It is obvious that investors look towards the oil and gas sector as crude oil prices hover over $100 a barrel mark. As the United States banned the import of Russian oil, liquefied natural gas and coal to their country, there is increased pressure from all corners to raise their domestic oil supply to meet rising energy demands. One way for investors to benefit from the rally in oil prices while also shielding themselves from high volatility in the energy sector is to invest in a diversified industrial giant like Caterpillar Inc (CAT).

Diversified sector exposure

While the company is widely known for its construction machinery business, Caterpillar also manufactures natural gas compressors, engines and gas turbines used for land-based and offshore drilling and well servicing by the oil and gas industry. Caterpillar is also a leading supplier of diesel engines and diesel-electric locomotives. Demand for reliable power backup is rising on the back of rapid post-pandemic economic recovery and increased investments in data centres. The global diesel-power engine market size is expected to grow at a compounded annual growth rate of 4.6% to $7.9 bn by 2025 from $6.3 bn in 2020. This way, Caterpillar provides exposure to multiple nuances of different segments like the industrial, materials and energy sectors.

Exhibit 1: Top global heavy equipment manufacturers, based on sales as of April 2021

Source: Statista.com

Global heavy equipment market leader

Caterpillar is among the leading heavy-equipment manufacturers worldwide. According to 2020 sales, Caterpillar is only second to Japan’s Hitachi in terms of total annual revenue. At home, Deere & Company (DE) is Caterpillar’s close competitor. However, their primary products are quite different from each other. While Caterpillar is mainly a construction equipment company that also manufactures farm equipment, Deere is primarily a farm equipment company which also produces construction equipment. However, Caterpillar offers bigger exposure to the energy sector as the segment’s contribution to the company’s overall revenue and profitability matches closely with its construction business. Moreover, Caterpillar’s dividend yield of 2.07% fares better in comparison to Deer & Co’s 1.08%. 

Rebound in construction and energy sector boosts fourth-quarter earnings

Caterpillar crawled its way back to glory as it reported a 23% increase in fourth-quarter sales. Total revenue for the quarter stood at $13.8 bn, compared to $11.2 bn a year ago. The company attributed this rise to the favourable impact of changes in dealers’ inventory. The dealers invest in equipment as they expect a rise in sales. The inventories improved in the second half of 2021 after seeing a severe decline in 2020. 

Exhibit 2: Caterpillar’s 4Q21 vs 4Q20 Financial Results

Source: Company Financials, January 2022

As per Chief Financial Officer Andrew Bonfield, public spending, like U.S. President Joe Biden’s $1 trillion infrastructure law, are giving Caterpillar’s customers the confidence to buy new equipment. The rebound in construction activity helped sales for this segment to rise 27% year-on-year. 

The energy and transportation segment posted quarterly sales of $5.7 bn, a jump of about 19% from a year ago. Increased volumes in reciprocating engine aftermarket parts and turbine-related services pushed the sales up. Another boost in sales came from higher deliveries of locomotives and rail services. The energy and transportation segment is catching up with the construction segment by contributing about 42% to company’s total sales and total operating profit each in the quarter.

Price increases and stronger sales likely to offset the rising manufacturing costs

Adjusted profit per share, for the quarter, increased to $2.69 from $2.12 last year. However, profit margins slipped to 11.7% in 4Q21 from 12.3% in 4Q20 due to higher manufacturing costs. In the first quarter of 2022, the company sees headwinds to its adjusted operating profit margin but expects improvement throughout the rest of the year. Nevertheless, Caterpillar anticipates price increases and stronger sales to offset rising manufacturing costs in 2022. Moreover, the company looks at $1.4 bn worth of capex for the entirety of 2022.

Consistently increasing dividend payout for 27 years in a row

Discipline in financial management has rightfully earned Caterpillar, the title of “dividend aristocrat” – a nickname given to those companies listed on the S&P 500 index that have increased their dividend payment every year for at least 25 straight years. Caterpillar has been consistently increasing its dividend for 27 consecutive years. In 2021, the company paid $2.3 bn in dividends and repurchased $2.7 bn in stock, signalling strong cash flow position despite being battered by the pandemic. Caterpillar ended 2021 with $9.3 bn of enterprise cash balance. This speaks volumes of the company’s ability to hold up in difficult times without depending on debt.

Caterpillar – a strong hedge to commodity and general inflation 

Exhibit 3: YTD price performance comparison between Caterpillar and S&P 500

The stock outperforms the broader market index

Caterpillar added 4% this year to close at $215.44 on 14 March, 2022. The S&P 500 index lost about 12% for the same period due to the broader market sell-off amid rising inflation and geopolitical fears. According to investment banking firm, Jefferies Financial Group, the war between Russia and Ukraine has significantly affected the global commodity markets, leading to a decade of reinvestment. This, as per Jefferies, sets the momentum for long-term outperformance for Caterpillar – a stock that has historically been seen as a “strong hedge” to a rally in commodity prices and inflation. The brokerage also raised its price target to $260 from $215 earlier and upgraded to “buy” rating from “hold”.

Analyst ratings of the stock with price targets