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Summary

  • From the surprise beat in the January quarter, management has proven that they have a strong pulse on what drives this industry.
  • I believe management will make the necessary operational adjustments to combat (among others) the weak mining market.
  • Assuming the company can continue cutting costs to improve margins, the stock is a sure-bet to reach $110, which is still $12 shy of analysts' highest price target of $122.

Warren Buffett once said, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." Although industrial giant Caterpillar (NYSE:CAT) has one of the best management teams in the market, they have not been immune to the poor conditions that have plagued the entire mining and construction industry. This led to Caterpillar posting an unassuming 3% stock gain for all of 2013 compared to the 26% gain of the Dow Jones Industrial Average (DJI).

But things have changed. With Caterpillar posting stronger-than-expected fourth-quarter results in January, analysts are back on-board. There is now optimism that any growth in commercial construction can help Caterpillar post "earth-shattering" results. And with evidence of moderate improvement in the U.S. housing recovery, this may very well prove true. But it's not yet time to get carried away.

This is not a slight against Caterpillar. But we've been down this road many times before, only to be met with disappointment. From results we've seen from the likes of Stanley Black & Decker (NYSE:SWK), housing-related stocks have not participated in the recovery as much as analysts had predicted. While Caterpillar management fit the description of having "done more with less," they don't need to be burdened with higher expectations. But regardless of what Thursday's numbers say, investors have to be encouraged that the worst in the construction industry is over.

Although analysts will be looking for a slight dip in profits on Thursday, overall the Street continues to remain positive. Consensus first-quarter earnings per share estimates are at $1.25, which is 6 cents lower than last year's mark of $1.31. The good news is, estimates have risen over the past three months by 3 cents. For the full fiscal year, analysts are expecting earnings of $5.87 per share.

In terms of revenue, analysts will be looking for $13.24 billion, which is marginally higher than last year's total of $13.21 billion. While this is not exceptional growth, consider that over the past four quarters, Caterpillar has posted an average revenue decline of 11%. This includes an 18% drop in the third quarter. From that standpoint, anything close to flat revenue would have been considered a win. For the full year, revenue is projected to roll in at $56.30 billion, which should also exceed last year's mark of $55.6 billion.

From my vantage point, now is the best time to buy Caterpillar. While I don't encourage doing so on the basis of this quarter's results, companies like Caterpillar still serve as strong defensive plays. Management has shown that it can withstand the downturn of cyclical construction. And considering that Caterpillar, by virtue of last year's 3% gains, has yet to participate in this "bull market," when the tides do turn, investors will have to consider safe bets like Caterpillar.

In fact, the entire construction industry, which includes the aforementioned Stanley Black & Decker, Mohawk Industries (NYSE:MHK) and Joy Global (NYSE:JOY), should all do well. For Caterpillar, the extent to which management can resolve operational deficits like weak machinery revenue, which led to a 44% decline in profits in the October quarter, this stock should continue to rebound.

On Thursday, investors should also pay attention to Caterpillar's order rates, which still aren't picking up, even amid modest commodity production. Likewise, I'm curious to hear what management says about its resource business, particularly the mining segment, which has plenty of room for improvement. Last but not least, if management can successfully align its costs with the industry's woes, Caterpillar should be able to stabilize its profits and balance sheet. And more than anything, these are why I continue to love this stock.

I expect management to deliver on the measures that I have just outlined. From the surprise beat in the January quarter, management has proven that they have a strong pulse on what drives this industry. And I believe they will make the necessary operational adjustments to combat (among others) the weak mining market. And assuming that the company can continue cutting costs to improve margins, the stock is a sure-bet to reach $110, which is still $12 shy of analysts' highest price target of $122.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's tech sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.

Source: Why Caterpillar Is Heading To $110