CAT – Now Mining Matters – And Trends Are Better

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 31st, 2014

CAT Now Mining Matters – And Trends Are Better

  • We have been proponents of Caterpillar for some time – after a nice move higher, a window-dressed Q2 report took some of the steam out of the stock. Our valuation work indicates that CAT is still trading at a discount, both relative to the broader Capital Goods sector and in absolute terms, but a number of factors must align in the company’s favor to support any further moves up.
  • Margins in Construction and Energy have risen to post-recession peaks, offsetting a cyclically declining Resources segment, but reflect cost cutting more than the volume gains that will likely be needed to move the needle further from here. Sales volumes in the Resources segment suggest that we may be on the upswing of the mining cycle.
  • What you need to believe to see further gains in CAT:
    • Construction activity will pick up. Trends, certainly in the domestic arena, have been underwhelming year to date in 2014 and are reflected in CAT’s slowing volume gains in this segment.
    • Mining will continue to turn the corner. Newmont announced it will spend upwards of $900 million to open a gold mine in Suriname and Freeport expects to complete an agreement with the Indonesian government allowing the immediate resumption of exports. Earnings for the miners have been solid on the average in Q2.
    • Energy margins can be maintained or expanded. Volume growth here has been up and down, but negative on the whole since the near term margin trough in Q4 2012. With the big CAT a bit leaner having raised margins despite this headwind, even a small subsequent ramp up in volume could translate into a significant increase in operating profit.
  • Our normalized model generates a current fair value of $145 per share, but we do not believe that CAT can get there without more broad volume gains.

Exhibit 1

Source: Capital IQ, SSR Analysis

Valuation

Relative to the broader Capital Goods sector, CAT has given back some of the record high discount it had when
we first highlighted the stock
. The dotted line in Exhibit 1 is the average divergence since 2000 – it would take a move to $120 a share for CAT to close this gap.

Our return on capital driven valuation model gives an even more ambitious target – fair value (the 0 line in Exhibit 2 below) using CAT’s historical ROC of 10% implies a share price of $145, offering 25% upside from current trading levels. The reason why this number is higher than the first is because our analysis shows that the Capital Goods sector is in aggregate inexpensive – so CAT has two sources of upside – catch-up with the group, and the group catching up with the broader market.

Exhibit 2

Source: Capital IQ, SSR Analysis

Q2 Results and Segment Analysis

Caterpillar’s strong EPS beat on 4% lower revenue suggested cost trimming, and investors were unenthusiastic about the quality of the results. Rising margins in the company’s Construction and Energy segments have in recent quarters countered a mining driven decline in the Resources segment – but the improvements in Energy margins have not been driven by sales volume and though Construction ended 2013 exhibiting strong volume growth, the trend over the past two quarters has been markedly downward – Exhibit 4. With margins in Construction and Energy at post-recession peaks, CAT will at some point run out of levers to pull absent a pickup in volumes.

Exhibit 3

Source: Company Reports, SSR Analysis

Exhibit 4


Source: Company Reports, SSR Analysis

Margins in the Resources segment have cratered since 2012, but the volume trends here show that we are perhaps on the upswing of the cycle – Exhibit 5.

Exhibit 6

Source: Company Reports, SSR Analysis

When CAT was bouncing around in the low $80s in early October
we noted
the stock was unlikely to break down below that level and indicated a fair value on our model of $130 per share. This has been one of our better calls and while our valuation work still sees upside in the stock, the quality of the most recent earnings gave us (and the market apparently) pause.

What you need to believe to see further gains in CAT:

  • Construction activity will pick up. Trends, certainly in the domestic arena, have been underwhelming year to date in 2014 and are reflected in CAT’s slowing volume gains in this segment.
  • Mining will continue to turn the corner. Newmont announced it will spend upwards of $900 million to open a gold mine in Suriname and Freeport expects to complete an agreement with the Indonesian government allowing the immediate resumption of exports. Earnings for the miners have been solid on the average in Q2.
  • Energy margins can be maintained or expanded. Volume growth has been up and down, but negative on the whole since the near term margin trough in Q4 2012. With the big CAT a bit leaner having raised margins despite this headwind, even a small subsequent ramp up in volume could translate into a significant increase in operating profit.

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