Time to Let the CAT Out of the Bag

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 19, 2013

Time to Let the CAT Out of the Bag

  • CAT has underperformed the market consistently for the last 18 months, suffering from: diversity, exposure to China, exposure to mining, exposure to Europe, etc. All the things that the market does not like.
  • Among the large cap industrial names it is now one of the cheapest, despite earnings that reflect normalized returns on capital and despite meaningful leverage to an economic recovery. As shown in our accompanying piece on complexity, the market is punishing companies that are focused outside the US and with diverse portfolios – CAT is a clear victim of this behavior.
  • We are not that bullish about mining – we expect a relatively stagnant market for a while, followed by a slow recovery. But we are more positive about everything else as we see spending recovering around the world. It will likely not get back to the levels seen pre 2008, but it does not need to for CAT to improve.
  • The new CAT is much better than the old CAT, in that the major decline in revenue we saw in 2009 would have resulted in huge losses had it happened 10 years earlier. The company has improved its operations such that return on capital and earnings volatility has been reduced. The company is close to normal returns today, but with ample operating leverage – the recent dividend increase suggests confidence in cash flows.
  • The risk is that we bounce along the bottom for a couple of additional quarters and perhaps see another earnings miss or further negative revisions, but the absolute and relative downside to the stock is, we believe, limited. The level of skepticism in the stock is the highest it has been since September of 2011.
  • Our valuation framework suggests that there is as much as 35% upside in the stock to reach what we would calculate to be “normal relative value”. Equally important, CAT today stands at its greatest ever discount to the Capital Goods sector – see chart, and would need to rise 23% to achieve a more normal relationship.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

CAT has been one of the most significant underperformers in the industrials space over the last 18 months – Exhibit 2, and now trades well below what we would consider to be “normal value” – Exhibit 3.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

This is a company that was being lauded only a few years ago for its improved production process. Part of that thesis was less volatile earnings (arguably shown in the 2009 numbers) and more operating leverage/greater capital productivity. If you believe that story, you would argue for improving returns on capital through a cycle. As shown in Exhibit 4, we do not have enough data to support that this is happening yet, but the last cyclical low was much higher than the prior cyclical lows. Our “normal value” methodology is based on a flat ROC trend at the historic average of the last 30 years – 10%. This generates a current normal relative value of $123 per share, given the current market multiple. If you could make a case for improving returns you could generate a higher price, but you do not need to stretch that far today.

Exhibit 4

Source: Capital IQ and SSR Analysis

Equally compelling is the discount that CAT shows to its peers. If we look at valuation relative to our Capital Goods index we show CAT at its widest discount to the group average, as we showed in Exhibit 1. It is not the cheapest Capital Goods stock based on our valuation framework, but it is an outlier – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Complexity Penalizes CAT

The accompanying piece that we published today talks about the market’s thirst for certainty and simplicity. If the incremental buyer of equities today is looking for something that resembles a bond as much as possible – the story needs to be easy to understand and the history of the company has to have minimal volatility. In the call we show how companies with limited return on capital volatility have outperformed companies with

high return on capital volatility significantly since 2009. CAT did not screen into either the low volatility or high volatility sample set in this analysis, but it is one of the more complex stocks, based on our definition.

More diversity should reduce earnings volatility, and given the production process changes at CAT we see evidence that CAT is becoming less volatile. The factors all point to our increased level of interest.

Other companies that fall into a similar bucket today would be DuPont, to a lesser extend Dow Chemical in the Chemical sector, as well as ITW, MMM and GE.

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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