CAT - Caterpillar Could Outperform Again In 2023

Summary

• Caterpillar has bucked the downward trend in the markets during 2022, and we think shares may be resilient (and may even outperform again) during 2023.
• The primary reason for this view, despite Caterpillar being a cyclical entity heading into recessionary economic conditions, is the firm's pricing power.
• We've simply been blown away by the strength of its operations, and we think there is more room for price increases across its product suite.
• We think Caterpillar's share price has upside to the high end of our fair value estimate range, which we will discuss in this note.
• Caterpillar is a Dividend Aristocrat, meaning it has increased its dividend each year for a long time and shares yield ~2% at the moment.

By Valuentum Analysts

Caterpillar, Inc. (CAT) has bucked the downward trend in the markets during 2022, and we think shares may be resilient (and may even outperform again) during 2023. The primary reason for this view, despite Caterpillar being a cyclical entity heading into recessionary economic conditions, is the firm's pricing power. We've simply been blown away by the strength of its operations, and we think there is more room for price increases across its product suite. Let's talk more about this.

When Caterpillar reported third-quarter 2022 results back in October, the company recorded a 21% increase in revenue while adjusted profit per share leapt to $3.95 from $2.66 previously, up 48%. Both higher prices and volumes drove the strong performance that showcased ~280 basis points of operating-profit margin improvement during the period. Higher dealer inventories (which advanced $700 million during the third quarter of 2022), headwinds related to foreign currency, a moderating outlook for residential construction, and weakness in Europe and China (the latter in the excavator industry) were a few concerns, but overall, the quarterly performance was impressive.

During the third quarter, Caterpillar returned $2 billion to shareholders in the form of share repurchases and dividends. Liquidity remains strong with the firm ending the period with an enterprise cash balance of $6.3 billion. Capital spending is targeted at $1.4 billion for the full year, and price realization should more than offset cost increases in the fourth quarter, as it did during the Caterpillar's third quarter. The firm's order backlog was up $1.6 billion on a sequential basis and up a solid $9.4 billion on a year-over-year basis in the quarter.

Key Investment Considerations

Caterpillar makes construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. It also owns Caterpillar Financial Services (Cat Financial). The machinery giant's operations are tied to cyclical end markets, and results are not immune to geopolitical risks either. It is based in Deerfield, Illinois.

Cat's dealer network is a significant competitive advantage. Its reach is phenomenal, with 45+ dealers in North America and 110+ outside North America serving 190+ countries. Mining and energy equipment sales remain tied to expectations of commodity prices.

Caterpillar has seen robust demand across its portfolio of late due to strength in North American construction activity and strong demand from resource extraction industries for the firm's equipment and services. Higher material and freight costs have been major headwinds of late, and Cat has turned to pricing increases to offset those headwinds.

Caterpillar is quite effective at managing costs through the course of the economic cycle. Part of Caterpillar's strategy when faced with revenue declines is to manage the fall such that the decrease in operating profit is less than 30% of the decline in revenue. We also like the focus on driving strong inventory turns.

Cat Financial's exposure to the volatile mining and energy arenas will always have us somewhat concerned. The hidden captive finance arms across the broader machinery sector may put surprising pressure on performance in the event of a downturn.

Caterpillar's Economic Profit Assessment

The best measure of a company's ability to create value for shareholders is expressed by comparing its return on invested capital [ROIC] with its weighted average cost of capital [WACC]. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Caterpillar's 3-year historical return on invested capital (without goodwill) is 22.2%, which is above the estimate of its cost of capital of 9.2%.

As such, we assign the Caterpillar a ValueCreation rating of EXCELLENT. In the chart above, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Caterpillar's Cash Flow Valuation Analysis

We think Caterpillar is worth $238 per share with a fair value range of $190-$286. Note, we've raised our fair value estimate since the last update . We think shares could run to the high end of our fair value estimate range. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them.

Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.3%.

Our model reflects a 5-year projected average operating margin of 17.6%, which is above Caterpillar's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For Caterpillar, we use a 9.2% weighted average cost of capital to discount future free cash flows.

Our Margin of Safety Analysis of Caterpillar

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate Caterpillar's fair value at about $238 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example).

After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock.

In the graph above, we show this probable range of fair values for Caterpillar. We think the firm is attractive below $190 per share (the green line), but quite expensive above $286 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

In light of Caterpillar's strong product pricing momentum and relative share-price strength, it wouldn't be out of the range of outcomes, in our view, to see its share price run to the high end of our fair value estimate range during 2023.

Caterpillar's Dividend Strengths and Weaknesses

Caterpillar is a Dividend Aristocrat and the firm paid out a special dividend in 2012. The company's machinery operations are tied to cyclical end market demand, which is impacted by changes in commodity prices, but its strategy when facing revenue declines is to manage costs such that the fall in operating profits is less than 30% of the drop in revenue. Though Caterpillar's cash flow generation has been volatile in recent years, the company's rolling free cash flow average has been more than sufficient in covering annual run rate cash dividend obligations. Lean manufacturing initiatives remain crucial through the course of the business cycle.

The cyclical end markets Caterpillar serves is but one of the major risks surrounding the sustainability of its dividend. Caterpillar also has a sizeable debt load largely due to its sizable financing segment. Its exposure to the volatile energy and mining sectors gives us additional cause for concern, and it has the potential to add an increasing amount of pressure in coming years. Competing capital allocation options have the potential to impact the pace of dividend expansion moving forward. Share repurchases have been material in recent years. Geopolitical risks and overall economic uncertainty do not bode well for this cyclical operator and the health of its dividend, but its operations remain strong heading into 2023.

Concluding Thoughts

Things are looking good for Caterpillar, and the company's free cash flow strength continues to support its payout and Dividend Aristocrat status. Caterpillar's results are cyclical and exhibit operating leverage, which cuts both ways, but the firm's pricing power is working wonders on its financials at the moment. Higher dealer inventories due in part to timing and labor shortages, foreign currency headwinds, and weakening dynamics in the residential construction market and in Europe and China are concerns, but the company's strong performance may continue into 2023. Its stock may very well outperform next year, too.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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