Caterpillar, Inc. November 17, 2015 Industrials Heavy Machinery Stock Rating Buy Investment Thesis Target Price $84-86

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1 The Henry Fund Henry B. Tippie School of Management Alec Davis Caterpillar, Inc. November 17, 2015 Industrials Heavy Machinery Stock Rating Buy Investment Thesis Target Price $84-86 Global macroeconomic factors have created severe headwinds across a majority of Caterpillar s markets, however business cyclicality is nothing new to this 90 year old company. Caterpillar has proactively moved to cut costs ahead of forecasted downturns and has managed to protect margins. The current price offers an attractive entry point for an industry leading blue chip manufacturer that is well positioned to weather the storm, and the board s recent affirmation of the dividend payout, currently at 4.3% yield, provides downside protection in the event market weakness persists longer than anticipated. Drivers of Thesis CAT is a market leader and continues to grow share while cutting costs during downturn in business cycle. The company s focus on Lean operations and reducing management headcount will make it better positioned for growth when the cycle turns. 2Q2015 cash flow from manufacturing operations of $1.6B remains strong despite double digit sales decline, indicating cash is not a concern. CAT is a leader in many of its markets, and with R&D spending over $2B has the ability to earn a premium through innovative and next generation products. Risks to Thesis 2016 is poised to be the first 4 year sales drop in the company s history, and has seen multiple recent downward revisions of revenue estimates. Global economic weakness threatens growth prospects across all industries, and weak commodity and energy prices will remain a drag on sales for several years at least. A strong dollar has increased competition domestically as global industrial manufacturers look to gain market share in the US. Important disclosures appear on the last page of this report. Henry Fund DCF $84.42 Henry Fund DDM $72.09 Relative Multiple EPS $74.17 Price Data Current Price $ Week Range $62.99-$ Consensus 1 YR Target $70.48 Key Statistics Market Cap ($B) Shares Outstanding (M) Institutional Ownership Five Year Beta 602.6M 67% 1.24 Price/Earnings (ttm) Price/Earnings (FY1) Price/Book (mrq) 3.31 EV/EBITDA 5.47 Profitability EBITDA Margin 15.39% Profit Margin 6.70% ROIC (ttm) 10.83% Return on Equity (ttm) 19.60% Source: Factset Earnings Estimates 0 Year E 2016E 2017E 2018E P/E ROE EV/EBITDA 12 Month Performance EPS $5.87 $5.99 $3.61 $3.57 $3.80 $4.46 growth % 2.04% % -1.11% 6.44% 17.37% Source: Factset Company Description 50% 30% 10% -10% CAT S&P 500 Caterpillar Inc. is a global manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. Its business segments include Energy & Transportation, Construction Industries, Resource Industries, as well as offering -30% -50% financing solutions through its financial products division. The company has operations in 36 countries and is headquartered in Peoria, Illinois. O N D J F M A M J J A S Source: Yahoo Finance CAT Industry Sector

2 EXECUTIVE SUMMARY Caterpillar is a global heavy-equipment manufacturer and blue-chip American company. The company has experienced severe headwinds across all business units due to macroeconomic factors, but remains committed to cutting costs and protecting market share and margins during downturns in the business cycle. We believe management has the foresight to accurately pair operational capacity with future demand and the focus on lean manufacturing and cutting management headcount will prove beneficial for the future. Additionally, CAT continues to invest in R&D and next generation products to meet tighter emissions standards and incorporate the newest product technologies. Given this, we anticipate CAT will maintain its market leader position across a majority of its business segments. Although top line growth will be limited over the 5-year forecast horizon, only returning to meager growth of less than 1% in 2017, the current price offers an attractive entry point for this industry leader and we believe management is capable of extracting maximum economic output from an otherwise soft demand environment. The recent affirmation of the company s dividend payout by the board of directors is a reflection of the company s strong cash flow during this downturn, and at a 4.3% yield, the dividend offers protection against further downside risk. Company Description Caterpillar Inc. is a global leader in heavy machinery manufacturing for the construction, transportation and mining industries. Founded in 1925 in Peoria, Illinois, the company has grown to over $50 billion in sales over its 90 year history. The company has 2 principal reporting segments. The Machinery, Energy and Transportation segment represents the majority of revenues and encompasses the entirety of Caterpillar s manufactured products. This unit is further subdivided into Energy & Transportation, Construction Industries, Resource Industries, and All other Segments. financial product segment includes Caterpillar Financial Services, Caterpillar Financial Insurance Services, and their respective subsidiaries. This segment plays an important strategic role in providing financing for customers that might otherwise not be able to obtain it. REVEUNE BY SEGMENT (2014) Financial Products All Other Segments 6% 4% Resource Industries 16% Construction Industries 35% Energy & Transporta tion 39% Source: CAT K Energy & Transportation and Construction have been the traditional largest business segments for Caterpillar. The company s 2011 acquisition of Bucyrus International for $8.8 billion significantly strengthened its position in the mining equipment space, now reported under Resource Industries. Caterpillar competes globally across its various markets. Emerging markets have driven a majority of the growth in the past decade, however this trend has reversed recently due to global economic slowdown and North America has again grown slightly as a percentage of sales. REVENUE BY GEOGRAPHY (2014) Latin America 12% Asia/Pacific 20% EMEA 24% North America 44% Source: Bloomberg Caterpillar s other reportable segment is its Financial Products segment, which primarily provides financing resources for purchases of Caterpillar equipment. The Page 2

