Caterpillar Will Gain From Global Recovery

May.18.13 | About: Caterpillar Inc. (CAT)

The global economic recovery appears to be promising; specifically, a few select sectors seem to be showing positive signs in FY 2013. Building and construction materials is one that is likely to attract investor interest as the global economic recovery picks up and the industry looks toward improving its profits through increases in volume instead of expense cutting. In this situation, Caterpillar (NYSE:CAT) is one of Barron's favorite picks as the financial magazine suggests that the market may be discounting a lot of bad news, making it a buying opportunity for investors. The research accepts that a further slowdown is likely to take the share price back to $80, but investor considerations will still be served to some extent through other sources. In this way, Caterpillar has adapted a risk/return metric, which is admittedly interesting for analysts to investigate.

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Source: Bloomberg.

The chart above represents the performance of Caterpillar's stock with respect to the S&P 500 over the past three years. Since FY 2010, the stock has consistently outperformed the market index, but in recent periods the market return has improved more than Caterpillar's. This supports the aforementioned notion of the stock's undervaluation. The trends over the past three years suggest that the company's stock may be very close to its transitional period.

Business Segments and Growth Strategy

Caterpillar's business is divided into four major segments: construction industries, resource industries, power systems, and financial products. The largest form of business operations for FY 2012 pertain to resource industries as the segment contributed 32% of the company's annual revenues.

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Source: Annual statement FY 2012.

The above figure represents the business segments of Caterpillar and the division of the business into its major segments. We can see that for FY 2012 resource industries is the largest source of revenues, but the other segments are not far off. The diversification with respect to forms of business operations is intelligent, as approximately equivalent exposure has been developed in construction, resource and power systems, whereas the high-risk segment of financial products has been limited to 4.7%.

The growth strategy of Caterpillar is similar to its business operations as the company has not relied entirely on one growth driver. The company's focus on strategic acquisitions is just as strong as its adaptation of new technology through increasing research and development expenditures. The company's overall capital expenditures have projected a CAGR of 30% since FY 2009.

Regional Diversification and Stability

Caterpillar has a global presence with operations spreading throughout North America, South America, the EMEA region, and Asia-Pacific. The company's highest exposure is directed toward North America, as 36.2% of the company's first quarter machinery and power systems revenues were generated in the region.

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Source: Annual statement FY 2012.

More importantly, the reason why analysts look toward Caterpillar is that the company has maintained its position in some very difficult times. In the financial crisis of FY 2008, the company continued to report profits. The chart above shows how the company's robust business model managed the adverse effects of the crisis as the company reported an operating profit of $577 million in FY 2009. Similarly, the construction materials industry in general is deemed robust in the EMEA region. Moody's has maintained a stable outlook for the industry despite the cost inflation pressures and their adverse effects on the margins.

Another important point to note is that throughout the difficult periods, the company has maintained its emphasis on growth and the focus on research and development has been sustained. The expenditure on research and development activities has demonstrated a CAGR of 20.2% since FY 2009. This shows that the business model, which is highly invested in the idea of across-the-board diversification, has proven to be robust.

Comparative Analysis

Caterpillar enjoys a strong position in the industry as compared to its competitors. This competitive positioning not only helps in improving profits, but also helps the company capture the prospective growth in the industry.

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Source: Data from Morningstar and Yahoo Finance.

The above table shows some key stats that reflect the positioning of the company in the industry as compared to its close competitors, which include Joy Global (NYSE:JOY), Deere (NYSE:DE), and Illinois Tool Works (NYSE:ITW). The table clearly illustrates that Caterpillar is the largest company in the industry in terms of revenues and market capitalization. The P/E ratio is substantially below that of the industry, indicating possible undervaluation of the company. The company's profit margins are lower than the close competitors as the company aims to maintain its volume advantage, which produces the large revenues. Despite this strategy, the profit margins of the company are higher than the industry average.

Potential Risk Factors and Investor's Approach

Operating at a financial leverage of 5.1, the company's financial risk is considerable. The debt-to-equity proportion of 1.58 makes the company sensitive to credit risk. Despite the fact that the company's business model is quite strong, substantial cost inflation threats in the EMEA region cannot be fully ignored. It should be recognized that the company's performance is highly susceptible to volatility in the global economy and a reversal of the economic recovery will prove harmful.

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Source: YCharts.

The above chart illustrates the debt-to-equity ratio and the dividends of Caterpillar since FY 2009. We see that the company has realized the high proportion of debt and has worked to decrease the financial risk over time as the debt-to-equity ratio has been decreased from 5.5 to 2.2. At the same time, the dividends declared by the company will help ease the effect of risk factors. The company's dividends have increased over the years, as shown in the chart above. Currently it is offering a decent dividend yield of 2.3% with a five-year dividend growth of 7.63%, according to Bloomberg statistics.

Conclusion

The building and construction materials industry is recovering at a commendable pace as the global economy looks toward recovery. Caterpillar is trading at a cheap valuation compared to the industry, offering a buying opportunity to investors. A buy stance is recommended to investors, as the company's business model makes it robust to financial and economic shocks, and historical performance supports its financial stability. Furthermore, the credit risk is being reduced over the years and the company's dividends are increasing. The improvement in the position of the industry is likely to support the stock price of Caterpillar and make it an attractive opportunity for equity investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.