September 18, 2015
Is This Fallen Blue Chip a Buy?
By Joseph Hogue
While investors are worrying about the direction of the general market, a few industries have been under the gun for a year or so already. Any industry tied to energy or commodities, for instance, has felt the sting of slowing Chinese growth and lower energy prices.
I'm optimistic the current price war in oil will eventually work itself out through economic growth and stabilized production, though. And even with a growth target of just 7% this year, China promises to be a huge consumer of industrial commodities for years to come, while economic growth in the United States should be supportive as well.
That's why I'm not worried about trying to time the market's neurotic ups and downs, nor am I worried about the recent underperformance of one American icon. This industry leader has suffered thanks to a perfect storm of headwinds, but it is prioritizing shareholder cash return and could make traders an annualized 37% gain.
Caterpillar's (NYSE: CAT) diversification across mining, energy and construction normally helps to smooth sales, but demand in all three of those segments fell dramatically during the past year.
In the second quarter, the company's machinery sales fell 14% from the prior year to $11.6 billion alongside a 3% drop in revenue from the finance division to $734 million. Management revised its full-year sales outlook down $1 billion to $49 billion but left its earnings forecast of $4.70 per share (including a $0.30 per share restructuring charge) unchanged.
As mentioned, a lot of the weakness has to do with slowing economic growth in China. Economic reforms checked the real estate construction boom, and the subsequent drop in commodities demand meant overcapacity in mining. Additionally, the drop in energy prices due in part to the U.S. production boom has sent oil and gas explorers scrambling to cut capital spending and protect cash flow.
But against the weak environment for heavy machinery is some good news: Analysts forecast oil prices could rise to an average of $57 per barrel next year as reduced spending by U.S. producers limits production growth.
Furthermore, 37% of Caterpillar's revenue is booked in North America where construction demand is still relatively strong. And sales in Europe, which account for 17% of revenue, could get a boost from economic growth and the ECB's massive $1 trillion stimulus program.
Caterpillar is the world's largest heavy machinery equipment manufacturer with a market cap of $45 billion and controls nearly a fifth of the global new construction equipment market. Dealers are located in 131 countries and are responsible for their service and repair network, helping to maintain the premium brand and customer loyalty the company has cultivated over more than a hundred years in business.
The demand for heavy machinery is very cyclical, and that means the cycle will eventually pick back up. In the meantime, Caterpillar has been making the difficult decisions to emerge a more profitable company. Its recent restructuring will reduce earnings this year but should drive savings and improve margins as soon as next year.
Plus, even with $3.3 billion in capital expenditures over the past 12 months, the company still generated nearly $4 billion in free cash flow during that time. That's more than enough to cover the annual dividend payment of around $1.9 million ($3.08 per share). It also covers the additional $1.5 billion in share repurchases the company announced it would make in the third quarter.
Given CAT's price-to-earnings ratio of just 12.8 and its 4.2% dividend yield, I am not worried about the fact that it may be a year before the company's earnings outlook improves. However, because this blue chip may offer limited upside potential in the near term, I'm not content just buying and holding shares. Instead, I'm going to use a simple strategy that pays me an extra "dividend" every few months while I wait for shares to rebound.
The strategy is known as a covered call, but around the Profitable Trading office, we like to call it an "income loophole." If you not familiar with the strategy or need a refresher, watch this short training video now.
With CAT trading at $74.06 per share at the time of this writing, we can buy 100 shares and simultaneously sell one CAT Jan 80 Call, which is trading around $1.44 ($144 per contract). This gives us a cost basis of $72.62 per share, a 2% discount to the current price.
If CAT closes above the $80 strike price at expiration on Jan. 15, our shares will be sold for that price. In this case, we will make $5.94 in capital gains. We'll also likely collect two dividend payments totaling $1.54. When you combine this with the option premium of $1.44 we received for selling the calls, we get a total return of $8.92, a profit of 12.3% over our cost basis of $72.62.
Since we'd earn that in 120 days, that works out to an annualized gain of 37% on a solid blue-chip stock that I'm confident could trade back above $100 once market conditions improve.
If shares don't reach the $80 strike price by expiration, I won't mind in the least. The company pays an attractive and stable dividend and has the financial power to survive the cyclical weakness in the industry. In this case, I will simply boost my income by selling covered calls every few months while I wait for the rebound.
Note: Profitable Trading's Amber Hestla, who is also bullish on CAT, just released a new presentation explaining how you could pocket $795 in the next 48 hours using a covered call strategy. In this 90-second explanation, she'll tell you how to generate up to $3,000 a month from stocks sitting in your portfolio. Click here to watch the presentation for free.
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