Long-Term Growth Makes Caterpillar a Smart Buy

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

The worldwide economic recovery appears to be encouraging; particularly, a couple of select sectors are demonstrating optimistic signs in fiscal year 2013. The industrial goods sector is one that is likely to entice investors as the worldwide economic recovery picks up. A stronger economy should help the industry to increase profits through improvements in sales volumes rather than expense cutting.

In this bright scenario, Caterpillar (NYSE: CAT) remains one of my favorite picks. And I really believe that the market is already discounting a lot of bad news on earnings (an earnings decline of as much as 40% this year appears to be embedded in the stock's valuation), which makes it a buying opportunity for investors. 

Diversified business

Caterpillar's business is actually broken down into four key segments: resource industries, construction industries, power systems, and financial products. The largest and most important segment for fiscal year 2012 pertained to resource industries as this section brought one-third of the company's total annual revenue.

The rest of the segments are also not far off. This diversity with respect to types of business operations is very intelligent, as approximately similar amounts of exposure have been granted to resource, construction, and power systems, whereas the high-risk section of financial products has been limited to less than 5%.

The expansion approach adopted by Caterpillar resembles its business operations as the company is not solely dependent on any single growth driver. The company has paid great attention to strategic acquisitions along with its adaptation of new technology through increasing R&D expenditures. The company's overall capital expenditures have projected a compound growth rate of 30% since fiscal year 2009.

How competitors are faring

<table> <tbody> <tr> <td> </td> <td><strong>CAT</strong></td> <td><strong>JOY</strong></td> <td><strong>DE</strong></td> <td><strong>ITW</strong></td> <td><strong>Average</strong></td> <td><strong>Industry</strong></td> </tr> <tr> <td><strong>Market Cap (billions)</strong></td> <td> 56.4</td> <td> 5.75</td> <td> 33.8</td> <td> 31.6</td> <td> 31.9</td> <td> 32.5</td> </tr> <tr> <td><strong>Revenue </strong><strong>(billions)</strong><br /></td> <td> 63.1</td> <td> 5.5</td> <td> 37.7</td> <td> 17.6</td> <td> 31</td> <td> 34.8</td> </tr> <tr> <td><strong>P/E</strong></td> <td> 12.3</td> <td> 7.9</td> <td> 10.7</td> <td> 11.9</td> <td> 10.5</td> <td> 25.8</td> </tr> <tr> <td><strong>Dividend Yield %<br /></strong></td> <td> 2.4</td> <td> 1.3</td> <td> 2.2</td> <td> 2.2</td> <td> 2</td> <td> 1.55</td> </tr> <tr> <td><strong>Profit Margin %<br /></strong></td> <td> 7.9</td> <td> 13.3</td> <td> 8.5</td> <td> 15.6</td> <td> 11.3</td> <td> 7.1</td> </tr> </tbody> </table>

When compared to its competitors, which include Joy Global (NYSE: JOY), Deere (NYSE: DE), and Illinois Tool Works (NYSE: ITW), the table above clearly shows that Caterpillar is the largest company in the industry in terms of both revenue and market cap. The P/E ratio is considerably below that of the industry, implying possible undervaluation of the company. The company's profit margin is lower than its close competitors as Caterpillar seeks to maintain its volume advantage, which generates the large revenue. Despite this approach, the profit margin of the company is greater than the industry average.

For Joy Global, given the existing levels of backlog of more than $2.2 billion and still enviable global aftermarket demand, the company has relatively good visibility in fiscal year 2013. This gives me assurance that any major drop in the stock price is very unlikely. Joy Global trades at trailing P/E of only 7.9, has a 15% long-term earnings growth rate, and a decent 1.3% dividend yield. The current payout ratio stands at just 10%, leaving significant room for dividend hikes.

More than 65% of Joy Global's revenue comes from coal-related projects as customers involved in coal mining provide the commodity for steel production. Therefore, any increase in steel-product-related activity is likely to improve demand for the Joy Global's products.

Deere recently reported second-quarter net income of $1.1 billion, or $2.76 per share. This measures up favorably to net income of $1.0 billion, or $2.61 per share, for the same period last year. Revenue increased by about 9% to a record $10.9 billion. Robust demand for farm machinery plus several new launched products led to these better-than-estimated results.

Deere's results are a manifestation of positive conditions in the worldwide farm economy, which continues to display remarkable strength. The company's performance also provides additional evidence of the proficient execution of Deere’s operating and marketing ideas, which are aimed at broadening its global market presence.

On the other hand, Illinois Tool Works reported a 28% drop in first-quarter net income as revenue fell 8%. The company sold its business of "decorative surfaces" and did not include those results in this quarter's numbers. At the same time, its operating margins improved 60 bps to 16.5%.

Operating margin is basically a measure of how much of the company's total revenue the company gets to keep. For most of the first-quarter, investors have focused on sales growth as companies have reported, but with Illinois Tool Works, better operating margins were all it took to lift the stock.

Conclusion and recommendation

Given Caterpillar's attractive valuation with a P/E of about 12.3 times analysts' consensus EPS estimate of $6.90 for fiscal year 2013 and 10.6 times the consensus number of $8.00 for fiscal year 2014, the stock does look undervalued. In the period, EPS growth in the mid-teens is expected, and analysts are also predicting a four-year compound annual growth pace of at least 14%.

If we incorporate Caterpillar’s dividend yield of 2.4% into that growth to get PEG+Y ratio, we find it even more attractive. The P/E-to-growth pace based on the current- year EPS estimate and a four-year growth outlook, incorporating the 2.4% dividend yield into the equation, would be 0.7; impressive to say the least.

Any addition of Caterpillar to your portfolio, however, will require keeping a very close eye on the economic outlook, and reconsideration of shares' valuation every month or two.

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.

Sarah Richard has no position in any stocks mentioned. The Motley Fool recommends Illinois Tool Works. 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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