Why You Should Buy This Machinery Stock Despite Near Term Headwinds

Madhukar 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) is expected to have a soft 2013 because of depressed capital spending by the mining industry (down about 10% to 15%, yoy). The main reason for this low spending is the sluggish Chinese economic environment in the last six months and theEuropean debt crisis, which ultimately resulted in a decline in iron ore and metal prices. This decline is bound to affect Caterpillar significantly as mining activity accounts for nearly 42% of the company's total business. However, I believe most of these negatives are already priced in and Caterpillar is taking a lot of strategic steps to diversify its business by trying to increase its footprint in the oil and gas market as well as innovating in its engine segment. Thus I would recommend long term investors to look past 2013 weakness in the business.

Innovation in Engine Segment

Recently, Caterpillar announced that it will be improving its LNG engine technology to provide more fuel efficient environment friendly engines for the marine industry. This effort will help it to produce marine focused engines meeting the latest emission requirements and low-sulfur fuel regulations (IMO II and IMO III) in emission-controlled areas. These sustainable and fuel efficient engines will increase productivity, longevity, and performance while providing ease to its customers to cope with strict emission requirements. This extension in its product line will enable Caterpillar to meet its customers’s demand of engines which are affordable while also easy to install. These efforts reflect that the company has a great understanding and commitment towards meeting its customers’s needs.

Increasing foot print in oil & gas markets

Caterpillar has entered into a 50-50 joint venture with Ariel Corporation, which is known for designing and manufacturing gas compressors with the name of Black Horse LLC. At present around 40,000 compressors produced by Ariel are being used across the energy industry worldwide for the purpose of extraction, process, store, transporting and distributing natural gas from the wellhead to the user. Under this joint venture both companies will provide well service pressure pumping products for customers in the oil & gas market. This joint venture further acquired ProSource, a pump manufacturer for designing and manufacturing reciprocating pressure pumps.

Caterpillar and Ariel's manufacturing expertise will be added to ProSource's product line serving the needs of the oil and gas customers with reliability and sustainability. Caterpillar in return will be benefited by the fact that its existing oil and gas customers will get a complete pressure-pumping solution along with spare parts and allied services at the same place. This full package of Frac pumps will be sold through Caterpillar's outlets under its brand name. The joint venture with Ariel and the acquisition of ProSource are expected to generate significant synergies that will be used in improving the existing product line, technology up-gradation, investment in R&D, and increasing manufacturing and customer service capabilities.

Peer group analysis

Caterpillar is trading inline with its other Machinery peers which are trading between 9-11x its forward earnings. CNH Global and Deere & Company are two of its immediate peers that compete in the agriculture endmarket.

CNH Global N.V. (NYSE: CNH) has recently announced that it has now entered into a definite merger with Fiat Industrial which was previously rejected by CNH Global. Fiat currently holds 88% of CNH's share and will acquire the remaining 12% giving Fiat 100% control of CNH. Both these merged companies will operate under a new company named NewCo. Under this deal the shareholders of Fiat Industrial are likely to receive one NewCo share for one Fiat Industrial share and the CNH shareholders will get 3.828 NewCo shares for each CNH share.

CNH has also announced a cash dividend payment of $10 per share to its minority shareholders. This special dividend has raised the value of the original merger proposal by 26%. Fiat has a new spin off company named Fiat SpA (F) which manufactures agricultural and construction equipment. CNH's restructuring activities and strength in markets lead to the better financial results and this deal will give CNH a direct exposure to agriculture and construction. It will further give CNH industrial and operational benefits that include the effective utilization of the financial and treasury operations of the broader group. This merger will simplify the lengthy equity capital structure and will further let shareholders of both companies benefit from the growth opportunities.

Deere & Company (NYSE: DE) is another peer group company of Caterpillar which competes in the agricultural and forestry equipment sector. The company is looking forward to focus on bigger infrastructure and non-residential construction contractors. The US is a big market for farming equipment and Deere already has a dominant position in the United States and Canada, contributing around 60% of its sales. The farm cash receipts are also expected to grow in Europe and North America which are the primary source of equipment purchases, creating an increased demand for such equipment in 2013. With this established position Deere is eying China, which is one of the fastest growing economies in the world and has a constantly rising population. The company sees China as a growth opportunity and invested $250 million in its R&D and assembling plant there, which will manufacture almost all models of agricultural machinery.

The bottom line

Caterpillar usually trades at a premium to these companies given its diversified nature. However, the premium has narrowed recently given concerns in the mining sector. I believe long term investors should utilize this opportunity to buy the stock. Caterpillar's increasing exposure to oil & gas markets and innovation in its engine segment makes it well positioned for the longer term.

madhudube 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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