Back in the early 2000s, when Federal Reserve lowered interest rates after dot com bust and 9/11 attack to stimulate the economy, it lead to a significant bull run in asset prices including housing and commodities. The recent developments like zero interest rate environment, Federal Reserve’s willingness to allow inflation to rise above its 2% target, and free money distributed in the form of stimulus are likely to create a bubble similar to what we have seen between 2001 and 2008. We have already seen a good rally in homebuilders (ITB) and gold (GLD) in anticipation of this. I believe mining companies will also join them in the near future as the global economy reopens.
I don’t cover the mining sector very closely except a couple of fertilizer companies. However, many companies in my industrial coverage manufacture equipments for the mining industry and have a good exposure towards them. Caterpillar (CAT) is one of the leaders in this area. In addition, Caterpillar’s other end markets like construction are also seeing or likely to see a benefit from low interest rates. This got me interested in the company and I decided of giving a closer look.
While the company’s end markets have seen a good deal of volatility in the recent past, I really liked the way its management is executing in the current environment. The company’s sales declined from ~$55 bn in FY 2014 to ~$39 bn in FY 2016 due to a recession in industrial sector. It recovered completely to ~$55 bn by FY2018 and then declined slightly to ~$54 bn in FY2019 as trade tensions resulted in softer end-market demand and caused dealers to reduce inventories.
While the company’s revenue performance in FY 2014 and FY2019 was almost similar, it posted ~15.4% operating margin in FY2019 which was 440 bps points higher than FY 2014’s adjusted operating margin of ~11%. Management has done a very good job in taking costs out of the business delivering $1.8 bn in structural cost reduction between 2014 and 2018 through closure or consolidation of 57 facilities; reducing manufacturing footprint by 25 mn sq. ft.; streamlining manufacturing operations; and reducing net fixed assets by $3.3 bn.
Historically, the company’s annual operating margins have oscillated between 7% and 15% during cyclical trough and peak. However, on its investor day last year, management has indicated that this range will likely be between 10% and 21% in the future. Now, FY 2020 has been an unprecedented year given the sudden nature of Covid-19 related shutdowns and maybe the operating margins this year will slightly miss the 10% trough level management indicated last year, but it will still be much better than the previous cyclical trough level of around ~7% seen in FY2016.
Looking forward, in addition to a potential cyclical uptrend in the company’s end market, Caterpillar will also benefit from management’s efforts to grow the company’s service revenues. On its investors’ day on May 2019, management discussed in detail its strategy to grow Machinery, Energy and transportation segment’s services sales to $28 bn by 2026 (from $18 bn in FY2018). Some of the initiatives included leveraging new capabilities like connectivity and utilizing the company’s new set of digital tools; focusing on adding value to the customers by helping them better manage their equipment and reduce downtime; and using CAT Financial (which has over 11,000 customer contacts per day) as a marketing tool to identify opportunities to offer services to the company’s customer base.
Services sales are usually higher margins and less cyclical in nature and I believe any increase in their proportion as a percentage of total sales will be perceived positively by investors. While the company’s target for 2026 is not easy and is more of an aspiration goal, I believe any increase in services sales (even if it is less than management target) will add to the benefits from the cyclical recovery in the end market. So, the revenue outlook over the medium to long term looks attractive.
I also like the balance sheet strength of the company. As of the last quarter-end, the company has $8,784 mn in cash and $11,124 mn in long term debt (out of which $1,395 is due within 1-year) of Machinery, Energy & Transportation segment. In addition, there is $23,184 mn of long term debt in the financial segment. However, there is a corresponding $21,341 mn in finance receivables which is offsetting it to a good extent. The company posted an EBITDA over $10.6 bn last year, and despite Covid-19 related headwinds, the current year adjusted EBITDA is expected to be around $6.4 bn (consensus estimates). So, the company is in a good financial shape and I believe management might consider some merger and acquisitions if an opportunity arises. This will further aid the company’s growth.
The stock is trading at 19.81x FY2021 consensus EPS estimates of $7.25 and has a 2.87% forward dividend yield which is attractive. I also believe there is an upside to FY2021 estimates. For FY2020 and FY2021, the current consensus estimates for revenues are $41.56 bn and $44.72 bn, respectively. However, according to the company’s CFO Andrew Bonfield, dealer inventory destocking is a big headwind which is expected to negatively impact sales by ~$2.2 bn this year, and it will not repeat next year. Below is the relevant excerpt from the company’s latest conference call,
In the first half of the year, dealers reduce their inventories by about $1.2 billion. As a reminder dealers are independent businesses and manage their own inventories. Based on their latest read on end-user demand we currently anticipate that dealers will further reduce their inventories by another $1 billion in the second half of the year. That is similar to the reduction they made in the second half of 2019. We anticipate that this reduction will enable us to produce in line with end-user demand in 2021.
So, the end market demand this year corresponds to $43.76 bn in revenues (if we add $2.2 bn to the current year expected revenues of $41.56 bn). Management expects no inventory destocking in FY2021. This means the sell-side is modeling just ~2.65% improvement in end-market demand in FY2021 over FY2020 ($44.72 bn versus $43.76 bn). I think it is conservative and the sell-side estimates may get revised upwards.
The company posted $11.06 in adjusted EPS last year. I believe we are still in initial phases of the upcoming commodity cycle and $11.06 in EPS will likely correspond to the mid-cycle level for Caterpillar’s business in this cycle (Last year’s operating margin of ~15.4% is also near the midpoint of management’s 10% to 21% target range). The company should be able to reach these levels again by FY2022 or FY2023. If we assume a mid-cycle P/E multiple of 18x, we get a price target of ~$199 which gives us ~39% upside over the next two to three years. Given the company’s good revenue growth prospects in the medium to long term, impressive margin performance in the recent past, solid balance sheet, conservative sell-side estimates, and reasonable valuations; I believe the stock is a good buy at the current levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.