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Caterpillar: Don't Buy At This Price

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About: Caterpillar Inc. (CAT)
by: Wolf Report
Wolf Report
Long only, value, Growth, growth at reasonable price
Summary

Caterpillar is a core portfolio company, a buy-and-hold-forever stock despite the inherent cyclicality related to its business.

Despite this, Caterpillar has become a value exercise. While many value-oriented investors consider the stock a buy, I don't. The downside/conservative case isn't "good" enough for me to invest.

Instead of investing, hoping for the base or upside case to materialize, I choose to stay on the sidelines for now - and I believe you should as well.

Caterpillar (CAT) is a great company. In my initial article titled "Caterpillar Is Now A Buy At An Impressive ~3.5% Yield," the company was something I considered an investment at an excellent value because... well, it's in the title. A 3.5% yield on Caterpillar indicated an impressive amount of historical undervaluation to future earnings prospects. This is something I latch onto - and I believe you should as well.

As a result, the returns since the article have not been shabby in the least.

(Source: Seeking Alpha)

As we can see from the graph, however, the situation is far different at this time. Not in that Caterpillar is no longer a great company, or is a "bad investment." I don't believe buying Caterpillar is really ever a bad investment, but I believe that the price demanded for the company at this time is, for lack of a better term, not discounted enough.

Let me show you what I mean.

Bildresultat för Caterpillar logo

Caterpillar - Recent results

For some context, we can look at the latest results, which happen to be 3Q19, and also look at what the market expects for 4Q19/FY19.

In the 3Q19 results, we find part of the reason why I believe that CAT just isn't investable outside of significant discounts at this time. The company reported:

  • Operating profit decreases of 5% and an 8% quarterly EPS decline.
  • Sales & Revenue down 6%
  • Stable/Flat margins
  • Lower volume trends impacting earnings which turned trend-negative YoY, despite favorable price realization and lower SG&A/R&D trends.
  • Resource and Construction were the two segments/markets showing most of the volume decrease.

(Source: Caterpillar 4Q19 presentation)

More importantly, the company significantly (more than 10%) lowered full-year profit estimates down to a range of $10.9-$11.4/share. This represents an upper-end guidance cut of almost 13% and goes to influencing profit expectations for 2020.

On the positive side, Caterpillar expanded digital capabilities, now with 100,000 monthly inspections. The company is increasing digital offerings and continuing to execute on its long-term strategy. So while this quarter was bad from a profit standpoint, it's a small lag in an otherwise excellent trend. With almost $8B available in cash at an enterprise level, the company needs hardly worry about a shortage or trouble here.

The trouble is really that none of Caterpillar's primary three segments showed any sort of positive performance for the quarter. Sales were down in all of them, most of it related to changes in dealer inventories.

The Resource Industries, in particular, was responsible for a particularly horrible 25% profit decrease, even if the reasons can be considered understandable.

(Source: Caterpillar 4Q19 presentation)

At the same time, Caterpillar has been busy continuing to buy back shares at comparatively cheap prices. $1.2B worth of capital has been used for this - and this doesn't include the $0.6B worth of dividends paid, which also included a 20% dividend bump.

So, there are both positives and negatives looking at recent development. Some news items from the past few months can put some more color to this:

  • CAT cut 120 workers from the Texas plant in the beginning of November due to "market conditions."
  • Company sales growth slowest since 2017
  • Overall pressure from lingering trade tensions in farming equipment weighing on the sector.

The company is also seeing some headwinds from certain sectors that are currently being cautious about replacing old equipment - the Mining/Resource segment is one place where we see this, so it makes sense that Resource continues down. Combine these sector-specific trends with the overall earnings slump that we're seeing, specific to certain geographies like Asia ex-China (mainly in construction), and we can see some of the underlying reasons why there's so much volatility in companies like Caterpillar.

Wrapping up, 3Q19 for the company and expectations for the year are now colored with a lower volume due to reductions in inventory on dealer level, and a demand that was lower than the company expected going into 2019. At the end of 2018, dealers increased their global inventory by $800M, anticipating massive sales and demand - but for 3Q19 the dealer inventories declined by about half that. That's not to say that Caterpillar's being inactive. Shorter lead times allow dealers to maintain less of a standing inventory and improves efficiency, but the fact is that for 3Q19, the company is going into a smaller demand phase - which involves reducing production to meet demands.

Let's look at where this leaves us in terms of valuation for Caterpillar.