3 Company Analysis Globally Caterpillar is a major competitor and market leader in a majority of business segments. The company has increased its revenues and market share over the past decade through a combination of organic growth and strategic acquisitions, most notably the 2011 purchases of Bucyrus International and ERA Mining Machinery Limited (China). The company competes in heavy and advanced machinery industries that require significant capital investment in both manufacturing and R&D. Current R&D expenditures are around $2.1B per year, and we forecast this dollar amount to remain relative stable to moderate growth given the commitment to innovation and need to develop products in compliance with tighter emission standards. Caterpillar products are sold through a worldwide network of independently owned and operated dealers. The size and scope of this dealer network is strategic advantage relative to other global heavy equipment manufacturing companies. By Caterpillar s estimates, there are 177 global dealers that collectively employ 160,000 people and are worth over $23 billion. Caterpillar Dealer Network Energy & Transportation The Energy and Transportation unit makes up the largest share of Caterpillar revenues. It sells reciprocating engines, turbines, diesel-electric locomotives, integrated solutions and related parts to the oil and gas, power generation, industrial, marine and rail industries. Demand for Energy & Transportation products has remained strong for Caterpillar over the past few years despite slowdowns in other areas of its operations. The recent drop in energy prices and subsequent reduction in related capital expenditure spending will put downward pressure on this segment in the short term. Our outlook for the E&T segment is negative for the next two years, with the segment returning to single-digit growth in 2018 as energy prices begin to rebound. Construction Industries The construction industries segment sells construction related products such as tractors, loaders, shovels and other equipment to the heavy construction, general construction, rental, mining and quarry and aggregates markets. Recently, global economic weakness and slowing development in China have hurt sales of construction industries products, however strength in US residential construction and private investment in North America has mitigated some of these effects. We forecast single-digit decline in sales in 2015/2016 and with slow growth beyond that as emerging markets recover from the current economic downtown and US and European sales remain stable. Source: August 2015 Investor Meeting Presentation Caterpillar maintains strong relationships with its dealers, incentivizing them to develop and promote the sale of its equipment in their respective territories. This relationship allows Caterpillar to focus on manufacturing operations and product development as its core strengths. Recently Caterpillar has focused on improving the capabilities and performance of its dealers as a strategic means for adding growth in weak markets. Resource Industries The resource industries segment sells trucks, tractors, loaders, drills and other equipment to the mining and quarry industries. With its acquisition of Bucyrus International, Caterpillar is able to offer the broadest product range in the industry. The mining segment has suffered severely from the fall of commodity prices related to mining activity over the past few years and continues to see double digit decline in sales annually. The trend has been significant to Caterpillar s sales, and we forecast sales to continue to decline by 29% Page 3

4 and 9% over the next two years, bringing Resources sales down to almost a quarter of peak levels from Caterpillar states that current sales level are below even replacement levels for mining equipment, and due to the extreme nature of the product uses, we expect a reinvestment cycle to begin in 2017 or 2018, leading to moderate sales growth of 3% and 5% in 2018 and All Other Industries Forestry, paving, industrial and waste customers were moved to the All Other Industries reporting segment in 2014 due to an internal reorganization. Although this segment accounts for less than 5% of revenue, the products are still core to Caterpillar s operations and market positioning. We forecast a decline for this segment over the next two years consistent with management guidance, and moderate 3-4% growth following as global economic activity and reinvestment cycles spur sales. Across its primary manufacturing product segments, the Energy & Transportation group produced the highest operating margins in 2014, primarily due to stronger global demand relative to Construction and Resources. 20.0% 15.0% 10.0% 5.0% 0.0% Operating Margin by Segment 2014 Energy & Transportation Construction Industries Resource Industries Source: CAT K While recent weakness in Energy & Transportation will hurt pricing margins in 2015, we forecast this to be more than offset by previously enacted cost cutting measures and lean manufacturing initiatives. Overall we expect equipment margins to improve slightly over the forecast window as the company makes necessary cuts to production and invests in lean manufacturing initiatives to improve quality and efficiency. Financial Products Caterpillar financial and insurance products account for 6% of revenue and have historically played a key strategic role in financing the purchases of Caterpillar products for customers who otherwise would not be able to obtain funding. The group maintains a match funding policy to match financial assets and liabilities in duration and interest rates, as well as interest swap agreements to minimize interest rate risk. The financial arm of Caterpillar has been a stable and secure means of boosting overall company revenues and profits over the years. Revenues from the financial products group have continued to grow even as machinery sales shrank over the past few years as a tighter credit market have helped pushed customers towards OEM financing. We forecast the financial products group to have a low single-digit decline over the next two years before beginning to grow again in line with overall equipment sales. Recently, global industrial conglomerate General Electric announced the sale of its finance unit, GE Capital, to Wells Fargo. Caterpillar has not state any intentions of spinningoff its finance unit, and we support this continued operations given the strategic link between the finance and machinery operations. Recent Developments Revenue Revision & Layoffs Announced On September 24 th Caterpillar announced a revision in 2015 revenue from $49B to $48B as well as restructuring and cost reduction initiatives that will result in the layoff of up to 5,000 salaried employees by the end of The announcement comes as Caterpillar is experiencing weakness across a majority of its industries due to a combination of global market effects, and included a forecast of 2016 revenues of 5% below 2015, indicating a strong possibility for revenue to fall four consecutive years for the first time in company history. The economic news has been almost entirely bad for Caterpillar over the past 18 months, but business cyclicality is nothing new to the company. We support management s decision to tighten the belt ahead of Page 4

