Rising Tariffs Will Erode Future Operating Margins

Key Takeaways

• Potential tariffs and economic uncertainty could hinder Caterpillar's profit margins and ability to capitalize on growth opportunities.
  
• Declines in cash flow and sales volumes may limit investment in growth and strain future earnings potential.
  
• Record backlog growth and resilient operations position Caterpillar for future stability, with efficient cost management and regional growth offsetting sales declines.

Catalysts

Manufactures and sells construction and mining equipment, off-highway diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives in the United States and internationally.

• Caterpillar is facing increased uncertainty due to potential tariffs, estimated at $250 million to $350 million as a cost headwind in Q2, which could negatively impact adjusted operating profit margins.
  
• Lower sales volumes driven by changes in dealer inventories, unfavorable pricing, and currency impacts resulted in a 10% decline in sales and revenues year-over-year, which could lead to lower revenue projections if these trends continue.
  
• The decline in ME&T free cash flow to $200 million, primarily due to lower profit and higher CapEx of $700 million, may limit Caterpillar's ability to invest heavily in growth, impacting future earnings potential.
  
• As dealer inventories increased merely by about $100 million versus earlier larger builds, any continued weakness in revamping dealer stock could further strain revenue growth and put pressure on net margins.
  
• Despite strong order rates and record backlog, ongoing economic uncertainty and potential tariff impacts may hinder Caterpillar's ability to fully capitalize on its growth pipeline, possibly leading to earnings below expectations.

Caterpillar Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Caterpillar compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Caterpillar's revenue will grow by 1.7% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 15.7% today to 17.0% in 3 years time.
• The bearish analysts expect earnings to reach $11.3 billion (and earnings per share of $24.75) by about July 2028, up from $9.9 billion today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 14.2x on those 2028 earnings, down from 20.2x today. This future PE is lower than the current PE for the GB Machinery industry at 22.9x.
• Analysts expect the number of shares outstanding to decline by 2.86% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.93%, as per the Simply Wall St company report.

Caterpillar Future Earnings Per Share Growth

Risks

• Caterpillar experienced record organic backlog growth, indicating strong demand and potential for future revenue stability, especially in Energy & Transportation where demand for power generation is growing rapidly.
  
• The company's net exporter status and diversified manufacturing locations provide resilience against trade and tariff uncertainties, which could help maintain profit margins.
  
• Despite lower first-quarter sales and revenue, Caterpillar's adjusted operating profit margin exceeded expectations due to favorable manufacturing costs, suggesting efficient cost management that could sustain earnings.
  
• Dealer inventory levels were stable and accompanied by strong machine sales to users, particularly in Construction Industries, which could bolster revenue if trends continue.
  
• Growth in specific global regions such as Africa, the Middle East, and Latin America suggests potential revenue opportunities offsetting declines in other areas, contributing to overall earnings.

Valuation

• The assumed bearish price target for Caterpillar is $294.6, which represents two standard deviations below the consensus price target of $406.04. This valuation is based on what can be assumed as the expectations of Caterpillar's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $500.0, and the most bearish reporting a price target of just $283.0.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $66.5 billion, earnings will come to $11.3 billion, and it would be trading on a PE ratio of 14.2x, assuming you use a discount rate of 7.9%.
• Given the current share price of $427.59, the bearish analyst price target of $294.6 is 45.1% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.