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Caterpillar to morph into a Butterfly, yet again

Jul 20,2014  INVESTMENT IDEAS  Comment: 0

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Houston, TX – (StockNewsDesk) – 07/20/2014 — After years of being subjected to weak demand and languishing development prospects, the mining and equipment sector is finally seeing new life will breathe into it this year. In late June, Credit Suisse reported in its industry review that the U.S. industrial equipment market is performing far better than expected.  Furthermore, Deutsche Bank recently said that sales of mining equipment are holding steady, and that excess capacity problems are showing significant improvements. Caterpillar is one company which was devastated by the global economic meltdown and consequently had to face revenue losses as its inventories flooded due to supply outstripping demand.

But it seems that the global economy and Caterpillar have turned a corner, both in their own capacities. The company’s restructuring is leveling out and beginning to show dividends as its revenues and return on assets level out and suggest impending growth for the coming quarter whose earnings release is on 24th July. It seems as though Caterpillar will base its forecasting and strategy for growth in the North and Latin American region, unlike earlier when it was heavily reliant on a swift-developing China. But the company’s future seems secure and somewhat hedged due to recent reports which have come out of China; the country’s growth clocked in at 7.4% which is a welcomed sight for Caterpillar.

CAT

The image above illustrates Caterpillar’s performance compared to an industry competitor Joy Global and Indexes for Construction and materials. It clearly outperforms joy global and is maintaining a healthy, upward trend after witnessing a dip around the end of January after restructuring measures were announced in the first quarter.

Performance

In the first quarter, Caterpillar’s profits grew as gains from cost reduction measures and higher construction equipment sales were able to overshadow the weak activity shown by global mining industry. Strong construction equipment sales are expected to continue throughout the year, enough to offset the mining weakness. The company’s positive sentiments regarding earning can very well be realized if the pace of spending and construction continues to increase in North America and China.

Indicator Caterpillar Joy Global
Market Cap $68.8 billion $6.4 billion
Price/Earnings TTM 18.7 20.1
PEG Ratio 1.4 2.5
Net Income Growth (3 Yr Avg.) 6.9 5.0
Net Margin% TTM 6.9 7.8
Dividend Yield, % 2.27 1.13
Return on Equity 19.9 11.7
Current Price $109.43 $64.83

In comparison to Joy Global, Caterpillar enjoys a healthy advantage regarding valuation – it is not only undervalued from the P/E perspective, but the PEG ratio also confirms the stock’s undervaluation after incorporating future growth. Over the past 4 four years, the company’s revenues have not increased at the same pace as its net income; in fact, revenues have shown volatility and an inability to grow. Despite this, net income has shown progressive increment on the back of cost cuts and improving net margins. Caterpillar also rewards its customers with a 2.27% yield while having a payout ratio of 29.9% – showing its flexibility for rainy days. Furthermore, the per-dollar return that investors get out of investing in Caterpillar is higher than Joy Global i.e. Return on Equity.

CAT-RETURN-OF-Assets

Amidst cost cutting and restructuring efforts, Caterpillar has improved its profitability tremendously for the upcoming quarter and the remainder of the year. A quick look at Return on Asset shows that the decline has stagnated; this is a good explanatory variable to make sense of restructuring efforts and whether they are having any effect on the company’s operations.

2004-12 2005-12 2006-12 2007-12 2008-12 2009-12 2010-12 2011-12 2012-12 2013-12 Latest Qtr
Revenue 32.9 20.13 14.25 8.29 14.16 -36.88 31.46 41.21 9.54 -15.51 0.23
Operating Income % 61.91 38.46 30.05 -9.61 -87.03 586.83 80.49 19.85 -34.35 14.78
Net Income % 85.17 40.25 23.93 0.11 0.45 -74.84 201.68 82.52 15.28 -33.3
EPS % 83.71 40.52 27.97 3.87 5.4 -74.74 190.21 78.31 14.59 -32.19 9.92

 

Looking at the previous ten years of Caterpillar’s Revenue shows little consistency due to torrid construction boom and bust across North America and China. Commendable though its net income has managed to be accentuated at times when the company reeks in revenue improvement. This is obviously due to the company’s high margins, which allows it to maximize profitability. The year-on-year increase is perhaps of most interest when it comes to EPS since this is the end product i.e. results that investors get and the picture looks fairly good for Caterpillar investors who have stuck with the largest construction company in the world for the past ten years. Other than 2009 when a financial crisis decimated operations of multiple industries which inadvertently affected construction business, Caterpillar’s growth has been strong. More importantly, it should be expected to gain momentum now that its restructuring has been almost completed.

Verdict

Despite restructuring, Caterpillar remains to be a high-risk stock whose potential will only be validated after the earnings are posted. However, the competition it faces from Joy Global in developing markets is not enough to undermine its performance. Furthermore, in order to minimize risk attached to the Caterpillar stock, it is advisable to focus on its 200 day moving average in order to get an idea of when to buy, hold or sell. Currently the stock is above its 50 and 200 day average and I do not see it hitting a snag anytime soon. Furthermore, there is a view that the company’s diesel engine department has supposedly lost out to General Electric’s engine division to take advantage of the upcoming regulations for locomotives; this isn’t so, because Caterpillar’s timeline for launching new regulation satisfying engines is well in line with testing, approval and sales deadlines for buyers. As I mentioned earlier, this is a high-risk stock, but brings big rewards along with it as well.

 

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