Caterpillar Inc. (NYSE:CAT) the Peoria, ILL based construction equipment manufacturer has been a Wall Street darling for decades. Over the past decade the stock has returned 15.9% per year far outpacing both the Dow Jones Industrial Average and the S&P500. With a diverse set of product offerings, a division for financing customer purchases, and excellent execution of its overall strategy its easy to see why.
But a closer look at the company’s financial statements yields some discomforting information. For instance, adjusting for goodwill (which has no real value as an asset from which a firm can borrow against), the company’s long-term debt-equity ratio is around 2.8x. If we include the current portion of long-term debt and notes payable we arrive at a leverage ratio of nearly 4x. Granted, this is a capital intensive business with what have been very high returns to equity for a long time, but I am always skeptical of firms that use large amounts of debt to gear their business. Personally, if I want additional financial risk, I can leverage my own portfolio. I don’t need the firm to do it for me.
Leverage also has the effect of increasing the underlying volatility of both the firm’s business and consequently, its stock price. This is reflected in the beta of Caterpillar which at 1.7 is rather lofty. The result is that when you plug this beta into most valuation models you arrive at lower valuations for the company. My personal opinion is that this high volatility is too steep a price to pay for whatever benefits Caterpillar gets for its additional leverage. Suffice it to say, the company currently disagrees!
During the financial crisis, Caterpillar stock collapsed from a high in April 2008 of around 85 to a low of 21 in March 2009. Obviously, the collapse of the housing market was the primary factor in Caterpillar’s loss in value but the additional financial risk in the company’s balance sheet only magnifies the business risk that is inherently there. Leverage is always a double-edged sword!
Caterpillar also looks to be trying to capitalize on the push into natural gas engines. Cummins Engine (NYSE:CMI) is also executing a similar shift in its product offerings. Both companies have seen drastic increases in their respective P/E ratios since the beginning of 2009 though it is far from conclusive as to whether that is the reason their valuations have gone up so sharply. Nonetheless, with the rise in the valuations of “clean energy” businesses over the past two years, both the narrative and timing are consistent with that trend.
The dollar’s weakness has also contributed to Caterpillar’s valuation since the depths of the financial crisis. With most of its business being done in international markets, a weak dollar would disproportionately benefit the company’s bottom line by making their products cheaper in foreign currency terms.
Most recently Caterpillar announced the planned purchase of Bucyrus (NASDAQ:BUCY), a designer and manufacturer of safe and mining equipment for the extraction of natural resources. With the overall outlook of an improving world economy, increasing overall capacity by way of acquisitions makes sense. And a company involved with natural resource extraction during what is expected to be an inflationary time period is a reasonable investment. Furthermore, Bucyrus has been showing annual growth in revenues of over 45% for the past 5 years so its lofty, pre-acquisition valuation could conceivably be justified by that growth.
I can’t make too many criticisms of Caterpillar’s business because they do a great job running it. The consensus earnings forecasts for the next four years are also very optimistic and if they come to fruition, they’d show the company’s bottom line more than doubling by 2013. But this is still a heavy equipment manufacturer in a cyclical and competitive business that has never exhibited the type of earnings or revenue growth that analysts are forecasting. While I would not take a short position in this company, I can’t say the upside is worth the risk at these prices either.
Disclosure: No positions in Caterpillar, its options, or its debt.
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