5 continued business weakness and maintain profitability and flexibility in leaner times. Our model incorporates the projected savings of $1.5B for 2015 and 2016, with almost half being attributed to SGA costs. Also included is $800M in restructuring charges for 2015, along with an additional $300M in 2016 and decreasing to $100M for the final two years. We anticipate further restructuring and reorganizations will be needed, though much smaller in scale, as the company looks to match operations with the demand outlook. The employee count has been dropping since hitting a high of 132k in the second quarter of 2012 following the postrecession boom, and historically management has demonstrated a strong ability to weather economic downturns. We expect reorganizations and capacity adjustments to help slow the tide of backlog reductions, but any further economic weakness could jeopardize revenue stability. Commodity Prices Drop The drop in commodity prices has severely impacted Caterpillar sales, most notably in the mining and quarry segments. The large commodity super cycle fueled by Chinese growth over the past decade has now sent the Bloomberg Commodity Index, a measure of 22 raw materials, to its lowest level in 22 years. Sales in the Resource Industries segment are down over 50% since their 2012 peak. Bloomberg Commodity Index Total Return CAT Employee Count Source: Google Finance Source: Bloomberg The most significant risk to the company s outlook is the recent decline in the order backlog. While Caterpillar was able to maintain a stable backlog in 2013 through the first half of 2014, the decline in energy markets has hurt its oil & gas business and forced the company to start to burn through its order backlog Order Backlog (US $B) Investment in mining related activities has fallen sharply, and global equipment supplies to this space have suffered as a result. We expect sales to remain relatively flat over the next two years, with a possibility for pick-up 2017 or 2018 driven both by an anticipated rise in commodity prices and a reinvestment cycle due to machinery depreciation in rugged operational conditions. The commodity price drop has a silver lining for Caterpillar, as raw material inputs make up a large portion of operational expenses, and thus the company enjoys a limited natural hedge related to business tied to commodity prices. Lower raw material prices for items such as steel have helped reduce variable costs during times of reduced production, helping to ease pressure on margins due to related sales drop. Source: CAT 10Q filings Page 5

6 Mining Machinery LTD, as well as the 2013 merger between Fiat Industrial SpA and its majority owned subsidiary CHN Global NV to form CNH Industrial NV. In 2013 Japanese equipment manufacturer Komatsu LTD purchased distributor Midlantic Machinery to increase its presence in the US. Komatsu is the number 2 global manufacturer of mining and construction equipment behind Caterpillar. Caterpillar Maintains Dividend Source: Ibisworld.com Caterpillar has paid a dividend every year since 1933 and has increased its dividend for the past 22 years. On October 14 th the board of directors voted to maintain the current quarterly dividend ($.77) despite the decline in revenues and weak economic outlook. This comes on the heels of a 10% increase in the dividend in June Since 2007 cash dividends for Caterpillar has more than doubled. We forecast the firm s payout ratio to grow above 80% for 2015 through 2017, and remain above 70% for the remainder of our forecast window, however dividend growth will be a modest 3-5% each year. This will be achievable through both free cash flow generation from operations, and reducing capex to minimal maintenance levels over the next several years. We view Caterpillar s latest dividend announcement as a positive reaffirmation of the company s ability to tighten the belt during downturns in the business cycle and continue to generate strong cash flows. Any indication that Caterpillar will cut its dividend, which currently offers a 4.3% yield, would be viewed as a negative warning sign for future profitability and cash flows. The consolidation trends have led to larger international players who must compete aggressively against one another to win business and offer diverse product ranges, we believe Caterpillar s commitment to product development and its dealer network give it an advantage over these international competitors. The company has the largest distributor network in the world amongst its competitors, and has managed to improve its product standing since 2010 despite the overall negative sales environment. The strength of the dollar compared to global currencies, most notably the Yen, has hurt Caterpillar to a degree, but the company s commitment to international operations and matching operating expenses geographically with revenues has allowed it to minimize these impacts. Slightly less than half of Caterpillar s workforce is located outside of the United States Trade Weighted Dollar Index INDUSTRY TRENDS Increased Globalization Mergers and acquisitions have driven increased globalization and consolidation in the heavy manufacturing industries as several major powerhouses compete for market share. Major acquisitions include Caterpillar s purchase of Bucyrus International and ERA Source: stlouisfed.com The strength of the dollar does pose a larger threat domestically however, as international competitors such as Komatsu now find their products relatively cheaper to sell in the United States. This currency effect will provide a drag on earnings going forward, however we believe the strength of Caterpillar s US position will allow it to mitigate most of this effect. Page 6

