Is Caterpillar Smoke and Mirrors?

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Caterpillar (NYSE: CAT) has been a winning investment for the better part of several decades, but this construction and mining equipment giant has also had some difficult stretches. Since Caterpillar manufactures and sells construction and mining equipment, it’s highly sensitive to global economic conditions. The stock tends to perform well when global demand is strong -- and poorly when global demand is weak. Global demand leaves a lot to be desired at the moment. Does this mean you should stay away from Caterpillar? 

Is Caterpillar still growing?

Caterpillar has consistently improved revenue and earnings over the last three years. Over that time frame, Caterpillar benefited greatly from strong growth in China. However, the pace in China has slowed. Overall, Caterpillar is dealing with five consecutive months of sales declines and rising inventories of unsold equipment. 

A quick glance at Caterpillar’s expectations:

  • Original FY2013 earnings expectation: $7.00-$.9.00
  • Current FY2013 earnings expectation: $7.00
  • Original FY2013 revenue expectation: $60 billion to $68 billion
  • Current FY2013 revenue expectation: $57 billion to $61 billion 

Even if earnings came in at $7.00 and revenue came in on the high side at $61 billion, they would both represent significant declines from 2012. Weak demand throughout the mining industry has played a key role in the company's lowered guidance. 

For those who haven’t been following, most commodities have been in decline for weeks -- especially gold. It’s also important to note that Ben Bernake is fighting against deflation. If he were to reduce his monthly $85 billion bond-buying program anytime soon (not likely), gold would be in serious trouble. In a deflationary environment, everything comes down. There is nowhere to hide. Global demand fades simply because confidence disappears. If a deflationary environment presented itself, it would further deepen Caterpillar’s problems. 

Smoke and mirrors?

Caterpillar is attempting to do everything it can to reward shareholders. While this has been a wise move, it also reeks of desperation. Hiking the dividend 15%, and resuming a stock repurchase program -- in which Caterpillar will buy $1 billion worth of stock from Citigroup in the second quarter -- might help buoy the stock. But dividends and stock buybacks don’t indicate organic growth.

The good news for investors (but not employees) is that Caterpillar is doing everything it can to cut costs, which will increase the odds of the company meeting its earnings expectations. For example, Caterpillar just laid off 260 workers in Wisconsin (effective June 24). This isn't likely to be the last of the layoffs. Stay tuned.

Still better than peers?

The Farm & Construction Machinery industry is cheap right now. Caterpillar is trading at 11 times earnings, Deere (NYSE: DE) is trading at 10 times earnings, and Joy Global (NYSE: JOY) is only trading at eight times earnings. This has led to many analysts recommending these companies as investments. However, the multiples are low for a reason: reduced global demand and an industry in decline. 

For those who still want to consider investing in the industry, dividend yields might play a role in your decision. Caterpillar currently yields 2.90%, Deere yields 2.40%, and Joy Global yields 1.30%. However, it's rarely a good idea to chase yield in a suffering industry. 

Conclusion

Due to weak demand and a reduced backlog, Caterpillar is doing everything it can to even out its supply-and-demand picture. As stated above, it’s cutting costs and returning more capital to shareholders. Can this work for a short period of time? Yes. Is it possible that bad news is priced in? Maybe.

However, that shouldn't matter. It’s unwise to invest in a company simply because bad news is priced in. Instead, consider investing in companies that are growing and increasing market share. 

Caterpillar will be around for a long time, and it’s likely to be a strong performer down the road, but that time isn't likely to be in the near future. If the Federal Reserve is fighting deflation, and it must eventually halt or at least slow monetary stimulus, then it's only a matter of time before nature takes its course. Once deflation sets in, commodities will suffer greatly, which would negatively impact Caterpillar.  

Caterpillar is the market share leader in an industry in which size matters, and its quality products, extensive service network, and unparalleled brand strength combine to give it solid competitive advantages. Read all about Caterpillar's strengths and weaknesses in The Motley Fool's brand new report. Just click here to access it now.


Dan Moskowitz 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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