Caterpillar, Inc. Equity Research

Transcription

1 Caterpillar, Inc. Equity Research Caterpillar, Inc. Caterpillar is the world s leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. Caterpillar previously operated in three lines of business: Machinery, Engines and Financial Products. However, in 2011, the company shifted their organization into two segments Machinery and Power Systems and Financial Products. Machinery and Power Systems Represents the aggregate total of Construction Industries, Resource Industries and Power Systems. Financial Products primarily includes Cat Financial and Caterpillar Insurance Holdings Inc. 1 Investment Thesis I am recommending a BUY rating for Caterpillar, Inc. with a 12- month price target of $ This represents a 23.4% growth potential above the current price of $ The company has experienced three years of robust sales growth during a period of economic uncertainty, however, I see a short term pull back with revenues falling by 10% in Opportunities Caterpillar is undervalued Outstanding management Strong economies in emerging markets Need to replace machinery and power systems in developed markets Mining in the long-term Increased government spend on infrastructure Risks Downturn in global economies Further negative announcements related to CAT s business expansions Additional decreases in mining related commodity prices Decline in users access to capital Reduction in government spending on infrastructure New emission standards for engines Continued strengthening of the U.S. Dollar High backlog levels Date of Report Recommendation Ticker Price Target Price (July 12, 2013) Projected Return Market Data Market Capitalization Shares Outstanding Dividend Yield Dividend 52 Week Price Range Month Price Performance Financial Summary Revenue Operating Margin EPS EV/EBITDA Wade Guzdanski Research Analyst guzdanski.2@osu.edu SIM Program Royce West, CFA Fund Manager July 12, 2013 BUY CAT $ S % $57.989B 657.5M 2.8% 2.4 $ $99.70 $65.9M 13.0% $ x Source: Yahoo Finance 1 Source: Caterpillar, Inc K 1

2 Table of Contents T Company Overview Business Segments Competition Competitive Advantages Recent News Acquisitions Macroeconomic Outlook Fundamental Drivers Peer Analysis Financial Analysis Financial Projection Valuation Discounted Cash Flow Recommendation

3 Company Overview Caterpillar traces its origins to a 1925 merger of the Holt Manufacturing Company and the C.L. Best Tractor company, creating a new 2012 Revenue by Geographic Region 69% 31% United States Outside United States entity, Caterpillar Tractor Company. In 1986, the company re-organized itself under the current name, Caterpillar Inc. 2 From its inception Caterpillar has enabled economic growth through innovative farming and infrastructure equipment. Caterpillar has rapidly expanded and currently has a significant global footprint with 69% of their sales coming from outside the United Sates. Source: Caterpillar, Inc K Business Segments In 2011, the company updated their organization into two segments Machinery and Power Systems and Financial Products. Machinery and Power Systems is comprised of Construction Industries, Resource Industries and Power Systems. Financial products primarily includes Cat Financial, Caterpillar Insurance Holdings Inc. (Cat Insurance) and their respective subsidiaries Revenue by Segment 5% 2% Construction Industries 29% Resource Industries 32% Power Systems Financial Products Other 32% Source: Caterpillar, Inc K Construction Industries Caterpillar s construction industries segment is primarily responsible for machinery in infrastructure and building construction applications. The majority of machine sales in this segment are made in the heavy construction, general construction, mining and quarry and aggregates markets. The construction industries product portfolio includes the following machines and related parts: backhoe loaders, compact wheel loaders, small track-type tractors, small wheel loaders, track-type loaders, medium track-type tractors, skid steer loaders, mini excavators, select work tools, multi-terrain loaders, small, medium and large track excavators, motor graders, medium wheel loaders, wheel excavators and pipelayers. 4 Resource Industries The Resource Industries segment is primarily responsible for supporting customers using machinery in mine and quarry applications. It also serves forestry, paving, tunneling, industrial and waste customers. The resource industries business was transformed by the acquisition of Bucyrus International, Inc. (Bucyrus) in July 2011, and now offers mining customers the broadest 2 Source: 3 Source: Caterpillar, Inc K 4 Source: Ibid 3

