Caterpillar's Attractive Valuation Justifies A Buy

| About: Caterpillar Inc. (CAT)

Shares of Caterpillar (NYSE:CAT) have dropped 27% from its 52-week high of $116.95 attained in February of this year. Being the leader in the industrial machinery sector with significant exposure to the fast-growing emerging markets, CAT has been a popular choice by many income investors -- especially now that the dividend yield has recovered to 2.2%. I am of the view that the downward price action has created an invaluable opportunity to accumulate shares and invest for the long term. My opinion is based on the following seven reasons:

1. The stock is very attractively priced relative to the company's financial performance and market position (see table below). Analysts on average predict CAT's revenue, EBITDA, and EPS to grow at strong two-year CAGRs of 11.6%, 14.9%, and 17.3%, respectively, over the current and next fiscal years. The estimates are substantially higher than the averages of just 7.0%, 6.1%, and 9.0%, respectively, for a peer group consisting of CAT's primary competitors such as Deere (NYSE:DE) and Cummins (NYSE:CMI). CAT's EBITDA margin is forecast to expand by 1% in the next two fiscal years, compared to the peer average decline of 0.4%. In addition to the strong growth prospects CAT also has a superior profitability, which is demonstrated by the above-average margin and capital returns measures.

On the leverage side, CAT assumes a slightly higher debt level as reflected by the higher debt-to-capitalization ratio. However, the firm's debt-to-EBITDA ratio is slightly below the average. In terms of liquidity, although CAT's LTM free cash flow margin is slightly negative, the level is still much better than the peer average of -2.5%. Due to the robust profitability, the company has been able to maintain a healthy interest coverage ratio at 19.7%. However, both the current and quick ratios are below the peer averages, reflecting a mediocre balance sheet. Moreover, CAT is also well-positioned to seize growth opportunities in the emerging markets given its large operating scale and solid exposure to Asian and Latin American regions (see chart below).

Click to enlarge images.

Overall, I believe that CAT's superior financial condition and growth potential over its peers should justify a stock valuation premium (i.e., 10% to 20%). Nevertheless, the current stock valuations at 8.1 times LTM EV/EBITDA and 9.6 times LTM P/E are in line with the peer-average EV/EBITDA and P/E multiples, suggesting that the stock is likely undervalued.

2. Accounting for CAT's earnings growth potential, the stock is trading at just 0.6 times PEG, significantly below the peer group average at 0.9 times (see table above).

3. Both CAT's LTM EV/EBITDA and LTM P/E multiples are trading close to their three-year lows, despite the significant improvement in the company's profitability over the three-year horizon (i.e., LTM EBITDA margin has expanded from 9.6% three years ago to 17.2% at present; see chart below).

4. Comparing CAT's P/E multiple to that of the S&P 500 index, CAT's valuation has underperformed the market index over the past 12 months (see chart below). It should be noted that analysts in average forecast a long-term earnings growth rate of 14.5% for CAT, which is significantly higher than the average long-term growth rate for S&P 500 companies.

5. From a technical perspective, the stock price has recently been trying to pass through the 100-day simple moving average, which has been a strong price support historically (see chart below).

6. CAT stock's 2.2% dividend yield is backed by management's strong commitment to a quality dividend policy. Annual dividend per share had been raised steadily by a 10-year CAGR of 10% from $0.70 in FY 2001 to $1.82 in FY 2011 (see chart below). It should be noted that the most recent three-year dividend CAGR has slowed to 4%.

7. Analysts are generally bullish on the stock. Of the 26 stock ratings according to Capital IQ, there are six strong buys, 10 buys, and 10 holds with a target price of $105.24, which is 24% above the current market price. Barclays Capital has recently reiterated its overweight rating on the stock with a target price of $116, indicating a 36% potential upside.

The bottom line is that the price decline over the past few months appears to be exaggerated, and thus has significantly enhanced the stock's margin of safety in terms of valuations. As such, I recommend acquiring CAT shares at the current price.

Comparable analysis table was created by author; all other charts are sourced from Capital IQ and all financial data is sourced from Morningstar, Capital IQ, and

Disclosure: I am long CMI, CAT. 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.