Recently, I had a look at heavy equipment manufacturers, namely Caterpillar (NYSE:CAT), and stumbled on related CAT competitors, Deere & company (NYSE:DE) and Cummins (NYSE:CMI). I found both stocks to be equally attractive based on business profile, product portfolio and performance metrics. Both stocks are heading downward at the moment, primarily driven by uncertainty about global growth and a recent profit warning from Cummins, which noted declining order trends in its key market US, Brazil and China. Since I believe those developments are only temporary in nature, savvy value investors with a long-term investment horizon might find deeply priced bargains as they go against the tide.
Deere is a 175-year old farm and construction machinery manufacturer focusing on the agriculture, construction and forestry industry. Products representing its portfolio include a variety of tractors, loaders, pickers and harvesters. Moreover, Deere & Company has expanded into providing financial services to complement its agricultural manufacturing business. Deere is a Fortune 500 company and has a market capitalization of $30 billion.
What I like about DE is its strong long-term EPS growth forecast of 12.75% (based on Nasdaq figures), decent dividend yield of 2.4% and strong agricultural product portfolio. And investors can pick up Deere on the cheap: DE trades at a multiple of only 8.8x forward earnings despite having superior profitability with a return on equity of over 40% and a net profit margin of 9%.
Deere was upgraded in February by UBS to Buy with a target price of $115 which is still low given the underlying profitability and EPS projections. Given the recent decline in DE's share price, about 14% from its 52 week high of $89.70, the stock has an upside potential of a staggering 51%. Given the overall pessimism in the market for heavy equipment manufacturers and their cyclical business model, this upside potential is not really surprising as share prices have been unreasonably driven down.
Risks stemming from a Deere & Company investment include lower tractor sales resulting from the drought in the Midwestern US as well as a relatively high debt burden of almost $30 billion.
Cummins is a diversified machinery manufacturer who specializes in diesel and natural gas engines as well as engine-related products worldwide. Products include fuel systems, controls, filtration and emission solutions and electrical power generation systems. Cummins can be better understood as a core components manufacturer in contrast to Caterpillar or Deere & Company which are integrating their components into complete applications. Cummins is a S&P 500 company and has a market capitalization of $16.6 billion.
Why to like Cummins
Cummins last week issued a profit warning saying that order trends are impacting its sales forecast. However, the EPS forecast is still quite high: Over the next five years, analysts that follow Cummins are expecting it to grow earnings at an average annual rate of 14.67%. In addition, UBS just reiterated its Buy rating on Cummins with a price target of $110 - which represents about 27% upside potential.
Investors do not only profit from high EPS growth going forward, but also from a discounted price in relation to the profit warning: The stock currently trades at only 8x earnings and has an earnings yield of over 12%. Cummins also shells out a 2.3% dividend. In addition, the company just raised its quarterly dividend to $0.50 a share from $0.40 which investors should see as management's confidence vote regarding its future earnings potential.
I have a 2013 EPS estimate of $10.30 on the stock which is even lower than the average 2013 analyst EPS estimate of $10.50. With a multiple of 15, which I consider adequate given the high return on equity of 36%, healthy dividend and strong projected EPS growth, CMI's intrinsic value stands at $154.5 giving the stock an upside potential of 79%. Correspondingly, I rate CMI a Buy.
Investors who are willing to go against the tide and buy highly profitable manufacturing companies on the cheap, are set to get good bargains at the prevailing prices. If the economic outlook worsens, cyclical companies are probably hit first as investors primarily seek out companies with stable cash flow and earning profiles. Investors should always enter volatile stocks with stop loss limits.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CAT over the next 72 hours.