Source: PaxForex Premium Analytics Portal, Fundamental Insight
Caterpillar's stock is currently trading near its recent all-time high, reflecting the company's robust performance across the board. In 2023, Caterpillar achieved record levels of revenue and profit, showcasing remarkable pricing power sustained throughout the year, resonating positively with its customer base.
Notably, management has raised its medium-term targets for both cash flow and profit margin. While there are many favorable aspects to Caterpillar's current position, the question arises – does it warrant a buy?
Management's guidance tacitly acknowledges the inherent cyclicality in Caterpillar's sales, earnings, and cash flow. The chart below illustrates the historical volatility of its revenue and operating profit margin, mirroring the fluctuations in its end markets, including nonresidential construction, infrastructure, mining machinery, energy, transportation, and power.
Given the company's relatively high fixed costs, its margins tend to expand with rising revenue and contract with declining revenue, a factor evident in the current guidance. The projected operating profit margin ranges from 10% to 14% at $42 billion in revenue, increasing to 18% to 22% at $72 billion in revenue.
For context, Caterpillar's revenue for 2023 stood at $67.5 billion, accompanied by an adjusted operating profit of 20.5%. Furthermore, management has refined its estimates for machine, energy & transportation (ME&T) free cash flow (FCF) throughout the cycle. This approach is common among industrial companies, providing a clearer view by excluding the impact of financial services on cash flow.
The recent positive results indicate an upgrade in management's expectations for FCF throughout the cycle, adding a favorable dimension to Caterpillar's outlook.
These ranges offer valuable insights for valuation purposes. For instance, applying a multiple of 20 times the Free Cash Flow (FCF) is reasonable when evaluating a mature industrial company. However, due to the cyclicality of earnings and FCF, averaging FCF throughout the cycle provides a more prudent approach. With the updated guidance indicating an average FCF of $7.5 billion, the target market cap stands at $150 billion, noticeably below the current market cap of $163 billion.
This observation gains significance as management's FCF guidance for 2024 suggests that earnings and FCF have peaked in the current cycle, signaling that the stock may be overvalued.
Nevertheless, investors shouldn't dismiss the stock just yet, primarily for two reasons.
Firstly, Caterpillar's status as a cyclical stock means its earnings are contingent on conditions in its end markets, which can fluctuate throughout the year. Notably, the company exceeded Wall Street estimates in every quarter of 2023.
Additionally, lower interest rates are expected to stimulate nonresidential construction and may drive demand for commodities, thereby increasing capital spending in the mining and energy sectors. Furthermore, sustained demand for infrastructure projects is anticipated, given the commitments outlined in the infrastructure bill.
Secondly, the recent revision in Caterpillar's targeted FCF guidance underscores its ability to consistently generate operating profit over its cost of capital. By expanding its services revenue, the company aims to achieve $28 billion in services revenue by 2026, up from $14 billion in 2016 and $23 billion in 2023. This strategy is expected to mitigate cyclicality in earnings and enhance return on capital and FCF throughout the cycle.
In summary, Caterpillar appears overvalued at present. However, if one is optimistic about potential lower interest rates and bullish on commodity and construction spending outlooks, the upside potential in Caterpillar's earnings for 2024 and medium-term FCF generation becomes apparent.
As long as the price is above 310.00, follow the recommendations below:
- Time frame: D1
- Recommendation: long position
- Entry point: 336.66
- Take Profit 1: 350.00
- Take Profit 2: 365.00
Alternative scenario:
If the level of 310.00 is broken-down, follow the recommendations below:
- Time frame: D1
- Recommendation: short position
- Entry point: 310.00
- Take Profit 1: 300.00
- Take Profit 2: 290.00
