As a major supplier of industrial engines, heavy construction equipment, and transportation goods, Caterpillar has been attempting to increase cash flow and profitability while lowering earnings volatility. In 2017, the company set goals to increase profits, produce $4 billion to $8 billion in free cash flow annually, and distribute all industrial free cash to shareholders in the form of progressive dividends and repurchases. Additionally, the company's yearly services sales reached $23 billion last year, meeting its goal of $28 billion by 2026. Increasing customer value agreements and machine digitization for predictive maintenance are two aspects of the services strategy. The US construction market has seen infrastructure spending and stable residential housing demand, while industrial production metrics have been moderate. Europe and China have struggled due to economic uncertainty, while the mining end market has experienced anemic demand. The company is not operating at peak cycle, but there are tailwinds to its end markets as the global economy transitions to sustainable energy, allowing for GDP-plus growth for an extended period.
Ken Fisher (Trades, Portfolio) has been buying this stock for past 2 years and CAT has rewarded his portfolio with generous returns. Additionally, CAT takes up 5% of Bill Gate's portfolio, something that speaks volume. However, on the contrary, PRIMECAP has been offloading CAT shares past 5 years but even then the money manager has a stake worth $429 million in Caterpillar. This begs the question whether Primecap trimmed its holdings in Caterpillar due to the fundamentals of the company or whether it was part of a strategic portfolio management decision.
Investment Upsides
For almost a century, Caterpillar, one of the top producers of machinery and equipment worldwide, has offered dependable, superior products at the lowest total cost of ownership. About 150 of the company's locations are in 25 countries, 125 of which are used for manufacturing. As a result, Caterpillar is now a well-known brand with a dominant market share. Durability and long operating times are essential in the harsh environments in which Caterpillar's products operate. Since Caterpillar's products have superior total cost of ownership, their longer-term operating results demonstrate significant pricing power.Additionally, the business owns patents and other intellectual property, especially related to different engine technologies, which supports the idea that Caterpillar creates high-quality machinery and makes investments in new features to maintain its competitive edge. With its network of nearly 160 independent dealers spread across nearly 2,800 locations worldwide, Caterpillar also enjoys a substantial competitive edge in distribution and service. These dealers support Caterpillar by offering the OEM wide sales coverage and the highest level of customer service through spare parts and repairs.
As much of the value chain as possible is captured by Caterpillar's dealer network and captive finance business over the course of the product lifecycle. Customers find switching extremely challenging because the company bundles essential services, such as financing and aftermarket support/servicing, through the dealer network. Due to the possibility of switching to a different product due to machine failures or lengthy lead times for equipment maintenance, customers are exposed to significant operating risk. In order to lock in more consistent, high-margin aftermarket sales, the company has prioritized services and attached a larger percentage of service contracts at the point of sale in recent years. A significant advantage over rivals is provided by the caliber and reach of the dealer network in terms of parts and service availability.
Due to weaker guidance for 2025, Caterpillar's fair value is estimated to be $299.58 per share. The enterprise value/2025 EBITDA multiple of roughly 12.5 and the 2025 EPS estimate are about 18 times lower than the fair value estimate. In 2024, the company's revenue decreased slightly in the resource and construction sectors, but it continued to grow moderately in engines and transportation. In 2025, it is anticipated that the company will still be weak in these sectors. In 2026, the business is anticipated to bounce back to high single-digit growth in all reporting segments.If the business keeps raising its service attach rates, the machinery segments might be able to keep their margins at slightly higher levels, which could turn out to be conservative.
Transportation and energy will also experience flattish margins, and the margin expansion thesis will continue to be more of a "show me" proposition for management to follow. When it comes to reaching the business's full margin potential, the company is in somewhat uncharted territory. Caterpillar has gone through downturns roughly every five years, but these cycles are unique and unpredictable. Management is strengthening the business's resilience and decreasing cyclicality with its increasing installed base of machines and improving attach rate of services. An estimated 16% investment rate, a 5% earnings before interest growth rate, a 3% perpetual growth rate, and an 8.6% weighted average cost of capital are all included in the Stage II forecast period.
Investment Downsides
Serving cyclical end markets, Caterpillar has a sizable installed base of machines in challenging conditions that need maintenance and parts. The group's operations are stabilized by this high-margin aftermarket business. Caterpillar has maintained its competitive position thanks to its well-known brands and wise investment choices. Over the next 20 years, Caterpillar's brand equity and switching costs are unlikely to be weakened by global competition. The competition typically employs a direct sales approach, and the company's dealer network is autonomous. Strong execution, end market exposure, and competitive advantage characterize Caterpillar. Investments in "connected assets" have been deemed essential by management for its long-term plan. Autonomous technology has the potential to boost customer value, particularly in Caterpillar's mining operations, while digital applications are anticipated to have a positive impact on service growth and profitability. The company can preserve or expand its economic moat by making these investments.
Portfolio Management
As a cyclical company, Caterpillar has made wise capital allocation choices and kept a healthy balance sheet. Under the direction of CEO Jim Umpleby, the business started taking strategic steps in 2017 to improve its margin profile and lessen cyclicality. Delivering profitable growth via lean initiatives to enhance cost and expand the services business, boosting margins and generating additional revenue streams, was the overarching idea. A virtuous circle is created by the additional cash flow from these initiatives, where management reinvests capital to support and expand the product offering and distributes the excess to shareholders. Focusing on autonomy, alternative fuels, connectivity, and digital, disciplined investments are made to protect or grow the company's economic moat, which is mainly organic in nature. Because these investments are very incremental, management faces less execution risk. Acquisitions act as add-ons for manufacturing or construction technology but are not crucial to Caterpillar's expansion. The remaining free cash generated by Caterpillar is distributed to shareholders in the form of buybacks and dividends. The management team has demonstrated exceptional discipline and executional skill, and the company has sufficient financial flexibility to meet future challenges. Caterpillar thus maintains its profitability and cash generation throughout the cycle, gaining the moniker "dividend aristocrat."
