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Overview

I recommend Caterpillar (NYSE:CAT) for its healthy demand environment for its products, good market share, profitability, healthy financials, and valuation based on its comparison with peers, industry, and recent financial reports and performance. Per my analysis, Caterpillar has better Return on Equity and assets, net margin, liquidity, and leverage ratios than its peers like Deere & Company (NYSE:DE). On top of that, Caterpillar stock has a higher fundamental value than its current market price, making it a good buy. I seek to reinforce my bullish view on the company by analyzing the following items and sharing the respective outcomes:

1. I will compare Deere and Caterpillar’s Return on Equity and Assets for the last five years.
2. I will compare the quality of earnings for the previous five years and the first six months of each year between Deere and Caterpillar.
3. I will compare leverage and liquidity between Deere and Caterpillar for the last five years and the first six months of each year.
4. I will compare the fundamental value of Caterpillar’s stock using the Gordon Growth Dividend Discount Model with its market price.

Brief Introduction: Caterpillar

Caterpillar is the world’s leading manufacturer and U.S. exporter of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. Caterpillar earns most of its revenues, about 47%, from sales in North American markets, followed by its EAME (European-African-Middle East) markets at around 22%, 20% from Asian markets, and 11% from Latin American markets, respectively.

Caterpillar has three main segments: the Construction and Forestry Industry, the Resource Industry, and the Energy and Transportation Industry.

Construction and Forestry Industry: The Construction Industry enjoys a revenue share of 39%. Management expects continued growth in North America due to the positive effects of public infrastructure spending and construction projects, especially in non-residential construction. In Asian markets, management anticipates stable growth, except in China, where there will be continued weakness due to low construction activity. At the same time, it contemplates construction activity in EAME and Latin America to be flat.

Resource industry: The Resource industry has a revenue share of 19% in 2022. Management forecasts healthy demand for Caterpillar’s products and services in the Resource industry because of the Energy Transition, high commodity prices, and healthy mining demand.

Energy and Transportation: This segment earns as much as 37% of total revenues. Due to solid order intakes for oil and gas equipment, solar turbines, and high-speed marine fleets, demand in this segment is expected to be robust in the future. Though management has increased investments in this segment compared to other segments in the past three years, foreseeing a more substantial market in this segment, I believe that the company should also consider increasing investments in different profitable segments as part of the segment/product mix, such as Construction segment, which is the most profitable segment at present.

Caterpillar enjoys being a leader with a high market share of around 11-12%. The average annual sales growth in the three industries for the past five years has been about 3%. Caterpillar’s average annual sales growth has been around 7% in the same period. Based on past analysis, the industry average yearly sales growth in all three segments should be about 1% to 3% in the next five years, and hence, Caterpillar’s annual sales growth should be around 3% to 7%.

Moreover, all three of its businesses demonstrated healthy sales growth in the last third quarter reports released just days ago compared to the same quarter a year ago. The Construction business showed the most robust sales growth due to demand remaining healthy in residential and non-residential construction due to continued public infrastructure spending and commodity price support. Management expects demand to stay healthy in 2024 and beyond despite the order backlog decline, which does not indicate that Caterpillar has reached its peak demand; instead, the decline was due to improving supply chain movements, and management commented that the company’s backlog as a percentage of revenues remains at higher levels compared to its historical levels.

Caterpillar vs Deere – Key Metrics

Return on Equity and Return on Assets

Caterpillar’s DuPont Decomposition

2022

2021

2020

2019

2018

Excluding unusual charges & unconsolidated affiliates:

Net margin

13%

13%

8%

12%

12%

ROA

10%

8%

4%

8%

8%

Fin Leverage

5.2

5.0

5.1

5.4

5.6

ROE excluding unusual charges & unconsolidated affiliates

7%

5%

2%

5%

6%

Click to enlarge

Deere’s DuPont Decomposition

2022

2021

2020

2019

2018

Excluding unusual charges & unconsolidated affiliates:

Net margin

14%

13%

9%

9%

6%

ROA

8%

7%

5%

5%

3%

Fin Leverage

4.4

4.6

5.8

6.4

6.2

ROE excluding unusual charges & unconsolidated affiliates

5%

5%

2%

3%

1%

Click to enlarge

Source: Author’s Compilations based on data from Caterpillar’s and Deere’s Annual SEC filings and Financial reports

I think Caterpillar fares slightly better regarding average net margin and return on assets (ROA) for the five historical years at 12% and 8%, respectively, compared to Deere at 10% and 6%, respectively. Similarly, Caterpillar’s average Return on Equity (ROE) is slightly better than Deere’s at 5% versus 3% for the past five years.

Quality of Earnings

Figures 1 and 2 compare Cash flow from Operations (CFO) with Earnings Before Interest and Taxes (EBIT) for the first six months of respective years between Deere and Caterpillar. Figures 3 and 4 compare CFO with EBIT annually between the two companies from 2019 to 2022. Per my calculations, Caterpillar has a slightly better quality of earnings because its CFO appears closer to EBIT most of the time than DE.

