Caterpillar: Near-Term Consolidation Probable

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The stock traded down about 3% after posting an $0.18 beat, about in line with buy-side expectations. Overall expectations were elevated going into the quarter, based on strength in North American production of construction equipment, though recent overall retail sales softness reined them in. Although Caterpillar raised the EPS guidance for the year by $0.10, it reduced the revenue outlook to the low end of the prior guidance range because of softness in emerging markets that has led to dealer inventory reductions and is offsetting strength in developed markets such as in North America.

The new revenue midpoint is $55 billion, compared with the prior $56 billion sales forecast. The $1 billion reduction is almost exclusively due to emerging market weakness, such as in China, Brazil, and the Middle East. Although the stock reacted negatively today, we see limited downside, due to an expected improvement in retail sales and dealer inventory reductions that should be right-sized by year-end. Overall retail sales and dealer inventories could finally become a tailwind next year. These opportunities, along with continued favorable capital allocation, would suggest that solid EPS growth potential for next year still exists.

Also, we expect continued growth in the pockets of the market like North American construction to be favorable. North America unit volumes are still about 20% below the prior peak and have been recovering cyclically. Given a depressed mining environment and further dealer destocking, this sets up for easier comparisons next year. We maintain our full year 2014 and 2015 estimates, reaffirm our Outperform rating, and reiterate our $118 price target. Our price target represents 16 times our 2015 EPS estimate of $7.25. The group has historically traded at around 10 times peak, 15 times midcycle, and 20 times trough earnings.

Taking the company as a whole, we believe a midcycle multiple is appropriate, given that mining is at trough levels and the construction and energy and transportation (E&T) segments as a whole are between midcycle and peak. We recognize that valuation is richer at these levels and note that Caterpillar had a tough time breaking $120 during the China/mining bubble. However, we do not anticipate much downside below $100, barring any huge shifts to the macroeconomic or end-market outlook. We do not believe a locomotive bear thesis is sufficient enough to negatively affect fundamentals.

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