What to Watch With Caterpillar Stock Before Investing

Caterpillar has some factors that might encourage management to raise long-term guidance.

AI and data center spending are supporting the investment case for the stock.

The current valuation appears to imply some optimistic assumptions about Caterpillar’s long-term growth.

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Caterpillar (NYSE: CAT) is an iconic company. Its mix of construction machinery, resources (mining and aggregates) machinery, and energy and transportation equipment is widely recognized, and its power generation engines have encouraged investors to bid the stock up, thanks to its potential role in artificial intelligence (AI)/data centers.

With these factors in mind, here’s what you need to know before buying the stock.

Burgeoning demand for power generation equipment for data centers (it provides backup power if needed) will benefit the company, but it isn’t likely to significantly move the growth needle. And it’s far from enough to make Caterpillar an AI/data center stock. For example, its power generation sales were $2 billion in the first quarter, representing almost 15% of its machinery, energy, and transportation (MET) segment sales. It’s not insignificant, and supports the case for buying the stock, but it doesn’t change the fact that Caterpillar is still a highly cyclical stock.

The cyclicality of its revenue, earnings, and cash flow is inherently recognized in the way management outlines its “target ranges” for key metrics during the cycle. Management last updated these ranges in early 2024, and they include a free-cash-flow (FCF) range of $5 billion to $10 billion through the cycle, and a range of operating profit margins depending on revenue. For example, the target call for an adjusted operating profit margin of 10% to 14% with revenue of $42 billion, reaching 18% to 22% with revenue of $72 billion.

As you can see below, Caterpillar’s revenue is cyclical, and its operating margin is a factor of its revenue.

One way to value Caterpillar is to price it at the midpoint of its free-cash-flow range and assume it’s a mature industrial company that trades at roughly 20 times its FCF. Doing so would give a “fair” value for the stock of 20 times $7.5 billion, or $150 billion. That approach would imply that Caterpillar is overvalued as it currently trades on a market cap of $200 billion.

That said, it’s important to note that this is a conservative approach. As mentioned earlier, management last updated these target ranges in early 2024, when it increased its FCF target range from $4 billion to $8 billion to the current range of $5 billion to $10 billion.