Caterpillar's DCF: A Buy Because Of Global Public Investments

Summary

• Caterpillar is the largest manufacturer of construction and mining equipment, industrial gas turbines, and diesel-electric locomotives.
• Close to 40% of the CAT’s revenue comes from the United States. In my view, if Biden finally approves his infrastructure plan, CAT will be most likely benefited.
• Market estimates include net sales of $50 billion and $60 billion in 2021 and 2023. Assuming a share count of 549 million, the implied share price is equal to $271.
• In August 2021, the US Government expects to approve the new infrastructure deal. In my opinion, market estimates don’t include the infrastructure bill that the government of the United States announced very recently.
• In my optimistic case scenario, CAT would deliver sales of $72-$103 billion from 2023 to 2025, and FCF will be equal to $7.4 billion. The result is an implied share price of $321.

Alex Wong/Getty Images News

Caterpillar (NYSE:CAT) operates in many areas where the governments are planning massive infrastructure programs. In my opinion, most market analysts have not included the new public investments in their revenue forecasts. In my best-case scenario, I forecasted sales of $72-$103 billion from 2023 to 2025 and 2026 FCF of $7.4 billion. With a WACC of 6%, the implied share price equals $321. The current market price is $190-$210, so I believe that the stock is a buy.

Caterpillar Will Profit From Infrastructure Programs All Over The World

Caterpillar is the largest manufacturer of construction and mining equipment, industrial gas turbines, and diesel-electric locomotives. The company operates under three segments; Construction Industries, Resource Industries, and Energy & Transportation:

Source: Company’s Website

Historically, close to 40% of the CAT’s revenue comes from the United States. In my view, if Biden finally approves his infrastructure plan, CAT will be most likely benefited:

Source: 10-K

That’s not all. The company also operates in Europe and Asia, where several governments have initiated public infrastructure programs, which will most likely be very profitable for CAT:

Source: €30 billion for infrastructure projects connecting EU region

Source: 10-k

In the last quarterly earnings report, the company noted strong demand in all regions. I would say that most construction companies all over the world are expecting a massive amount of public investments, and maybe making purchases of machinery. This is purely my assumption:

Source: Company’s Website

The order backlog is what makes me think that sales will most likely pick up soon. As shown in the image below, in 2Q 2021, the company reported significant increases as compared to 1Q 2021, 4Q2020, and 2Q 2020. The infrastructure plans were announced in the last part of 2020 and 2021, which explains why the order backlogs are currently increasing:

Source: Company’s Website

Balance Sheet

With an asset/liability ratio of more than 1x and $11 million in cash, CAT’s financial position appears solid. Also notice that more than 40% of the total amount of assets are current assets because CAT reports a significant amount of accounts receivables. In sum, CAT does have the liquidity to finance new projects and sales and marketing campaigns:

Source: 10-Q

I wouldn’t expect investors to be afraid of CAT’s total amount of debt. In the last quarter, the company reported long-term debt worth $26 billion, and $6 billion in post-employment benefits. With $11 million in cash, the company’s net debt is equal to $27 billion. If we assume a 2021 FCF of $4.91 billion, the company’s FCF/net debt is 5x, which is not worrying:

Source: 10-Q

Base Case Scenario With Market Estimates

Market estimates include net sales of $50 billion and $60 billion in 2021 and 2023 respectively. Analysts also believe that the company’s FCF will increase from $5.3 billion in 2021 to $7.4 billion in 2023. In my opinion, the net sales don’t include the infrastructure bill that the government of the United States announced very recently:

Source: Market Estimates

In my base case scenario, I assumed sales of $55 billion in 2022 as other analysts did. The FCF is close to market estimates in 2021, 2022, and 2023. I assumed 2024 FCF of $4 billion and 2025 FCF of $3.9 billion. The FCF/Sales is close to that observed in 2020-2023. With regards to the cost of equity and the cost of capital, I used a WACC of 6%, which is quite conservative and close to that of other competitors:

Source: CAT WACC % | Caterpillar - GuruFocus.com

Besides, note that the company is paying interest of 2.6%-3.25% for some of its senior notes. I am assuming a WACC of 6%, which is way below the company’s cost of equity. In fact, my figure appears quite conservative:

