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Discussion Points for Caterpillar Inc. (CAT):

Accounting Issues

  • Revenue - Negative trends, backlog and increasing DSOs
  • Inventory - Elevated DIOs

Earnings Analysis

  • Earnings Quality - Earnings from acquisitions/divestitures
  • Deteriorating Earnings Growth - Declining net income/margin
  • Decreasing Segment Operating Margins

Valuation

  • Shares trade at a slight premium to peers

Analysis Summary

We are concerned about CAT's ability to sustain its revenue and earnings growth. An 8% year-over-year decrease in revenue in Q4 2012, along with decreasing backlog, increasing DSOs and elevated production levels, indicate potential income and margin pressure.

Elevated inventory levels and high production, coupled with high DIOs, may lead to increased inventory costs and lower future earnings.

CAT's shares trade at a premium to peers based on 12-month forward earnings, and its shares are at the mid-point of their 52-week range. Given the revenue and earnings pressure the company faces, we believe the share price could be pressured going forward.

Revenue - Concerns

Negative Cyclical Sales Trend and Decreasing Backlogs: We are concerned about CAT's ability to meet future sales projections, and the potential for aggressive future sales recognition in order to meet targets, due to declining cyclical sales (Construction Industries) and reduced orders (Resource Industries).

CAT's CEO expects the first half of 2013 to be more challenging than first half 2012, per the Q4 2012 Earnings Release:

If the recent improvement in economic indicators continues, 2013 could be another record year for Caterpillar. We expect the first half of 2013 will be weaker than the first half of 2012 (our emphasis), with better growth in the second half. However, if, like the last two years, growth and confidence decline in the second half, 2013 could be a tough year.

Sales Discounts: CAT has elevated financial reporting risks related to revenue recognition due to accrual of post-sales discounts recorded as reductions to sales. Estimating post-sales discounts can be complex and require significant management judgment. Post-sales discount reserves have trended up through Q4 2012.

Increasing DSOs: CAT's DSOs have increased, indicating potentially weakened sales, extended credit terms, ineffective collections, or fictitious sales. DSOs have increased year-over-year and trended up for the past three quarters.

Revenue - Background

CAT projects 2013 revenue of $60 to 68 billion. Revenues were $65.9 billion for FY 2012, an increase of $5.7 billion, or 10% from FY 2011.

Negative Cyclical Sales Trend: Revenues for FY 2012 included Machinery and Power Systems ("MPS") sales of $63.1 billion and Financial Product revenues of $2.8 billion. MPS revenue includes segment revenue from Construction Industries, Resource Industries, and Power Systems. Chart 1 shows MPS segment sales for the past eight quarters.

(click to enlarge)

Sources: Prior 10-Qs and 2012 10-K.

MPS Q4 2012 sales decreased year-over-year by $1.2 billion or 8%. Construction Industries sales had the largest decrease of 25%. CAT explains the decrease in Construction Industries sales as follows:

Sales decreased in all geographic regions of the world, driven by dealers reducing new machine inventory levels in the fourth quarter of 2012 compared with dealers increasing inventory levels in the fourth quarter of 2011. Dealer-reported new machine inventory decreased about $950 million during the fourth quarter of 2012 compared with an increase of about $525 million during the fourth quarter of 2011. Dealer deliveries to end users were about the same as the fourth quarter of 2011.

Resource industries sales increased 14% during Q4, but decreasing new orders may pressure future sales. CAT explained the increase in Resource Industries sales as follows:

As a result of increased production capability, coupled with our existing mining order backlog, sales were higher than the fourth quarter of 2011. However, new orders were well below the fourth quarter of 2011 (our emphasis).

Decreasing Backlog: Backlog has decreased sequentially for the last three quarters. Chart 2 shows backlog trends for the past eight quarters.

(click to enlarge)

Sources: Prior 10-Qs, 2012 10-K, and Independent Calculations.

Q4 2012 backlog decreased $3.5 billion or 15% from Q3 2012. CAT provides the following explanation for its decreasing backlog:

The most significant decrease in the fourth quarter of 2012 was in Resource Industries. Although dealer deliveries to end users in the fourth quarter of 2012 remained about flat compared with the third quarter of 2012, orders received from Cat dealers have continued to be well below end-user demand.

