Caterpillar Inc. (NYSE: CAT), a worldwide leader in the manufacture and sale of heavy equipment and diesel engines, deserves to be a core holding, and if you own it, keep it. But I’m reluctant to recommend starting a new position at current valuations. There are several reasons. But first, let’s take a look at CAT’s business.
Caterpillar sells to three different markets: construction companies; natural resource companies, including miners and forest products; and buyers of power systems, which includes diesel engines for locomotives, industrial gas turbines for electric utilities, and equipment for the oil and gas industry, all of which accounted for 95 percent of its $55 billion in sales in 2013. It also has a financial business, mostly to help its customers buy its equipment; it generated 5 percent of CAT’s revenues last year.
Caterpillar has been in business for more than 100 years, and sells its trademark yellow bulldozers, excavators, pipe-layers, earthmovers and scores of other kinds of equipment to customers on six continents ( it relies on the U.S. for just 30 to 33 percent of its sales). It’s consistently considered one of the best-managed companies in the world, and the most admired in its industry.
That being said, it’s essential for investors to recognize that Caterpillar is a cyclical business: when the global economy is humming, so is CAT. The reverse is also true: when either economies or certain industries decline, Caterpillar feels it.
Fiscal 2013 was an example of the downside. For the year, sales fell 16 percent, from $66 billion to $55 billion, and earnings took a deeper dive, down 32 percent from $8.48 a share to $5.75. Driving those results were a particularly sharp decline of 37 percent in sales to the mining industry, its largest business in 2012 and where it has some of its highest-margin products. But sales also fell in the other two equipment segments, by a total of 6 percent.
Despite these results, a number of management initiatives helped buoy the company’s financials and stock. One was an aggressive restructuring campaign that cut inventory by $2.9 billion in inventory, and operating costs by $1.2 billion. As a result, Caterpillar achieved record operating cash flow for the year of $9 billion, and cut its debt-to-capital ratio by 30 percent, to its lowest level in more than 25 years.
When it released its 2013 earnings report in January 2014, the company forecast flat revenues, but raised its earnings guidance for the year $5.30. That, an announcement of a new $10 billion stock repurchase plan; a first-quarter upside earning surprise, and a 17 percent dividend hike to $2.80 a year, announced in June, helped the stock – which lingered between $77 and $88 for most of 2013 – to rocket some 30 points from December to $111 by early July 2014.
Which brings us to the current moment. On July 7, CAT closed at $110.16, on trailing 12-month earnings of $5.88, for a PE of 18.7. That compares to its 13-year median PE of 15.1. To me, that says CAT is fairly valued at its current price, if not slightly overvalued.
Another valuation metric I rely on is the 5-year PEG ratio, which compares a company’s PE ratio to its estimated earnings growth rate. A ratio of less than 1.2 for me is a buy, between 1.20 and 1.30 a hold, and over that it’s a sell. CAT’s 5-year PEG is 1.40, officially, a sell. So why don’t I recommend you sell CAT? Several reasons.
First, analyst estimates are just that – estimates, and they can run too high or too low. To me, there’s a margin of error in the PEG that enables me to adjust my recommendation based on other factors. For CAT, the consensus earnings growth rate is 12.81 percent a year for the next five years, suggesting earnings will be as high as $11.60 in five years. I moderate that projection by applying a PE of 15.1 –CAT’s median for the last five years – instead of the current trailing PE of 18.7, and I come up with a future stock price of $175 and change. With reinvested dividends, that generates an average annual return of 10.1 percent, enough for me to hang in there.
But there are enough headwinds to produce enough uncertainty for me to back off recommending investors initiate a position here. The company is calling for continued declines in mining equipment sales, there’s slowing construction activity in China, sluggish economic growth in the U.S. and worldwide, and the prospect of higher interest rates a few years down the road that could choke off any robust economic growth here or overseas. And, as in 2005, the company has been known occasionally to slash its dividend, at least temporarily. (In that year, the board cut the dividend from $1.64 to $1.00; three years later it was $1.68).
Look at it this way: for the five years from 2009 through 2013, CAT’s earnings grew at an annual rate of 30.21 percent. The number for the next five years, according to Wall Street, is less than half of that (12.81 percent). At an increase in the future estimated growth rate to 16 percent, or a price decline to around $95 – back where the stock was in March and April this year – I’m a buyer.
About Lawrence Meyers Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at email@example.com.
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