Caterpillar: Still A Long Story, But Here Is How You Should Trade

| About: Caterpillar Inc. (CAT)

Shares of Caterpillar (NYSE:CAT) have appreciated by 22.7% from their 3-month low of $81.10 touched in November 2012. At $99.49, the stock is trading at around the mid-point of its 52-week price band between $78.25 and $116.95 and offers a solid dividend yield at 2.1%. Should investors ride on the current price uptrend? In this article, I will elaborate on my valuation analysis which may assist you in formulating the appropriate investment decision.

Sell-side analysts on average predict Caterpillar's revenue, EBITDA, and EPS to grow at CAGRs of 2.6%, 5.7%, and 2.9%, respectively, over the current and next years (see comparable chart below). The consensus estimates are notably below the averages of 3.8%, 8.3%, and 8.0%, respectively, for a group consisting of Caterpillar's primary peers listed in the US market. The firm's EBITDA margin is forecasted to expand by 1.0% over the same period, fairly in line with the peer average also at around 1.0%. On the profit side, Caterpillar has demonstrated a robust margin performance as all of the firm's margin and capital return metrics are above the par. In addition, Caterpillar carries a relatively higher level of debt as reflected by the company's above-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, the firm's trailing free cash flow margin is slightly above the peer average. Both the firm's current and quick ratios are slightly below the par, reflecting a mediocre balance sheet performance.

To summarize the financial comparisons, Caterpillar's significantly larger size as well as its solid performance in profitability, capital return, and free cash flow generation should be the primary support to the stock valuation. However, given the firm's lackluster growth potential, I believe Caterpillar would not trade at a large premium over the peer-average valuation level. The stock's current valuations at 9.6x forward EV/EBITDA and 12.1x forward P/E together represent an average premium of 4.0% over the peer-average trading multiples (see chart above), suggesting the stock is reasonably priced now on a relative basis.

Caterpillar's forward PE multiple of 12.1x is currently trading at 15.0% discount to the same valuation multiple of the S&P 500 Index, which stands at 14.3x now (see chart below). I believe the notable market discount implies a somewhat attractive valuation level provided that 1) Caterpillar's long-term estimated earnings growth rate of 12.2% is considerably above the average estimate of 8.6% for the S&P 500 companies; 2) The firm has a solid market position in the global industrial heavy equipment sector and a significant scale of operation; and 3) the stock offers a 2.1% dividend yield, which is fairly in line with the average yield for the S&P 500 stocks.

Moreover, Caterpillar also appears to be fairly priced from a historical valuation standpoint. The stock's trailing EV/EBITDA and P/E multiples are both trading at discounts of 31.4% and 34.3%, respectively, to their 5-year historical averages (see charts below). The currently discounted valuations seem somewhat tempting given that 1) the market's consensus estimates predict the EBITDA margin to slightly improve from its 5-year historical average level and stabilize somewhat; and 2) despite a significant drop in the Q4 2012 growth as a result of a goodwill write-down for the firm's Chinese acquisition, the firm's revenue, EBITDA, and EPS growth rates are estimated to recover and remain fairly in line with their 5-year historical level (see charts below).

On the qualitative side, Caterpillar is poised to benefit from some favorable market developments. Alexander Potter, a research analyst at Piper Jaffray, wrote in a recent research note (sourced from Thomson One, Equity Research):

"In late December the Chinese government announced its intention to discontinue intervening in the pricing of thermal coal as of January 1, 2013. The reforms seem likely to bolster state-run miners and energy producers/importers, many of whom have struggled in recent years due to government-imposed caps on energy pricing. In general we regard these reforms as positive for companies (i.e. Caterpillar) which sell equipment to China's miners and/or oil & gas producers."

Further, a China excavator research performed by Macquarie's research analyst, Sammer Rathod, also suggests a favorable trend for Caterpillar (Thomson One, Equity Research):

"We analyze the past 3 years of monthly excavator sales trends in China and find that Caterpillar continues to gain market share despite the downturn in equipment sales. Although CAT did not improve its market share rank in 2012 from 6 in 2011, it has continued to nibble away at excavator market share. We estimate CAT had 6.6% in 2012 compared to 6.4% in 2011."

Bottom line, given the improved global market environment and commodity price, which are supported by ample liquidity released by central banks in the developed world, Caterpillar should be a decent proxy to capitalize on the favorable trend. As the stock price is not significantly cheap, to limit the investment risk, I recommend selling out-of-money put options to either collect upfront premium or take a potential opportunity to acquire the shares at a lower valuation level.

The comparable analysis chart is created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated data in the article and the charts is sourced from Capital IQ unless otherwise specified.

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.