4 product range in the industry. Subsequently the company announced their intention to transition the Bucyrus distribution business to the independent Caterpillar dealers who support mining customers. The Resource Industries product portfolio includes the following machines and related parts: electric rope shovels, large electric drive mining trucks, industrial swing machines draglines, tunnel boring equipment, select work tools, hydraulic shovels, large wheel loaders, forestry products drills, off-highway trucks, paving products, highwall miners, articulated trucks machinery components, underground mining equipment, wheel tractor scrapers, electronics and control systems, large track-type tractors, wheel dozers, large mining trucks and compactors. 5 Power Systems The Power Systems segment is primarily responsible for supporting customers using reciprocating engines, turbines and related parts across industries serving electric power, industrial, petroleum and marine applications as well as rail-related businesses. Power Systems sales increased globally in 2012, driven by increased customer demand, and included a full year of sales by MWM Holding GmbH (MWM). The Power Systems portfolio includes reciprocating engine powered generator sets, integrated systems used in the electric power generation industry, reciprocating engines and integrated systems and solutions for the marine and petroleum industries, reciprocating engines supplied to the industrial industry as well as Caterpillar machinery, turbines and turbine-related services, diesel-electric locomotives and components and other rail-related products and services. 6 Financial Products Segment The Financial Products segment is primarily driven by Cat Financial, a wholly owned finance subsidiary of Caterpillar. Cat Financial s primary business is to provide retail and wholesale financing alternatives for Caterpillar products to customers and dealers around the world. Retail financing is primarily comprised of the financing of Caterpillar equipment, machinery and engines. Cat Financial also provides financing for vehicles, power generation facilities and marine vessels that, in most cases, incorporate Caterpillar products. In addition to retail financing, Cat Financial provides wholesale financing to Caterpillar dealers and purchases short-term receivables from Caterpillar and its subsidiaries. The various financing plans offered by Cat Financial are primarily designed to increase the opportunity for sales of Caterpillar products and generate financing income for Cat Financial. A significant portion of Cat Financial s activities are conducted in North America, however, Cat Financial has additional offices and subsidiaries in Asia, Australia, Europe and Latin America. 7 Dealers and Distributors Caterpillar machines are distributed through a worldwide dealer network with 48 locations in the United States and 141 located outside the United States. In total Caterpillar serves 182 countries and 3,494 places of business, including 1,249 dealer rental outlets. 2 The majority of the worldwide dealers are independently owned and operated. Standard sales and service agreements determine rights to purchase and sell products, geographic service territory and 5 Source: Caterpillar, Inc K 6 Source: Ibid 7 Source: Ibid 4

5 transactional pricing. The vast reach and long standing relationships Caterpillar has developed with their dealers significantly outpaces their competitors and is a major source of competitive advantage. 8 Competitors The competitive environment is fierce and the specific competitors vary across segments. Each segment is highlighted by large multinational competitors, however, regional competitors also pose a significant challenge for Caterpillar, especially in China and other emerging markets. Caterpillar s major global competitors are as follows: 9 Construction Machinery Komatsu Ltd Deere & Co. Doosan Infracore Co., Ltd Volvo Construction Equipment (Volvo Group) Hitachi Construction Machinery Co., Ltd Hyundai CNH Global N.V. J.C. Bamford Ltd Resource Industries Komatsu Ltd Volvo Construction Equipment (Volvo Group) Deere & Co. Joy Global Inc. Atlas Copco Hitachi Construction Machinery Co., Ltd Wirtgen Power Systems Cummins Inc. Mitsubishi Heavy Industries Ltd. MAN Diesel & Turbo SE Tognum AG Deutz AG Siemens Energy GE Oil & Gas Wartsila Corp. Rolls Royce Group plc GE Power & Water Kirloskar Oil Engines Limited Weichai Power Co., Ltd Volvo Penta (Volvo Group) Competitive Advantage The largest competitive advantages for Caterpillar come from the quality of their products, economies of scale and the supply chain that the company has been able to build over time. The company focuses on being a leader in everywhere they do business, and in order to generate superior financial results this must be done on a large scale. Caterpillar has a distribution network and supply chain that is world class, which provides a significant competitive advantage. Through economies of scale, Caterpillar is able to produce high quality products at competitive prices. The benefit of competitive pricing and superior products flows through the network and results in greater profits for their customers, which in turn drives loyalty and growth. Recent News July 1, Caterpillar Inc. announced they have signed a definitive agreement to acquire Johan Walter Berg AB (Berg), including its core brand of Berg Propulsion. Berg is a leading manufacturer of mechanically and electrically driven propulsion systems and marine controls for ships. With the acquisition, Caterpillar will transition from selling only engines and generators to providing complete marine propulsion package systems Source: Caterpillar K 10 Source: Ibid 11 Source: 5

