Caterpillar: High-Water Mark Indeed

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About: Caterpillar Inc. (CAT)
by: Stone Fox Capital
Summary

Caterpillar spooked investors on the Q1 earnings call.

The cyclical company has seen the peak delta between prices and costs.

The P/S multiple crashed in the previous cycle long before revenues peaked.

Caterpillar (CAT) was crushed following a concerning warning from the CFO on the recent earnings call. The massive stock gains of the last couple of years set the stock up for failure when the company reached peak earnings momentum after already zooming past the last cycle peak. For these reasons, the stock should be avoided going forward.

Source: Caterpillar website

High-Water Mark

For Q1, Caterpillar generated a massive EPS beat of $0.75 and boosted 2018 guidance by $2 per share to a midpoint of $10.75. The heavy equipment manufacturer used a booming market and tax reform to zoom past estimates.

As with any cycle, Caterpillar benefited from a rebound in market demand before the impact of higher labor and material costs. Going forward, the cost absorption will hurt margins despite the benefit to customers caused by demand from higher commodity prices.

CFO Brad Halverson had the following to say on the earnings call regarding the quarterly sequence of earnings:

There were several positives in the fourth quarter that we would not expect to continue for the full year. The price versus material cost delta was very favorable in the first quarter, and better than we expected. We expect this delta of price versus material cost to be negative for the balance of the year... We expected targeted investments for future growth to be higher over the remaining three quarters. The outlook assumes that first quarter adjusted profit per share will be the high-water mark for the year.

The key to the story is that Caterpillar stretched costs as far as possible and the dam will finally break in Q2. Sales will continue to rise and probably EPS in 2019 and beyond, but the margins are a different story.

After the company earned $6.88 per share last year, the market already expected the EPS growth trend to materially slow. The big jump in 2018 would be followed by roughly 8% growth with the company ultimately earning an estimated $12.68 per share in 2020.

Chart

CAT EPS Estimates for Current Fiscal Year data by YCharts

One can already see the trend in the sales numbers. The three-month rolling sales trend only grew 26% in March, dipping from 33% in the February period and 34% in January. Sales in key Asia Pacific have collapsed from 51% growth to 31% in a matter of months.

Source: Caterpillar Form 8-K

Caterpillar will clearly continue growing for months, if not years. The rate of growth though is what dictates the stock price going forward. Note that the stock started the initial rally back in 2016 when the rolling growth rates were negative so one should expect the stock to peak while the sales trend is positive.

The negative call has nothing to do with the macro trends or global growth prospects. In fact, global growth forecasted by The World Bank at 3.1% is supportive of the growth prospects for Caterpillar. The stock is a different story though.

The worst outcome for shareholders was the massive $0.75 per share beat placing a cap on the cycle for now. The market is all about trends and a negative one is never great for a cyclical stock no matter whether it involves massive cash generation or not.

Cyclical Stock Peaks Early

My previous research on Caterpillar shows how the P/S multiple and hence stock price peaks long before revenue maxes out. Back in 2011, the P/S multiple hit 1.5x sales long before revenues peaked around $65 billion a few years later in 2013.

Chart

CAT PS Ratio (TTM) data by YCharts

During this cycle, the P/S multiple surged beyond 2x trailing sales while revenues only recently started to grow again. Note that Caterpillar traded for years at multiples below 1x sales.

If one argues that Caterpillar generates higher margins in the next cycle trough and thereby deserves a higher multiple this time, the stock still lost 50% of the multiple last cycle. In this case, the stock would trough at 1x trailing sales or somewhere in the $60 billion market cap range come 2020. Again, this is supportive of a global economy growing 3% and Caterpillar growing revenues in excess of global growth. Downside risk to this target exists if the global economy slows down in the next couple of years.

The stock started the day before earnings on April 24 with a market cap of $92 billion and ended last week at $86 billion. One can easily do the math that the typical cycle trough would leave Caterpillar with a market valuation around $60 billion in 2020 for about 30% downside from the current price of $145.

Takeaway

The key investor takeaway is that the stock appears tempting at these levels following a nearly $30 selloff from the peak in January at $173, but investors would be wise to stay clear. History of the cyclical stock suggests Caterpillar has already exceeded traditional peak levels and has tons of downside risk over the next couple of years.

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.

Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.