Connoisseur of the untold stories on Wall Street, skewed toward activist hedge funds

Can CAT Claw Its Way Back?

Added on by Gordon Gekko .

Be sure to check out our detailed stock analysis (click here). Year-to-date, Caterpillar (NYSE: CAT) is down 10%. This is just part of the story, as the stock has greatly under-performed the broader market, but why? Sure it's been pressured by the slow economy and had recent accounting issues surrounding its purchase of ERA Mining Machinery and its subsidiary Siwei, but the economy is turning around, so Caterpillar could be too cheap to ignore.

The bad

Caterpillar posted first quarter EPS of $1.31, which missed consensus of $1.40. What's worse is that the company cut its full-year outlook, and now expects to report a profit of $7 per share, this comes after EPS of $9.35 in 2012, which was an all-time record and increased 6% from the prior 2011 period.

The good

Although the recent results and downward guidance are not stellar developments, Caterpillar has remained resilient given its international diversify. Over the last 10 years through 2012, Caterpillar managed to record a compound annual growth rate in earnings per share of 23%.

Caterpillar CEO Doug Oberhelman noted that “while 2013 will be a challenging year, we are confident about the long-term, China—even with a little bit weaker [economic] number in the first quarter—the stories there are still pretty good." He's right, over the longer-term, Caterpillar should perform well on the back of an improving economy.

This is namely from strong economies in emerging markets (thanks to rising urbanization) and a rise to replace machinery in developed markets. Analysts expected Caterpillar to grow EPS at an annualized 14% over the next five years. This, coupled with its cheap valuation, makes the stock a great growth at a reasonable-price opportunity (with a PEG of 0.75). 

The KHL Group reports that sales of construction equipment by the world's 50 largest manufacturers grew 25% in 2011, to $182 billion (latest available). This surpassed the prior record of $168 billion in 2008 by 8%.

This was driven by rising demand in nonresidential markets and a substantial level of construction projects in emerging markets. Although challenges in economies abroad, namely China, slowed the pace in construction-equipment markets in 2012, KHL expects growth in 2013 to benefit from global stimulus programs.

Although the interim has been tough for Caterpillar, there's one investor who has a big bet on the equipment giant; billionaire Bill Gates' Foundation Trust holds the most valuable position among hedge funds, with a $919 million position in the stock, comprising 5.5% of its 13F portfolio. What's more is that fellow billionaire Jim Simons' of Renaissance Technologies has the second largest position. 

How the competition stacks up?

Joy Global (NYSE: JOY) is a manufacturer of mining equipment, primarily for coal extraction and other ores. Although Joy's after-market business (60% of sales) helps to insulate it from the cyclicality of commodity markets, there is no denying the fact that weak commodity demand has had a negative impact on the company's earnings. The other downside to Joy is the fact that its top 10 customers account for more than 35% of revenue. 

Although Caterpillar is breaking into the mining market, it's still not as dependent on the market as Joy. Joy only reports operations in two segments, underground mining machinery and surface mining equipment. Caterpillar gets around 30% of revenue from construction industries, resource Industries and power systems each. 

Deere (NYSE: DE) operates three segments, agriculture and turf, construction and forestry, and financial services. Unlike Caterpillar's exposure to the construction and mining market, Deere gets nearly 75% of revenue from its agricultural and turf segment. Deere expects equipment sales to grow around 4% in the second quarter of fiscal 2013 and 6% for the full year, on the back of increasing commodity prices and strong farm incomes.

Kubota (NYSE: KUB) is another key manufacturer of farm and construction machinery. Making Kubota a compelling opportunity is strong expected construction machinery sales in Japan and other parts of Asia.

Like Deere, Kubota has the majority of its revenue tied to the farm and industrial equipment industry, where 70% of 2012 sales were derived from the segment. These include tractors, combine harvesters, rice transplanters and power tillers. As a side note, Kubota also has strong international exposure, where over 65% of sales were overseas, but I still prefer Caterpillar's product diversity.

By the numbers

Caterpillar is one of cheapest stocks in the industry,

Caterpillar is not only one of the cheapest stocks in the industry, but it pays investors a nice dividend.

As far as profitability goes, Caterpillar is again near the top of the industry.

Don't be fooled

While Caterpillar and Joy Global trade inline with similar price-to-earnings ratios and margins, I like Caterpillar's greater diversity with respect to product portfolio, where Joy is much more heavily tied to the mining industry. As well, Caterpillar dominates both Joy Global and Deere with respect to expected earnings growth. Analysts expect Caterpillar to grow EPS at an annualized 14% over the next five-years, compared to Joy's 10.8% and Deere's 10%. It's easy to see why Caterpillar is an interesting long-term investment choice.