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Caterpillar Inc. (NYSE:CAT) is now the leading manufacturer of original mining equipment throughout the world, and the merger with Bucyrus has given it a strong foothold in China and India. The merger will also allow it to significantly leverage Bucyrus' booming aftermarket part business while providing support and services for its own equipment. It has a healthy 3-5 year EPS estimated growth rate that is in excess of 11%. As the long-term outlook for the company is still bullish, the current pullback could prove to be a long term buying opportunity.

Caterpillar will be examined from a technical and fundamental perspective. We will start off by putting it through a simple selection process to make sure it meets with some basic requirements.

The selection process:

  1. A positive levered free cash flow
  2. Net income and cash flow per share has been trending upwards for the past 3 years
  3. A 3-5 year EPS estimated growth rate of 10% or higher
  4. A five year dividend growth rate of 5% or higher
  5. A strong interest coverage ratio of 7 or higher
  6. A low payout ratio of 25% or less

Caterpillar met or exceeded all the above listed requirements.

Reasons to consider Caterpillar:

  1. The company's focus on expanding by opening up new facilities in emerging markets will help provide new streams of future revenue and growth.
  2. It still has a substantial backlog of roughly $23 billion
  3. A strong quarterly earnings growth rate of 48.9%
  4. A levered free cash flow of $2.65 billion
  5. A five year dividend growth rate of almost 6%
  6. A low payout ratio of 19% which leaves it plenty of room to increase its dividend
  7. An excellent retention rate of 81%
  8. A good interest coverage ratio of 8
  9. A 3-5 year projected EPS growth rate of 11.8%
  10. A five year dividend growth rate of 5.6%
  11. A strong interest rate coverage of 8.52
  12. A five year average ROE of 33%
  13. Annual EPS before NRI increased from $5.37 in 2007 to $7.81 in 2011.
  14. The merger with Bucyrus has made it the leading mining original equipment manufacturer on the globe. This acquisition helps Caterpillar gain a strong foothold in strong mining markets such as China and India. It will also be in a good position to leverage Bucyrus' thriving aftermarket parts business while providing supporting services for its own equipment.

How does Caterpillar fare against the competition?

It will be compared against its competitors using several key ratios such as quarterly revenue growth, P/E, operating margin, PEG, etc. If you feel that a competitor would make for a better investment, you could utilize a similar strategy. It has much higher operating margins than its competition and its operating margin of 0.14 is 50% higher than the industry average of 0.07. It also has a strong quarterly earnings growth rate of almost 49% and a healthy 5 year EPS growth rate of 10%.

CAT

(NYSE:CNH)

(KMTUY.PK)

(VOLVY.PK)

Industry

Quarterly revenue growth

0.05

0.04

-0.06

-0.06

0.08

Revenue

67.04B

20.30B

24.48B

47.79B

1.05B

Gross Margin

0.27

0.24

0.27

0.24

0.28

EBITDA

12.10B

2.83B

4.17B

4.19B

68.66M

Operating Margin

0.14

0.12

0.12

0.07

0.07

Net Income

6.53B

1.14B

1.76B

2.25B

N/A

EPS

9.76

4.73

1.84

1.11

N/A

P/E

8.35

9.28

11.73

11.85

15.85

PEG (5 yr expected):

0.65

1.12

-3.39

1.32

0.84

P/S

0.79

0.51

0.84

0.55

1.05

M= Million B= Billion

Technical outlook

It is currently trading slightly above the first layer of support ($79.00-$80.00) but a quick move down to the $78.25-$78.50 ranges would be a positive development as long as it does not close below this level on a weekly basis. If it tests the $78.25-$78.50 ranges, but ends the week on a positive note, it will have also completed a double bottom formation. These formations are generally bullish for they usually indicate that the stock has bottomed out and is ready to trend higher.

If it closes below $78.25 on a weekly basis, it will most likely test its two-year lows ($68.00-$69.00) before moving higher. The support at this level is much stronger than the support provided in the $79.00-$8.00 ranges and should serve as an initial floor to lower prices. Consequently, a close above $90 would signal that the worst is behind it, and that it is ready to test the $100-$105 ranges.

Wait for a test of the $79.00-$80.00 ranges before committing new money to this play. It would be best to divide the money you intend to invest in this play into 2-3 portions. You can then deploy one portion in the $79.00-$80.00 ranges and the other if it drops down to the $68.00-$70.00 ranges.

Charts and tables of interest

(click to enlarge)

When a stock is trading above the EPS and EPS consensus estimate line, it is a bullish phase, and the outlook is for higher prices. The stock is trading below the EPS consensus line but the EPS consensus line is still in a strong up trend and so the overall outlook for the stock remains bullish.

Earnings History

Dec 11

Mar 12

Jun 12

Sep 12

EPS estimate

1.73

2.13

2.28

2.22

EPS actual

2.32

2.37

2.54

2.54

Difference

0.59

0.24

0.26

0.32

Surprise %

34.10%

11.30%

11.40%

14.40%

The company has beaten the consensus EPS estimate for the past 4 quarters in a row.

(click to enlarge)

The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long-term entry point. The stock is currently trading below this line which means that the current pullback could prove to be a long term buying opportunity.

Conclusion

Consider waiting for the stock to trade to the $79.00-$80.00 ranges before jumping in. It would be best to divide your money into 2-3 portions and then deploy one portion in the $79.00-$80.00 ranges and the other one if and when it trades down to the $68.00-$70.00 ranges. Alternatively, you could also sell puts at strikes you would not mind owning the stock at. The advantage of doing this is that it provides you with a chance of getting into the stock at a price of your choosing. If the stock is not put to your account, you at least get paid for your efforts. The disadvantage is that there is no guarantee that the stock will be put to your account, but the premium you receive could be applied towards any future purchase.

EPS chart sourced from zacks.com. Competitor's data sourced from yahoofinance.com.

Disclaimer

It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.

Source: Caterpillar: A Great Company But Wait A Bit Longer Before Getting In