A potential beneficiary of high inflation

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Caterpillar (CAT) is a company that manufactures and sells heavy machinery. The company is potentially well positioned for an inflationary environment. Be that as it may, we are neutral on the stock because its valuation does not offer a large margin of safety.

Measuring Caterpillar Operational Efficiency

Companies like Caterpillar need to keep large amounts of inventory to keep the business running smoothly. For this reason, the speed at which a business can move its inventory and convert it into cash is critical in predicting its success. To measure Caterpillar’s efficiency, we’ll use the cash conversion cycle, which indicates the number of days it takes to convert inventory to cash. It is calculated as follows:

CCC = Current Inventory Days + Current Sale Days – Current Payment Days

Caterpillar’s cash-to-cash cycle is 113 days, which means it takes the company 113 days to convert inventory to cash. Over the past few years, this number has been volatile, given the cyclical nature of the business.

Company efficiency has increased from a low of 93 days in 2018 to a high of 135 days in 2020 over the past decade. Compared to the industrial sector, CAT’s cash conversion cycle is above the industry average of 65 days. Although not ideal, it is not cause for concern.

In addition to the cash conversion cycle, let’s also look at Caterpillar’s gross margin trends. Ideally, we would like to see a company’s margins increase every year. This, of course, unless gross margins are already very high, in which case it is acceptable that they remain flat and stable.

Again, the cyclical nature of the business makes the gross profit margin volatile. Nevertheless, margins have remained consistently above 20% over the past decade, with a low of 21.1% in 2016 and a high of 27.2% in 2018. Therefore, we do not believe the competition has eroded CAT’s profitability.

Growth catalysts

Throughout the past year, commodity prices have skyrocketed due to strong demand relative to supply. Moreover, inflation is at its highest level in decades. Fortunately, Caterpillar is well positioned for this type of environment.

Since the company sells heavy machinery specifically for the energy, resource and construction industries, rising commodity prices should translate into increased demand for its products.

In addition, since CAT’s customers depend on its products and also realize higher profits, CAT will easily be able to pass on any inflation-related increase in production costs. So Caterpillar can potentially act as an inflation hedge as long as the Federal Reserve doesn’t raise rates too quickly.

Risks

Just as raw material prices can be a tailwind for Caterpillar, they can also be a risk. Prices can fluctuate rapidly and drop suddenly. In such a situation, the demand for its products will drop as its customers will become less profitable.

However, there are other risks associated with Caterpillar. According to TipRanks’ risk analysis, the company disclosed 26 risks in its latest earnings report. The highest level of risk came from the macro and political category.

The Taking of Wall Street

On Wall Street, Caterpillar has a Moderate Buy consensus rating, based on eight buys, five holds and one sell given over the past three months. Caterpillar’s average price target of $236.79 implies an upside potential of 23.36%.

Analyst price targets range from a low of $164 per share to a high of $290 per share.

Final Thoughts

Caterpillar is an industry leader that can potentially benefit from the current inflationary environment. Additionally, analysts see more than 23% upside potential in the stock price. Nevertheless, we remain neutral as the 23% rise does not provide a sufficient margin of safety to compensate for the cyclical nature of the company.

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