Jarretera/iStock Editorial via Getty Images

Jarretera/iStock Editorial via Getty Images

In the current environment, Caterpillar (CAT) has many tailwinds in its favor: industrials are reaching record-high revenues, President Biden announced a Housing Supply Action Plan demand for construction equipment is at all-time highs. However, while these factors should boost net profits for a company such as Caterpillar, we see that the benefits are being offset by high inflationary pressure on raw materials. Furthermore, when I evaluate the company, I think that today Caterpillar is fairly priced and I thus rate it a hold.

Caterpillar is the world's largest manufacturer of construction and mining equipment, off-highway diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. In 2021 its sales and revenues reached almost $51 billion, a 22% increase YoY, but still below the numbers it achieved 10 years ago (in 2012, the company's sales and revenues reached $65.8 billion). The company divides its operations into four main branches that can be seen in the image below: construction, resource, energy & transportation, and CAT financial. The company is also slowly rebalancing its sales between domestic and foreign markets, moving U.S. sales down from 41% of sales in 2016 to 38% last year, as shown in the 2021 Investor Presentation. In the meantime, Europe and Asia have expanded.

From this image above we understand that the two key sectors for the company are construction and energy & transportation, which account for 76% of total revenues.

Even though Caterpillar's revenue is still less than what it achieved ten years ago, the company has kept on improving its operating profit margin and its free cash flow, trying to offset from these metrics part of the effects of the industry's cyclicality. We see, in fact, that as revenues decreased a bit, the operating profit margin increased throughout the last cycle.

The company is also well known for its financial stability and its ability to protect and raise constantly its dividend, making it a Dividend Aristocrat (as shown by the image below). As we can see, even during the troughs of the cycles shown in the picture above, Caterpillar kept on increasing its dividend without deteriorating the underlying business.

Caterpillar has a balance sheet with $6.48 billion in cash and a debt of $37.58 billion, making it a levered business. This may expose the company to some pressure when SG&A expenses and production costs grow at a faster than expected pace, eroding margins. This is exactly what Caterpillar had to deal with in the most recent months, as expenses grew due to inflationary pressure.

In the Q1 2022 results presentation, Caterpillar showed that the construction unit saw an increase in sales YoY from $5.5 billion to $6.1 billion. However, the profit decreased from 19.1% to 17.3% because of higher manufacturing costs. The energy & transportation unit was hit even worse, as sales grew from $4.5 billion to $5 billion, but profitability decreased from 15% to 10.7%.

During the earnings call, Caterpillars' CFO Andrew Bonfield, made this comments about this data:

Energy & Transportation took price increases later in the year 2021 given the different marketing dynamics as compared to the other primary segments. However, similar to the other segments, we expect margins to improve through 2022 as the benefit of higher price realization starts to pull through. [..] In a normal year, we'd see strong margins in the first quarter with margins decreasing sequentially through the fourth quarter. However, this year, we expect margins to improve in the second half of the year compared to both the first half and the comparable period of 2021 as the impact of price actions accelerate.

In other words, he said that the company was surprised by the rapid surge of inflation that outpaced the price increases that were regularly scheduled. Usually, a company increases prices at the beginning of the year and this is why higher margins are expected in the first quarters. Then, as the year moves on, margins shrink a bit because of normal inflation, until the next price increase. This is quite a normal dynamic among industrials. However, this cycle has been broken and we will have to see if Bonfield's outlook of higher marginality in the second half of the year will prove true or not.

I surely expect the company to be able to run its business smoothly and I continue to consider its dividend very safe, although I expect the payout ratio to increase a bit from its current 41%. However, with the order book already full, we will have to see how many sales the company will be able to make at increased prices and how many are already linked to the older price list.

Caterpillar's main peer in the construction industry is Deere (DE). I covered the stock a few weeks ago, highlighting that the shrinking marginality issue hit this machinery giant, too. So far, the only company I know of that has been able to increase it in the construction industry is CNH Industrial (CNHI), even though it was starting from a very low point and its construction unit is very little compared to its other peers.

Don't get me wrong, I still think that a 10.7% margin is very healthy, given the industry we are in. But Caterpillar has gotten us used to better numbers as it can leverage its brand value and its market leadership. If the marginality will contract so will its multiples.

Caterpillar is trading at 17.48 forward PE, higher than Deere's 15.59 and CNH Industrial's 11.09. It is also slightly above the sector median of 16.5. This is why its Quant Rating is a C+. From a forward price to sales point of view, Caterpillar is a bit cheaper than Deere with a 2.23 versus a 2.43, but it still is more expensive than CNH Industrial that currently at 0.59. The EV/EBITDA multiple is almost the same between Caterpillar and Deere, 15.09 for the former, 15.06 for the latter, with both, being market leaders, about 40% above the industry average. CNH Industrial is the cheapest with 13.58. Year to date, Caterpillar is one of the few stocks that has positively rewarded investors with a 6% return, however, it is still down about 11% from its ATH reached a year ago. During the past year, the stock has basically traded sideways, as it is consolidating as it probably priced in a lot of future expectations which are now being digested. As we can see from the chart below, during this past year, the PE ratio has also come down significantly not only because of a price decline but because of strong earnings. Historically, Caterpillar has traded between a 10 and a 16 PE ratio, making me think that it is still a bit too early to call a buy for the stock.

In the discounted cash flow model I use, I had a result that confirms my hold. I expect the company to grow in the next 5 years at a CAGR of around 4% and marginality to grow at 2% CAGR. My discount rate is 7.7%, starting from the consideration that the risk-free rate is now at 2.7% and that Deere's average cost of capital is around 5%. The equity risk premium I used was 5.5%, which is quite common for U.S.-based companies. This gives me a target price of $216 which is very close to today's price of $213.

Caterpillar manufacturers beautiful machines and will keep on being the market leader for a long time. However, the stock still seems as if it is consolidating last year's massive surge, waiting for its multiples to contract back to normal before heading towards new highs. I rate it as a hold, but I will keep on watching it carefully to pick it up if it drops enough to give me a margin of safety.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.