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Summary

  • This article highlights Caterpillar’s strengths and weaknesses.
  • It takes a look at past returns, as well as future growth and income potential.
  • Valuation is also discussed, with Caterpillar being compared to a GICS sub-industry peer.

In this article, we're focusing on the strengths and weaknesses of Caterpillar (NYSE:CAT), and comparing it to PACCAR (NASDAQ:PCAR). While the two companies differ significantly in terms of their size, with Caterpillar having a market cap of $66 billion and PACCAR having a market cap of $22 billion, the two companies sit in the same GICS sector of industrials, and also in the same GICS sub-industry of construction and farm machinery and heavy trucks. Therefore, we feel a comparison could prove to be useful since many investors apportion their capital based upon GICS sectors and GICS sub-industries.

Balance sheet risk

For us, the level of financial gearing makes a significant impact upon the future prospects for a company. Indeed, this is all the more relevant at a time when interest rates are at their lowest ebb and are likely to increase in the months and years ahead. So, we were slightly concerned when Caterpillar's debt to equity ratio of 192% came to light, since at first glance it appears to be rather high. However, delving deeper into Caterpillar shows that the company does not appear to be running too much debt on its balance sheet, since it has an interest coverage ratio of 12. This highlights the fact that even with higher interest rates to come, Caterpillar's current level of profitability is sufficient to enable the company to have adequate headroom when servicing its debt in future.

Profitability

Of course, a capital structure that contains a significant amount of debt and relatively low amounts of equity helps in regard to profitability figures. For instance, Caterpillar's return on equity is a highly impressive 20.1%, which shows that the company is able to deliver a substantial return for its shareholders. In addition, a return on assets number of 4.4% shows just how efficiently the company utilizes its asset base.

Perhaps expectedly, PACCAR's return on equity is slightly lower than that of Caterpillar at a nevertheless impressive 18.6%. However, its lower debt to equity ratio likely holds it back somewhat, although evidence of its efficiency can be seen in the return on assets measure of 5.6%. This is ahead of Caterpillar's return on assets ratio and shows that PACCAR appears to be slightly more efficient when it comes to squeezing profit out of its asset base.

The future

Clearly, there little to choose between the two companies when it comes to historic profitability measures. However, Caterpillar has the edge when it comes to the future, since it is forecast to increase EPS by a mightily impressive 15% next year. This is slightly higher than PACCAR's forecast growth of 13.2%, and shows that, while Caterpillar is the larger stock, a bigger size doesn't necessarily mean a slower grower rate when it comes to the bottom line.

Income potential

The first thing to note with regards to Caterpillar's dividend payments is that they could be a lot higher. Indeed, the company's payout ratio stands at a rather low 40%. Sure, it needs to reinvest in the business through new plant and machinery, but as a mature business in a mature sector, we feel that it could be more generous in this regard. Still, a forward yield of 2.6% is pretty impressive and isn't far short of the key 3% level that we know many income investors keep an eye out for. Similarly, although to a lesser extent, PACCAR could boost its forward yield of 1.4% by increasing its 49% payout ratio.

Valuation

Both stocks seem to offer good value for money right now when it comes to the PEG ratio, with them both having attractive PEGs of 1.3. However, we're surprised to see that Caterpillar trades at a discount to PACCAR on a couple of key valuation multiples. For example, Caterpillar's forward P/E is slightly lower at 14.5 versus 15.1 for PACCAR, while its EV/EBITDA ratio is just 10.6 versus 12.5 for PACCAR. We feel that Caterpillar actually deserves to trade at a premium to PACCAR on these metrics, owing to its superior profitability, better growth forecasts and higher yield potential. As a result, we think that Caterpillar could outperform its sub-industry peer going forward.

Conclusion

Although we're impressed with both Caterpillar and PACCAR, we feel that Caterpillar could be the better buy right now. That's because it has superior profitability (while maintaining an acceptable level of balance sheet risk) and also offers superior growth prospects, as well as a higher yield that has more potential to be expanded due to a lower payout ratio. Indeed, a lower forward P/E and lower EV/EBITDA ratio seem to highlight what we feel could be a mispricing. As such, we think that Caterpillar could outperform its sub-industry peer going forward, with the market bidding up the price of Caterpillar so as to correct the mispricing moving forward.

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Source: Why Caterpillar Could Be A Better Buy Than This Sub-Industry Peer