1 Key Number That Could Send Caterpillar Stock Higher

Long-term investors in Caterpillar (NYSE: CAT) already know it's a cyclical company whose revenue and profit margins bounce around with its end markets. That knowledge won't stop traders from trying to guess the timing of the cycle. That's fair enough, but 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.

Caterpillar's cyclical revenue, margins, and earnings

First, a graphical depiction of Caterpillar's cyclical revenue is useful. Note that its operating profit margin tends to follow revenue, leading to wild swings in its profits. When construction, mining, energy, and transportation spending on machinery is booming in response to strong construction activity, relatively high mining commodity and energy prices, and transportation spending, Caterpillar's profits boom; and they slump when these markets reverse.

CAT Revenue (TTM) data by YCharts

Most investors know this, and the following points should be noted:

• Acknowledging the cyclicality, management's guidance includes a variety of outcomes for revenue and margins.
• Just as investors shouldn't price in a valuation for Caterpillar based on peak earnings, they shouldn't do so for trough earnings; a balanced approach is needed.

Caterpillar's cyclical guidance

Management gave a range of operating margins as a function of revenue in its Investor Day presentation in 2022, and it also said that free cash flow (FCF) generation through the cycle would range between $4 billion and $8 billion.

Fast forward to the fourth quarter of 2023 and management saw fit to raise the high end of the margin ranges by 100 basis points (100 basis points equals 1%). The new ranges are shown below. In addition, management raised its estimate for FCF through the cycle to between $5 billion and $10 billion.

Data source: Caterpillar presentations.

Management's 2024 guidance

Caterpillar's recent results were mixed. Management now expects revenue to be slightly lower than the $67 billion reported in 2023 but "adjusted operating profit margin to be above the top end of the target range."

Consequently, Wall Street analysts are assuming $66 billion in revenue for 2024. Now, let's crunch some numbers to see the significance of the margin ranges and the abovementioned changes. As you can see below, the Wall Street consensus (in line with management's latest guidance) implies a profit that's 19% above the profit implied in the midpoint of the guidance on the investor day in 2022.

The increase in operating margin matters, and if Caterpillar can maintain this momentum, its management could raise its expectations for margins and FCF throughout the cycle.

Data source: Caterpillar presentations, calculations by author.

To illustrate how this might impact valuations, consider FCF (a function of profit and profit margins). One way to avoid the dangers of using peak or trough earnings or cash flow is to price Caterpillar at the midpoint of its FCF guidance. In this case, it's the midpoint of $5 billion to $10 billion, or $7.5 billion. Using a multiple of, say, 20 times FCF gives a target market cap of $150 billion, 6% below the current market cap.

However, Caterpillar's margin and FCF expectations could rise over time, leading to a valuation expansion and upside for the stock.

Image source: Getty Images.

Are Caterpillar's margin and free-cash-flow generation rising?

As already noted, this is a down year for sales, but margins are coming in above the target range given in the fourth quarter of 2023. One reason for this comes down to the fantastic job Caterpillar is doing with price realization in terms of operating profit. This represents the incremental profit generated by raising the price of the same product and is distinct from the incremental profit from selling more products at the same price (sales volume).

The chart below shows how price realization offset sales volume declines in terms of profits even as overall sales turned negative.

Data source: Caterpillar presentations.

To be clear, management expects "flattish price realization in the third quarter versus the prior year due to" improved product availability. Still, the outlook for margins to exceed the high end of the range illustrates how strong price realization has been this year.

However, given the startling performance on pricing and how that translates to improved margin and cash flow performance, It's possible Caterpillar could be seeing a structural improvement in margins, which could lead to an upside for the stock.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.