Caterpillar: Should I Buy Or Should I Sell?

When you travel abroad, you can be far away from anything resembling home. But just about anywhere you go, you’ll still find

Caterpillar (CAT

) vehicles. Be it in the Bolivian Amazon or the Guatemalan highlands, I’ve seen Caterpillar in places no other American brand has gone before; what’s that say for CAT stock?

CAT Caterpillar stock Inc. (NYSE:CAT)

It’s truly one of America’s most iconic companies. Founded 91 years ago, Caterpillar is the world’s largest heavy machinery company. Anywhere you see residential building, highway construction, mining, or logging, you’re quite likely to find Caterpillar equipment in use. With the recent slowdown in the world economy, CAT stock has been falling. Will it land on its feet?

Caterpillar Stock Pros

Huge Yield: For a Dow Jones member, CAT stock offers a truly compelling yield. Of the 30 bedrock American companies, CAT shares provide the 2nd highest yield, at 5%. This trails only struggling oil company

Chevron (CVX

). While Caterpillar has its problems (we’ll get to those in the stock cons), Caterpillar has the highest safe and sustainable dividend out of the Dow’s top blue chip stocks.

Caterpillar’s dividend payout ratio of 79% indicates that the company has a decent amount of excess earnings beyond what they pay in the dividend. Over the past 10 years, CAT shares have traditionally yielded 2%, with that yield spiking up to 5% only during the 2008 financial crisis and today. Caterpillar was able to maintain the dividend in 2008, and this time around isn’t all that likely to be different. The company still has an impressive “A” credit rating and faces no near-term pressure to cut the dividend.

Nearing A Cyclical Low: CAT stock is notoriously cyclical. Caterpillar’s underlying business is heavily exposed to global economic cycles. The company has exposure to many different sectors, however many of them are commodity based. Oil and gas, base metal mining, and precious metal mining have all been on the decline for at least the past two years.

Some markets such as residential and commercial construction in the United States are holding up. But even these segments are really starting to trail off in emerging markets including notable weakness in China and Brazil. Transportation has also seen its share of slowness, though a new highways funding bill in the US should help a bit.

Historically, CAT revenues peaked at $51 billion in 2008, enjoying strong support from the overheated housing and oil and gas sectors. Caterpillar saw revenues drop by more than 30% in 2009 to just $32 billion. But by 2012, the the Caterpillar stock price hit new highs as revenue more than doubled to $65 billion. Gold and silver prices peaked in 2011, leading to big drops in demand for Caterpillar mining equipment. Other sectors started following shortly thereafter. Since 2012, revenue has fallen three consecutive years to just $47 billion today. Like in 2009, there’s a good chance that when the cycle turns, revenues will explode to new highs.

Cheap Valuation: CAT stock currently trades at 14x earnings. That’s better than it sounds, since earnings have come down along with revenues. Earnings also peaked in 2012 and have been dropping.

This offers two ways to win, as earnings head back to their $8 2011-12 peak year, a 14x multiple would offer substantial gains as CAT stock went back over $100. And there’s a decent possibility that the P/E ratio would rise as investor sentiment improves. Finally, it should be noted that there are roughly 12% fewer shares of CAT stock than there were a few years back, as Caterpillar has been buying back stock aggressively. If revenues return to their 2012 peak, earnings would be more than 10% greater thanks to the reduced number of outstanding shares.

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CAT Stock: Cons

China Is An Important Driver Of Earnings: As everyone has seen in recent months, China is undergoing some serious economic spasms. This is bad news for the global economy as a whole. It’s downright dreadful news for a company like Caterpillar.

CAT stock is exposed to the country through vehicle sales for residential and commercial construction in China. It is exposed to China’s transportation sector, which until recently was booming. And as China buys fewer minerals and other raw materials from emerging markets, Caterpillar’s mining equipment segment also takes a hit.

End of China Supercycle: The counterpoint to the stock pro listed above about cycles is that the most recent upcycle was the idea that this may have been a once in a lifetime sort of occurance. Between 1994 and 2002, CAT stock did nothing, trading around 15-20 (split-adjusted) for the decade.

Once the huge growth cycle really got going in China, a commodity boom of incredible proportions began. Oil went from $15 to $150. Gold from $300 to $1,900. Copper quadrupled. And so on. And China threw up thousands of skyscrapers at an unprecedented rate. The bears argue the growth seen in China was a one-off event driven by irrational government policy that won’t be seen again. If oil and metal prices stay at or near current levels, there will be no cyclical upturn for awhile.

Earnings To Drop Again in 2016: Caterpillar has seen monthly sales decline a stunning 37 months in a row. That’s more than three years without an uptick. And as you can see in this article, the recent declines are, rather remarkably, accelerating in speed.

Anyone buying CAT stock here is buying with a long-term view and with patience for the global economy to stabilize. There’s no evidence to suggest 2016 will necessarily be the year that marks the 2012-onward recession low in Caterpillar’s revenues or earnings per share.

Caterpillar Stock Verdict

There isn’t a lot going right for Caterpillar lately. However, I’m fine with that. China remains a fearful place for investors, and 2016 most likely isn’t going to be a banner year for CAT stock.

On the plus side, you get a great starting yield that has grown nicely over the past 10 years. And the company is reasonably priced on an earnings basis. While the China cycle may be over, at some point oil, gas, and mining demand will return. And Caterpillar still has construction and transportation businesses that offer value while waiting for the commodities sectors to rebound.

At this time of this writing, Ian Bezek owned shares in Caterpillar. You can reach him on Twitter at @irbezek.

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