Amidst volatility, Caterpillar (NYSE:CAT) is currently trading at the same levels as it was in July 2018. While there is little doubt that global economic growth is sluggish and that impacts Caterpillar stock, I believe that it is a buy.
The Federal Reserve Bank of New York reports probability of recession as predicted by Treasury spreads. According to latest data, the probability of recession by May 2020 is 30%. This is the highest level reported since the financial crisis of 2008-09.
Further, according to the GDPNow model (Federal Reserve Bank of Atlanta), real GDP growth for 2019 is likely at 1.3%. The US PMI reported in June 2019, has also dropped to the lowest level since September 2009.
Clearly, there is a meaningful slowdown and US-China trade conflict can potentially worsen the growth outlook for 2020.
Broad Economic Factors and Caterpillar Stock
Donald Trump has been calling for rate cut, but the Federal Reserve has not relented.
However, it finally seems that the central bank officials might be starting to believe that rate cut is needed in the foreseeable future.
If GDP growth weakens further in the second and third quarter, renewed expansionary monetary policy is very likely. I believe this will be positive for Caterpillar stock from a business growth as well as a stock upside perspective.
In general, markets trend higher on rate cut and the can move with the broad momentum. In particular, Caterpillar is attractive as it trades at attractive forward valuations.
Straight to Valuations and Caterpillar Stock
Before talking about the business triggers, I want to emphasize on the fact that Caterpillar is trading at a valuation gap compared to peers.
Caterpillar currently trades at a forward PE of 11.1 with Deere & Company (NYSE:DE) trading at a forward PE of 15.3. Caterpillar trades at a valuation gap even when we consider the industry average forward PE of 12.6.
Another good valuation indicator is the PEG ratio. Caterpillar trades at a forward PEG of 0.6 as compared to its five-year average PEG of 1.7.
Clearly, Caterpillar is inexpensive at current levels and that makes the stock attractive at a time when possible expansionary monetary policies can trigger positive market reaction.
Monthly Retail Statistics Remain Firm
Even with clear signs of global economic weakness, Caterpillar has reported healthy monthly retail statistics. Machine retail sales for April and May have trended higher by 7% and 6% respectively.
While sales in the construction industry have declined as compared to the first three months of 2019, resource industry sales have surged higher. After declining for two consecutive months, energy & transportation segment sales have moved higher by 1% in April and May.
The key point I am making is that Caterpillar is heading for a relatively healthy 2Q19. If the company reiterates the guidance for 2019 amidst economic slowdown, the undervalued stock is likely to trend higher.
It is also worth noting that any potential rate cut will translate into a weaker dollar. In turn, energy and commodity prices are likely to trend higher. This will be positive for activity in the resources and energy industry segment.
From a business growth perspective, I see the company’s investment in services as another source of revenue and EBITDA growth. The company’s long-term plan (by 2026) is to double Machine, Energy & Transportation services sales.
Just as an example, Caterpillar plans to product upgrade on mining trucks, diesel generators and marine applications. These upgrades will potentially be related to emission reduction, which is a critical service offering considering the environmental concerns.
The strategy to expand services will unfold in the coming quarters with the core idea to add customer value and cater to diverse customer needs. However, if services do gain traction, Caterpillar is positioned to witness margin expansion in the coming years.
Shareholder Value Creation
Another key factor that will keep the stock firm is the fact that Caterpillar is a quality income stock. The stock currently offers an annual dividend of $4.12, which implies a healthy dividend yield of 3.0%. In addition, Caterpillar repurchased stocks worth $751 million in 1Q19 and this provides additional EPS growth trigger.
Amidst economic slowdown, dividend might potentially remain stable at current levels in the foreseeable future. I don’t see dividends declining considering the company’s robust cash buffer of $7.1 billion and strong cash flows at operating level.
Amidst the positives, it is worth mentioning that Caterpillar stock has a beta of 1.51. Purely from a stock price perspective, any sharp broad market correction can take the stock lower. I am of the opinion that expansionary monetary policies will support asset classes in the coming quarters.
The business downside risk also sustains, but I do believe that Caterpillar is already trading at a discount to peers. Caterpillar also trades at a discount as compared to the S&P 500 index PE. In other words, economic concerns are discounted in the price.
If expansionary monetary policies are pursued, renewed growth in the construction, resources and energy sector can support the company’s growth targets.
The Bottom Line on Caterpillar Stock
Caterpillar has remained largely sideways in the last 12-months and the stock trades at a valuation gap.
Even amidst economic concerns, I believe that CAT is worth accumulating with the stock providing healthy dividend payout.
It might however make sense to gradually accumulate than take a big plunge.
As of this writing, Faisal Humayun held no position in any of the aforementioned securities.