By Al Root

March 20, 2019 - The mining business was booming in 2012. The Commodity Research Bureau spot metals index hit an all-time high of 1117, up 186% from the depths of the financial crisis. Mining companies were spending big dollars, too. Caterpillar resource division sales surpassed $20 billion, up from $5.9 billion in 2009.

But the cure for high commodity prices is—as they say—high commodity prices. By 2016, commodity prices fell by half and capital spending collapsed from $77 billion to $30 billion. Caterpillar (ticker: CAT) resource division sales fell all the way back to $5.7 billion. That kind of volatility is hard to endure. That’s why Caterpillar made changes to its manufacturing system. Changes that should improve margins in the next downturn; changes the market isn’t giving the company credit for yet.

“We recognize we’re cyclical and we needed to be more flexible. We always knew it, but now it’s a foundation for operating the company,” says Denise Johnson, Caterpillar’s president of resource industries. “Managing capacity in the peak and trough of the cycle is all about flexibility.”

In the past, Caterpillar organized factories by product—with one product per assembly line. Today, the company builds multiple products on each line. “We’ve closed 30 or more lines, but build the same number of units,” Johnson explained. Caterpillar now manufactures its massive 797, 794 and 793 mining trucks on the same assembly line.

A 797 Caterpillar mining truck is a sight to behold. Its tires are over 13 feet tall and it can carry 400 tons of material while the engine puts out 4,000 horsepower. It weighs nearly 700 tons and its fuel tank holds 1,000 gallons.

Manufacturing multiple models on the same assembly line creates added complexity. Inventory management and material handling become much harder. “We have made progress with kits, that’s everything you need for a day,” says Johnson. “That means less material beside the line.”

The changes Caterpillar has made appear unique. It’s showing up in operating margins and other companies haven’t realized the same level of improvement. Baird analyst Mig Dobre explains that Caterpillar has expanded margins by over 4 percentage points. “ Deere (DE) cannot claim that, the smaller cap guys are nowhere near that level of improvement,” he adds.

“Caterpillar has spent $4 billion restructuring since 2014,” adds JPMorgan analyst Ann Duignan. She wonders whether Caterpillar has cut too far.

Johnson has no such doubts, and she wants to keep costs low throughout the cycle. “We are still in the process of connecting all our plants around the world, and doing factory simulations. That helps us maximize output and tackle bottlenecks—ultimately it helps us not deploy fixed costs when volumes rise.”

So far, investors aren’t impressed. Analysts expect the company to earn $9.5 billion in operating income this year—a record despite sales remaining $9 billion below the 2012 peak of $66 billion. Yet Caterpillar shares trade for 11 times estimated earnings. That’s a 35% discount to the broader market and a 20% discount to Caterpillar’s historical average.

Of course, Caterpillar earnings are cyclical. The downturn from the 2012 mining peak sent earnings down 60%. And cyclical stocks trade for high earnings per share multiples in the trough of the cycle because things always get better. In 2016, Caterpillar stock traded for 30 times bottomed-out earnings. If the changes Caterpillar has made to its operations make earnings even a little less cyclical then its shares look like a bargain.

Even if Caterpillar earnings fall 50% from expected 2019 profits and traded for 25 times that number Caterpillar stock would hit $150 per share. That’s 9% higher than today’s price and it’s supposed to be where the stock trades in the depths of the next downturn (which hasn’t arrived). The shares also offer a 2.6% dividend yield.

Higher valuation multiples and less cyclical earnings might seem like a Panglossian view for a machinery maker. But don’t tell that to Denise Johnson. “You have to be low cost to grow, [Caterpillar] has a history of continuous improvement, we want to grow.”

It looks like Caterpillar, which was a Barron’s2019 top pick in December, is on the right path.