Buy Caterpillar: It's Still Cheap

Jul.25.12 | About: Caterpillar Inc. (CAT)

Caterpillar (CAT), the world's largest producer of construction and mining equipment, announced all time record quarterly earnings before the start of trading today. EPS of $2.54 beat analyst estimates by 11%. Also, the quarterly sales figure of $17.37 billion is 2% higher than sell side expectations. This earnings release has marked nine straight quarters of steady growth for the company.

Separately, the company has changed its future outlook for 2012. Where the sales estimates have been revised from $70 billion to $68 billion, the EPS estimate has been increased from $9.5 to $9.6. As a result, the stock has surged 4.6% since this morning.

This news is a surprise for the market given the current global economic meltdown, as the company is a pure player on global economic conditions. However, the company's management believes that even though the Euro debt crisis will take some time to improve, the Chinese and Brazilian economies will be in a much better shape by the end of this year.

Press Release:

Crisis and End Markets

The company generates its revenues from various parts of the world. Following chart shows the main regions in this regard:

CAT is considered to be the bellwether of the U.S. economy, as the company's products derive their demand from the country's economic activity. U.S. construction activity is slowly recovering after the housing sector recently began to seen slight growth. However, as the stagnant Architectural Billing Index (ABI) indicates, the pace is not enough to offset the declining business in Europe, which is struggling through a financial crisis.

Emerging Economies

The Chinese economy has not grown at the pace that was expected by economists, and has been slowing down for six consecutive quarters. Currently, the Chinese economy relies a lot on investment for growth. According to the IMF, future growth is possible if the source of growth shifts from investment to domestic consumption. Also, leaders need to employ an expansionary monetary policy to channelize household savings towards acceleration of consumption. The IMF forecasts the growth rate to be 8% for China. The company's management is hopeful that given the relaxation of the monetary policy, the economy will recover its pace by the end of the year.

Despite the slowdown in its economy, China is still the largest market for construction equipment. However, CAT derives only 3% of its revenues from China. Future prospects are bright for CAT as it penetrates the Chinese market more vigorously.

Brazil's economy is expected to grow at 2.5% this year and 4% the next year. The growth has remained stunted, as the government tightened its monetary policy last year to achieve a growth-inflation balance. However, as the government has loosened the aforementioned policies, the economy is slowly recovering from a recession. For future growth, the economy needs a balanced consumption-investment ratio and an increase in net exports. As the lag time of 9-12 months between the policy making and its impact on the economy passes by, the Brazilian economy is expected to grow much faster. The upcoming FIFA 2014 World Cup and Olympics 2016 will certainly boost investment in the host country, which is expected to significantly benefit CAT.

Competitors' Analysis

CAT's improved outlook surprised the market as its competitors had shown a bleak market outlook for this year. Joy Global (JOY), a manufacturer of mining equipment, trimmed its future earnings in light of the soft global demand. Cummins Inc (CMI), a diesel and natural gas engine manufacturer, also renounced its earlier forecast of an increase of 10% in its revenues by declaring that its sales would remain in line with last year due to weak demand from emerging economies.


The stock is trading at cheap multiples. ROE of 39% is thrice that of the industry. Its forward price to earnings multiple is 7x. After this earnings release investors will be more confident on the future growth and we can see the stock trade up as p/e multiple expands. Currently, its PEG ratio is 0.5x.

Historical values show that the earnings miss has led to larger percentage decreases in the stock's value, as compared to the percentage increase in the stock's value after beating earnings. The company has beaten earnings in nine out of the last ten earnings releases (for revenues it's seven out of ten times). The average percentage surprise in earnings has been 22%. The average percentage change in price, after beating the earnings, has been +3%.

Given the current global economy, and the expected emerging markets demand, we recommend the stock as a buy, in line with our previous recommendation, which can be read here.

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