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Caterpillar (CAT) has been up big lately, especially for a stodgy industrial the likes of CAT.  It’s name has been dropped incessantly in the past few days when analysts talk about the “big earnings surprises” of the March quarter.  Shares currently trade for about $73.30, and are up nearly 20% YTD after an impressive $0.13 beat in the 1^st quarter and “raised guidance” to a range of $5.30 to $5.80 for the year, up from previous calls for $5.20 to $5.70. 

The 1^st quarter net income figure was actually down 3% YoY, but everyone had been expecting the worst, with continued weakness in U.S. housing and trucking sales slowed down by rising fuel costs and new emission standards.  We have seen this fuel cost story play out in the higher pricing of the rails (with a big assist from Buffet), one of the hottest sectors of the year.

Going into CAT’s earnings, we expected weak domestic sales of construction equipment, and management didn’t call for anything different for the remainder of the year.  Same goes for sales of truck engines domestically.  And yet they kill their estimates for the last quarter, this company that traditionally lives and dies surfing the front of the business cycle.  If investor perceptions were the same towards CAT as say, five years ago, CAT would be rolling around the gutter right now, as it has every time the U.S. economy slows down.

CAT is already a company trading on the cheap at only 13 times 2007 estimates, and despite the inclination to sell into economic weakness, their stunning growth internationally can’t be ignored.  Neither can record-high commodity prices, which are driving heavy worldwide demand in mining, metals, and oil production.   

And we must not forget that Caterpillar is exposed to the trough of the housing cycle as we speak.  The truth of the matter is that most of the analyst community wrote Caterpillar off starting in the second half of last year, and they’re now just coming around to what management stated quite clearly starting in mid-2006: 

We are expecting to grow earnings at a 15% CAGR for the next five years. 

The words were simple and direct, yet now everyone seems to be scrambling to update their models.  There’s certainly nothing wrong questioning what comes out of the mouths of managers, even the smartest ones that run the biggest companies in the world.  It’s a “show-me” world, especially in the stock market. 

How’s this for show: 

Europe, Africa, & Middle East:  36% revenue growth year-over-year

Latin America:       15% growth

Asia/Pacific:        22% growth

A weakening dollar adds a great kicker, as most of those international sales can be favorably exchanged.  The international growth more than made up for the 13% shortfall in North American sales of $450 million, as total revenue in the quarter was up 7% YoY. 

So does CAT deserve a higher multiple?  Probably, but who will give it to them?  It’s not the traders or the opportunists who may currently be parked in CAT.  It’s going to have to come from the long arm of the buy-side managers, who collectively look this quarter’s numbers over and say “This company deserves a market multiple” (i.e., 15x to 17x earnings). 

This stock has the potential to attract a wide demographic of investors – the value guys, the opportunists, as well as the existing group of “mandatory” buyers who are there simply for index or sector representation.  And if this company, this industrial company, can grow earnings 15% while experiencing troughs in their core market, then they do deserve a market multiple.  It’s a simple and convincing argument that we first made in our break-up analysis of CAT back in February.  Back then, we said this stock could be worth $85. 

At the time, it was a big target, but now it just seems to be the mid-point of price targets coming from the sell-side in the past few days.

Ryan Barnes

April 27, 2007

Ryan Barnes can be reached at ryanbarnes@247wallst.com; he does not own securities in the companies he covers.