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Morningstar | Caterpillar's Restructuring Produces Significant Gains. See Updated Analyst Note from 09 Oct 2018

We are raising our fair value estimate for Caterpillar to $178 per share from $125. Much of this increase is due to substantial operating performance improvements in the past two quarters aligned with management’s clearly articulated strategy. Hence, our opinion of Caterpillar’s long-term prospects has improved significantly. With this new information in hand, we currently view the stock as undervalued.

Under the leadership of Jim Umpleby, who became CEO in 2017, Caterpillar has significantly improved its operating performance. Through its new operations and execution strategy, the company improved margins through better asset allocation and lean manufacturing. While sales dropped 43% from 2012 to 2016, Caterpillar was able to cut costs and streamline operations. Through these restructuring efforts, Caterpillar has emerged from the longest downturn in its history leaner and stronger. This shows up in a dramatic increase in operating margins that we estimate will be 16.3% in 2018 versus 13.8% in the company's highest revenue year, 2012.

Caterpillar benefits from its strong brand and extremely broad portfolio of products. We believe its recent approach of providing lower-cost equipment for emerging markets is a wise strategy. We are enthusiastic about Caterpillar's technology advances, which should allow the company to maintain its market-leading position. Our analyses of several end markets suggest that many of the geographic/segment combinations are far below peak revenue levels.

In recent years, Caterpillar has reduced manufacturing floor space by 25%, or 20 million square feet, and trimmed its head count by 16,000, or about 14% of its workforce. Between 2012 and 2017, it reduced total assets from $57.9 billion to $48.5 billion. During this process, it consolidated or closed 30 facilities. Many of these locations were older, inefficient operations including former Bucyrus facilities. At the same time, quality has improved by 40%. We view the asset rationalization as wise, providing for durable returns. More important, these changes give Caterpillar a more flexible cost structure to respond to a variety of competitive threats. We think its cost paring is mostly permanent.

Caterpillar exhibits the cyclicality we expect from a business that focuses on resources and construction. However, neither the segments nor geographic regions are completely synchronized. It is also helpful that the significant installed base provides a steady stream of parts revenue. While the high-margin parts revenue is not reported by Caterpillar, we know that product support (parts and service) can account for more than 50% of revenue at dealers.

We envision that most heavy equipment will become progressively more sophisticated, principally through digital technology. Currently, Caterpillar has 700,000 connected devices with solutions like Cat Connect for construction industries and Minestar for resources industries. The strength of these technology platforms will help Caterpillar gain a larger share of its customers’ wallets by fostering the adoption of new services like fleet monitoring.

In the future, autonomous vehicles will play a bigger role in the mining and construction industries, and we think Caterpillar’s technology leadership will place it in an advantageous position. More important, market penetration of autonomous construction and mining vehicles is currently extremely low. We estimate that even in the most common use for Cat's autonomous technology, operating large mining trucks, market penetration is approximately 1.5%.

Longer term, demographic trends are in Caterpillar’s favor. Global GDP and population are growing while more people are moving to urban areas. Oxford Economics estimates global infrastructure spending should increase 2.8% annually until 2040. In the United States, the American Society of Civil Engineers rates America’s infrastructure at a D+. Much of the world lives in poverty, lacking access to modern infrastructure like permanent housing structures, paved roads, and indoor plumbing. The World Bank estimates that 13% of the world’s population lacks access to reliable electricity. Caterpillar stands to play a vital role in bringing growth and development projects to fruition.