Caterpillar Is Executing Well, But Shares Are Getting Pricey (CAT)

Caterpillar (NYSE:CAT) has rallied dramatically in the past 3 months, rising 47% from the 12-month low closing price of $162.44 on September 27th to the current level, $239.33. The low was established due to increasing fear of an imminent recession. The shares have returned a total of 18.0% over the past year, as compared to 14% for the farm and heavy industrial machinery industry group (as tracked by Morningstar) and -19.7% for the S&P 500 (SPY). CAT’s trailing 3-year annualized return, 19.4% per year, is 2.8 times the S&P 500’s annualized return over the same period (6.98% per year).

12-Month price history and basic statistics for CAT (Source: Seeking Alpha)

CAT reported record earnings for Q3, with EPS 25% above the consensus expected value. Earnings have recovered to, and then surpassed, the pre-COVID levels. The Q3 results were above the prevailing trend established over the previous 8 quarters. The consensus outlook for Q4 has EPS exceeding the Q3 results, with moderating growth over the next year or two. The consensus outlook for EPS growth over the next 3 to 5 years is 13% per year.

Trailing (4 years) and estimated future quarterly earnings for CAT. Green (red) values are amounts by which EPS beat (missed) the consensus expected value (Source: ETrade)

Q3 2022 revenues and sales were up 21% YoY (slide 4), with solid growth in CAT’s 3 primary segments: construction industries, resource industries, and energy and transportation (slides 11, 12, and 13). Management anticipates that price increases in Q4 will continue to exceed rising manufacturing costs (slide 16) and that sales volume will also continue to increase. The company is making notable strides in electric vehicles (EV’s), as well, with a long-term contract to provide electric hauling trucks to BHP. The company has a compelling pipeline of EV technologies (also see here).

CAT’s forward P/E of 17.2 is somewhat high compared to the range over the past decade, but not especially so. Seeking Alpha has a sector relative grade of C for the forward P/E, but an overall valuation grade of D for CAT. The rally over the last several months has made the shares expensive enough to give me pause.

CAT has benefitted from the broad market rotation from favoring growth to favoring value because CAT is a value stock. A 3-factor Fama-French analysis of CAT results in a statistically significant value loading over the past 3 years. CAT is a holding of the iShares S&P 500 Value ETF (IVE). Value stocks have greatly outperformed growth stocks in 2022. IVE has a YTD return of -6.7% vs. -30.6% for the iShares S&P 500 Growth ETF (IVW).

I last wrote about CAT on February 15, 2022, about 10 ½ months ago, and I maintained a buy rating on the shares. At the time of this post, CAT was trading at $199.52. The current price is $240.91, a gain of 21% (not including dividends). The Wall Street consensus rating on CAT was a buy, and the consensus 12-month price target was 17.8% above the share price at that time. Earnings had rebounded from the COVID-driven lows to almost the levels in 2019, and further improvement was expected. The forward P/E was about 17, higher than the pre-pandemic level. The market-implied outlook, a probabilistic price forecast that represents the consensus view from the options market, was bullish to the middle of 2023 and predominantly neutral for the full year, with an expected volatility of about 33.5% (annualized). As a rule of thumb for a buy rating, I want to see a 12-month expected return that is at least ½ the expected volatility. With the dividend, and taking the Wall Street consensus price target at face value, CAT meets this criterion.

For readers who are unfamiliar with the market-implied outlook, a brief explanation is needed. The price of an option on a stock reflects the market’s consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options at a range of strike prices, all with the same expiration date, it is possible to calculate the probable price forecast that reconciles the options prices. This is the market-implied outlook. For a deeper discussion than is provided here and in the previous link, I recommend this outstanding monograph published by the CFA Institute.

I have calculated updated market-implied outlooks for CAT and compared these with the current Wall Street consensus outlook in revisiting my rating.

Wall Street Consensus Outlook For CAT

ETrade calculates the Wall Street consensus outlook for CAT using the views of 14 ranked analysts who have published ratings and price targets over the last 3 months. The consensus rating is a buy, as it has been for all of the past year. The consensus 12-month price target is almost identical to the current share price. This situation suggests a positive long-term outlook but that the shares have priced in the next year’s expected growth.

Wall Street analyst consensus rating and 12-month price target for CAT (Source: ETrade)

Seeking Alpha’s version of the Wall Street consensus outlook is based on the views of 29 analysts who have published ratings and price targets in the past 90 days. The consensus rating is a buy, but the consensus 12-month price target is 2.8% below the current share price.

Wall Street analyst consensus rating and 12-month price target for CAT (Source: Seeking Alpha)

The Wall Street consensus outlooks calculated by Seeking Alpha and ETrade are bullish, but indicate that the shares are fully priced to reflect potential growth in the next 12 months.

Market-Implied Outlook for CAT

I have calculated the market-implied outlook for CAT for the 5.5-month period from now until June 16, 2023 and for the 12.6-month period from now until January 19, 2024, using the prices of call and put options that expire on these dates. I selected these two expiration dates to provide a view to the middle of 2023 and through the entire year.

The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for CAT for the 5.5-month period from now until June 16, 2023 (Source: Author’s calculations using options quotes from ETrade)

The outlook to the middle of 2023 is generally symmetric, with comparable probabilities of positive and negative returns of the same magnitude, although the maximum probability corresponds to a price return of 4.5% (a bullish tilt). The expected volatility calculated from this distribution is 34.8% (annualized).

To make it easier to compare the relative probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).

Market-implied price return probabilities for CAT for the 5.5-month period from now until June 16, 2023. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

This view shows that the probabilities of positive returns are consistently higher than the probabilities of negative returns of the same magnitude (the blue line is above the dashed red line over most of the chart above). This is a slightly bullish outlook, albeit less bullish than the 4.5-month outlook from my February post.

Theory indicates that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. There is no way to measure the magnitude of this bias, or whether it is even present, however. The expectation of a negative bias reinforces the bullish interpretation of this outlook.

The market-implied outlook for the 12.6-month period to January 19, 2024 has a closer match between the probabilities of positive and negative returns, but there is a range of the most-probable outcomes over which the probabilities of negative returns are elevated (the dashed red line is above the solid blue line over most of the left third of the chart below). Given the expectation of a negative bias, I interpret this outlook as neutral. The expected volatility calculated from this distribution is 34.7% (annualized).

Market-implied price return probabilities for CAT for the 12.6-month period from now until January 19, 2024. The negative return side of the distribution has been rotated about the vertical axis (Source: Author’s calculations using options quotes from ETrade)

The market-implied outlook is slightly bullish to the middle of 2023, but neutral for the full year. The expected volatility is stable at about 34.75%.

Summary

CAT shares have performed very well in 2022, with strong revenue and earnings growth, and boosted by a shift in market sentiment to favor value stocks. The shares have substantially outperformed the broader market for the year. CAT has turned in solid results across its 3 major operating segments in the post-pandemic period. The company’s progress on electric vehicles and related technologies is notable and furthers CAT’s position as a global market leader. The Wall Street consensus rating continues to be a buy, although the 12-month price target is almost exactly equal to the current share price. In other words, the positive outlook for the company is largely priced in. The market-implied outlook to the middle of 2023 is slightly bullish, although the outlook to the start of 2024 is neutral. I am going to maintain my buy rating on CAT for the time being, but I plan to revisit this analysis around the middle of 2023.