6 June 12, 2013 Caterpillar announced an increase in their quarterly cash dividend by eight cents to sixty cents ($0.60) per share of common stock, which equates to a 15% increase. 11 April 25, 2013 Caterpillar announced a $1 billion accelerated stock repurchase program. 12 April 22, 2013 Caterpillar revised their guidance for 2013 to reflect revenues in a range of $57 to $61 billion, with profit per share of about $7.00 compared to their previous outlook for 2013 revenues of $60 to $68 billion and profit per share of $7.00 to $ Acquisitions Caterpillar has a history of expansion through acquisition. In addition to the Bucyrus acquisition mentioned above, below is a list of some of the more significant recent acquisitions: August 31, 2011 Caterpillar Inc. acquired 100% interest in the Pyroban Group Ltd. Pyroban Group is a leading provider of hazardous area safety solutions to the oil and gas, industrial material handling, mining and marine markets. The purchase allows Caterpillar Global Petroleum to offer customers an enhanced range of Cat brand fully-integrated power solutions and grow its presence in the global hazardous area protection industry. 14 October 22, 2011 Caterpillar agreed to buy MWM Holding GmbH, Germany-based manufacturer of combustion engines for $806 million. MWM is recognized for their technology and product strength, particularly for its highly efficient range of engines. 15 June 6, 2012 Caterpillar Inc. announced the completion of its tender offer for ERA Mining Machinery Limited, including its wholly-owned subsidiary Zhengzhou Siwei Mechanical & Electrical Manufacturing Co., Ltd., commonly known as ( Siwei ). ERA manufactures and sells underground coal mining equipment in mainland China through Siwei. 15 Macroeconomic Outlook Caterpillar s operations are materially impacted by conditions in the global economy and the various capital markets. The demand for their products is cyclical and is significantly impacted by higher unemployment, lower consumer spending, lower corporate earnings and lower levels of government and business investment. The economic situation in the U.S. has been steadily improving since the recent recession and has shown continued positive signals. Based on recent performance and an improving future outlook, I am bullish on the economy in the United States in the near term. 11 Source: 12 Source: Ibid 13 Source: Ibid 14 Source: 15 Source: Ibid 16 Source: 6

7 GDP growth has been positive over the last few years, however, the first quarter 2013 rate was revised down to 1.8% from 2.4%. 17 Uncertainty exists around the monetary policy of the Federal Reserve, which will definitely impact the capital market and economic growth. However, I expect to see steady growth and slight expansion continue in the near term. Source: Haver Analytics The U.S. unemployment rate continues to drop from recessionary highs as more people rejoin the workforce. The steady decrease in the unemployment rate shows that employers are investing back into their business and are beginning to hire new workers, which helps confirm the economic recovery trend. Source: Haver Analytics Source: Haver Analytics Companies in the U.S. are beginning to increase capital spending as they look past the recent issues of sequestration and depressed global growth. Investment has steadily picked up since the recessionary lows and is forecasted to continue in the near term. The increase in orders for capital goods is set to drive revenue growth. Source: 17 Source: 7

