Notable Calls

Morgan Stanley is making a significant call on Caterpillar (NYSE:CAT) upgrading the stock to Overweight from Underweight with a $70 price target (prev. $51).

Firm notes they are upgrading Caterpillar’s shares to Overweight, the first time they’ve been positive on the shares in three years of coverage. Firm notes they are now more bullish than consensus on both the pace of cyclical acceleration and on CAT’s ability to deliver on its structural transformation and, potentially, $8-10 in earnings. Upside risk is material in 2-3 years if structural changes work, i.e. shares could double.


Morgan Stanley's contacts in the supply chain tell them structural changes are real and are starting to work. In contrast they think many investors are still highly skeptical, specifically on CAT’s $8-10 earnings goal in 2012. They’re not completely there yet either, but this feels like an area where too many are underestimating CAT. The company earned $5.66 in the last cycle despite being hampered by lack of capacity and an outdated production system. The company’s move to streamline parts and materials—verified in their supplier conversations—could save hundreds of millions to billions. Warranty, variable labor, and de-bottlenecking should also push that number much higher in this cycle.

Structural changes look increasingly positive to US, market still feels skeptical. In August 2009 CAT outlined a number of initiatives that it felt would structurally improve operations and earnings. MSCO mentiones some of those: better quality leading to lower warranty, higher labor productivity, better parts and purchasing. The company aims to save 15% on transportation cost, 10% on direct materials costs 10%, and indirect materials costs 20%. Goal in August of 2009 was to reduce direct materials 2-3% in 2010. All these goals are ambitious, and on a $21 bn purchasing base (back at peak) the savings would be $2 bn plus, or ~$3 per share.

Cyclical forces look to be getting better, faster than consensus expects: 1) MSCO notes they are strong believers in a robust oil/gas cycle, and think that recovery may be getting underway even as CAT’s engine margins shrink near term. 2) They continue to hear near universal positive data points on mining, where CAT’s positioning is exceptional. 3) They think CAT (and Deere) will emerge with a structurally stronger position in the US construction market, as weaker competitors’ dealer networks will struggle to remain viable.

The firm also notes they have been hearing from suppliers for 6 months to a year that there has been a sea change in how CAT thinks about supplier relationships, with a focus on production flow and system cost rather than on capturing more of the margin pool at suppliers’ expense. Thus far their conversations remain mixed: there are suppliers who tell them they are saving money for CAT while making good margins, and there are those who tell them CAT still beats them up on pricing.

Cultural change and imported expertise. The seeming shift to a more integrated and collaborative relationship with suppliers was the biggest change the firm noted, but Cat also says in the past 3 years it has brought in more outside talent than ever before in the company’s history. The culture at Cat is loyal and insular, they think, so the changes are interesting. Many of the new hires have been in production—from Toyota and GM—but there is a new openness, they believe. MSCO has heard from more than one mid level manager at CAT that the initial steps on CPS were not exceptionally impressive, but that more recently the program is more robust and gaining traction.

Morgan Stanley's bull case scenario includes a price target of $108 based 12x 2013e EPS of $9.00.

Notablecalls: As Morgan Stanley notes they have been neutral-to-negative on CAT for the past 3 yrs. Until today. This is something I like to see - a major change in opinion.

With Morgan Stanley calling for a potential double saying the next cycle may benefit the co more than the last one, I think the stock will see significant buy interest.

I think CAT will see the $53 level today (up 5%) and I would not be surprised to see $53.50 during the day if the market plays ball.