caterpillar

Guest Post Blue Harbinger: Attractive Income As Healthy Blue Chip Sells Off (Options Trade)

This is the second of our dividend stock series of exclusive articles from Blue Harbinger's The Value and Income Forum.

Summary

We just placed a new high-income-generating options trade on a healthy dividend paying blue chip stock that just sold off.

We believe this is an attractive trade to place today, and potentially tomorrow, as long as the share price doesn't move too dramatically before then.

We just placed a new high-income-generating options trade on a healthy dividend paying blue chip stock that just sold off. We believe this is an attractive trade to place today, and potentially tomorrow, as long as the share price doesn't move too dramatically before then.

The Trade:

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We Sold PUT Options on Caterpillar (CATwith a strike price of $115 (7.5% out of the money), and expiration date of February 15, 2019, and for a premium of $1.05. That’s an extra 10.7% income for us on an annualized basis (1.05 / 115) x 12 months). If the shares get put to us before the options contract expires then we're happy to buy the shares of this blue chip dividend-payer at the lower price of $115. And if the shares don't get put to us, we still get to keep the extra income we generated no matter what.

Your Opportunity:

We believe this is an attractive trade to place today and potentially tomorrow as long as the price of Caterpillar doesn't move too dramatically before then, and as long as you’re able to generate annualized premium (income for selling, divided by strike price, annualized) of approximately 10%, or greater.

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Our Thesis:

Caterpillar is an attractive long-term investment with a healthy dividend and trading at an attractive price relative to its long-term value. Near term technical conditions and fear related to the China "trade war" have already caused the share price to sell off too far (management just provided weaker 2019 guidance than previously expected). But because of the attractive premium income, and because we understand near-term volatility can drive the share price lower, we've elected to sell the puts (instead of buying the shares outright), which gives us the chance to pick up the shares at an even lower price (if they fall below the strike price and get put to us before expiration). Important to note, because near-term volatility and fear are higher, so too is the premium income available in the options market and on this trade specifically.

Near-Term Volatility:

Caterpillar announced earnings on Monday, and the market didn't like it. In particular, the company's revenue continued to grow across segments (construction revenue was up 8%, the resource industries segment grew 21%, and the energy and transportation segment grew 11%), but margins were weaker than expected (particularly in the construction segment where operating margin declined to 14.8% from 15.8%) and management provided lower than EPS guidance for 2019 than the Street was expecting (2019 GAAP EPS guidance of $11.75 to $12.75, versus the Street's expectation of 12.73). Global trade headwinds and fear (particularly related to China "trade wars") have been impacting the stock. However, in the long-term, the shares are increasingly attractive.

Long-Term Value:

In the long-term, Caterpillar shares are attractive because revenue is growing (and is expected to keep growing), but near-term volatility and fear have caused the shares to sell-off to an increasingly attractive price. In particular, even though margins, earnings and guidance came in below expectations, revenue continue continues to grow, and revenue and EPS are expected to keep growing.

About Caterpillar:

Briefly, if you don't know, Caterpillar engages in the manufacture of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. It operates through the following segments: Construction Industries, Resource Industries, Energy and Transportation, Financial Products, and All Other. The Construction Industries segment supports customers using machinery in infrastructure and building construction applications. The Resource Industries segment is responsible for supporting customers using machinery in mining and quarrying applications and it includes business strategy, product design, product management and development, manufacturing, marketing and sales and product support. The Energy and Transportation segment supports customers in oil and gas, power generation, marine, rail, and industrial applications. The Financial Products segment offers a range of financing alternatives to customers and dealers for Caterpillar machinery and engines, solar gas turbines, as well as other equipment and marine vessels. The All Other segments includes activities such as; the business strategy, product management and development, and manufacturing of filters and fluids, undercarriage, tires and rims, engaging tools, and fluid transfers. The company was founded on April 15, 1925 and is headquartered in Deerfield, IL.

