Caterpillar Stock Now Looks Expensive After A 2x Rally

Caterpillar stock (NYSE: CAT) is up 16% since the start of the year and it has gained around 2x from its March lows. Caterpillar faces downside risk as the company’s revenues in the last four quarters have declined by 21%. The ongoing Covid-19 crisis and the economic uncertainty has hit the company’s construction as well as energy equipment business. This is likely to impact the revenue growth rate of the company – leading to a drop in the stock price.

Following a large 2x rise since the March 23 lows of this year, at the current price near $175 per share, we believe CAT stock has reached its near term potential. CAT stock has rallied from $92 to $175 off the recent bottom compared to the S&P which moved 60% over the same time period. Better than expected Q3 earnings and a faster than expected rebound in economic activity has helped the stock in beating overall markets. Moreover, the stock is up 36% from levels seen in early 2019, over a year ago. CAT stock has fully recovered to the level it was at before the drop in February due to the coronavirus outbreak becoming a pandemic, and it is now 28% above the pre-Covid highs. This seems to make it fully valued as, in reality, demand and revenues will likely be lower this year than last year. Our dashboard ‘Buy Or Sell Caterpillar Stock’ provides the key numbers behind our thinking, and we explain more below.

Some of the stock price rise over the last year is justified based on the company’s fundamentals. While Caterpillar’s revenues have declined 1.7% from $54.7 billion in 2018 to $53.8 billion in 2019, its EPS actually increased 4.4% from $10.39 to $10.85. This mismatch can primarily be attributed to a 5.1% decline in total shares outstanding due to share repurchases amounting to $4.0 billion. Also, the company expanded its net margins marginally to 11.3% aiding the overall earnings growth.

Finally, Caterpillar’s P/E ratio expanded from 12x in 2018 to 14x in 2019. While the company’s P/E has now increased to 16x, it is trading higher compared to the levels seen over the recent years, P/E of 12x in 2018, and P/E of under 14x as recently as late 2019. We believe there is a possible downside risk for Caterpillar’s multiple, and the stock is unlikely to see much upside after the recent rally and the potential weakness from a recession-driven by the Covid outbreak.

How Is Coronavirus Impacting Caterpillar Stock?

The global spread of coronavirus has affected industrial and economic activity across the world, including Caterpillar, as demand for its industrial equipment has declined. This resulted in Caterpillar taking a hit when the pandemic started. That said, now with economies gradually opening up, there has been an increase in demand for Caterpillar’s products. For Q3 though, total revenues were down 23% to $9.9 billion while earnings declined 54% to $1.22 per share, driven by margin contraction due to higher operating costs given the impact of Covid-19.

Diving into the individual segments, Energy & Transportation saw the largest impact with sales down 24% to $4.2 billion, due to reduced oil & gas demand. Construction segment sales were down 23% to $4.1 billion as demand for non-residential construction remained low. These trends will likely weigh on Caterpillar’s near term sales growth, leading us to believe that the stock is currently overvalued. In fact, overall revenues for the full year 2020 are estimated to decline 23% to around $41.5 billion, while earnings are estimated to be $5.44 on a per share basis, much lower than the $11.06 figure reported in 2019. Not only is the impact on revenues and earnings high when compared to the previous year, the recent rally in the stock has meant an expensive valuation multiple for CAT stock, making it vulnerable to downside risk. At the current price near $175, CAT stock is trading at 32x its 2020 expected EPS of $5.44 and 24x its 2021 expected EPS of $7.38, compared to levels of under 15x seen over the recent years, seemingly making it vulnerable to downside risk.

Looking at the broader economy, the actual recovery and its timing hinge on the containment of the coronavirus spread. Our dashboard Trends In U.S. Covid-19 Cases provides an overview of how the pandemic has been spreading in the U.S. and contrasts with trends in Brazil and Russia. Following the Fed stimulus — which set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view. With investors focusing their attention on 2021 results, the valuations become important in finding value. Though market sentiment can be fickle, and evidence of an uptick in new cases could spook investors once again.

What if you’re looking for a more balanced portfolio instead? Here’s a high-quality portfolio to beat the market, with over 100% return since 2016, versus 55% for the S&P 500. Comprised of companies with strong revenue growth, healthy profits, lots of cash, and low risk, it has outperformed the broader market year after year, consistently.

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