Seeking Alpha
Long/short equity, growth at reasonable price, hedge fund manager, contrarian
Profile| Send Message|
( followers)

Taking the same approach to analysis I’ve been using for my Buy It Like Buffett series, I decided to take a look at one of the most popular cyclical stocks of the recent bull market, heavy equipment maker Caterpillar (NYSE:CAT). Since Buffett famously avoids cyclicals, I felt it would be instructive to put one to the test.

Brand Recognition

There’s no doubt Caterpillar’s name carries a lot of weight in building and construction. It makes durable, high quality machinery and as far as brand names go, ranks among the best of American industry. Unfortunately the company also operates a financial services arm and we all know how that can end. Think GM, another strong global brand which felt compelled to leverage its business via the debt market.

Earnings Trend

A strong and rising earnings trend often indicates a business benefiting from a durable competitive advantage and profit-minded management.

Caterpillar Earnings per Share

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

1.16

1.15

1.57

2.88

4.04

5.17

5.37

5.66

1.43

4.15

For a cyclical, Caterpillar’s earnings are actually less erratic then some. Mining and energy equities can swing wildly year-to-year to match the volatility in the underlying commodity while “picks and shovel” type businesses like Caterpillar trend more smoothly. Caterpillar’s problem is 2009, a year where earnings plunged 75%. Could it happen again? Might Chinese growth falter? Might we see another downturn in the US housing market?

Debt

Great businesses typically generate strong cash flows and require little debt financing. Specifically, I like to see long-term debt less than three times current net earnings. With long-term debt of 20 billion and trailing 12-month net income of 3.8 billion, it would take Caterpillar five years to pay off its debt. The excessive debt is complicated by the earnings picture above – if earnings are peaking and begin to turn down again, the debt load becomes even more onerous. As a potential investor, do you have the stomach to watch earnings constantly going to paying down debt, or would you rather see them profitably reinvested in the business?

Return on Equity

Companies that consistently deliver high returns on equity create the true wealth for shareholders. Average businesses typically offer a 12% return on equity while great businesses return over 15%. However there’s one major exception to this rule. Companies that carry large debt loads can show high returns on equity simply because the denominator in the equation, the equity base, is so small. In these instances it’s more instructive to use ROIC, or Return on Invested Capital, which looks at returns on the whole capital base (shareholder’s equity + debt).

Caterpillar Return on Invested Capital

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

3.75

3.52

4.48

7.15

8.76

10.35

9.91

9.01

2.18

6.78

Caterpillar’s 10-year average ROIC is a lowly 6.6%.

Retained Earnings

Whether it’s via share buybacks or new investment in the core business, Buffett wants to own companies that are free to reinvest retained earnings at high rates of return. What he doesn’t want to see is high research and development costs or capital expenditures in the form of plant and equipment replacement.

In addition to the high cost of actually building Caterpillar’s line of bulldozers and excavators (gross margin is 29.1%), the company is spending close to 2 billion a year on research and development and nearly the same amount on “other operating expenses.” Current cap ex is 35% of operating cash flow and ranges as high as 50%. What’s left over for you the investor?

Between 2002 and 2010, Caterpillar earned a grand total of $31.42 per share. During that same time the company paid out $10.48 per share in dividends. This leaves 20.94 in retained earnings, which were plowed back into the business. Earnings per share were 1.15 in 2002 and 4.15 in 2010 with the incremental profit equaling 3.00 (4.15 – 1.15). Utilizing 20.94 in retained earnings, the company realized a 14% return (3.00 / 20.94), or a couple percent per year. Not impressed.

Summary

While buying and selling Caterpillar in sync with the economic cycle might appeal to short-term traders, keep in mind that Peter Lynch frequently pointed out that the time to buy cyclicals was when the P/E ratio reached the high end of a range. This is because earnings crash on the downside of the economic cycle and the distance between price and earnings jumps dramatically. In 2009, Caterpillar’s P/E clocked in at 40 and if you look at a chart, you’ll see it was an excellent time to buy.

Caterpillar is a giant lumbering ox of a company with a product crucial to global growth, but this doesn’t make it a smart investment. From the potential of big earnings misses to the debt to the cost structure, the fundamentals are fraught with risk and long-term investors have plenty of better options.

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

Source: Caterpillar: Plenty of Better Options for Long-Term Investors