From 2012 to 2014, Caterpillar Inc. (NYSE:CAT)’s stock generated an annualized return of 2.8%, significantly trailing the market’s annualized return of 20%. Year-to-date, CAT is down 22% and lags the market by more than 20%. As the commodity super cycle fueled by China’s unsustainable infrastructure growth continues unwinding, it comes as no surprise to see CAT struggle over the last few years.

The company expects revenue to be down another 5% in 2016, marking the first stretch of four consecutive years of revenue declines in the company’s 90+ year history.

CAT has experienced cyclical downturns before, but the current depressed environment seems different, more prolonged. Unlike the typical V-shaped cycle, this one is coming off of 10+ years of what looks to have been excessive commodity demand, driven by China’s debt-fueled infrastructure binge.

As seen below, the price of copper (a proxy for China’s demand growth) skyrocketed from 2003 through 2008, rising from less than $1 per pound to nearly $4 at the peak. Since 2012, when CAT’s current bout of weakness started, copper has painfully slid from about $4 per pound to $2.40 per pound today. Not a complete retracement to pre-boom levels, but a substantial amount of pain has already been incurred. Still, we could reasonably see another few years of declining prices as global growth remains anemic, China’s economy continues transitioning, and commodity producers slowly rebalance supply with demand after years of overbuilding mines and infrastructure.

CAT Copper Price

Source: InfoMine

When you combine this fact with the long-lived nature of CAT’s large machinery (most equipment is expected to last 10-20 years), the fragile financial state of many commodity producers (i.e. CAT’s customers), and the significant amount of uncertainty surrounding global growth, it is no surprise to hear that many customers are not even replacing their current equipment fleets, much less ordering new machinery.

Just how bad are things today? Within CAT’s dwindling mining business, sales are below the levels it experienced during the financial crisis and, according to management, are “far below replacement levels.” Within China’s construction markets, CAT noted that the industry there is near 10-year lows and also operating below replacement level.

The collapse in oil price, strong US dollar, recessionary conditions in emerging markets like Brazil, and sluggish demand trends in developed countries have further exacerbated CAT’s weakness. Altogether, revenue has declined by more than 30% since 2012, with weakness in CAT’s most profitable Resource Industries segment (mining business) driving 2/3 of the losses. Sales fell 19% in Q3 and are expected to retrace another 5% next year.

We are most concerned about the mining industry going forward. Oil headwinds seem likely to continue hurting the business over the next year and potentially even worsen (e.g. smaller US operators declare bankruptcy), but the price of oil seems to have less secular headwinds than metals overall (your macro forecast on this one is as good as ours). Within construction, outside of China, we don’t see secular pressure either – economies will continue to (slowly) grow.

To be clear, we wouldn’t be interested in the stock if mining end markets still accounted for a substantial amount of CAT’s earnings (we estimate mining sales are less than 15% of the business, with a large amount of that related to aftermarket business). We only buy dividend-paying companies that we think will generate substantially more earnings in five years than they do today, and we can’t say that about most companies depending on the mining industry.

CAT is doing the best it can to weather this storm, announcing substantial restructuring actions in September – a sign that management isn’t bullish on market weakness subsiding anytime soon – and maintaining a stronger balance sheet than it had going into 2008-09. We are also keeping our eye on CAT’s financing arm, which helps dealers to sell or lease equipment to end users on favorable terms. At the end of the quarter, past dues were 2.68% compared with 2.81% at the end of the third quarter of 2014. CAT’s allowance for credit losses was 1.26% of finance receivables, compared with 1.37% last year. Despite challenging markets, CAT’s credit portfolio continues to perform relatively well and doesn’t appear to be in any danger of blowing up despite customers’ struggles.

CAT’s market share has also increased every year since 2010, and its competitive advantages are only strengthening relative to its competitors, in our opinion. While it won’t help demand trends over the next few years, CAT’s massive dealer network makes it a more attractive supplier for customers since it can reliably keep their expensive equipment up and running almost anywhere around the globe. Unplanned downtime is extremely costly, so this is a very important advantage.

We expect the company’s dealer network improvement plans and data and analytics initiatives to further capitalize on this foundational strength. CAT has more than 3 million machines and engines in service around the world. With smarter analytics and sensors, CAT’s dealers can predict maintenance needs, better track assets, and more to improve high-margin service revenue and raise customer intimacy even more. While these investments are being made, the company’s restructuring plan announced in September will help offset some of the earnings decline related to declining sales growth. CAT’s restructuring actions are expected to lower operating costs by $1.5 billion annually once they are fully implemented, with about $750 million of that expected in 2016. To put the size of these benefits in perspective, CAT generated about $5.6 billion in free cash flow last year. $1.5 billion in annual cost savings is significant, and most of the benefits seem fairly low risk (layoffs and some plant closures).

