Over the past twelve months, the shares of Caterpillar Inc. (NYSE:CAT) are up about 60%. In my view, shareholders would be wise to take the money and run at this point. I’ll go through my reasoning by reviewing the financial history here, and by looking briefly at forecasts for the growth in global construction and mining over the next few years, as I think it’s fair to say that as these industries go, so goes Caterpillar. I’ll then focus in on the valuation of the stock itself by looking at what the market seems to be assuming about long-term growth and by looking at price to free cash flow. For those who can’t stand the suspense or my writing, Caterpilllar has more downside than upside ahead of it over the next three years.
Even the most ardent bulls at some point have to look at financial history and face the question, “What will have to happen to transform this into a high growth company?” Caterpillar has had negative growth for the past several years. Although there’s reason to feel some optimism about an uptick in the business, the relevant questions are how much and when?
Specifically, revenue has grown at a CAGR of about negative 4.2%, and consolidated net income is down massively from 2013 to 2017.
Source: Company filings, 10-K, Gurufocus for free cash figures
Turning to the capital structure, as revenue and profitability have declined over the past five years, the company has taken on massive obligations. For instance, long-term debt has grown at a CAGR of about 8.4% from 2013 to now. It should be noted that fully 70% of the company’s total long-term obligations are due between now and 2022 (36% of those obligations due in 2018 alone), right in the teeth of rising interest rates.
Source: Company filings, 10-K
History may offer an interesting insight into how a company has performed, but the past is only so relevant to investors. We’re more interested in the future than the past, for obvious reasons. It may be the case that revenue and net income are about to pick up massively, making history less relevant. In my view, this is unlikely, given reasonable forecasts of the construction and mining industries. Although there’s some growth expected, it’s much more tepid than is presumed by the market at the moment.
It seems that the construction equipment market is expected to grow at a CAGR of about 6.5% between now and 2020. Mining is expected to come out of the doldrums somewhat, but not by much. In fact, it might be reasonable to suggest that miner CAPEX is actually coming down after a slight uptick in 2017. It’s also fairly apparent that miners themselves don’t seem to think we’re going to return to the high activity halcyon days of Chinese demand surges. In fact, it's reasonable to suggest that miner CAPEX will fall into 2020.
img src="https://static.seekingalpha.com/uploads/2018/4/16/48515253-15238935901034894.png" width="640" height="709" data-width="640" data-height="709" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>Source: SP Global Ratings, Metals and Mining Forecast, 2018
So to sum up so far, Caterpillar is a company that has loaded up debt as revenue and earnings have declined. At the same time, the prospects of significant industries aren’t that great from Caterpillar’s perspective, suggesting that the miracle turnaround isn’t coming anytime soon. These may not be sufficient reason to not invest, though. It’s often the case that a slow growth company can be an excellent investment if the stock price is low enough. Thus, I should spend some time looking at whether a low stock price compensates an investor adequately for taking on the risk of owning this name. Sadly, it does not.
I judge whether an investment is priced cheaply in a host of ways, two of which I’ll go through in this article. The first of these involves looking at the expectations about perpetual growth embedded in the share price. The second involves looking at the company’s price to free cash flow relative to its own past.
To perform the first exercise, I turn to the methodology outlined by Professor Stephen Penman in his excellent book “Accounting for Value.” In this book, Penman walks the reader through how they might come to understand the market’s growth assumptions about a given company. Penman uses some high school algebra to isolate the “g” variable in a standard finance formula. When I run through this exercise for Caterpillar, it seems that the market is assuming a perpetual growth rate of about 7.75% for this company. In my view, that’s a very optimistic (and therefore highly risky) forecast.
For those interested in a more traditional valuation methodology, the price to free cash flow per share might be more relevant. As is plain from the graphic below, the shares are expensive on a price to free cash flow basis - both objectively and relative to their own past.
img src="https://static.seekingalpha.com/uploads/2018/4/16/48515253-15238928673680208.png" width="640" height="329" data-width="640" data-height="329" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>Source: Gurufocus
In my view, generally speaking, the more you pay for something, the lower your subsequent returns are going to be. The one exception to this phenomenon can be a situation where a company that is priced for perfection executes perfectly and grows revenues and earnings at an even higher rate than the market is forecasting. In my view, given the above, I see no evidence of this happening in this case, and the balance of risk-reward therefore favors taking profits in this name before price inevitably falls to long-term value.
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