The Slow Crawl: Caterpillar Is Undervalued, But Not An Obvious Buy (Yet)

Caterpillar (CAT) is a global powerhouse, a maker of construction, power system, and mining equipment that sells its goods worldwide. A member of the Dow’s Industrial Average (DIA), Caterpillar is an industrial bellwether, a stock that soars when the market is feeling its oats – see October 2011-March 2012 – and plummets when the market senses the sky is falling – see the last three months. All this makes sense, as the end markets – mining, construction, railways, etc. – Caterpillar operates in run at their best when the economy is at its best and demand is high. If demand on a global level drops off, the need for mined resources, new homes, or shipping goods lessens, and Caterpillar’s sales slow, clamping on earnings growth.

CAT Chart


The market can be irrational in its efforts to predict what’s coming for the company in the immediate short term and in sticking to its Pavlovian habits of rotation, rotation, rotation without maintaining a long-term perspective. Caterpillar put up its best profit ever in the first quarter of 2012. The company raised its guidance, even. It has fully reestablished its earnings power since the 2008-2009 crisis, and has done so while consistently growing its dividend and remaining profitable through the recession. The company just raised its dividend and has announced exciting new projects.

CAT Chart


Despite all this, the stock is down about 30% from its earlier year highs and 14% year to date. With a few heaves and rolls in the eurozone crisis, a series of bad economic reports out of the U.S., and alarm bells sounding everywhere from Brazil to China, there is a heavy sentiment that Caterpillar, like other cyclical plays, won’t make its numbers this quarter and will further have to lower guidance. The recent Cummins (CMIwarning is viewed as a sign of what’s to come for other industrials, Caterpillar chief among them.

The reaction is a bit overdone, of course. Caterpillar, despite being a leading industrial, is currently trading at about 8.4x 2012 earnings and just over 7x 2013 earnings. Not only lower than historical averages or its peers, this P/E ratio includes the assumption of huge earnings misses. Analysts have not changed earnings estimates for Caterpillar much over the course of the quarter, but the market has been extremely pessimistic. Consider this scenario: if Caterpillar’s profits came 10% lower than estimates for 2012 (Cummins dropped its revenue estimates by 10%), Caterpillar would still be trading at just over 9.3x 2012 earnings while still growing earnings by 17.7% off of a record-breaking year as a base. Heck, even a 20% miss on yearly earnings would have Caterpillar setting records and trading for about 10.5x 2012 earnings, albeit with much lower earnings growth. In the face of uncertainty about Caterpillar’s profits, the market has overdone it a bit.

(Sources: WSJ, TDAmeritrade)

As of Q1 2012

(Price as of July 16th close)

CAT CMI Deere Co.


Danaher Corp (DHR) Manitowoc Co Inc.


Market Cap $52B $16.1B $32.0B $34.8B $1.4B
Quarterly Revenue Growth (Y-over-Y) 23.41% 15.91% 5.55% 28.99% 17.49%
Yearly Revenue Growth 41.21% 36.44% 23.15% 21.87% 16.23%
EPS Growth (Annual) 49.78% 91.50% 54.06% 26.51% 49.52%
Estimated Earnings Growth (next 3 years) 20.62% 11.74% 10.70% 13.27% 74.28%
Earnings 2011 7.4 9.07 6.63 2.83 0.38
Earnings 2012 (Est.) 9.68 10.35 8.25 3.31 0.79
Earnings 2013 (Est.) 11.23 11.56 8.67 3.69 1.46
Free Cash Flow 2011 4.63 7.17 1.53 3.27 -3.7
2011 P/E 10.97 9.54 11.58 17.77 28.63
2012 P/E 8.38 8.36 9.31 15.19 13.77
2013 P/E 7.23 7.49 8.86 13.63 7.45
2011 P/FCF 17.53 12.07 50.18 15.38 neg.
PEG Ratio 0.53 0.81 1.08 1.34 0.39
Price 81.15 86.56 76.78 50.29 10.88
Dividend 2.08 2 1.84 0.1 0.08
Dividend Yield 2.56% 2.31% 2.40% 0.20% 0.74%

On the other side of the equation though, we as investors and/or analysts should know by now that the market is irrational and overdoes it. It’s no secret that the market will amplify each iota of data, kings at making mountains out of molehills. We need to operate in this setting, imperfect as it is. While I do not advocate a hyper-rotation approach that leads investors to switch stocks every time the market sentiment turns for better or for worse (the diversified portfolio with slight re-weighting is enough to get through the lumpy periods), it doesn’t make sense to jump right into the teeth of the market. Ignorance and defiance may be noble mottos in some arenas, but an investment strategy they do not make.

Anybody reading investment websites knows that there are tons of bullish articles out there on Caterpillar (here are two). The essence of those articles is fine: Caterpillar is a good long-term play. The dividend at these levels is increasingly attractive. The company’s first quarter was a very successful one despite what the company acknowledged was a slowing economy in China, Brazil, and Europe. Despite all the bad reports coming from all sectors of the economy this quarter, Caterpillar’s dealer sales have still been growing over last year’s record numbers, even if at a slowing pace.

What’s silly about the bold, positive statements coming out on Caterpillar is how little weight they assign to the current market sentiment. It is a safe bet that Caterpillar will trade well above current prices at some point – 12x 2013 estimates yields a target price of 135/share, a ridiculous 69% above current levels – but until Caterpillar proves that it has somehow detached its earnings potential from the overall economic climate, or until that economic climate hits bottom, any investor looking to get in with surety that they won’t lose money may miss out lower entry points and better profits in the long run. This is a time to make a shopping list, but to shop carefully.

To reiterate, I like Caterpillar as a stock. It is an industrial leader, has a strong global business operating at top levels, and whatever one thinks about the current global economy, and however long it takes, at some point the economy will return to prosperity and a stable short-term growth cycle. At that point, Caterpillar could be a huge beneficiary.

In the meantime, the market in all its myopic wisdom is very negative on the company and has not yet worked out all its fear over the growth slowdown – the S&P 500 (SPY) is still up 6% on the year. I’m already long Caterpillar and view this as a time to grit my teeth and wait, with a chance to lower my cost-basis if I can get it. But for those who are not yet owners of the stock but interested in the idea, we’re in a touchy moment. Buying Caterpillar is a fine idea, but unless one is sure Caterpillar will meet its estimates, beat the whisper number, or otherwise prove that the market has overdone it this quarter, it might be worth holding off (or starting just a small position) until the quarter and the summer passes. It could be that in the hyper-cyclical post-crisis economy of autumn sees the world working itself back into shape, a la 2011.

Doing well in investing means finding good, undervalued companies that have the earnings potential to outperform in the long term. Caterpillar fits the bill on all counts. But beating the market does not necessarily mean defying the market. These days, cyclical stocks are on sale and there’s a good chance the price will drop further. Caterpillar may well return big for investors down the line, but at this point the stock should be approached cautiously. This episode in market irrationality and overreaction doesn’t look to be finished quite yet.

Daniel Shvartsman


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