The Business Description for Caterpillar (CAT – Free Value Line Research Report) aptly describes the company as the “world’s largest producer of earth moving equipment.” In fact, it is hard to come up with a better term for a company that makes major machinery for the mining, logging, agriculture, petroleum, and construction industries, among others. Over 65% of its sales are derived from foreign markets, and the list of products Caterpillar makes is a virtual wish list for the toy set of every little boy in the world, including such incredible delights as tractors, scrapers, graders, and loaders.
Producing high-quality products is, indeed, what has allowed Caterpillar to establish itself as the lead player in the “earth moving” arena. That said, great products alone do not make a great investment. Caterpillar is still subject to the workings of the market no matter how good its products. The company’s economic sensitivity was on clear display between 2008 and 2009 when a worldwide recession took earnings from $5.71 a share to $1.68. As the Quarterly Earnings box documents, the company’s earnings started to decline in the third quarter of 2008 and then virtually fell off a cliff in 2009 and into the first quarter of 2010. It wasn’t until the second quarter of last year that earnings began a meaningful recovery.
The massive share net decline was accompanied by a stock price decline from $86 to $22, a disturbing drop captured in the Graph. Note that the decline takes place entirely within the gray shaded box that highlights the recent recession. The impact of this recession was far more severe than the one that took place in 2001 (again highlighted by a gray bar on the Graph), judged by both share price action and earnings. Indeed, as the historical portion of the Statistical Array shows, earnings didn’t decline nearly as much in the previous business downturn as they did in the most recent one.
The earnings turnaround that started in the second quarter of 2010, however, has been impressive and, after hitting a low in the first quarter of 2009, Caterpillar’s shares have rocketed to a recent high of $95 a share. (The high and low prices for a year are presented across the top of the Graph.) From the trough to the recent high, the shares are now more than four times higher than they were just two years ago. While some of this advance represents a recovery from what most would agree was a fear-induced selloff, the shares advanced almost 70% in 2010 alone. This raises the question, “is there still room for a further advance?”
On an operating basis, Value Line analyst David Reimer believes the company has a fairly bright future over the next three to five years. As the projections in the Statistical Array show, he expects earnings to advance to over $10 a share over that period. (Projections are presented in the far right column of the Statistical Array and are in bold font.) This translates into annualized earnings advances of some 16% per year, as the Annual Rates box on the left side of the page shows. This would be a fairly impressive increase over the company’s annualized 10-year earnings growth average of 10.5%, though down materially from the recession-biased annualized five-year advance of 33%.
Clearly, Reimer believes Caterpillar has a bright future. However, using an average price-to-earnings multiple of 10; in line with the company’s average in the late 1990s, earnings of $10 a share only translates to a projected price range of $80 per share on the low end and $120 on the high end. Both the projected P/E and the Average Annual P/E ratio can be viewed in the Statistical Array. The price range, meanwhile, is displayed visually by the dotted lines to the right of the Graph and numerically in the Projections box. It is clear that the current price of Caterpillar stock resides firmly within the projected price range. Thus, much of its positive outlook appears priced into the stock.
Although some might argue that based on more recent P/E multiples, the Value Line projection of 10 is low, it would require a 30% to 40% increase in the projected P/E multiple to create meaningful appreciation potential. While those P/E levels were certainly achieved in the past, it is important to remember that Caterpillar is exposed to the ebb and flow of economic activity, so an economic soft spot would likely depress revenues. Moreover, the company’s manufacturing facilities cost a lot to maintain regardless of revenues. So, placing a prudent P/E multiple on the stock is conservative, but logically so.
It appears then, that Caterpillar would either have to outperform its longer-term historical earnings growth rates materially or be awarded a much higher multiple by investors to merit a long-term commitment at the current price. While continued solid results might push the price higher over the near term, this would more likely be a speculative advance born of “market spirits” than fundamental analysis. This doesn’t even take into consideration the headwinds the company faces in the form of foreign competition.
At this point in time, long-term investors should probably avoid Caterpillar shares and consider companies with similarly strong business outlooks but that remain at more reasonable share price levels.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.