Should You Sell Caterpillar?

By Christopher French - February 13, 2012 | Tickers: CAT, DE | 0 Comments

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I’ll wear my tin hat and duck before I say this: Sell Caterpillar (NYSE: CAT). Many will think I’m mad, others might think I should be certified. I last wrote about Caterpillar in August last year. Back then, I could see growth potential and an oversold position building. That was when the stock traded at around $77. Now, at a share price of $112, the shares trade at a higher trailing price to earnings ratio (15.1 vs August’s 13.23). Dividend yield, at 1.60% is lower now than back in August, also: 1.6% as against 2.4%.

Why will investors be saying that I need certifying?

The world’s largest construction and mining equipment manufacturer has recently reported a set of sparkling fourth quarter results, in my opinion. Earnings per share for the quarter were $2.32 versus a market consensus estimate of $1.73, and revenues ripped through market estimates, too. Year over year, earnings per share grew by 715 and revenue was up by 41%. In fact, the company is so busy that it is extending its delivery time on new orders and has an order backlog of 37%. In order to cope with this, and reduce its backlog, Caterpillar is increasing its expenditures this year, with its capex budget rising to $4 billion. Fortunately, the company has increased its revenue guidance to $72 billion from $68 billion.  These are all positives, and the raised revenue guidance warrants a higher earnings multiple.

Caterpillar management noted that its sales in emerging economies, particularly India and China, was the force behind its revenue growth, and is predicting the same again this year. Europe has performed well for Caterpillar, too, and, even though it sees a mild recession in Europe – which it doesn’t expect to spill over to other parts of the world – it expects capital spending in the area to increase, and sales of machines into Europe to be about the same as in 2011.

It also expects economic growth of 8.5% in China, and noted that it believes this will be sufficient for growth in mining and construction spending to continue.  Caterpillar also sees sales from Bucyrus (recently acquired for $8.8 billion) and MVM to total around $6 billion through 2012, as against its partial $2.6 billion contribution in 2011.

Caterpillar expects higher sales in power systems, higher sales in China, and higher sales in North America. It also expects mining to be strong globally, a segment in which it has a particularly high backlog.

All this bullishness from the company has led it to increase its 2012 earnings guidance to $9.25 per share. At this level, the shares would currently be trading on a forward price to earnings ratio of 9.25.

Current margins are reasonable at Caterpillar. Its sales produce an operating margin of 11.89%, with a profit margin of 8.19%. It holds a heap of debt – around $35 billion – though this is partially offset by its cash of $1.83 billion and its operating cash flow of over $7 billion. The company expects interest rates to remain low globally, with the likelihood of further falls.

So, why am I bearish on Caterpillar?

Contrary to what Caterpillar has seen in its European operations, construction spending across the Eurozone is ready to collapse. Sovereign debt and the need for austerity are beginning to impact building at the base level. The flow of funds from cash-strapped sovereign governments to local government, and then onward to private construction firms is beginning to slow markedly. Construction projects are being mothballed or cancelled with 35,000 in construction layoffs in 2012 in France alone. These phenomena lag and have been given a boost by a general weakening of monetary policy and growth initiatives over the last couple of years.  I feel there is more downside risk than upside potential.

Caterpillar sees little to no possibility of a recession in Europe spreading to other parts of the world. Europe is the world’s second largest economy, after the US.

Caterpillar has upped its forecast revenue by $4 billion for 2012. The profit on this will be consumed by its $1.4 billion increase in capex. In the event of a deeper economic slowdown than Caterpillar is predicting, its sales will suffer. Its capex may be harder to pull back.

Caterpillar expects China to grow at 8.5% this year does not explain from where that growth will come.  The IMF recently cut its forecasts for Chinese growth to 8.2% from 9%, and its Indian growth forecast to 7% from 7.5% (another target market for Caterpillar).  In my opinion, China has overspent on heavy industry equipment and construction and is experiencing a glut.

The only caveat that Caterpillar put on its optimistic forecasts was that if central banks react to the first signs of better growth by raising interest rates then this could lead to slower growth. Higher interest rates, of course, would not only dampen Caterpillar’s sales but potentially impact its debt repayments and bottom line.

Overall, the company has performed extremely well over the past twelve months, and shareholders have been rewarded accordingly. At this point in time, however I believe most investors are not fully accounting for the risks to earnings growth that Caterpillar faces.  Company projections remain too optimistic for the global economy over the next twelve months.  In my opinion, I anticipate that increases in revenue will largely be eaten up by increases in capex.

Competitor Deere's (NYSE: DE) most recent earnings came with a more cautionary 2012 outlook when compared to Caterpillar's outlook, despite Deere's superior position for growth.  Deere's outlook is for 15% growth in sales, mostly coming from farmers.  The company dominates the farm equipment market whereas Caterpillar is much more entrenched in serving global construction.  These two markets should not be grouped because agricultural demand for equipment is likely to remain robust on the back of higher grain and commodity prices.  Caterpillar is in a broader, weaker market, in my opinion and its outlook remains lofty.  Indeed, Deere saw North American sales advance only 4-5% in the first quarter despite significant advertising and revamped products.  This does not bode well for Caterpillar in its domestic market.

At $77, the shares were a buy. At $112, and near their all time high, shares have gotten ahead of themselves. The rise in share price over the past couple of months has been accompanied by lower volume than seen in the fall during August and the subsequent rise to $95 through to December. I expect the shares to retreat to around $90 to $95. I would recommending anyone holding this stock to take profits until uncertainty surrounding Europe and North American construction dissipates.

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