Caterpillar's Earnings: Global Demand And China Scandal Fallout In Focus

| About: Caterpillar Inc. (CAT)

Caterpillar (NYSE:CAT) will announce its fourth-quarter and full-year 2012 earnings on Monday, Jan. 28. A weak global economy and the accounting fraud uncovered last week at the recently acquired Chinese company, Siwei, will weigh down Caterpillar’s fourth-quarter profits. The company forecasts a non-cash charge of $580 million or $0.87 per share arising out of the deliberate misconduct at Siwei in the fourth quarter.

For full year 2012 though, CAT’s earnings will show impressive growth on strong performance in the first three quarters. The company forecasts earnings in the range of $8.13-$8.38 per share in 2012, including the charge from Siwei, up from $7.40 per share in 2011.

We currently have a stock price estimate of $90.26 for Caterpillar, approximately 5% below its current market price.

Siwei Accounting Misconduct

On Jan. 18, 2013, CAT announced that an internal investigation at Siwei, the Chinese subsidiary of its recently acquired ERA Mining, revealed a deliberate, multi-year accounting misconduct. The investigation revealed that the senior management at Siwei had engaged in wrongful revenue recognition practices for several years to overstate profits. Consequently, CAT removed several senior managers at Siwei and is currently considering legal action to recover its losses.

Caterpillar had completed the acquisition of ERA Mining in June 2012 and uncovered the scam during the integration of Siwei. Siwei manufactures roof support products for underground mining and has a significant presence in the local Chinese market. Caterpillar does not anticipate any significant losses arising out of this mismanagement beyond the fourth quarter of 2012. Further, the company says that despite this scam, the acquisition of ERA is well aligned with its growth strategy in China and that it will maintain the Siwei brand.

Weak Global Economy

Additionally, the company’s fourth quarter earnings will be impacted by the weakness in the mining industry worldwide. Several big metals and mining companies like Vale (NYSE:VALE), Rio Tinto, BHP Billiton and Fortescue Metals Group (FMG) have indicated lower spending due to declining prices of certain base metals. This will impact sales of mining equipment and machinery manufactured by CAT. The mining business constitutes 39% of Caterpillar’s total value, according to our estimates.

Further, in the third quarter, the purchase activity of CAT’s dealers had declined below that of end-user purchase levels in an attempt to lower inventory levels in light of the weak global demand environment. We anticipate this trend to persist in the fourth quarter and continue to impact sales and earnings.

Monetary Easing in China

On the bright side, construction spending particularly in China is on the rise after the Chinese government raised key interest rates in mid-2012. Coupled with a slew of infrastructure projects announced in the country in the third quarter, demand for construction equipment manufactured by CAT will likely be higher in the fourth quarter. The construction business constitutes around 21% of Caterpillar’s total value, according to our analysis.

Disclosure: No positions.