Shares of Caterpillar (CAT) jumped up on Monday after the company received a big upgrade from analysts at Bank of America. While shares might offer appeal on the back of solid operating leverage if green shoots materialize, I think analysts are too early to upgrade Caterpillar given the soft outlook for 2014.
I remain on the sidelines.
The Bullish Notes
Analyst Ross Gilardi at Bank of America (BAC) upgraded Caterpillar from "Neutral" to "Buy." In the meantime, Gilardi raised the price target by some $13 to $100 per share. The higher price target suggests that shares have some 21% upside potential from Friday's levels.
Gilardi notes that the preliminary outlook to a flattish Power Systems top line outlook in 2014 feels conservative. I find this strange as Caterpillar only released the guidance little over a month ago. Positive growth in the segment could result in earnings per share of at least $4.50-$5.00 per share in 2014, at least in Gilardi's worst-case scenario.
Given the poor earnings in the mining and construction division, Power Systems are expected to make up half of 2014's operating earnings. Earnings at the business should be well supported on rising oil and gas production. Increased exploration and production investments, a strong SOLAR after market performance and a solid growth in data centers are an expected boost to earnings as well.
Third Quarter Results
About a month ago, Caterpillar released its third quarter results. The company reported revenues of $13.4 billion, which is down 18.4% on the year before. On the back of the poor revenue trends, earnings have nearly halved, falling by 44% to $946 million.
Note that Caterpillar's revenue and earnings swings are usually reinforced by inventory swings causing an extra boost when things go well, but putting additional pressure on results in the current weak environment. Note that the Power Systems division was the only unit-which performed relatively strong over the quarter.
Caterpillar ended the quarter with $6.4 billion in cash and equivalents. Total debt stands at $9.4 billion, for a net debt position of $3.0 billion. Note that this excludes the very sizable debt holdings of Caterpillar's financial unit, which total $30.2 billion.
Full year revenues are seen around $55 billion, as earnings are expected to come in around $5.50 per share, or around $3.6 billion.
Trading around $84 per share the market values Caterpillar at $54 billion. This values the company's equity at 1.0 times annual revenues and 15 times expected earnings.
Caterpillar pays a quarterly dividend of $0.60 per share, for an annual dividend yield of 2.8%.
Some Historical Perspective
Given Caterpillar's huge and profitable mining exposure, shares have been tied to the fate of this global commodity sector. Shares have risen to highs of $80 in 2007, to fall to lows of $25 during the crisis.
Shares have seen a very steady rebound hereafter, trading as high as $115 in 2011 and 2012. Yet a continued slowdown in mining, as miners cut back on projects and thus equipment, were resulting in less demand. On top of this came the Chinese-specific problems, which have resulted in a pullback with shares trading at $84 at the moment.
Between 2009 and 2012, Caterpillar has more than doubled its annual revenues to $66 billion. Earnings came in as high as $5.7 billion last year, expected to come some 37% lower this year.
Caterpillar has had a terrible year so far. A month ago, it warned for the third time about its earnings for this year.
At the time, I took a look at Caterpillar's prospects. I concluded that the third warning is bad enough as it is, yet the real disappointment is that Caterpillar does not even see any improvements into 2014.
To somewhat please shareholders Caterpillar upped the pace of share repurchases. Year to date repurchases stand at $2 billion, with another $1.7 billion being authorized within its current program. This repurchase pace at roughly 4-5% comes on top of a near 3% dividend yield, pleasing shareholders to soften the pain somewhat.
Still these payouts cannot make up for the weak operational performance as strong payouts boost leverage, with payout ratios exceeding the 100% ratio by far. Note that payouts in this perspective are seen as repurchases and dividends combined.
I must applaud Caterpillar for being lean. While the fact that earnings were cut in half in the third quarter is bad enough as it is, the company has quite some operating leverage in its business model given the nearly 20% drop in quarterly revenues. This is partially to thank to rationalized production and cutbacks in staff levels.
As such, Bank of America is positive on the expected operating leverage once sales tick up a bit. In hindsight this makes the acquisitions of Bucyrus and ERA Mining Machinery in recent times extra painful.
Given the very limited visibility, the high financial leverage and the valuation at 15 times earnings, I would not be eager to pick up some shares at this point in time. This is despite the underperformance so far this year.
The very long-term prospects for Caterpillar continue to look rosy, but a real recovery might not materialize before 2015 at the earliest. The stock is not an obvious short candidate as miners can't delay investments forever. A long position remains risky as well given the rather high valuation based on historical multiples and the implicit leverage of the financial division.
I remain on the sidelines.