ATLKY - Caterpillar Offers An Intriguing Mix Of Cyclical Drivers

2023-03-08 09:32:33 ET

Summary

• Caterpillar is a hotly-debated bellwether in the heavy machinery market, as bears believe most of the business is at or near the top of the cycle.
• Light construction does indeed look "toppy" to me, but I think underlying strength in heavy construction (infrastructure), mining, and oil/gas could prove stronger for longer.
• Caterpillar has traded at 20x to 25x trough EPS in the past.
• If a 20x to 25x P/E multiple is still valid, 20x the lowest EPS estimate on the board right now ($13.50 in FY'24) supports a fair value of $270.

Cyclical companies are always more challenging to model, as getting the magnitude and timing of the peaks and troughs correct more than a year out is tough for even the best analysts and investors. It gets even more interesting in cases like Caterpillar ( CAT ) where there are multiple trends cutting in opposite directions.

I do see vulnerability in light construction equipment, as well as businesses exposed to industrial, data center, and transportation customers (more rail than marine), and I'm concerned that input costs could prove stickier for longer. On the other hand, I see a strong upcoming infrastructure cycle and a lot of catch-up opportunities in markets like mining and oil/gas, not to mention the re-opening in China. Trading at less than 20x what I believe will be trough earnings for the cycle, I think these shares are interesting for investors with a contrarian streak willing to bet on a relatively soft "mini-trough" and better growth beyond that.

The Negatives - Weaker Light Construction And Some Risk To Margins

On the negative side of the ledger, I've been consistently negative on the near-term outlook for non-residential construction for a little while now. While I think certain categories are still attractive (like aerial work platforms for Oshkosh ( OSK ) and Terex ( TEX )), I'm not as bullish on light construction equipment for the residential and non-residential markets in North America and Europe, and I do still see risk to the property sector in China.

To this end, I'd note that management at CAT now believes that U.S. construction dealer inventories are back to normal levels, and this normalization happened a fair bit faster than the Street expected.

I do also see a potential for near-term weakness in some segments of the Energy & Transportation segment, including diesel engines, gensets for industrial and data center customers, and capex for rail (locomotives).

I also believe that expectations that strong pricing will translate into quick margin relief in 2023 could prove too optimistic. Analysts can't have it both ways - commodity input prices can't stay strong and yet Caterpillar still expect to see meaningful relief on commodity-driven inputs like steel, and while I do see semiconductor and other component costs easing, there could still be risk here for Caterpillar's margins if inflation remains stubborn.

The Positives - There Are More Than A Couple!

I do see risks to the light construction equipment part of Caterpillar, but historically that's been the modestly smaller part of the Construction Industries mix. In contrast, I think heavy construction equipment could start coming into its own in 2024 and beyond on increased infrastructure spending.

Between healthy state-level budgets and federal stimulus, there's a lot of money out there ready to be deployed into roads, bridges, water systems, and other projects that will require heavy equipment and I believe the fleet serving these markets is at least somewhat overaged. Not only could heavy equipment demand offset what I think will be a relatively brief correction in light equipment, heavy equipment has historically carried better margins.

There have also been years of significant underinvestment in many of Caterpillar's core markets. In addition to years (if not decades) of under-spending on North American infrastructure, there has been global underinvestment in mining and oil/gas infrastructure. While mining companies have been leveraging stronger prices to refresh their fleets (which reached a multi-decade high of around 12 years during the pandemic) there's still a long way to go, and mining companies are also looking to take advantage of increased automation and ESG-compliant machinery ( BHP Group ( BHP ) and Rio Tinto ( RIO ) are both working with Caterpillar on zero-emission equipment).

In the oil/gas market, rig counts are still about a quarter below their prior peak, and drillings only recently started outpacing completions. I do expect oil and gas companies to be more responsible with their leasing and drilling this time around ("helped" by reduced access to cheap capital), but that doesn't change the fact that a lot of equipment in the field is overaged. Likewise, with pipelines and midstream assets; Atlas Copco ( ATLKY ) has continued to see healthy demand for gas processing compressors, and I believe Caterpillar's Solar business (which has nothing to do with solar power) will see strong demand for a while longer.

On top of all that is the re-opening trade in China. I'm honestly less certain about this driver, as there are still significant issues in China's property sector, but I do think it's likely to be an incremental positive for Caterpillar, as it makes up around 5% to 10% of Caterpillar's revenue base.

The Outlook

A key question in my mind is how strong the "strong" markets can be for Caterpillar. I do think there will be actual acceleration in heavy construction equipment, but increasingly difficult comps in Resource Industries will tamp down some of the upside from still-healthy end-markets.

I do see a risk of an "air pocket" in Caterpillar's revenue growth in FY'24, with 7% to 8% growth in FY'23 and FY'25 dimpled by flat-to-low-single-digit year in FY'24. Beyond that I expect healthy demand in FY'26 and long-term revenue growth in the low-to-mid single-digits. There will be a more significant correction at some point, perhaps in FY'26 or FY'27, but I refer back to my initial comment about the challenges of accurately predicting peaks and troughs more than a year out.

Caterpillar doesn't look all that cheap on long-term discounted cash flow, but that doesn't really surprise me given where the shares are trading. Using a different approach to valuation, I've decided to ignore my own model and look for the lowest EPS number I can find, and that's currently $13.50 in FY'24. In the past CAT shares have traded at 20x to 25x trough EPS, and 20x times $13.50 is $270.

Of course, that leaves plenty of room to debate whether $13.50 will be the actual trough and whether 20x is still appropriate as a low end of the range, but I think it's a workable framework for the time being.

The Bottom Line

Is roughly 10% upside enough? Would 15% upside be enough, assuming the trough is closer to $14.25? Readers have to decide that for themselves, and weigh the risks that stronger resource and heavy construction machinery market outlooks are already in the price. Still, given the balance of headwinds and tailwinds, I like the odds of a softer cycle this time around and believe these shares could still surprise to the good.

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