In the last year, Caterpillar (CAT, Financial) has largely been on a sustained downtrend with the stock touching lows of $57.91 as of Jan. 25. Subsequently, the stock has trended higher by 26% and currently trades at $72.80. This article discusses if the stock is worth buying after the recent rally and the factors that investors need to closely watch before buying the stock.
The first point that I want to mention is that Caterpillar expects (for FY 2016) construction industry sales to decline by 5% to 10%, energy and transportation industry sales to decline by 10% to 15% and resources industries sales to be lower by 15% to 20% during the year. Therefore, this factor is already discounted in the stock and any performance worse than this will trigger downside.
For the month of January, the company’s construction industry sales declined by 7%, resource industry sales declined by 35% and energy and transportation industry sales declined by 39%. Therefore, two segment's performance was worse than expected. While I expect the performance to improve for February, there is a reason to be cautious.
In particular, China is in renewed economic downturn with share decline in manufacturing and non-manufacturing PMI for the month of February. If the downturn sustains in China, the estimates for 2016 can potentially take a hit and in such a scenario, Caterpillar can again trend lower. Therefore, for investors considering fresh exposure to Caterpillar, it would be advisable to wait and watch for economic data and its impact on sales.
From a valuation perspective, Caterpillar currently trades at 20 times FY 2017 earnings and I don’t see valuations as a concern. Further, the company has a robust dividend payout of $3.08, which is sustainable through 2016. Therefore, I don’t see current valuations as a concern. I would worry only if China’s downturn sustains and U.S. economic activity also weakens as a result.
While there are worries in terms of slowdown in several markets, oil price trending higher in the recent past can be a silver lining for the company. Caterpillar caters to the energy industry in North America, and if oil producing countries can agree on production freezes, the investments in the industry can witness some improvement.
Another factor that is likely to play an important role in the company’s profit outlook for 2016 is the dollar strength. While a strong dollar has impacted profitability in FY 2015, I expect the dollar to weaken in 2016 (relatively). In my view, there is unlikely to be another rate hike through 2016 and this will push the dollar lower.
From an EPS perspective, the share repurchase plan is a factor that can boost EPS in 2016 and beyond. In 2015, Caterpillar reported $2 billion in share repurchase besides the healthy dividend payout. In 2016, I expect share repurchase and dividends to remain at least the same.
Overall, Caterpillar still has concerns related to China and the resources industry. While the company’s dividend and share repurchase are a positive, investors need to remain cautious until broad industry conditions improve meaningfully. However, investors with a time horizon of three to five years can still consider small exposure to the stock at current levels and add on any correction. Caterpillar has a strong business globally and has been a value creator in good times. I expect value creation to resume once there is some stability in commodity prices.
Disclosure: No positions in the stock.