Attractive Qualities:

1. Revenue and Earnings Growth

As mentioned above, Caterpillar's revenue continues to grow. Here are more specific details from a recent Morningstar report, by segment, emphasis ours:

Caterpillar shares declined nearly 10% after the company reported fourth-quarter adjusted EPS of $0.44, 15% below consensus estimates. The main contributor to the miss was lower operating margin in construction industries. Management also shared its 2019 GAAP EPS guidance of $11.75 to $12.75, which was below our estimate of $12.81.

The performance of the construction industries segment during the quarter was the biggest disappointment. While revenue grew approximately 8% year over year, operating margin declined to 14.8% from 15.8%, well below our estimate of 20.7%. Issues cited for the margin decline included weak demand in Latin America and the Middle East. At the same time, freight and materials costs were elevated. Consistent with our research, management was upbeat on U.S. construction activity for 2019.

Caterpillar's resource industries segment maintained its upward growth trajectory, increasing revenue 21% year over year, and segment operating margin increased to 14.3% from 9.1%. Mining customers continued to invest in capital equipment as commodity prices remain supportive. Management remained positive about its 2019 outlook for the segment due to ongoing reductions in customers’ idle assets. Additionally, there are early indications of strong demand for quarry and aggregate machinery.

Caterpillar’s energy and transportation segment also showed healthy growth in the quarter. Revenue increased 11% year over year, while operating margin increased to 17.2% from 15.5% in the year-ago period. Strong power generation sales, especially to data centers, contributed to the segment’s performance. Rail service revenue also increased. A strong U.S. economy and robust demand for gas compression equipment are likely to boost 2019 segment revenue 2019.

2. Attractive Growing Dividend

Also very important, Caterpillar continues to generate plenty of healthy income to support its continuing long-term dividend growth.

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Here is a look at Caterpillar's uses of cash, which shows after debt servicing and dividend payments, the company has plenty of cash to support share repurchases and growth.

And for reference, Caterpillar's debt is rated fairly highly according to the rating agencies. This is an indication of the company's long-term strength and health, despite the good, but softer than expected, earnings announcement.

3. Attractive Valuation:

Also important, Caterpillar's valuation is currently reasonable, and will be even more reasonable if the shares get put to us at the lower price, ceteris paribus.

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For example, here is a look at the price targets set by Wall Street analysts covering the stock.

And as you can see many of these price targets have been updated since the earnings announcement (see table below), and they are still expecting upside for the stock (although there may be near-term volatility, which is why we elected to sell the puts instead of buying outright).

For more perspective, here is our previous Caterpillar article from many months ago (9/27/17) when we elected to sell our CAT shares for a very large gain. We sold the shares at a slightly higher price than they trade at now, but the earnings have grown dramatically since then, making the current valuation even more attractive, in our view. Here is an excerpt from that article:

Caterpillar has a lot more long-term upside potential, but we sold 100% of our Caterpillar shares this morning for a gain of +110% after owning them for 19 months.

Important Trade Considerations:

Two important considerations when placing options trades are upcoming earnings announcements and dividend dates because they can increase volatility and dramatically impact the value of your options contract in unexpected ways. However, in the case of Caterpillar, they are largely non-issues. First, CAT just announced earnings, therefore we don't have to worry about earnings surprises for this trade considering the next announcement comes after the options contract has expired. And with regards to the dividend, CAT just went ex-dividend on its quarterly dividend last month, so we don't have to worry about any quarterly dividend payments impacting the options value during the life of this options contract which expires in less than one month.

Conclusion:

Caterpillar is an attractive, long-term, blue chip, dividend-paying company (we believe the dividend will keep growing). However, the shares just sold-off dramatically because the latest 2019 earnings guidance provided by the company was weaker than expected. Nonetheless, CAT is still expected to grow, and the valuation is relatively attractive by historical standards. Rather than purchasing shares outright, we have elected to sell income-generating put options. The premium income on these options is attractive because short-term fear and volatility is high. And if short-term fear and volatility drive the share price even lower, then we're happy to purchase shares at the lower price, per our options contract. And if the contract never gets executed, and the shares never get put to us, then we're still happy to simply keep the attractive premium income we just generated, no matter what (i.e. we keep the premium income whether or not the shares get put to us).

Disclosure: I am/we are short CAT Puts. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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