Caterpillar (CAT +9.88%) stock is down nearly 20% in the last month as broader market volatility and ongoing supply chain issues pressure infrastructure companies and equipment manufactures. Adding to the downward pressure are a couple of analyst price target adjustments.
A Cowen analyst kept an outperform rating and lowered his price target from $255 per share to $225 per share, while a Citigroup analyst lowered his price target from $225 per share to $190 per share while maintaining a neutral rating. Trading at less than $175 per share at the time of this writing, both analyst ratings still signal upside for Caterpillar.
Let's dive deeper into Caterpillar to see what's pressuring the company and why the stock quickly went from a commodity play to out of favor on Wall Street.
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Caterpillar's business in a nutshell
Caterpillar is a massive global company that generates the majority of its revenue from outside of North America. Its three main divisions include energy and transportation (oil and gas, power generation, rail transportation, etc.), construction, and resource industries (mainly mining). One unit of Caterpillar equipment is expensive, let alone the costs associated with outfitting an entire fleet with brand new Caterpillar engines, dozers, excavators, etc. Therefore, it's not too surprising that Caterpillar has a large financing arm known as Caterpillar Financial.
Generally speaking, Caterpillar does well when the global economy is growing. Demand for new oil and gas production, farming, infrastructure spending, raw materials in mining, more power to the grid, etc. all benefit Caterpillar. Caterpillar is seen as a bellwether of the industrial economy. When Caterpillar's dealers aren't knocking on Caterpillar's door for more equipment, that could mean they sense customer demand is drying up. Conversely, if dealers have too much inventory and can't move products off the shelf, that could also mean demand is low.
Caterpillar's business took a big hit in 2020 as the COVID-19 pandemic threw a wrench in the global economy. However, Caterpillar generated record-high net income in 2021 despite lower sales.
CAT Revenue (Annual) data by YCharts
Caterpillar's challenges
Caterpillar's Q1 2022 earnings saw decent growth thanks to the strength of the oil and gas industry and demand for higher mining output. But Caterpillar's profit margins came under fire due to ongoing supply chain constraints and higher input costs. Many of the industries Caterpillar serves are doing well. The issue so far is that customers don't seem to be motivated to buy new equipment. There could be a few reasons for this.
For one, many of the industries that are doing well right now (like oil and gas) are coming out of a multi-year period of mediocre performance followed by a complete collapse in demand in 2020. Put another way, one or two good years isn't enough to jolt spending. Secondly, rising interest rates make it more expensive to finance new equipment purchases. And finally, Caterpillar's customers may be reading the tea leaves and thinking that business is about to get a lot worse in a recession. After all, we've already seen West Texas Intermediate crude oil prices fall back below $100 a barrel. Tight supply paired with rising demand can boost prices. But if demand starts falling across Caterpillar's industries, then new equipment purchases will undoubtedly fall.
Outside of the U.S., rising demand for fossil fuels amid the European energy crisis bodes well for the long-term strength of the oil and gas industry. However, it will take time to fund and install increased import capacity of oil and liquefied natural gas (LNG). Additionally, China's economy and its population growth are slowing down, which could weaken the demand for infrastructure spending that benefits Caterpillar's construction business. A U.S. recession paired with geopolitical tensions and rocky economies for major global economies weighing on the short-term outlook for Caterpillar.
NYSE: CAT
Key Data Points
A compelling long-term investment thesis
Given the challenges discussed, it makes sense that Caterpillar's stock price would come down. But for long-term investors, the sell-off in Caterpillar stock could present an excellent buying opportunity.
Caterpillar stock trades at a price to earnings (P/E) ratio of just 14.6, which is far below its five-year median P/E ratio of 21 or even its 10-year median P/E ratio of 16.9. However, it's worth mentioning that Caterpillar's P/E ratio tends to decline when earnings expectations are weak and rise when earnings expectations are strong. Put another way, Caterpillar stock's surface-level inexpensive valuation is more of a result of the business cycle than it is about the stock being particularly cheap. But Caterpillar stock has a lower P/E ratio than during past low points in the business cycle, suggesting it could be undervalued if the earnings hit isn't as bad as some fear over the next few years.
The good news is that Caterpillar has continued to raise its dividend despite market cycles, with a current dividend yield of 2.7%. Caterpillar stock's decline raises the dividend yield, making its appeal as a dividend stock more attractive. Caterpillar is a Dividend Aristocrat, having paid and raised its dividend for 27 consecutive years.
Aside from being a good value and providing a reliable source of passive income, Caterpillar is the industry leader in many of its product categories. So that when the economy does rebound, Caterpillar has the track record, dealership network, and service network capable of serving industries around the world.
Caterpillar has also invested heavily in the energy transition by making lower-emissions products, such as blending natural gas with diesel. Caterpillar also has several software solutions, such as Cat Connect, that remotely monitors emissions and performance. Simply put, Caterpillar is well positioned to support its legacy industries as they transition toward a lower-carbon future.
There's no telling how much further Caterpillar stock could tumble in the short term. In a prolonged recession, Caterpillar's earnings will likely fall, and its valuation will look more expensive. However, Caterpillar's sizable dividend balances out this volatility nicely so that investors can be patient and let time work in their favor. Given Caterpillar's market position and lower stock price, now seems like a good time to buy Caterpillar for investors looking for a blue-chip dividend stock to add to their portfolio.
