Caterpillar – The Right Timing to Buy Tonkas

Caterpillar Inc. is a manufacturer of construction and mining equipment, diesel & natural gas engines, industrial gas turbines & diesel-electric locomotives. Its segments include Resource Industries, Construction Industries and Power Systems. It is highly linked to the mining and home construction industries. stock report

-Seven Year Revenue Growth Rate: 3.78%
-Seven Year EPS Growth Rate: 2.61%
-Seven Year Dividend Growth Rate: 12.84%
-Current Dividend Yield: 3.17%

Overview

While the US housing construction industry finally came back from the dead, the mining industry is falling into a deep sleep due to the lack of demand. Emerging markets are not so emerging anymore and their appetite for resources has slowed down. But this is short term news. The truth is that CAT is highly diversified among the mining, construction & energy and transportation industries. Global energy demand growth will continue to sustain the E&T division while construction won’t slow in the States anytime soon. Since sales and profits have declined over the past 12 months, CAT has tightened its control over inventory and costs. The company is now leaner and stronger. The demand for resources will reappear at one point and the mining industry will benefit from it. CAT is the leader in mining equipment; it will get its share of the cake at that point.

While CAT is a very strong pick for a long term perspective, it might be riskier over a short period such as 12 months. If the mining industry continues to slow down as is the case right now, CAT might not be able to meet its double digit growth projection. For that reason, I think you should take a careful look at this company before going forward.

Ratios

Price to Earnings: 14.17
Price to Free Cash Flow: 13.46
Price to Book: 3.145
Return on Equity: 20.73%

Revenue

CAT Revenue

As previously mentioned, Caterpillar is suffering from the global economic slowdown for resources. Low oil prices reduce the demand for drilling equipment. Then, emerging markets appetite for resources has seriously declined leading the mining industry downward. The US construction environment is doing well, supporting Caterpillar’s revenue at the moment. However, we don’t expect much growth in the upcoming year. CAT is a cyclical company evolving in a tough market at the moment. It may be the right time to invest. Let’s take a look at others metrics.

Earnings and Dividends

CAT earnings and div

Throughout the years, I’ve built a serious investing model including 7 rules of investing. These rules were built based on much stock researches and my 13 years as an investor. Here’s the first rule:

#1 High Dividend Yield Doesn’t Equal High Returns

It has been proven that high yield dividend stocks (over 5%) underperform the market. It’s only normal as companies paying over 5% dividend yield show a high level of risk or limited growth potential when most money is simply redistributed to investors through dividends. Those companies (such as MLP’s) are good for retirees seeking income, but not really interesting for a young investor like me (I’m in my 30s). Let’s take a look at CAT’s dividend yield throughout the years;

Approximate historical dividend yield at beginning of each year:

CAT historic yield

 

 

 

 

 

As you can see, CAT shows a relatively low dividend yield over the past 7 years but recently went over the 3% bar. This places CAT in a good position for dividend investors.

#2 If There is One Metric; It’s Dividend Growth

The second rule is quite simple, but really effective. If there is only one metric you should be looking at, it has to be the dividend growth. If a company grows its dividend year after year, it means profit and sales are also increasing.

While CAT is going through a tougher period at the moment, we can appreciate a strong annualized dividend growth of 12% over the past 5 years. Here again, the company fits my investing criteria.

#3 A Dividend Payment Today is Good, a Payment for the next 10 Years is Better

As previously mentioned; a company increasing its dividend payment year after year must also show revenue and profit growth to sustain its distribution. A good way to see if the company can make it through the next 10 years is to look how the payout ratio has evolved through time. In the previous graph, we see a payout ratio under 50% for the past 4 years. This is a very good indication that the dividend is sustainable.

#4 The Foundation of Dividend Growth Lies in its Business Model

Warren Buffet once said he invests only in businesses he understands. This is crucial to making rational investment decisions. Caterpillar’s economic moat is quite interesting. This business is selling world class equipment for various industries.

The company evolves in cyclical markets and revenues and profits fluctuate over time. However, it’s a leader in its industry and the quality of its equipment is well appreciated around the world.

How Does CAT Spend Its Cash?

The company has well defined priorities for its cash flow:

#1 Maintain financial strength

#2 Growth

#3 Pensions

#4 Dividends

#5 Stock Repurchases

This quote from their last earnings call with management resumes how CAT manages its cash flow:

The top cash deployment priority is to maintain a strong financial position to support our credit rating. As such, the ME&T debt-to-capital ratio was 37.1 percent, down slightly from 37.4 percent at the end of 2014. Our cash and liquidity positions also remain strong with an enterprise cash balance of $7.563 billion as of March 31, 2015. Additionally, cash will be used to support growth, appropriately fund employee benefit plans, pay dividends and repurchase common stock. During the first quarter of 2015, capital expenditures totaled $0.5 billion; funding for defined benefit pension plans was $0.1 billion; the quarterly dividend payment was $0.4 billion; and common stock repurchased was $0.4 billion.

