The Big Cat Looks Good- Almost

I was running various stock screens on Saturday morning and no matter how tight I made the screen conditions based on my stated parameters, one name kept showing up, Caterpillar. Once that happens, as I have said in previous posts, you are then obligated to take a closer look. I also want to say one of the screens produced 58 companies, 53 of which have stocks prices that are up for the past 52 weeks. I really like those odds.

When you think of construction sites and of the machines you see at them what comes to mind? Me too, Caterpillar. Investing in construction of either homes, roads, cities, or anything else that involves big heavy stuff being moved begins and ends with Caterpillar. That gives it a durable competitive advantage which is something I have mention in conjunction with Cat in a previous post.

Let's look at some Cat numbers to see how well it stacks up against what we are looking for: The following are total amounts followed by (annual averages)

5 yr. earnings growth: 345% (69%)
Shares outstanding: decreased 5.3% (past 3 years)
Dividends increased: 66% (12.1%)
Cash flow from operations increased: 114% (23%)

So far so good. Let's see what is happening in the future. The Peoria, Illinois-based company said its board of directors authorized a $7.5 billion stock repurchase program, which will start when the current $6.4 billion buyback program is completed in the next few months, a year and a half ahead of schedule. Cat will have 640 million shares outstanding at the end of the current buyback authorization, Caterpillar spokesman Rusty Dunn said. With the current share price, the $7.5 billion buyback would reduce the number of shares by about 17 percent in the next 5 years (about 112 million shares). Translation? The current buyback will add about 3.5% to eps each year for the next 5 years. If you want to look at it another way, we have an 3.5% cushion in eps each year before it even starts. Remember, this amount will bounce up and down depending on the number of shares bought back in any given year. Since I do not know how much will be bought back and when (only management does) I will average the numbers out for examples. Now, it would make sense that the company would want to even out earnings in lean years by buying back more shares then, this would enhance the "buyback" effect on earnings, making them more consistent. Cat bought back $2.8 billion worth of shares last year at price levels similar to where the stock trades now so it is not unreasonable to assume another huge chunk this year.

Where does that leave us with pricing and what should we pay? Currently Cat shares trade at about $67 a share and 13 times 2006 earnings. We now need to figure earnings growth for 2007 as accurately as possible to determine if they fit our pe/eg ratio requirement of close to one. Estimates for next year are all over the place so I will give my 2 cents. This gets complicated because we need to answer two questions. First, what will eps from operations be and then, what will the effect of the buybacks have on eps? Excluding buybacks, I figure next years eps to grow to $5.45 per share or 5.4% (I am using a middle of the road estimate). Now we have to account for the buybacks. The current buyback will reduce share count to 640 million and then the new buyback begins. Assuming regular purchases, the buyback will reduce shares an additional 22.5 million in 2007 leaving a total of 617.5 million shares outstanding. This effect will push eps up to $5.73 a share or (10.8% growth) and the 2007 pe to 11.8 based on today's price. Remember, this assumes earnings essentially flat in 2007 vs 2006. Any large improvement in earnings or larger share buybacks this year (both scenarios are very probable) and these estimates look conservative. That gives us a ratio at current prices of 1.09.

What else is happening that could drive earnings?

The company is in talks to raise its stake in a construction machinery venture with Japan's Mitsubishi Heavy Industries Ltd., to beef up Caterpillar's presence in Asia. Mitsubishi said Caterpillar is looking to raise its stake in the 50-50 joint venture to about two-thirds. This would extend Cat's dominance into the world's fastest growing region.

Much has been said about Cat's ties to the US housing market and yes, it will be effected by it. But, if we are looking to purchase Cat for a long term investment (we are), we can honestly only view it in terms of the world's growth. Cat is rapidly expanding its presence in China and the rest of Asia. This is key as growth there has outstripped the current ability of those areas to provide infrastructure for that growth. This is where Cat comes in. In China, Cat has said they expect sales to quadruple as a percentage of its global sales by 2010 (up to 10%) as the country rapidly builds more ports, energy projects and roads. After a time, this growth will insulate Cat from the US housing market swings, much like international expansion has made Portfolio holding Dow Chemical less cyclical.

What is stopping me from buying now? Cat has had a big run the past month, up almost 14%. Typically after runs like this, stocks tend to retreat. Once the initial money is made, traders sell the stock and move on to the next thing. Important point, these are traders and not investors. We will wait for the price of Cat to come back down and settle before buying. Now, the caveat as always is it may never come down and we may never own it. I would rather that happen than buy it and then have it sell off. If you absolutely must own this stock and plan to hold it for years go ahead and buy it now. Selling at $67, shares are fairly priced but not priced great. Cat at this level is not a value, at $58 it was but that was before the buyback was announced. If my middle of the road estimate is too high then shares fall from here, if it is low they go up. The risk / reward is evenly balanced. To minimize this risk and tilt the balance in my favor I will wait for a great price, one that prices in the potential for an earnings miss. "What price is that" you ask?

Cat is currently another high fastball. Shares are priced fairly for 2007's growth after the recent run. I need to have shares at about $62 (7% lower) before I pull the trigger. I will add it to the watch list and we will see what happens. Let's this fastball come down in the strike zone before we swing...