Is Caterpillar Inc. A Buy?

| About: Caterpillar Inc. (CAT)

Summary

Caterpillar has emerged as the best performing Dow Jones component, rising by almost 28% this year.

The company has also received praise from analysts recently.

But investors should be careful before buying Caterpillar's stock.

Caterpillar Inc. (NYSE:CAT), the world's leading maker of construction and mining equipment, has enjoyed one stellar 2016. On a year-to-date basis, Caterpillar's stock has gained almost 28%, settling at $86.97 on Thursday, easily outperforming the broader Dow Jones and the S&P 500 which have risen by 3.9% and 4.3%, respectively, in the same period. In fact, Caterpillar is easily the best performing Dow Jones stock, significantly ahead of Merck & Co. (NYSE:MRK), the second best performing Dow Jones company which has gained 18% in the same period.

Bullish commentary from a number of analysts has also helped. Earlier this week, analysts at Barclays and Jefferies Group raised their share price targets on Caterpillar's stock by 15.4% and 11.1% to $90 and $80, respectively. Barclays and Jefferies rate Caterpillar's stock equal weight and hold, respectively. At the same time, analysts at Goldman Sachs upgraded Caterpillar's stock to buy from neutral while boosting the price target by 47.4% to $112. This came a few weeks after analysts at Credit Suisse and Deutsche Bank awarded Caterpillar with a buy rating.

I believe the rally in Caterpillar's stock has been driven largely by two factors. Firstly, the prices for a number of commodities, such as iron ore, crude oil and zinc, have rebounded this year after slumping in 2015. The Bloomberg Commodities Index, which tracks the price of almost two dozen raw materials, has gained more than 11% this year, reflecting strong performance from a number of commodities such as crude oil and iron ore that have posted double-digit gains this year. This has sparked optimism that the mining companies and oil and gas producers, who have been keeping a lid on spending levels amid the commodities rout, would finally begin to increase capital expenditure. That could increase the demand for mining equipment, fueling Caterpillar's turnaround.

In addition to this, in an uncertain global economic environment in which many large companies are finding it difficult to grow earnings, investors have to flock to stocks like Caterpillar which are generally considered as reliable dividend payers. The company has recently announced a dividend of $0.77 per share, which translates into a forward yield of 3.5%. Although Caterpillar has kept the dividend flat since last summer, it comes with an incredible track record of growing payouts for the last 23 consecutive years.

However, despite the stock's strong performance this year, positive commentary from analysts and the company's dividend growth history, I believe investors should approach Caterpillar's stock with caution.

That's because the rally in Caterpillar's stock isn't backed by a strong performance from the company or any improvement in its future earnings outlook. The company has done a decent job of managing the downturn by keeping a lid on costs, but its revenues and earnings have been going downhill.

In the first six months of this year, Caterpillar's sales and profits tumbled 20.8% and 59.9% to $19.8 billion and $821 million, respectively. The company expects to generate $40 billion to $42 billion in sales and revenues and a profit of around $3 per share (including restructuring charges) in 2016. That would be down from revenues of $47.01 billion and a profit of $3.50 per share in 2015. As for the future earnings estimates, analysts believe that Caterpillar can generate a profit of $3.53 per share in 2016 which will improve slightly to $3.60 per share in 2017, as per data from Thomson Reuters. But a year ago, the mean profit estimate was $3.85 per share for 2016 and $4.33 per share for 2017.

Caterpillar is facing serious headwinds. Although the commodities price environment has improved in 2016, as highlighted earlier, that may not fuel Caterpillar's turnaround, at least in the short term. That's because most miners and oil and gas producers will only ramp up capital spending if the prices increase and stay at higher levels for a sustainable period.

Furthermore, the broader global economic environment isn't getting any better, which does not bode well for Caterpillar. The joint IMF-World Bank Development Committee has recently noted that global economic growth will remain "sluggish" in 2016 and will only witness a "modest uptake" in 2017. Demand for goods and services in the developed world is still weak, despite support from stimulative monetary policies, while foreign direct investment in the developing world has been declining. China, the world's second largest economy and a crucial market for Caterpillar, has shown signs of life this year, but that has largely come on the back of increase in lending. The US economy, the world's largest, has been giving mixed signals, which has fueled uncertainty over the Federal Reserve's ability to increase interest rates later this year. Meanwhile, Europe continues to battle with high unemployment and low inflation which remains below the European Central Bank's 2% target.

In addition to this, Caterpillar's dividend is also looking less secure than before, thanks to declining cash flows. In the first six months of 2015, the company generated $1.89 billion of free cash flows, or cash flows in excess of capital expenditure, which was more than twice (2.2x) as large as dividend expenditure of $846 million. On the other hand, in the first six months of this year, Caterpillar generated $1.20 billion of free cash flows which were just 1.3x as large as dividends of $898 million. If Caterpillar's cash flows continue to decline, then soon the company won't be in a position to self fund all of its dividends from free cash flows.

For these reasons, despite the bullish commentary from analysts regarding Caterpillar's stock, I believe investors should stay on the sidelines.

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Disclosure: I/we 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.