On September 19, 2019, we issued $1.0 billion of 3.250% Senior Notes due 2049 and $500 million of 2.600% Senior Notes due 2029. On April 9, 2020, we issued $1.2 billion of 3.250% Senior Notes due 2050 and $800 million of 2.600% Senior Notes due 2030. Cat Financial’s medium-term notes are offered by prospectus and are issued through agents at fixed and floating rates. Medium-term notes due after one year have a weighted average interest rate of 2.0% with remaining maturities up to 7 years at December 31, 2020. Source: 10-K

With all the assumptions mentioned, the sum of the free cash flows from 2021 to 2025 is $22 billion. With a terminal FCF of $4.1 billion, the terminal value stands at $153 billion. Finally, assuming a share count of 549 million, the implied share price is equal to $271:

Source: Author, Price Target $271 With 4% growth And WACC of 6%

Under this case scenario, the terminal value represents more than 88% of the total valuation obtained. It means that the long-term growth assumed and the WACC used are extremely important. With this in mind, I used a different model with a WACC of 7%. The result was interesting. The DCF model revealed a share price of $168, which is way below the previous price target obtained with a WACC of 6%. In sum, investors need to be very careful because a small increase in the interest rates could lead to massive value destruction:

Source: Author, Price Target $168 With 4% growth And WACC of 7%

Optimistic Case Scenario: The New Infrastructure Bill

I don’t believe that analysts included the new financing from the infrastructure bill in their future sales forecast. According to Fortune, politicians will approve $110 billion to finance new roads and bridges, $17 billion for port infrastructure, and $39 billion to improve public transit among other initiatives. In total, we are talking about one trillion dollars that will most likely have a positive impact on the company’s revenue line.

In August 2021, the US Government expects to approve the new infrastructure deal. The financing will be distributed in the future, which means that CAT may get to work on the new projects from 2022 to 2025-2030. In this optimistic case scenario, CAT would deliver sales of $72-$103 billion from 2023 to 2025, and FCF will be equal to $7.4 billion. The result is an implied share price of $321:

Source: Author, Price Target $321 With 4% growth And WACC of 7%

Inflation Risks And Dealers

CAT uses significant steel and other commodities to manufacture its products. If commodity suppliers increase their prices, CAT may have to sell its products at a more expensive price. As a result, the number of units sold by CAT may decline. Both the revenue lines and the market valuation would decline:

We are a significant user of steel and many other commodities required for the manufacture of our products. Increases in the prices of such commodities would increase our costs, negatively impacting our business, results of operations, and financial condition if we are unable to fully offset the effect of these increased costs through price increases, productivity improvements, or cost reduction programs. Source: 10-K

CAT uses independent dealers to market its products. Dealers may decide to accumulate inventories at a low price, and stop purchasing products from CAT. As a result, the company may not report sales growth:

We sell finished products primarily through an independent dealer network and directly to OEMs and are subject to risks relating to their inventory management decisions and operational and sourcing practices. Both carry inventories of finished products as part of ongoing operations and adjust those inventories based on their assessments of future needs and market conditions, including levels of used equipment inventory and machine rental usage rates. Such adjustments may impact our results positively or negatively. If the inventory levels of our dealers and OEM customers are higher than they desire, they may postpone product purchases from us, which could cause our sales to be lower than the end-user demand for our products and negatively impact our results. Source: 10-k

If the US Government increases taxes, CAT will report less net income. But, that’s not all. CAT is also operating in other jurisdictions, which may increase taxes too. That’s a risk because most shareholders cannot follow tax increases in many countries at the same time. The company explains this issue with the following words:

We are subject to income taxes in the United States and numerous other jurisdictions. Our future results of operations could be adversely affected by changes in the effective tax rate as a result of a change in the mix of earnings between U.S. and non-U.S. jurisdictions or among jurisdictions with differing statutory tax rates. Source: 10-K

Conclusion

In my opinion, in the coming years, the company’s business model will benefit from the public investments of governments all over the world. I believe that CAT’s market analysts have not included the infrastructure plan from Biden and the new plans from Europe. I designed a DCF with a WACC of 6%, sales of $72-$103 billion from 2023 to 2025, and 2026 FCF of $7.4 billion. The result is an implied stock price of $321, which is well above the current mark of $190-$210. In sum, I believe that the stock is a buy.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CAT either through stock ownership, options, or other derivatives. 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.