Buy Caterpillar For Its Compelling Valuation And Dividend

| About: Caterpillar Inc. (CAT)
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Shares of Caterpillar (NYSE:CAT) have declined by 30.5% from its 52-week high of $116.95 attained in February. At $81.30 per share, the stock is trading very close to the 52-week low of $78.25 and offers a decent dividend yield of 2.4%. The pullback presents investors a great buying opportunity, given the stock's tempting valuations and attractive dividend yield. In this article, I will elaborate on the analysis that supports my bullish view on this investment.

CAT's valuations are cheap based on the company's strong financial performance relative to its peers (see comparable analysis table below). Analysts on average predict CAT's revenue, EBITDA, and EPS to rise by two-year CAGRs of 7.1%, 9.1%, and 8.5%, respectively, over the current and next fiscal years. The growth estimates are largely better than the average estimates of 5.7%, 5.2%, and 8.1%, respectively, for a peer group consisting of CAT's primary competitors such as Cummins (NYSE:CMI) and Deere (NYSE:DE). In addition, CAT's EBITDA margin is forecast to expand by 0.6% over the same period, compared to an average flat estimate of -0.1% for the comparable companies.

On the profit side, CAT has an industry-leading margin performance. All of the firm's profitability and capital return metrics are above the par. It should be noted that CAT's EBITDA, EBIT, and net profit margins are the highest in the group. The company carries a slightly higher level of debt as reflected by the above-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, CAT's trailing free cash flow margin of 3.9% is considerably better than the peer average of only -2.4%. Due to the strong profitability, the company was able to maintain a healthy interest coverage ratio. However, both the firm's current and quick ratios are below the par, reflecting a mediocre balance sheet.

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To summarize the financial comparisons, CAT's leading performance in growth, profitability, and cash flow generation should command a solid premium valuation for the stock. Nevertheless, the current stock valuations at 7.9 times forward EV/EBITDA, 9.8 times forward P/E, and 0.79 times PEG represent an average valuation discount of 14% to the peer-average trading multiples, suggesting that the stock is likely undervalued.

Moreover, CAT's trailing P/E multiple is trading at 44.8% discount to the same multiple of the S&P 500 Index (see chart below). Given that the company's long-term estimated earnings growth of 12.4% is markedly higher than the average estimate of 7.9% for the S&P 500 companies, I believe this sizable discount is somewhat exaggerated.

Furthermore, both CAT's trailing EV/EBITDA and P/E multiples are now trading at discounts of 58.8% and 46.2%, respectively, to their 10-year historical averages (see chart below). Again, I believe this signals an undervaluation provided that: (1) CAT's capital return measures including ROA, ROE, and ROIC are currently at or close to their 10-year high levels; (2) the firm's current profitability is at the 10-year high, and its EBITDA margin is expected to be stable; and (3) although revenue, EBITDA, and EPS growth rates have slowed down from their peak levels in 2010, the expected growth rates are fairly close to their 10-year averages (see charts below).

On top of the cheap valuations, CAT's dividend yield and future dividend growth would also provide a solid downside protection. Due to the pullback in 2012, the yield rose from its trough level at around 1.60% to the current level of 2.6% (see chart below). Given the cheap stock valuation and the current low-interest market environment, I believe the yield's further upside is quite limited.

CAT's dividend per share had been raised by 4.8%, 4.5%, and 13.0% consecutively since 2010. Assuming a target dividend yield range between 2.2% and 2.8%, and supposing that the annualized dividend per share would be raised by 5% from the current level of $2.08 to $2.18 in the July 2013 payment period, the relatively conservative scenario would imply a stock price range between $78.00 and $99.27, indicating a limited downside.

Based on CAT's estimated long-term earnings growth rate of 12.4% and the peer average PEG of 0.98 times, I believe CAT should at least trade in a forward P/E range between 10.0 times and 12.0 times, which is fairly in line with the current peer average of 10.8 times. Assuming the analysts' estimated FY 2014 EPS of $9.83 can be maintained, this range would suggest a one-year target price from $98.30 and $117.96, representing an average upside of 33%.

Bottom line: In light of CAT's cheap valuation and decent dividend yield, the investment presents an attractive risk/reward profile. As such, I recommend acquiring the shares now.

The comparable analysis table was created by the author; all other charts are sourced from Capital IQ, and all financial data is sourced from Capital IQ.

Disclosure: I am long 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.