Of course, management’s commentary from the Q3 earnings call encouraged investors to think longer-term about population growth, the need for infrastructure spending, and increasing consumption of resources eventually creating a much healthier environment for its customers. While these are fair assumptions, they could also be 5+ years away from materializing and do nothing to help the stock until then. Although we typically invest with a 3-5 year time horizon in mind, most investors want to know what will happen with profits over the next year or two, and we can’t blame them with such a cyclical stock. Before we explore a few downside scenarios, let’s take a quick look at the health of CAT’s dividend.

Dividend Analysis

CAT’s dividend continues to clock in average Safety (47) and Growth (54) scores using our proprietary dividend rating system. Management has repeatedly stated the dividend is a priority, and CAT’s actions have more than demonstrated this fact. The company has paid a quarterly dividend every quarter since 1933 and has raised its dividend every year for over 20 consecutive years – it will likely become a dividend aristocrat in three years, barring a prolonged global recession.

Looking at some numbers, CAT has about $6 billion in cash on hand compared to the $1.6 billion it paid out in dividends last year, and its debt ratios are reasonable. The company has generated free cash flow in each of the past 10 years, including $2.82 free cash flow per share during the financial crisis. The current annual dividend payout is $3.08 per share, suggesting CAT is in good standing even in the event of another unlikely crash. Recently announced restructuring actions provide further cushion.

Valuation & Closing Remarks

During the depths of the 2008-09 financial crisis, CAT’s stock traded down to $23, but mostly hung out around $30 to $35 during the market’s darkest days.

The company’s free cash flow per share troughed at $2.82 in fiscal year 2008 and its earnings per share (excluding labor redundancy costs) were $2.18 in 2009, meaning the company traded at about 10-13x trough-level profits during this depressed period.

Heading into the recession, CAT enjoyed 14% sales growth in 2008 and saw total revenue reach $51.3 billion (compared to expectations of -5% growth and sales of $45.6 billion in 2016) before being blindsided. Earnings fell around 60% the next year as sales collapsed by 37% to $32.4 billion.

Year-to-date, CAT’s free cash flow generation is down 30% compared to the first three quarters of 2014. The company looks like it will generate about $6.25 per share in free cash flow for the full year, nearly a 40% decrease since fiscal year 2013.

We view another 50% plunge in cash flow as being extremely unlikely. CAT’s historically most profitable business, mining, is less than 15% of revenue today, with a substantial amount of that residing in less cyclical aftermarket business. In Q3, the segment holding most of CAT’s mining-related revenue (Resource Industries) did not contribute positively to operating profit either. As such a small portion of CAT’s overall mix, it poses much less downside risk than it did in 2008-09.

Regardless, let’s look at a few “what-if” scenarios. The top table below projects CAT’s free cash flow per share for 2016 (or later) based on four different growth assumptions: -10%, -25%, -40%, and -55%. The range of outcomes is from $2.81 (in line with the 2008-09 low) to $5.63. On the right, we apply trough-level free cash flow multiples ranging from 10x to 13x to derive a range of potential stock prices.

The next table shows the price return (excluding dividends) that would result from the first set of assumptions. The final table shows the implied dividend yield based on each potential stock price.

CAT Downside Risk Analysis

Source: Simply Safe Dividends

The rows highlighted in yellow represent our best guess at reasonable downside scenarios, with price returns ranging from -15% to -30%. This would imply a dividend yield between 5% and 6%, similar to where CAT traded during the financial crisis (its average low stock price range of $30 to $40 per share was good for a dividend yield of 4.2% to 5.6%, but it did plunge to a low of $23 for one day – a yield of 7.2%).

While a global recession could cause a cyclical company like CAT to slump 40%+, we think that is an extreme and unlikely outcome – just today we saw China cut rates again and free up its banks to lend more (granted it was in response to continued sluggish growth trends), and the European Central Bank is hinting at additional stimulus as well. While central governments cannot fight the forces of nature and free markets forever, we would be shocked if they let the world slip into another recession without using all of the firepower they have left to try and fight it off.

To conclude, expectations surrounding CAT have significantly declined over the last three years. The commodity super cycle could take another several years to unwind, but the area we have been most concerned about (mining) has become a nearly insignificant portion of CAT’s overall mix. Should construction activity pick up in developed markets or oil prices recover, we think the stock could enjoy a substantial return relative to our current estimate of downside risk.

Dividend investors who cannot stomach much volatility or maintain a 3-5 year investment time horizon would be best looking elsewhere for yield. Otherwise, we think the stock’s 4.3% dividend yield and reasonable downside risk are attractive despite the negative macro news surrounding the business. CAT is one of the stocks we consider for our Top 20 Dividend Stocks list.

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