CAT - Caterpillar: Cyclicality Fears Have Arisen

2023-04-09 12:15:01 ET

Summary

• Shares of Caterpillar have fallen more than 15% over the last couple of weeks, with the market concerned about tightening monetary conditions.
• I was very aware of the cyclicality of the shares in February, as the current pullback is interesting but does not come unexpected.
• While the pullback is substantial, I am not buying the dip, as monetary tightening will hurt the prospects for 2023 earnings.

A month ago I called the performance of Caterpillar ( CAT ) simply impressive. This came as the company has become more diversified and resilient, with infrastructure and the energy transition being key drivers in an uncertain economic environment. At the same time I feared that a traditional cyclical player had not lost all of its cyclicality, making me cautious.

A Quick Recap

Pre-pandemic, Caterpillar generated $54 billion in revenues in 2019 on which it reported operating earnings just in excess of $8 billion and net earnings of $6 billion, with adjusted earnings equal to about $11 per share. The company guided for 2020 earnings to fall to $8.50-$10.00 per share, and that was already ahead of the impact of the pandemic.

Net debt, in the traditional definition, stood at $29 billion. This was defined as cash and equivalents minus debt, which includes large debts related to the financing activities. These are largely offset by large receivables as well, in fact some $22 billion at the time.

Despite 20-30% declines in quarterly revenues in 2020, Caterpillar was able to maintain profitability in a solid fashion, causing shares to end 2020 around the $180 mark, levels higher than the start of the year. The pandemic clearly demonstrated the improved resilience of Caterpillar in a big way.

What followed was a rally to $250 in the summer of 2021, as the company did see strong 2021 results, a year in which revenues were up 22% to $51 billion. These revenues trailed the 2018 and 2019 numbers, but adjusted earnings near $11 per share were quite good.

This momentum was prolonged in 2022, as was evident in the full year results released earlier this year. Full year sales for 2022 rose 17% to $59.4 billion, although that revenue number included a $2.4 billion inventory built-up component at dealers. Adjusted earnings rose to nearly $14 per share as momentum was strong throughout the year.

The fourth quarter revenue contribution of Caterpillar was exemplary of the improved diversification, as many still think of mining and resource industries if they think about Caterpillar. In fact, 40% of sales are derived from construction industries and energy & transportation activities, with resource industries responsible for a mere fifth of revenues.

Net debt stood at $30 billion, largely offset by a $21 billion financing receivables book, as profitability have largely been used for accelerated buybacks which reduced the float to 520 million shares.

With shares trading at $250 at the start of March, the resulting 16-17 times multiple based on earnings power trending at $15 per share by the fourth quarter looked reasonable.

The issue is that we likely find ourselves at an above-average point in the economic cycle. Besides this challenge are issues around cyclicality, labor shortages, the re-opening of China (which re-opened competition as well) and a transition to electrical vehicles to be made. Being mindful that shares had risen some 90 dollars in the time frame of just half a year, I was cautious, looking for an entry point around $200 before potentially getting involved.

$200 Arrived Quickly

With shares trading at $250 at the start of March, shares have now come down to $209 per share, marking a big >15% pullback in the time frame of about four weeks, as the stock took a beating amidst concerns in the banking sector which might limit capital expenditures and financing of large equipment as well. More so, while the company has reached a deal with the UAW for a new six-year contact, it did not come cheap.

This comes as the troubles in the financing markets are going to hurt demand across the economy as it will hurt lending and thus economic growth. This limits growth across the board, but notably through lesser construction activity and perhaps fewer mining activity as well, as infrastructure projects should likely be somewhat resilient.

That said the uncertainty around the business was evident in the 2023 guidance (range) provided by Caterpillar upon the release of the full year results late in January. This suggests revenues at a midpoint of $57 billion in 2023, although the company expects non-quantified sales growth which would imply that revenues would come in a bit higher. The issue is that the range around this indicative revenue guidance is quite wide.

That same presentation revealed that operating margins should come in between 14 and 17%, making 2023 largely similar to 2022 on that front, albeit that there are risks to the downside, and potentially to the upside as well. That being said, it seems evident that tightening makes it more likely that risks are seen to the downside here.

And Now?

The reality is that a 16-17 times earnings multiple early in March has fallen to just a 14 times multiple based on the $15 earnings per share number. This suggests that multiples have fallen a fair bit, or the equivalent is that earnings might fall towards a $12-$13 earnings per share range, while keeping the current 16-17 times earnings multiple intact.

This looks a lot more compelling, but I am mindful that shares of the company traded at just $160 in September, and that was ahead of this current monetary tightening, the impact of which is still hard to gauge here.

Amidst all this I can only conclude that I am more appealed to Caterpillar here, but given the events of the last couple of weeks, I am cutting my targeted entry point from $200, to let's say $180 per share as we likely see some real pressure on the business here.

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