Caterpillar: A Stock Poised to Move Higher

 | Jun 11, 2013 | 9:00 AM EDT
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The market has had an impressive move in the 52 weeks. As a result, there are fewer compelling opportunities than there were a year ago. One area to look at to identify possible opportunities is with stocks that have lagged the rally. In doing this, we warn investors to be wary of lower quality companies or companies with real longer-term business issues.

In the realm of recent laggards, one particularly attractive possibility is Caterpillar (CAT) whose shares are down more than 6% for 2013 and down 2% for the past year versus a 16% gain in the S&P 500 for the YTD and more than 26.5% in the past year.

Caterpillar is the leading producer of earthmoving equipment such as trucks, tractors, and bulldozers for the global construction, mining and power industries. The firm's mining businesses have been under significant pressures over the past year as leading global mining companies such as BHP, Rio-Tinto, Barrick Gold and Peabody Coal have reduced capital expenditures on falling commodity prices.

During the recent quarter, Caterpillar reduced global mining sales estimates from $19 billion to $12 billion for 2013. The company also reduced its overall earnings estimate from $8 to $9 per share to $7 per share. CAT earned $8.53 per share in 2012.  

Business is expected to remain sluggish throughout 2013. For one, as previously described, the mining operations will be a significant drag this year. Secondly, Caterpillar's main business, global construction equipment sales has yet to fully recover from the effects of a weak global construction environment. Europe is still declining, while China is relatively flat. The U.S. is just beginning to see a pick-up in activity, but this is still quite muted.  

Nevertheless, valuation levels are beginning to look attractive after the recent price drop. Caterpillar is trading at 12.25 times depressed earnings of $6.84 per share for 2013 (slightly below the company's guidance and at 9.8 times 2012's earnings of $8.53 per share). In more normal environments, Caterpillar trades for 14 to 15 times earnings. The shares should have limited downside in this slow but steady environment. The balance sheet continues to sport a strong A-Plus credit rating.  

Investors have very low expectations for the company over the next six to 12 months after its recent earning disappointment and reset. However, we do believe that the reset numbers should be a floor on Caterpillar's fundamentals, which should begin to build positive earnings momentum from here in the coming 12 to 24 months.

Why? The U.S. construction markets are just beginning to pick-up into positive territory after years of subpar performance. Europe should be at a bottom. Japan is beginning to ramp up construction activity. China and the emerging markets should continue to see a positive inflection of activity in construction due to the continued demands for more urban infrastructures. Caterpillar is in the lead position to help with this turnaround.

Furthermore, mining shouldn't subtract from here while Caterpillar's power systems units continue to see record orders for movable power systems, locomotives and engines.

Notwithstanding likely near-term sluggishness, at its current price, we would buyers of Caterpillar with an upside target of $125 in the coming cycle.

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