Liquidity Ratios

Figures 7 and 8 compare the Cash Conversion Cycle (CCC), Days Inventory on Hand (DOH), Days Sales Outstanding (DSO), and Days Payables for the first six months of respective years between Deere and Caterpillar. Figures 9 and 10 show the picture of CCC, DOH, DSO, and Days Payables for the full years from 2019 to 2022. Deere takes fewer days to sell inventory and pays back suppliers close to the industry’s average level compared to Caterpillar. However, per my analysis, Deere takes more days to collect cash from customers than Caterpillar, such that it has higher cash conversion days than Caterpillar, despite both companies having above industry average cash conversion cycles. On a positive note, dealer inventories at Caterpillar increase only when dealers’ independent businesses foresee higher and stable demand, especially in Construction Industries, so higher DOH at Caterpillar is acceptable.

Leverage Ratios

Even though the total debt to capital ratio is the same at the companies, in my view, Deere appears to have higher leverage because it has higher long-term Debt to Equity, despite the two companies’ leverage ratios being above the industry’s average.

Valuation – Caterpillar

I will value Caterpillar using the Gordon Growth Dividend Discount Model. I chose the Gordon Growth Dividend Discount model because Caterpillar is a stable dividend-paying stock for an average investor. As per my calculations based on historical averages, with an estimated average sales growth between 3-7%, an estimated average Earnings per share (EPS) growth rate should be around 7%-10% for the next five years. With the average retention ratio for the last five years at 57%, the average dividend payout ratio for the next five years would be around 43%. Hence, the average annual Dividend Per share (DPS) growth rate is 7-8 % for the next five years. The 2022 Dividend per share DPS or D0 for Gordon Growth Model calculations was $4.6.

Please refer to the following table for calculations:

In Millions

2023 E

2022

2021

2020

2019

2018

Net Sales

$66,587

$59,427

$50,971

$41,748

$53,800

$54,722

Operating Profit

$11,320

$7,904

$6,878

$4,553

$8,290

$8,293

Net Profit

$8,744

$6,705

$6,489

$2,998

$6,093

$6,147

Weighted-average common shares O/S (millions)

515.70

530.40

548.50

548.60

567.50

599.40

EPS Earnings Per Share

$16.96

$12.64

$11.83

$5.46

$10.74

$10.26

Dividends paid

$2,521

$2,440

$2,332

$2,243

$2,132

$1,951

DPS Dividends Per Share

$4.89

$4.60

$4.25

$4.09

$3.76

$3.25

CAGR Compounded Annual Dividend Growth rate

8.47%

Click to enlarge

Source: Author’s Compilations based on data from Caterpillar’s 10 K and 10 Q SEC filing reports

As per my estimates, the net sales at Caterpillar will reach around $66.5 billion in 2023, operating profit will be approximately $11,320 million, and net profit will be about $8,744 million. Per my calculations, dividends distributed in 2023 will reach $2,521 million. So, DPS will be $4.89. Hence, I reckon the compounded annual average dividend growth rate from 2018 – 2023 to be 8.47%.

Cost of Equity Calculations

Since various Cost of Equity estimates can change the stock valuation vastly, it is better to provide different scenarios for multiple Costs of equities estimated with distinct Equity Risk Premiums (ERP) calculated using different approaches.

I have used the CAPM approach for calculating various Costs of Equity. I figured the historical U.S. Equity Risk premium of 6.25% using historical 5-year S&P 500 returns of 10.54% and current 5-year YTM Treasury of 4.29% to arrive at the Cost of Equity of 11.01%.

Similarly, I have also used Aswath Damodaran’s calculations of implied Equity Risk Premiums of 5% and 4.4% to arrive at the Cost of Equity of 9.66% and 9.02%, respectively.

Gordon growth model’s formula is:

Therefore, with the current Caterpillar market stock price at $249.45 on Nov 29, 2023, the 2022 dividend per share of $4.6, and various costs of equity, I calculated Gordon Growth implied growth rates of 7.05% and 7.68% from the formula above.

Scenario Analysis

Thus, based on the Gordon Growth Dividend Discount model’s formula, with different growth rates and Cost of equities calculated previously, I arrived at an average range of price target of $249 – $317.88 for Caterpillar stock on November 29, 2023. Hence, I recommend buying Caterpillar at the current price of $249.45 because the market undervalues it.

Risks

1) Recession in the U.S.: A recession in one of its major markets in the U.S. could affect its profitability since construction activity in the U.S. commands most of its revenue share.

2) Raw material price increase and supply chain shortages: Caterpillar is a significant user of steel and many other commodities required to manufacture its products. Circumstances like wars in Ukraine and Israel could drive up commodity prices, and supply shortages could decrease its profitability due to increased costs if it cannot fully offset these increased costs through price increases.

3) Dealer Inventories risks: One of the main operational risks at Caterpillar, a standard forward-looking metric in the Industrial sector, is Dealer Inventories. The company is subject to inventory management decisions of independent dealers. So, one of the concerns is that higher inventory levels than desired could lead to those dealers postponing product purchases from the company, leading to lower future sales. Meanwhile, declining order backlogs could indicate lower future demand or lower inventory, which could result in a loss of sales due to insufficient inventory to meet customer demand.

Conclusion

To summarize, I assign a buy recommendation for Caterpillar stock for its strong position in the industry, healthy financials, stable profitability, stable dividends, and valuation. Based on my calculations, I recommend buying Caterpillar at the current market price because its target price of $317.88 is higher than its current market price.

Note: The above presentation and analysis are based on past performance, management’s expectations, and market insights, which are subject to risks.