Why Caterpillar Is A Buy

| About: Caterpillar Inc. (CAT)

Amid economic uncertainty, construction ebbs off. People are building less. In turn, construction companies make do with even less, repairing equipment that in bull markets they would have replaced. As a result, the companies that make the equipment for these companies see reductions in sales - it is a trickle-down effect and only the strongest survive. Caterpillar Inc (NYSE:CAT) is one equipment manufacturing company that is answering that call and bringing the sort of numbers that have helped the company return over 15% year to date.

In order to stay competitive and reduce costs, in this down, albeit rapidly improving, economy, Caterpillar has introduced "flexible" workers to its staff - part-time, contract or agency workers that are employed by an outside agency. In fact, over 18% of its 152,000 full-time workers fall into the "flexible" category. It is a move that has paid off well.

Since the same quarter a year earlier, Caterpillar's revenues have increased by nearly 35% to $17.2 billion, beating its industry's average growth of roughly 28%. Its earnings also improved, moving up just under 60% to $2.32 per share. Over the last few years, Caterpillar has demonstrated a positive earnings growth trend as well. The company made $7.40 per share last year, versus $4.15 in 2010 and $1.43 in 2009. It is expected to make $9.45 per share this year, up 27.7% from its EPS in 2011.

Currently, Caterpillar is trading at roughly $106 per share, which puts its current P/E ratio at 14.3 and its forward P/E ratio at 11.2. In comparison, the company is priced at a discount to its peers - the average current and forward P/E ratios of the machinery industry are 22.05 and 13.59, respectively.

In addition to its attractive valuation levels, Caterpillar also pays decent dividends. The company's current dividend yield is about 1.7%. While that figure may not be very high, we see a lot of potential growth in its dividends. The company has been raising its dividends for 18 consecutive years and we expect Caterpillar will continue to do so in the near future. Plus, it has a low payout ratio, at about 24%, so we do not anticipate this being a problem.

The company has a robust earnings growth expectation of 15% annually. We think this figure is pretty accurate and may even be low. As global economic conditions improve, we expect that Caterpillar's bottom line is going to follow suit. The companies that delayed upgrading its equipment will need to replace their existing equipment sooner rather than later. This, combined with the company's aggressive streamlining actions and solid presence in emerging markets, makes for a very positive outlook for Caterpillar.

Caterpillar is also positioned well strategically. It recently acquired mining equipment company Bucyrus in a 2011 deal valued at $8.8 billion - a move that will help the company establish a stronger foothold in the mining markets, which could be a major boon thanks to the ramped-up production seen in emerging economies like India and China right now. Caterpillar was able to reduce its costs in the deal by paying cash. It also reduced its costs further by selling a part of Bucryrus' distribution business to Sime Darby Berhad (OTCPK:SMEBF) in a deal valued at $360 million. It was only about a month after that that Caterpillar sold the rest of Bucryrus' distribution business to Finning for $465 million.

Overall, we like Caterpillar, and we aren't alone. Hedge funds also seem to love this stock. Caterpillar is the most popular Farm & Construction Machinery stock amongst the 350+ hedge funds we track. At the end of last year, there were 39 hedge funds that listed Caterpillar in their 13F portfolios, up from just 33 hedge funds at the end of the third quarter. In total, they had $1.9 billion in total invested in the company at the end of December, versus $1.1 billion at the end of September.

Of the hedge funds we track, Ken Fisher was the most bullish about Caterpillar. His Fisher Asset Management had $373 million invested in Caterpillar at the end of 2011. Charles Clough was also in favor of Caterpillar. Clough Capital Partners initiated a position in Caterpillar during the fourth quarter last year.

We rate this stock as a buy.

Note: This article is written by Guan Wang and edited by Meena Krishnamsetty.

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