By: Rob Wertheimer
Machinery stocks continue to trade at extreme weak valuations, but with improving cash positions and probably lower tariff risk. The best machinery franchises trade at near record discounts to the multi-industry stocks, and at record discounts to the S&P as well.
Broader industrials net debt levels are well above historical ranges; Davis highlighted that on our webcast last week. The median XLI net debt to EBITDA is 1.7 turns, while the average across the past fifteen years is half a turn lower, at 1.25. industrial debt levels relative to EBITDA haven’t been this high since the early 2000’s. Obviously with interest rates and taxes structurally lower, higher debt makes some sense.
But machinery is strikingly different, with record low leverage. The four largest and most defensible machinery franchises are CAT, Deere, Cummins and Paccar. In our coverage we can include Europe based Volvo. Debt to EBITDA across this group is about two turns less than the XLI median. Remarkably four out of five are essentially net cash, (excluding both finance sub debt and receivables). That represents lower cycle risk than in past cycles, with the cash and debt capacity representing a cushion. It’s also a substantial opportunity for earnings growth: with shares trading in high single to low double digit PEs, our companies can grow earnings through share buybacks to a far greater extent than most.
CAT is the biggest outlier and change from history: CAT net debt to EBITDA ranged between half a turn and 1 turn of debt in the past two cycles. Right now it’s close to zero. Deere net debt to trailing EBITDA is over half a turn, Cummins has spent years with excess cash on the balance sheet, and Paccar runs itself with a structurally positive cash position. All those are healthy positions, and generally much better than in past cycles. For CAT, net cash with years to run in end demand is markedly below history.
Tariffs are also starting to look more positive for machinery than for other parts of the S&P. Most machinery companies reporting this quarter supported our view that the bulk of the tariff hit was identified by midsummer, with steel and aluminum tariffs having a bigger impact than the later tariff lists that leaned more towards the consumer side. Time will tell if any cost blow-ups are hidden in the supply chains, but we suspect most of the pain has already been taken. That’s far from true for retail and consumers.
Within the opportunities presented by low valuations and cash balance sheets, CAT, and to a lesser extent Cummins, is also lower in the cycle than most. It’s easily forgotten amidst CAT’s high margins and a decade of overall economic recovery, but recent years have not been good for CAT markets. Two of the worst three downturns in CAT’s history have come in the past ten years, with third (and worst) being 1929. Our market by market supply based framework has CAT revenues just now climbing up to midcycle.
Midcycle earnings, no net debt, and a PE under 10x next year make for highly favorable risk versus reward. CAT shares are pricing in a recession on the scale of 2008 or 2012, but ignoring the lack of excess spend seen in 2008 and 2012, and ignoring the improved financials at CAT .