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Should You Buy Caterpillar Stock?

What to do with Caterpillar (NYSE:CAT) stock after its recent first-quarter earnings presentations? The results and outlook were solid enough, but cyclical and competitive risks remain. Let’s take a look at what you need to know before deciding whether to buy the stock.

What moves Caterpillar stock

Caterpillar is a cyclical stock and its prospects will vary in line with conditions in its end markets. That said, with cyclicals, it’s often the case that the variance in its earnings from a relatively small part of revenue can be the swing factor in determining the company’s prospects. Confused? I’ll explain.

Let’s start by looking at Caterpillar generated its profit in the first quarter — the financial products segment profit of $211 million has been excluded from the analysis for ease of comparison.

The company is best known to the wider public as a construction machinery company, and as you can see below, its construction industries segment is indeed its biggest profit generator.

How Caterpillar intends to improve performance

A breakout of the increase in segment profit shows just how Caterpillar managed to increase equipment profit in the first quarter. As you can see below, resource industries was the big swing factor in the first quarter’s profit growth.

Moreover, the profitability of the resources industries and energy and transportation segments is the key to Caterpillar meeting its full-year outlook for profit per share of $12.06-$13.06, representing growth of 7.5% to 16.4% on last year’s $11.22.

Indeed, Evercore analyst David Raso asked around the subject of orders “growing year over year in the second half of 2019” and CFO Andrew Bonfield highlighted two areas where management expected improvement — neither of them related to the construction segment.

First, Caterpillar continues to expect mining capital spending to increase in 2019, therefore “mining CapEx is one area where, obviously, we’re expecting the order rate to continue to accelerate the year,” according to Bonfield.

Second, in the energy and transportation segment, he expects “to see some order improvement in second-half” in “particularly as the Permian takeaway issues are started to moderate.” 

By “Permian takeaway,” Bonfield is talking about the need to build pipelines in order to increase takeaway capacity in the Permian Basin. 

The interesting thing from an end-market perspective is that mining commodity and energy prices have, so far this year, moved in the right direction to support Caterpillar’s positive outlook.

Meanwhile, the construction industries segment is expected to benefit from ongoing growth in the U.S. economy and what CEO Jim Umpleby described as “stable local funding for infrastructure development.”

Two areas of concern

That said, it won’t be completely smooth sailing in 2019. Caterpillar still needs growth from construction industries, and there are some concerns here. For example, construction industries retail sales to the Asia/Pacific region were down 10%, 2%, and 1% in January, February, and March, and Bonfield admitted that “very” competitive pricing had had an impact on the company’s market share in China. Thus, Caterpillar expects industry sales to be up in China for the full year but the company’s sales to be flat — a particular worry when considering the potential for further friction in the U.S./China trade dispute.

Another area of concern comes from the pricing/cost dynamic. For example, price realization added $292 million to operating profit in the first quarter, but this was more than offset by a $375 million increase in manufacturing costs. Bonfield is expecting better price realization in the second quarter, but less of an increase in the second half.  

On the cost side, lower steel prices should come through in the second half and some potential cost savings from an easing of bottlenecks in its supply chain are also expected.

It’s something that needs watching closely because management’s full-year guidance assumes price increases will offset manufacturing cost increases — something that didn’t happen in the first quarter, as noted above.

Is Caterpillar a buy?

The recent trend in commodity prices is positive for Caterpillar and could lead to some upside potential for sales. However, the latest results raise some concerns about Caterpillar meeting its full-year guidance or at least the high end of the range.

Investors will want to see some improvement in the price/cost dynamic and the ongoing trade dispute won’t lead to the company missing its estimate for flat construction sales in the country. Thinking longer-term, the competitive pressure in China, referenced by Bonfield on the earnings call, could turn into a longer-term problem in a key market for the company.

The analyst consensus for full-year EPS of $12.34, putting Caterpillar on a forward PE valuation of less than 11 times earnings. That looks cheap, but given the slightly disappointing first-quarter earnings and the ongoing risks, investors might want to monitor events before assuming Caterpillar will meet its full-year guidance. 

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