Not all stocks get cheaper as they go down. That's the lesson with the stock of Caterpillar (CAT), which reports Thursday and it is, unfortunately, incredibly instructive at this difficult moment for Cat's stock specifically and the market in general.
First, let's stipulate some things. No one disputes that Caterpillar makes fabulous machinery. I have been around long enough and spoken to enough CEOs who have bought Caterpillar equipment that its top-notch quality is a given. I mention that because, typically, if you make the best product, and are therefore best of breed, it should matter in the equation.
Right now, though, it doesn't. It is completely irrelevant that Caterpillar's got a long history of excellence dating back to 1886. Nor does it matter that the company's been public since Dec. 2, 1929 ¿ OK, an inauspicious year, but you get the picture.
What matters is that Caterpillar sells equipment worldwide that's purchased for massive construction projects of all sorts, roads, or buildings, or housing developments or commodity extraction and processing. Right now, sadly for CAT and many companies caught up with these same customers, there's a sharp drop in demand, much more than would have been anticipated just 18 months ago.
How sharp? While I don't expect it to be as vicious as the 2008 to 2009 period when Caterpillar's earnings went from $5.83 to $1.45 as a consequence of the Great Recession, I do expect the decline to be brutal. However, unlike the Great Recession, when Caterpillar's earnings bounced back almost immediately, first to $4.28 in 2010, then to $7.64 in 2011 and all the way to $8.71 where they peaked in 2012, I expect no similar bounce back.
This time, when the company reports Thursday, I expect to see the fourth quarter very weak -- Wall Street analysts are looking for $0.69 vs. last year's $1.35 -- and the earnings for 2016 to come down dramatically from the $4.58 CAT may have made last year.
And therein lays the problem. Caterpillar seems dirt cheap down here, if you look at the rearview mirror. With the stock at around $57, you are looking at a company that would be selling at 12x 2015 earnings and less than 9x 2014 earnings. Remember the average stock in the S&P 500 sells at 16x earnings, so you are getting CAT at a huge discount. But hindsight is 20-20.
If Caterpillar earns, for example, what Goldman Sachs says it will earn in its Friday evening downgrade from "hold" to "sell", namely $3.51, that would put its price-to-earnings multiple at 16.5x forward earnings, which is more expensive than the average stock.
But are its prospects better than the average stock? I would argue, no, not at all. Given that 60% of its earnings come from overseas, I would contend that its prospects are far worse. Or, to put it in English, because Caterpillar's future earnings prospects are so murky, we can't use past history to judge the stock.
But, you say, can we value Caterpillar another way? For example, even in this hideous environment, the stock of Verizon (VZ) went higher after it reported a good number, and given that Verizon gave you a 5% yield going into that quarter, it was worth the risk. Caterpillar now yields almost exactly what Verizon yielded, so why not bet that Caterpillar's got the same dividend support to embolden you to buy it ahead of the quarter?
Simple, because if Caterpillar earns as little as Goldman says it will, then Caterpillar will be spending too much money on its dividend and it would be too risky to bet on that support holding. We've seen this dividend risk develop with many a mining and oil stock here, why can't it happen to a company that's a principal supplier to those companies?
Plus, unlike the last downturn, when Cat's earnings came right back, the cutbacks in capital spending announced recently for the oil, gas and mining companies are monstrous and could be long-lasting if commodities don't turn around in price. Given how weak demand is in China for minerals, and how strapped the oil and gas companies are, I think we are looking at a prolonged decline in orders and earnings. Making matters worse, with 60% of its earnings coming from overseas, the strong dollar will play havoc even with those results.
So, the bottom line is that as Caterpillar's stock goes down, it actually gets more, not less, expensive relative to earnings, and riskier, not safer relative to that yield. And that's why, even down here, the Goldman sell rating seems reasonable and the worries for this great company well-warranted.