Risks

While CAT is a very strong pick for a long term perspective, it might be riskier over a short period such as 12 months. If the mining industry continues to slow down as is the case right now, CAT might not be able to meet its double digit growth projection. For that reason, I think you should take a careful look at this company before going forward.

The company currently focuses on cost management to maintain its profit while waiting for the next resource driven wave to improve its results.

Conclusion and Valuation

The first valuation method used is a look at the historical PE ratio. It gives me an idea of how the market values the company:

CAT PE Ratio

Due to the economic slowdown, we see CAT losing strength in the valuation multiplier. Not so long ago, the company traded around 18 but it is now back to 14 times the benefits. The company seems slightly undervalued using the PE historic method. Let’s see what it looks like with the Dividend Discount Model:

CAT intrinsic value

Considering a 10 year dividend growth of 5% (considering the current market headwind) and a 7% average dividend growth rate for the future, we get a fair value at $84.59 while the stock is currently trading at $88-$89. I’ve used a discount rate of 10% as the company is very stable and will continue to be a leader in its industry.

In the light of both valuation methods; I can say Caterpillar is a good addition to a portfolio at the current price. What do you think?

Full Disclosure: As of this writing, CAT is part of our DSR Portfolios.

 Dividend Insights Newsletter

We respect your email privacy

Microsoft – a Little bit Late for the Party, Still Growth to Come from the Clouds

Microsoft is the best known and most important software company in the world. Along with its famous line of software products, Microsoft also offers various services such as servers (including cloud systems), business solutions (support and consulting), entertainment (Xbox) and other online services.stock report

-Seven Year Revenue Growth Rate: 9.71%
-Seven Year EPS Growth Rate: 8.23%
-Seven Year Dividend Growth Rate: 12.56%
-Current Dividend Yield: 2.55%
-Balance Sheet Strength: Strong

Overview

We all know Microsoft for their Windows operating system and Office Suite. At several occasions in time, we have seen competitors try to steal market share away from the giant. I remember watching an interview with the Microsoft CEO years ago and the reporter asked if he was concerned about the rise of Linux.

Linux what? He answered

I was surprised to see MSFT’s big boss not even consider that a competitor could hurt Windows’ market share. Today, I understand that there is not many competitors can do to battle with the “mother” of computers.

Business Segments

The company is simply divided into two segments:

Devices & Consumer

Here we find all products offered to “regular” consumers.It showed an 8% growth in revenue during the past quarter lead by sales of Office 365. I was also surprised to see how BING posted strong revenue growth (21%) in advertising income.

Commercial

s consumers we all know Microsoft, while MSFT makes the bulk of its income from its commercial segment (12.8 billion this quarter vs 9 billion from consumer segment). Revenue in this segment grew 5% this quarter lead by… the cloud business (+106%). The cloud business is definitely a great part of MSFT’s future. This is especially true when we consider that office suite sales declined during the last quarter. Many companies won’t update their software bundle as fast as MSFT will upgrade them.

Ratios

Price to Earnings: 20.14
Price to Free Cash Flow: 14.93
Price to Book: 4.36
Return on Equity: 22.25%

Revenue

MSFT Revenue

Revenue Graph from Ycharts

Similar to Apple’s revenue depending on how many iPhones versions it launches; Microsoft revenue growth is linked to how many software upgrades it can create. We can see that MSFT is not lazy when it’s time to provide new versions of their famous software. On top of that, MSFT diversified its revenue sources by investing massively in two other business sectors; game consoles with the Xbox and cloud services.

Earnings and Dividends

MSFT earnings and dividendsSource: Ychart

Earnings were temporarily hit by the Nokia adventure. While MSFT usually shows strong abilities investing in new businesses in order to generate growth, I’m not truly convinced it will be able to get something strong out of Nokia. Nonetheless, it seems MSFT doesn’t need Nokia to be profitable since its other businesses are doing well. I guess this is the benefit of being the world leader in software.

Approximate historical dividend yield at beginning of each year:

MSFT historical yield

 

 

 

 

 

As you can see, MSFT became very interesting as a dividend stock not so long ago. Prior to 2011, the yield wasn’t the most appealing. However, now the dividend is constantly increasing and the yield remains around 3%. Considering a relatively low payout ratio (under 50%), we can expect more dividend growth in the future.

