These two companies are known for having cyclical earnings and two stocks that have both had excellent years and trounced the S&P 500 index. But between copper miner Freeport-McMoRan (FCX 2.23%) and heavy equipment company Caterpillar (CAT 1.59%), which is the better buy now? Let's take a closer look.
The case for Caterpillar stock
The equipment company is probably harder to understand, so I'll start with it and its recent barnstorming set of second-quarter earnings. The earnings exceeded analyst expectations, and management's full-year outlook impressed. For example, adjusted operating profit is expected to come in at the top end of management's targeted range, and more importantly, its machinery, energy, and transportation free cash flow (FCF) is expected to be around the top of its target range of $4 billion to $8 billion range.
In case you are wondering, management's $4 billion to $8 billion range reflects the cyclical nature of its business and is supposed to frame the low and high end of FCF performance through the cycle. I'll come back to this point in a moment, but let's focus on where Caterpillar is outperforming and what to expect in the future.
Caterpillar's sales trends
The following chart shows Caterpillar's retail sales growth. The company makes most of its sales through independent dealers, so the retail sales data reflects its end-market demand. Indeed, the retail sales data reflected Caterpillar's sales data in the period with broad-based strength in resource industries (mining and aggregate machinery) sales (up 20%), leading to a $385 million increase in the segment's profit. Energy and transportation had an excellent quarter, with a 27% sales increase leading to a $610 million profit increase, and finally, a 19% sales increase in construction industries leading to an $814 million increase in profit.
Data source: Caterpillar presentations.
While the uptick in retail sales and Caterpillar's earnings are impressive, it's important to note a few things:
- Caterpillar's mining and energy-related sales are ultimately tied to the direction of commodity prices.
- Digging into the retail sales data for construction industries, only North American retail sales grew year over year in the quarter -- a reflection of the nonresidential construction boom in the U.S.
As such, to buy into Caterpillar stock, you should be confident in the long-run outlook for commodities because it's unlikely that North American nonresidential construction spending can continue to grow at the torrid pace it's set this year.
Turning to valuation, if you accept the $4 billion to $8 billion FCF range and take the midpoint of $6 billion, the average through the cycle, and put a 20 times FCF multiple on the stock, the target market cap comes to $120 billion. Caterpillar stock currently stands at a 23% premium to that value.
The case for Freeport-McMoRan stock
Investing in the copper miner also manifests a belief in a commodity and management's ability to keep producing it. As previously discussed, the argument for rising copper prices doesn't just rely on the electrification-of-everything trend -- the growing use of copper in electric vehicles, renewable energy, smart buildings/infrastructure, etc. It's also driven by the increasing difficulty of obtaining mining permits and, in some countries, dealing with political instability.
Freeport-McMoRan stands relatively well placed here, with most of its copper coming from the U.S. and Indonesia. Moreover, Freeport-McMoran is working on leaching technology that management believes could lead to 800 million pounds of copper per annum recovered from stockpiles -- a figure equivalent to around 20% of its expected 4 billion pounds' worth of copper sales in 2023.
Based on a copper price of $4 per pound (Freeport-McMoRan realized a price of $4.11 in the first quarter and $3.84 in the second quarter) management expects $11 billion in earnings before interest, taxation, depreciation, and amortization (EBITDA) in 2024 through 2025 -- a figure that would put Freeport-McMoRan on an enterprise value-to-EBITDA multiple of less than 6 times in that period.
Image source: Getty Images.
Caterpillar or Freeport-McMoran?
On balance, Freeport-McMoRan looks better right now. Granted, Freeport-McMoRan has more downside potential for commodity prices (including copper) to collapse. On the other hand, it has more upside if its key commodity price continues to rise.
However, in the base case scenario where commodity prices stay (roughly) flat from here, Freeport-McMoRan will still look like a good value. Caterpillar is a good value based on the current FCF generation. Still, there's no guarantee it will continue at this level, mainly due to its reliance on North American construction spending.
