A month ago, the last time I wrote on Caterpillar (NYSE:CAT), I discussed CAT's different segments and gave a future outlook for CAT's business in different geographical regions and the overall mining industry. Since the MinExpo held in September, the market has been bearish about the overall mining industry, and it has reason to be so. Many mining companies have announced CAPEX reduction in recent months. Important examples include slash in CAPEX guidance by Vale S.A. (NYSE:VALE), the second largest producer of iron ore in the world, and Fortescue Metals (Australian mining company).
J.P. Morgan (NYSE:JPM) made the situation even more serious by, recently, downgrading CAT from Overweight to Neutral. A JPM analyst reduced the FY12 EPS estimate to $9 from $10.92, citing that CAT does not have the balance sheet cushion to support share repurchases as a means to bolster the EPS. This news meant that not only CAT's performance is going to be damaged by a weakness in the macro environment but also that CAT does not have enough 'strength' in the balance sheet to improve its results. Not only this, the analyst also believes that the re-election of Obama will negatively impact the coal sector, and hence hurt CAT's revenues in the future.
An Update On The Mining Industry
This Tuesday, CAT reported its worldwide retail sales of machinery for the three months through October 2012. The sales were up by 8% Y-o-Y. The growth rate was more than the 6% growth rate reported for the period July-September 2012. However, it was way less than the 13% growth rate for three months ended August 2012. Following table shows the results:
Also, according to an article published in The Wall Street Journal, many US companies are scaling back investment plans at the fastest pace since the recession. More than half of the nation's 40 biggest corporations have announced a reduction in CAPEX for this year. The market fears that the re-elected government may not be able to resolve the fiscal cliff and this might lead to another recession in the economy.
In its Q3 earnings release, CAT lowered its 2012 EPS guidance to the range of $9-$9.25 from $9.60. At the start of the year, CAT expected to spend a CAPEX of $4 billion through the year. However, last month, CAT declared that it will not reach that target.
The sell-side is also bearish about the mining industry. JPM believes that the global mining CAPEX is expected to decline by 10 percent in 2013 and 5% in 2014. When combined, the mining industry is expected to see a 14% decline from 2012 peak spending of $136 billion.
Therefore, the mining CAPEX remains pressured as companies continue to assess their investment plans for the longer term.
Also, the cuts are becoming more broad-based; for example, Kinross Gold Corp (NYSE:KGC) recently announced reductions in its CAPEX outlook (gold had previously been viewed as "exempt" from spending cuts).
JPM believes that Obama's re-election will have a significant impact on the coal and energy sector. As already mentioned in my article on the US railroads, the market is cautious about coal stocks after Obama's re-election given that Obama's administration has passed laws that have restricted consumption of coal. A reduction in coal demand will hurt the results of CAT's Resource Industry segment.
Coal exports are also falling. The metallurgical coal market remains weak. Though, JPM believes that the international thermal coal market bounced off the bottom in Q3'12, still appetite for new coal contracts remains limited as coal inventories remain high at the utilities.
Problems with Balance Sheet
When we analyze CAT's balance sheet from 2010 onwards, we can see that CAT's inventory levels have steadily increased as a percentage of sales over the past few years, with significant expansion in the work-in-process and finished good levels. This presents a significant risk as the sales growth rate continues to decelerate. The inventory days on hand have also trended upwards, signaling CAT's questionable ability to accurately forecast the end market demand. Indeed, even when the demand is expected to decelerate-as it has in China-the management is maintaining higher levels of inventory in the region than the company did during the last economic recession (CAT's CEO mentioned in the earnings call that inventory levels are being maintained at high levels in China so that CAT benefits fully from a turnaround in the economy). Should these inventory management issues persist, CAT could be faced with additional costly inventory liquidations beyond early 2013, which could weigh on the earnings for longer than originally anticipated.
The inventories are high at the dealer's end as well which has resulted in reduction of the overall orders. This means that CAT will have to reduce the production rate, which means layoffs are expected in the near future.
Why I said that the company does not have the balance sheet to support share repurchase is because firstly, a large chunk of the cash reserve is tied up with the inventories. Moreover, the company's net debt to total capital is 30%, and debt reduction and the payment of dividend remain the highest capital allocation priorities.
The stock is currently trading at a cheap forward multiple of 9x (lower than the average multiple of 11x for the industrials). It also pays a healthy dividend yield of 2.5%. There is no doubt about the fact that the company is facing the problem of high inventories and a weak global macro environment. In the short-run, I will recommend that investors stay away from the stock given the prevalent uncertainty in the economic environment. However, in the long run, we all know that the mining industry is here to stay for always. Despite all the problems that CAT is facing, the stock is still trading below its target price (JPM's estimates) of $90. The cheap valuations and a healthy dividend yield compel me to take a bullish stance on the stock in the long-run.