Caterpillar Is In Trouble

| About: Caterpillar Inc. (CAT)
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Summary

CAT has seen a sharp selloff in recent days.

Pessimism about the near future and the top of a cycle have hit CAT shareholders hard.

I think earnings estimates will come down and that the stock is expensive right now.

Shares of Dow component Caterpillar (NYSE:CAT) have been one of the more volatile issues in the prestigious index in recent memory. Shareholders have seen the value of their holdings fluctuate wildly during periods of optimism only to see their hopes dashed and shares punished when the optimism wanes. We are in one such period right now as CAT has seen its stock come down from $107 to $95, where it trades as I write this, in a matter of days. Given that volatility and the company's volatile customer base, is this time different? In this article, I'll take a look at CAT and see if it could be worth a look or if it is a value trap.

To do this I'll use a DCF-type model you can read more about here. The model uses basic inputs including earnings estimates, which I've borrowed from Yahoo!, dividends, which I've set to grow at 8% per year and a discount rate, which I've set at the 10 year Treasury plus a risk premium of 5.75%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$5.79

$6.56

$7.04

$7.95

$8.98

$10.15

x(1+Forecasted earnings growth)

13.30%

7.30%

12.98%

12.98%

12.98%

12.98%

=Forecasted earnings per share

$6.56

$7.04

$7.95

$8.98

$10.15

$11.47

Equity Book Value Forecasts

Equity book value at beginning of year

$31.09

$34.85

$38.87

$43.55

$49.01

$55.35

Earnings per share

$6.56

$7.04

$7.95

$8.98

$10.15

$11.47

-Dividends per share

$2.80

$3.02

$3.27

$3.53

$3.81

$4.11

=Equity book value at EOY

$31.09

$34.85

$38.87

$43.55

$49.01

$55.35

$62.71

Abnormal earnings

Equity book value at begin of year

$31.09

$34.85

$38.87

$43.55

$49.01

$55.35

x Equity cost of capital

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

=Normal earnings

$2.49

$2.79

$3.11

$3.48

$3.92

$4.43

Forecasted EPS

$6.56

$7.04

$7.95

$8.98

$10.15

$11.47

-Normal earnings

$2.49

$2.79

$3.11

$3.48

$3.92

$4.43

=Abnormal earnings

$4.07

$4.25

$4.84

$5.50

$6.23

$7.04

Valuation

Future abnormal earnings

$4.07

$4.25

$4.84

$5.50

$6.23

$7.04

x discount factor(0.08)

0.926

0.857

0.794

0.735

0.681

0.630

=Abnormal earnings disc to present

$3.77

$3.64

$3.84

$4.04

$4.24

$4.44

Abnormal earnings in year +6

$7.04

Assumed long-term growth rate

3.00%

Value of terminal year

$140.81

Estimated share price

Sum of discounted AE over horizon

$19.54

+PV of terminal year AE

$88.74

=PV of all AE

$108.28

+Current equity book value

$31.09

=Estimated current share price

$139.37

As we can see the model produces an eye-popping fair value of $139, more than 40% higher than shares trade for today. That would indicate that CAT is perhaps the best value in the market today, but what exactly are we looking at? The model's job is to provide investors with a price at which a margin of safety is afforded; given that CAT is so far beneath the fair value price it would seem we should all get second mortgages and buy shares. However, I think there is a lot more at play here.

For one, CAT's earnings are notoriously volatile. That makes forecasting virtually impossible and it also means that estimates tend to swing too high during good times and too low during the rough years. I think we are near one of the tops in terms of earnings estimates for CAT and that means they will start coming down. In fact, analyst estimates for next year are down about 3% in just the past couple of months; just the start of what I suspect will be further reductions.

The reason is because CAT is subject to boom and bust cycles in commodities. Its equipment is used to build roads and buildings, mine materials from the earth and other activities that see huge swings up and down in demand. That means investors have little visibility into CAT's earnings and that makes them volatile when compared to estimates. This leads investors to discount earnings and that is part of the reason why the fair value from the model is so high; investors will discount CAT's earnings due to the lack of visibility and stability of CAT's earnings.

I also happen to think the market thinks CAT's earnings estimates will continue to come down and that is why the stock keeps selling off. We've seen this time and again before; earnings estimates begin to fall and investors crowd the exits on CAT and I think it's happening right now.

Unfortunately it is hard to tell how far CAT could fall because there is little visibility into what it could be earning next year. If demand falls off a cliff, as it has in years past, we could see $4 in EPS instead of the ~$7 analysts have right now. While forecasting the bottom is hard to do, one thing I'm pretty confident about is that CAT's EPS will not be $7 next year and that means the stock is expensive.

In addition, CAT has been a serial underperformer against the Dow (NYSEARCA:DIA) peer group as seen in this chart below.

As the market was rallying CAT was bouncing around in a channel, vastly underperforming the market. This is indicative of a stock that doesn't have investors' confidence and deservedly so; this business is tough and CAT is suffering for it.

CAT does pay a very nice dividend that is yielding almost 3% after the selloff, perhaps the only saving grace for CAT at this point in the cycle. We've seen the upswing and now we're bracing for the downswing but the dividend is solid. For income investors, CAT may become interesting in the low $80s, the area where shares consolidated after the last crash in the price. We're still ~$13 away from that but I think it will happen and at that price, CAT's ample dividend would be providing investors with a juicy 3.4%+ yield.

CAT is at the point in the cycle where I think it is a case of look out below. CAT will likely trade down into the $80s in pretty short order, perhaps by January, as it crashes once more. The boom and bust cycle of CAT has yet to be broken and as earnings estimates come down, so will the stock. I think CAT's fair value right now is about $80 and that when it gets to that price, the yield will prop it up until sentiment improves once more and we see the stock shoot higher again. But until that happens, I'm staying away.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.