Welcome to the wonderful world of highly cyclical stocks! Just as their earnings tend to oscillate wildly, so do their stock prices. That's particularly the case with equipment machinery manufacturer Caterpillar (CAT 1.58%). The stock started 2021 on a powerful note, but it's down more than 9% over the last three months. So what's going on, and is the dip a buying opportunity?
Why Caterpillar's stock declined
There are probably three key reasons:
- Rising raw material prices have pressured margins at machinery manufacturers, and Caterpillar and others are seeing rising costs.
- China's growth appears to be slowing, and this has caused fears that it might be time to bail out of cyclically exposed stocks like Caterpillar.
- Caterpillar's valuation got ahead of itself, and consequently, the market sold the stock off.
These bearish points received some support from the recent second-quarter earnings.
Image source: Getty Images.
Raw material costs
Starting with raw material costs, CFO Andrew Bonfield said during the earnings call that the third-quarter profit margin would "moderate" from the second quarter. Furthermore, he went on to note, "we do expect higher manufacturing costs, which means that our gross margin percentage will be moderately lower in the second half of the year versus the first half."
That's a disappointment, as a critical aspect of cyclical stocks is that profit margins tend to expand strongly as revenue grows, leading to a super increase in earnings. Of course, the standard response is to try to pass on costs through price increases -- something Caterpillar is doing -- but as Bonfield notes, Caterpillar's gross margin is set to be lower in the second half.
Growth in China
Usually, with cyclical stocks, each region of the world tends to operate in tandem. However, COVID-19 originated in China and then spread to the rest of the world, meaning that China's growth trend has fallen out of step.
As you can see below, the Asia/Pacific region recovered quicker than Europe and North America. The China economy was hit the hardest in the first quarter of 2020, while the rest of the world followed in the second quarter of 2020.
The year-over-year growth in the Asia/Pacific region is now coming up against tougher comparisons with 2020. Meanwhile, year-over-year growth in Europe and North America is surging as those regions are coming up against very weak comparisons with 2020.
In a nutshell, the market appears to be worrying about the fall in the year-over-year growth rate in Caterpillar's machine retail sales in Asia.
Data source: Caterpillar presentations. YOY = year over year. Chart by author.
Valuation concerns
Valuing a cyclical stock is always tricky. Not least because it sometimes makes sense to buy cyclical stocks on a high valuation and sell on a low valuation. They tend to trade on a high valuation precisely when earnings bottom and then take off. The cycle continues until they trade on low valuations at peak earnings, just as earnings start declining.
You can see these dynamics expressed in the charts below. EBITDA is earnings before interest, taxation, depreciation, and amortization, and EV is enterprise value (market cap plus net debt).
Wall Street analysts are forecasting that Caterpillar's EV/EBITDA multiple will drop to 15.6 times EBITDA in 2021, 13.4 times EBITDA in 2022, and 12.3 times EBITDA in 2023. However, as the chart below shows, those valuations are pretty high for Caterpillar at peak EBITDA, so it appears that the market is pricing in a multi-year recovery.
Data by YCharts
The bulls' case
In response, it's worth highlighting a few points. First, rising raw material prices are an issue, but they stem from the fact that construction activity is strong, and so is energy and mining demand. That's arguably a net positive for Caterpillar's revenue generation, and once the company starts pushing through price increases, its margin should improve.
Second, the worries over China's growth are simply a sentiment issue. China's year-over-year growth may be slowing, but that's largely down to the fact that it recovered before Europe and the Americas. The reality is Caterpillar's sales are still forecast to grow by 18% in 2021 and 11.5% in 2022.
Image source: Getty Images.
Third, with Caterpillar's mining and oil and gas customers still being relatively conservative -- despite strongly rising commodity prices -- it's likely that Caterpillar should see an extended upcycle in its resource machinery and oil and gas equipment sales. Throw in an infrastructure bill, and there's even more long-term upside potential. As a result, Caterpillar's earnings could grow on a multi-year basis.
There's a case to be made for buying the stock, but most investors will want to see some consensus-busting earnings in the next couple of quarters before buying it at such levels.
