24/7 Wall St. 2007 Break-up Values: Caterpillar $85 (Current Price $65)

By Ryan Barnes. Edited By Douglas A. McIntyre

Caterpillar Inc. (CAT) Price $65; Breakup Value $85

Caterpillar currently trades at a large discount to industry averages, and it is hard to determine why.  Company management is very optimistic about future prospects, going so far as to project a 15% CAGR for earnings over the next 5 years.  And yet the stock trades for just 12x current earnings and a PEG of only .65!  The most likely culprits are investor perceptions about the company’s exposure to the U.S. housing market and CAT’s hefty $18b debt load. 

The debt figure is misleading, however, as the majority of company debt is not being used to finance manufacturing of products; instead it’s being used within the financial segment of Caterpillar, known as CAT Finance, which grants loans and insurance products to both customers and dealers. 

The concerns about the U.S. housing market are warranted, especially considering that both the core business segments (Machinery and Engines) and the financial segment are exposed to the effects of the downturn.  The effects of owning CAT financial amplify the problem, because most financing is for U.S. customers, which means if things turn bad default rates will grow, and things could get ugly in a hurry.  While machinery sales would suffer as well, this can be counter-balanced by strong housing markets in the rest of the world, where CAT conducts almost half of its business. 

Spinning off the U.S. business is not really an option.  Caterpillar is first and foremost a U.S. company, and the perceptions about growth rates at home would depress the multiple of the spin-off from the get-go.  The best way to enhance shareholder value is to divest the Cat Financial division; by selling it to a larger financial institution that could handle the debt load and diversify the economic risks, CAT could take almost $14b in debt off the balance sheets and allow shareholders to see that business is very promising not only abroad but in other industrial segments of the U.S. economy. 

Cat Financial produced over $600m in operating profit in 2006 with strong growth yoy and solid 25% margins.  The unit could sell for 15-20x profits ($11.3b) and still perform the valuable function of providing financing for CAT products worldwide.  By eliminating the “double-whammy” exposure to a falling housing market and reducing overall debt by over 75%, CAT should trade in line with peers, which trade for P/Es in the range of 15 to 17.  We’ll be conservative and say that Caterpillar minus the leveraged finance group should trade for a P/E of 15 (and a PEG of 1 based on company projections), bringing the total breakup value in this scenario to an impressive $85/share. 

Ryan Barnes

Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others.  Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.

Methodology