CAT - Caterpillar: A Buy After Hitting Record Highs

2023-08-14 12:59:37 ET

Summary

• Caterpillar's stock has been performing well, with shares up 37% since earlier this year, despite what could be an economy getting ready to slow down in the next year.
• Still, analysts expect earnings to continue climbing, driven by growth in various segments of the company, which saw significant margin improvement year-over-year.
• Caterpillar remains a solid long-term investment option with a shareholder-friendly approach, even if the short-term could see some pressures on the share price.

Written by Nick Ackerman

Caterpillar ( CAT ) has been plowing higher since our last update. On a total return basis, the company's shares are up ~37% since earlier this year when the banking crisis put the talk of a serious economic slowdown on the table. That said, I felt that CAT was still a solid long-term buy despite what could possibly lead to some short-term noise.

We aren't in too much of an entirely different position today, either. The short-term could continue to have some noise, potentially creating even better buying opportunities. However, this stock remains a buy for the long-term dividend investor despite hitting record highs recently.

Will CAT Stock Fall?

Banks have stabilized, and economic numbers are coming in quite strong; all the while, inflation has become much more tame to allow the Fed to ease off of the aggressive rate hikes we had last year.

At the same time, most are predicting a recession to come near the end of 2023 or sometime during 2024. That could be a potential headwind for CAT as a cyclical company that's reliant on a strong economy to perform at its peak. Generally speaking, a Fed rate hiking cycle is ended due to a black swan event or an economic slowdown. That's literally their goal to slow the economy down, and that means they are working against CAT's business prospects.

This is where the short-term softness could see CAT shares fall in the near term when looking out over the next year. It's pretty much why short-term tactical traders would say that CAT is probably a sell at this time. I don't blame them either, as I would have to agree, but I've always taken a longer-term outlook of what could be in the next five to 10-plus years.

With that being said, analysts aren't actually expecting any slowdown in earnings going forward. This would be assuming that several of these analysts are expecting a recession, too.

CAT has been working on services revenue that can be more sticky relative to equipment sales, which is something that can help stabilize earnings. However, even the CEO has acknowledged that they'll never be able to avoid being a cyclical company but merely hope to "dampen the impact of cycles." It's just the core of their business being equipment sales that is something they can't change completely.

Why Did CAT Stock Rally?

Latest Earnings Help Drive Run

During the time since our last update, CAT also delivered a solid earnings report which saw its shares rise materially. That definitely helped with the valuation multiples as it pushed the company. As we mentioned above, analysts expect earnings to climb materially this year and continue higher in the following fiscal year.

Given that they've already put up record earnings of $10.46 in the first half of the year, these aren't lofty goals with this trajectory. These also are record earnings, easily surpassing the annual EPS figure the company hit in 2018 - which, in turn, is what is helping propel this stock higher.

While I noted services specifically as being one area they wanted to focus on to dampen the cyclical nature of their business; it was really across the board that the entire company saw incredible growth.

• Construction was up 19% for total sales, and profits were up 82% as operating profit margins went from 16.4% to 25.2%.
• The resources industries segment saw sales increase to 20%, with profit surging 108% with margins expanding there from 12 to 20.8%.
• Energy and transportation saw a strong sales climb of 27%, helping to push profit up 93% as operating profit margins expanded from 11.6% to 17.6%.

Those are the company's core ME&T businesses. The financial products segment is their smallest, but that saw revenues increase by 16%, with profits climbing 11%.

With the type of growth across the board with the latest earnings, it really isn't any surprise to see record revenue and record earnings with their latest results.

Operating profit margins are above the company's expected 18% to 21% range overall at around 21.4%. This was good enough to allow management to bump up their financial targets after crushing with these types of results.

For the year, we now expect our adjusted operating profit margin to be close to the top of the targeted range at our anticipated sales level. We also expect ME&T free cash flow to be around the top of our $4 billion to $8 billion target range.

Free Cash Flow Helps Translate Into Better Earnings and Capital Return to Shareholders

Free cash flow is particularly important because CAT is a shareholder-friendly stock. They delivered $2 billion to shareholders in the second quarter of the year through repurchases and dividends, below their $2.6 billion ME&T FCF.

Being shareholder friendly also is reflected through the company becoming a dividend aristocrat with nearly 30 years of annual dividend growth behind them. However, it should be noted that the company doesn't always raise every four quarters. Instead, keeping their balance sheet strong during economic downturn periods such as the Global Financial Crisis, the oil price crash and during COVID.

I view this as a positive and not a negative for the company that during these periods, they'd choose to hold the payout steady for an extra quarter or a few in order to conserve cash. They ultimately end up raising in time before it would show two back-to-back years of the same dividend payout level.

Their goal is to return all FCF back to shareholders through dividends and share repurchases. The share repurchases piece is the more flexible of the two, where management and the board can turn those off or on depending on cash flows. Generally speaking, it's a huge negative if a company has to cut its dividend, so that's often avoided. Here's what they had to say in their last earnings call when prompted by a question about having excess FCF that they haven't returned yet.

As we said, our intent is to return substantially all of our ME&T free cash flow to shareholders through dividends and share repurchases over time. We do maintain a healthy balance sheet for a whole variety of reasons. When we went into COVID in 2020, I was very pleased that we had a strong balance sheet.

We also have increased our dividend since we introduced our new capital allocation strategy. In May of 2019, we've increased the dividend per share by 51% since that period of time. So again, we're proud of our Aristocrat status. So certainly wouldn't be surprised. It's a board decision, but if we continue to increase our dividend and continue to share repurchases as well.

When it comes to share repurchases, they aren't simply balancing out huge stock bonuses. There has been a material decline in shares outstanding over the years.

Therefore, surging sales, earnings and cash flow can help the stock rally higher over time. With CAT, it also leads to the company directly returning capital to shareholders. Rising FCF means more share repurchases are likely, and that provides support for further earnings growth. So it creates a sort of positive feedback loop scenario that's playing out.

Valuation Isn't Absurd

Finally, a tough economic period could see CAT's earnings slip and result in an overpriced stock. It actually really isn't there yet, if we're looking at today's numbers. This is because, off of the back of record earnings and expected earnings climbing going forward, the stock still only trades around 14.5x P/E. This is despite shares being up nearly 19.5% on a year-to-date basis and up so much since our prior update.

Historically speaking, that isn't absurd at all, as the company has trended in the range of 14x to 20x. Thus, we're closer to the lower end of their fair value range based on this metric than being overvalued. Shares traded at a P/E of around 13.6x in our prior update, so there was some multiple expansion on top of the growing earnings that helped drive such a strong move.

All that said, the latest stock surge is merely helping return the shares back into their longer-term fair value range, where it was traded below this channel previously.

Conclusion

Despite what was a monster run higher for CAT, shares aren't necessarily overvalued. The strong earnings helped top off this latest run, which also was partially due to being undervalued as the shares dipped due to an overall expectation of rougher economic conditions when banks were collapsing. While the short term could see a recession, and that certainly could take down CAT with it, the company remains solid for a long-term shareholder willing to ride out short-term noise that could manifest itself over the next year. In fact, it would likely only create an opportunity to pick up a position in this company or add to it in one's portfolio. Still, for the long-term investor, I'd still consider this a "Buy."

For further details see: