The definition of a cyclical company might as well be one that sells construction equipment, mining equipment and gas turbines. Trying to time when to invest in these heavy cyclical companies is almost more of an art than a science.
The global leader in this field is Caterpillar Inc. (NYSE:CAT), with operations in over 50 countries around the world. The name was derived in 1904 when Benjamin Holt replaced the rear wheels from a Holt steam tractor with a pair of tracks to help farmers deal with soft soil. During a field test in 1905, the company photographer exclaimed that the machine crawled like a big caterpillar.
Caterpillar is expected to generate over $58 billion in revenues in 2022 and currently has a market capitalization of approximately $119 billion. It’s still going strong for now, but as a recession begins to unfold and construction begins to fall off, Caterpillar shareholders could be in for trouble as their shares are trading near all-time highs at the moment.
About the company
Caterpillar operates through four segments: Construction, Resource, Energy and Transportation and Financial Products. The Construction segment makes a wide variety of construction equipment, such as asphalt pavers, excavators, cold planers, etc. The Resource segment provides electric rope and hydraulic shovels, draglines, rotary drills, hard rock vehicles, wheel dozers and other machines used primarily for mining and heavy construction. The Energy and Transportation segment manufacturers engines and integrated systems for power generation purposes in a wide variety of industries and applications. Lastly, the companys Financial Products segment provides financial support for customers to buy its products through operating and finance leases, installment sale contracts, working capital loans and wholesale financing, as well as insurance and risk management products.
The company recently reported third quarter results for 2022, and it appears the company is firing on all cylinders. The Construction segment saw sales increase 19% and operating profits rise 40%, the Resource segment boosted revenues by 30% with segment profits increasing 81% and the Energy and Transporation segment increased revenue by 22% and segment operating profits by 32%. The familiar theme in these strong increases was favorable price realization, meaning the company is raising prices on all their customers, which is also a familiar theme in most industries today.
The operating margin was 16.2% for the quarter compared with 13.4% for the prior-year period. Adjusted profit per share was $3.95 compared with third-quarter 2021 adjusted profit per share of $2.66.
Chairman and CEO Jim Umpleby stated, Our team remains focused on serving our customers as we continued to see healthy demand across most of our end markets during the third quarter.
The company has a complicated balance sheet because it finances a large portion of its equipment sales. The company has $22.7 billion in financing liabilities, which makes it a fairly decent-sized bank. That line item is offset by financing receivables of $20.7 billion. Traditional debt stands at $13.7 billion against cash of $6.3 billion.
During good times, the company generates strong free cash flows,and for the first nine months of 2022, operating cash flow was $5.0 billion and capital expenditures were $868 million. The company repurchased shares during this period totaling $3.3 billion. Yet, investors should question this buyback strategy as the stock has been trading near all-time highs throughout much of the year.
The 30-year earnings history of Caterpillar is choppy as it often struggles through recessions. In 2009, revenues dropped 37% and earnings per share dropped 75% from the prior year.
Nonetheless, consensus earnings per share estimates are $13.89 for this year and $15.00 for next year, which seems odd in my view with high chances of a recession occurring in 2023. That puts the company trading at 16 times this year’s forward earnings and 15 times 2023 earnings.
The GuruFocus discounted cash flow (DCF) calculator gives us a value estimate of $175, or 31% below today’s prices, using next year’s earnings per share estimate of $15.00 and a long-term global GDP growth rate of 4.0% to sub in for long-term company growth, as Caterpillar is too cyclical to value it accurately in the near-term. During major recessions, companies in this industry can suffer major earnings and share price declines.
The company pays an annualized dividend of $4.80, which equates to a 2.08% dividend yield. The payout ratio is below 50% based on current earnings per share estimates for this year and next.
Gurus who have purchased Caterpillar stock recently include Murray Stahl (Trades, Portfolio) and Mairs and Power (Trades, Portfolio). Gurus who have reduced or sold out of their positions include Mario Gabelli (Trades, Portfolio) and Diamond Hill Capital (Trades, Portfolio).
Caterpillar is highly levered to both macroeconomic issues and commodity prices such as steel and oil. With an inverted yield curve and mass layoffs occurring at major corporations, the odds of a recession next year are fairly high. With its stock trading near all-time highs, it is likely not a good time invest in Caterpillar stock in my view. Typically the best time to invest in cyclical stocks like this has been in the middle of an recession after revenues and profits have materially declined, leading to a plummetting share price, and were not at that point yet.
This article first appeared on GuruFocus.