Why Caterpillar Is the Cat’s Meow Right Now

Infrastructure spending has a long timeline. The U.S. Infrastructure and Jobs Act is expected to fuel increased domestic investment in capital equipment. The legislation includes around $550 billion in new federal investment in America’s roads, bridges, and water infrastructure, plus rural broadband and resilience efforts to address the impact of climate change on communities.

The tragic war in Ukraine will also unleash a torrent of machinery demand in multiple sectors. Governments and industries worldwide are scrambling to replace the disrupted Russian commodities supply chains, leading to incentives for companies to expand commodity production in mining and energy.

Higher demand for renewables promotes substantial construction growth in solar energy and wind power as well. Farm machinery is another source of strength, especially with higher prices for agricultural commodities due to limited export supply from Ukraine and Russia. Lastly, it’s more than wishful thinking to expect a “Marshall Plan” to reconstruct Ukrainian cities after the war, funded by nations around the globe.

How can investors play all this?

Durable economic trends have generated strong demand for Caterpillar’s (CAT) machinery, and these trends will continue for years to come. What’s more, the stock is reasonably priced with plenty of upside as robust demand and earnings growth are far from fully baked-in.

In an upgrade of CAT earlier in March, Jefferies noted, “Recent turmoil in Eastern Europe fundamentally reshapes global commodity markets, driving structurally higher pricing and after years of underinvestment capacity additions and supply diversification will be necessary in both mining and oil & gas sectors, though new projects will take time. CAT has historically been a strong hedge to commodity and general inflation. We increase our rating to BUY from HOLD and increase our price target to $260.”

Strength in residential construction has also driven demand for construction equipment. Although mortgage rates have increased meaningfully, housing inventory is low and demand is still firm. Nonresidential construction is likely to see a boost from various government incentives and funding to build manufacturing plants domestically. Auto makers and chip producers are spending significant sums to build out capacity.

Another essential trend is the push to mitigate environmental impact. Caterpillar’s customers are focused on reducing the carbon intensity of their operations, and seek the low-carbon vehicles the company has developed. For instance, Caterpillar has a deal with Newmont (NEM) to deliver fully automated zero-emission mining equipment.

Meanwhile, Caterpillar’s burgeoning services business is a continued growth driver, with plans to double revenues over seven years to $28 billion by 2026. CAT has over 500 software-enabled mining trucks operating autonomously at various quarry sites, leading to higher machine utilization and productivity.

Almost all of Caterpillar’s free cash flow is returned to shareholders via dividends and buybacks. The $5 billion returned in 2021, split between a 2% dividend yield and a $2.5 billion in buybacks, amounted to about a 4% total return.

Like most manufacturers, Caterpillar is experiencing commodity inflation and higher freight costs, leading to margins pressure. But Caterpillar’s management expects more operating efficiency when demand can be met as supply-chain bottlenecks abate. Still, Caterpillar has been able to pass along price increases, mitigating higher input costs.

Business in China has been one of the few soft spots. Indeed, an overbuilt residential construction sector may be an overhang. Some stimulus is expected from the Chinese government that will offset much of the weakness.

With Caterpillar’s demand exceeding supply due to supply-chain constraints and visibility for robust demand stretching for years, the business cycle is likely to be elongated. CAT shares should benefit as industry trends favor its machinery while the company has room for operational improvements. Strong earnings and cash flow at a reasonable 18 P/E make this stock one to own.