How Does MSFT Spend Its Cash?

It’s funny to see a company that didn’t want to pay a dime in dividends a short while ago increase its dividend payment aggressively by 12.56% (annualized) over the past 5 years, right? During the last quarter alone, MSFT redistributed $7.5 billion to shareholders through share repurchases and dividend payments. The share repurchase program is authorized up to 40 billion dollars.

As any other techno companies, MSFT must invest massively into R&D. in 2014, the company spent 11.4 billion, an increase of 1 billion compared to 2013. Share repurchases and dividend payments are great, but I also like the fact MSFT is cautious about reinvesting massively into its operations. While MSFT focuses on improving existing products and services, they also spend lots of money on developing new innovation.

Investment Thesis

Microsoft finds another niche to dominate; here’s why the cloud business will push this giant higher. Both INTC and MSFT surged this year and even share a few points in common; strong demand for PCs in the market and their weakness to enter the mobile market. Microsoft also tried to “buy” its entry into the mobile market with the acquisition of Nokia. Now that they have announced a cut of 18,000 jobs (mainly in the Nokia division), we can wonder why it paid that much to acquire a cheap phone maker. Nonetheless, I prefer Microsoft over Intel for one reason; MSFT has found another niche to dominate with the cloud business. We all know the strength of Microsoft lies with all businesses using their services (Windows, Office series but also servers and business services). Since the cloud is the next big thing for most companies, Microsoft can expect huge growth from this segment in the future.

Risks

A few years ago, I wasn’t as confident in Microsoft’s future; the Xbox wasn’t doing that well, BING seemed like just another Yahoo! trying to compete with Google and Windows’ sales weren’t impressive. However, a few years later, BING generates revenues, Xbox is a strong player in the gaming industry and cloud services came out of nowhere with great growth potential. I guess this summarizes the risk you face while investing in a techno stock.

Overall, I think the risk is minimal since MSFT sits on strong and diversified sources of income. The software business will continue to generate strong cash flow while the growth will come from cloud services and other projects. Still, keep in mind that if MSFT wastes money like it did with Nokia, the future could turn rapidly into a nightmare.

Conclusion and Valuation

Using the historic price-earnings ratio will tell me how the market values MSFT over time:

MSFT PE ratio

My understanding of this graph is that MSFT is catching the attention of Mr. Market recently. The cloud business is a buzz word and it resonates throughout the MSFT valuation. Considering the company used to trade over a 22 multiple and as high as 27, the stock seems underpriced at the moment. Do we have a buy opportunity? The answer is probably yes… about a month ago! Let’s dig further.

Using the Discounted Cash Flow Analysis, we look at MSFT as a simple money making machine. The point is to assess the value of the company by considering its cash flow generation capacity. Considering the cash flow to continuously grow by 5% for the next five years and then by 4% and a discount rate of 10%, we have a stock trading at a 20% discount as the current company’s market value is at 392 billion.

MSFT Intrinsic Value 1

Then, by using the Dividend Discount Model, I keep the 10% discount rate and use a 10% dividend growth for 10 years (definitely supported by the cloud service growth and the upcoming delivery of Windows 10) and a 7% dividend growth rate afterward. Here’s what we get:

MSFT Intrinsic Value 2

According to this chart, the stock is trading at a 10% discount.

Overall, it seems that Microsoft is currently trading at a good price. The perfect time was definitely before its latest earnings report, but I’m fairly confident that the stock will continue to show strong results in the future.

Full Disclosure: As of this writing, I MSFT is part of our DSR Portfolios.

 Dividend Insights Newsletter

We respect your email privacy

Maiden Holdings – The Secret Small Cap with Strong Dividend Growth

Maiden Holdings Ltd (MHLD) is organized to provide, through an insurance subsidiary, property and casualty insurance and reinsurance business solutions mainly to small insurance companies and program underwriting agents in the United States and Europe. The company is based in Bermuda.

-Seven Year Revenue Growth Rate: 3.07% stock report
-Seven Year EPS Growth Rate: 5.98 %
-Seven Year Dividend Growth Rate: 18.70%
-Current Dividend Yield: 3.53%
-Balance Sheet Strength: Strong

Overview

MHLD is not the classic blue chip dividend payer you usually find in a dividend investor’s portfolio. The reinsurance business is a very stable business with predictable income. It’s a small cap with a low valuation (P/E around 15) and a reasonable yield (3.50%). This is probably one of the rare cheap opportunities on the market right now.