8 The Federal Reserve s $85 billion in monthly bond buying helped spur the U.S. housing recovery and the recovery is starting to take hold. However, recent discussions around whether the Federal Reserve will begin to taper this buying has raised doubts regarding the stability of the housing recovery. In the Federal Reserve meeting minutes from June 2013, the Committee discussed that they should not sell agency mortgage-backed securities (MBS) as part of the normalization process, 18 which suggests that when tapering commences that purchasing will slow down for Treasury purchases before MBS purchases. The longer it takes for the Federal Reserve to sell MBS the better it will be for the housing market. Source: Haver Analytics Source: Haver Analytics The foreign macroeconomic outlook is being heavily influenced by the Eurozone debt crisis, China s growth slowdown, Japan s recession and instability in the Middle East and Africa. As the Eurozone and Japan work to recover from their recessions revenue growth and profitability will be impacted. China s gross domestic product rose 7.5% for the second quarter 2013., while China s industrial production rose 8.9% percent in June compared to last year. The June industrial-production growth matched the slowest pace since the global financial crisis began. 19 China s June excavator data showed June sales were down 1% versus last year and year-to-date sales are down 12%. Despite this, Caterpillars sales were up 35% year over year. While China currently makes up a small portion of Caterpillar s revenue, China and other 12% 10% emerging markets are the drivers of future growth. 8% 6% 4% 2% 0% -2% -4% -6% International GDP Growth Rates World East Asia & Pacific Europe & Central Asia Latin America & Caribbean Middle East & North Africa China Source: In summary, I believe we will continue to see a slow but positive U.S. and global economic growth in the near term. 18 Source: 19 Source: Jefferies LLC 8

9 Fundamental Drivers Trend Analysis When analyzing a 10 year historical period, Caterpillar s stock price is highly correlated to the S&P 500. However, when looking at more recent results, there appears to be no relationship. In 2013 Caterpillar s stock price has gone in the opposite direction of the greater market. As evidenced by Caterpillar being up only 8.7% over the last year compared to the S&P 500 which is up 23.8%. Additionally, Caterpillar s stock price is currently down over -12% from their 52 week high in February. 20 The market has beat down Caterpillar for its lowered guidance in 2013, however, the fundamentals are strong and as a result Caterpillar stock is relatively cheap compared to its upside. Source: Thompson Reuters - Baseline Source: Thompson Reuters - Baseline 20 Source: Yahoo Finance 9

10 Peer Analysis The charts below provide a comparison of Caterpillar to their industry peers: PEER ANALYSIS LTM Revenues Growth % Source: Capital IQ LTM Net Income Margin % Company Name Market Capitalization LTM Revenue LTM EBITDA Margin % AB Volvo (OM:VOLV B) 28, ,116.9 (10.24%) 6.7% 2.35% AGCO Corporation (NYSE:AGCO) 5, , % 9.5% 5.15% CNH Global NV (NYSE:CNH) 10, , % 14.3% 5.85% Cummins Inc. (NYSE:CMI) 22, ,784.0 (10.05%) 12.5% 8.77% Deere & Company (NYSE:DE) 32, , % 16.3% 8.51% Joy Global, Inc. (NYSE:JOY) 5, , % 23.5% 13.28% Komatsu Ltd. (TSE:6301) 23, ,965.6 (4.88%) 16.2% 6.70% PACCAR Inc. (NasdaqGS:PCAR) 20, ,198.7 (9.24%) 13.4% 6.30% Terex Corp. (NYSE:TEX) 3, , % 7.8% 1.47% Caterpillar Inc. (NYSE:CAT) 57, ,104.0 (0.10%) 16.5% 7.88% PEER ANALYSIS Company Name LTM Total Debt/EBITDA P/E LTM P/BV LTM 5 Year Beta AB Volvo (OM:VOLV B) 7.1x 28.3x 5.2x 1.14 AGCO Corporation (NYSE:AGCO) 1.5x 10.3x 3.0x 1.94 CNH Global NV (NYSE:CNH) 6.4x 8.8x 1.8x 2.58 Cummins Inc. (NYSE:CMI) 0.4x 14.9x 3.7x 1.94 Deere & Company (NYSE:DE) 5.5x 10.3x 4.5x 1.58 Joy Global, Inc. (NYSE:JOY) 1.1x 7.6x 6.2x 2.13 Komatsu Ltd. (TSE:6301) 2.2x 18.1x 2.1x 1.27 PACCAR Inc. (NasdaqGS:PCAR) 3.7x 19.7x 3.4x 1.38 Terex Corp. (NYSE:TEX) 3.7x 30.1x 10.9x 3.12 Caterpillar Inc. (NYSE:CAT) 3.9x 11.9x 7.7x 1.92 Source: Capital IQ Based on the major competitors analyzed above, Caterpillar is the clear leader in terms of revenue and market capitalization. Revenue growth varies significantly among the peers as each company responds to the uncertain global economic environment. Margins appear to vary depending on company size. With the exception of Joy Global, companies with higher market capitalizations seem to have the higher margins. Joy Global appears to be a little bit of an outlier, upon further inspection, Joy Global specializes in resource industries and as indicated in the next section Caterpillar s resource industries segment enjoys the highest operating margin of any of their segments. 10