Valuation

Despite 3Q19 weakness, the stock price has actually gone up since the announcement. It's as though a lot of investors either recognize the company's inherent long-term value creation ability, or they believe that the stock is still currently undervalued. Both of these things are, as I see them, true.

(Source: F.A.S.T. Graphs)

CAT remains an A-rated Dividend stock with excellent growth potential and the ability to navigate virtually any economic cycle. It's only a question of time until earnings once again go up - the question is, how much time, and what happens until then.

Here's the rub - based on what Caterpillar is forecasting, earnings are likely to decline not only in 2019, but analysts expect an FY20 decline as well, based on current trends, only changing back to earnings growth in 2021. By buying the company today, if you assume CAT's guidance and analysts' expectations are somewhat accurate, you're essentially buying into a negative earnings growth for the coming year, at what I see as not enough of a discount, and assuming/hoping that the stock price won't be pressured down by short-term movements.

While I would never fault anyone for investing in a fundamentally appealing stock, there are two problems with doing this with Caterpillar at this time.

(Source: F.A.S.T. Graphs)

First, assuming an estimate-based conservative forecast for the coming 5 years, the conservative rate of return for the company is below 10%. It's more than the S&P 500 is expected to return - but not by much. In this scenario, I've used, beyond forecasted estimates for 2021, an earnings growth rate of 4% which corresponds well to the company's average 10Y EPS growth rate of 4.5%.

What this means, in a nutshell, is that the market is currently asking too much money for a share of Caterpillar compared to what you can get out of the investment. If the company traded closer to the price where I bought my shares, your potential returns, even in this conservative case, could be well above double-digits. That is not the case at this valuation, however.

I don't share other investors' opinions - that cyclicals like Caterpillar or Cummins (CMI) are to be avoided. I do think you should invest in them at a bottom in terms of a realistic forward earnings potential. The simple fact is that you'd be investing in a company conservatively offering you returns of 6-8% annually over the course of 5 years while there are multiple alternatives in other sectors and geographies offering conservatively forecast rates of return that are far higher than that (15-20%).

Secondly, you really only need to look at Caterpillar's share price, earnings and company history to note the inherent volatility to CAT's earnings and trends.

(Source: F.A.S.T. Graphs)

While some cyclicals showcase a far higher resilience towards macroeconomic volatility, the fact is that Caterpillar is exposed to not only sensitive sectors, but FX, geographies and other factors make this company more susceptible than others to these movements and earnings shifts. If/when we get another downturn, Caterpillar may, if history is any guide, drop like a stone.

(Source: F.A.S.T. Graphs)

Looking at the company's historical record, it's not hard to understand why investors keep buying into CAT. More than doubling the S&P 500 in terms of growth, tripling the dividends marks a great company. I've no doubt it can do so again. But as with any volatile stock, the key is to buy at an appealing valuation.

Caterpillar is currently trading at around 13.5X P/E for the expected 2019 earnings. Since 2020 earnings are expected to be similar, the P/E is around there for FY20 as well, based on the current market price. While this is discounted in terms of historical valuation, it's not discounted in terms of the earnings growth that Caterpillar is expected to deliver in FY19 and FY20 - namely a negative earnings growth.

You could buy the company here, but my view is that better opportunities will come around, as softness is far from over.

Thesis

So, even though Caterpillar is a great company, one I own in my portfolio and one I hope to buy again, I don't consider the company all that appealing from a current earnings forecast perspective, because profits are essentially expected to be negative or flat until the end of 2020. For my investments, I want a conservatively adjusted annual rate of return of above 10% - and Caterpillar currently doesn't offer that. Were the company to drop back down to around 11-12 times earnings, or below ~$130/share, the company would look interesting again, because the potential upside would be far greater even if/when earnings came in lower.

I want to emphasize that I don't consider this company a bad investment in any way. It's entirely possible that it continues to appreciate above 15 times earnings - and heck, I'd be happy if it did, considering I'm long CAT at a significant portfolio stake.

However, at this time the company doesn't fulfill my investment criteria for an investment of this sort - so I'm comfortable staying on the sidelines for the time being and merely observing the company as well as enjoying my quite appealing 3.55% YoC.

I also believe that while it's possible to invest in the company at this time, there are better alternatives out there, and CAT will present better entries going forward into 2020.

Thank you for reading.

Stance

While Caterpillar is a great company and investment, the current risk-adjusted potential upside is too meager to justify investing at this valuation, given current guidance for 2019-2020 EPS growth. This makes the company a "Neutral" and a "Hold" in my view.

Disclosure: I am/we are long CAT, CMI. 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: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.

I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.