Caterpillar: Is This A Breakout Or Will The Stock Fall Back To $85?

Apr.20.14 | About: Caterpillar Inc. (CAT)

Summary

What is Caterpillar's current value?

How does management intend to use their excess cash?

What role does the net debt play in a potential breakout?

Caterpillar Inc. (NYSE:CAT) looks to be an interesting play as the global economy slowly recovers. After a period of consolidation where the stock price hovered around $85.00, the stock recently gained some traction and rose up to ~$102.00. A reason for this traction is the increased demand for machine retails within the construction industries. This segment has indicated leadership and is up ~9% month over month in 2014. Even though there are segments of the company that are displaying leadership, a key aspect of the company that is consistently strangling shareholder value is the net debt.

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CAT data by YCharts

As the stats below indicate, over the past five years, Caterpillar's net debt has increased by 14.06%.

  • 2009 - $27.764 billion
  • 2010 - $24.824 billion
  • 2011 - $31.535 billion
  • 2012 - $34.653 billion
  • 2013 - $31.669 billion

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CAT Net Total Long Term Debt (Annual) data by YCharts

The question is, what effect does this debt have on shareholder value?

In the section below, I will calculate Caterpillar's value using the discounted cash flow method. I will do the calculation two times. The first time, the calculation will including the net debt. The second time, the calculation will exclude the net debt. The purpose of these calculations is to show how the net debt is limiting potential capital appreciation for the shareholder.

Including the Net Debt

FY 2011 FY 2012 FY 2013
Operating Income 7,153 8,573 5,628
Taxes 1,720 2,528 1,319
Unlevered Net income 5,433 6,045 4,309
D&A 2,527 2,813 3,087
EBITDA 9,680 11,386 8,715
Free Cash Flow 3,086 165 5,745
WACC 6.73%
Terminal Value 10.48X EBITDA 91,333
Total Cash Flow 3,086 165 100,329
Net Present Value $85,557.89
Total Debt $37,750
Cash and Cash Equivalents $6,081
Net Debt $31,669.00
Equity Value $53,888.89
Shares Outstanding 637.82
Current Value $84.49
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As you can see in the chart above, Caterpillar has a NPV or net present value of $85.557 billion. This valuation is based on the industry average trading at 10.48X EBITDA. As the net debt is currently $31.669 billion, this leaves $53.888 billion in equity value. Currently, the net debt has eroded ~37% of the shareholders' NPV.

Excluding Net Debt

In calculation below, I will subtract the net debt and give it a value of $0. This calculation will give a company value excluding the net debt.

FY 2011 FY 2012 FY 2013
Operating Income 7,153 8,573 5,628
Taxes 1,720 2,528 1,319
Unlevered Net income 5,433 6,045 4,309
D&A 2,527 2,813 3,087
EBITDA 9,680 11,386 8,715
Free Cash Flow 3,086 165 5,745
WACC 6.73%
Terminal Value 10.48X EBITDA 91,333
Total Cash Flow 3,086 165 100,329
Net Present Value $85,557.89
Total Debt 37,750
Cash and Cash Equivalents 6,081
Net Debt $0.00
Equity Value $85,557.89
Shares Outstanding 637.82
Current Value $134.14
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In the calculation above, I have used the same formula but have eliminated Caterpillar's net debt to find shareholder value. Without the debt, the stock is worth ~$134.14.

In understanding that part of Caterpillar's financial business is to borrow money, purchase or build equipment, then lease, rent or sell it to customers, the ROCE or return on capital employed will give us an understanding of how much capital the company is making on its borrowed money.

Return on capital employed = EBIT / (Total Assets - Current Liabilities)

This ratio indicates the efficiency and profitability of a company's capital investments. The higher the percentage the better.

ROCE should always be higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice-versa. A good ROCE is one that is greater than the rate at which the company borrows.

  • 2011 = $7.549 billion / $52.885 billion = 14.27%
  • 2012 = $9.040 billion / $59.601 billion = 15.17%
  • 2013 = $6.093 billion / $57.599 billion = 10.58%

If the ROCE is compared to Caterpillar's current WACC of 6.73%, this indicates that Caterpillar is making profits from its borrowed money. So at this point in time this is proving to be positive strategy for the company.

In the 2013 Q4 quarterly report management stated how they intend to use their cash.

Our priorities for the uses of cash are providing capital to support growth, appropriately funding employee benefit plans, paying dividends and repurchasing common stock with excess cash.

These incentives will increase shareholder value but at this time with low interest rates, a cost of debt at ~3.803% and a WACC at 6.73%, I believe this is a prime opportunity to significantly reduce the company's net debt.

Conclusion

As the global economy begins to improve, Caterpillar will be a company that is well positioned to capitalize on this. Having stated that, my concern with the company is that the net debt is very high and is showing no signs of decreasing. In understanding that a significant part of Caterpillar's profitable business is to borrow money to support growth, the evidence above states, if Caterpillar's management uses some of this cash to reduce the net debt, this will create a catalyst for the stock price. As the DCF valuation indicates, the stock is still worth ~$84.49, so I have Caterpillar as a hold.

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.