About the Company

Caterpillar Inc. (CAT) is a leading manufacturer of construction and mining equipment, off-highway diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives.

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The company has three key segments: construction industries, resource industries, and Energy & Transportation. Furthermore, Caterpillar extends its services beyond manufacturing, offering financing and related assistance to its clientele. The Construction Industries segment, constituting 43% of total revenue, provides support to customers utilizing machinery in infrastructure development, forestry operations, and building construction. Meanwhile, the Resource Industries segment, accounting for 22% of total revenue, caters to customers engaged in mining, heavy construction, quarrying, and aggregates, delivering the necessary machinery and equipment. Lastly, the Energy & Transportation segment, which contributes 39% of total revenue, supports customers operating in oil and gas, power generation, marine, rail, and various industrial applications.

Caterpillar's recent performance in the stock market has been noteworthy, witnessing an approximate 20% increase since hitting a low of $205.60 in May 2023. This positive trend can be attributed to several factors, including the announcement of a dividend increase, a robust labor market, and optimistic consensus estimates for 2023. In Q1 2023, the company reported a significant 17% year-over-year surge in revenue, primarily driven by higher price realization and growth in volume. Moreover, Caterpillar's adjusted operating margin increased by 740 bps year-over-year to 21.1% due to better-than-anticipated manufacturing costs, enhanced efficiencies, absorption efficiencies, stronger price realization, and notable volume growth.

Revenue Outlook

Caterpillar's performance in the first quarter of 2023 showcased robust demand for its products and services across various end markets. This strong demand, coupled with notable improvements in the supply chain, resulted in significant volume growth. Notably, dealer inventory experienced a substantial increase of approximately $1.4 billion, contributing to the overall volume growth achieved. Sales to end users in Q1 FY23 also witnessed an impressive 13% year-over-year rise.

In the Construction Industries segment, sales to users remained flat compared to the previous year due to strong demand in the North American residential and non-residential construction sectors, partially offset by weakness observed in the Latin American and Asia Pacific regions. On the other hand, the Resource Industries segment experienced a noteworthy 18% year-over-year increase in sales to users, driven by a higher level of commissioning in mining operations and robust demand in the heavy construction, quarry, and aggregate markets. The Energy & Transportation segment witnessed an outstanding 39% year-over-year surge in sales to users, primarily driven by strong demand in the oil and gas market, turbines, related services, and a healthy power generation market.

Looking ahead, Caterpillar is well-positioned to maintain its growth trajectory. The company boasts a robust backlog that grew by 13% year-over-year, reaching $30.4 billion by the end of 2022. With the improvement in supply chain constraints anticipated for 2023, Caterpillar is expected to convert this backlog into sales at a faster pace. Despite the prevailing global economic conditions, demand across Caterpillar's segments remains strong. The Construction Industries segment is poised to benefit from the Infrastructure Investment and Jobs Act, along with healthy backlogs in North America. Infrastructure projects such as road reservicing have already begun. The Asia-Pacific region, excluding China, is projected to witness favorable growth due to positive public infrastructure spending prospects. The tailwinds in the non-residential market are anticipated to compensate for weakness in residential construction, which contributes 25% of revenue in the Construction Industries segment.

In the Resource Industries segment, the mining market continues to thrive as commodity prices remain high. Increased equipment utilization and low levels of parked trucks bode well for future demand for Caterpillar's equipment, parts, and services. Furthermore, the company is set to benefit from infrastructure projects in the heavy construction and aggregates sectors. Within the Energy & Transportation segment, the demand for power generation and data centers remains robust, and orders for new equipment under the Solar Turbine brand continue to show strength. Solar, a leading provider of industrial gas turbine engines, compressors, and mechanical drive packages, is experiencing a strong order rate driven by increased LNG exports and the underinvestment in the Oil & Gas sector over the past few years.

While sales to users are expected to remain positive throughout 2023, it is important to note that the second half of the year will be impacted by dealer inventory. In the previous year, the company benefited from the buildup of approximately $2.4 billion worth of inventory, which is now returning to its historical range of three to four months of projected sales. Consequently, the benefit from dealer inventory restocking is expected to be absent in FY2023. However, I believe, despite this impact, overall revenue growth for 2023 should remain positive. 

Margin Outlook

Caterpillar's strategic pricing actions and impressive volume growth have proven to be highly advantageous, surpassing the impact of increased manufacturing costs, including those related to commodities, freight, and energy. As a result, the company achieved a remarkable year-over-year improvement of 740 basis points and a sequential improvement of 410 basis points in adjusted operating margins.

Looking ahead, the positive effects of the pricing actions implemented in 2022, particularly in the latter part of the year, are expected to carry over into 2023, further bolstering the company's margins. Moreover, input costs have begun to stabilize in 2023, which should contribute to margin enhancement. Although expenses for sales, general, and administrative (SG&A) activities and research and development (R&D) are projected to rise in 2023, Caterpillar's investments in service expansion and technological advancements, such as digitalization, electrification, and autonomy, are anticipated to yield substantial benefits. I believe that these gains will more than offset the increased expenses. Thus, my outlook remains optimistic regarding the company's prospects for margin improvement.

Valuation

In my DCF calculations, I am assuming revenue growth to be in the high single digits in 2023, given the healthy demand in Caterpillar’s end markets and strong order backlog. Beyond 2023, I have assumed growth to be in the low-single digits, with a terminal growth rate in the low-single digits, as the company will continue to benefit from funding from the IIJA. I used a discount rate of 8.02% and arrived at a fair value of $247.25 for CAT.

Conclusion

In summary, Caterpillar Inc. is well-positioned for future growth, supported by its strong backlog, positive demand in its segments, and the potential advantages of infrastructure projects. The company should benefit from lower manufacturing costs, higher price realization, and investments in digitization, which should positively impact its bottom line. While Caterpillar's prospects for growth are promising, it is important to consider its valuation. Currently, the company is deemed fairly valued. Therefore, I believe it may be prudent to exercise patience and wait for a potential opportunity until the stock becomes undervalued.

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