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Introduction

Caterpillar (NYSE:CAT) is one of the most undervalued growth companies among the Dow Component stocks. The stock is -25.77% from its 52-week high and is likely to recover going into 2013. I anticipate the recovery in price will result in a phenomenal investment opportunity for investors.

Qualitative Analysis

Source: Information pertaining to Caterpillar came from the shareholder annual report and year in review

The company builds machinery and power systems, while providing financing/leases for their products. The company offers a unique portfolio of capital goods that includes: mining equipment, diesel/natural gas engines, industrial gas turbines, construction equipment, and etc.

(click to enlarge)

Caterpillar's primary growth initiative is the Chinese market. Caterpillar estimates that the list of infrastructure needs that will need to be fulfilled by 2025 is going to be enormous. They expect the urban population in China to reach 350 million people, with an estimated 600,000 miles of road, 170 mass transit systems, and 97 new airports projected to be built by 2025. These types of infrastructure projects are going to require Caterpillar products. The greatest strategic imperative for Caterpillar is to "win in China." Caterpillar will continue to grow their presence in China, making this a growth investment with international exposure.

Caterpillar operates at economies of scale and is able to produce goods at prices that local competitors may not be able to compete at. Caterpillar also has ownership of unique intellectual property making them well-positioned in foreign markets. The elasticity for mechanical engineering products and instrument engineering products ranges from 1.39 to 1.10. This means that buyers of these types of products are prince sensitive and will react more adversely to changes in price. Since Caterpillar operates at economies of scale, Caterpillar is able to lock-out competitors by offering lower prices. Buyers are sensitive to pricing; they will buy a Caterpillar product over the products of other competitors, because Caterpillar products are likely to be less expensive.

Caterpillar's strategy in developing markets continues to succeed as they grew sales by 45% in Asia and 41% in Latin America between 2010 and 2011. I remain optimistic on Caterpillar because of the favorable economic conditions it operates under, it's trend of sales growth, along with continued investment in developing and emerging markets.

Caterpillar competes for market share with companies like: Deere & Company (NYSE:DE), Kubota (KUB), Fastenal (NASDAQ:FAST), CNH Global (NYSE:CNH), Joy Global (NYSE:JOY), AGCO (NYSE:AGCO), among many others.

Technical Analysis

In the beginning of December 2013 the stock was able to break above the one-year symmetrical triangle formation. The technical analysis indicates that the stock may be recovering from what has been an awful year for the stock price.

(click to enlarge)

Source: Chart from freestockcharts.com

The stock is trading above the 50 - Day Moving Average while trading below the 20- and 200-day Moving Average. This implies that the stock is in the intermediate stages of an up-trend. A break above a triangle formation usually implies a strong move in the direction the triangle formation is broken. In this case, the stock is likely to trend higher going into 2013, and the recent drop in stock price had more to do with the fiscal cliff and less to do with the actual fundamentals of the stock. Therefore I remain optimistic going into 2013.

Notable support is $69.00, $81.00, and $82.50 per share.

Notable resistance is $96.00, $110.00, and $116.00 per share.

Street Assessment

Analysts on a consensus basis have very reasonable expectations for the company going forward.

Growth Est

CAT

Industry

Sector

S&P 500

Current Qtr.

-25.40%

15.50%

4.00%

9.40%

Next Qtr.

-22.80%

23.90%

27.80%

15.00%

This Year

23.40%

36.50%

35.20%

7.10%

Next Year

-4.70%

10.90%

-25.90%

13.10%

Past 5 Years (per annum)

16.66%

N/A

N/A

N/A

Next 5 Years (per annum)

14.00%

13.89%

13.70%

9.10%

Price/Earnings (avg. for comparison categories)

9.51

16.97

16.17

12.49

PEG Ratio (avg. for comparison categories)

0.68

1.35

1.54

1.34

Source: Table and data from Yahoo Finance

Analysts on a consensus basis have a 5-year average growth rate forecast of 14% (based on the above table).

Earnings History

11-Dec

12-Mar

12-Jun

12-Sep

EPS Est

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%

Source: Table and data from Yahoo Finance

The average surprise percentage is 17.8% above analyst forecasted earnings over the past four quarters (based on the above table). Upside surprises may be in store for the company.

Forecast and History

Year

Basic EPS

P/E Multiple

2003

$ 1.59

52.21

2004

$ 2.97

32.83

2005

$ 4.21

13.72

2006

$ 5.37

11.42

2007

$ 5.55

13.07

2008

$ 5.83

7.666

2009

$ 1.45

39.3

2010

$ 4.28

21.88

2011

$ 7.64

11.86

2012

$ 9.13

9.51

Source: Table created by Alex Cho, data from shareholder annual report, and price history is from Yahoo Finance.

The EPS figure shows that throughout the 2003-2008 period, the company was able to grow earnings. In 2009 top line revenue dropped by $20 billion over previous year, this resulted in a low EPS figure of $1.45 for 2009. The company is cyclical and is affected by macroeconomic events. After the great recession the company was able to recover earnings throughout the 2010-2012 period.

(click to enlarge)

Source: Table created by Alex Cho, data from shareholder annual report

So as long as emerging market demand continues to improve, the company will generate reasonable returns over a 5-year time span based on the forecast below.

(click to enlarge)

Source: Forecast and table by Alex Cho

By 2018 I anticipate the company to generate $18.66 in earnings per share. This is because of earnings growth, improving global outlook, and earnings management.

The forecast is proprietary, and below is a non-linear chart indicating the price of the stock over the next 5-years.

(click to enlarge)

Source: Forecast and chart by Alex Cho

Below is a price chart incorporating the past 10 years and the next 6 years. Detailing 16 years in pricing based on my forecast and price history on December 31st of each year.

(click to enlarge)

Source: Forecast and chart created by Alex Cho, data from shareholder annual report, and price history is from Yahoo Finance.

Investment Strategy

CAT currently trades at $86.81. I have a price forecast of $110.49 for December 31st 2013. The stock is below value, and I anticipate a price recovery during 2013.

Short Term

Over the next twelve months, the stock is likely to appreciate from $86.81 to $110.49 per share. This implies 27% upside from current levels. The technical analysis indicates a trend reversal. While the previously mentioned price forecast using fundamental analysis further supports the assessment.

Investors should buy CAT at $86.81 and sell at $110.49 in order to pocket short-term gains of 27% in 2013.

Long Term

The company is a great investment for the long-term. I anticipate CAT to deliver upon the price and earnings forecast despite the risk factors (missing analyst expectations). CAT's primary upside catalyst is international expansion, the urbanization of the middle class, and earnings management. I anticipate the company to deliver upon my forecasted price target of $237.01 by 2018. This implies a return of 173% by 2018. When factoring back in the dividends (based on the table below) the company will generate a combined return of 193%. This rate of return is exceptional, but comes with high-risk (5-year beta of 1.9).

Year

Dividend Yield @ $87.58 per share

Cumulative Total

2012

2.40

2.40

2013

2.63

2.63

2014

2.88

5.51

2015

3.16

8.68

2016

3.47

12.14

2017

3.80

15.94

2018

4.16

20.11

Source: Forecast and table by Alex Cho, dividend data from shareholder annual report

A higher yielding investment opportunity albeit having even higher risk is to buy the Jan 17, 2015 calls at the $85.00 strike. The call premiums trade at $14.70. The price forecast for the end of 2014 is $128.71. The rate of return if the calls expire at $128.71 is 185%, the option will break-even when the stock trades at $99.70.

CAT has a market capitalization of $56.8 billion; the added liquidity makes this an investment opportunity appropriate for larger institutions.

Conclusion

Investors should remain optimistic on Caterpillar as it is likely to outperform the Dow component going into the second half of 2013.

The conclusion remains simple: buy Caterpillar on long-term growth.

Source: Caterpillar Is One Of The Best Investment Opportunities On The Dow