Wednesday, October 3, 2012

Caterpillar Still Has Room To Run After Early 2012 Rally

Caterpillar, Inc. (CAT) trades at about $110 a share after a 22 percent pop thus far in 2012. Is this stock washed out, or is it just getting into high gear? Let's analyze this bellwether equity to see if there's additional upside.

We will review some fundamentals benchmarks, the current charts, recent news, and project a reasonable valuation.

Business Brief

Caterpillar is the world's leading manufacturer of construction and mining equipment. The company was founded in 1925 and is headquartered in Peoria, Illinois. In July 2011, CAT completed the acquisition of Bucyrus International, a leading mining equipment manufacturer.

Fundamental Highlights and Analysis

Caterpillar shareholders have enjoyed solid return fundamentals of late. I like to check return metrics, EPS growth, and margins to screen company performance.

Management has lead the company to register a TTM 38 percent return-on-equity and a 6 percent return-on-assets. The RoE figure is far ahead of their industrial peers. A 13.5 percent return-on-capital-employed (ROCE) buttresses the ongoing efficient use of capital.

Earnings per share has risen dramatically over the past several years. EPS has rallied from $2.09 in 2009 to $7.40 in 2011. Management announced midpoint guidance of $9.25 a share in 2012. Meanwhile, revenues have nearly doubled in this period. Sales of $32 million in 2009 have ballooned to $60 million last year. Revenues of $70 million are projected for this year.

Using recently released figures, the gross margins ex-Bucyrus eased from 28.7 percent in 2012 to 28.1 percent last year. However, net margins have increased over the same YoY period.

Behind the numbers is a management team that has demonstrated the discipline to get cash to the bottom line. During the previous business up-cycle in the mid 2000s, Caterpillar management was not as fixated upon this. Margins deteriorated as the business ramped up. Of late, the company has beat the Street in ten of the last twelve quarters. Indeed, management has provided strong guidance forecasts throughout. Despite the economic and political turmoil, Caterpillar management has not wavered. They continue to remain bullish on future prospects for the company.

Recently, Caterpillar CEO Ed Rapp offered his opinion that Caterpillar is only two years into what is typically a six or seven year cycle. Furthermore, "tail winds" from eventual North American and European economic recoveries will propel the business in the out years.

Caterpillar booked a record order backlog of almost $30 million heading into 2012, putting an exclamation point on the narrative.

Technical Charts and Review

CAT shares have offered technicians a solid chart for some time now. I do see a few trends that indicate the stock may tire in the near-term. The 3-year weekly RSI is looking a little frothy, while the Slow Stochastic is in overbought territory.

On the flip side, the 50-day moving average just crossed the 200-day MA for the "golden cross." Chartists may see a reverse "head and shoulders" pattern that unfolded over the second half of 2011 blossom into a powerful January 2012 uptrend. I now see the stock sitting at a $111.50 resistance level. A breakout above that could take the stock up to $115 a share: the all-time high.

Trading volume has been good over the last several months.

Valuation Targets -- Yes, there's More Upside

My basic valuation methodology is straightforward. I project future EPS, then apply what I believe is the appropriate multiple using history and my experience as direction.

Caterpillar management has projected a 2012 EPS midpoint of $9.25 per share. Given their recent track record of beating expectations consistently, this is a good starting point. For the record, the Street consensus is a bit higher; about $9.38 a share. I suggest using the management benchmark affords a margin of safety; recall they have beat the street ten times in the last three years.

Reviewing historic Caterpillar P/Es during previous up-cycles, I apply a multiple between 13X (low end) and 15X (high end). These bookends will be largely contingent upon the strength of the overall market, the economy, and of course the company's ability to meet the Street.

Note to reader: The TTM P/E is 15X. The 2012 EPS P/E is 12X. The five-year average multiple is 18X earnings.

As an adjunct, I'm also heartened by a current Price/Cash Flow multiple of 9.6. Anything below 10 is good. This is another confirmation that cash is getting to the bottom line. A safe dividend of $1.44 a share provides a little extra juice to this stock.

Going through the math, my 2012 target range is $120 to $139 a share. That's enough to keep me in the game. Assuming we are still relatively early in the global business up-cycle, this CAT may have a lot more room to run. Each quarter, I re-evaluate everything via the conference calls, financial statements, and 10-Q reports.

While not a trader, I do acknowledge that the stock has run up fast and hard of late. It would not surprise me to see a pullback on any market weakness. Selling some March $120 call options on part of a position or placing a limit order to sell a few shares around that mark (with the intent to buy them back upon retracement) is a reasonable strategy.

In any case, I believe this company has plenty of gas left in the tank.

Disclosure: I am long CAT.

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