Caterpillar - High Uncertainty, High Valuation
- Caterpillar shares have been trending up despite significant deterioration in revenue and GAAP margins.
- The stock is also showing a low correlation with crude oil compared to its history.
- There is a high level of optimism priced into the stock at the current levels, and risk looks skewed to the downside.
Financial Trends And Valuation
It’s well known to any investor who has taken a look at the company’s financials that Caterpillar (NYSE:CAT) stock has shown some significant non-fundamental trading. Caterpillar’s revenue and GAAP margins have been declining for several years but the stock kept going higher and higher. Although I have been following the stock for a while, I have always been amazed by how the market could send the stock higher and higher even without and a strong sign of operational improvements.
Let’s consider what happened between 2012 and today. Revenue declined from $65,872 million to $38,898 for the TTM, marginality fell sharply and net income went from $5,681 million to negative territory. In the charts below, you can see this trends.
CAT Revenue (TTM) data by YCharts
The strange thing is that, despite the strong deterioration in basically every metric in the income statement, the stock’s valuation didn’t suffer at all, and it’s actually at the highest levels in the last 25 years. price to sales or EV/revenue were not affected at all by the deterioration in profitability, a clear indication that the market does believe that all, or almost all, the current weakness in margins is just a result of temporary phenomena and non-recurring charges, or that the market is willing to ignore the fundamentals. Despite the recent weakness, it seems that the market is expecting Caterpillar’s future to be brighter than ever.
CAT PS Ratio (TTM) data by YCharts
It’s true that market valuations discount future developments, and any analysis that is based purely on past events wouldn’t be very useful, but seeing CAT's valuation multiples at all-time highs while the company is reporting such poor margins does give us a reason to be a bit skeptical. I used multiples based on revenue so that we can have an idea of the market’s expectations about margins in a clear way. From an operational standpoint, there are few things that can justify the current valuation:
- Strong revenue growth, or at least stronger than any time during the last 10 years.
- A strong expansion in margins, hopefully at a level in line with the levels of 2012, or better.
- A combination of the two above.
Given that CAT’s revenue has been falling since 2012, I can assume that any improvement can lead to the best revenue growth in the last 5-6 years, and would justify the valuation premium, but margins should also improve dramatically from the current level. Given that the stock is trading at the highest multiples of the last 25 years, it’s reasonable to assume that the combination of revenue growth and margins is expected to be the highest in this time-frame. But even if we consider what happened between 2009 and 2012, the company had years of recovery from the great financial crisis, with revenue growth up to 40% YoY and margins constantly expanding, with operating margin reaching a top of 13% in 2012 - yet the stock was still trading at or below the current multiples. Based on these factors, it’s reasonable to assume that the market is at least expecting revenue growth to be healthy and GAAP margins to return to normal.
Downside Risks: Oil Correlation, Construction And Mining
In order to justify the current valuation, many things should go well for the company, suggesting potential sources of earnings/margins growth. After analyzing industry trends and the macro environment, I wasn't able to see powerful sources of upside risks. Let’s consider the O&G segment, for example. Crude oil seems to be trending up a bit (at least in the last few weeks), but it’s still just in the mid-40s, well below the levels of the last 2 quarters. This weak trend in crude oil prices is a negative for sure, but the stock seems to become increasingly detached from oil price, while it was showing a strong correlation until 3 years ago. This is evident in the chart below:
The weaker correlation means investors are focused on other factors. I think the main sources of “optimism” are two. The first has been the good results in the aftermarket segment (four consecutive quarters of incremental sales), which has led to improving margins.
The second factor is obviously the expected stimulus in the construction sector under Trump. On this point, we have very little information about the potential stimulus, and given the industry/macro trends, I doubt the construction sector could accelerate without any stimulus. In this regard, I think Deutsche Bank gave us a good summary of the situation in its last report on Caterpillar, writing:
While we concur that inventory destocking should stop sometime soon (since dealers view their inventory levels to be low), the NA non-resi construction cycle seems long in the tooth , and so we find it difficult to gain conviction in a robust recovery, above and beyond the low-single digit growth we have embedded within the CI segment in our model. As per Figure 7 below, private construction put-in place has already recovered to levels in excess of the prior peak, and while public construction spend looks low vs. history, we have no visibility into if/when an infrastructure stimulus bill might be passed in the US, which would drive increased project activity.
Deutsche Bank’s point makes sense. Since the private construction market is already well above the pre-financial crisis top, we can reasonably expect that growth in the category will largely depend on whether the stimulus will materialize and in what measure.
Last but not least, the mining segment also deserves a mention. After a sharp rise in prices, mined commodities have shown weakness for several months. The chart below shows prices for copper and iron ore – they peaked in February/March and they have been stalling/declining since then. Moreover, according to the management, there still is a lot of excess capacity in the mining industry for the mining manufacturers, which is putting a lot of pressure on prices.
This is not meant to be a one-sided article with the goal of proposing a bearish thesis on CAT. The higher emphasis on downside risks is only an obvious consequence of the rich valuation multiples and the market’s optimism in spite of mixed fundamental trends. It’s also obvious that there are some upside risks that could unlock further upside for the stock.
- Strength in emerging markets. China has performed very well recently and is in the middle of a cyclical uptrend following a trough reached in 2015 when sales of excavators fell to just 25,000 units from 120,000 in 2011. Sales of excavators are recovering fast and rose 99% in Q1 2017. Although China accounts for just roughly 10% of CAT’s revenue if this strength continues fundamental trends could improve as a consequence.
- Stimulus package. We don’t know if it will come and in what measure, but the positive effects of strong stimulus measures may be not fully priced in the stock.
- Upward acceleration in oil prices. So far, oil prices haven’t posted the recovery that many were expecting, and the current levels don’t seem to support the expectations of strong demand for CAT’s machinery in the industry. If oil prices start to accelerate upwards for any reason (geopolitical events, output cuts, etc.), CAT would surely benefit.
I do like Caterpillar as a company. It has a solid balance sheet, it has a strong competitive position in its industry, it pays a decent dividend that is well covered by free cash flow, and so on. Nonetheless, I remain skeptical about the prospects of an investment at these levels, due to the high valuation and the positive expectations that current multiples seem to price in. There are some potential sources of growth for sure, but risks seem to skew to the downside, due to a lot of uncertainty and mixed signals– ongoing weakness in GAAP margins, doubts on the Trump stimulus program, declining correlation with oil prices, and so on. I maintain a neutral stance because I see limited upside from these levels.
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