period thanks to its restructuring efforts.

Along with its excellent A credit rating from Standard & Poor's, Caterpillar remains positioned to continue rewarding income investors with dependable dividends regardless of where the economy heads. 

Though the business and its stock price will continue their cyclical swings, the world's growing population should support more demand for infrastructure and commodities over time, supporting Caterpillar's long-term outlook for growth.

However, there are several important risks investors need to keep in mind.

Demand for Caterpillar's heavy equipment is very sensitive to commodity prices (oil, coal, iron ore, copper, etc.) 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 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 represent major investments 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.

Caterpillar's strong balance sheet, structurally improved free cash flow generation, and increased focus on non-discretionary services should keep its dividend secure during future downturns, but long-term investors holding the stock need to be prepared for periodic bouts of macro-induced volatility.

Otherwise, given Caterpillar's large and diversified installed base, plus the mission-critical nature of its products, it's hard to identify risks that could impair the firm's long-term outlook. 

Perhaps the biggest challenge will be Caterpillar's ability to maintain premium pricing as technology (i.e. connected machines) has the potential to transform relationships with customers in the years ahead. However, management appears to be making the necessary investments to keep Caterpillar a leader.

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 time.

However, investors considering the stock need to have a stomach for volatility given Caterpillar's sensitivity to the global economy. The best time to buy a company like Caterpillar is usually when investors are pessimistic about short-term demand trends.