7 Non-Road Diesel Emission Standards The US Tier 4 emissions standards for non-road diesel engines have been under rolling implementation since These regulations, and similar ones in Europe, have driven a large degree of product development throughout the industry. The final stages of the new standards will be in effect as of August Product development for these standards drove a majority of R&D spending in the Construction Industries segment at Caterpillar in 2014, and we forecast the company will continue to invest in R&D at similar levels moving forward. Global regulations are in varying degree of harmonization with US laws, and similar to most environmental issues, are most advanced in the EU and other industrialized nations. While we view increased regulation of non-road diesel engines as a positive development for Caterpillar given the lack of alternative power sources and the company s capability of developing market leading next generation products to meet new standards, there has been one notable area where the company has lost ground to competition. The company, which entered the locomotive space with its 2010 acquisition of Electro-Motive Diesel, has stated that its tier 4 compliant long-haul locomotive engine will not be ready for sale until 2017, while rival GE is currently in advanced testing stages for its locomotive. Caterpillar has seen weak locomotive sales thus far in 2015 according to management, and the early indication may be that there has been higher early demand for next generation engines. It s too early to make a full determination on this product battle, but we recognize the potential for this to be a missed opportunity for Caterpillar s product development team. This would be a strategic and symbolic loss for a company that is known for top of the line products and constant innovation. Dealers are increasingly becoming involved in equipment rental as well as service and fleet maintenance, and the latest generation models are capable of providing a wealth of data on performance and service needs, increasing the scope and opportunity for both service and preventative maintenance. Caterpillar and other large equipment manufacturers would prefer that customers purchase new equipment, but as industry trends change, the company must adapt to the trend towards equipment rental. The American Rental Association estimates that the % of construction equipment rented in the US has increased from 40% to 54% over the past decade. We expect this trend to continue, though at a more moderate pace. Caterpillar has responded to these developments with its 2014 initiative Across the Table, in which it will focus on improving dealer performance in these areas and creating new incentive metrics for dealers. Given the strength of Caterpillar s global dealer network, this has the opportunity to yield positive results in an otherwise weak economic environment, however the challenge in getting performance alignment across such a varied network remains strong. Specific areas of improvement that we believe will add the most value to Caterpillar from this initiative will be standardizing service standards across the network in order to better serve large multi-national customers, and increasing incentives for dealers to sell top-tier service and fleet management contracts, which allows Caterpillar better access and control to selling parts and repair solutions. The company has identified an additional $18B of potential revenue through its dealer distribution network, although the specific breakdown of dealer versus company impact has not been disclosed. Expanded Role of Dealers The market for heavy machinery continues to evolve, and this expanded scope has put more emphasis on the companies involved in the distribution and maintenance of the equipment. While traditionally manufacturers employed a distribution network to sell their equipment to local customers in each geography, this role now includes and expanded scope of responsibilities. Source: 2015 Investor Presentation Page 7

8 We believe continuing to build on the strength of its network and working to develop additional revenue streams through these channels will be important to adding growth in otherwise weak demand environments. While this will undoubtedly put more pressure on Caterpillar dealers, we believe the strength of the brand will allow it to maintain these relationships will increasing mutually beneficial results. Markets and Competition Caterpillar primarily competes in mature, competitive markets with moderate to high barriers to entry. Within these markets, product differentiation, customer relationships, and pricing are all key factors in securing business. Caterpillar is a leader in many of these key areas and thus has been able to secure growth both domestically and internationally. Competition can vary from a variety of small regional players to large international corporations such as John Deere, Komatsu LTD, CNH Industrial NV, Cummins Inc., Baker Hughes Inc., and National Oilwell Varco Inc. On average, the heavy machinery manufacturing sectors are moderately concentrated, with large internationals such as Caterpillar competing with peers as well as smaller regional and niche producers. There is an increasing trend of market consolidation, primarily through acquisition in these markets, and this trend is increasing due to tough economic conditions, especially in the Mining, Oil and Gas sectors. Construction Machinery Manufacturing in the US Market Share (2014) John Deere, 15.6% Caterpillar Inc., 30.9% Other, 53.5% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% Caterpillar is the market leader for Construction Machinery in the US, with only John Deere owning more than 10% of the market. Other companies include Komatsu, Terex, and CNH NV, all of which have less than 5% market share. The strength of the dollar however has led to an increase in imports within this space, and we expect their share to grow moderately moving forward. Halliburton Company, 6.5% Mining, Oil and Gas Machinery Manufacturing in the US Market Share (2014) Baker Hughes Inc., 11.4% Caterpillar Inc., 20.7% National Oilwell Varco Inc., 24.4% Other, 37.0% 0.0% 20.0% 40.0% 60.0% 80.0% 100.0% Source: Ibisworld.com Within the Mining, Oil & Gas Machinery segment, Caterpillar enjoys a strong position, and overall offers the broadest selection of products to meet these market needs. We expect Caterpillar to maintain its position in this space, however low commodity and oil prices will continue to drag on industry growth for at least 2 more years. Although Caterpillar does not compete head to head across all product lines with any one competitor, the many overlap across multiple markets. There is a high barrier to entry for many of these markets due to significant amounts of capital and technical expertise required, especially with respect to the larger, more complex product lines in mining and larger construction and engine products. Customer profile can vary across markets and geographies. Customer size can be as small as municipal governments and contractors focused on small-scale local projects, to large multinational construction or Energy companies. Caterpillar dealers tend to be larger, and better financed than their competitors, allowing them to serve a variety of customers profiles. Product sales to industrialized customers tend to focus on performance, cost of ownership and reliability, while those in emerging markets are more concreted along lower margin product lines. Recent pull backs in commodities and emerging markets have hit sales to these regions especially hard, with sales to Asia and Latin American sales falling 36% and 26% respectively since Page 8

9 Peer Comparisons Due to the large number of industries to which Caterpillar sells equipment, direct peer comparisons are difficult to make. We use a cross-section of global heavy machinery manufacturers such as CNH International NV, Komatsu, Cummins Inc., Terex, Joy Global, and John Deere Data CAT TEX DE CNHI CMI JOY Revenue ($B) Market Cap ($B) P/E ttm P/E FY EBITDA % NI (%) P/B P/FCF EV/Sales EV/EBITD A Dividend Yield % Employees (000s) Sales/Emp (000s) Caterpillar currently trades in line with most of its peers on a number of valuation metrics. Most global heavy equipment manufacturers are currently trading at low multiples due to macro conditions, and Caterpillar s entry into the mining sector has seen its shares trade lower as sales to that industry have slowed. Although 2 year forecasts for Caterpillar remain week, we like the company relative to its peers because of its strong margin positions, and more importantly its strong price to free cash flow, as the company still remains a positive cash generator even during a severe slowdown in its markets. The company is also more diversified across industries than many of its peers, while at the same time remaining a market leader in most of its segments. ECONOMIC OUTLOOK A combination of several global macroeconomic forces have has led to multiple downward revisions of 2015 revenue projections for Caterpillar, and 2016 is expected to witness a decline as well. Low commodity prices, low energy prices, and weak global GDP growth are all contributing factors. The slowdown in China has had a particular effect, not only due to the lowered demand for construction and transportation products there, but the second order effects on commodity and energy prices. 120, ,000 80,000 60,000 40,000 20,000 0 Nominal Global GDP (US $B 2010 dollars) Nominal GDP % Growth 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% Source: IMF We anticipate a return to growth globally in 2017 in line with IMF forecasts, as contractions in emerging markets begin to stabilize and the commodity and energy markets move upwards. Caterpillar sales will trend upwards, trailing the 5% growth as the market reacts cautiously to positive movements in the global economy. A resilient US economy and increased private investment in housing construction has been one of the few bright economic indicators for the company currently. We believe that the strength of Caterpillar s home economy relative to other international competitors will provide a small benefit in the near term. Page 9

