Caterpillar: Thoughts On The 5-Day $10/Share Rally

About: Caterpillar Inc. (CAT)
by: Michael Fitzsimmons

Shares of the equipment maker have rallied $10+/share over the past 5 trading days (9.6%).

The shares trade at a modest P/E=12, and yield 3.2%. The quarterly dividend is up 20% yoy.

The rally in CAT shares appears to follow a rally in WTI over the past week. Oil is at a 6-week high and could juice CAT's O&G segment.

Meantime, the company continues to perform well operationally and financially.

With the majority of its restructuring now behind it, CAT's rock solid balance sheet has it much better positioned for a potential cyclical slowdown.

Caterpillar (CAT) has quietly broken out of a one-month base and rallied nearly 10% over the past five trading days. While volume hasn't been particularly strong on the run, it is today (9/10). With 20 minutes of trading to go, shares are up over 2% on volume of ~7 million shares - which is 1.7x the average daily volume (~4.1 million shares). We'll check back at the end of this article and see if the shares can hold or even extend the gains going into the close.

Source: Yahoo Finance

The rally is particularly notable given the primary concerns hanging over the company:

  • Effects from the US/China trade war.
  • Chinese competitors nibbling on CAT's market share.
  • CAT is in a highly cyclical market and may not be able to sustain "peak cycle" margins going forward.

Yet Caterpillar still has several nice tailwinds:

  • A very robust dealer network.
  • A management team with a proven track record when it comes to improving margins even during downtrends.
  • Several of its business segments are already operating at less than mid-cycle levels, which could result in significant revenue growth in the years to come.

Q2 EPS Report

On July 24, CAT released a Q2 EPS Report that disappointed and shares dropped 6%. Sales were up 3% and EPS came in at $2.83, flat yoy. And while management maintained its full-year profit per share outlook ($12.06 to $13.06), CAT said it expects to be at the lower end of this range.

There was some good news in that Q2 was loaded with restructuring costs that will decline "significantly" in the 2H of the year. Note that inter-segment "corporate items and eliminations" were a $1.2 billion hit to consolidated sales and revenue in Q2.

On shareholder returns, Caterpillar Chairman and CEO Jim Umpleby said:

Our strong operating cash flow in the quarter allowed us to repurchase shares and pay dividends of about $1.9 billion. This is in line with our intention to return substantially all free cash flow to shareholders.

The company expects FY2019 profit-per-share to be a record. CAT currently has a P/E=12, pays a $1.03/share quarterly dividend, which equates to a 3.2% yield. And note the quarterly dividend is up ~20% yoy.

Source: CAT Q2

Glancing at the segment results above, it is a bit concerning to me that Q2 was propped up by a 44% yoy gain in the Financial Products Segment. While that's all good, the Energy & Transportation Segment - CAT's second largest segment - was down 12%. Perhaps the recent closure of two coal mines in Wyoming swamped and lower oil & gas activity in the Permian Basin is a drag: sales to the O&G sector were down 11% yoy. That may be, in part, why CAT's stock price has followed the rally in oil:

Source: Business Insider

Summary & Conclusion

The market rally in Caterpillar appears to be due to the big rally in WTI over the past 5 trading days. That's because CAT's Q2 miss was due, primarily, to an 11% yoy decline in O&G sales (as well as the big corporate charge mentioned earlier). Yet note that margins were up nicely in both the Construction and Resource segments.

Overall, CAT appears to be fairly valued given the great uncertainty the US/China trade war is putting on the macro US, Chinese, and global economies. CAT generates ~10% of revenue in China.

Meantime, CAT management continues to focus on growing its parts & service business, which supports its very strong dealer network and is a very lucrative business. And with the majority of the restructuring behind it, CAT's rock solid balance sheet is better positioned for a cyclical downturn.

I rate the stock a HOLD here. But with good news on global trade issues combined with a continued rally in WTI, CAT could easily rally up to $150/share (15% higher).

Just to circle back to the stock action today, yes, CAT did rally into the close: $130.29 +$3.04 (+2.39%) on strong volume of 8.4 million, more than 2x the average daily volume.

Disclosure: I am/we are 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.

Additional disclosure: I am an engineer, not a qualified investment advisor. While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. Therefore, I cannot guarantee its accuracy. I advise investors to conduct their own research and/or consult a qualified investment advisor. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles. Thanks for reading and I wish you much success with your investments.