Why Caterpillar Should Continue Beating The Market

| About: Caterpillar Inc. (CAT)


Caterpillar posted solid first-quarter results on the back of solid execution of strategies.

Caterpillar's construction industries business is on the growth track while the mining segment seems to have bottomed, indicating better times ahead.

Caterpillar's valuation is also attractive as compared to peers, making it a good pick.

Shares of construction and mining equipment giant Caterpillar (NYSE:CAT) are beating the market so far this year. Caterpillar is up more than 13%, and the company's first-quarter results that were reported recently were also strong. As a result, it is not surprising that Caterpillar shares have done well this year after two strong reports.

Robust growth pointing toward long-term gains

Caterpillar's focus on aggressive cost reduction has helped the company outperform expectations. In the previous quarter, Caterpillar posted earnings of $922 million, or $1.44 per share, up from $880 million, or $1.31 per share in the year ago period. In addition, Caterpillar raised its 2014 earnings forecast to $6.10 per share, excluding restructuring costs, from the earlier $5.85 per share. Hence, it looks like Caterpillar's good performance should continue going forward, and a look at the company's strategies will reveal the same.

Growth-oriented strategies

Caterpillar is seeing some great momentum in its construction business. The Construction Industries segment was up 20% year-over-year in the previous quarter. Since this is Caterpillar's largest segment by sales, a solid performance here indicates that Caterpillar is set for better times going forward. In fact, Caterpillar saw sales growth across the board, with revenue from the segment up about 36% in North America, 20% in Europe, Africa, Middle East, and 10% in Asia Pacific.

Moreover, Caterpillar is seeing an increase in dealer inventory due to an increase in end-user demand. Its dealer deliveries for the first three months of 2014 have increased 9% in construction.

However, the mining segment, which has been declining since mid-2012, continues to be a sore point for Caterpillar. This decline was seen once again the first quarter as order rates for new equipment remained weak in the first quarter, and substantially below the peaks that were seen in 2012.

However, Caterpillar's order rates as compared sales in the first quarter were close to equilibrium. As a result, the order backlog was fairly close to being flat with that seen in year-end 2013. Since Caterpillar is producing more this year, it's seeing an increase in efficiency. Inventory reductions from last year had resulted in negative inventory absorption impacts on the profit, but this year, this phenomenon has diminished.

Going forward, to ward off the weakness in the segment, Caterpillar will continue focusing on managing costs. The company is shutting down plants and laying off employees to take additional production offline and improve its profit. As reported by Bloomberg --

Caterpillar Inc. will cut 380 full-time and 130 temporary jobs as it moves marine-engine production from South Carolina to Georgia to improve efficiency.

The Fountain Inn, South Carolina, plant will reduce production in the second quarter and close by the end of the year, the company said in a press release today. Adding the ability to make marine engines at the company's Griffin, Georgia, facility will improve efficiency.

Earlier today, the Peoria, Illinois-based company announced that it will close a plant in Pearisburg, Virginia, which rebuilds and repairs underground mining machinery. The company will ask dealers to handle those processes starting in July. The shutdown of the plant in Virginia will affect 50 employees, the company said in a press release.

A mining rebound in the cards?

Hence, Caterpillar is doing the right thing by controlling costs in a weak mining environment. However, there is a chance that the mining industry could rebound going forward after bottoming out this year. As reported by Reuters earlier this year --

Oberhelman said on Monday that Caterpillar expects those headwinds to continue in 2014, with mining equipment sales declining another 10 percent. He said that the company would "take additional actions" during the year to cut costs. He characterized the moves as "tough decisions necessary to better position us down the road when economic conditions improve and our sales rebound."

Brian Langenberg, an analyst with independent research firm Langenberg & Co, said Caterpillar's latest results suggested the "the worst is over." Even the continued challenges in the mining sector will get "less bad" in 2014, Langenberg said.

Fundamentals and final words

Thus, the combination of a strong construction business along with a revival of the mining business is a good sign for Caterpillar going forward. Moreover, considering the company's valuation and expected growth rate, Caterpillar looks like a good buy.

Its trailing P/E and forward P/E ratios are 18 and 14, respectively. This indicates earnings growth going forward, primarily driven by the cost cutting efforts of Caterpillar. Also, Caterpillar's PEG ratio of 1.27 is far better than its competitors such as Deere & Company (NYSE:DE), which has a PEG ratio of 1.32 and Komatsu (OTCPK:KMTUY), which has a ratio of 6.27.

More importantly, analysts expect Caterpillar's earnings to grow at a CAGR of 12.81% for the next five years. In addition, Caterpillar also has a dividend yield of 2.30%, while its payout ratio is just 39%. As the company's earnings are expected to grow at a good pace going forward, investors can expect a bump in the dividend. All in all, Caterpillar looks like a pretty solid investment from all angles despite its solid run this year.

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.