10 1,100,000 1,050,000 1,000, , , ,000 US Value of Construction Put in Place (Total in $M) While we expect growth to remain slow for the next 2 years, we do see a rebound in energy and commodity prices as they hit the bottom of their economic cycles in the coming 6-12 months. Our 2 year consensus outlook for oil at $70/bbl remains well below peak levels, but investment will remain a necessity in this capital intensive and economically critical industry. CATALYSTS FOR GROWTH The short term outlook for Caterpillar remains weak due to many of the factors described above. However, the cyclical nature of its industries will mean a return to growth towards the end of our five year forecast. In the meantime, the company is making proactive moves to cut costs, restructure and become a leaner more efficient organization. The current moves will help Caterpillar maintain margins and boost efficiencies, making it a leaner more profitable operation as global growth picks up in Caterpillar s heavy investment in R&D could also provide an economic boost as the company works on developing next generation technologies. The company s investments in analytics will help drive improved maintenance and service plans in order to maximize machine efficiency, and by working with dealers to identify additional points of service and revenue streams, they will ensure their dealer network remains a top strength. These differentiators allow the company to maintain healthy margins and provide differentiated products to its customers. Globally, a quick rebound in commodity prices or energy prices will prove to be the biggest catalyst for growth, however our outlook for this is weak. Rather, we expect low to moderate growth as the global economy recovers and adapts to a new Chinese economy, but we feel Caterpillar will be well positioned to capture growth during this period. INVESTMENT POSITIVES CAT is expanding market share and generating strong free cash flow during period of economic weakness in a majority of its markets. R&D investment (over 4% of sales) and a strong dealer network make Caterpillar an industry leader that will be well positioned to capture growth when the cycle rebounds. The share buyback and dividend reaffirmation means the company is committed to returning value to shareholders during this down cycle, and a 4.3% dividend yield provides helpful protection against downside risk. INVESTMENT NEGATIVES Revenue is forecasted to fall for 4 consecutive years for the first time in company history, and 2016 will like come in $20B below 2012 figures.. Commodity and energy prices could remain suppressed for years, and any further downward revenue revisions will likely send the stock lower. Market consolidation means global competitors are approaching size and scale to be able to compete with Caterpillar and a strong dollar is making imports more attractive at home. Valuation A 5 year forecast window was used for DCF and DDM valuation methods. Top line revenues for 2015 and 2016 are in line with management s guidance of $48 and $45B billion, with Resource Industries and Energy & Transportation making up the biggest declines as those sectors continue to suffer from weak economic conditions. We forecast slight growth of 0.3% in 2017 before more modest growth of 3.0% and 4.1% in 2018 and 2019, reflecting an upswing on energy and mining activity as those industries enter growth cycles again. Despite lowered sales total, we forecast a slight increase in margins for 2015 as the company benefits from Page 10

11 previously enacted restructurings and lean manufacturing initiatives, as well as a shift towards more sales contribution from higher margin industrialized nations. We forecast cost of goods sold to improve by 25 bps to 67.66% in 2015, and improvement over the past 4 years. R&D will remain mostly steady as management has not guided for any reductions in activity, and development remains a key differentiator for Caterpillar. Capital Expenditures have fallen to less than half of their 2012 levels, and we expect spending to remain suppressed as management has stated they are in minimal maintenance mode and working on active facility consolidations. S&G expense is expected to fall by $458M in 2015 and $156M in 2016 due to restructuring and management reductions, though these will be offset by one-time expenses of approximately $800M, $300M, and $250M in 2015, 2016, and 2017 respectively as the company restructures to meet the current economic environment. We forecast ongoing restructuring costs of $100M in each of the final two years, reflecting continued reorganization of the business. Caterpillar currently has approximately $7B of a $10B share repurchase reauthorization remaining, and we forecast this activity to continue at levels of $1.7B, $1B, and $750M in 2015, 2016 and 2017 respectively, until accelerating economic growth drives the company to deploy cash towards operations and expansion. We expect the company to maintain a heavy total payout ratio around 150% over the next 3 years as the company returns a majority of free cash flow to shareholders. A beta of 1.24 was used in the analysis, representing the average of the 1 year through 5 year betas, and reflective of the current risk environment of the company relative to the stability and growth it had enjoyed over the past 3 years. With our fund market premium of 4.85%, this yields a cost of equity of 9.03%. The cost of debt was modeled at 4.4%, the current yield to market of its most recently issued long term notes. As Caterpillar is almost 50% debt funded, this yields a final WACC of 6.17%. The company maintains an investment grade rating for credit, and due to continue strong operating cash flows, we do not forecast any change to the capital structure going forward. A final discounted cash flow stock price of $84.42 per share, a 22% upside over the current price, was calculated after adjusting for excess cash, debt, operating leases and ESOP. This price a terminal growth rate of 2.5% which we believe reflects Caterpillar s participation in mature industries but with the ability to maintain or slightly growth market share. A continuing EPS growth rate of 5% was used in dividend discount valuation as we believe Caterpillar s ability to employ lean manufacturing principles and reduce management overhead expenses will allow it to continue to growth EPS faster than revenue and market growth. The CV of ROE was 17.8%. For relative P/E, comparable firms John Deere, CNH International NV, Cummings Inc., and General Electric were used. A relative P/E valuation of $74.17 was calculated after adjusting 2015 earnings to subtract restructuring expenses. While the current lower P/E multiples of industrial manufacturers reflects the weak economic condition of the industry, we believe Caterpillar is deserving of trading above its peers due to its diversified industry base, strength in markets, and higher dividend payment. KEYS TO MONITOR Global GDP growth, commodity prices and energy prices are all key drivers to our investment thesis. We expect prices to remain relatively flat over the next 1-2 years, but project moderate increases beyond that. GDP growth will be important across all geographies, but we expect US and European economies to maintain low to moderate growth, and that China will continue to slow beyond its current 7% growth prospects. A turnaround in the Brazilian economy, which has been plagued by a number of problems recently, could provide an additional boost to the stock price, as 2015 witnessed a large order delay in Brazil due to economic uncertainty. Specific keys to monitor for Caterpillar going forward will be the continued guidance for its dividend payment and the order backlog. While the company maintains a $15B backlog, this is down over 15% from the previous year, and continued depletion of the backlog will challenge the company s ability to maintain volume and margins. The company s recent affirmation of its dividend in light of the revenue downgrade and restructuring activities is viewed as a positive indicator of the board s trust in the company s ability to meet current cash flow obligations. We do not anticipate any near-term raises in the dividend, but should the amount be reduced we would view this as a negative indicator for our outlook. Page 11

