Caterpillar (CAT 1.58%) stock will always divide investors. It's a highly cyclical stock with relatively volatile revenue and profit margins. While management is doing a great job of reducing the cyclicality in its business and raising its long-term margin trends, its revenue and earnings are still guided by its end markets, and that's where the heart of the debate will lie.
Caterpillar's earnings cyclicality
The following chart shows just how volatile Caterpillar's revenue, operating margin, and free cash flow (FCF) have proved over time. Given the company's end-market exposure to construction activity, mining and infrastructure spending, energy capital spending, transportation, and power, it's hardly surprising. These are end markets whose growth prospects often depend on the economy.
CAT Revenue (TTM) data by YCharts
That said, Caterpillar's deliberate focus on growing its services revenue will help reduce cyclicality -- it's on track to double its services revenue from $14 billion in 2016 to $28 billion in 2026 -- and encourage investors to pay a higher valuation multiple for the stock.
In addition, management is doing a good job of raising the trend line of its profit margins and cash-flow generation. The table shows managements estimates through the cycle, which means they estimate the upper and lower ends of the business cycle.
|
Metric |
May 2022 Guidance |
December 2023 Guidance |
Change |
|---|---|---|---|
|
Free cash flow |
$4 billion to $8 billion |
$5 billion to $10 billion |
Raised midpoint by $1.5 billion |
|
Adjusted operating margin range |
10%-13% at revenue of $42 billion, 18%-23% at revenue of $72 billion |
10%-14% at revenue of $42 billion, 18%-24% at revenue of $72 billion |
Raised high-end of margin guidance by 100 basis points |
Data source: Caterpillar. 100 basis points = 1%.
One way to value is to assume Caterpillar is a mature industrial company and price it as such using the midpoint of its FCF generation through the cycle. For example, on a valuation of 20 times FCF, the midpoint of its current FCF range of $7.5 billion would mean investors might value the stock at around $150 billion or a stock price of $300.
However, Caterpillar bulls will undoubtedly argue that this is too conservative, because:
- It doesn't reflect the company's improving margin trend line driven by growth in services revenue and cost management efforts.
- It also doesn't reflect the company's improving end market and, in turn, revenue outlook.
Caterpillar's end markets
Of course, as the first chart above shows, Caterpillar's revenue growth also drives margin expansion, so it makes sense to focus on its end market prospects. These are driven by the outlook for non-residential construction, including infrastructure spending, mining and aggregates (mainly for roadbuilding), energy (gas compression and well servicing equipment), transportation (rail locomotives), and power (including generators to back up and power data centers).
In a nutshell, if you believe in the long-term supercycle for commodities, rising infrastructure spending, and solid demand for nonresidential construction, then Caterpillar's valuation deserves a rerating as the margin ranges and FCF ranges (as outlined in the table above) will need to be updated.
Chart by author. Data source: Caterpillar presentations.
Three reasons for near-term caution
The bullish case is understandable enough, but the company's recent results and near-term outlook suggest it's passed a local peak in its earnings and cash flow. There are a few reasons for this.
First, management reiterated its outlook for 2024 sales to be similar to 2023 and said that FCF would be between $7.5 billion and $10 billion, compared to $10 billion in 2023.
Second, a chart of its retail sales (Caterpillar primarily sells through independent dealers) shows its resources and construction industries customers aren't likely to pick up the pace of orders in the near term.
Third, in common with the fourth quarter of 2023, Caterpillar's sales volumes declined in the first quarter, but unlike the fourth quarter of 2023, its price realization wasn't enough to fully offset the decline in sales volume.
Chart by author. Data source: Caterpillar presentations.
Is Caterpillar stock a buy?
The long-term case for Caterpillar is compelling as it has some powerful trends behind it, but that doesn't mean this is the best time to initiate a position. That said, it's definitely the sort of stock investors should have on their watch list with a plan to pick up shares on any significant weakness.
