Here's What Will Make Caterpillar Stock a Buy

Caterpillar (CAT 1.59%) just delivered one of the best earnings reports in the industrial sector this earnings season. As the chart below demonstrates, its stock price continues to rise. However, the question now is what will make the stock a buy for investors. Here's what you need to know.

Three things to make Caterpillar a buy

There are three key answers to this question, and I will flesh them out below:

• A lower stock price because Caterpillar's valuation is starting to look stretched.
• An improvement in earnings from better operational execution.
• An upside catalyst to earnings from an improvement in its end markets.

Caterpillar's valuation

The stock is an excellent value based on its trailing earnings and free cash flow (FCF). For example, earnings per share (EPS) of $21.21 puts it on just 15.2 times earnings, and machine, energy & transportation (ME&T) FCF of $10 billion puts it on 16.4 times FCF.

However, there's something else to consider: Caterpillar is, and always will be, a cyclical company (more on that later), and its earnings and FCF history reflect that.

CAT Free Cash Flow data by YCharts.

Take FCF, for example. Management previously guided toward $4 billion to $8 billion through the cycle. The good news is that the guidance was raised to $5 billion to $10 billion through the cycle. For 2024, CFO Andrew Bonfield expects "to be within the top half of our updated ME&T free cash flow target range of $5 billion to $10 billion."

In summary, Caterpillar's guidance implies that its FCF may have peaked in 2024, so investors shouldn't consider the $10 billion reported in 2023 as a base level.

A conservative way to value a cyclical like Caterpillar is to take the midpoint of its FCF range through the cycle. Using the updated guidance of $5 billion to $10 billion and the midpoint of $7.5 billion and applying a 20 times FCF multiple to it (reasonable for a mature industrial), Caterpillar is better valued at $150 billion -- an 8.5% discount to the current price.

Operational improvement

Caterpillar is doing an excellent job operationally, and investors can be confident that the company can potentially improve its profitability, FCF, or earnings quality. There's no better way to tell if a company has a strong product lineup than by looking at its pricing power, specifically comparing the profit change due to sales volumes vs. price realization.

As the table below shows, sales volumes declined in the fourth quarter but were more than offset by powerful price realization. Clearly, Caterpillar has pricing power, and it might be able to increase profits even as volumes decline.

Data source: Caterpillar presentations.

In addition, management can improve the quality of its earnings by continuing to grow its less cyclical services revenue. Indeed, it aims to hit $28 billion in services revenue by 2026, given that it increased services revenue from $14 billion in 2016 to $23 billion in 2023. It's reasonable to expect Caterpillar to hit its target, which might lead investors to value the company on higher earnings and FCF multiples.

Improving end markets

There's little doubt Caterpillar's growth is slowing, and Bonfield's full-year guidance calls for sales to "be broadly similar to 2023." Moreover, a look at Caterpillar's retail-sales data (Caterpillar primarily sells its machines and power systems to independent dealers, who then sell to end users) shows the slowdown graphically. The data below is retail sales to end users.

Data source: Caterpillar presentations.

Strength in U.S. infrastructure spending will support construction sales in 2024, but China is softening, and Caterpillar sees Europe declining in 2024. Bonfield expects "lower sales versus 2023, impacted by lower machine volume primarily in off-highway and articulated trucks" in resource industries. Finally, Bonfield thinks energy and transportation sales will only be "slightly higher" in 2024.

Lower interest rates will support construction activity and possibly lead to higher commodity prices, encouraging investment in oil and gas and mining industries.

Image source: Getty Images.

Is Caterpillar a buy?

Based on the idea that its earnings have hit a local peak, the stock looks overvalued. On the other hand, this is a high-quality company with strong pricing power, so don't be surprised if its earnings surpass estimates if the global growth outlook improves. Caterpillar is the kind of company investors should look to pick up should the market present a better opportunity, though.