CAT - Caterpillar: Simply Impressive

2023-03-05 04:56:26 ET

Summary

• Caterpillar has become a more diversified and resilient empire.
• Current momentum remains strong with infrastructure and energy transition driving secular growth, amidst an uncertain economic environment.
• Earnings multiples look reasonable, yet I am fearful of a cyclical component to these earnings, as I am happy to start considering again if shares see a retreat.

Shares of Caterpillar ( CAT ) continued to hold up just fine, trading near their all-time highs despite a rocky economic environment. My last take on the business dates back to October 2020 when I provided a small update after the company acquired the Oil & Gas business from Weir, a transaction which looked well-timed.

A Small Reap

In the fall of 2020, Caterpillar announced a deal to acquire the oil & gas business from British-based Weir. At a purchase price of $405 million, the deal was relatively small for Caterpillar, although the transaction was set to contribute more than $800 million in sales based on the 2019 numbers, albeit that margins were only coming in at mid-single digits. Of course, these were numbers from the year before as these results arguably would not be replicated in 2020.

The deal had just a tiny impact on the results as Caterpillar posted a 2% fall in 2019 revenues to $53.8 billion, with the deal set to add little over a percent to total revenues. Amidst cost control, Caterpillar posted flattish operating profits of $8.3 billion, as net earnings of $6.1 billion came down to $10.74 per share, with adjusted earnings posted a few pennies above the $11 per share mark. There was a complication with this, as the company guided for 2020 earnings to fall to $8.50-$10.00 per share, and that was pre-pandemic.

The balance sheet was and remains complicated as traditional net debt stood at $29.4 billion, but many of these loans were the result of the financing activities of the business, in part offset by $22 billion in financing receivables. If these are included - that is treated as cash - net leverage looks very modest.

The pandemic hit the business hard as first quarter sales fell 21% and second quarter sales fell as much as 31%, as the company retained solid profitability. With shares trading at $150 in October, the same levels at the start of the outbreak of the pandemic, the 544 million shares awarded the company an $82 billion equity position, or $100 billion if net debt was included. That worked down to 2 times sales and 11 times earnings (based on normal performance).

I applauded Caterpillar for becoming more stable, not being as sensitive to capital cycles in the mining industries (as was the case in the past). This came as the company has broadened its activities, creating more stable performance. Still believing there was a cyclical element to the business, I pegged sales at a range of $40-$70 billion throughout the cycle, with margins seen between 10-20%, still resulting in wildly varying operating profits between $4 and $14 billion. If this was realistic, earnings might come in anywhere between $3 and $20 per share.

Doing Well

Believing that quite some good news was priced into the shares at $150 nearly two and a half years ago, we have seen a big rally to $250 in spring 2021 as shares fell back to $160 during the pullback of last summer, albeit that shares have rallied all the way back to $255 here, trading within imminent reach of the highs.

Early in 2022, the company posted a strong set of 2021 results. Full-year revenues rose 22% to $51 billion, thereby still trailing the 2018 and 2019 revenue results. Full-year adjusted earnings of $10.81 per share showed a big improvement as well, basically at par with 2019.

Momentum continued throughout 2021 with first quarter sales up 14% as the renewed operating momentum triggered the company to hike its dividend by 8% to $1.20 per share. Second quarter sales rose 11% as inflationary pressures made that third quarter sales rose as much as 21%.

Forwarding to January of this year, Caterpillar announced 20% revenue growth for the final quarter, making that full-year sales rose 17% to $59.4 billion, albeit that it includes a $2.4 billion demand-driven component as a result of an inventory built-up at dealers. Moreover, adjusted earnings per share rose in a more pronounced manner to $13.84 per share as well, with momentum in the fourth quarter being very strong on all fronts.

The fourth quarter revenue composition clearly shows the increased diversity of Caterpillar. The company now generates approximately 40% of sales from the construction industries business and the energy & transportation business, with resource industries responsible for the remainder.

Net debt has risen to $30 billion, with net debt defined as cash minus all financial debt, although still largely offset by $21 billion in financing receivables. The company has been quite aggressive to buy back stock, having reduced the shares count to 520 million shares, providing some upward pressure on earnings.

And Now?

Despite the tough environment in 2022, due to rising interest rates and continued supply chain disruptions, Caterpillar has benefited from pricing, navigated labor shortages, and has been able to benefit from rising demand in end markets. Given all this, the company is now posting earnings at a run rate of $15 per share, at arguably a good point in the cycle.

Trusting this earnings power, a $250 per share valuation only comes in at 16–17 times, but this is likely an above-average point in the cycle, as some cyclicality will need to be priced into the share.

Besides the issue regarding cyclicality and where we find ourselves in the economic cycle, there are many other moving parts as well. Inflationary pressures and labor availability is key and for that reason, it is comforting to hear that Caterpillar has reached a deal with UAW for the coming six years.

Another driver is the opening of China which will not just increase demand, yet it results in increased competition as well, as Caterpillar furthermore has to make a transition into electrification (on which it has made some strides already).

Given all of this, I am impressed with Caterpillar, in the sense that the business appears to have become a lot more diversified and resilient than it was let’s say ten years ago. Amidst all this, I am constructive on the business, yet fear that the current reasonable 16-17 times multiple is a bit misleading as we find ourselves at a pretty good point in the cycle. I am furthermore mindful that shares have risen by about $90 over the past six months, as I am waiting for a reset of the $200 mark before getting involved here.

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