Caterpillar's (CAT -0.30%) near-term headwinds are growing, and they are threatening the investment case for the stock. That's the key conclusion to be drawn from the recent disappointing sales update. Let's take a look at the details behind the report in the context of the valuation of the stock and what it means to investors.
Caterpillar is a cyclical stock
Caterpillar has always been a highly cyclical stock and always will be. When the economy is going great, people want to launch construction projects, so Caterpillar sells more construction equipment. Similarly, miners see stronger demand for metals and minerals in boom times so they spend on Caterpillar's mining equipment. Conversely, when the economy turns down, the company's sales start to tumble.
As such, it's sometimes tricky for investors to get a handle on the correct way to value the stock. There are two main reasons for this. First, its earnings-based valuations tend to be very low just as its revenue/earnings are about to peak because the market is pricing in a fall in its future earnings. On the other hand, its valuations tend to be very high just as revenue/earnings are about to trough.
The chart below shows these relationships quite well, and part of the case for buying Caterpillar right now is based on the idea that its sales are set to trough; analysts expect Caterpillar's sales to increase nearly 8% in 2021 from 2020, so the current valuation is attractive based on historical standards.
Hard to predict the cycle
Second, it's very difficult to predict just when Caterpillar's sales will peak and trough. Indeed, the company's earnings expectations are often subject to substantive revisions. They tend to overshoot on the way down and undershoot on the way up.
Putting all of this together, the case for buying Caterpillar rests on the idea that valuations (see previous section) are cheap for a company that Wall Street analysts believe is going to see a bounce in sales next year.
The bullish case sees a recovery in the U.S. housing starts should lead to an increase in non-residential construction as infrastructure is built around new housing. Moreover, mining commodities and energy prices -- Caterpillar also sells oil and gas equipment, and energy is a contributor to construction activity -- are starting to stabilize after steep falls earlier in the year.
In short, everything points to a pickup in Caterpillar's end markets.
Unfortunately, there's a fly in the ointment, and it isn't going away anytime soon. Despite the recovery in the global economy, Caterpillar's retail sales continue to decline, and they don't appear to have bottomed yet.
Moreover, there's no guarantee that non-residential construction will bounce strongly because the COVID-19 pandemic has created significant problems for certain industries. For example, the hospitality industry (hotels, restaurants, etc.) is likely to remain challenged for a while. Meanwhile, the retail sector could remain challenged by changes in customer behavior as a result of COVID-19, and growth in work-from-home initiatives may hold back investment in commercial offices.
Turning to mining machinery, it's a fact that the long-anticipated cycle of capital investment in the mining industry is yet to materialize, and there's no guarantee that it will.
Meanwhile, the bounce in the Asia/Pacific region seems to be running out of steam. If the region is a template for North America and Europe, then investors would be right to question the strength of the recovery to come.
What it means for investors
On balance, it's probably a good idea to give Caterpillar the benefit of the doubt here. The global economy is slowly recovering, and the pandemic won't be here forever. History suggests Caterpillar's sales will recover in line with the economy, and the company will surely see better days.
However, the sluggishness in the recovery in its retail sales suggests Caterpillar's revenue and earnings won't hit a trough for a while yet. As such, don't be surprised if the company disappoints with its earnings in the near term.