Yesterday marked another volatile day in the stock market, as the major indices posted big losses during the trading session – the Dow, for example bottomed out about 500 points below Monday’s close – but managed to claw back late to finish about .5% lower for the day. The market was chewing on a new round of earnings reports to mixed results. Caterpillar Inc. (CAT) was one of the biggest losers on the day, plunging more than 7.5% following its earnings report.
The drop seems a little ironic, given that the company reported increasing earnings and revenues versus the prior year and above analyst expectations; it seems that the stock was a victim of its own previous success, as investors seem to think that since the company had so far seemed invulnerable to rising tensions and tariffs and increasing interest rates, the same would continue to be true. That apparently translated to even higher investor expectations than those posted by analysts, and so when the company’s report included good, but not blowout numbers relative to predictions, the market decided to react negatively.
The truth is that since posting an all-time high at around $173 in late January of this year, the stock is down more than 30%, establishing a downward trend has really start to accelerate since the beginning of October. The stock peaked during the first week of the month at nearly $160 per share, but has dropped sharply from that point as the broad market’s volatility has increased. Is that a good thing for investors that are willing to a long-term view and can see the stock trading significantly below its all-time highs?
The truth is that the stock’s fundamental profile is really quite strong; the company has healthy free cash flow, good liquidity, and a solid margin profile that got better over the last quarter. Even so, good fundamentals don’t automatically translate to a great value, and a conservative, value-oriented investor would be foolish not to acknowledge the effect of increasing bearish volatility on the stock’s price. The stocks’s decline this month alone amounts to about 20% as of yesterday’s close, and the plain truth is that I don’t think the bottom is in for CAT. How far could it go, and at what price do I think the valuation becomes too compelling to ignore? Let’s take a look.
Fundamental and Value Profile
Caterpillar Inc. is a manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The Company operates through segments, including Construction Industries, which is engaged in supporting customers using machinery in infrastructure, forestry and building construction; Resource Industries, which is engaged in supporting customers using machinery in mining, quarry, waste and material handling applications; Energy & Transportation, which supports customers in oil and gas, power generation, marine, rail and industrial applications, including Cat machines; Financial Products segment, which provides financing and related services, and All Other operating segments, which includes activities, such as product management and development, and manufacturing of filters and fluids, undercarriage, tires and rims, ground engaging tools, fluid transfer products, and sealing and connecting components for Cat products. CAT’s current market cap is $70.7 billion.
- Earnings and Sales Growth: Earnings and sales growth was one of the hallmarks of the company’s report yesterday, as earnings were 46% higher than the same quarter a year ago. Sales were also healthy, posting an increase a 21% for the last three months. Both of these gains came in the face of tariff headwinds, to which management attributed about $40 million in increased costs in the quarter. The company’s margin profile is very healthy, with Net Income running at 7.3% of Revenues for the last twelve months, and increasing to 12.7% in the quarter that ended September 30.
- Free Cash Flow: CAT’s free cash flow is healthy at about $3.2 billion for the last twelve months as of the second quarter of the year. This number may decline somewhat, as the company’s total cash and liquid assets declined about 10% versus the beginning of 2018, but I don’t see it declining enough to warrant concern.
- Debt to Equity: CAT has a debt/equity ratio of 1.59. This number is higher than I generally prefer to see, but isn’t unusual for Industrial stocks. The company’s balance sheet shows that operating profits are more than adequate to service their debt; in addition, CAT has healthy liquidity with cash and liquid assets in the last quarter of a little over $8 billion.
- Dividend: CAT pays an annual dividend of $3.44 per share, which translates to a yield of 2.9% at the stock’s current price.
- Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for CAT is $25.14 per share and translates to a Price/Book ratio of 4.73 at the stock’s current price. The stock’s historical Price/Book ratio, however is only 3.62, suggesting that stock is about 23.5% overvalued right now. The stock is also trading about 22% above its historical Price/Cash Flow ratio, which means that the baseline “fair value” for the stock is really around $91 per share. That’s not the bargain price, mind you – that’s just the price that most value-oriented investors would concede represents a fair value for the stock under normal market conditions.
Here’s a look at the stock’s latest technical chart.
- Current Price Action/Trends and Pivots: The chart above outlines the stock’s movement over the past year. The stock saw a pretty steady decline from its high in January, but managed to stage a pretty impressive rally in late August and through September, rising from around $133 to about $158 dollars in the first week of October. The stock broke through support at around $133 earlier this month, but with yesterday’s drop looks like it could drop as far as $105 or possibly lower before it finds its next major support level.
- Near-term Keys: Trying to find a short-term bullish trade with CAT is a fools’ game right now; the stock could begin to stabilize and establish new support around its current level, but the fact is that is a very low-probability scenario right now. It is far more likely that, even if the stock does attempt a temporary rally from its current level, it will resume the path set by its bearish momentum through the month. If you don’t mind being very speculative, there is a technical theory that posits stocks that create overnight gaps tend to fill those gaps by at least 50%. That could yield a very near-term gain of about $6 per share, with a target in the $125 price area. Assuming the stock keeps dropping, you might consider shorting the stock or buying put options with a target price around $110 in the very near term. What if you want to take a value-based approach? I would wait out this latest run of bearish momentum, and wait to see if the stock eventually offers a too-good-to-pass up price. Based on my traditional valuation metrics, that price would be around $70 – a level the stock hasn’t actually seen since mid-2016.