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Summary

  • Continued slump in the resources industry sales will keep Caterpillar's revenue and EPS growth muted.
  • China's economy is expected to grow at a sluggish pace over the next two years according to IMF and this will impact Caterpillar.
  • Based on the forward PE valuation and current EV/EBITDA valuation, Caterpillar is expensive and a correction is likely.

Caterpillar (NYSE:CAT) has rallied by 19% in 2014 and by 26% in the last one year. This article looks into the reasons why the industrial goods major can be avoided at current levels.

China Growth Concerns Remain

The industry specific factor and the China growth factor are important to consider for Caterpillar. The company's revenue in FY11 and FY12 was $60.1 billion and $65.9 billion respectively. However, after a slump in economic growth in China, Caterpillar's revenue declined to $55.7 billion in FY13 and the company expects margin revenue growth to $56 billion in FY14. It is therefore important to look at where China is headed from a GDP growth perspective.

According to IMF estimates, China's GDP growth for 2014 and 2015 is expected to decline to 7.5% and 7.3% respectively from 7.7% in 2013. This implies that China's economic scenario will remain very sluggish at least for the next two years. It is therefore not surprising to see Caterpillar guiding 2.2% EPS growth to $6.1 in FY14 from $5.97 in FY13.

The results for Q1 2014 are also an indication of the extent of slump witnessed in China. For Q1 2014, the sales for resources industries slumped by 37% as compared to Q1 2013. This decline has primarily been due to the sluggish mining activity in China.

This decline in revenue for the resource industries was offset by an increase in revenue from the construction industry (North America). However, the sustainability of growth in the construction industry also remains doubtful.

The weak trend might be accelerating in the resource industry with the company's retail statistics showing that machine sales have declined by 49% in April (the steepest in 2014). Machine sales growth in the construction industry and the energy industry remains positive. It remains to be seen if these two industries continue to offset the slump in the resources industry machine sales.

Declining Capital Expenditure

It is the company's capital expenditure that sets the trend for future growth. The capital expenditure incurred translates into revenue and cash flow growth when projects go on-stream. The capital expenditure trend for Caterpillar is a concern and also underscores the point that the company is not positive on near-term growth prospects.

Caterpillar's capital expenditure declined to $2.5 billion in FY2013 from $5.7 billion in FY2012. For Q1 '14, the company's capital expenditure was $454 million as compared to $896 million for Q1 '13. Caterpillar might not sound too bearish on the global growth outlook, but the capital expenditure trend speaks volumes on the likely growth trajectory in the medium-term.

With China's growth expected to remain sluggish along with relatively weak growth in the developing markets, the company's expansion plans will remain muted and this will have an impact on the growth outlook in the foreseeable future.

Rich Valuations

At a current market price of $106.67 and an estimated EPS of $6.21 for FY2014, Caterpillar is currently trading at a forward PE of 17.2. Further, the EPS for FY2013 was $5.75 and this translates into an EPS growth rate of 8% considering the FY2014 consensus estimate of $6.21.

The current PE and the expected growth rate imply a PEG ratio of 2.1, which does indicate that Caterpillar is overvalued. If broad market sentiments weaken, the stock can witness meaningful correction.

Even considering a mean 5-year future growth rate of 13.42 and the trailing twelve month PE of 18.1, the stock is trading at a PEG ratio of 1.3, which is expensive considering the challenges in terms of growth.

Even on a relative basis, Caterpillar looks expensive. Deere & Company (NYSE:DE) is currently trading at a trailing twelve month PE and EV/EBITDA valuation of 9.9 and 10.2 respectively as compared to Caterpillar's same valuation metrics of 18.1 and 11.1 respectively. The advantage with Deere & Company is that it primarily caters to the agriculture, construction and forestry sector. Caterpillar has been negatively impacted by its strong presence in the mining sector. I am certainly not suggesting that the good days are over for the mining sector.

However, the mining sector will remain depressed in the medium-term. If I had to choose a industrial goods company for investing, Deere & Company would be my first choice from a valuation perspective and also from a sector exposure perspective.

Conclusion

Caterpillar is a strong company fundamentally and the company will certainly bounce back when growth in emerging markets trends higher. For now, the stock has run up too fast and the valuations underscore my point.

I am of the opinion that the broad markets are also likely to correct at some point of time. The best strategy for now would be to book profits and exit the stock. I can say with some conviction that investors will get this stock at a relatively attractive valuation few months down the line.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Caterpillar Is An Avoid At Current Levels