11 Financial Analysis The chart below provides historical financial results for each segment at Caterpillar. Being a multi-segment business, it is important to analyze the revenue growth and operating margin of each segment including its contribution to the consolidated financial statements. The company revised their reportable segments in 2011, therefore, we were unable to obtain the same level of detail for Revenue: FY 2009 FY 2010 FY 2011 FY 2012 Construction Industries 8,507 13,572 19,667 19,334 Resource Industries 5,857 8,667 15,629 21,158 Power Systems 13,389 15,537 20,114 21,122 Financial Products 3,139 2,946 3,003 3,090 Other 1,504 1,866 1,725 1,171 Total Revenue 32,396 42,588 60,138 65,875 Operating Income: FY 2009 FY 2010 FY 2011 FY 2012 Construction Industries (768) 783 2,056 1,789 Resource Industries 288 1,789 3,334 4,318 Power Systems 1,660 2,288 3,053 3,434 Financial Products Other (1,002) (1,326) (1,877) (1,731) Total Operating Income 577 3,963 7,153 8,573 Sales Growth: FY 2009 FY 2010 FY 2011 FY 2012 Construction Industries 59.5% 44.9% 127.3% Resource Industries 48.0% 80.3% 261.2% Power Systems 16.0% 29.5% 57.8% Financial Products -6.1% 1.9% -1.6% Other 24.1% -7.6% -22.1% Total Revenue 31.5% 41.2% 103.3% Operating Margin: FY 2009 FY 2010 FY 2011 FY 2012 Construction Industries -9.0% 5.8% 10.5% 9.3% Resource Industries 4.9% 20.6% 21.3% 20.4% Power Systems 12.4% 14.7% 15.2% 16.3% Financial Products 12.7% 14.6% 19.5% 24.7% Other -66.6% -71.1% % % Total Operating Income 1.8% 9.3% 11.9% 13.0% Source: Caterpillar, Inc K Coming out of the recession Caterpillar has experienced tremendous revenue growth and improved margins. Resource Industries has beat the other segments and has established itself as the most important segment for Caterpillar. 11

