Cat Shares Still Look Undervalued

We may slightly trim our $111 fair value estimate after reviewing  Caterpillar's (CAT)  third-quarter results. Sales in the firm's core machinery and power systems businesses climbed 5% from a year ago, with volume increasing just 4% compared with double digits over the past several quarters.

We're not surprised by the slower volume growth, given more-difficult comparisons and challenging economic activity in nearly all major regions outside North America. Beyond North America, only geographies that are less meaningful to overall results--such as Australia, other non-China portions of the Asia Pacific region, and the Middle East, Africa, and Commonwealth of Independent States--enjoyed positive top-line gains during the quarter. Latin American sales were flat, while Europe and China continued to suffer year-over-year declines.

We're encouraged that Cat continued to garner positive price (contributing about 2% to growth in the quarter), but as we noted to be likely following the company's recent analyst day, Cat lowered its full-year sales outlook by $2 billion given dealers' inventory-reduction efforts. This updated projection ($66 billion, including Cat Financial, at the midpoint) is roughly in line with our 2012 revenue estimate. However, the firm also reduced its near-term profit outlook given the lower sales base and temporary production shutdowns and outlined top-line 2013 growth of between negative 5% to positive 5%, below our high-single-digit forecast. As such, we plan to trim our near-term projections, though we don't plan to alter our long-run expectations. We still believe the company can reach the low end of its recently reduced 2015 earnings per share goal of $12-$18, barring another severe economic recession.

Cat's continued solid execution also provides some relief, in our opinion. For the third quarter, the company enjoyed solid profitability expansion from a year ago, as operating margins (excluding a one-time gain from the sale of its logistics operations) climbed to 14.1% from 11.2%. Year to date, the firm has posted a 37% incremental operating margin excluding all acquisitions and divestitures, well above both last year's high-teens mark and management's own 25% target.

On the downside, Cat's high degree of fixed costs typically lead to margin degradation in periods of declining sales, although to a lesser degree; the company's decremental margin was only about 16% in 2009 due to cost-saving initiatives, layoffs, and facility closures. Already, Caterpillar has announced production shutdowns at its Decatur, Ill., plant for November and December and temporary layoffs of its flexible workforce worldwide. If the company's bear case for next year proves correct and sales fall about 5%, we estimate EPS would tumble roughly 10% (to about $8.20 from Cat's updated 2012 $9.13 midpoint), assuming a similar 16% decremental operating margin. With the firm's stock currently trading at about $83--just 10 times this downside EPS--we think the market is already pricing in the low end of Cat's near-term guidance.

Of course, there is risk of further downside in Cat's business if China's economy continues to slow. The company's Resource Industries segment, which is primarily mining, has contributed more than half of Caterpillar's operating profits year to date, and these end markets are heavily tied to China's demand for mined commodities. The firm has seen delays and cancellations in this segment in recent quarters, and we think further challenges beyond what we currently expect open the possibility for additional downside on Cat's 2013 sales guidance. That said, management acknowledged the potential of such a scenario at its recent analyst day and targets $6 of earnings per share in this case. While the company's valuation would probably take another hit in this case, we don't think the cyclical downswing would threaten Cat's competitive position or wide economic moat, as all players in the mining equipment industry would most likely face similar headwinds.

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