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On Thursday, Deutsche Bank (NYSE:DB) analyst Vishal Shah argued that Caterpillar (NYSE:CAT) shares could rally 25% to $122. As the following chart shows, that would represent an all-time high for the machinery giant. While CAT bulls certainly hope that Mr. Shah is right, I believe he is being far too optimistic about the company's future given the depressed state of the mining industry and an over-hyped construction recovery. In fact, CAT looks expensive at current prices, let alone at $122.

(click to enlarge)

(Chart from Google Finance)

As the chart shows, CAT shares neared $120 in 2011 and 2012. Since then, shares have traded lower and have been stuck mostly between $80 and $100. It is worth considering CAT's historic and current earnings power to see if this decline makes sense. In 2011, CAT earned $7.40, and in 2012 CAT earned $8.48 with shares trading 13-15x those earnings (historical financials here). In 2013, CAT generated only $5.75 in earnings, down 32% year over year. Given this, it really isn't surprising shares have dropped so far from their highs. With this low earnings rate, returning to $120 seems extremely optimistic.

Now, stocks price in future earnings, so a rally could be justified if we are going to see a major bounce back in coming years. Unfortunately, 2014 is going to look very similar to 2013. Over the past two years, management has had a history of being too optimistic about its business, and hopefully it is being more realistic with current guidance. It currently expects 2014 revenue to be roughly equal to 2013 +/- 5%. Thanks to some to headcount reductions, CAT anticipates EPS growth of 1.7% to $5.85 (guidance and financial results available here). With virtually no near term growth and earnings down 32% from their peak, reaching an all-time high seems extremely optimistic. Shareholders should be glad CAT is down less than 20% from its peak given the deterioration in earnings.

Simply put, Caterpillar's 2012 earnings were unsustainable because they were driven by bubble like activity amongst mining companies. With gold and other metal prices at extremely high prices, mining cap-ex spending was extremely high, which helped CAT sell more and more mining machinery. Last quarter alone mining sales were down 48%. Now, I agree with Deutsche Bank that revenue declines in this segment will be slower going forward. Nonetheless, I expect another sequential decline in 2014. While gold prices have stabilized, which limits the probability of bankruptcies, prices are too low to justify expanding cap-ex budgets.

Further, many mining firms have promised shareholders they will cut cap-ex budgets over the coming years. This in part is due to ill-timed acquisitions. Many firms dramatically expanded their portfolios during the boom years and are carrying a significant amount of debt. They will be using cash to restore the balance sheets rather than spend on cap-ex. Freeport-McMoRan (NYSE:FCX) has pledged to reduce cap-ex by $1.5 billion. Thanks to the suspension of its Pascua-Lama project, Barrick Gold (NYSE:ABX) is going to halve its cap-ex budget to about $2.5 billion. We are seeing further cuts at Newcrest Mining, BHP Billiton (NYSE:BHP), and Rio Tinto (NYSE:RIO). These diversified giants have also been taking some business to Chinese machinery firms to maintain good standing with the government.

While there will not be another 40%+ decline, mining remains challenged. Unless gold rallies past $1,600 and brings other metals with it, the focus over the next three years will be on balance sheets not growth. 2011 and 2012 cap-ex budgets were based on bubble-like pricing in precious metals, and it will take many years, perhaps even a decade, to return to that level.

With mining still a drag, CAT's only source of growth will be from power generation and construction machinery. Power generation will help to offset mining to a degree, but construction is a bit of a cloudy picture. Residential activity is starting to improve (though the weather is causing near-term headwinds) and barring a major spike in interest rates will be a decent tailwind. Deutsche Bank also points to impending strength in non-residential construction as a catalyst. On this point, I disagree.

Non-residential construction can essentially be broken into three categories: government infrastructure, retail, and commercial. While American infrastructure clearly needs an upgrade, the current setting in Washington precludes investment. While President Obama supports spending $50 billion on infrastructure, Republicans remain focused on the debt and deficit. With a midterm election in November and a new Presidential cycle starting immediately thereafter, there is little incentive to compromise. While state budgets are improving, few are in a position to undertake major projects on a meaningful scale. Government construction spending will remain lackluster.

Retail and commercial (i.e. office space) also have headwinds. With more and more Americans shopping online, there is no need to build new malls or big-box stores. In fact, many retailers are closing or consolidating locations. There is no impetus to undertake major physical store expansions. Further, the labor market is still mixed with many firms having headcount below their 2007-2008 peak (employment details available here). As a consequence, there is little demand for new office space especially with some regions like Northern New Jersey and California having excess capacity for lease. While non-residential construction isn't as bad as it once was, it is far from robust and cannot compensate for the decline in mining.

Overall, Caterpillar has limited growth prospects over the next 2-3 years. Mining continues to struggle, and construction is a mixed bag. Moreover, Caterpillar Financial continues to increase leverage, which will make dividend payments to the parent more difficult. It will take over 5 years to return to peak earnings. As such, I think calling for a new all-time high is far too optimistic. At current prices, CAT is trading over 17x earnings, which is expensive for a firm with limited growth over the next 12-36 months. Without a turn in mining, shares will be hard-pressed to reach $122. At current prices, I would sell not buy.

Source: Caterpillar Doesn't Have 25% Upside