12 REFERENCES 1. Bloomberg Terminal 2. Factset.com 3. Caterpillar K 4. Caterpillar Q 10Q Construction Machinery Manufacturing in the US Industry Report Ibisworld.com Mining, Oil Gas Machinery Manufacturing in the US Ibisworld.com 7. Jefferies Investor Conference Presentation, August 12 th 2015, retrieved from 8. Caterpillar SWOT Analysis retrieved from Thompson One. 9. US Construction spending Index. US Census Bureau. dex.html 10. From dumb iron to Big Data: Caterpillar's dealer sales push Caterpillar Focuses on Dealer Performance to Drive Results in a Tough Macro /03/11/caterpillar-intensifies-focus-ondealer-performance-to-drive-results-in-a-toughmacro/ 12. Caterpillar Falls Behind GE in Locomotives Race Commodity Rout Has Room to Run as Fund Sees Oil, Iron at $ merchant-fund-says 14. Start-up Matches Heavy Equipment Owners and Renters matches-heavy-equipment-owners-and-renters the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. IMPORTANT DISCLAIMER Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at Page 12

13 Caterpillar, Inc. Key Assumptions of Valuation Model Ticker Symbol CAT Current Share Price $69.39 Current Model Date 11/17/2015 Fiscal Year End Dec. 31 Pre-Tax Cost of Debt 4.40% Cost of Debt 4.40% Cost of Equity 9.03% WACC 6.17% Beta 1.24 Risk-Free Rate 3.04% Equity Risk Premium 4.85% CV Growth of NOPLAT 2.50% CV Growth of EPS 5.00% Current Dividend Yield 4.3% Marginal Tax Rate 28.5% Effective Tax Rate 28.5% DCF Price $84.42 CapEx as % of Sales 7.0% Asset Replacement % 4.00% Asset Depreciation Ratio 17.00% % 18.29% 16.82% 16.46% 16.37% Long-Term Debt/Equity Ratio 38% Capex Spending Schedule % of Sales 6.0% 5.5% 6.0% 6.5% 7.0%

14 Revenue Decomposition Caterpillar, Inc. (thousands) Fiscal Years Ending Dec E 2016E 2017E 2018E 2019E Total Revenues 65,875,000 55,656,000 55,184,000 47,954,950 45,483,682 45,632,114 46,998,439 48,908, % -15.5% -0.8% -13.1% -5.2% 0.3% 3.0% 4.1% Energy & Transportation 21,122,000 20,155,000 21,727,000 18,685,220 17,377,255 17,377,255 18,072,345 18,975,962 Construction Industries 19,334,000 18,445,000 19,362,000 18,006,660 17,466,460 17,641,125 17,993,947 18,533,766 Resource Industries 21,158,000 13,270,000 8,921,000 6,333,910 5,763,858 5,648,581 5,818,038 6,108,940 All Other Segments 1,501, ,000 2,251,000 2,115,940 2,115,940 2,179,418 2,244,801 2,334,593 Corporate Eliminations (47,000) (62,000) (119,000) (107,100) (101,745) (104,797) (107,941) (111,180) Machinery and Power Systems 63,068,000 52,694,000 52,142,000 45,034,630 42,621,768 42,741,581 44,021,190 45,842,081 Financial Products 2,807,000 2,962,000 3,042,000 2,920,320 2,861,914 2,890,533 2,977,249 3,066,566 Segment Growth Energy & Transportation 5.0% -4.6% 7.8% -14.0% -7.0% 0.0% 4.0% 5.0% Construction Industries -1.7% -4.6% 5.0% -7.0% -3.0% 1.0% 2.0% 3.0% Resource Industries 35.4% -37.3% -32.8% -29.0% -9.0% -2.0% 3.0% 5.0% All Other Segments -25.7% -41.0% 154.1% -6.0% 0.0% 3.0% 3.0% 4.0% Corporate Eliminations 20.5% 31.9% 91.9% -10.0% -5.0% 3.0% 3.0% 3.0% Financial Products 2.22% 5.52% 2.70% -4.0% -2.0% 1.0% 3.0% 3.0%

