Why Caterpillar Is A Buy On The Recent Pullback

| About: Caterpillar Inc. (CAT)

It is hard to buy a stock when the company lowers guidance. CEOs often overestimate profits in tough economic times, but no investor wants to think that management is pessimistic about the company's business.

Caterpillar (NYSE:CAT) has been on of the most volatile market leaders over the last three years. The stock crashed to $33 dollars a share in 2008, rebounded to $115 in 2010, and currently trades at $86. The stock recently rallied from $77 a share several months ago, to over $90 this month, prior to selling off on the recent lowering of guidance for 2015.


Caterpillar's earnings come from three main divisions: industrial equipment, the resource division, and power generation. Caterpillar's stock has been volatile because the economic outlook has been so uncertain, and the company has consistently revised its earnings outlook over the last three years.

This is why the market is overreacting to CEO Doug Oberhelman's decision to lower 2015 guidance from $15-18 dollars a share, to $12-18 dollars a share, with the Caterpillar executive saying the company expects $80-100 billion by 2015 as well.

The market knew Caterpillar's 2015 earnings targets were simply a road map, not hard numbers that the company needed to meet by a certain deadline. Caterpillar is on very short-term business cycles, and the stock has sold of over 30% since January. Caterpillar's first fiscal quarter earnings report was still the company's strongest on record, and the company's recent earnings per share of $2.54 was well ahead of analyst estimates of $2.28.

Caterpillar's recent acquisitions of companies such as Bucyrus and successful recent labor negotiation with unions in states such as Illinois have also positioned the company very well for the future. Caterpillar forecast 50% growth in the company's mining business just last year, but current weakness in Chinese real estate and construction markets have drastically changed management's recent outlook. The company still recently reported over 50% growth in the company's resource division, 14% growth in the company's industrial equipment division, and 12% growth in the engine division, and 8% growth in power generation.

Caterpillar was simply too bullish, forecasting 70% growth in iron ore and copper markets, and demand for construction equipment in China has dropped dramatically in the last year, with bulldozer sells down over 40%. Companies such as Rio Tinto (NYSE:RIO) and BHP Billition (NYSE:BHP) have drastically cut capital expenditures as well.

If we look at Caterpillar's recent growth, North American markets remained strong, well European and Asian markets have weakened. Europe was obviously the company's weakest market. If Caterpillar can earn over $10 a share and show high single digit growth with Europe growing at recessionary levels and Asia still weak, the company's current 2015 guidance of $12-15 dollars a share seems very conservative.

Caterpillar currently trades at 8.4x forward earnings despite the company showing year-over-year growth of nearly 10%, and the company's cash flow remains at 10%, so the dividend is well covered. Capital expenditures are only projected to be 10-15% of cash flow moving forward. Caterpillar gets nearly 70% of its revenues overseas, and if we assume that the company's earnings in Europe and Asia can grow at the same low double digit rate the company's business in these regions was growing at just two years ago, Caterpillar should be able to earn $12-15 dollars a share by 2012 as management currently projected.

The primary reason Caterpillar is undervalued is that the company's margins will likely expand as earnings and growth accelerate. Caterpillar's biggest input costs are steel and labor, and the company has been able to secure long-term labor agreements with key unions in Illinois at record low wages while also buying steel at ten year lows. Caterpillar manufactures in Europe and Asia, but the company also exports products. Steel prices remain low globally as well. Caterpillar has also been able to earn an industry leading return on equity of 40%, and the company also has industry leading operating margins of 13%.

If Caterpillar is able to increase earnings in the company's industrial equipment and resource division by double digits in Europe and Asia, and continue the strong high single digit growth in the power generation business, earnings and margins should expand significantly in coming years. Caterpillar typically trades at 12x forward earnings, and the company's growth rate is accelerating when earnings grow at the rate that management has conservatively projected over the next several years, the stock should trade at 12x a low estimate of $12 a share in earnings. The company also has a strong history of raising its dividend at the pace of earnings growth, and management has not cut the dividend in over a decade. Buying the company when expectations are very low is probably a good idea as well.

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.

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