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3 Reasons Why the Caterpillar Stock Rally Can Continue

By Lee Samaha – Mar 30, 2016 at 8:00AM

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The oil services and construction machinery manufacturer, alongside oil related stocks such as Dover Corporation and Emerson Electric, has been flying lately -- but can it last?

Almost every oil related stock got beaten up in 2015, but as you can see below, Caterpillar, Inc (CAT 0.85%) has bounced back strongly in recent weeks. Moreover, other industrial stocks with heavy energy exposure, such as Dover Corporation (DOV -0.79%) and Emerson Electric (EMR 0.23%), have followed suit. Can the rally continue? Let's take a look at three reasons why it can.

CAT Chart

CAT data by YCharts

Sentiment change
Market sentiment is inevitably fickle, but it's hard not to argue that investors are now seeing the glass half full with Caterpillar and company. For example, at the Bank of America Merrill Lynch Industrials Conference on March 17, Caterpillar gave first-quarter guidance significantly below market estimates.

Moreover, Caterpillar's guidance for $9.3 billion to $9.4 billion in first-quarter sales & revenue leaves it hard pressed to make full-year guidance (which management surprisingly maintained at the conference) for sales & revenue of $40 billion to $44 billion. In the last 20 years, on average, Caterpillar has generated 23.3% of full-year sales in its first quarter; if the historic ratio is applied to the mid-point of first-quarter guidance, it would produce $40.1 billion in full-year revenue -- right at the bottom of the full-year guidance range.

No matter. Caterpillar's stock promptly continued rising, and it's the same story with Dover Corporation. In advance of attendance at the conference discussed above, Dover issued a business update stating "As a result, we expect that our first quarter results will be well below our prior expectations, entirely driven by our businesses with exposure to US oil & gas markets." The stock has appreciated since.

Investing conclusion: When stocks rise on bad news, it's usually a sign that the weak holders have already been flushed out of the stock.

Valuation and turnaround prospects look good
All three companies are trading at attractive valuations. The following chart compares Enterprise Value (market cap plus net debt) to free-cash-flow -- a useful way to compare companies with different debt loads.

As you can see below, Dover's valuation is compelling -- a ratio of 15.6 times implies the company is generating 6.4% of its EV in free-cash-flow.

DOV EV to Free Cash Flow (TTM) Chart

DOV EV to Free Cash Flow (TTM) data by YCharts

Moreover, on Dover's first-quarter earnings call, CEO Robert Livingston outlined how full-year guidance assumed oil prices of "roughly $30" for the first four months of 2016, and then around "$40 oil price in the second half." It's still March, and oil prices have already nearly hit $40.

DOV Chart

DOV data by YCharts

Turning to Caterpillar, readers already know that the stock's prospects are largely tied to energy prices in 2016. Caterpillar does have significant mining exposure, but its beleaguered peer Joy Global (NYSE: JOY) received cheers from the market recently by merely maintaining guidance As for Caterpillar's valuation, it may look high, but consider that when oil prices moved from $35 to nearly $100 in the three-year period from 2009 to 2012, Caterpillar's EBITDA more than doubled.


CAT EBITDA (TTM) data by YCharts

Emerson Electric's management is predicting its orders will turn positive in April, and sales growth is forecast to turn positive in the third-quarter. As previously discussed, if and when Emerson starts to report these events, the market is likely to take a positive view. Furthermore, guidance for free-cash-flow of around $2.4 billion in 2016 implies a forward EV/FCF ratio of around 16.4 times -- still attractive despite the recent rise, and that's before the recent rise in oil prices.

Investing conclusion: All told, Caterpillar's earnings are highly cyclical and somewhat tied to oil prices, and alongside Dover and Emerson Electric, its current valuation is already attractive. 

Good dividends
Finally, all three stocks sport attractive dividend yields, and healthy cash dividend payout ratios (dividends divided by free-cash flow). Emerson's may look high, but reported 2015 free-cash flow was reduced by $500 million due to taxes on divestitures.
DOV Dividend Yield (TTM) Chart

DOV Dividend Yield (TTM) data by YCharts

Where next?
Provided oil prices keep rising or even just stay around the $40 mark, Caterpillar's rally can continue. In fact, valuations for all three stocks look attractive (if forced to pick one, the author would choose Emerson Electric), and market sentiment seems to have turned with regard to the sector.

All three offer good exposure to energy prices in 2016, and attractive dividend yields in the current low interest rate environment

Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Emerson Electric. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Stocks Mentioned

Caterpillar Stock Quote
$230.92 (0.85%) $1.94
Joy Global, Inc. Stock Quote
Joy Global, Inc.
Dover Stock Quote
$137.26 (-0.79%) $-1.09
Emerson Electric Stock Quote
Emerson Electric
$94.93 (0.23%) $0.22

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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