Macroeconomic choppiness and declining demand for mining equipment have weighed down on the economic bellwether Caterpillar (CAT). Macroeconomic uncertainty will continue to define the stock's short-term performance but at the current relatively depressed valuation of just 9.3x forward earnings, the stock is poised to deliver strong performance for investors who have a long-term investment horizon. Although mining equipment demand is faltering, uptick in Chinese and other key emerging markets' economies should provide a support level for commodity prices and in turn should check the strength of fall in mining capex. Given CAT's brand power, global footprint, and high correlation with the world economic activity, I am bullish on the stock for the long term.
Caterpillar is the maker of the world's leading construction and mining machinery, and it also produces engines and turbines for industrial and transportation use. 4Q'12 adjusted EPS of $1.46 (excluding the goodwill impairment charge) was below the consensus of $1.70. Revenues of $16.01 represented a fall of 6.8% YoY, driven by fall in the Construction segment. The impairment charge relates to the accounting misconduct at ERA Mining Machinery it acquired to tap into the lucrative annual $68bn machinery market in China; a market dominated by local manufacturers.
Since the industrials sector is highly leveraged to the health of the global economy, continued global macroeconomic uncertainty has made making estimates a difficult task. The management, for example, projected EPS of $7 - $9 on sales of $60bn - $68bn.
Although China still contributes less than 5% of total revenue for CAT, a pickup in economic activity in the country means stronger demand for commodities and consequently a mitigation of the impact of falling mining capex which many believe has peaked. Overall, I believe the mining endmarket for CAT has weakened given the fall in commodity prices but as China and other heavyweight developing markets make up lost ground, some support for commodity prices and mining capex is in order. China remains a long-term growth driver for CAT and catching up to local manufacturers will be an uphill struggle. That said, CAT recently reported 3-month rolling dealer sales for February 2013 which revealed that machinery sales were down 13% YoY and Power System sales declined by 7%. These results point out the continued weakness in mining machinery demand. However, encouragingly, CAT has won a five-year contract, valued at $633mm, to supply equipment to the U.S. military.
On the other hand, many believe that improvements in Latin America construction would support the demand for CAT products. Growth supportive government policies in Brazil, which include substantial infrastructure development, should boost demand for construction equipments. Construction activity in North America remains below the peak levels but is picking pace and I believe CAT stands to benefit from a resurgence in construction activity.
Furthermore, given the need to build energy related infrastructure, I am bullish on energy related demand for CAT's petroleum business. In this respect, demand for high margin Solar Turbines is likely to go up. In addition, I view the joint venture with Ariel Corporation to provide pressure pumping solutions to oil and gas drillers as a definite boost to CAT's existing petroleum portfolio.
CAT currently trades at 9.3x it forward earnings, reflecting investor uneasiness with the stock. CAT has a current ratio of 1.43, debt to equity ratio of 228.97% and interest coverage of 18x, highlighting no problems for CAT in meeting its obligations. CAT also provides a safe dividend yield of 2.38%. Analysts expect a long-term earnings growth rate of 14%. I apply a P/E multiple of 12x its forward 2014 earnings of $9.40 to arrive at a target price of $113, i.e. a potential of 30% price appreciation. Given the facts and estimations provided in the article, CAT is a play on the long-term performance of the global economy and the company's particular strengths will allow it to benefit the most as the economy eventually improves.