12 The chart below provides consolidated historical financial results for Caterpillar. FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 Sales of Machinery and Power Systems 48, , , , ,068.0 Revenues of Financial Products 3, , , , ,807.0 Total Revenue 51, , , , ,875.0 Operating Costs: Cost Of Goods Sold 38, , , , ,055.0 Selling General & Admin Exp. 4, , , , ,919.0 R & D Exp. 1, , , , ,466.0 Interest Expense of Financal Products 1, , Goodwill Impairment Charge Other Operating Expense/(Income) 1, , , , Total Operating Costs 46, , , , ,302.0 Operating Profit 4, , , ,573.0 Interest Expense Excluding Financial Products Other (Income) Expense (327.0) (381.0) (130.0) 32.0 (130.0) Consolidated Profit Before Taxes 4, , , ,236.0 Provision (Benefit) for Income Taxes (270.0) , ,528.0 Profit of Consolidated Companies 3, , , ,708.0 Equity in (Profit) Loss of Unconsolidated Affiliated Companies (37.0) (14.0) (Profit) Loss Attribuatble to Noncontrolling Interests 28.0 (68.0) Profit 3, , , ,681.0 Earnings Per Share Basic EPS $ 5.83 $ 1.45 $ 4.28 $ 7.64 $ 8.71 Diluted EPS $ 5.66 $ 1.43 $ 4.15 $ 7.40 $ 8.48 Source: Caterpillar, Inc K Caterpillar experienced a significant drop in profitability during 2009, however, has successfully rebounded during the last 3 years. Margins, profit dollars and earnings per share continue to increase as Caterpillar executes their disciplined growth strategy. In addition to short-term profitability, the company has invested significant amounts of capital to support future growth initiatives. Capital expenditures have increased each year since 2009 with an incremental $835 million being spent in The company has issued guidance that 2013 capital expenditures will be $3.4 billion. Research and development expense has also increased steadily over the past four years. The Company has derived some of their savings by leveraging their expenses, specifically selling, general and administrative (SG&A). While total SG&A dollars have increased the company has leveraged their sales increase to reduce the SG&A as a percent of sales. In 2012 the company incurred a $580 million impairment charge related to their acquisition of ERA Mining Machinery Limited, Siwei. This write-off almost equals the purchase price of $653 million. With the number of acquisitions that Caterpillar executes it is critical that no other investments turnout as poorly as this one did. 12

13 Financial Projections The chart below provides projected financial results for Caterpillar: Sales Growth: FY 2012 FY 2013E FY 2014E FY 2015E Construction Industries -1.7% 9.0% 8.0% 8.0% Resource Industries 35.4% -50.0% 4.0% 15.0% Power Systems 5.0% 9.0% 8.0% 8.0% Financial Products 2.9% 5.0% 6.0% 7.0% Other -32.1% 0.0% 0.0% 0.0% Total Revenue 9.5% -10.3% 7.0% 9.0% Operating Margin: FY 2012 FY 2013E FY 2014E FY 2015E Construction Industries 9.3% 10.0% 10.5% 11.0% Resource Industries 20.4% 18.0% 20.0% 21.5% Power Systems 16.3% 16.0% 16.3% 16.5% Financial Products 24.7% 20.0% 24.0% 25.0% Other % % % % Total Operating Income 13.0% 12.1% 13.1% 13.9% Caterpillar s projected revenues are significantly impacted by the downturn in the Resource Industries segment. Decreases in commodity prices, especially iron ore, have triggered a significant decrease in the demand for mining equipment. Our 2013 revenue forecast includes a 50% decline for the Resource Industries which matches the companies revised guidance from April 22, Sales growth for the remaining segments were determined based on historical growth factors and analysis of consensus revenue data. In terms of operating margins, even with the slowdown in the economy Caterpillar was able to effectively manage their margins. The company has observed steady improvements in the last three years, therefore, we projected similar year over year improvements with the exception of 2013 (due to 50% decrease in revenue from the Resource Industries segment). The operating margin for 2013 was projected to decrease 90 basis points to 12.1% due to the sudden decrease in Resource Industries revenue. The projected margins for the other segments improve slightly as I anticipate the company will continue to identify operational efficiencies and effective cost savings. 13

14 The chart below provides projected consolidated financial results from Caterpillar: FY 2013E FY 2014E FY 2015E Sales of Machinery and Power Systems 55, , ,258.3 Revenues of Financial Products 3, , ,679.9 Total Revenue 59, , ,938.2 Total Operating Costs 51, , ,334.1 Operating Profit 7, , ,604.1 Interest Expense Excluding Financial Products Other (Income) Expense (118.2) (126.5) (137.9) Consolidated Profit Before Taxes 6, , ,259.4 Provision (Benefit) for Income Taxes 2, , ,777.8 Profit of Consolidated Companies 4, , ,481.6 Equity in (Profit) Loss of Unconsolidated Affiliated Companies (Profit) Loss Attribuatble to Noncontrolling Interests Profit 4, , ,407.1 Earnings Per Share Diluted EPS $ 6.96 $ 8.06 $ 9.28 Consensus $ 6.94 $ 8.05 $ 9.27 Guidance $ 7.00 Projected revenues and operating margins were determined based on projecting segment level results. All line items below operating profit were projected primarily based on analysis of historical trends. Based on our projections, we see EPS improving by 33% over the next three years. 80,000 Revenue Growth Trend 70,000 60,000 50,000 40,000 30,000 20,000 10,000 FY 2008 FY 2009 FY 2010 FY 2011 FY 2012 FY 2013E FY 2014E FY 2015E Revenue 14

