Nobody said investing in equities was easy, and that observation certainly holds when examining the investment proposition at Caterpillar (CAT -1.25%) right now. There is a robust case for buying shares of the heavy machinery maker today, but there’s one key thing investors will want to see before buying the stock.
The case for buying Caterpillar stock
Despite a 10% year-over-year decrease in sales in the first quarter and a whopping 27% decline in operating profit, there’s still a robust case for buying Caterpillar. It’s based on three interconnected factors.
- The company’s retail sales data was better than expected in the first quarter and indicates an upturn is coming.
- Its dealers’ inventory position in the first quarter suggests a favorable setup for Caterpillar sales for the rest of 2025.
- Management estimates for earnings and cash flow imply the stock is a good value for a company in the trough year of its earnings cycle.
Before supporting these points in detail, it’s worth noting that Caterpillar generates the overwhelming majority of its sales through independent dealers to end users. The dealers manage their inventory of equipment, and the sales data in the chart below reflects their sales to end users.
A better-than-expected first quarter
During the first-quarter earnings call in late April, outgoing CEO Jim Umpleby noted, “Machine sales to users were stronger than we expected in the first quarter, resulting in flat machine dealer inventory, versus our expectation for growth in dealer inventory during the quarter.”
Caterpillar’s retail sales to end users in the construction and energy and transportation segments were in positive growth territory in the first quarter, with only a 10% decline in resource industries (mining and aggregates) pulling down total machine sales (which include construction and resource industries sales) into negative territory.
Data source: Caterpillar presentations, chart by author.
The better-than-expected end user sales (remember, they represent dealers’ sales) led to dealers only increasing inventory by $100 million in the first quarter. By way of comparison, dealers increased inventory by $1.4 billion in the first quarter of 2024.
Given current sales patterns, “dealers are ordering to replenish” according to CEO Joe Creed, giving credence to management’s forecast for flat sales in 2025.
Overall, management’s full-year guidance, excluding the impact of tariffs, is for flat sales, an adjusted operating profit margin in the top half of its cyclical range (which is approximately 16% to 20%), and free cash flow (FCF) toward the top half of the $5 billion to $10 billion range.
For reference, Wall Street analysts have penciled in $8.4 billion in FCF for 2025, a figure that would put Caterpillar stock at 19.6 times FCF in 2025 — a good valuation for a cyclical company in a trough year. That’s the buy case, and it’s pretty compelling.
Image source: Getty Images.
The key metric to keep an eye on
That being said, there are a couple of considerations to keep in mind. First, there’s the great unknown of the tariff landscape. Management’s commentary on the matter includes changing guidance from “top half” of the ranges discussed above to “within,” assuming the tariffs in place at the end of April. Since then, there has been a de-escalation, giving investors reason to feel more positive.
The second consideration is more problematic and relates to “price realization.” This refers to the impact of pricing on sales and operating profit, independent of the effect on sales volumes. Positive price realization implies Caterpillar was able to achieve better pricing on machinery, and can also reflect relatively better sales of higher-priced machinery or in more lucrative geographies. Negative price realization suggests that Caterpillar may be offering discounts or incentives in response to competition.
The change in operating profit is almost entirely attributable to changes in sales volume (Caterpillar’s sales volume, not dealers’ sales, as outlined above) and price realization. As the chart below demonstrates, positive price realization was able to offset declining sales volumes until the second quarter of 2024, after which both trends turned downward in the third quarter.
Data source: Caterpillar presentations, chart by author.
What it means for Caterpillar investors
Negative price realization is likely to continue in the second quarter as it comes up against a difficult comparison with the second quarter of 2024. However, suppose Caterpillar’s sales are set to improve in the second half, in line with the positive trend in user sales and dealers’ inventory positions. In that case, it’s reasonable to expect some improvement in price realization in the third quarter, and possibly in the second quarter as well.
It’s a key metric to watch, indicating a strengthening of market conditions and Caterpillar’s ability to grow earnings and meet its full-year targets.
