The Ultimate Emerging Market Stock

It looks as if we’ve dodged a bullet, and the U.S. economy will be able to avoid another deep slump. But tepid growth may be the best we can hope for in the foreseeable future. Yet beyond our borders, growth should prove more dynamic, especially in emerging market economies. As China, Vietnam, Indonesia and other neighbors transform into world-class economies, they’ll need to ensure that their infrastructures can handle a steady wave of growth. And they’re likely to continue consuming large amounts of oil, gas, and other commodities to build the highways, power plants, and other hallmarks of a modern economy.

I can think of no clearer way to play that trend than Caterpillar (NYSE: CAT), the global heavy machinery powerhouse. Caterpillar has steadily increased its exposure to the Asian economies during the past few years, and also stands primed to benefit from rebounding demand for excavation and mining equipment to pull all of the key commodities out of the ground.

Like many multi-nationals, Caterpillar has surely seen some tough times. Sales fell a hefty -37% in 2009 to $32.4 billion, the lowest level since 2004, and per-share profits fell nearly -75% to $1.43.  That’s well below the $5 to $6 a share the company earned in the previous three years. Yet there is a clear silver lining: management has implemented a wide range of improvements to the business with an eye toward boosting profit margins. As a result, profits should be sharply higher in the next peak of the economic cycle.

For starters, the company is sharply reducing the number of parts used to build its various machines and engines. That has given Caterpillar pricing leverage with suppliers, as higher volumes of fewer parts yield price concessions. Moreover, the company has hired a range of external manufacturing managers from firms such as Toyota (NYSE: TM) and General Motors that bring expertise in terms of material handling, production de-bottlenecking and quality control. As a result, the company thinks it will save several hundred million dollars annually on warranty claims, labor productivity and transportation costs.

#-ad_banner-#These steps are just getting underway, and any benefits are being masked by a still-weak global economy. Yet signs are emerging that the U.S. economy is no longer in freefall, and Asian economies are starting to heat up. Asia, in particular, bears close scrutiny. Analysts at Smith Barney believe that the Asian region will see $700 billion in infrastructure spending over each of the next five years. That’s up from $370 billion in each of the last two years. They and others note that Caterpillar’s exposure to China is especially appealing.

In the United States, the upturn will be slower to materialize, and could take two to three years to reach fruition. For example, the company’s network of dealers reduced inventories in 2009 by nearly $4 billion, down to bare-bones levels. It’s not clear when normal inventory levels will rebuild, but they should provide a solid tailwind, exceeding actual end-user demand. In addition, the U.S. and European construction markets, which have been in a slump for some time, should start to thaw over the next 12 to 24 months. Morgan Stanley’s analysts note that the dealer networks for rival equipment manufacturers “struggle to remain viable” after the sharp sales slowdown, which should lead to rising U.S. market share for Caterpillar and Deere (NYSE: DE).

To be sure, Caterpillar’s transformation will not happen quickly, but shares should benefit from a sense that the company will emerge from the downturn in a very strong position. As cash flow rebuilds, look for the company to boost its dividend (which currently yields nearly 3%), buy back stock and pay down debt. As noted, per-share profits could exceed $8 if sales rebound to 2007 levels, thanks in large part to the myriad streamlining efforts.

With the exception of some especially bullish and bearish market phases, shares have traditionally traded for around 15 times profits. Assuming shares only trade up to around 12 times peak cycle profits of $8 a share, then the stock could well rise close to the $100 mark. That’s roughly 65% above current levels. It will take several years for that investment thesis to be realized, but Caterpillar clearly stands out as a platform for the global economic rebound – especially in Asia and in commodities.

P.S. We’ve already seen how Caterpillar’s shares can zoom with the right profit catalysts: Soaring commodity prices in 2003 helped trigger a rush for Caterpillar’s products that pushed up its revenue by +100%, its profit by +220%, and its stock price by over +200% in the following five years. Go here for a list of our favorite “profit catalyst” stocks for today’s market.