Infrastructure Programs and Industry Growth Will Push Earnings Higher

Key Takeaways

• Government spending on energy and infrastructure globally will be the biggest growth drivers
• Market will re-rate CAT to industry PE of 20.2x, up from 15.6x as growth becomes appreciated
• Buyback program will support price appreciation of 5+% per year
• Industry is expected to grow earnings by 13% annually, but CAT won’t grow as quickly
• CAT can grow earnings by 5.75% annually to reach $10.4B in 2028

Catalysts

Company Catalysts

Growth in Latin American development projects

For the company, regional development and government programs should be monitored because developing markets like LATAM and Asia Pacific have a lot more economic growth avenues to cover and require supporting machinery to build commercial, residential and industry projects. A well-established brand like CAT may be in a good position to secure new long-term public and private projects.

Business stabilizes in the Asia Pacific region

CAT has the potential to increase earnings by capturing new projects stemming from infrastructure bills, as well as passing down inflation costs to the customers. This pricing power is evident in their last two reports (1, 2) where we see price realization being a large contributor to the bottom line.

Government Spending in Energy and Infrastructure Globally

The US and Europe bring in the highest dollar value for Caterpillar, and these regions have collectively announced increased government spending on energy and infrastructure bills. These could be key drivers for future revenue for Caterpillar. Large Infrastructure bills include:

• Infrastructure Investment and Jobs Act ($1.2T) 
• Climate and Energy Provisions of the Inflation Reduction Act of 2022 ($737B)
• Recovery plan for Europe (€2.018T)

Inflation Reduction Act

Reaffirmation or increase of buybacks

I believe the buyback program will continue and could possibly increase in size. CAT returns more than 2.2% as a dividend yield. However, the 2022 yield including buybacks is 5.92%. 

The company currently returns $3.807B to shareholders per year in buybacks, and I believe this will scale back to historical averages, and potentially grow over the next 5 years. If the historical trends continue, with an average share reduction of 2.9%, this could reduce the share count to 447M from 516.2M today.

The market will re-rate the company higher

While the company currently trades at a 15.6x PE multiple, I believe that the above growth avenues will lead investors to re-evaluate the company and pay the median industry 20.2x PE multiple. 

Assumptions

Government spending sweetens revenue prospects

I assume an average revenue growth of 7.01% per year. This is significantly slower than the 17% growth in the last 12 months and is closer to the expected growth rate for an established company. While I expect cyclicality in the next 5 years, I think that the 7.01% rate is a reasonable average, which will lift the revenue baseline mostly due to inflation as well as government incentivized spending in construction. CAT will benefit from government spending across all segments, but mostly in construction as companies increase the machinery commits for new projects. This leads to my estimated revenue of $87B for 2028.

Net margins will see a slight uplift

I assume that CAT will converge to a 12% net margin in the next five years because competitive pressures will make it difficult for CAT to retain pricing power even as it scales revenue growth. This is roughly in-line with historical data, yielding $10.4B in earnings. My estimate is close to analysts’ estimates, which I feel are justified for the mature company. Given that the estimates are 1.2% above the expected nominal growth rate of the economy, CAT may have more room to surprise on the upside, which is why I am comfortable with these estimates.

Buybacks will continue into the future

I assume the buybacks continue and the share count is reduced, starting at the current 3.45%, to an average of 2.9% per year in 2028. This results in 447M shares, down 13% from the current 512M. I expect that CAT returns $2.9B on average per year via buybacks.

Risks

Competition from lower-margin peers

As CAT continues to invest in automation and remote operation, it is likely to attract competitors that are willing to sell at a lower margin. This could pressure CAT's margins and profitability. This is a key risk factor as the industry will naturally converge to an industry average over time and CAT’s excess value will dissipate.

Slowdown in infrastructure spending

CAT's sales are sensitive to government spending on infrastructure, especially in Latin America where the company grew 9% and has a high growth runway. If there is a slowdown in infrastructure spending, it could hurt CAT's sales. Key projects in the EU and USA that should be monitored include: 

• Infrastructure Investment and Jobs Act ($1.2T) 
• Climate and Energy Provisions of the Inflation Reduction Act of 2022 ($737B)
• Recovery plan for Europe (€2.018T)

Geopolitical risks

CAT's business is global, and it is exposed to geopolitical risks. For example, a slowdown in economic growth in China or a trade war between the US and China could hurt CAT's sales. Asia Pacific is important as it accounted for 18.6% of the revenues, and rivals are consolidating market share on their home terrain. Companies that investors should monitor in relation to CAT’s Asia Pacific market share include: Sany Heavy Industry, Zoomlion, the Japanese Komatsu, etc. 

Semiconductor shortage

CAT competes for the same chips used in electrical vehicle manufacturing, so the semiconductor shortage is a risk for the company. If the shortage continues, it could lead to production delays and lower sales for CAT. This is a minor risk within a stabilizing situation, and CAT may be able to obtain priority shipments as long as it retains its pricing power and higher margin sales as vendors would prefer selling to more lucrative customers.