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Announcement on 06 September, 2024
Rate Cuts Sustain Caterpillar's Value In The Face of Declining Growth
In Q2’24 Caterpillar’s revenues were $16.7B, a 4% decrease YoY from $17.3B. This was primarily due to lower sales volume, especially in the construction and resource segments. The revenue decline was partly offset by an increase in pricing, mostly coming from the energy segment. This indicates that the company is experiencing a general reduction of demand, while pricing increases are offsetting the drop.
There is a notable difference in geography regarding sales. The largest declines are seen in the EAME (Europe, Africa, Middle East) region, with revenue down 15%, driven by a 27% decline in construction industries. Asia/Pacific is in a similar situation with a decline of 9%, also driven by a 15% decline in construction. The North America segment remained flat on average, and Latin America grew 5%, driven by a 20% growth in construction. In general it seems that the Asia and Europe growth stories are now in decline while the U.S. shows resilience and Latin America is experiencing secular growth.
The stock has rebounded since the earnings selloff, indicating that most investors were unphased with the low performance. Assuming that the market is right, the price rebound could be because investors are expecting these declines to be temporary, or they may expect a further positive offset from future rate cuts. In my view, we may not be in a good position to be able to evaluate how long the growth decline in EAME and Asia/Pacific will last, and while rate cuts will enable cheaper financing for new capital projects it also carries with it the possibility of a stagnating economic environment.
In the earnings report, management seemed focused on emphasizing records in adjusted operating profit. While this metric is still important, I view it as a distraction from the core KPI of declining demand. Management also updated the forecasts from a flat 2025, to expecting a decline roughly equal to the decline in the first half of the year. Given that CAT made $33.88B in the second half of last year, a 2% decline implies revenue of $33.202B for H2’25. Along with the first half revenue of $32.488B, the implied revenue for 2025 becomes $65.7B.
It seems that analysts are predicting a recovery after 2025. This is a reasonable assumption, as erring on the side of a growing economy seems to be a smarter strategy throughout history. However, to me it seems like CAT is entering another downwards cycle as it had in 2019 and 2015. In this scenario, I expect the North America and Latin America segments to be the most resilient economies. I anticipate a sharper drop in Asia Pacific, but a quick recovery as real growth offers investment avenues. The European story may remain unstable for longer as the region is economically mature and may be losing some of its past growth drivers such as cheap energy.
Valuation Update
Given the estimated changes, I am reworking my valuation with the following parameters:
- Average revenue growth 4%, revised down from 7.5%. Leading to 2028 revenues of $78.8B
- 2029 net margin target unchanged at 12%, resulting in $9.5B earnings
- Discount rate revised from 9% down to 7% to reflect anticipated changes in rates
The new resulting future value for CAT is $191B. Despite the changes in the discount rate, the present value remains around $306 per share, close to my previous estimate of $309 per share.
Because of the changes listed above, my present value of CAT decreased from $309 to $281 per share, somewhat below the current price.
Conversely, investors that believe I am too strict with my future profitability estimate of 12% given the current 16.6% net margin, may find the company even more appealing.
I expect that the company’s main true risk to its top-line is a prolonged slowdown in demand, anything other than that is inconsequential in the long run. Note that the argument for my lower 12% net margins was an intensified price war among competitors. I maintain this sentiment and expect that CAT’s technological advances will not be able to keep it from lowering margins in order to retain market share.
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)
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.
How well do narratives help inform your perspective?
