Caterpillar: Potential Tailwinds From New Infrastructure Bill

Summary

• The $1 trillion package intends to invest in refurbishing roads, bridges, ports, water pipes, and the power grid while simultaneously focusing on supply chain issues, internet access, and climate change.
• As the world's leading manufacturer of construction equipment, Caterpillar will potentially experience immense tailwinds from this spending package.
• With valuation multiples relaxing from being near all-time highs earlier this year, Caterpillar could potentially be an alpha-rich investment as this new spending package unfolds.

guvendemir/iStock via Getty Images

Thesis

Even with the current stock price up almost 40% from just prior to the COVID meltdown, valuation levels for Caterpillar (NYSE:CAT) have become relaxed over the past five months, in my opinion. With trailing twelve month [TTM] revenue and net income still 11.5% and 16.2% lower (respectfully) than 2018 figures, I believe Caterpillar still has room for appreciation regarding earnings. With the massive infrastructure bill being released while interest rates domestically remain near all-time low levels, Caterpillar has potential earnings catalysts for the foreseeable future. Currently trading below 20x next twelve month [NTM] P/E, Cat may represent a viable investment opportunity moving forward.

Background

Caterpillar is currently the world's leading manufacturer of construction & mining equipment, diesel & natural gas engines, industrial gas turbines, and diesel-electric locomotives. Cat is a staple in the industrial sector operating primarily through its four reportable segments:

1. Machinery, Energy, and Transportation: Relates to the design, manufacturing, and marketing of products relating to construction industries, resource industries, and energy & transportation.
   • Construction Industries: Responsible for supporting customers using Cat machines relating to infrastructure, forestry, and building construction. The majority of construction sales are related to general construction, rental, quarry, and mining.
   • Resource Industries: Responsible for supporting customers using Cat machines relating to heavy construction, quarry, and aggregates. Cat develops and manufactures highly efficient equipment for both underground and surface mining operations globally.
   • Energy & Transportation: Supports customers in oil & gas, power generation, marine, rail, and industrial applications. The products in this segment's portfolio include reciprocating engines, generator sets, gas turbines, and turbine-related services, diesel-electric locomotives, and other rail-related products and services.
2. Financial Products: Caterpillar's wholly-owned finance and insurance subsidiaries (Cat Financial) provide retail and wholesale financing to customers globally. Retail financing is primarily in the form of installment sale contracts and equipment-related loans. Wholesale financing is typically inventory and rental fleet financing.

Source: CAT Q3 2021 Investor Presentation

Infrastructure Bill

This week Congress voted to pass the largest infrastructure investment bill our country has seen in the past decade. The total spending package equates to $1 trillion and is intended to refurbish roads, bridges, ports (to ease supply chain bottlenecks), harmful lead pipes, broadband internet access, our nation's power grid, and infrastructure resilience surrounding climate change aspects. The bill intends to change/affect the ways Americans commute, travel, transport goods, access the internet, get water to our homes, and cope with climate change. Caterpillar may not see direct tailwinds from all these areas but I believe they will be materially impacted by the new investment windfall in the following categories:

• How We Commute: This category is expected to make up 22.6% ($226 billion) of the total bill spending and focuses on refurbishing roads as well as new transportation projects like additional light rails. While many of the projects in this category may not be in the construction stage for a year or longer (due to the planning period), the eventual construction will provide positive top-line tailwinds for Cat, in my opinion.
• How We Travel: Similar to 'How We Commute,' this segment will provide potential construction-related tailwinds for Cat through the refurbishment of airports. With a focus on expanding rail lines nationally, this segment may specifically boost earnings in Cat's energy & transportation segment as well.
• How We Transport Goods: While this segment will focus on freight projects and reducing supply chain bottlenecks, it encompasses plans for the construction of new roads and bridges.

While the other aspects of the bill may have small impacts on Caterpillar's future earnings, I believe these segments will provide immense tailwinds in the years to come. Below I projected earnings out to FY 2025 and I believe much of the potential infrastructure spending will be represented in Cat's earnings over that period.

Financials

Model

Based on my views regarding the infrastructure bill and future growth potential for Cat, I have disclosed my financial model highlights below:

Source: Created By Author Using Data From CAT 10-K

Valuation

Cat currently trades below 20x earnings on an NTM basis:

Source: Koyfin

I believe Cat's typical historic NTM P/E channel oscillates between 10x and 25x with the median being 17.5x. Purely based on NTM P/E, Cat trades almost in-line with fair value.

