Caterpillar Looks Expensive at Current Levels

Caterpillar (CAT) has surged by 31% in 2013 on the back of a broader market surge and an annual EPS estimate revision in the first quarter of 2014. The stock, however, seems overvalued based on its earnings forecast. This article looks at some of the key factors, which lead to the conclusion that Caterpillar can be avoided at current levels and investors can consider this stock on correction.

The China Factor

Robust economic growth in China and emerging Asia has a key role to play in Caterpillar's growth and outlook. In 2011, Caterpillar recorded revenue of $60.1 billion, which surged to $65.9 billion in 2012.

However, after the growth slump in China, Caterpillar's revenue declined to $55.7 billion in 2013 and the company forecasts that the revenue for 2014 will be marginally higher at $56 billion. The EPS for 2013 was $5.97, which slumped from $8.48 in 2012.

It is clear that economic growth in China has a key role to play in the company's revenue growth and stock upside. According to IMF's World Economic Outlook, China's GDP growth expectation for 2014 and 2015 is 7.5% and 7.3%, respectively. This is marginally lower than China's actual GDP growth of 7.7% for 2013. In other words, China's economic outlook is likely to remain depressed for the next two years.

It is therefore not surprising to see Caterpillar estimate muted revenue growth for 2014 at $56 billion from $55.7 billion in 2013. Even on the EPS front, the EPS for 2014 is expected at $6.1 from $5.97 in 2013. I believe that low growth will sustain for Caterpillar over the next two years.

The Valuation Factor

While low growth is a factor the market participants are aware of, Caterpillar has been surging high on the back of a broad market rally and a annual EPS estimate revision in the first quarter of 2014. However, even after discounting the good results, the stock is overvalued.

Coming to the estimate revision, Caterpillar's revenue guidance for the full year remained unchanged at $56 billion. On the EPS front, the company announced a positive revision to the full-year outlook. The revised EPS forecast for 2014 was $6.1 per share as compared to the previous outlook of $5.85 per share.

An EPS of $6.1 implies a PE of 17.7 for 2014. The key factor here is the EPS growth rate as it helps calculate the PEG, which would give a clear picture of undervaluation or overvaluation. An increase in EPS from $5.97 in 2013 to $6.1 in 2014 implies an earnings growth rate of 2.2%. Even on considering a mean five-year growth rate (according to analyst estimates) of 13.4%, the PEG ratio comes to 1.3.

The PEG therefore comes significantly above 1 and this does suggest overvaluation. I am not suggesting that Caterpillar stock will decline very significantly. However, it is clear that current levels are not good from an investment perspective. It is definitely good from a profit booking perspective.

Conclusion

Caterpillar is a giant in the industrial goods industry with a current market capitalization of $67 billion. The company has a strong operating cash flow profile and has done well in terms of cost control in a relatively sluggish growth environment.

There is no doubt on the point that Caterpillar has the potential to bounce back in terms of revenue and EPS growth when China's economic worries decline. However, the stock has run-up too fast in the current phase of the rally and is certainly not a value pick. On the contrary, it is a good profit booking opportunity for investors who have made gains in the current rally.

I would suggest that investors stay in the sidelines and wait for a market correction before considering exposure to the stock. The economic data from China also needs to be watched for closely and sustained economic growth (without government support). It will be the best time to reconsider the stock.

About the author:Faisal HumayunSenior Research Analyst with experience in the field of equity research, credit research, financial modelling and economic research

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