Founded in 2007, MHLD is born from what was previously the GMAC reinsurance platform. Most MHLD senior management are also former GMAC management team members.

This is not exactly the type of stock that shows up on my radar but it scored very high on my Dividend Stocks Rock Ranking and I thought about digging a little further.

Diversified Reinsurance

The company operates in two different segments: Diversified reinsurance and AM Trust Reinsurance.  The Diversified Reinsurance business consists of a portfolio of property and casualty reinsurance business focusing on regional and specialty property and casualty insurance companies located, primarily in the United States and Europe.

I’ll stop right here and provide you with additional information on what “reinsurance” means in the first place (definition coming from investorpedia):

“The practice of insurers transferring portions of risk portfolios to other parties by some form of agreement in order to reduce the likelihood of having to pay a large obligation resulting from an insurance claim. The intent of reinsurance is for an insurance company to reduce the risks associated with underwritten policies by spreading risks across alternative institutions.

Also known as “insurance for insurers” or “stop-loss insurance”.

Read more

Here’s how MHLD reinsurance products are split:

MHLD diversification

Ratios

Price to Earnings: 14.58
Price to Free Cash Flow: 1.55
Price to Book: 1.164
Return on Equity: 11.58%

Revenue

MHLD revenue

The revenues are keeping a steady and clear line headed skyward. However, one must remember the core business of MHLD is car reinsurance and the automobile industry has been doing very well over the past few years and MHLD obviously benefits from a good position and timing in its business.

Earnings and Dividends

MHLD earnings and div

I like the fact the dividend yield was relatively stable and the dividends paid keep increasing. Also, the payout ratio is relatively stable since 2013. This is quite a feat considering the important dividend payment increases since MHLD’s creation.

Approximate historical dividend yield at beginning of each year:

MHLD div yield

 

 

 

 

 

What catches my attention from the previous graph is how the dividend tripled in only 7 years. I know it’s impossible for the company to keep hiking its dividend at this rate, however, since the payout ratio has stayed relatively low, we could see other strong increases over the next few years.

How Does MHLD Spend Its Cash?

The company used some serious debts to buy GMAC RE back in 2007. Since then, MHLD’s focus was to repurchase this junior debt in order to reduce its cost of capital and eventually be able to give more to shareholders. Last year, the company repurchased all of the outstanding Trust Preferred Securities (the “TRUPS Offering”), with a face value of $152.5 million

In 2014, the board approved a 75 million budget for share repurchases while management keeps hiking dividend payments year after year since its creation.

Investment Thesis

MHLD is evolving in a relatively stable and predictable market. The company focuses on building strong partnerships with insurance companies that constantly require MHLD services to pursue their business.

The management team shows very strong experience with the previous GMAC RE background. The company continues to post solid results quarter after quarter and is well positioned to gain more business in Europe as MHLD provides solutions for new risk base regulations coming to Europe.

Therefore, we should see revenues continue to grow in the upcoming years.

Risks

There are possible conflicts of interest as MHLD’s founding shareholders own and control 53.9% of the outstanding shares of AM Trust Financial Services which is MHLD’s main client since 2008. There are also several short sellers around this stock due to these possible conflicts of interest. This is the reason why we will use a higher discount rate to value the stock

Conclusion and Valuation

The first step for stock valuation is to look at its historic P/E ratio to see how the market values MHLD.

MHLD PE ratio

There have been several ups and downs in the valuation. To be honest, I’m not a big fan of companies without a steady valuation. Could MHLD be worth as little as 7.5 times the earnings or as much as 26? This is hard to tell at the moment and I will use the Dividend Discount Model to give a better value to the stock.

Because MHLD has a client generating the bulk of its income and MHLD’s management controls this client, I will use a discounted rate of 12%. This is higher than my usual discount rate for a solid dividend stock. I usually consider a discount rate between 9 and 11%, but MHLD shows higher risk in my opinion. I use the two stages DDM calculation from The Dividend Toolkit as I think the dividend growth can continue increasing by 10% for the next 10 years but will reduced to 7% afterward.

MHLD intrinsic valueSource: Dividend Toolkit Calculation Table

As you can see, the stock is slightly over valued using these metrics. For someone who is willing to take additional risk in their portfolio, he will most likely be rewarded with this company as I was quite severe in my valuation. Still, I almost get to the current value.

In other words, if you have a strong portfolio including several blue chips, adding MHLD to your portfolio will probably be a good trade.

Full Disclosure: As of this writing, MHLD is part of our DSR Portfolios.

 

 Dividend Insights Newsletter

We respect your email privacy