Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
With their shares up 48% over the past year, Caterpillar (NYSE:CAT) investors have every reason to be happy. And according to one analyst, there's even more good news in store as the market realizes that Caterpillar is a lot more profitable than it appears on the surface. This morning, investment banker UBS upgraded Caterpillar stock to buy and assigned a price target of $140 on the shares.
Here are three things you need to know about that.
1. What's going on at Caterpillar right now
Caterpillar held an investor meeting in Tucson last week. Among other revelations made there, TheFly.com reports that Caterpillar expects:
- Operating profit margins rising by an average of 2.5 percentage points over the "long term." From today's level of 7.2%, that should work out to nearly a 10% pre-tax operating profit margin for Caterpillar.
- Helping to achieve this goal, Caterpillar will be reining in its capital spending program, holding it below the level of depreciation and amortization of past capital spending for "some time."
- On the revenue front, Caterpillar sees its construction equipment business growing 15% this year, and its struggling mining equipment business -- which was at one time even bigger than construction -- reviving through reduced costs and a resurgent mining industry, globally.
2. What's going on in mining, in particular
Regarding that last point, Caterpillar's assessment jibes with a report out of Ernst & Young earlier this year, which noted that "Chinese growth has surprised on the upside this year at 6.8% and has boosted demand for commodities and pushed up prices." E&Y highlighted resurgence in the prices of aluminum and zinc this year as particular bright spots, and "global economic growth is expected to remain fairly robust" in 2018 as well.
All of which bodes well for Caterpillar's attempt to turn around its mining equipment business.
3. What really gets UBS excited about Caterpillar
Of course, all those macro trends are secondary to what really gets UBS excited about Caterpillar: Its cash.
Even with mining being in a slump these past few years, and Caterpillar's GAAP profits along with it (Caterpillar actually lost money last year), UBS notes that Caterpillar has been a robust producer of cash profits all along.
From 2013 through 2016 and even into this first half of 2017, Caterpillar has generated far more real free cash flow than it's been allowed to report as net income under GAAP. Over the past 12 months, for example, Caterpillar generated positive free cash flow of $4.3 billion -- far more than the $106 million in net income it was allowed to report.
The most important thing: Valuing Caterpillar stock
So what does all this mean for investors? First, let me give credit where credit is due, and acknowledge that UBS is right to point out how Caterpillar generates far more cash profit than its income statement lets on. And yet, the fact that Caterpillar stock has performed so strongly over the past year suggests that UBS may be mistaken when it argues that Caterpillar's "cash story is particularly underappreciated, and will become more of a visible part of the investor dialogue going forward."
Seems to me investors who have been buying Caterpillar stock hand over fist over the past year were probably doing so for a reason. With net income reported at a lowly $106 million, I doubt that was the reason. It's more likely the investors who have been buying Caterpillar stock recently have done so because they want to own a piece of the $4.3 billion in cash profits Caterpillar is bringing in the door. They're buying, in short, because they do appreciate the company's "cash story" already.
Of course, if Caterpillar's cash flow isn't as big a secret as UBS thinks, then this doesn't bode so well for UBS' buy argument today. Thanks to the stock's steep run-up, Caterpillar shares now sell for 16.7 times trailing free cash flow. And with most analysts predicting that Caterpillar will grow its profits at no better than 10% annually over the next five years, the stock looks (more than) fully valued to me now.