I've argued for most of this past year that fair value for Caterpillar (NYSE:CAT) was somewhere in the mid-$60s, and the stock has hit those levels, and then some at Friday's close of $62.24:
Indeed, even I've been surprised by the speed and consistency of the year's decline; save for a fall bounce, CAT has shown little strength in declining ~40% from mid-2014 highs over $100.
But with shares now at ~$62, after a nice gain following Thursday's fourth quarter earnings, I'm turning cautiously bullish on the stock. The fundamentals are awful, sentiment is terrible, and analysts are fleeing - always a bullish contrarian sign for a stock as cyclical as CAT. A collapse in oil and gas and mining sales - which have driven the stock down, and assuming FY16 guidance is remotely close to correct, led Caterpillar to post four straight years of declining sales for the first time in its history - should be largely lapped by the end of this year. Other end markets aren't exactly roaring, but there is (finally!) a new highway bill, a decent environment for US residential and non-residential construction.
To be sure, there are risks, and some likelihood that any additional broad market weakness will lead the stock back to the mid-$50s lows seen earlier this month. More broadly, I'm not sure I see a 2016 catalyst to support the argument to buy shares now. But from a long-term perspective, a single-digit multiple to peak earnings and an ~18x multiple to 2016 EPS (when excluding a benefit from pension accounting) seems reasonably attractive. The bull case for Caterpillar at the lows is based in part on the premise that CAT always comes back. At $90, that argument didn't seem all that enticing; at a reasonable multiple to what should be trough or near-trough EPS, it seems a lot more compelling.
Q4 and 2015 Earnings
2015 results were difficult to say the least; revenues were down nearly 15% year-over-year, and EPS excluding restructuring costs fell about 27%. But even those figures don't clearly show where the business sits at the moment. For one, EPS figures benefited from a ~4.4% reduction in diluted share count, and a one-time $0.14 gain in Q1; backing those out, adjusted net income fell over 30%. Meanwhile, the profit decline accelerated through the year: Q1 EPS actually increased YOY, with revenue down just 4%. In the last three quarters, revenue fell 18%, and EPS declined over 40% against the year-prior periods.
None of this is news, of course; the slump in oil and gas and mining has hurt sales, currency has impacted revenue, and the world economy isn't exactly running on all cylinders. Looking backward at 2015 performance, the question really is whether there is some sort of problem at CAT, whether related to execution, management, or competitive strength. And truthfully, that doesn't seem to be the case. Peer Komatsu (OTCPK:KMTUY) saw sales in USD in its Construction, Mining and Utility Equipment segment fall 17% over the last nine months of CY15, just one point better than Caterpillar's figures.
Caterpillar was overaggressive in its initial full-year projections (particularly relative to sales, originally guided to $47B against a $44B result), but that aside execution seems reasonably decent. Decremental margins - ie, the percentage of lost sales that turn into lost operating profit - have been kept to 20% per the Q4 conference call. For the most part, Caterpillar is doing its best to manage a huge downturn, and from here, it looks as if that downturn is caused by factors outside Caterpillar's control.
Looking For A Bottom
The soon-to-be four-year decline in sales has been driven in large part by the shale boom in the U.S. and the huge gains in commodity prices (and subsequent mining investment worldwide) earlier this decade. As CEO Doug Oberhelman explained on the Q3 conference call, "There's no question that the China-driven commodity supercycle drove a lot of things up in the world the last decade or so. And now we're living off the backlash of that." In the Q3 presentation, Caterpillar detailed just how much of the recent decline is attributed to mining and wildcatting:
source: CAT Q3 presentation
At $90 (and $74), this issue drove my bearishness: assuming that always-cyclical CAT could retake 2012 peaks (when EPS was nearly $8.50) ignored the fact that early-decade profits were fueled by what in retrospect seems like a low interest rate-fueled bubble in shale gas and mining investment seeking to capture once-in-a-generation commodity prices.
At $62, however, that's less of an issue. And as time goes on, the impact of these declines is abating. Resource Industries (ie, mining) segment's sales have dropped from $22.3 billion in 2012 to less than $8 billion in 2015. Guidance for another 15-20% decline in 2016 hardly is bullish, but relative to the business as a whole the impact (down to about ~$1.5 billion, or ~3.5% of FY15 revenue) is becoming far less of a headwind. Meanwhile, the oil-related business almost can't fall any lower; per the Q4 release, new orders in that portion of the Energy & Transportation business were down "close to 90 percent" year-over-year.
To be sure, the bottom isn't here yet and doesn't look to be arriving in 2016. CAT still is guiding for Construction Industries to fall 5-10%, and Energy & Transportation's business is guided for another 10-15% decline. I've long worried whether decremental margins could hold, and guidance for a ~25% decline in EPS - excluding a $0.53 boost from pension accounting - seems to imply that Caterpillar is having a more difficult time holding the line there.
But, at the very least, Caterpillar, at least, is entering a more normalized environment in 2016 and - in particular - 2017, with the "backlash", as Oberhelman put on the Q3 call, beginning to fade. That gives some hope that CAT finally can find a new base from which to restart growth.
The problem at the moment with any bull case is what reason there is to buy Caterpillar now, even assuming the company is closer to the end than the beginning in terms of working through the oil and mining busts. Valuation is reasonable - 15.6x 2016 guidance - but, as the old saying goes, "valuation is not a catalyst", and the stock seems likely to be punished if broad market volatility continues. And excluding the pension impact from 2016 guidance - which really is an accounting change, not an impact relative to cash flow, liabilities, or the operating business - the multiple is closer to 18x, not terribly out of the ordinary relative to CAT's historical valuation.
There is one key factor here: Caterpillar's dividend, which yields 4.95% at the moment. That dividend should see another raise this summer, as Caterpillar has no intent to cut, or, it appears, even freeze its dividend. Oberhelman spoke positively of the company's free cash flow given current guidance relative to capex and the dividend, and said in the Q&A that "if we have to get to a point in '16 or '17 to use the strength of the balance sheet to protect the dividend, we will".
One would imagine in a still historically low interest-rate environment that a 5% yield (a price of $61.60 at the moment) could provide some support. Fellow Dow component Chevron (NYSE:CVX) has seen its yield clear 5% (though, like CAT, it rebounded sharply last week) but its dividend seems far less stable.
That said, the dividend support may be more useful in terms of trading than long-term investing; a 5% yield (or a 6% yield) won't offer much defense against a further decline in economic sentiment and/or the broad market. And I'm not sure what the compelling catalyst is for an entry point here, other than for investors with a multi-year time horizon with a moderate (or better) near-term outlook on the broad market/macro situation (which implies a better entry point won't soon be available).
Really, the only case right now is as a classic contrarian play. CAT, of course, is one of the "Dogs of the Dow", and analyst sentiment has turned notably negative: the stock got downgrades, sell ratings, or negative commentary from Goldman, Barclays, Macquarie, and Citi in January alone. There's some logic to trying to make that trade, or taking advantage of higher volatility to sell puts: the January 2017 55 is bid at $4.70, a return over 9% with downside near $50 (over a 6% yield itself). Assuming that upside in 2016 may be limited by the lack of a catalyst, that seems like a potentially interesting strategy.
All told, I don't think the worst is over for Caterpillar (neither does its management, for that matter), but it does seem likely that the worst of the worst is over. As the company clears the biggest impact of the commodity bust (and Q1, where a strong comp will make even an EPS beat look disastrous), at some point it seems likely a 'turnaround' narrative will take hold. That may not come soon, and I'm not quite ready to call a near-term bottom in the stock. But there is a bull case for CAT, even if it might be a bit early.
Disclosure: I/we 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.