Taking it a step further, I wanted to value Cat based on implied competition multiples. Using competitors from the primary four operating segments, I've conducted an implied sum of parts valuation for Caterpillar:

Source: Created By Author Using Data From Koyfin

After analyzing Cat's comps broken out by segments and weighted based on NTM revenue makeup, I found that their implied NTM P/E multiple was 16.6x, roughly in-line with the historical NTM P/E channel median.

Price Targets

Using my FY 2025 EPS projections and bear, base, and bull case P/E multiples I have conducted price forecasts for Caterpillar: (The base case multiple is the median of the comp. implied and the midline of the historic channel.)

Source: Created By Author Using Data From Koyfin

EPS-based PTs are calculated by multiplying EPS of $16.61 by the P/E multiples of 25.0x, 17.1x, and 10.0x. % Return and CAGR columns use a present value share price of $205. CAGR is using an n=4.25 years.

I have also included a normalized price target discounted back to present value using a discount rate of 8% and my base case assumptions:

Source: Created By Author Using Data From Koyfin

Risks

Spending Stalls

If actual expenditure from the bill takes longer than investors expect, I believe sentiment could shift negatively regarding Cat's stock if the potential infrastructure bill tailwinds aren't realized in earnings. While I believe much of the spending will occur over a long period of time, there's potential for Cat's management to guide higher in lieu of the bill which could possibly set the company up for downward revisions in the future.

Chinese Real Estate

While the true impact of a potential slowdown in the Chinese real estate market may be minimal for Cat, I wanted to point it out because of their resource industry exposure to iron ore, coal, and other mineral/ore mining. Because of Cat's international exposure and the $167 billion size of the Australian iron ore market, potential downfalls of this market in relation to a slowdown in Chinese real estate development could be a potential Caterpillar headwind. I believe these risks are evident when looking at Australia's largest iron ore company's stock chart since news of Evergrande's (EGRNF) potential loan default made headlines:

Source: TradingView

Summary

Since Cat bottomed at ~$90 during the COVID market meltdown, its stock price has recovered over 125%. After price fell over (15%) since June and earnings have begun rebounding, Cat's P/E multiple has begun normalizing in my opinion. I believe Cat currently trades roughly in line with historical valuation medians making the stock neither discounted nor expensive on that basis. With a history of returning capital to shareholders and a massive infrastructure spending bill being passed, Caterpillar shareholders could generate alpha in the foreseeable future if potential tailwinds become realized in earnings.

Source: CAT Q3 2021 Investor Presentation

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in CAT over 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.

This analysis is not a guarantee of future results, models and projections are based on inputs that are likely to exclude all factors that may reflect a complete analysis. Furthermore, calculation errors, inaccurate reporting, and unseen inputs could bias results. For financial advice please consult with your advisor or other professional. This commentary reflects the personal opinions, viewpoints and analyses of the Alpha Squared Capital, LLC’s employees providing such comments, and should not be regarded as a description of advisory services provided by Alpha Squared Capital, LLC or performance returns of any Alpha Squared Capital, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this article constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Alpha Squared Capital, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Alpha Squared Capital, LLC provides links for your convenience to websites produced by other providers or industry-related material. Alpha Squared Capital, LLC is not responsible for errors or omissions in the material on third-party websites, and does not necessarily approve of or endorse the information provided. Users who gain access to third-party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from use of those websites.

Comments

[Nescience]

This piece, though well intentioned, fails to address with hard data the two most salient aspects of the so-called "Infrastructure Bill," to wit:

- Expenditures ("investments" in Beltway Newspeak) contemplated in this legislation occur over a period of 10 years. That's 2.5 Presidential terms of office. This fact dilutes and therefore rarely appears alongside the "$1 Trillion" windfall kabuki incessantly bandied about. And in any event the total package value is ~$1.2 triilion, not $1 trillion.

- Only a portion of the approximate $1.2 trillion 10-year total funds tangible ("hard") infrastructure likely to benefit cyclical industrials such as $CAT directly. A more useful analysis would endeavor to evaluate the projected annual value of such funding, and further the fraction of such value likely to appear in $CAT revenue.

I'm a long-term (> 10 years, no plans to sell) $CAT shareholder and certainly want revenues, earnings, and most importantly cash flow to increase, but I'm a long way from hyperventilating over the potential of this legislation to be in any way transformative to those metrics.

[tomcaddy]

Just think what impact the Eisenhower Interstate System had on Cat in the 60s and 70s. I think it will be even more.