Investors and potential investors in Caterpillar (CAT 0.19%) are in an unusual position. There’s no shortage of speculation about the possibility that the global economy will experience a significant slowdown in 2023, and that’s usually bad news for a stock traditionally labeled as “cyclical.”
On the other hand, there’s no guarantee a serious slowdown is imminent, and many arguments suggest that Caterpillar is well-positioned to thrive in the current environment. Let’s look at his investment thesis from both sides.
Review by Caterpillar
For cyclical companies, it’s a good idea to view their valuations in the context of their revenue, earnings, and cash flow volatility. For example, the chart below (shaded areas indicate periods of recession) shows how volatile Caterpillar’s sales have been. Also note that operating margin tends to fluctuate in conjunction with revenue generation — resulting in fluctuating operating profits that generate volatile free cash flows.
Typically, Caterpillar’s margins increase as production volume grows. This is normal in the manufacturing industry because companies can reduce their unit cost of production as volumes increase and they benefit from scaling.
Data from YCharts. TTM = Trailing 12 Months.
The chart shows free cash flow because I’m using it for the valuation — or rather, what Caterpillar calls its “machinery, energy, and transportation (ME&T) free cash flow” — a metric that excludes funds generated by its finance department. which can distort things.
For example, at the company’s 2019 and 2022 Investor Day meetings, management outlined a target for ME&T’s free cash flow of $4 billion to $8 billion over the cycle. Assuming a valuation of 20 times free cash flow (a reasonable assumption for a mature industrial company) and taking the low and high ends of the range, Caterpillar’s valuation range would be between $80 billion and $160 billion. However, both the high and low numbers are inappropriate as they don’t really reflect the company’s earnings potential. So let’s take the midpoint of the range: $120 billion. And that’s what Caterpillar’s market cap is.
Is Caterpillar fairly priced?
Based on the argument above, readers could conclude that Caterpillar is fairly valued and walk away from the stock. After all, investing in undervalued stocks is undoubtedly more attractive than buying fairly priced stocks.
But the bullish case for the stock argues that there are reasons why earnings and free cash flow on average could move toward the high end of that $4 billion to $8 billion range.
- Caterpillar’s margins are now being negatively impacted by supply chain inflation. That should ease going forward, allowing it to expand its margins.
- The company has strong pricing power: Price realization was responsible for $1.6 billion of the $2.6 billion revenue increase in Q3 2022 (from $12.4 billion to $15 billion). . This gives him the opportunity to offset cost increases through price increases.
- Caterpillar is exposed to oil and natural gas spending (in both the Energy and Transportation and Construction segments) and mining spending (through the Resources segment), so it has a long growth path ahead if commodity prices remain relatively elevated (see chart below) .
- Caterpillar’s growing service revenue has made its earnings and cash flows more resilient to recessions. This suggests that the lower end of the free cash flow range could be raised.
Data from YCharts. The S&P GSCI Energy Index is a weighted index representative of energy commodity prices and the S&P GSCI Industrial Metals is a weighted index representative of industrial metal prices.
The bearish case
In contrast, bears will argue that weakness in the housing market (which accounts for just 25% of Caterpillar’s construction sales but is often viewed as a leading indicator of non-residential construction spending) could lead to a slowdown in sales growth. Getting back to the point about expanding production growth margins, it’s worth noting that the third-quarter revenue increase was driven more by price ($1.6 billion) and less by volume increases ($1.3 billion).
In fact, CEO Jim Umpleby reiterated this point on the recent conference call: “In the environment we are in today, where a relatively larger portion of the revenue growth is attributable to price realization, there is less operational leverage that allows these progressive margins to be achieved harder to get to,” he said.
Is Caterpillar a buy?
Caterpillar shares are suitable for investors seeking a long upcycle in energy and mining commodities related investments as the outlook for construction spending is uncertain. But if you’re not convinced that commodity inflation will last or are looking for a purer way to play the issue, then Caterpillar stock is one to watch.
Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.