Why Caterpillar Is A Value Trap

Sep. 5.12 | About: Caterpillar Inc. (CAT)

It is always easy to buy stocks when companies are reporting record profits. While buying companies during periods of weakness is often the best strategy, buying at the top is always tempting.

The S&P 500 and its tracking exchange traded fund, SPY (NYSEARCA:SPY), has rallied over 25% from the market lows of last summer. Still, many cyclical sectors such as energy, the industrials, and the financials, have underperformed the S&P 500 over the last year.


Market leaders in cyclical sectors such as Exxon-Mobil (NYSE:XOM), Caterpillar (NYSE:CAT), and Citigroup (NYSE:C), are also well off these stocks fifty-two week highs.


Caterpillar topped out at around $120 a share in early 2011 before selling off to around $63 a share in the summer of last year. Caterpillar rallied to around $110 a share earlier this year, prior to selling to around $77 a share in early June. The stock trades at nearly $82 a share.

Caterpillar has repeatedly reported record profits over the last several years, and most of the company's divisions have rebounded strongly over the last four years. The company trades at a seemingly low price to earnings ratio of 8. Still, while the company's earnings have been very strong over the past couple quarters, the stock remains very volatile.

This past quarter Caterpillar again reported records earnings of $2.54 per share, well ahead of analyst estimates for $2.28 a share. The company reported year-over-year revenue growth of 8% in its construction division, 69% in its resource division, and 12% growth in the company's power systems division. Caterpillar slightly lowered estimates for 2012 to $68-70 billion from the company's previous guidance of $68-72 billion.

This is why I think the company's recent earnings report is particularly interesting.

Caterpillar has repeatedly reported record earnings over the last year, and the company's strong recent earnings reports are impressive. Still, the company's recent earnings report showed some disturbing trends as well. Caterpillar's sales growth has been consistently slowing over the year, and the company's recent guidance also suggests that analysts' earnings estimates for this year are likely too high.

Caterpillar reported a 60% rise in earnings from the third to fourth quarter last year, with management reporting third quarter earnings $1.71 a share in the third quarter, and earnings of $2.32 a share in the fourth quarter of last year. Still, while Caterpillar reported strong first earnings of $2.37 a share, the company's sequential growth was basically zero, and the recent quarter also showed that the company's sales growth continues to slow dramatically.

Caterpillar recently reported strong revenue growth in the construction division of nearly 8%, with revenues in North America increasing by 42%. Still, steel prices continue to remain at historic lows, iron ore and coking coal prices are the lowest these commodities have traded at in nearly three years, and growth estimates for the U.S. economy and most major emerging markets remain continue to fall as well.

Low interest rates create a significant incentive for companies with modest prospects of new business to extend equipment rentals, since companies can keep equipment without having to refinance or pay new fees to reorder the equipment. With many companies expecting a stronger economic recovery in North American construction markets late last year, many companies that recently ordered significant equipment will likely face tough choices in coming quarters if residential and commercial construction markets remain weak.

Likewise, the company's recent sales growth in its resource division also seems unsustainable. Caterpillar recently reported a 68% increase in revenues in this division, with the company's strongest recent growth coming in Asia. Still, iron ore prices recently fell to near three year lows, and major North American steel companies such Arcelor Mittal have significantly revised down guidance for 2012 in just the last couple months as well. Major suppliers to the steel industry, such as MacArthur Coal, are also facing solvency issues.

Caterpillar's power generation business will also likely face significant challenges as well. While the company recently reported revenues rose 12% in this division, with management seeing fairly strong growth in most if its major markets, there are signs that Caterpillar's sales growth in this division will likely continue to slow in coming quarters as well. One of Caterpillar's biggest competitors in this sector, Cummins (NYSE:CMI), recently lowered the company's guidance by nearly 10%, and slowing loan growth in China has delayed many construction and infrastructure projects. Cummins has consistently been an industry leader in this business for many years, and the company heavily leveraged to many of Caterpillar's largest markets, such as India and China.

To conclude, while Caterpillar's recent earnings reports have been impressive, the company's sales growth is slowing dramatically, and the stock is not cheap. Caterpillar's recent earnings over the last several years are nearly double what the company earned on average from 2004-2008, the U.S. construction market is still weak, and China's real estate market remains significantly overbuilt. Caterpillar trades at nearly 11x trailing earnings and nearly 8x average estimates for next years likely earnings, but estimates for the company's likely earnings next year continue to drop. With many of the Caterpillar's core businesses on short-term business cycles, the company will likely trade at 6-7x lowered estimates for next years earnings if revenues and sales growth continue to slow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.