Can Caterpillar Inc Continue to Push Higher?

Caterpillar has had a good year so far but can this performance continue? It's unlikely.

May 25, 2014 at 10:37AM

There is no question that Caterpillar's (NYSE:CAT) performance so far this year has been impressive. The company's shares have surged, rising nearly 16%.

The company has also outperformed almost all of its peers, including smaller peer Joy Global (NYSE:JOY), which has seen its shares go nowhere during the past five months.

The question is, will Caterpillar's impressive performance continue?

Impressive first quarter
Caterpillar's performance so far the year can be traced back to a solid set of first quarter numbers. The company's earnings per share for the first quarter came in at $1.61, beating forecasts for EPS of $1.23. What's more, the company revised full-year guidance higher.

Caterpillar now expects to earn $6.10 per share during 2014, up from the figure of $5.81 previously expected.

These good results are attributable to strong performance from Caterpillar's construction and power systems divisions. Unfortunately, the company's main business, manufacturing mining equipment, continues to perform poorly.

Indeed, Caterpillar's own management stated on the first quarter earnings call that the company continues to see low order rates for mining equipment:

The company expects mining orders will begin to improve at some point, but not likely in time to increase Resource Industries' sales in 2014

The power systems and construction side of Caterpillar's' business only account for around 23% of the company's overall revenue, the rest is dependent on mining equipment orders. So, while the company may be reaping the benefits from an economic recovery within the U.S. now, it will be unable to stage a full recovery until capital spending within the mining industry recovers.

Unfortunately, many analysts believe that the market for mining capital equipment will continue to contract at a rate of around 10% per annum in the near future. Some estimates claim that the market will return to growth during 2016, but there are some conflicting views on the matter; ultimately the mining industry is dependent on global economic growth.

While this is bad news for Caterpillar, the company's power and construction businesses are taking up some of the slack. Joy Global, however, is more of a pure-play mining equipment producer, and the company is likely to suffer more than its larger peer.

Bad news for Joy
Not only is Joy Global a pure-play mining equipment company, the company also specializes in the production of equipment for coal mining. With both the price of coal and demand for mining equipment slumping since the financial crisis, Joy has been hit hard.

That being said, there are some signs developing within the coal market that point to a recovery, a relief for Joy. Actually, thanks to the harsh weather conditions in the U.S. this past winter, coal reserves have hit a low not seen since the 90's, and this should work in Joy's favor.

Indeed, when Joy reported its fiscal first quarter earnings results, management highlighted the fact that the global coal market was seeing a recovery in China and India, but the U.S. was yet to see a recovery. Hopefully, with inventories falling to low levels demand for coal mining equipment within the U.S. should rise, boosting Joy's outlook.

Still, even if the coal market is not ready to stage a cyclical upswing just yet, Joy's aftermarket services division is expected to generate $650 million per quarter for the company, easily enough to cover the company's dividend payout and stock repurchase program. Joy is planning to buy back $1 billion of stock, 17% of its outstanding shares over 36 months, and currently offers a 1.2% dividend yield.

One thing that worries me about Caterpillar is the company's currently valuation. In particular, Caterpillar currently trades at a forward P/E of 17.2, based on the figures above.

A forward P/E of 17.2 is a relatively high valuation, especially considering the fact that Caterpillar's main market, the mining industry, is still contracting. Additionally, Caterpillar's smaller peers all trade at P/E ratios in the low-teens.

All in all, Caterpillar looks expensive considering the mining industry is still contracting and when compared to the valuation of its peers.

Foolish summary
So overall, Caterpillar's shares have put in a good year-to-date performance, but this may not continue. Firstly, the company will not be able to return to full health until mining industry capex begins to recover again. And secondly, the company is currently trading at a higher than average valuation.

Unless the company can continue to grow sales at its construction and power systems business faster than its mining business is contracting, it is likely that Caterpillar is due for a correction sometime soon.

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Rupert Hargreaves owns shares of Joy Global. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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