Should You Buy Caterpillar (CAT) Today?

CAT is at five-year lows, but is it a good value yet? 

Caterpillar (CAT) stock has fallen 7% in two days after the company issued an earnings warning and announced over 10,000 job cuts last Thursday. Now at five-year lows, this could represent a once-in-a-decade buying opportunity in the blue-chip heavy machinery stock.

However, some signs suggest Caterpillar is still a falling knife, even at these levels.

The best argument in CAT’s favor today is that it’s undervalued. After falling 30% year-to-date, CAT now offers a competitive dividend yield of 4.7%, well above its historical average yield of 2.2%, and also above the industry average of 3.5%.

The stock is also trading at only 11 times earnings, below the industry average of 12 times and well below the company’s own historical P/E of 18.

However, after last week’s earnings warning, the company’s forward P/E is now higher than the current P/E, at 14. That’s a red flag, since the stock is likely to decline along with earnings.

Management’s cut to 2015 revenue expectations last week was the second this year, reflecting a still-worsening demand situation. Management is now predicting that revenues will decline in 2016, by about 5% year over year. The company is hoping to get itself back on track by 2017, thanks in part to the job cuts (“restructuring” in company parlance) also announced last week.

But the pain will persist in the meantime, and the restructuring itself is predicted to cost Caterpillar $2 billion over the next two years. The charge will be reflected in earnings already reeling from the evaporation of demand in CAT’s biggest end markets, mining, energy and construction.

Caterpillar has always been highly dependent on commodity prices, and has become even more so over the past decade, with commodity-related businesses generating 42% of revenues in 2012. So as a wide range of commodity prices have crashed over the past several years, CAT has been caught squarely in the cross hairs.

Caterpillar (CAT) stock chart

CAT has amplified commodity price movements over the past decade, as shown in this chart comparing CAT to the Dow Jones basic materials total return index.

Management says that the restructuring will bring commodity-price-dependent businesses a more reasonable 30% of revenues, mostly by upping dependence on the construction industry. However, even the construction business is facing headwinds today, as sales of equipment in China have slowed dramatically.

The mining, energy and construction industries are all highly cyclical, with boom and bust cycles of supply and demand amplified by volatile commodity prices. Caterpillar has faced situations like this before, and is confident that today’s cuts will position the company for a strong recovery when cycle begins to swing the other way. But how long will it be?

Merrill Lynch analyst Ross Gilardi believes that EPS will bottom in 2016, and that steady growth will resume in 2017. Since stocks tend to look six to nine months ahead, investors who buy today could find themselves riding a recovery rally as little as six months from now.

However, a delay in the beginning of the next upleg for commodity prices, or slower-than-expected economic growth in the U.S. and abroad could all mean significant deviation in that time frame.

Investors looking to make a quick buck could find themselves waiting a very long time for a small return instead.

For longer-term investors, CAT is also a high-risk proposition because of cyclicality of its end markets. Investors looking for a long-term dividend-paying investment in the heavy machinery industry would do better to consider Cummins (CMI), a 3.6% yielding maker of heavy-duty engines.

Analysts expect Cummins to report revenue growth of over 3% this year and next. The company’s end markets are well-diversified: Cummins engines and generators are the gold standard in industries including automotive, onshore and offshore drilling, maritime and rail transportation.

The stock is down 25% year-to-date, and trades at a current P/E of 12 and forward P/E of 10. Cummins’ current dividend yield is also above its historical and industry averages.

Sure, CAT might outperform CMI for a year or two once (and if) the commodity price cycle changes direction, but over the long-term, investors will be better rewarded by higher-quality, less-cyclical Cummins.

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