CAT Is Ready to Pounce

 | Jan 31, 2014 | 9:30 AM EST
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On Monday, Caterpillar (CAT) reported better-than-expected fourth-quarter quarter revenue and earnings, when investors had expected yet another poor quarter after a disappointing 2013. Last year, the company's resources and mining operations were a significant drag as the unit witnessed a big revenue decline on customer cutbacks and significant inventory destocking. The construction and power units also showed underwhelming numbers throughout the year. As a result, the Caterpillar shares ticked up just 3.3% for the year, significantly lagging the broad market.

In this past quarter, however, matters have changed dramatically. Aside from besting expectations, the company also underwent a major change in tone, from a negative bias to a positive one. Sales came in at $14.4 billion, topping the $13.7 billion views, and earnings had an even a bigger bump: Per-share income totaled $1.54 vs. expectations of $1.28.

A substantial part of the upside came from better-than-anticipated construction revenue, which totaled $4.85 billion against a $4.60 billion consensus. Also reporting above-consensus sales were the mining-and-resources and power-systems divisions. Construction enjoyed a solid recovery in North America, while Europe and China also reflected respectable numbers. Mining-and-resources is still struggling, but management believes the business has reached a bottom and that the numbers should get better -- or, at least, less negative -- going forward. The power-systems business showed consistent numbers across the board

Aside from revenue, also driving the earnings beat were aggressive cost-cutting and productivity programs. As a matter of fact, many of the analysts covering Caterpillar attributed most of the profit beat to the cost-cutting programs. Management believes these should add to earnings for all of 2014, and this is rather likely, given that the bulk of these programs are already in place.

Caterpillar also improved its balance sheet, and the debt-to-capitalization ratio continued to steadily decline to below 30%. The company is also pursuing further shareholder-value-enhancing programs, having initiated a much larger share-buyback program: It expects to repurchase $10 billion of stock by 2017, or approximately 20% of the current share base. In addition, Caterpillar announced that it expects to complete the remaining $1.7 billion of its previously announced buyback during the first quarter. This is a significant pick-up to its pace in 2013, when the company bought $3 billion for the entire year.

So, after a dismal 2013, we're looking to a good year ahead: The business should turn, and the stock should reap the benefits. We find the stock price, recently trading around $93, to be very reasonable. We believe Caterpillar can easily top last cycle's peak earnings, in 2012, of $8.49 per share, and the stock has historically traded for 14x to 15x these peak earnings. The company also pays a good dividend of $2.40, resulting in an above-average 2.65% dividend yield.

Altogether, the low valuation, favorable dividend yield, and improved capital allocation strategies -- along with an improving business outlook -- should result in a higher stock price in the upcoming year.

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