Caterpillar Inc. – Rocky Road Ahead
A fall in mining activity and growth in dealer inventories are likely to limit Caterpillar's growth in the coming year, and we believe the stock does not offer much upside to investors at current valuations
Caterpillar Inc. (CAT), which designs, produces and sells machinery for construction and mining operations, has been in the market for over 85 years now. Deriving almost 94% of its revenues from its Resources, Construction and Mining segments (CAT Financial generates the remaining 6%), it reported sales of $55.5 billion in 2013.
2013 was a challenging year for the company: sales declined 16% year-over-year (YoY), with the Mining segment leading the decline following a global slowdown in mining output. And while revenues generated by CAT’s Construction segment stabilized, they were not enough to offset overall losses. The Power Systems segment remained stable through the year, as it has for quite some time now.
In the fourth quarter of fiscal 2013 (4QFY13; ended December 31, 2013), sales dropped 10% YoY to $14.4 billion. Earnings per share, however, were up $0.50 from the comparable period last year to $1.54. The drop in revenues was attributed to a fall in sales of mining machinery, which pressured full-year earnings to decline from $8.48 per share in 2012 to $5.75 in 2013.
The decline in sales, while somewhat anticipated, was more than what the company had provisioned for, as the company lost sales of some of its highest margin products.
The company took many cost cutting measures during the year, including shutting plants and laying off employees. These measures helped it reduce its burgeoning inventory levels by $2.9 billion. Dealer inventories fell $3 billion over the same period.
The decline in CAT’s income is attributable to the weakening demand for mining equipment and machinery, which brings in approximately a third of the company’s revenues. Slow activity in the mining sector, along with reduced orders from dealers, is expected to continue pressuring CAT’s revenues in the coming years.
Caterpillar relies on a network of dealers to sell its machinery and equipment to end users, which include mining and construction firms. Owing to lower demand from end users, Caterpillar dealers cut their machine inventories by 12% and power systems inventories by 5% between 2012 and November 2013. With global mining capital expenditures cut from $38 billion in 2011 to $31 billion in 2013, this trend is expected to continue in at least the first quarter of the ongoing year.
Mining capex has dropped from $6.8 billion in 1QCY12 to $2.08 billion as of the end of 2013.
Mining machinery and equipment orders have fallen because mining companies are trimming their operating expenses by delaying the replacement of machine parts, which has led to lower sales for machinery companies, including CAT.
The Bloomberg Base Metals index has been trending down from 239.96 in 4QFY10, and is forecasted to fall to 192.31 in 1QFY14. The downtrend reflects the falling production and mining of base metals, which is consistent with our forecast of depressed mining activity moving forward. And though coal production is up, it is growing at a slow rate. Furthermore, coal CAPP prices have been falling, having dropped from $73.58 in 2011 to current levels of $57.51. This may lead to a tapering of output in the future.
There is, however, some light at the end of the tunnel. Certain industries are showing signs of recovery, and orders are trickling in from others. Copper prices are expected to rise to $7, 317 per metric ton (/mt) in 1QFY14 from $7,169.13/mt in 4QFY13. As miners increase copper output (Chile has recorded an increase of 7.6% in copper production), increased mining activity will generate business for CAT.
CAT has also won a fight against miners who were opposing an export deal that would prevent US companies from participating in the Roy Hill mine project in Australia. The win is expected to broaden the market for machine manufacturers, and the project is expected to generate $500 million in sales as it gets underway.
The Construction Industries segment accounts for about a third of the company’s business. The segment supplies machinery, including haulers, tractors, pavers and others to contractors and builders around the world. The segment’s performance is dependent on infrastructural development and construction spending; so much so, that US construction spending is positively correlated to CAT’s earnings by a factor of 0.6.
CAT’s earnings per share are positively correlated to US construction spending by a factor of 0.6
Construction spending in the US has been rising steadily over recent quarters. Residential construction spending increased by an average 16.4% YoY every quarter in 2012, and has been outpacing spending on non-residential projects over the last two years, which has grown by less than 2% over the same timeframe.
Residential construction spending has outpaced non-residential construction spending by an average of 15% every quarter over the last two years.
Caterpillar’s inventory turnover – the number of times the company’s inventory was sold and replaced over a specific period – was around 2.8 times in the last quarter, significantly lower than the inventory turnover rate of Deere & Co. (DE), which is 5.8x. The two companies, however, serve different end-user markets: a majority of Deere’s business is generated in the agriculture and forestry industry, while CAT’s earnings are predominantly driven by sales to mining and construction businesses.
CAT has a higher inventory turnover rate when compared to Joy Global Inc. (JOY) and Komatsu Ltd. (KMTUY). However, their turnover rates are generally low, reflecting an industry-wide slump that is affecting all major players, regardless of their geographic location.
CAT’s inventory turnover rate has dropped from almost 4x to 2.7x over the last three years.
These companies’ inventories have been declining as they cut production and manufacturing to offset lower end-user demand. Deere is the only company that has maintained production at the same levels as it is more exposed to the agriculture business, which has been growing; on the other hand, Komatsu has reported growth in inventory levels ever since it took ownership of its dealer and distributor inventory in 2013.
Inventories have been declining since mid-2012 as manufacturing levels have dropped. CAT alone closed four plants and laid off close to 13,000 employees in 2013.
CAT’s earnings have historically been positively correlated with growth in the global GDP, owing to the company’s large size and geographic dispersion. This means that demand for CAT’s equipment is likely to grow with increased infrastructural development and urbanization as world GDP grows, and fall if it contracts.
CAT’s EPS and global GDP growth are positively correlated, as the company depends on a number of markets to drive growth for its products.
CAT has forecasted revenue growth to remain flat in 2014, with growth in the construction industry partially offsetting the slowdown in resource industries. Sales from the power systems segment are expected to remain stable through year.
As far as its Construction and Mining segments are concerned, CAT can expect improvements only in the long run. Future growth will be driven by increased global demand for infrastructure and energy development; especially from emerging economies, where a burgeoning middle class and rising urbanization is expected to drive demand for machinery manufacturers like CAT.
Growth in the global middle class is likely to lead to rural-urban migration, which will, in turn, necessitate the construction of more roads, bridges, and other urban infrastructure. When that is likely to happen, and at what rate is another matter: while developed nations are now showing signs of picking up, recent numbers out of China and other emerging markets have failed to impress.
Given Caterpillar’s three-year historic price-to-earnings multiple of 13x, and its current and forward multiples of 16x and 15.5x, we believe the stock is slightly overvalued at a price of $90.6. The stock has yielded around 2.5% in dividends over the last few years, but given the flat outlook for the company, continuing uncertainty in end-user markets and volatility in emerging markets, the stock seems like a risky investment till macro conditions show signs of a significant improvement. We recommend you to Sell.