Should You Buy Caterpillar?

Year-to-date, Caterpillar  is down more than 10%. Meanwhile, the S&P 500 is up almost 23%. Some may think this looks like an opportunity to pick up shares of Caterpillar on the cheap, but there are good reasons for the price weakness.

Big, yellow, and familiar
Caterpillar is a $53 billion heavy equipment manufacturer based in the US. According to brand management firm Interbrand, Caterpillar is among the 100 most valuable brands in the world. People everywhere recognize the big, yellow trucks that Caterpillar is known for, and that kind of familiarity can be comforting for investors.

Comforting or not, Caterpillar has had its share of troubles lately. According to Reuters, the company recently shut down or downsized seven manufacturing facilities, including laying off 900 employees while restructuring two large plants in Illinois and Wisconsin.


What Caterpillar is choking on
Over the past few years, Caterpillar stepped up its presence in emerging markets, specifically in mining. Strategically, that made sense. According to Morningstar, mining equipment is one of the most profitable segments for Caterpillar and it also represents about one-third of the company's revenue.  

However, Caterpillar may have bitten off more than it could chew. In 2010, Caterpillar acquired Bucyrus International, a U.S.-based manufacturer of mining equipment with established relationships in emerging markets. Shortly afterward, Caterpillar also acquired ERA Holdings, a China-based manufacturer of mining equipment. 

How did those moves work out? According to Forbes, the ERA transaction was tarnished by alleged fraud. Last year, Caterpillar announced almost $600 million in losses tied to the purchase. The writedowns appear to stem from years of inappropriate accounting practices at the Chinese company.

Though the Bucyrus transaction was free from fraud, it was poorly timed. At $7.6 billion, the acquisition was substantial and one of the largest in Caterpillar's history. Unfortunately, since the deal closed, economic activity has steadily slowed in China, a trend that is expected to continue. The chart below shows annual GDP growth for China from 2010-2016 (2013-2016 are estimates).

 

Source: International Monetary Fund, BCM

As expected, mining activity has also slowed in the region, which has affected Caterpillar's bottom line. In October, the company reported earnings that trailed the average analyst estimates. In addition, Caterpillar also gave cautious guidance and lowered its outlook for 2014. 

Keeping Caterpillar company
For what it's worth, Caterpillar's wasn't the only company champing at the China bit. Joy Global , a mining equipment company based in the US, and a competitor with Caterpillar's mining business, acquired China-based International Mining Machinery in 2011. Joy estimated the cost to be about $1.4 billion -- a big bet, since Joy's market capitalization is only about $6 billion.

While Joy and Caterpillar are racing to get ahead in emerging markets, they still trail Komatsu  a $20 billion company based in Japan. Komatsu is the world's second-largest heavy equipment manufacturer (after Caterpillar), but is the frontrunner in key emerging markets. Local to Asia with almost a century of history, Komatsu enjoys a home-court advantage, and it's established operations in China, India, and Thailand. 

By the numbers
Despite Caterpillar's recent troubles, some may think it's a good value at $83. Based on the numbers, I disagree. The table below shows some key financial measures for Caterpillar versus its industry:

Measure  Caterpillar   Industry 

 Revenue Growth TTM 

9.5% 10.7% 
EPS Growth TTM  (44.7%)  6.7%
Price to Earnings 15.9 7.7
Price to Book 2.94 2.44
Dividend Yield 2.90% 3.40%
Quick Ratio 0.8

1.6

Debt to Equity 2.18 2.26

Caterpillar looks relatively unattractive in terms of growth, valuation, and financial condition. While Caterpillar's price-to-earnings ratio of 15.9 times isn't high in absolute terms, it's two times the industry average. Also, notice that Caterpillar's quick ratio is low -- only half the industry average. 

The bottom line
Based on relative valuation, using an average of earnings, cash flow, and book value, I estimate fair value for Caterpillar to be about $83 per share. Thus, even following its poor price performance, the company is only now trading near fair value.

Judging by its recent missteps, cautious guidance, and relatively unimpressive fundamentals, I see no reason for Caterpillar to trade at a large premium above it's peers. All else equal, I'd want to see another 20% discount, or a price tag of $66, before considering Caterpillar a compelling buy.  

The article Should You Buy Caterpillar? originally appeared on Fool.com.

Victor Lai is an investment advisor representative with Bellwether Capital Management LLC, a registered investment advisor. Victor Lai does not own any positions in the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own positions in the securities referenced in this post.  This post is for informational purposes only and does not represent advice.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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