If you are looking for high-risk investments that appear to be offset by potential rewards, the construction and agricultural machinery industry may be your thing. Businesses within this sector are trading at overly low multiples while the economy is, as a whole, heading in the right direction. In my view, Caterpillar (NYSE:CAT), Deere (NYSE:DE), and Manitowoc (NYSE:MTW) are all undervalued. They all have high betas, which indicate abnormally high volatility, and analysts are mostly reserved, but I find that growth expectations have not been fully factored into the stock prices. As discount rates come down, this translates to multiples expansion. Below, I review the fundamentals of all three.
Caterpillar is personally one of my favorite stocks on the Street. It trades at just a respective 9.8x and 8.3x past and forward earnings while being forecasted for 17.5% annual EPS growth over the next half decade. To put this into perspective, consider that the PEG ratio of the stock is 0.56, which indicates future returns have not been fully factored into the stock price. Consider further that the average PE multiple of the firm is 16.8x, and it has only temporarily been this low in end of 3Q08 to end of 1Q09.
Free cash flow, on the other hand, has been very volatile with the ups and downs on the market. 2Q12 free cash flow TTM came out to $2.3B versus $4.5B in 2Q11 and $3.3B in 2Q10. Assuming normalized historical levels of $4B, Caterpillar is fairly compelling at a valuation of $56.91B when you consider future growth. Gross margins have noticeably increased from 26.3% in 2Q08 to 29.3% in 2Q12. Carrying forward this progress under normal economic activities, Caterpillar appears to have much greater reward than risk.
Profitability has been consistently above peers in terms of margins. Ditto in terms of returns on invested capital. Despite solid progress, the stock is closer to its 52-week low than its 52-week high. I strongly recommend investors accumulate shares before signs of a quickening recovery dissipate much of the upside.
Deere is also a compelling buy at a respective multiple of 10.9x and 9.2x past and forward earnings. Annual EPS growth forecasts are lower at 9.7%, and the economic moat is smaller. Growth forecasts have been more reasonably inputted into the stock price than Caterpillar, as evidenced by the PEG ratio of 1.13.
During the second quarter, management released impressive results with quarterly net income in excess of $1B - a record - and a 12% rise in the top-line. Indicators in the farm economy were so strong that management increased earnings guidance to $3.35B. Perhaps even more impressively, global equipment sales rose 13% sequentially to $9.4B. The company expects to actually see strength in European agriculture, particularly in the northern regions where farm sizes are larger, under resilient support from attractive commodity prices.
Assuming that the company is able to grow EPS by 9.7% annual, the stock should be worth $170.40 by 2016 at a 15x multiple. Discounting backwards by 12% yields a present value of nearly $100 - well in excess of the $78.97 current market valuation. With impressive momentum under its feet and low multiples, the stock is much more positioned for the upside than the downside.
Manitowoc trades at 8.5x forward earnings with a small dividend yield of 0.6%. According to data sourced from FINVIZ.com, analysts rate the stock around a "hold" despite forecasting 15% annual EPS growth over the next 5 years. ROA and ROI are all in the low single-digits while the quick ratio of 0.6 indicates liquidity pressure.
Free cash flow generation has floundered of late with negative losses being accorded in 2Q11 through at least 1Q12. The company's $1.64B current valuation is, however, only 11.2x the historical 5-year average free cash flow level. Combine this with the fact that gross margins have risen by around 200 bps over the last four years, and you have a company with impressive potential under the backdrop of a full recovery.
Manitowoc is a very cyclical stock, so timing is everything. As it stands, the PE multiple is well below normalized levels, but the stock is slightly closer to its 52-week high than its 52-week low. The large debt load adds to the woes, and, unlike Deere, Manitowoc is extremely reserved on Europe. In my view, while risk/reward is more compelling at larger peers Deere and Caterpillar, Manitowoc is overly priced for the worst. Broad diversification is almost always recommended to hedge against instability in any one competitor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.