Investors in Caterpillar (CAT -0.51%) recently received one of the most positive bits of news on their company's sales in some time. It's not that year-over-year sales growth turned positive -- that will take a while yet. Instead, investors can take heart from the fact that, while year-over-year sales remained in decline, the rate of decline slowed. For a highly cyclical stock like Caterpillar, that's usually a very good sign, but does it make the stock a buy?
Caterpillar's sales appear to have bottomed out
Going back to the company's third-quarter earnings call at the end of October, CFO Andrew Bonfield said, "Overall, we expect to see less of a decline in end-user demand in the fourth quarter compared with the third based on what we hear from dealers and see in orders." That's a view that's supported by the latest retail sales data in the chart below.
Caterpillar is hoping global construction activity will remain strong in 2021. Image source: Getty Images.
As a reminder, Caterpillar's sells most of its machinery to independently-owned dealers, and the sales figures below represent three-month rolling sales compared to the same period last year. In a positive move, Caterpillar's overall sales turned up in October, and all the end markets were better than in September. In addition, sales in the key construction end market have improved for the fourth month in a row.
Data source: Caterpillar presentations.
Why sales trends matter a lot to Caterpillar
The improving trend in Caterpillar's sales has led Wall Street analysts to forecast that those sales will bottom out in the fourth quarter, then turn positive on a year-over-year basis in the first quarter of 2021. The chart below shows you why that's so important for Caterpillar.
In the past, Caterpillar's share price has done very well after its sales have troughed. In addition, note that Caterpillar exhibits a valuation dynamic that's very typical for a cyclical stock. In other words, its valuation (in this case enterprise value to EBITDA) tends to be high just as sales are about to trough and low as sales are about to peak.
Data by YCharts
Is Caterpillar stock a buy?
Do the latest sales data from Caterpillar -- and the forecast for year-over-year quarterly revenue growth to turn positive in the first quarter of 2021 -- make the stock a buy?
The answer depends partly on your investment needs. If you are looking for a relatively safe dividend yield, Caterpillar's 2.4% might attract you. The dividend looks well covered, and 2020 is likely to prove the bottom in its earnings/free cash flow.
On the other hand, if you are looking for a good entry point into a cyclical stock, then Caterpillar's current stock price might prove a little rich. There are three reasons why. First, based on the current stock price, Caterpillar's EV/EBITDA multiple is expected to be 20.1 times EBITDA at the end of 2020. Based on the chart above, that looks a relatively high multiple compared to the past.
Second, Caterpillar's end markets don't look like they are in the best of shape. For example, its mining and energy machinery sales often get a fillip when economic growth returns, particularly from China's demand for resources. However, the price of oil per barrel still has a $40 handle, and the idea that mining commodities are just about to embark on a long cycle of capital spending is long in the tooth -- particularly considering that the coal industry appears to be in a long-term decline.
Image source: Getty Images.
Third, Caterpillar's stock valuation appears to be pricing in a strong recovery in line with previous recoveries. That may or may not happen, but ideally, investors would like to buy into a stock before the market prices in positive assumptions into it.
The bottom line
Caterpillar will still attract income-seeking investors, but its current valuation looks heady, even for a cyclical company that's set to see its sales trough. The company will surely see better days ahead, but cautious investors may well want to wait for a dip and/or some hard confirmation of where the global economy is heading in 2021 before buying in. All told, Caterpillar is probably one for the watch list right now.
