Digging for Deep Value in Caterpillar

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

Located in Peoria, Illinois, Caterpillar (NYSE: CAT) is the worldwide market leader in construction and mining equipment.  The company also manufactures and markets diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.  Through its financial products arm, Caterpillar offers retail financing of its equipment, engines, and vehicles.  Its large, yellow earth-moving machines are identifiable in almost any part of the world.  Though capital intensive, Caterpillar's business is very profitable and generates a lot of cash.  Through the third quarter of 2012 Caterpillar has experienced its most profitable year on record.  You certainly wouldn't know it from the stock price though.  Shares of Caterpillar are down nearly 2% year to date while the S&P 500 is up about 12%.

You see, Caterpillar is a cyclical company that acts as a proxy for the global economy.  The global economy's outlook just hasn't been that good.  China is in a slowdown, Europe is an economic mess, and the U.S. has been muddling along for several years.  Caterpillar, though, has been busy taking advantage of the global uncertainty.  Last year, Caterpillar purchased mining giant Bucyrus for a tidy $8.8 billion.  It was Caterpillar's largest purchase in history.  The deal, although questioned by some, looks to have been a good one.  Caterpillar has reported that its expected synergies are coming along ahead of schedule.  The deal placed Caterpillar at the top of the mining equipment sector.

North America has been a bright spot for Caterpillar.  This has offset weakness in other key markets.  Despite the muddling U.S. economy, Caterpillar reported that North American sales increased 9% in the third quarter of 2012 versus last year.  Asia/Pacific also outperformed, up 8% year over year.  The Asia/Pacific gains didn't come from China, as it remained a drag but was offset by sales in other markets.  The following breakdown shows Caterpillar's revenue by region at the end of 2011.

<img src="/media/images/user_12885/cat1_large.png" />

Viewing this graph, it's easy to see why Caterpillar is a proxy for the global economy.  Despite uncertainty all around the globe, I believe the future of Caterpillar is brighter than it might appear.

The Opportunity

"It's always darkest before the dawn" according to the proverb.  The outlook for Caterpillar has certainly seemed dark.  Last quarter, Chairman and CEO Doug Oberhelman lowered expectations for overall 2012 performance.  He sees year-end profits coming in at $9.00 to $9.25 per share due to a slowly deteriorating global economy.  This would still mark the most profitable year in history, but the forecast was below previous guidance of $9.60 per share. 

He also added that 2013 wouldn't be much better, predicting sales and revenue to be in a range of up 5% to down 5%.  I view the fact that Oberhelman lowered expectations as good news.  If the global economy performs only slightly better in 2013, Caterpillar could easily top its own predictions.  In fact, analysts are expecting Caterpillar to earn only $8.75 per share in 2013, below what the company will earn this year. 

There is a lot of pessimism about the future global economy, but I see things somewhat differently.  First of all, it appears that China's economy may be at or near the trough.  Recent data showed that the current slowdown may be turning around.  The IMF predicts that by the end of 2014 China's total GDP will have grown by nearly 22% from current levels and that by the end of 2017 China will have overtaken the total GDP of the United States.  China accounts for only about 3% of Caterpillar's current business, making it a huge growth opportunity.

Second, the so-called fiscal cliff has greatly clouded the outlook for the U.S. economy.  Predictions are that if the U.S. were to plunge off the fiscal cliff we would experience a rather deep recession in 2013.  Although the predictions are dire, history has shown that after much wrangling and gnashing of teeth our politicians usually come to some agreement.  I don't foresee Washington allowing us to go over the cliff and stay there for very long.  The pain for both parties will be too great as they experience the backlash of their constituents. 

In fact, I see the current situation as more of a set-up to achieve some much needed long term economic reforms in 2013.  A long term resolution from congress can and will set the U.S. on a path for a much brighter economy which will continue to lead the world.  Since North America still accounts for 36% of Caterpillar's business, this would mean a tremendous boost to the company.  In addition, a stronger U.S. economy will help the budding housing recovery, which is essential to Caterpillar's ongoing success in North America.

Those are some catalysts for Caterpillar's stock performance in the future, but the biggest opportunity may lie in where shares of the company currently are trading.  In my opinion, Caterpillar's stock has reached a level of extreme undervaluation.  At $89 per share, the company is currently trading at only 9 times this year's earnings.  This is far below the historic 15 year average P/E of 16.3.  If Caterpillar were trading at those levels, the stock would be worth about $149 per share, indicating that Caterpillar is trading at about a 40% discount to its normal price. 

I prefer to look at its current earnings and growth rates and base my valuations off of that.  Based on the current year-end earnings prediction of $9.12 (mid-point of the company's range) and earnings growth of 11.1% annually, the earnings-justified price of Caterpillar would be $137 per share.  Still, this indicates that Caterpillar is trading at a 35% discount to its intrinsic value.  If you take those numbers out a few years the opportunity looks even greater.  Based on projected earnings of $10.80 per share in 2015, Caterpillar's intrinsic value is around $162 per share.

The company's management team is strong, and they have been effective in their use of resources.  Caterpillar boasts a return on equity of 40% and a return on assets of nearly 8%.

The Risks

Despite the opportunity ahead, there are still some risks for investors to take into consideration.  The biggest risk for Caterpillar seems to lie in China.  The company has identified China as a huge opportunity for growth.  It aims to be the market share leader in China over the coming decade.  Therefore, if China's economy deteriorates more or stays at lower growth rates for a long period of time, the opportunity there becomes much smaller for Caterpillar.  I believe that China will continue to be a growth powerhouse for years to come, consuming a large amount of global resources and moving a lot of earth (essentially what Caterpillar does).  But there definitely is the risk that the China growth story doesn't continue or falters somehow.

Another risk I see is in North America, in particular the United States.  A lack of a resolution to our long term fiscal problems will harm the future prospects for economic growth in the U.S.  Specifically, no resolution to our problems could cause unemployment to remain high for years, harm a budding housing recovery, stifle construction and keep us from utilizing and exporting our vast natural resources.  In the short term the U.S. must resolve the fiscal cliff issue and prevent our economy from slipping into recession in 2013.

The final important risk for investors to consider is that Caterpillar faces some pretty intense competition in all of its segments.  In particular, Deere & Company (NYSE: DE) is aggressive in large earth-moving and farming equipment.  The company has been growing smartly around the globe and has posted 5-year annualized revenue growth of 8.5% and earnings growth of 13.8%.  Its big green machines are also recognized worldwide.  Deere's management has been effective, posting return on equity of nearly 45% and return on assets of nearly 6%.  In addition, Caterpillar faces competition in its newly acquired mining business from companies such as Joy Global and a host of smaller rivals in the Chinese market.

The Foolish Bottom Line

There is a lot of opportunity ahead for Caterpillar.  China offers a key to the company's future growth.  Other catalysts, such as the recovering U.S. housing market, should provide plenty of upside potential for shares.  Going forward, expectations are low and Caterpillar is trading at a historic discount.  The risks are clear but a lot of pessimism has already been priced into the stock.  Caterpillar has a dividend yield of 2.3% and a history of raising payouts, making it an attractive company for dividend investors to own.  The bottom line is it looks like its time to dig in to Caterpillar.

fjconstantino has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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