DRIP Portfolio Candidate: Caterpillar

This week, Fool analysts Todd Wenning and Bryan Hinmon are presenting two stock ideas for inclusion in the Fool DRIP Portfolio. Industrial stocks are on the docket today, with Bryan presenting Badger Meter and Todd making a case for Caterpillar.

If you'd asked me as a kid what I wanted to be when I grew up, I would have told you either the first baseman for the Cincinnati Reds or a bulldozer driver. Playing baseball and tearing up my parents' backyard were my two first loves (sorry, Honey). Unfortunately, my baseball career died with a whimper when I was 18, and my nose got buried in history and investing books in college rather than operating manuals. Yet I still dream of playing first base for the Reds and moving a few hundred tons of dirt with a 904 horsepower Caterpillar 854K Wheel Dozer (argh, argh, argh!).

Fortunately, I don't need to quit my day job to stay interested in heavy machinery. Reading Cat's reports satiates my interest in the industry and keeps me from tearing up my own backyard. So as I perused the list of stocks available for DRIP investing, I was immediately attracted to Caterpillar (NYSE: CAT  ) . Upon further investigation, here's what I found.

3 reasons to invest in Caterpillar

  • Tremendous brand. Caterpillar's brand name is iconic and can be found stamped on consumer products like clothing, toys, and even office supplies. This may sound like a minor point, but it speaks to the deep-rooted loyalty of its customers and suppliers. Which brand do you think the builder wearing the "CAT" shirt will go to when he needs a backhoe?
  • Global titan. Caterpillar may be an American icon, but in 2009 only one-third of its sales came from the U.S. Just five years earlier, 47% of its sales were made in the U.S., so its international expansion -- particularly in emerging economies -- has been rapid and successful. By comparison, in 2009, Deere (NYSE: DE  ) did 64% of its sales in the U.S.
  • Solid free cash flow generation. Over the past 12 months, Caterpillar has generated roughly $2 billion in free cash flow, despite the shaky economic foundation. This more than covers its $1 billion annual dividend payout (2.4% yield) and gives Caterpillar some fiscal flexibility by paying down debt, boosting its cash reserves, or repurchasing shares.

3 reasons not to invest in Caterpillar

  • Big pension obligations. As of December 2009, Caterpillar's pension plan is underfunded (liabilities exceed assets) by $3.78 billion and could thus have a suppressive effect on earnings in coming years, especially if equity and bond returns are low. Caterpillar's pension plan is 67% invested in stocks, 27% in fixed income, and 6% in alternative assets like real estate. In short, Caterpillar is keeping its fingers crossed for a robust stock market recovery.
  • Mighty headwinds for construction. According to IHS Global Insight, global construction activity is expected to remain flat during 2010 and then grow nearly 5% in 2011. That's great news for Caterpillar if that's what actually occurs, but with China concerned about its own real estate bubble, various stimulus packages coming off line, and lingering sovereign credit worries, I am skeptical of such a sharp recovery. What's more, analysts appear to be pricing a recovery into Caterpillar shares -- Wall Street consensus estimates have Caterpillar's sales jumping 15.2% from 2010 to 2011. It's a similar story at Deere and Terex (NYSE: TEX  ) , where analysts expect 10% and 17% sales growth, respectively.
  • The stock looks expensive. To value Caterpillar, I used a two-stage discounted free cash flow to firm model. Assuming an 8.2% cost of capital as my discount rate and 2% terminal growth, I put a fair value for Caterpillar between $57 and $60. If I bump up the terminal growth rate to 3%, I would get $71-$74 -- right near today's prices. Some analysts would be comfortable assuming a 3% terminal growth rate, but I'd prefer to err on the side of caution given the likely slow economic recovery.

Foolish bottom line
Hey, I'd love to buy Caterpillar. I think it's a great company, but I only want to buy it at a good price, and frankly I don't believe we have that opportunity right now. I'd much rather buy it closer to $60. Given the long time frame of the DRIP Portfolio, we are OK with waiting for a better entry price. Until then, Bryan and I will keep pitting our candidates against one another in search for the next addition to our DRIP lineup.

Do you have an industrial DRIP candidate whose shares are on sale? Drop a comment in the box below and let us know.

Previous DRIP Portfolio Articles:

Fool analyst Todd Wenning does not own shares of any company mentioned. The Fool has a disclosure policy.


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