Can Caterpillar Dig its Way Out of A Poor Second Quarter?

To say that Caterpillar (NYSE:CAT) "experienced headwinds during the [second] quarter"—as CEO Doug Oberhelman did in Wednesday's earnings release—is an understatement. Earnings per share decreased 43 percent on a year-over year basis, while revenues were around $2.75 billion lower than in the previous year's quarter. Caterpillar has always been a "buy and hold" stock, but will its short-term woes create irreversible structural problems for the company down the road? Let's use our CHEAT SHEET investing framework to decide whether Caterpillar is an OUTPERFORM, WAIT AND SEE, or STAY AWAY.

C = Catalysts for the Stock's Movement

The market did not react well to Caterpillar's second quarter earnings report; shares have fallen more than 4 percent to $82.02 since the company announced earnings on July 24. The heavy equipment maker reported second quarter earnings of $1.45 a share, 15 percent lower than analysts' estimates of $1.71. Inventory reductions of $1 billion from dealers and $1.2 billion internally hurt Caterpillar's sales; however, free cash flow increased substantially from the previous year's quarter. The company stated in the report that it does not expect inventory levels to improve in the near-term and estimates a further $1.5 billion to $2 billion decline in inventory before the end of the year.

While Caterpillar manufactures equipment for construction and power systems in addition to mining equipment, weakness in the mining industry crippled the company's potential sales for the quarter. Mining companies such as Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP) have slashed their CAPEX because of decreased worldwide demand and cyclically low commodity prices. Caterpillar bears the brunt of these CAPEX cuts because, unlike new building construction, it’s relatively easy to cancel the purchase of say a Caterpillar backhoe. Caterpillar hopes to improve its long-term inventory picture by underselling in this weak market. The company is in good shape to experience organic sales growth once the mining industry recovers.

Over the long-term, Caterpillar still holds a dominant position in the heavy machinery market. Caterpillar is focusing on expanding its dealer network throughout China as the company has always been very bullish on Chinese growth. Sales to China actually increased last quarter, despite shortcomings in virtually every other market. Additionally, because of the company’s vast economies of scale in manufacturing and distribution and high barriers to entry in the heavy equipment industry, Caterpillar is relatively well protected from competition over the long-term.

E = Excellent Performance Relative to Peers?

Caterpillar stacks up well against three of its biggest competitors: John Deere (NYSE:DE), Komatsu (KMTUY.PK), and Volvo (VOLVY.PK). While these companies are not perfect competitors to Caterpillar, it may be a useful exercise to compare their key financial statistics to get a better sense of how the company performs in the overall industry. Caterpillar has a very attractive price to earnings growth ratio of 0.61, far less than the other three companies. A PEG ratio under one implies that the company is undervalued relative to its earnings growth potential. Additionally, Caterpillar has a trailing price to earnings multiple of 11.02, second only to that of John Deere. This multiple is slightly lower than that of the industry, suggesting that the company is attractively priced.

Caterpillar has a debt to equity ratio of 2.21, which seems high, but is fairly reasonable given that the industry average is 2.20 and competitor John Deere has a debt to equity ratio of more than 4. Additionally, Caterpillar has an interest coverage ratio of 6.63, meaning that its earnings can cover its interest payments more than 6 times over.

Long considered an exemplary dividend play, Caterpillar's current dividend yields an attractive 2.80 percent, compared with the industry average of 1.90 percent. The company recently announced a dividend increase of 15 percent to $0.60; this will be the seventh year in a row that the company has increased dividends. The higher dividend will take some of the bad taste out of shareholders' mouths due to the lackluster quarterly performance. Additionally, Caterpillar has announced plans to use some of this cash flow to repurchase $1 billion of stock in the next quarter, which should help soften the impact that the weak mining sector will have on the stock price.

	CAT	DE	KMTUY	VOLVY
Trailing P/E	11.02	10.22	13.64	30.51
PEG Ratio	0.61	1.11	1.26	2.86
Debt/Equity	2.21	4.12	0.54	1.77
Profit Margin	7.88%	8.51%	6.70%	2.35%
Dividend Yield	2.80%	2.40%	N/A	N/A

*Data sourced from Yahoo! Finance

Conclusion

While Caterpillar has experienced several difficult quarters, the causes have been external rather than internal—namely, a depressed mining sector leading to inventory problems. By underselling demand for the rest of the year, Caterpillar is exchanging short-term sales weakness for an attractive inventory position in the future leading to sales growth beginning in 2014. Moreover, investors thinking about going long Caterpillar can use recent weakness to buy the stock at a more attractive level than before.