CAT - Caterpillar Should Continue To Outperform

Summary

• CAT’s revenue should benefit from strong end markets, healthy backlog levels, and improvement in supply chain constraints.
• The margins should benefit from the higher price realization and moderation in higher input costs.
• The stock is currently trading below its historical levels.

Investment Thesis

Caterpillar Inc.’s ( CAT ) stock has risen approximately 40% since my bullish article in September last year. Looking forward, the company is expected to see strong demand in its end markets, driving sales growth in 2023. Increased backlog levels and easing supply chain constraints should also contribute to sales growth. The benefit of pricing actions taken in 2022 should carry forward into 2023, leading to higher price realization and improved margins. The company's good growth prospects and reasonable valuation make it a good investment opportunity and I believe it can continue to outperform.

CAT’s Q4 FY22 Earnings

Caterpillar Inc. recently reported mixed Q4 FY22 financial results. The company's revenue of $16.59 billion (up 20.3% Y/Y) was higher than the consensus estimates by $760 million. Meanwhile, the adjusted earnings per share of $3.86 increased 43.5% YoY but missed the consensus estimate of $4.03. The higher revenue was driven by strong price realization and volume growth, partially offset by negative foreign currency translation. The adjusted operating margin increased 560 basis points YoY to 17% due to favorable price realization and volume growth, despite increased manufacturing costs. The improvement in the adjusted operating margin positively impacted the adjusted EPS in the quarter. However, FX played spoilsport and resulted in a $0.41 per share headwind, mostly related to balance sheet translation, causing the company to miss the earnings.

Revenue Outlook

During the fourth quarter, CAT saw strong demand for its products and services across its end markets. The strong demand, coupled with improvements in the supply chain, resulted in volume growth. The dealer inventory rose by approximately $700 million sequentially, which also aided the volume growth.

The sales to end users in Q4 FY22 rose 8% YoY. In the Construction Industries segment, sales to users increased 1% YoY due to strong demand for both residential and non-residential construction in North America, partially offset by weakness in the EAME and Asia Pacific regions. The Resource Industries segment saw a 13% YoY rise in sales to users, driven by strong demand in the heavy construction and quarry and aggregate markets. The Energy & Transportation segment saw a 19% YoY increase in sales to users, driven by strong demand for turbines and related services, as well as healthy demand in the power generation market.

Looking ahead, CAT is well-positioned to continue its growth trajectory. The company has a robust backlog that rose 32% YoY to reach $30.4 billion at the end of 2022. With the improvement of supply chain constraints in 2023, CAT should be able to convert this backlog into sales at a faster pace. Despite the current global economic conditions, demand across the company's segments remains strong. The Construction Industries segment should benefit from the Infrastructure Investment and Jobs Act and healthy backlogs in North America. The outlook of public infrastructure spending is also constructive in the Asia Pacific region. EAME's business activity should be flat to slightly positive YoY with a healthy backlog and strong construction demand in the Middle East offsetting challenging conditions in Europe. These tailwinds are expected to more than compensate for the weakness in residential construction, which contributes 25% of revenue in the Construction Industries segment.

In the Resource Industries segment, the mining market continues to thrive as commodity prices remain high. The higher utilization of equipment and low levels of parked trucks bode well for future demand for CAT's equipment, parts, and services. The company should benefit from infrastructure projects in the heavy construction and aggregates sector. In Energy & Transportation, demand for power generation and data centers is robust, and orders for new equipment in the Solar Turbine brand remain strong. Solar is a leading provider of industrial gas turbine engines, compressors, and mechanical drive packages. The strong order rate can be attributed to increased LNG exports and underinvestment in the Oil & Gas sector for the past several years.

The strong demand in end markets is expected to result in higher sales to users in 2023. However, the growth won’t be as strong as in FY2022, as last year the company benefited from the build-up of ~$2.4 billion worth of inventory. The dealer inventory has now returned to its historical range of three to four months of projected sales. So, the benefit from dealer inventory restocking should be absent in FY2023.

The current sell-side consensus estimates are building in mid-single-digit revenue growth for CAT in FY2023, which seems reasonable with a solid backlog, easing supply chain constraints, and strong demand in most of the end markets more than offsetting weakening residential and European markets.

Margin Outlook

In Q4 FY22, the company's pricing actions and strong revenue growth more than offset higher material costs, including commodity and energy costs. This resulted in 560 bps Y/Y and 50 bps sequential improvement in adjusted operating margins.

Looking ahead, the benefit from the pricing actions taken in 2022, especially in the back half of the year, should carry forward into 2023 and further boost the company's margin. Additionally, the input costs have started to moderate in 2023, and this should also help margins. While, expenses for SG&A and R&D are forecasted to rise in 2023 due to the company's investment in service expansion and technological advancements, such as digitalization, electrification, and autonomy, management is expecting a decrease in short-term incentive compensation to more than offset the impact of these increased investments. So, I am optimistic about the company’s margin improvement prospects.

Valuation & Conclusion

The stock is currently trading at a P/E multiple of 16.14x based on the FY23 consensus EPS estimate of $15.63, and 14.98x based on the FY24 consensus EPS estimate of $16.84. This is below its five-year average forward P/E of 17.81x. The company's revenue is expected to benefit from high price realization, healthy backlog levels, and improvements in supply chain constraints. The margins are expected to benefit from higher price realization, moderation in input costs, and improvements in the supply chain.

Some investors are worried about the cyclical nature of the business and are assigning a lower-than-historical multiple to the company, assuming that CAT is near its cyclical peak. However, I don’t agree with this assessment. I believe the demand in the company’s key end market should continue to be strong. If we look at the construction end market, the funding from the Infrastructure Investment and Jobs Act (IIJA) has just started flowing through the projects. Given the longer-term nature of these infrastructure projects, they should continue to provide strength to the company’s construction end-markets for the next few years. The energy market has suffered from almost a decade of underinvestment, and only after the recent Russia-Ukraine conflict, the governments across the world are waking up to the need for energy security. This should drive investment in this sector in the medium term. The mining industry has also seen years of underinvestment and is trying to catch up.

Also, while Caterpillar is a cyclical business, it is focusing on growing its aftermarket and services business, which should reduce its cyclicality and result in a P/E multiple re-rating. Management’s target is to increase its services business from ~$19 bn in 2021 to ~$28 bn in 2026. The company is progressing well on these targets, and in FY22 the company achieved ~$22 bn in sales from its services business.

I believe, given the strong medium-term demand outlook of CAT’s end markets and its focus on increasing its aftermarket and services business, the stock deserves to trade at a higher multiple. Hence, I continue to have a buy rating on the stock.

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