Should I Buy CAT Stock? 3 Pros, 3 Cons

by Dan Burrows | October 23, 2013 11:25 am

CAT Should I Buy CAT Stock? 3 Pros, 3 Cons[1]Caterpillar (CAT[2]) coughed up an ugly third-quarter earnings[3] report Wednesday, pushing CAT stock firmly into the red for the year-to-date.

CAT — the world’s largest maker of heavy construction and mining equipment — said profit tumbled 44%, missing Wall Street’s average estimate for Caterpillar by a wide margin. Sales declined and also came up short of forecast.

But worst of all, Caterpillar, a component of the Dow Jones Industrial Average, slashed its full-year outlook and was exceedingly cautious about its prospects for 2014.

The awful quarterly showing came courtesy of the mining division at Caterpillar. Sluggish global growth and lower commodities prices have been sucking the air (and revenue and profits) out of mining equipment sales for years.

Unfortunately for Caterpillar — in a case of especially bad timing — the company doubled-down on mining right before the bottom fell out, acquiring mine-equipment giant Bucyrus International for about $7.5 billion in mid-2011.

Anyone holding Caterpillar stock has seen the value plunge 21% ever since. Heck, after Wednesday’s beating, CAT stock is down more than 5% for the year-to-date, lagging the broader market by nearly 30 percentage points.

On the bright side, with its global footprint, strong balance sheet and ever-leaner cost structure, Caterpillar is as well positioned as any company to benefit from a rebound in the global economy, and especially in China. That bodes well for anyone holding CAT stock for the long haul.

However, less optimistically, there’s a very real possibility we’ve entered a prolonged period of tepid global growth. China, which is moving toward consumption and away from investment, may never consume commodities as voraciously at it once did.

Meanwhile, more than a dozen major mining projects around the world have been shelved. If the commodities super-cycle is indeed over, Caterpillar may rue the day it decided to be the world’s mining equipment king.

So, should you buy CAT stock? To help decide, let’s look at some of the pros and cons:

CAT Stock Pros

Global Rebound. World purchasing manager surveys for both manufacturing and services have improved recently, Caterpillar CEO Doug Oberhelman said Wednesday, signaling the world economy is rebounding from more than two years of slowing growth. Recent economic indicators also suggest that growth in the U.S., Europe, Japan and China in 2014 should match or exceed 2013 growth.

Valuation. Underperformance has made the valuation on CAT stock pretty compelling. The forward price-to-earnings ratio (P/E) of 12 offers a discount of more than 25% to its own five-year average, according to data from Thomson Reuters Stock Reports. Caterpillar stock also trades well below its own five-year average on a trailing earnings basis. And, with a long-term growth forecast 20%, that forward P/E of 12 really looks like a bargain.

Prepped for Patience. Despite weak sales, Caterpillar is expecting 2013 to be the second-best year in its history for cash flow — and not far off from its own record. The strong cash flow has enabled Caterpillar to shore up its balance sheet. Debt-to-capital is down to 34% from 58% five years ago. The strong cash flow also enabled Caterpillar to buy back $2 billion in CAT stock so far this year and raise its quarterly dividend by 15%.

CAT Stock Cons

Medium-Term Weakness. Eurozone economies are far from healthy and China continues to transition to a more consumer-demand led economy, Caterpillar CEO Oberhelman said in press release. Additionally, despite higher mine production around the world, new orders for mining equipment remain “very low,” he added. As a result, Caterpillar will report 2014 revenue in line with 2013, plus or minus 5%.

Poor Visibility. As bad as things have been for Caterpillar for a couple of years now, it’s still catching Wall Street by surprise. Caterpillar has missed analysts’ average earnings estimates for three consecutive quarters. That makes it tough to have confidence in projected earnings and Caterpillar’s long-term growth rate. It’s also a huge reversal for CAT stock, which, prior to the string of misses, had beaten Street estimates in 17 out of 20 quarters.

Stingy Dividend. The yield on the CAT stock dividend stands at just 2.7%, but the payout ratio is only 33%. Yes, the company is returning cash to shareholders by repurchasing Caterpillar stock, but with such strong cash flow and reliable earnings, Caterpillar could easily hike its dividend. Investors in CAT stock are going to have to be patient with Caterpillar. A more generous dividend would help cushion any downside in Caterpillar stock, and the stream of income would make the wait easier.

Verdict

Caterpillar is uniquely positioned to benefit from the secular demand for commodities. The market has slowed markedly, but — eventually — it will have to bounce back. Population growth creates demand for iron ore, copper, coal — you name it — as well as for infrastructure and commercial and residential construction. Caterpillar machines serve those needs, making its long-term outlook bright.

But, in the words of the CEO, there is no sign of a turnaround yet for CAT stock. Caterpillar stock is a buy because its shares are cheap and don’t reflect the inevitable — if long overdue — acceleration in global growth. But be forewarned that anyone initiating a position in Caterpillar stock is going to need to be patient for a couple of years at least.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2011/08/CAT.jpg
  2. CAT: http://studio-5.financialcontent.com/investplace/quote?Symbol=CAT
  3. ugly third-quarter earnings: http://finance.yahoo.com/news/caterpillar-reports-third-quarter-results-113000529.html

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