15 Caterpillar, Inc. Income Statement (thousands) Fiscal Years Ending Dec E 2016E 2017E 2018E 2019E Sales of machinery & power systems 63,068,000 52,694,000 52,142,000 45,034,630 42,621,768 42,741,581 44,021,190 45,842,081 Revenues of financial products 2,807,000 2,962,000 3,042,000 2,920,320 2,861,914 2,890,533 2,977,249 3,066,566 Total Revenues 65,875,000 55,656,000 55,184,000 47,954,950 45,483,682 45,632,114 46,998,439 48,908,647 Operating Expenses: Cost of Goods Sold 44,930,000 38,408,000 37,476,000 32,446,319 30,774,259 30,892,941 31,822,643 33,164,954 depreciation 2,421,000 2,710,000 2,795,000 2,818,090 2,746,632 2,627,655 2,568,826 2,571,561 Amortization of Intangibles 392, , , , , , , ,589 Gross Income 18,132,000 14,161,000 14,545,000 12,340,941 11,630,671 11,786,041 12,288,002 12,859,544 Selling, general & administrative expenses 5,742,000 5,443,000 5,672,000 5,213,400 5,056,998 5,107,568 5,209,719 5,366,011 Research & development expenses 2,466,000 2,046,000 2,135,000 2,156,350 2,177,914 2,243,251 2,310,548 2,379,865 Operating Income (EBIT) 9,924,000 6,672,000 6,738,000 4,971,191 4,395,759 4,435,222 4,767,734 5,113,668 Nonoperating Income - Net 217,000 (57,000) 73,000 68,620 70,679 66,438 68,431 64,325 Interest Expense 1,268,000 1,186,000 1,097,000 1,222,496 1,244,193 1,166,747 1,129,928 1,127,886 Unusual Expense - Net 637, , , , , , , ,000 Consolidated profit/loss before taxes 8,236,000 5,128,000 5,083,000 3,017,315 2,922,245 3,084,913 3,606,237 3,950,107 Income tax provision/(benefit) 2,528,000 1,319,000 1,380, , , ,200 1,027,778 1,125,781 Profit/(loss) of consolidated companies 5,708,000 3,809,000 3,703,000 2,157,380 2,089,405 2,205,713 2,578,460 2,824,327 Equity in profit(loss) of unconsolidated affiliates 14,000 (6,000) 8, Total profit/(loss) of consolidated and afilliates 5,722,000 3,803,000 3,711,000 2,157,380 2,089,405 2,205,713 2,578,460 2,824,327 Less: Profit/Loss attributable to noncontrolling interes 41,000 14,000 16,000 14,400 13,680 14,022 14,583 15,750 Profit/(loss) attributable to CAT shareholders 5,681,000 3,789,000 3,695,000 2,142,980 2,075,725 2,191,691 2,563,877 2,808,577 Year End Shares Outstanding (000) 652, , , , , , , ,828 Net Earnings (Loss) per share - basic $8.71 $5.87 $5.99 $3.61 $3.57 $3.80 $4.46 $4.89 Dividends per Share $2.02 $2.32 $2.70 $2.94 $3.03 $3.18 $3.34 $3.51 Increase 0.00% 14.85% 16.38% 8.89% 3.00% 5.00% 5.00% 5.00% Payout Ratio 23.20% 39.51% 45.10% 81.44% 84.81% 83.59% 74.86% 71.75%

