For many years, Caterpillar (CAT) was known as a dividend growth company and it had a long history of raising dividends year after year; however, since the summer of 2015, the company has been going 11 quarters without a meaningful dividend increase if we don't count the 1 cent-per-share increase that happened last July, moving the company's payment from 77 cents per share to 78 cents per share. In this article, I will explain several reasons that compel me to think that a meaningful dividend raise is in the horizon.
Reason 1: CAT's balance sheet is in much better shape
In the last few years, Caterpillar has been on a mission to improve its balance sheet. The company has been adding to its cash position while reducing its debt load. As a result of this, since the big reorganization in 2015, the company's net total long-term debt dropped from $33 billion to $26 billion, representing a solid drop of 21%.
During the same period, the company's cash position improved significantly from $6 billion to $8.26 billion, an increase of 38% and this is despite the fact that the company spent a lot of money on reorganizing and reinventing itself while closing down facilities, opening new facilities, moving production from one location to another, and each of these activities are known to be capital intensive. It is very rare for manufacturing companies to increase their cash position while going through a major re-organization but Caterpillar has accomplished that.
Between 2014 and 2015, the biggest threat for Caterpillar was the massive amount of inventory the company was sitting on. It had too many products but not enough buyers while the company struggled to become flexible enough to reduce its inventory by cutting production when demand for its products was falling. Since then the company was able to get a better control over its production rate and became better at inventory management. Since 2014, finished goods inventory levels fell from nearly $8 billion to $4.76 billion. While things are not yet perfect, they are in a much better shape and the company is in a much more comfortable position to manage its inventory.
As a result, the company's long-term debt (net of pension obligations) have been getting under control. Since 2015, Caterpillar's long-term debt levels have been coming down steadily and the company's balance sheet is in a much better position than it was back then.
Reason 2: The reduced share count makes it cheaper for pay dividends
Even though the company went through 11 quarters without increasing its dividend payments meaningfully, it continued to buy its shares back as much as it could. As a result, the company's diluted share count dropped from 670 million to 607 million between 2014 and now. This represents a drop of 9%, which means that there are now 9% fewer shares that are getting dividend payments from the company. As a result, the company's total dividend payment dropped by 9% during this period and now it can afford to raise the dividend by at least this much without suffering much. Considering that the company currently pays 78 cents per quarter per share, it pays $3.12 per share annually. A drop of 63 million in share count saved the company nearly $200 million per year in dividend costs this year compared to 2014.
Reason 3: The future looks brighter for the company
After reaching its "peak performance" in 2012 with revenues reaching $66 billion and net profits passing $5.68 billion ($8.48 per share), the company's financial performance dropped year after year, finally bottoming in 2016 with revenues of $38.5 billion and "adjusted" profit of $3.42 per share. Now Caterpillar's financial performance has a lot of catching up to do until the company repeats its 2012 performance and the company is better positioned to get there.
If Caterpillar were to repeat its "peak performance" of 2012, it would generate much better results than it did back then. Let me explain why this is the case. The global economy has been growing at an annual rate of 2.5% between 2012 and now, which means that the global economy is currently 16% larger than it was back in 2012. Since it will probably take Caterpillar 5 years to reach its peak performance at the current growth rate, our target date is 2023 (we'll work our way back from 2023 to 2019). By then, the global economy will be 31% bigger compared to its size in 2012 (yes, this is a good example for power of compounding). So the company's potential revenue will be as high as $87 billion since the company achieved a revenue of $66 billion when the global economy was 31% smaller.
At the same time, as I've already said before, the company's share count has been dropping significantly at an average rate of 1.5%. By 2023 (our target date), the company's share count will be about 20% lower than what it was in 2012. This boosts the "average per share" gains significantly. If the company was able to earn $8.48 per share on revenues of $66 billion and an average share count of 670 million, it should be able to achieve a much higher number on revenues of $87 billion and share count of 540 million. We are looking at anywhere from $11 to $13 per share in net income. We are not finished though.
Now we have to calculate the fact that Caterpillar's tax bill will be much smaller than what it was in 2012 due to the tax bill that was passed by the congress and signed by the president. In 2012 at its peak performance, Caterpillar paid $2.53 billion in income taxes on an income of $8.24 billion, a rate of 31%. Now with the new corporate tax rates, the company's tax rate should drop by anywhere from 8 to 10% and its income should get boosted by that much. Now we are looking at $12 to $14 per share.
If the company can achieve that, it can easily support a dividend of $5-6 per share. Since the current dividend payment is $3.12 per share, we are looking at a dividend growth rate of anywhere between 40% to 90% in the next 5 years. Of course, this won't happen overnight, so the company will be raising its dividends in smaller steps. Working out way back from 2023 to today and using compounding mechanics, we find that a 10% annual dividend growth rate from today's $3.12 would give us $5 per share and a 14% annual dividend growth rate would give us $6 per share by 2023. Given Caterpillar's past performance and current growth trajectory of the company (and accounting for global GDP growth, reduced share count and lower tax rates), the company is in a good position to deliver this.
In conclusion, I wouldn't be surprised to see a 10-14% dividend rise next year and every year after that for the next 5 years.
Disclosure: I am/we are long CAT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I've worked with Caterpillar as a consultant in the past but I don't represent the company in any way, shape or form.
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