Like many other listed companies, Caterpillar has benefited from investors' return to riskier assets in recent months. What makes it risky is the nature of its business, which is tied to cyclical end markets and volatile commodity prices.
Summary
- Caterpillar's stock price has jumped more than 60% over the past few months amid profitable 2022 and investors returning to riskier assets.
- Caterpillar's stock price has historically correlated significantly with commodity prices, especially copper.
- Caterpillar is expected to benefit from the shift towards sustainable energy sources leading to a remarkably increased demand for metals and minerals.
- Key risks for Caterpillar include higher material costs, supply chain disturbances, and uncertainties related to the Chinese market.
- Due to the recent price outbreak, the stock seems overvalued, but investors may take advantage of upcoming market corrections to obtain company shares at a better valuation.
Caterpillar has recently experienced strong demand across its range of products and services due to increased construction activity in North America and heightened demand for its equipment and services from the resource extraction industries. However, the company has faced significant challenges in the form of increased material and freight costs and has resorted to price hikes to address these challenges.
Financials
In 2022, sales and revenues for the whole year amounted to 59.4 billion USD, marking a 17% increase from the 51.0 billion USD recorded in 2021. The rise was attributed to favourable price realisation, higher sales volume, and the impact of changes in dealer inventories, in addition to increased services and equipment sales to end users. Dealer inventories increased by 2.4 billion USD in 2022 while mainly remaining unchanged in 2021. The company's full-year profit in 2022 was 12.64 USD per share, compared to 11.83 USD per share in 2021. Additionally, the adjusted profit per share in 2022 was 13.84 USD, a significant increase from the adjusted profit per share of 10.81 USD recorded in 2021.
Source: Caterpillar 4Q2022 earnings report
In the fourth quarter, Caterpillar's total revenue was 17 billion USD, with the Construction and Energy & Transportation segments each contributing 6.8 billion USD and Resource industries contributing 3.4 billion USD. The Construction segment was the most profitable, with a profit margin of 21.7% in the fourth quarter, compared to 17.6% and 17.3% for the Resource and Energy & Transportation segments, respectively.
A worrying figure in the company's accounts is the high ratio of total liabilities to equity, which currently stands at 415%. Both – liabilities and equity – have been relatively stable over the years, meaning that the company may be comfortable with increased leverage. Furthermore, Caterpillar has a robust cash and liquidity position, generating an operating cash flow of 7.8 billion USD in 2022. As of the end of 2022, the company had 7 billion USD in cash and short-term investments, while its long-term debt was 9.5 billion USD. Over the years, Caterpillar has significantly improved its times' interest earned ratio, which currently stands at 9.7, up from a base of 4.5 in 2017. Nevertheless, monitoring the company's cash reserves and interest expenses would be useful.
Caterpillar may be slightly overvalued at its current stock price compared to its sector peers, although below the S&P500 median. The company's price-to-book value per share appears disproportionately high. However, this may be due to the relatively low level of equity used to calculate the book value per share. The above observation may also be extended to the return on equity ratio, which appears to be significantly larger than that of its peers. At the same time, the net profit margin is just slightly higher than the sector median.
* Sector: Manufacturing - Construction and Mining
Source: Zacks.com
Caterpillar as commodity proxy
Although Resource industries represent only 20% of total revenue, Caterpillar's stock price has historically had a significant correlation with commodity prices. It is mainly because its other two segments are also influenced by energy prices and transportation demand, which are known to be highly cyclical.
Caterpillar's stock price has a strong correlation with copper price - since 2016, the prices for both assets have been moving hand in hand, although the stock has seen an increased boost in the price for the past months compared to the commodity. For investors agreeing with the mean reversion strategy, this factor may signal that current Caterpillar's stock price may be overvalued, and a correction may be expected in the near future.
Source: TradingView
A number of factors speak in favour of the company, such as its ability to deliver value to its shareholders. This includes offering a steadily increasing dividend and buying back shares, which is not possible for a commodity. In addition, some of the difference in price movement may be due to the fact that the commodity business is not a significant part of Caterpillar's overall operations, and the exceptional results of 2022 in other divisions may be reflected in the company's stock price.
Net Zero Future for Caterpillar
Governments worldwide are implementing environmental measures, including subsidies for renewable energy sources and penalties for pollution through carbon pricing. This shift towards sustainable energy sources is expected to significantly increase the demand for metals and minerals, making efficient mining essential to a successful energy transition.
According to the International Energy Agency, an electric car requires over 200 kilograms of minerals, including copper, nickel, manganese, and graphite, in stark contrast to conventional vehicles. Annual copper demand is expected to increase by 53% to nearly 40 million metric tons between 2021 and 2040, with transportation demand outpacing construction demand in less than eight years. To address an 8-million-ton deficit, miners might be required to spend up to 150 billion USD in the next ten years.
Caterpillar is preparing to meet the growing demand by investing in cutting-edge technologies and working with the world's largest mining companies, making it a key player in the transition to cleaner energy. By 2025, the company plans to roll out an initial electric mining truck pilot project, followed by full-scale production after 2026.
In addition, Caterpillar recently announced its collaboration with Lithos Energy, which specialises in "the design, development and manufacture of shock resistant and high-performance battery solutions for applications including off-road and marine", further demonstrating its commitment to expanding into hybrid and all-electric machines and power generation products.
To learn more about the potential upcoming commodities supercycle, read our article The odds in favor of commodities.
Risks
Caterpillar faces several challenges, including higher material costs, particularly steel, as well as increased freight costs and labour shortages. These factors are possible to put pressure on the company's margins. Ongoing supply chain issues have also led to manufacturing inefficiencies, limiting the company's ability to meet customer demand. The company's cost of sales is expected to increase by 3.6% in fiscal 2023.
Furthermore, due to the tightening of regulatory controls and the slowdown in China's real estate industry, Caterpillar may experience weak demand for its 10-ton and above excavator market in China, which was previously one of its largest markets. The construction industry in China has yet to fully recover from the pandemic-related slowdown, and the continued restrictions on highly leveraged property developers have constrained real estate investment. As a result, the company's construction segment might be affected.
Conclusion
The success of the current energy transition hinges on the extraction of metals and minerals. However, a combination of low commodity prices, environmental regulations and underinvestment has created a situation where material shortages might be possible. This jeopardises efforts to reduce global pollution.
Caterpillar is well-positioned to capitalise on the high demand, long replacement cycle, and strong pricing power that may continue for decades. With its significant presence in the industry, focus on innovation, and strong customer relationships, the company could expand its market share and grow beyond its Resource Industries segment.
Despite the rally Caterpillar's stock has experienced in recent months, it may still be viewed as a quality long-term investment with higher-than-average dividends. As the stock is cyclical and somewhat volatile, investors may use market corrections to obtain shares in this company at lower prices.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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