Caterpillar announced second quarter earnings Tuesday morning and management raised its revenue growth and EPS guidance for the year. The stock is soaring now, and, from our perspective, is solidly overvalued. We will publish a new Tear Sheet on the company soon, but here is our initial analysis of the announced numbers.
We have written extensively about Caterpillar – you can find those articles and research through this link.
The comments here compare Caterpillar’s actual results to our operational projections for the current year.
The firm generated $21.2 billion during the first half of 2017, compared to $19.8 billion during the first half of last year – an increase of 7%. In addition, the firm provided upward guidance for full-year 2017 revenues of between $42 billion and $44 billion. In contrast, our model originally forecast a range of $39 billion to $47 billion; we have since tightened our forecast range from $42 to $46 billion as a result of the guidance. The new forecast range implies revenue growth of between 10% and 20% during 2017.
Our original model (built before the release of 2016 actuals) forecast 2016 revenues to come in between a range of $38 billion and $41 billion. Caterpillar’s actual revenues came in at $39 billion – toward the worst-case end of our range.
Comparing our prior projections to actuals and also our 2017 projections to the company’s guidance, we believe our revenue model to be fairly well-tuned.
Caterpillar provides a complete Statement of Cash Flows, so it is possible to calculate 1H17 Owners’ Cash Profit (OCP) for the company as we usually do. According to our estimates, the company generated $2.5 billion of profit, implying a 2017 OCP run-rate of around $5.0 billion. In contrast, our original model forecast a range of $2.7 billion to $4.7 billion for the company.
Part of the reason for our shortfall was that our projections for 2016 OCP margin were two percentage points too low – 6% (forecast) versus 8% (actual).
When we made our original forecast, we had seen that over three quarters, the company had generated OCP margins of 6%, and so projected that profits would remain at that level. We failed to appreciate the degree to which Caterpillar management was skillful at converting revenues to profits. This is a mistake we will no longer make!
We continue to believe that Caterpillar’s OCP is being boosted by working capital gains, that may well reverse themselves before the end of the year.
Excluding working capital, there is only a $227 million change between 1H16 and 1H17 Cash From Operations – the figure on which we base OCP. You’ll notice in the figure above, the influence of an increase in accounts payable as well as a big change in accrued wages, partially offset by a decrease in receivables and an increase in inventories.
Rather than assume that this working capital situation will reverse, however, we have increased our assumptions for this year’s best-case OCP margin to 14% – a rate at which historically, has been seen only one time in the past 10 years. This profitability bump came in 2007 – the height of the boom in housing in the US and of Chinese-focused mining activities.
For 2017, our OCP range is from $4.2 billion in the worst-case to $6.5 billion in the best (OCP margin range of 10% to 14% versus an actual 1H17 OCP margin of 12%). As you can see from the figure above, historically, years that have seen a large rise in OCP are generally followed by a drop-off in the next year.
No company provides enough disclosure in its earnings announcement to accurately calculate Framework’s measure of investment spending: Net Expansionary Cash Flow.
Between the years of 2006-2015, Caterpillar spent an average of 61% of its profits on its investment spending. 2016 spending fell to 3% of profits. In contrast, we are expecting the firm to gradually increase its investment spending over the next five years to return to a level of historical normality.
During the first half of the year, Caterpillar actually increased its cash flow by about 41% through its investments (e.g., it generated more in sales of businesses than it spent in the acquisition of businesses and collected payments from distributors greater than the amount it loaned out). This means that our estimate of Caterpillar’s actual Free Cash Flow to Owners (FCFO) is higher than our estimate for OCP.
While our FCFO projection is lower than the actual so far this year due to this “calling in the chips” dynamic, we believe that our projections over the long-term are probably in the right ball-park.
The sum of our model’s worst-case FCFO over the next five years is $12.2 billion and the sum of our best-case FCFO is $23.3 billion during this period. In contrast, the firm generated $12.0 billion of FCFO in aggregate over the last five years and $17.9 billion over the last 10 years.
Our model takes a statistical look at historical patterns in Caterpillar’s growth and we still believe this pattern will hold going forward. As in our previous model, we do not believe that worst-case revenue growth in the short-term will be followed by worst-case FCFO growth in the medium term. Conversely, we also believe the combination of best-case short-term revenues followed by best-case medium-term FCFO growth is impossible, so we are leaving our medium-term assumptions as they are.
If it is true that we are in a period of relatively rapid growth, the most likely valuation range is between $67 and $112 per share, with an equally-weighted average of these scenarios at $88 per share. We will update Framework members with a new Tear Sheet on Caterpillar very soon.