16 Caterpillar, Inc. Balance Sheet (thousands) Fiscal Years Ending Dec E 2016E 2017E 2018E 2019E Assets Current assets: Cash & Short-Term Investments 5,490,000 6,134,000 7,341,000 9,123,905 8,367,000 8,015,899 8,104,712 8,332,208 Short-Term Receivables 19,520,000 17,852,000 17,511,000 14,820,289 14,056,553 14,102,426 14,524,683 15,115,026 Inventories 15,547,000 12,625,000 12,205,000 10,933,995 10,279,564 10,221,847 10,433,914 10,857,991 Other Current Assets 1,967,000 1,724,000 1,810,000 1,667,356 1,581,432 1,586,593 1,634,099 1,700,515 Total current assets 42,524,000 38,335,000 38,867,000 36,545,545 34,284,549 33,926,764 34,697,408 36,005,740 Gross Property and Equipment 29,932,000 31,316,000 31,572,000 33,969,748 36,016,513 38,298,119 40,883,033 43,817,552 less: accumulated depreciation 13,471,000 14,241,000 14,995,000 17,813,090 20,559,722 23,187,376 25,756,203 28,327,764 Property and equipment, net 16,461,000 17,075,000 16,577,000 16,156,658 15,456,791 15,110,743 15,126,830 15,489,788 LT Investment - Affiliate Companies 272, , , , , , , ,050 Long-Term Note Receivable 15,345,000 16,323,000 16,145,000 15,499,200 15,189,216 15,341,108 15,801,341 16,275,382 Goodwill, net 6,942,000 6,956,000 6,694,000 6,694,000 6,694,000 6,694,000 6,694,000 6,694,000 Intangible Assets Gross 4,840,000 4,766,000 4,452,000 4,452,000 4,452,000 4,452,000 4,452,000 4,452,000 Accumulated Amortization of Intangibles 824,000 1,170,000 1,376,000 1,725,600 2,057,720 2,383,198 2,702,166 3,014,754 Intangible Assets, net 4,016,000 3,596,000 3,076,000 2,726,400 2,394,280 2,068,802 1,749,834 1,437,246 Deferred Tax Assets 2,011, , Other Assets 1,785,000 1,745,000 3,065,000 3,126,300 3,188,826 3,252,603 3,317,655 3,384,008 Total Assets 89,356,000 84,896,000 84,681,000 80,937,388 77,387,194 76,574,137 77,572,579 79,479,213 Liabilities and Equity Current Liabilities: ST Debt & Curr. Portion LT Debt 12,391,000 11,031,000 11,501,000 10,925,950 10,816,691 11,033,024 11,253,685 11,478,758 Accounts Payable 6,753,000 6,560,000 6,515,000 5,866,299 5,563,990 5,582,148 5,749,290 5,982,964 Income Tax Payable 66,000 86,000 62,000 37,837 36,645 38,685 45,222 49,534 Other Current Liabilities 10,545,000 9,620,000 9,799,000 8,441,158 8,006,159 8,032,287 8,272,791 8,609,031 Total current liabilities 29,755,000 27,297,000 27,877,000 25,271,245 24,423,485 24,686,144 25,320,987 26,120,288 Long-Term Debt 27,752,000 26,719,000 27,784,000 28,277,120 26,516,968 25,680,171 25,633,768 26,051,491 Liability for Post Employment Benefits 11,085,000 6,973,000 8,963,000 9,052,630 8,871,577 8,694,146 8,520,263 8,349,858 Deferred Tax Liabilities 484, , , , , , , ,636 Other Liabilities 2,698,000 2,582,000 2,817,000 2,375,568 2,253,148 2,260,501 2,328,185 2,422,812 Total Liabilities 71,774,000 64,018,000 67,855,000 65,349,163 62,419,148 61,682,010 62,171,474 63,320,084 Equity: Common Stock Par/Carry Value 4,481,000 4,709,000 5,016,000 5,080,519 5,145,038 5,209,557 5,274,076 5,338,596 Retained Earnings 29,558,000 31,854,000 33,887,000 34,284,706 34,600,008 34,959,569 35,604,029 36,397,533 Cumulative Adjustment/Unrealized For. Exch. G 456, ,000 (1,107,000) (1,107,000) (1,107,000) (1,107,000) (1,107,000) (1,107,000) Unrealized Gain/Loss Marketable Securities 25,000 83,000 83,000 83,000 83,000 83,000 83,000 83,000 Other Appropriated Reserves (6,914,000) (4,152,000) (5,407,000) (5,407,000) (5,407,000) (5,407,000) (5,407,000) (5,407,000) Treasury Stock (10,074,000) (11,854,000) (15,726,000) (17,426,000) (18,426,000) (18,926,000) (19,126,000) (19,226,000) Total stockholders' equity 17,532,000 20,811,000 16,746,000 15,508,225 14,888,046 14,812,126 15,321,105 16,079,129 Accumulated Minority Interest 50,000 67,000 80,000 80,000 80,000 80,000 80,000 80,000 Total Equity 17,582,000 20,878,000 16,826,000 15,588,225 14,968,046 14,892,126 15,401,105 16,159,129 Total Liabilities & Stockholders Equity 89,356,000 84,896,000 84,681,000 80,937,388 77,387,194 76,574,137 77,572,579 79,479,213

17 Caterpillar, Inc. Cash Flow Statement Fiscal Years Ending Dec Operating Activities Net Income / Starting Line 2,758 4,981 5,722 3,803 3,711 Depreciation, Depletion & Amortization 2,296 2,527 2,813 3,087 3,163 Depreciation and Depletion 2,202 2,294 2,421 2,710 2,795 Amortization of Intangible Assets Other Funds Funds from Operations 5,523 7,965 8,924 7,372 7,427 Changes in Working Capital (514) (955) (3,683) 2, Receivables (2,320) (1,345) (173) Inventories (2,667) (2,927) (1,149) 2, Accounts Payable 2,570 1,555 (1,868) Other Accruals (307) (387) 891 Other Assets/Liabilities (186) (421) (747) Net Operating Cash Flow 5,009 7,010 5,241 10,191 8,057 Investing Activities Capital Expenditures (2,586) (3,924) (5,076) (4,446) (3,379) Net Assets from Acquisitions (1,126) (8,184) Sale of Fixed Assets & Businesses 1,469 1,730 1, Purchase/Sale of Investments 11 (89) (15) Purchase of Investments , Sale/Maturity of Investments , Other Funds 637 (960) (2,716) (1,661) (1,137) Other Uses (8,498) (10,041) (12,010) (11,448) (11,354) Other Sources 9,135 9,081 9,294 9,787 10,217 Net Investing Cash Flow (1,595) (11,427) (6,190) (5,046) (3,627) Financing Activities Cash Dividends Paid (1,084) (1,159) (1,617) (1,111) (1,620) Change in Capital Stock (1,872) (3,995) Repurchase of Common & Preferred Stk (2,000) (4,238) Sale of Common & Preferred Stock Issuance/Reduction of Debt, Net (3,846) 4,824 5,377 (1,611) 2,444 Change in Current Debt 291 (43) 461 (69) 1,043 Change in Long-Term Debt (4,137) 4,867 4,916 (1,542) 1,401 Issuance of Long-Term Debt 8,324 15,460 16,015 9,328 10,649 Reduction in Long-Term Debt (12,461) (10,593) (11,099) (10,870) (9,248) Other Funds (263) Other Uses (132) (11) (455) (13) (7) Other Sources Net Financing Cash Flow (4,613) 3,966 3,549 (4,511) (2,996) Net Change in Cash (1,199) (451) 2, ,434