Caterpillar Stock Is Digging Out of the Mining Malaise. Why It’s Time to Buy.

The stock, however, at about $378, only recently eclipsed its record high set in early April, and its multiple, at about 17 times 12-month forward earnings, is in line with its five-year average. That’s a sign that investors haven’t given the company full credit for improvements made to profitability and efficiency over the past few years, let alone the good news that could arrive in the months ahead.

Wall Street “estimates do not fully appreciate management’s ability to drive margin improvement,” writes J.P. Morgan analyst Tami Zakaria, who has an Overweight rating and a $435 price target on the shares. “The company has been able to cut fixed costs by restructuring its [mining] business, which should provide earnings upside as volumes push higher.”

Caterpillar is an American machinery giant. Its backhoes are ubiquitous on construction sites, and its massive mining trucks haul 400 tons of ore—sometimes without a driver in the cab. CEO Jim Umpleby, who took the reins of the heavy-equipment maker at the start of 2017, set the company on a path of profitable growth by cutting costs, expanding product offerings, and offering more recurring service-like sales.

His strategy has yielded benefits. Operating profit margins are currently about 21%, up nine percentage points since 2017. And since then, Caterpillar has generated some $35 billion in free cash flow, returning $15 billion in the form of dividends—it currently yields 1.5%— and buying back $25 billion of stock to reduce shares outstanding by about 19%.

While Caterpillar has paid out more than the total free cash flow it has generated, its balance sheet remains in excellent shape. At the end of the second quarter, the company had about $5 billion in debt less cash, a fraction of the $15.5 billion in earnings before interest, taxes, depreciation, and amortization, or Ebitda, it’s expected to earn this year. Investors typically don’t start thinking about debt levels until they approach two times Ebitda.

Caterpillar’s construction business is also performing strongly, boosted by the Inflation Reduction Act, other government spending, and the artificial-intelligence data center boom, says Stephanie Link, Hightower Advisors’ chief investment strategist. That strength can continue, which is good news for a business that accounts for roughly 40% of total sales.

But things could always be better. In the U.S., industrial activity has been mired in a prolonged slump, with the Institute for Supply Management Purchasing Managers’ Index—a measure of overall industrial activity in the U.S.—coming in below 50 for 21 of the past 22 months, one of the worst streaks on record. (A reading below 50 indicates that activity is contracting.)

Manufacturers probably breathed a collective sigh of relief when the Federal Reserve Board cut benchmark interest rates by 0.5 percentage point on Sept. 18, the first cut after 11 consecutive hikes. Lower financing costs can help end inventory destocking and poor industrial activity—and would help industrial manufacturers like Caterpillar.

Signs of improvement are already starting to show up. Inventories at Caterpillar’s 160 dealers, which serve 197 countries, dropped by $200 million in the second quarter, a good sign after rising by $1.4 billion in the first quarter. Falling inventories at retail locations are a harbinger of future sales growth.

But the biggest gains could come from Caterpillar’s resource business, which sells and services machines for the global mining industry. Mining-related activity accounts for around 20% of Caterpillar’s sales. That business is about 40% below its peak reached in 2012. That’s due, largely, to weakness in China, the world’s largest producer and consumer of mining commodities, where a slowdown in economic growth has hurt demand.

That has been tough for Caterpillar’s Asia-Pacific sales, which account for roughly 20% of total revenue, with China making up about half that. “China has been really a small part of our portfolio over the last couple of years,” said Caterpillar Chief Operating Officer Joseph Creed at a J.P. Morgan conference this past Tuesday.

Now, Chinese officials are trying to give the economy a kick-start, with interest-rate cuts, a reduction in required bank reserves to increase lending, and even a rate cut for existing mortgages, among other measures. “A recovery here will have implications for not only higher revenues but higher margins, as well,” notes Hightower’s Link, who calls the resource division “underappreciated.”

Just how effective the stimulus will be is hard to say. When the mining cycle turns, however, the impact can be material. BofA Securities analyst Michael Feniger noted in a recent report that capital expenditures in the global mining business are down about 30% from their 2012 peak, and as much as 50% when adjusted for inflation. As a result, the age of mining equipment has risen to record levels, as the industry has preferred to rebuild their machines, rather than buy new ones, to save some money.

When things improve, Feniger is looking for Cat to benefit from higher demand and higher pricing. He rates the shares a Buy and has a $376 price target for the stock, close to where the stock currently trades.

His target price, however, works out to about 14 times his estimated 2026 earnings per share of $27. With a resource recovery boost, earnings should easily top $30 a share by then, sending Caterpillar stock closer to $450, up about 20% from recent levels.

With improvement on the horizon, it’s still not too late to dig into Caterpillar stock.

Write to Al Root at allen.root@dowjones.com