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Caterpillar (NYSE:CAT) posted fourth-quarter earnings this morning of $1.04 per share, compared with $2.32 per share in the same quarter a year ago. This looks ugly until you notice that $0.87 per share was lost due to a goodwill write down of a Chinese coal mining supplier the company bought in 2012. This $650 million acquisition has now been written down to almost nothing, and the resulting EPS reduction has been accrued to the fourth quarter's results.

In addition, management has said that 2013 will be "tough" as Caterpillar struggles to sell of its glut of excess inventory built up due to the global economic slowdown. Management estimates that roughly $2 billion of excess inventory was sold off during the fourth quarter, a stellar development. Another $1 billion is expected to need to be sold off to reach 'normal' inventory levels for CAT, but this will almost certainly be accomplished in the first half of the year. Finally, management provided extremely vague 2013 EPS guidance of $7 to $9 per share. This article will take a look at CAT's intrinsic value based on updated forecasts and business guidance provided in the fourth-quarter earnings release.

Valuation

We will take a look at a DCF-type analysis to determine what CAT shares are worth, given today's news. As with any DCF-type analysis, estimates are needed and are subject to conjecture. My estimates are: 1) 2013 EPS estimate is from the press release, 2) dividend growth rate is assumed to be 5%, 3) discount rate is 9% (my number), 4) perpetual earnings growth is 3%, 5) buybacks are not factored in, making the estimates more conservative, and, finally, 6) future EPS growth rates are from Yahoo Finance analyst compilations. Obviously, you may disagree with the efficacy of my numbers, but any forecast is inherently imperfect.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$9.12

$8.03

$9.15

$10.43

$11.89

$13.55

x(1+Forecasted earnings growth)

-12.00%

14.00%

14.00%

14.00%

14.00%

14.00%

=Forecasted earnings per share

$8.03

$9.15

$10.43

$11.89

$13.55

$15.45

Equity Book Value Forecasts

Equity book value at beginning of year

$27.35

$33.19

$40.05

$48.07

$57.43

$68.33

Earnings per share

$8.03

$9.15

$10.43

$11.89

$13.55

$15.45

-Dividends per share

$2.08

$2.18

$2.29

$2.41

$2.53

$2.65

$2.79

=Equity book value at end of year

$27.35

$33.19

$40.05

$48.07

$57.43

$68.33

$81.00

Abnormal earnings

Equity book value at begin of year

$27.35

$33.19

$40.05

$48.07

$57.43

$68.33

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

$2.46

$2.99

$3.60

$4.33

$5.17

$6.15

Forecasted EPS

$8.03

$9.15

$10.43

$11.89

$13.55

$15.45

-Normal earnings

$2.46

$2.99

$3.60

$4.33

$5.17

$6.15

=Abnormal earnings

$5.56

$6.16

$6.83

$7.56

$8.39

$9.30

Valuation

Future abnormal earnings

$5.56

$6.16

$6.83

$7.56

$8.39

$9.30

x discount factor (9%)

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

$5.10

$5.19

$5.27

$5.36

$5.45

$5.55

Abnormal earnings in year +6

$9.30

Assumed long-term growth rate

3.00%

Value of terminal year

$155.05

Estimated share price

Sum of discounted AE over horizon

$26.37

+PV of terminal year AE

$92.45

=PV of all AE

$118.82

+Current equity book value

$27.35

=Estimated current share price

$146.17

What we see from the model is that CAT shares are worth something like $146 today, given my model's inputs. Given that the EPS impact of the Chinese acquisition has nearly entirely been accrued to the fourth quarter, shareholders need not fear further surprise EPS reductions in the future. In addition, using my 9% discount rate, we see that CAT produces an enormous amount of economic value from its assets. This is extremely bullish for investors as it proves management can earn its cost of capital plus a significant amount more for shareholders. As the dividend is decent, but not great, I think we will see CAT continuously raise its payout to reward investors once the uncertainty of 2013's global economic outlook has passed.

I don't like it when management of any company provides guidance that is as wide as CAT's was this morning ($7-$9 EPS for 2013), but I believe this reflects the extreme uncertainty its business faces and management wants to set low expectations. I appreciate under-promise/over-deliver far more than the other way around, and I think we'll see CAT's 2013 EPS at or above the midpoint of that guidance. The risk exists, of course, that even this less-than-sanguine guidance will be missed, but with an intrinsic value of roughly 40% higher than the shares trade today, I believe that possibility is priced in.

Indeed, shares were trading up to roughly $97 as of this writing, and CAT is poised for further gains in 2013 for patient shareholders. Any company that is leveraged to the global economy as CAT will experience cyclicality in its earnings, and we are seeing some cyclical uncertainty in management's 2013 EPS forecast range. However, the time to buy is now for robust gains in the future as 2013's uncertainty subsides and Caterpillar unlocks $10-plus per share in earnings in 2014 and beyond. Couple the roughly 10% capital returns I'm forecasting for CAT shares with the dividend of over 2%, healthy gains can be likely expected for years to come barring any global recessions.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CAT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Caterpillar Forecasts A 'Tough' 2013