The strong rally of Caterpillar (NYSE:CAT) over the last few months brought the company to a noticeable premium over the sector’s median. However, I don’t expect a handbrake turn as the stock price has been backed up by strong capital returns for quite a while. In the meantime, the company has a fundamentally strong business, where global investment in infrastructure projects as well as decarbonization trends will drive demand for Caterpillar machinery and equipment further. Moreover, CAT could also benefit from Europe’s plans to phase out Russian gas and fleet replacement cycles.
The main growth driver for the US construction industry and Caterpillar, as one of its largest players, remains increased investment in infrastructure underpinned by a more than $1 trillion infrastructure development bill. In addition, the Inflation Reduction Act, which aims to fight inflation and catalyze investments in domestic manufacturing, includes $369 billion in funding for energy security and climate change programs, in particular clean energy production and new technologies.
Beyond doubt, decarbonization remains one of the strategic priorities of governments around the world, where Caterpillar is positioned well to help customers in various sectors of the economy achieve their (own or possibly forced) emissions targets by offering a wide range of hydrogen-fueled power solutions and installations, electric fleets, and exploring a new application of fuel cell technology.
The reopening of the Chinese economy after the end of the zero-COVID policy with infrastructure investments and government efforts to boost the real estate market will also promote demand for CAT’s yellow products.
Caterpillar will also benefit from Europe’s plans to build LNG terminals and upgrade refineries in order to phase out and reduce dependence on Russian fossil fuels.
But one might inquire how about the green and decarbonization agenda of the EU economy, aimed at reducing its reliance on fossil fuels. Well, there are obviously a lot of green points in the above chart, however necessary to cope with the rise of LNG imports from the US and Qatar and ensure full gas storages.
Now back to the point. Caterpillar dealers increased their inventory levels in the fourth quarter of 2022 alone by $700 million, compared to a $100 million reduction a year ago. Moreover, the company’s order book in Q4 expanded by $7.4 billion on annum, which will ensure a stable demand for the company’s machinery and equipment going forward.
Financials and expectations
CAT achieved strong results in the fourth quarter of 2022 with total revenue up 20.3% YoY to $16.6 billion, due to favorable pricing and higher sales volume driven mainly by inventory accumulation. Segment-wise, Resource industries delivered $3.3 billion (+26.6% YoY), followed by Energy&Transportation sales of $5.7 billion (+19.3% YoY) and Construction sales of $6.8 billion (+19.8% YoY). Financial products also increased ($0.9 billion; +9.9% YoY) and contributed positively to the top-line.
The strong quarterly performance resulted in a 4.4% YoY gain on the EBIT line, which amounted to $1.7 billion, while a 255bps deterioration of the respective margin to 10.1%. The operating profit was limited mainly by a $0.9 billion goodwill-related impairment charge during the quarter. As a result, net profit decreased to $1.5 billion, or $2.79 per share, compared to $3.91 per share a year ago.
The management also gave guidance for 2023 where sales are expected to come in the $42-72 billion range and adjusted profit margin is anticipated at 10-13% for the lower sales band, and 18-21% for the upper one. I assume revenue in 2023 will reach $71.4 billion (+20.1% on annum), driven by double-digit expansion among the ME&T segments. With a 20% increase in OPEX, operating profit should gain 20.9% YoY to $9.6 billion, and stood on a margin of 13.4%. Assuming $2.4 billion for depreciation allowances, EBITDA for the full 2023 year should reach 12 billion (+18.1% YoY).
When it comes to the valuation, I applied the sector median multiples derived from Seeking Alpha based on the above expectations for 2023. The fair value is estimated by EV/Sales and EV/EBITDA with 40:60 weight in between.
CAT is currently trading at EV/Sales and EV/EBITDA forward multiples of 2.0x and 11.8x, respectively when applying my estimates. This represents a premium of between 7.5% to 13% to the sector’s median multiples of 1.8x and 11x. The model yields an Enterprise value of $128 billion, and Equity value of $118.7 billion after adjusting for cash and IB liabilities, and corresponds to $228 fair value per share. The valuation suggests that the stock is overvalued by 10%. However, I believe it’s justified for CAT since it bears a Dividend Aristocrat designation.
Caterpillar has been maintaining or raising dividend payments for 29 consecutive years, going through different economic environments. In the third quarter, management increased the quarterly dividend by 8.1% YoY from $1.11 to $1.20 per share. Payouts in 2022 amounted to $2.4 billion, or $4.62 per share, with a yield of 1.8% at the current price. In addition, for the four quarters since the beginning of 2022, Caterpillar returned back to the shareholders $6.7 billion through dividends and share repurchases, compared to $5.0 billion in the same period last year.
The main risk to CAT remains its exposure to the cyclical end-markets, which could be affected significantly in case of a prolonged macro downturn. Caterpillar also has a large pile of debt, related mainly to the financial products segment.
I am in for staying HOLD on CAT stock as the discount to the current price could be explained by the strong management’s commitment to returning capital to shareholders. I believe Caterpillar has a favorable market position, pricing power and north (upside) tailwinds to keep on generating strong ME&T free cash flow going forward. This will power continuation of the capital return procedures for investors, and could keep the stock at a premium valuation as well.