- Caterpillar has projected to do just over $41 billion in sales in 2016. It did $65 billion in 2012 when the stock price had reached $116 a share.
- Cuts will make the company more efficient and boost EPS but sales will continue to lag.
- China's PMI index continues to contract. This is bearish for Caterpillar's prospects.
Crude oil has managed to rally past $37 a barrel in the last few trading sessions and the rally has really impacted Caterpillar (NYSE:CAT) stock in a big way. Energy and transportation is one of the largest segments of Caterpillar. In fact, over the last month oil has rallied 13% and so has Caterpillar (see chart) which on the surface seems bullish.
The mining complex has also rallied strongly since the start of the year with the mining ETF up almost 50% year to date which explains why Caterpillar stock has held its gains so far this year (approximately 10% ) despite the price of crude being down. As a result of the apparent bottom in commodities, many investors who are looking to deploy capital in this sector are looking at Caterpillar to fill that void.
On the surface, Caterpillar seems a good fit as it is definitely the market leader in its sector. It has raised its dividend for the past 22 years, returns million of dollars to its shareholders through stock buybacks and is noted for the large amounts of cash flow it generates (even in commodity bear markets). However, stocks with financials and dividend strength (4.12% yield) such as Caterpillar always sells at a premium which is a crucial aspect for investors who want to project upside potential. I believe Caterpillar will underperform other companies in the commodity sector (especially in energy and resources) and this article will explain why.
Firstly, Caterpillar's recent rally has spiked the company's earnings multiple to almost 22. Some would say that this is not cheap especially considering that earnings have dropped from $5.68 billion in 2012 to $2.1 billion last year. However, I would recommend not paying attention to the price to earnings ratio. Caterpillar's industry is highly cyclical and the market has this priced in well in advance.
A more accurate valuation metric is its price to sales metric which is currently just over 0.9. We get this by dividing 2015 sales ($47.01 billion) by the current market cap of $44.18 billion. Now Caterpillar's 10-year average sales multiple is 1.05 meaning that on average the company's market cap has always been around 5% larger than the company's sales.
In saying this, what is definitely in the company's favor is its share buyback program. Caterpillar bought back almost $2 billion in shares last year and if it does the same this year, it could reduce the current float ( 582 million shares) by another 5%. This is crucial as ongoing reductions in the float enables the share price go higher over time and increases EPS automatically.
However, its ugly sales outlook ( only $41 billion projected in 2016) is going to keep the stock down in my opinion. Yes, buybacks will help but the market won't leave the price to sales multiple go beyond 1.1-1.15 which is a 10 to 15% hike from today's share price of $74 but not much more beyond that unless there is a miraculous turnaround in sales.
Also, investors have to take into account that the restructuring and cost-cutting measures Caterpillar is currently undergoing will have serious consequences going forward. Apart from the manufacturing facilities that will be closed in the near term which will involve up to 5,000 job losses in 2016 alone, restructuring costs estimates have ballooned to over $800 million. Granted cost cutting initiatives will lower operating costs over time but the problem I see here is the scale. I see Caterpillar struggling if the global economy picks up in earnest.
The problem with intensive cost cutting is that if the company cuts in the wrong places, it makes it ultra difficult to participate in any upswing when it eventually arrives. The 10,000 layoffs by 2018 particularly in manufacturing is worrying in the sense that the company is becoming increasingly smaller which in my opinion will mean it will under-perform when the commodity cycle rallies in earnest. 20 Production facilities have been closed and 31,000 jobs culled since 2012. This will have repercussions as the company will simply not be able to scale meaningfully if required going forward.
Finally, Caterpillar has the two-fold problem of sustained dollar strength which is adversely affecting its revenue outside the US and creating weak demand from emerging markets. Furthermore, Caterpillar's share price performance is a mirror image of the emerging markets fund iShares MSCI Emerging Markets (NYSEMKT:EEM) over the last past five years. It makes sense. China consumes over 40% of the world's copper and is the biggest buyer by far of commodities in the world.
Well since the start of the year iShares MSCI Emerging Markets has underperformed Caterpillar by 8% which indicates to me that Caterpillar's rally won't last unless China joins in. At the moment that doesn't seem likely when we look at the country's purchase manager index (PMI) which still looks to be in contracting mode. If this metric doesn't remain over 50, it will be difficult for Caterpillar to rally in my opinion. China's PMI is an indication of global trade which means if it continues to contract, Caterpillar's rally will be halted even if commodities themselves like oil and copper continue to trade at higher prices.
To sum up, Caterpillar may have a strong balance sheet, ample cash flow for its dividends and a premium brand but the cuts it had to undergo will affect the company in an adverse way going forward. It simply won't be able to scale to meet demand if we do get a violent upswing in commodity prices. Furthermore due to the carnage we have seen in the commodity sector over the past few years, its customers' balance sheets are very weak at the moment and buying new equipment won't happen at levels like we have seen in the past. Therefore, I believe upside in the Caterpillar stock is limited. Invest only for income purposes.