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Caterpillar (CAT) did not have a good start to the year, as their quarterly revenue fell by 8% from the previous quarter. One of the biggest players of the Resource and Construction Industry, the company is expected to face some headwinds as its end markets tumble in the face of the global economic meltdown, which has severely affected the demand of commodities, and the worldwide infrastructural development. YTD performance of -12% for such a giant proves that the world economy is slowing down.

On July 10, Cummin Inc (CMI), one of the leading engine manufacturers, recently slashed its next quarter earnings forecast by 13%, predicting that the revenues are expected to be affected from the soft demand from emerging economies this year. This announcement brought a lot of industrial stocks down, including a 2% fall in CAT, which depended a lot on emerging economies to earn incremental revenues this year.

However, given the scale at which CAT operates, it is quite natural that such a global player is affected by a world-wide recession. Given the fact that the incremental revenue from emerging economies is still part of the secular trend and will be realized sooner or later, as the world economy recovers, it is a golden opportunity to buy CAT since it has sufficient resources to fight through this bottoming process.

Company Introduction

CAT is a large-scale manufacturer of mining and construction equipment. Not only this, the firm also produces diesel and natural engines and industrial turbines. This product range clearly shows why the firm's revenues are a good indicator of how the world economy is performing. Following is the break-up of revenues earned by the firm in the first quarter of 2012:


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The graph depicts that revenues are more or less equally divided amongst the different segments. The following graph shows the revenue geographically:


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A large part of the revenues depend upon the Asia-pacific region, which is not growing at a rate as expected by the market at the start of the year. The following table shows the margins for the company:


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The table shows some positive signs:

  • Only margins for resource industries declined YoY.
  • The margins went down in the second and third quarter of 2011, but they are slowly recovering, showing a sign of a slight economic recovery.

U.S. Market

The firm, in its future outlook for 2012, has admitted that its revenues have been hit by the global recession, and will continue to be adversely affected this year. However, the firm is hopeful that the U.S. economy will gradually recover this year, as their revenue for the first quarter rose by 17% YoY. Following factors will come into play to decide the fate of this stock:

  • The company has forecasted a 3% growth in the U.S. economy, this is greater than the IMF figure of 2.1% growth in Real GDP.
  • Architectural Billing Index (ABI), a leading indicator of construction activity in the U.S., fell by almost 6% in the May from its previous score of 48.6 in April.
  • Following is the detail of the global machinery demand growth. It clearly shows the falling demand of construction equipment in the economy.


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However, the following positive factors can't be ignored:

  • The total fleet utilization rate in the U.S. increased by 1% YoY in May, according to a JPMorgan report.
  • Quantitative easing by the Federal Reserve and other major central banks of the world.
  • According to a JPMorgan's analyst, residential construction is expected to go up this year by 3%.
  • $100 billion transportation bill has been signed by the Federal government.

Emerging Markets

CAT was relying on incremental revenue from growing economies for the next few years. Even though the economies are expected to bloom, the current economic crisis tells us that they are not going to grow this year according to expectations.

  • Chinese GDP growth rate is 8.2% lesser than the 8.5% figure that CAT estimated.
  • The Asia-Pacific region covering China and India, accounted for 27% revenues from the construction activity for CAT in the first quarter of 2012. Given its importance, the regions' economy will have a large impact on the firm's future revenues. Chinese construction activity has slowed up because of weak demand, the current summer season, and the floods that have affected the overall economic activity within the Asian giant.


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  • A good indicator of construction activity is to analyze the demand of steel and iron ore. Around 60% of the world's steel is consumed in China. However, this consumption rate is expected to come down due to decelerated construction activity.


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Despite all that, following are positive for the company:

  • As mentioned earlier, the urbanization rate has picked up in China, and according to a Mckinsey study, 350 million Chinese are expected to move to urban areas and 50,000 skyscrapers will be built in a period of 15 years. An estimated 60,000 miles of new roads, 170 mass transit systems and 97 new airports are on the list. This is expected to add to CAT's sale.
  • Also, both the Chinese and Brazilian governments are cutting the rates to curb economic sluggishness in the region.
  • Brazil will play an important role as it prepares to host the 2014 Fifa World Cup.

Other factors that need to be considered when evaluating the stock's future are:

  • As Russia enters the WTO agreement in 2012, it can become a huge market for CAT's equipments. That is probably why CAT CEO Oberhelman is stressing upon relaxation of trade laws with Russia.
  • The recent CAT-Bucyrus merger is likely to bring at least $450 million of operating income and will help a great deal in establishing a strong foothold in India and China.
  • It has signed an agreement with Westport Innovations (WPRT), the engine manufacturer, to produce natural gas engines. Big fortunes await the company, as the industry moves to cheaper alternative sources of fuel.

Valuations

CAT is currently trading at a cheap multiple of 11x (TTM). It is making ROE of 39% , thrice that of the industry. The stock is trading at a forward multiple of 7x and its earnings are expected to grow 18% per annum for the next five years. The PEG ratio of 0.49 is also promising. Given that the firm has no debt or cash flow related problems, it is recommended as a buy.


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Note: Stock price is calculated using a forward p/e of 7x.

Source: A Golden Opportunity To Buy Caterpillar At Cheap Valuations