Few companies have been greater beneficiaries of the emergence of the emerging economies over the last decade than Caterpillar Inc. (CAT). As the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives, Caterpillar is the premier company for large-scale construction and infrastructure projects. While there is no doubt that the economy in Europe is an utter disaster, while Asia is slowing rapidly, and the United States is in a prolonged period of anemic growth, Caterpillar stands to benefit once this economic malaise subsides. Astute businessmen buy businesses during recessions, or when quality businesses are out of favor due to short-term issues, and the overall global economic uncertainty provides an attractive opportunity to acquire shares in this market leader.
Between 2002 and 2011 Cat grew revenue from $20.152 billion to $60.138 billion, while profits followed suit, growing from $798MM to $4.928 billion respectively over the same period of time. Massive infrastructure spending particularly in Asia, and to a lesser extent Latin America, were the primary drivers of this growth. The Caterpillar brand is known for its exceptional quality, and on multi-million dollar heavy machinery quality matters! The company's vast global distribution network of independent dealers and its formidable finance division provides the company with a reasonable economic moat.
Caterpillar has three primary business divisions including construction, mining, and power systems. While all three divisions are cyclical in nature, Caterpillar has increased diversification by making sizable acquisitions in both mining and power systems. In 2011 Cat purchased the mining equipment maker Bucyrus for $8.8 billion using a combination of cash and debt. It is likely that Caterpillar overpaid for Bucyrus as it was acquired in the midst of a very buoyant mining market, but the impact is somewhat reduced by the obscenely low interest-rates at which the company was able to issue debt, as this lowers the hurdle rate on the investment. In emerging economies there is a gigantic migration to urban centers, which require enormous infrastructure development. I've long believed that Chinese infrastructure spending exceeded demand but the long-term trends bode quite favorably for Caterpillar in Asian and Latin America. Housing is starting to stabilize in the United States and in many areas of the country there is a severe shortage of new homes, meaning that it is likely that construction should grow in 2013 and 2014. Any improvement in Europe would be a plus for the company, but most importantly at some point Asia and Latin America will pick up steam again providing a dramatic boost to Caterpillar's bottom line, as the company really serves as a levered bet on economic expansion.
On October 22nd, Caterpillar reported the highest sales and profits of any third quarter in the company's history. Revenues were up about 5% YoY to a little over $16.4 billion, while earnings per share of $2.54 tied an all-time company record. There was a little bit of noise in the quarter as the company sold a majority interest in its third-party logistics business, which resulted in a pretax gain of $273MM, but this gain was mostly offset by negative currency effects. Sales volume improved by $622MM and price realization was a favorable $305MM from last year's third quarter. Sales in North America and Asia-Pacific were up 9% and 8% respectively, while the rest of the world was about flat. Mining and resources sales were up 13% YoY, while Power Systems were up 5% and Construction was basically flat.
Caterpillar made news by lowering its 2012 outlook to revenues of $66 billion and EPS of $9-9.25, versus prior estimates of $68 billion and $9.60 a share respectively. Sales in China in particular have slowed down materially causing inventories at dealers to remain at an elevated level. To combat this Caterpillar is cutting production levels in the 4th quarter and this could continue into the beginning of 2013. Most of Cat's expenses are fixed so the company only has so many levers it can pull when times get tough, but the good news is that they generally fare better than the competition. Construction in Asia and Latin America is where the largest slowdown is seen, while mining budgets are really on hold until there is more clarity pertaining to the Fiscal Cliff and Chinese growth. CAT expects the developing world to grow by 5.5% next year, and Chinese growth to improve to about 8.5%. Perhaps I am pessimistic, but I believe that these numbers are likely to be overly optimistic. Barring a dramatic increase in Chinese stimulus, I believe that the country's economy is likely to face a little more pain as many of its primary manufacturing customers in the United States and Europe are facing significant difficulties. While housing in the United States is a bright spot, the Fiscal Cliff and a completely paralyzed executive branch and Congress have provided virtually no support to the Federal Reserve's unprecedented stimulus measures. Despite these short-term problems, Caterpillar is a stock that should be acquired in times of extreme uncertainty.
2008-2009 was a real watershed for Caterpillar. The company was faced with pressure in all of its businesses and the company even had to resort to allowing dealers to cancel previously placed orders. Earnings were paltry at best and the stock plummeted, offering a phenomenal buying opportunity. Clearly the stock has performed well since then, but at just over $80 a share, I believe Caterpillar has about 50% upside over the next 3 years. Management believes that by 2015 the company should be on pace to earn between $12-18 per share. Putting a simple 10 times multiple on the low-end of that number would put the stock at $120. Caterpillar has nearly $40 billion in debt and it has an underfunded pension plan so the investor needs to be disciplined at what price they pay for the stock. Capital allocation has not been too great, as the company has issued more stock than it has bought back over the last couple of years and that is quite frustrating, especially when you look at the price paid for Bucyrus.
I believe the strategy that makes the most sense is to take advantage of the elevated volatility in the stock due to uncertainty about the near future through selling long-term put options. This is better than buying the stock primarily because of my concerns that the company is likely to struggle to meet earnings estimates over the next year so I'd prefer to get in at a cheaper price. The January 2014 $80 put options are going for about $10.00 in 448 days. This equates to a return of 14.2% on the maximum risk of $7,000, or around 11.6% annualized. At $70 a share the investor would own Caterpillar at less than 6 times expected 2013 earnings, allowing for ample upside whenever the economy improves materially. $70 represents a 17% discount from Friday's closing price of $84.25 meaning that an investor can almost endure a bear market in Cat stock before losing a penny. If the option expires worthless the investor will have made a nice return while having taken considerably less risk than just owning the stock outright.
Disclosure: I am long CAT.