If any large-cap company represents the U.S. construction sector, it would be Caterpillar (NYSE:CAT). You may have seen the company’s logo on heavy machinery throughout the nation.
Caterpillar’s quarterly earnings results weren’t the most closely watched, as all eyes have been on technology stocks in 2023. Yet, Caterpillar garnered attention after reporting its third-quarter financial results.
Unfortunately, it wasn’t positive attention, as Caterpillar stock tumbled 6% and stayed down throughout the trading session. However, you might be surprised to discover the reason for the sell-off. Moreover, after a close inspection of the data, you might even be compelled to take a position in Caterpillar.
Constructing a bull case for Caterpillar
First and foremost, it should be noted that Caterpillar stock doesn’t often move 6% in a single day. It’s usually a low-volatility stock that’s appropriate for risk-averse investors.
Thus, it’s clear that something about Caterpillar’s quarterly earnings report bothered stock traders. Come to think of it, something’s been bothering investors about Caterpillar for a while now, as its shares have lost roughly 20% of their value since the beginning of September.
It’s likely that high interest rates are to blame. The housing market is under tremendous pressure, with the 30-year fixed mortgage rate hovering near 8%. Remember, this rate was 3% to 4% just a few years ago.
Hence, if people aren’t buying homes in 2023 due to high mortgage rates, this will certainly have a negative impact on Caterpillar’s top- and bottom-line results — right? Not necessarily, as the company actually had a decent third quarter.
As it turned out, Caterpillar’s revenue increased 12% year over year to $16.8 billion in Q3, beating Wall Street’s estimate of $16.6 billion. That’s impressive, considering the state of the housing market this year.
Meanwhile, Caterpillar reported adjusted earnings of $5.52 per share, easily surpassing analysts’ consensus estimate of $4.80 per share. Again, there’s nothing objectionable here, and the sell-off in Caterpillar stock seems irrational, so far.
Along with all of that, Caterpillar’s margins improved. Specifically, the company’s third-quarter 2023 adjusted operating profit margin was 20.8%, versus 16.5% in the third quarter of 2022.
This is significant during a time when many businesses have taken a hit from reduced profit margins due to the high costs of materials. Thus, Caterpillar Chairman and CEO Jim Umpleby earned the right to brag about the company’s “strong adjusted operating profit margin.”
Why Caterpillar stock pulled back
By now, you should have the impression that Caterpillar’s quarterly results were actually quite good. However, investors clearly weren’t in the mood to buy Caterpillar stock. Baird analyst Mig Dobre helped put the company’s results in context.
“In a nutshell, during first quarter 2023 and second quarter 2023 [earnings reports], investor focus rested on potential margin upside from normalizing supply chains and price/cost tailwinds,” Dobre wrote.
To put it another way, investors would have been impressed with Caterpillar’s profit margin improvement earlier this year. Now, they’ve come to accept it as a natural result of factors that are largely out of the company’s control.
When looking at Caterpillar’s third-quarter results, investors evidently had a different focus in mind.
“Attention will now shift to backlog/order progression,” Dobre explained.
Here are the stats on that. Caterpillar ended Q3 2023 with an order backlog of roughly $28.1 billion, versus $30.7 billion in the previous quarter and $30 billion in the year-earlier quarter. Thus, no matter how you slice it, Caterpillar’s backlog is an issue for nervous shareholders.
Edward Jones analyst Faisal Hersi pointed directly to this troubling trajectory.
“I think there’s some concerns around the backlog… This is going to continue to be something investors keep a close eye on, especially after strong performances over the last few years,” Hersi warned.
The analyst even seemed to suggest that the entire construction sector, not just Caterpillar, may be in a state of decline.
“When you have that ‘peak’ narrative, it starts to creep up that this is a cycle peak, and it’s a really tough thing to shake,” Hersi elaborated.
Dig in with a small position
I understand Hersi’s concern, but there’s no need for investors to draw any hasty conclusions. There’s no conclusive evidence that Caterpillar and the rest of the U.S. construction machinery industry are in a “cycle peak.”
Therefore, I’m not against the idea of buying a few Caterpillar shares and collecting the company’s 2%-ish annual dividend. Unless the “cycle” really has “peaked,” Caterpillar should be able to recover, and calm investors can enjoy strong returns and consistent dividend distributions.
