Long-term investors in caterpillar (CAT 0.62%) already know that it’s a cyclical company whose revenue and profit margins fluctuate with its end markets. That knowledge won’t stop traders from guessing the timing of the cycle. While that’s fine, longer-term investors will want to focus on the key things that can change Caterpillar’s long-term value. So here’s a look at one of them.

Economic changes in Caterpillar’s ​​sales, margins and profit

First, a graphical representation of Caterpillar’s cyclical sales is helpful. Note that operating profit margin tends to follow sales, leading to wild swings in profits. When spending on equipment in construction, mining, energy, and transportation booms due to strong construction activity, relatively high mining raw material and energy prices, and transportation spending, Caterpillar’s profits rise; and they collapse when those markets reverse.

CAT sales data (TTM) from YCharts

Most investors are aware of this and should therefore consider the following points:

• Taking cyclicality into account, management’s forecasts assume different results in terms of sales and margins.
• Investors should not evaluate Caterpillar based on its peak earnings, nor should they do so based on its bottom earnings. A balanced approach is needed.

Caterpillar economic forecast

Management provided a range of operating margins depending on revenue in its 2022 Investor Day presentation and also said that free cash flow (FCF) generation will be between $4 billion and $8 billion during the cycle.

In the fourth quarter of 2023, management saw fit to raise the upper bound of the margin range by 100 basis points (100 basis points equals 1%). The new ranges are shown below. In addition, management increased its full-cycle FCF estimate to $5 billion to $10 billion.

Data source: Caterpillar presentations.

Management forecast for 2024

Caterpillar’s recent results were mixed. Management now expects 2023 revenue to be slightly below the reported $67 billion, but “adjusted operating margin will be above the high end of the target range.”

Consequently, Wall Street analysts are forecasting revenue of $66 billion in 2024. Now let’s look at some numbers to see the importance of margin spreads and the changes mentioned above. As you can see below, the Wall Street consensus (in line with management’s most recent guidance) implies earnings that are 19% higher than the earnings implied at the midpoint of the investor day guidance in 2022.

Operating margin expansion is important, and if Caterpillar can maintain this momentum, management could raise its expectations for margins and FCF throughout the cycle.

Data source: Caterpillar presentations, author’s calculations.

To illustrate how this might affect valuations, let’s look at FCF (a function of earnings and profit margin). One way to avoid the pitfalls of using peak or trough earnings or cash flows is to value Caterpillar at the middle of its FCF forecast. In this case, that’s the midpoint between $5 billion and $10 billion, or $7.5 billion. For example, taking 20x FCF gives a target market cap of $150 billion, or 6% below the current market cap.

However, Caterpillar’s margin and FCF expectations could increase over time, leading to valuation expansion and upside potential for the stock.

Image source: Getty Images.

Are margins and free cash flow generation increasing at Caterpillar?

As mentioned, this is a down year for revenue, but margins are above the target range provided in Q4 2023. One reason for this is the fantastic job Caterpillar is doing in price realization in terms of operating profit, which represents the additional profit made by increasing the price of the same product and is different from the additional profit made by selling multiple products at the same price (sales volume).

The following graph shows how price realization was able to profitably offset the decline in sales volume, even when total sales became negative.

Data source: Caterpillar presentations.

To be clear, management expects price realization in the third quarter to be “flat year-over-year due to improved product availability.” Nevertheless, the outlook for margins above the upper end of the range shows how strong price realization has been this year.

However, given the amazing price performance and the resulting improvement in margins and cash flow, it is possible that Caterpillar will see a structural improvement in its margins, which could lead to an uptrend for the stock.