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From the Caterpillar, Inc. ("CAT") earnings release on January 28, 2013:

"The outlook for 2013 is sales and revenues in a range of $60 to $68 billion and profit per share of $7.00 to $9.00."

This morning, consensus expectations for 2013 dropped to $8.347/share from the $8.500 context (my bet is the consensus moves closer to the $8.00 mid-point, with a slight skew toward the higher end). At the mid-point of guidance, CAT is trading at 12.2x, which is not particularly expensive contextually relative to the historical multiple range for this business (15.0x-20x context, for the better part of the past decade). Relative to the long-term bull thesis (which I will discuss shortly), the stock remains inexpensive.

However, what's interesting is not the valuation around the current and long-term for CAT (which very much "works" to the upside) but rather, the market reaction (trading the stock up 1.96%, bringing the YTD return to 8.75%) to this guidance (which is "a tell" for not just CAT but the entire market, but we'll focus on CAT).

Specifically, from the corporate press release:

"The range of our 2013 outlook reflects the level of uncertainty we see in the world today. We're encouraged by recent improvements in economic indicators, but remain cautious. While we expect some improvement in the U.S. economy, growth is expected to be relatively weak. We believe China's economy will continue to improve, but not to the growth rates of 2010 and 2011. We also remain concerned about Europe and expect economies in that region will continue to struggle in 2013," said (Caterpillar Chairman and Chief Executive Officer Doug) Oberhelman.

What CAT basically told the market is that the global economic conditions remain highly uncertain, and while there is upside in the event that momentum forward improves, management is not willing to put chips on the table and commit to the upside at this point. While this type of commentary isn't really new for CAT (which generally offers wide, cautious guidance), the way I read the guidance, in light of the opening market action to 2013 is as follows:

  • Holding the multiple constant at 12.2x (as throwing out the expectation of multiple expansion gets tricky), realization of the upside to $9.00/share high-end of guidance is worth about $8.00/share of value to the current stock price. Realizing the $7.00/share low-end of guidance would lead to a $16.50/share drop in the stock price. As such, holding the multiple constant, it would appear that reasonable fundamental expectations would support a $106.50/share upside price (if you believe in the upside) and an $80.95/share downside price (if you believe that the global economy is not in recovery mode) in 2013. The consensus has already driven the stock up to within around 9% of the full upside, with the downside from here being a bit over 20% should expectations not work out. It seems to me that more good is being priced in than bad, which is fine, if the good plays out.

  • For those that were looking forward in the back half of 2012 and added CAT in the high 70's or low 80's, the stock has rewarded that foresight by pricing in a considerable amount of the upside to the 2013 earnings. For those considering investment in CAT now, the near-term prospects for further share appreciation are driven by a binary outcome (either the global economy improves or it does not) and thus, ownership over the medium-term is less about CAT and more about "macro" stuff (to which even management doesn't want to take a real view).

  • Thus, right now, if your time horizon isn't long-term (let's define long-term as beyond 2013), adding exposure to CAT now doesn't feel like it has the best risk/reward, unless you want to make a macro call (which is unrelated to CAT, in that you are venturing away from the fundamentals and guessing on the global economy).

  • However, if your time horizon is the long-term, still holding CAT, for the bull thesis, makes sense. Specifically, management has outlined $12.00/share - $18.00/share guidance for 2015, which implies (using the low-end of $12.00/share against 12.2x, a higher multiple than I have used previously but will roll with the current market) value of $146.4/share, or an annualized return of 14.5% before dividends. Considering the consensus is at $11.06/share in 2015, the market is pricing well off the expectations.

The bottom-line: the prudent trader might want to take some chips off the table and deploy capital elsewhere, to reflect the view that the stock is pricing in the recovery to the global economy without that actually happening (it might, but you are paying for it). The long-term investor should continue to hold, as the long-term bull thesis is intact.

Source: Caterpillar: Near-Term Binary Skewed But The Long-Term Bull Holds