15 Valuation Sector Valuation The table below provides valuation multiples for the Industrials Sector on an absolute basis and relative to the S&P 500. Valuation analysis is based on ten years of financial history. Industrials Sector Valuation Absolute Basis High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Relative to SP500 High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Source: Thompson Reuters - Baseline The price of the sector appears to be relatively inline, possibly slightly cheap, when compared to the market. This was determined by looking at current valuations relative to their history. Price to forward earnings and price to cash flow are inline as their current valuation relative to the market matches the 10 year median. Price to trailing earnings and price to sales are slightly cheap and price to book is at a slight premium. The net of these valuations would suggest the sector valuation is inline. Industry Valuation The table below provides valuation multiples for the Machinery, Construction and Farming Industry on an absolute basis and relative to the S&P 500. Valuation analysis is based on ten years of financial history. Machinery Construction/Farming Industry Valuation Absolute Basis High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Relative to SP500 High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Source: Thompson Reuters - Baseline 15

16 The industry appears to be relatively cheap when compared to the market. Price to forward earnings, trailing earnings and cash flow are currently at ratios less than the median for the past 10 years. Price to book and price to sales are both inline. To understand if these results are skewed due to changes in growth or risk, I also looked that the ratios over the past 5 years noting the results were consistent with the figures shown above. Caterpillar Valuation The table below provides valuation multiples for Caterpillar on an absolute basis and relative to the S&P 500. Valuation analysis is based on ten years of financial history. Caterpillar Valuation Relative to Industry High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Relative to S&P 500 High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Source: Thompson Reuters - Baseline Absolute Valuation High Low Median Current Target Target Target Price Multiple Earnings (F x G) A. B. C. D. E. F. G. H. P/Forward E P/S P/B P/EBITDA P/CF This final view of the valuation of Caterpillar indicates that the stock is relatively cheap. When compared to the industry four of the five current ratios are less than the median. The story is even worse when compared to the market with all five current ratios being less than the median. As a result, I used target multiples between the current and median ratios which reflects the undervalue of the stock. Based on my target multiples the target price for Caterpillar ranges from $96 to $

