CAT - Caterpillar: Benefiting From Favorable Construction And Mining Tailwinds

2023-06-27 16:20:56 ET

Summary

• Caterpillar is poised to benefit from the strong momentum in construction spending, especially on the non-residential side.
• Residential construction spending is also starting to rebound, with recent housing starts data coming in well above consensus.
• The consumption of specific minerals and commodities continues to increase, which should boost the company's equipment demand.
• The favorable tailwinds and discounted valuation make the company an attractive investment opportunity.

Investment Thesis

Caterpillar ( CAT ) is the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, etc. The Texas-based company currently operates in 193 countries with over 160,000 employees.

Caterpillar's performance has been underwhelming this year, with its share price vastly underperforming the S&P 500 ( SPY ), as shown below. However, I believe the company should bounce back in the second half as its backdrop is looking very strong. Overall construction spending continues to trend upwards while residential construction is also starting to rebound, as the housing sector stabilizes. The increasing demand for commodities and minerals should also present major tailwinds for the company moving forward.

Strong Construction Spending

Despite rising interest rates and tighter credit conditions, the construction industry remains extremely strong, as it continues to benefit from the Infrastructure Bill and Inflation Reduction Act. According to the FRED (Federal Reserve Economic Data), the US seasonally adjusted annual construction spending hit an all-time high in April, up 7.1% YoY (year over year) from $1,781 billion to $1,908 billion. On an MoM (month over month) basis, it also grew by 1.3%. The non-residential segments were particularly strong, which increased 25.4% YoY from $840 billion to $1,053 billion.

Jim Umpleby, CEO, on strong construction momentum :

In North America, overall, we continue to see positive momentum in 2023. We expect growth in nonresidential construction in North America due to the positive impact of government-related infrastructure investments and a healthy pipeline of construction projects.

The residential side has been soft, but it finally rebounded in April as well. Residential construction spending grew 0.5% from $851 billion in March to $855 billion in April. I believe the spending on residential construction will continue to rebound as other leading economic indicators are looking very upbeat. For instance, the recent housing starts in May came in at 1.63 million, up 21.7% MoM from 1.34 million and well above the consensus of 1.4 million The strong momentum in non-residential spending and the rebounding residential spending should provide meaningful tailwinds for Caterpillar as the company generates nearly 40% of revenue from the construction industry.

Favorable Commodity Trends

Caterpillar should also benefit heavily from favorable commodity trends. For instance, the ongoing energy transition continues to drive the demand for key commodities such as Copper, Zinc, and Graphite. According to the company , EV (electrical vehicle) uses over 200 kg of minerals per vehicle, 500% higher than conventional cars that use around 30 kg.

With the EV penetration rate forecasted to reach 50% by 2030, according to S&P Global ( SPGI ), the demand for critical minerals should continue to grow. The Inflation Reduction Act passed last year should also provide compelling incentives for green energy-related investments. According to the IEA (International Energy Agency) , the overall CAPEX of major mining companies such as Teck Resources ( TECK ) and Glencore ( GLNCY ) has nearly doubled from $20 billion in 2017 to $40 billion in 2022 and should continue to grow.

Besides critical minerals, the demand for coal has also been on the rise amid the increasing need for electricity generation, particularly in countries such as China and India. According to the IEA , global investment in coal production has been trending upwards and is forecasted to increase further by 10% from around $135 billion in 2022 to $150 billion this year, as shown in the chart below. The increasing consumption of different commodities and minerals should boost the spending of mining companies, which subsequently drives the demand for Caterpillar's mining and construction machines.

Jim Umpleby, CEO, on favorable commodity trends :

We expect healthy mining demand to continue, as commodity prices remain above investment thresholds. As I have mentioned during the last few years, customers remain capital-disciplined, which supports a gradual increase in mining over time. We continue to believe the energy transition will support increased commodity demand, expanding our total addressable market and providing further opportunities for profitable growth.

Valuation

Despite being up over 40% from its 52-week low, Caterpillar's valuation still looks compelling in my opinion. The company is currently trading at an fwd PE ratio of 13.2x, which is pretty cheap on a historic basis. As shown in the first chart below, the multiple is near the low end of its historical range, representing a meaningful discount of 25.4% compared to its 5-year average fwd PE ratio of 17.7x.

There should be ample opportunities for multiple expansions considering the company's upbeat growth rate. During the latest quarter, revenue growth came in at 16.7%, which is near the high end of its historical average, as shown in the second chart below. I believe the strong growth should be able to support a higher valuation moving forward.

Investors Takeaway

The near-term outlook of Caterpillar looks highly favorable. The ongoing increase in construction spending and the rising demand for commodities and minerals should continue to be significant tailwinds that drive growth.

Recession is a notable risk that will impact demand and push back investments and spending, but I am not too concerned right now as the economy remains resilient. For instance, the Federal Reserve recently raised its median GDP projection for the year from 0.4% to 1%. The current valuation is also discounted on a historical basis, which should present ample upside if growth can hold up. Therefore, I rate the company as a buy.

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