I saw this recent article on Seeking Alpha, presenting a soft bear case to the Caterpillar (CAT) story. In light of my article from yesterday and my position in CAT, I want to go through the bear thesis presented and offer a different perspective.
Bear Thesis: "Not a good dividend investment."
Reply: The current dividend yield of 2.07% is right in line with that of the S&P 500 (the yield on SPY is 2.08%), which is more than adequate. CAT is not a traditional "dividend" play (think utilities or telecom) and, as such, an investment in CAT should not be predicated on the dividend alone. The author indicates that CAT should be compared to Microsoft (MSFT), Dominion Resources (D), and Hewlett-Packard (HPQ), which is somewhat absurd considering the vast differences across those businesses. CAT makes machinery, MSFT makes software, D is a utility, and HPQ makes computers, printers, and other hardware. There is no connection, other than a random walk through companies that pay dividends (to which I could find three companies that pay an inferior dividend to CAT and make an opposite case that would be equally flawed).
Bear Thesis: "Valuation is not cheap."
Reply: I firmly disagree on valuation. Backward-looking valuation metrics are largely irrelevant as stocks are valued forward. CAT is trading at 11.40x 2013 and 10.09x 2014 consensus estimates, which is predicated upon a decline of 6.1% to 2013 earnings vs. 2012 (and a 13.1% recovery off of 2013 levels in 2014). At 11.4x, CAT is trading close to the trough multiple with a normalized multiple (since the 1990s) looking more within the context of 15x. Relative to the peer group (call them the "Construction and Farm Machinery Group") CAT trades within the context to below the group, which highlights opportunity considering the company's leadership position. Furthermore, the market is pricing in some softness in 2013, which is not consistent fully across peers (giving way to the potential for an upside surprise).
Bear Thesis: "Management has messed up in China."
Reply: I've mostly addressed what it means that "management messed up in China." A disappointment on the write-down for sure, but it's non-substantive long term assuming CAT management improves the acquisition process. But the premise that CAT "messed up" in China due to the lack of market share is a premature conclusion. The company continues to invest in the region. Let's see what the next several years look like (part of the bull case).
Bear Thesis: "Levered to a global economic slowdown."
Reply: If CAT is levered to "a global economic slowdown," then CAT is also levered to a global economic recovery. The author offers his opinion on the state of the global economy. I am not going to debate this perspective (there's no point, as the author offered little to no supporting arguments other than opinion). But I agree that CAT is levered to the global economy (albeit a bit differently, as infrastructure development is a lower-hanging fruit than, say, high-end retail), but the point that a global slowdown will impact CAT is true.
Bear Thesis: "Competitive pressures."
Reply: The author cites competition as a reason not to invest in CAT. Most businesses have competition, and the businesses highlighted by the author aren't exactly new. The reality is that CAT has been and remains the market leader for a long time. Why is competition any more a risk today to an investment in CAT than before?
As I said in my article yesterday, the CAT bull thesis is pretty simple: Management has outlined $12-$18 share of earnings in 2015, based on assumptions around the global economy and forward prospects for the business. Using the low end of forward guidance ($12/share) against the current 11.00x multiple, the stock is worth $132/share, or 37.5% more. Even if it takes three years to get to that $132/share, the annualized return of 11.20% before dividends (12.9% including the current $0.52/share dividend) highlights an attractive opportunity within the context of the trough multiple (there is upside), using the low end of guidance (there is upside), and the $10.50/share consensus estimate for 2015 (there is upside) all against the current valuation. Basically, in light of the consensus view (pricing in a lot of the risk) and the trough multiple, ownership of CAT for the long term seems to have a reasonable balance to the risk/reward.
However, there are some near-term risks for CAT that are worth noting:
- Dealer statistics have been on the decline in North America and the world for several months. If the metrics do not recover, the 2013 consensus estimates could prove high, even with the discount relative to 2012 embedded into the numbers already. The reason I still own the stock: I believe the recent weakness in the dealer stats are priced in to forward expectations.
- The market has priced in (rather quickly) an improvement in the stats, with the stock rallying over 20% off the November bottom, pushing the valuation higher (still low historically, but higher) and pricing in the expectation of an improvement in market conditions. An earnings flub by the company on Jan. 28, or subpar guidance even below the soft 2013 expectations would lead to a disruption in value. This is a risk to any company and the current consensus view seems tempered, though, and so I am willing to be patient.
- The China story hasn't played out for CAT at this point (notwithstanding the write-off, but bigger picture). The 2015 story ($12-$18 of earnings) has growth in China embedded into the numbers. Some progress would be nice to see, or CAT would truly have "messed up" in China. That said, and as noted above, the company has been making investments in China -- not all of which are fraudulent, so, again, I am willing to look through the current underwhelming performance.
I remain a holder of CAT for the longer term. Volatility should be expected, though, and the cautious trader could wait until after the earnings before making a decision about investment now or later. Even the prudent investor could consider ways to hedge risk to the recent gains, but I'll leave that to the imagination of the readers.