Stock Analysis & Ideas

Caterpillar: Effective Hedge Against Inflation?

Fears of a recession have gripped stock markets amid rising commodity prices and inflation. The Russian war on Ukraine has only added fuel to the fire, and trends were accelerated yet again after the U.S. government announced on Tuesday that it will be banning all oil imports from Russia. Additionally, the same day, European Union announced that it will reduce its gas imports from the aggressor nation by about 67% by the end of 2022.

While the raging war in Ukraine is not showing any signs of abating, investors have been caught between a rock and a hard place looking for stocks that would provide an effective hedge against inflation.

A Safe Hedge

Well, there’s one such stock that has caught the attention of Jefferies analyst Stephen Volkmann.

Shares of Caterpillar (NYSE: CAT) rose 6.8% on Tuesday to close at $210. The stock got a boost yesterday after the five-starred analyst pointed out that the stock has “historically been a strong hedge to commodity and general inflation.”

Let us look at the rationale behind Volkmann’s opinion.

Caterpillar is a manufacturer of construction and mining equipment, off-highway diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. The company has three business segments – Energy and Transportation, Resource Industries, and Construction Industries.

Volkmann upgraded Caterpillar from a Hold to a Buy yesterday. The analyst said that earlier the stock’s Hold rating was based on concerns regarding that CAT’s “constrained capex” would lead to “much more modest cyclical growth than in past cycles.”

Giving his reason for the upgrade, Volkmann explained that the crisis between Russia and Ukraine “has fundamentally altered global commodity markets and is likely to drive a decade of reinvestment.”

Elaborating further, the analyst expects that Russia is likely to be shut out of global commodity markets for the foreseeable future, and capacity for commodities including minerals, energy, and precious metals like gold and silver will probably to be shifted elsewhere.

While this may take some time, Volkmann thinks that the stage is set “for long-term outperformance by commodity-related machinery names like CAT.”

Moreover, Caterpillar is likely to benefit from increased infrastructure spending or higher reinvestment across its business segments.

CAT’s management echoed this sentiment on the company’s Q4 earnings call, with Caterpillar’s Chairman and CEO Jim Umpleby adding, “In China, we expect the industry for excavators above 10 tons to return to 2019 levels, reflecting weakness in housing construction.”

Reinforcing the above view, Volkmann added that CAT is well-poised to capitalize on higher spending in renewable energies. In 2021, this segment made up 43.4% of CAT’s total revenues of $51 billion.

For the Resource Industries business segment, Caterpillar expects that higher commodity prices could result in elevated demand for the company’s mining products and services. While agreeing with this outlook, Volkmann also feels that reinvestment post-2024 for a longer-term could boost additional production capacity.

This business comprised around 20% of CAT’s sales in 2021.

As the Western focus shifts to increasing production of oil and liquefied natural gas (LNG) outside Russia, elevated infrastructure and pipeline spending could bolster Caterpillar’s considerable energy and transportation business. The segment represented about 35% of the firm’s total revenues in 2021.

Summing it up, the analyst concluded, “CAT has historically been a good inflationary hedge, driving multiple expansion and ultimately earnings upside. …When coupled with earnings growth, CAT outperformed the market by ~100% for most of the 1970s.”

Beyond upgrading the stock, the analyst also raised the price target from $215 to $260, implying an upside potential of 23.8% from Tuesday’s closing price.

Other analysts on Wall Street, however, don’t seem to share Volkmann’s bullish stance. Instead, many are cautiously optimistic about the stock with a Moderate Buy consensus rating. This rating is based on nine Buys and four Holds. The average CAT stock prediction is $245.85, which implies upside potential of approximately 16.52% from intraday trading on Wednesday, at 10:52am EST.

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