Caterpillar downgraded at Morgan Stanley on concerns about valuation

Caterpillar (NYSE:CAT) was hit with a downgrade from Morgan Stanley on Thursday, as analyst Angel Castillo lowered the stock to Underweight from a previous investment rating of Equal-weight, warning that the stock is “priced for perfection” amid deteriorating pricing trends and margin pressures.

The move comes on the heels of Caterpillar’s (NYSE:CAT) second-quarter earnings miss and a mixed fiscal 2025 outlook that, while pointing to improved revenue, also flagged weakening margins.

Despite the underwhelming print, shares of Caterpillar (NYSE:CAT) have remained resilient, a dynamic Morgan Stanley attributes to stronger-than-expected backlog growth, improved volumes driven by the company’s power generation segment and a bullish narrative that demand is firming beneath the surface.

But Castillo believes that optimism may be misplaced.

“We view deteriorating price/margin as more important KPIs of underlying health of demand and fundamentals,” Castillo wrote in an August 7 note to clients. “Sequential volume/orders improvements in 2Q are a notable positive, but in our opinion a head fake with potential pull forward.”

The analyst cut his price target to $350, representing roughly 18% downside from Caterpillar’s current $428 per share level. His updated forecast implies a 20 times price-to-earnings multiple on 2025 adjusted earnings of $17.53 a share, significantly less than the 25 times multiple currently implied by the market.

Risk to the downside

Castillo sees Caterpillar (CAT) facing a negatively skewed risk/reward profile, estimating a bear case with as much as 50% downside versus just 29% upside in a bullish scenario.

“Our updated forecasts suggest a 2-to-1 negatively skewed risk/reward for shares from current levels,” he wrote.

Central to Castillo’s concern is what he views as a market underestimation of pricing declines, particularly in the company’s core construction industries (CI) and resource industries (RI) segments.

“A -7% decline in Construction Industry prices underscores that CAT has adopted a volume over value strategy, which as the premium player in the market is a signal to competitors which could spur more competition,” he noted.

“Price was more unfavorable than we had anticipated, as our attractive merchandising programs stimulated higher-than-expected sales to users in North America,” Caterpillar (CAT) acknowledged on its earnings call, a comment Castillo highlights as evidence of underlying pricing weakness.

Additionally, Castillo warned that merchandising incentives and concerns over 2026 tariff-related price hikes may have pulled demand forward into Q2, creating a misleading picture of momentum.

Tariff headwinds and earnings quality

The report also took aim at how Caterpillar (CAT) accounted for tariffs during the quarter. Castillo noted that the company initially allocated a portion of the tariff-related costs to its Corporate segment due to timing issues. When reallocated to operating segments, margins in CI and Energy & Transportation (E&T) would have appeared weaker.

“Although it would not impact adjusted EPS, we think optically lower segment margins would have had a material impact on investor sentiment and stock performance on the day,” Castillo wrote.

He also pushed back against bulls who suggest investors should exclude tariff costs when evaluating Caterpillar’s (CAT) performance.

“We disagree with bulls’ pushback that CAT’s results should be looked at excluding the Tariff headwind as these are a very real cost of doing business, and one that we expect to remain in place for the foreseeable future,” he wrote.

Morgan Stanley said these pressures could worsen in 2026, making Caterpillar (CAT) one of the few companies unable to mitigate or pass through tariff costs.

Skeptical of V-shaped recovery

While Caterpillar’s (CAT) management is forecasting a sharp rebound in equipment demand in the second half of 2025, Castillo is unconvinced.

“We view the company’s full year outlook, which calls for an atypical v-shaped recovery / re-stocking at the end of the construction season, as optimistic with downside risk,” he said.

Channel checks suggest that many Caterpillar (CAT) dealers are currently restocking inventory ahead of actual retail demand, an indication that equipment backlogs may not translate into real end-market strength. Castillo warns this could lead to excess inventories and further de-stocking in late 2025 or early 2026.

Even if the Federal Reserve begins cutting rates, Morgan Stanley believes any policy easing tied to deteriorating macro conditions may not materially revive construction activity in the near term.

Upside limited, downside exposed

While acknowledging strengths in E&T’s Power Generation segment, Castillo maintains that it’s not enough to offset pricing and volume concerns elsewhere.

“We have strong sustained growth baked into our E&T segment assumptions… and without getting overly aggressive on our estimates in CI and RI, we still come out with -4%/-18% downside to 2025/2026 consensus Adj. EPS estimates.”

With Caterpillar (CAT) trading at a 25 times multiple — well above its historical range of 12 to 21 times — the analyst said the stock already discounts an “earnings inflection, data center tailwinds, and a U.S. re-shoring renaissance.”

“Said another way, we think the stock is already priced for perfection and thus if we’re wrong and all those factors come to fruition, then the upside risk feels relatively contained.”

Castillo does acknowledge the possibility that he could be wrong if non-residential construction and data center investment rebound faster than anticipated, scenarios that could justify a re-rating of the stock toward $550.