17 Discounted Cash Flow To better analyze the price target for Caterpillar we performed a discounted cash flow model. The below model shows the detailed behind our discounted cash flow model: Terminal Discount Rate = 11.0% Terminal FCF Growth = 3.5% Year 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E Revenue 59,092 63,237 68,938 73,074 77,459 81,719 86,214 90,524 95,051 99, ,301 % Growth -10.3% 7.0% 9.0% 6.0% 6.0% 5.5% 5.5% 5.0% 5.0% 4.5% 4.0% Operating Margin 7,173 8,285 9,604 9,865 10,302 10,705 11,122 11,497 11,881 12,118 12,396 Operating Margin 12.1% 13.1% 13.9% 13.5% 13.3% 13.1% 12.9% 12.7% 12.5% 12.2% 12.0% Interest and Other Interest % of Sales 0.6% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% Taxes 2,046 2,391 2,778 2,850 2,974 3,089 3,207 3,313 3,422 3,486 3,564 Tax Rate 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% Profit (Loss) of Unconsolidated A % of Sales 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% Net Income 4,709 5,510 6,407 6,571 6,857 7,119 7,390 7,633 7,882 8,028 8,204 % Growth -17.1% 17.0% 16.3% 2.6% 4.3% 3.8% 3.8% 3.3% 3.3% 1.9% 2.2% Add Depreciation/Amort 2,836 2,846 2,964 3,142 3,331 3,514 3,707 3,802 3,992 4,172 4,339 % of Sales 4.8% 4.5% 4.3% 4.3% 4.3% 4.3% 4.3% 4.2% 4.2% 4.2% 4.2% Plus/(minus) Changes WC 6,473 (544) (588) (1,315) (1,394) (1,471) (1,552) (1,629) (1,711) (1,788) (1,859) % of Sales 11.0% -0.9% -0.9% -1.8% -1.8% -1.8% -1.8% -1.8% -1.8% -1.8% -1.8% Subtract Cap Ex 3,400 3,162 2,964 3,142 3,331 3,514 3,707 3,802 3,992 4,172 4,339 Capex % of sales 5.8% 5.0% 4.3% 4.3% 4.3% 4.3% 4.3% 4.2% 4.2% 4.2% 4.2% Free Cash Flow 10,619 4,650 5,819 5,256 5,462 5,648 5,838 6,004 6,171 6,240 6,345 % Growth 512.4% -56.2% 25.1% -9.7% 3.9% 3.4% 3.4% 2.8% 2.8% 1.1% 1.7% NPV of Cash Flows 34,367 53% NPV of terminal value 30,836 47% Terminal Value 87,558 Projected Equity Value 65, % Free Cash Flow Yield 18.00% Free Cash Yield 7.25% Current P/E Terminal P/E 10.7 Projected P/E Current EV/EBITDA Terminal EV/EBITDA 6.9 Projected EV/EBITDA Shares Outstanding Current Price $ Implied equity value/share $ Upside/(Downside) to DCF 10.6% Debt 33,039 Cash 5,490 Cash/share

18 Terminal Growth Rate Assumptions My discounted cash flow model provides an estimated implied value for Caterpillar of $ or a 23.4% increase from the current stock price. This is consistent with the target range of $96 - $112 based on multiple valuation. The key assumptions used in the calculation of my model are as follows: The terminal growth rate for the S&P 500 is approximately 3.5%. The industrials sector and Caterpillar specifically require slightly higher grow rates, therefore, I added 50 basis points and used a rate of 4%. This decision was driven by Caterpillar consistent history of performance combined with the higher growth rates expected in emerging markets. A discount rate is used to adjust the value of forecasted cash flows for risk that may not materialize. A typical discount rate of 10.0% is used as a market average. Caterpillar is a cyclical company with some volatility, therefore, I added 50 basis points and used a discount rate of 10.5%. Sensitivity Analysis The two main assumptions that drive the final discounted cash flow value are the terminal growth rate and discount rate. To understand the range of impact when changing these assumptions I created a sensitivity table that shows the sensitivity of the price to these two factors. I analyzed a 50 basis point swing in each direction for each factor. The range given in the sensitivity table below shows possible prices between $94.39 and $ In terms of growth potential, this sensitivity analysis represents a range of 11% - 41% growth. Discount Rate 10.00% 10.25% 10.50% 10.75% 11.00% 3.50% % % % %

19 Recommendation Based on the analysis in this report, I am initiating coverage on Caterpillar, Inc. with a BUY rating and a price target of $ This price target would give an expected price appreciation of 23.4%. When combined with the dividend income of $2.40, total expected return is 26.0%. Caterpillar is well positioned as the leader in the industry and will be able to drive revenue, profitability and market share in both the short-term and long-term. Below is a listing of opportunities and risks associated with this recommendation. Opportunities Caterpillar is undervalued Outstanding management Strong economies in emerging markets Need to replace machinery and power systems in developed markets Mining in the long-term Increased government spend on infrastructure Risks Downturn in global economies Further negative announcements related to CAT s business expansions Additional decreases in mining related commodity prices Decline in users access to capital Reduction in government spending on infrastructure New emission standards for engines Continued strengthening of the U.S. Dollar High backlog levels Analyst Certification I, Wade Guzdanski, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject security. I also certify that no part of my compensation was, is, or will be directly or indirectly, related to the specific recommendation or view expressed in this research report. 19