Caterpillar's Earnings Say More Than You Think

Hunter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Caterpillar (NYSE: CAT) posted earnings Wednesday July 24 and fell short of Wall Street’s expectations. The earnings statement along with the conference call were filled with cautious statements by management and pessimistic questions from analysts. Top line sales came in about 3% shy of what investors were looking for, and management guided down estimates for the full-year.

The real story isn’t what happened, that’s old news. The real story is looking at Caterpillar now, comparing it against its peers, and reading between the lines going forward.

Caterpillar against its peers

<img alt="" height="185" src="http://g.fool.com/editorial/images/61239/chart-1_large.jpg" width="314" />

A comparison of Caterpillar against the industry based on 8 common multiples highlights its position as ‘Best of Breed.’ Examine the two most important metrics, Price to earnings and price to sales. Caterpillar is significantly stronger than the industry as a whole. 

<img alt="" src="http://g.fool.com/editorial/images/61239/chart-2_large.jpg" />

Profitability metrics are comparable to the machinery industry as a whole. Caterpillar is a fairly leveraged company and uses debt well. This can be seen in the difference between ROA and ROE.

5 Ways to Examine Caterpillar

There are many factors and characteristics that an investor can look at or consider when analyzing Caterpillar. I regularly look at 92 different items, and find it useful to break them up into 5 families or styles. Below you can see how Caterpillar stacks up in these 5 families. Numbers are relative to peers. Notice the reading of 57.7% for the Valuation Family. This means that Caterpillar is stronger than 57% of all companies based on the factors in this family (P/E, P/CF, P/B, P/Growth, etc). Breaking up the analysis into these families makes it easier to identify strengths and weaknesses relative to peers.

<img alt="" src="http://g.fool.com/editorial/images/61239/chart-3_large.jpg" />

If you're an active investor in the mining industry, you're probably trying to make an investment decision between Caterpillar, Joy Global (NYSE: JOY) and Deere (NYSE: DE).

Joy Global is having the most difficult time in this economic environment. An announcement last year by management discussed reducing its sales force. Cutting staff is another way for management to say 'we can't make it work just on sales, we have to get slimmer to keep this business going.' Investors saw it countless times in 2008 with financial companies like Citigroup and Merrill Lynch. 

<img alt="" height="215" src="http://g.fool.com/editorial/images/61239/joy-global-ratio-analysis_large.jpg" width="348" />

Above is the ratio analysis for Joy Global versus the Machinery industry.  Other than poor earnings growth this year over last, try and identify one metric that makes the company more expensive than peers.

I will say this positive comment about Joy Global though. Even though sales, earnings, and employee count are all declining, the company value is right near $5 billion right now, making Joy Global an excellent candidate, size wise, for Deere or Caterpillar to expand their mining equipment repertoires. 

<img alt="" src="http://g.fool.com/editorial/images/61239/de-ratio-analysis_large.jpg" />

While Caterpillar certainly has the available cash right now to speculate as a possible suitor for Joy Global, I have to imagine the acquisition would be a better fit for Deere.  The company has available cash, $3.6 billion, and the balance sheet for Deere is significantly less leveraged than that of Caterpillar at 7.0 times debt to equity. 

Reading between the lines

There was no good news on the most recent conference call. What is important, though, is how the stock price reacted. Caterpillar was a cheap stock before the call. Valuations were low and expectations for declining sales were already built into the price. After the call, and the rest of the week, the price continued to drop, probably too low.

There were a couple highlights in the call that may have gone overlooked. Without going too far into the idiosyncrasies of earnings accounting, there is a ‘non-cash’ charge of more than $1 billion this quarter. Management took this opportunity to reduce inventory, which can be interpreted as a long term positive signal for a company focused on operational efficiency. In fact, in the last four quarters management has lowered inventory by more than $3 billion. This shows up as a negative effect on earnings presently, and we expect a very positive sign for 2014 earnings.

Block out the ‘media noise’ for a minute and take a look at Caterpillar for what it really is. Valuations are low, expectation are low, and the potential for positive surprise next year is very high. 

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Hunter Orr has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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