3 Reasons to Like Caterpillar

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

I’ve been a Caterpillar (NYSE: CAT) shareholder for years, and it’s treated me pretty well. Recently I began going through my holdings, deciding whether I want to sell or add to my holdings. My opinion: I plan on holding, but if the market (and CAT) has another big pullback, I will purchase some more shares. Here’s why:

By any measure, CAT is cheap. Caterpillar's trailing twelve months PE is 8.6, on record earnings per share of $9.76 in the last twelve months. Cat is a member of both the DOW Industrials and the S&P500, which have average PE ratios of 14.16 and 16.74, respectively. While CAT is listed as being a member of the conglomerate industry along with companies such as Dow Chemical, 3M, and United Technologies, it’s not a terribly relatable peer group, as Caterpillar has a huge exposure to construction and mining, while the others do not. Even so, the market cap weighted PE of the conglomerate industry is 14.23, again much higher than CAT’s. A better peer group would consist of other companies in the mining and construction industries, such as Joy Global (NYSE: JOY), GE (NYSE: GE), CNH Global (NYSE: CNH), and Deere & Co. (NYSE: DE). This peer group has an average PE of 11.49, although GE, which has a relatively small construction and mining segment, has the highest PE, which skews the number up a little. Regardless, CAT is undervalued when compared to this peer group also.

Aswath Damodaran, a Professor at New York University’s Stern School of Business and a noted valuation guru, regularly formulates market wide regressions to calculate various expected ratios. One of the most reliable regressions is his equation for the Price to Sales Ratio. The average P/S for CAT’s industry is given on Damodaran’s site as 1.03: CAT’s Current P/S is .80, and the expected P/S ratio using Damodaran’s regression is 2.23, mostly due to CAT’s exceptional growth and profit margin. Again, undervalued, and according to this regression, CAT should be at $236. That’s a little optimistic even for me, a current shareholder, but a guy can dream, right?

Speaking of growth, CAT’s five year Earnings Per Share growth is 7.4%; while not exceptional, remember this is coming off a fairly high base in 2007, before the recession. CAT earned $1.44 in 2009, and is expected to earn $9.00 to $9.25 in 2012. Taking the low end of this range, we find their 3 year EPS growth rate to be 84%. Obviously, the five year rate is too low because of the recession in the middle of the time period, and the three year rate is too high because the base IS the recession, but the growth rate is somewhere in the middle. Combining the growth rate and the PE, we find a PEG ratio of between .1 and 1.16, assuming the growth remains between the two extreme growth rates. Going a little further back, in 2002 the company had earnings of $1.15 per share. This gives a ten year growth rate of 23%. This seems a little more reasonable, and contains multiple business cycles.

Of course, the question on everyone’s mind is always “Can that growth continue in the future?” With Caterpillar, its products will be in demand as long as countries are building infrastructure, buildings are being built, mining is occurring, and extra electrical generation is needed. With the burgeoning middle class worldwide, I’m fairly certain that these types of activities will continue occurring. Many people focus on China as a big stumbling block for CAT, repeating endlessly the mantra that if China slows, CAT will fall. However, China’s ruling party will do everything they can to make sure growth doesn’t slow by building more infrastructure, and that means CAT won’t be hurt. On top of that, CAT gets only a quarter of its sales from the Asia Pacific region, of which China is a part. As big of a deal as China is on the world stage, I’m not too worried about a portion of a quarter of my company’s revenue being diminished.

3. Caterpillar’s market cap is approximately the same as Deere, JOY, and CNH combined. GE is a different story, being quadruple CAT’s size, but it has many businesses unrelated to construction and mining. In fact, they just recently started a mining segment, which they hope to have revenues of $5 billion in a few years. Compare this to the $16.5 billion in revenue CAT realized this past QUARTER. While GE may be bigger in size, it is not bigger in mining. JOY, CNH, and the construction and forestry segment of Deere combined for revenues of $31 billion over the last year. Cat has had $67 billion in revenue over the same time period, again dwarfing their competitors. Manufacturing construction and mining machinery is a capital intensive business. Add to that Caterpillar’s top notch research and development, and you’ve got a company in a leadership position in an industry making products with few alternatives, and little chance of incredibly disruptive new technologies coming forward.

Caterpillar’s low valuation, high possible growth, and market dominance has convinced me to re-up my commitment to the company. In fact, if the price drops a little more, to the mid $70’s, I’ll look to purchase more. I have a lot of faith in the management, and the dividend yield of 2.4% that is growing at a five year rate of 7% is a great plus for weathering these downturns.

Invest to Impress

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 Fool’s brand new report. Just click here to access it now.

Fool blogger Tim Noffsinger is long CAT. The Motley Fool owns shares of General Electric Company and Joy Global. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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