Sales Discounts: Sales discount reserves is in an upward trend, with the past four quarters being the highest of the last eight. CAT records dealer discounts as reductions to sales.

Chart 3 shows post-sale discount reserve balances compared to trade receivables and sales for eight quarters through Q4 2012.

(click to enlarge)

Sources: Prior 10-Qs, 2012 10-K, and Independent Calculations.

Increasing DSOs: DSOs have trended up for the past three quarters. DSOs for Q4 2012 were 67 days, an increase of 6 days or 11% from Q4 2011. Chart 4 shows average DSOs and trade receivables for the past eight quarters.

(click to enlarge)

Sources: Prior 10-Qs, 2012 10-K, and Independent Calculations.

Inventory - Concerns

Inventory and DIOs Remain Elevated: Inventory and DIOs are higher than for Q4 2011, despite a $2 billion reduction of inventory during Q4 2012. If management overestimated demand during 2012, there could be valuation risks related to excess or slow moving inventory.

Production: CAT appears to have a history of over-production. Production-to-COGS ratios above 100% indicate potential over-production. CAT's production-to-COGS ratio was above 100% for seven of the past eight quarters, which indicates management may have overestimated demand. It may also indicate that cost absorption levels were too high in prior periods and not sustainable. This could result in higher future COGS and lower operating income margins.

Inventory - Background

Inventory and DIOs Remain Elevated: DIOs increased 23 days or 23% in Q4 2012 compared to Q4 2011. Inventory at the end of Q4 2012 was $15.5 billion, a $2 billion decrease from the previous quarter, but an increase of $1 billion or 7% from the end of Q4 2011.

Chart 5 shows trends in inventory balances and DIOs for the past eight quarters.

(click to enlarge)

Sources: Prior 10-Qs, 2012 10-K, and Independent Calculations.

The CEO provided the following quote in the Q4 Earnings Release related to Q4 inventory levels:

I'm extremely pleased with our performance on reducing inventory $2 billion in the fourth quarter. As the world economy began to soften at mid year, we increased our focus on reducing inventory. Cat dealers also worked to lower their inventories, and, as a result, reduced their order rates during the second half of 2012. The result was a substantial reduction in our production levels and inventory. The reductions had a significantly negative impact on fourth-quarter sales and profit. The $2 billion inventory reduction in the fourth quarter was a remarkable effort, but we're not done. Reduced production levels are likely to continue at least through the first quarter of 2013 until inventories and dealer order rates move back in line with end-user demand.

Production: Production-to-COGS ratio was greater than 100% for seven of the past eight quarters. Chart 6 shows production and production as a percentage of COGS over the past eight quarters. Production included in this analysis is calculated as COGS plus the change in quarterly inventory (beginning inventory minus ending inventory).

(click to enlarge)

Sources: Prior 10-Qs, 10-Ks, and Independent Calculations.

Earnings Analysis

Earnings Quality - Concerns: Earnings and revenue growth from acquisitions and divestitures may not be sustainable, and increases the risk of earnings management in order to maintain growth, or may hide falling organic revenues. Incremental profit margin - increase in operating profit/increase in revenues - was 25%. Excluding acquisitions and divestitures, incremental profit margin was 43%. Operating profit margins from acquisitions were negatively impacted by a $580 million goodwill impairment related to the Siwei acquisition in 2012.

Earnings Quality - Background: Acquisitions and divestitures added $2.7 billion to 2012 revenues and $674 million to operating profit. These amounts represent 47% of the increases in revenues and operating profits, and are primarily related to the acquisition of Bucyrus in 2011 and the divestiture of a majority interest in the third party logistics business in the third quarter of 2012.

Deteriorating Earnings Growth - Concerns: Earnings decline puts pressure on management to show better operating results, increasing the risk of aggressive revenue recognition or earnings management.

Deteriorating Earnings Growth - Background: Net income decreased $850 million, or 55% in Q4 2012 compared to Q4 2011. Net profit margin decreased to 4.3% for Q4 2012, from 9% in Q4 2011. The reason for the earnings decline is disclosed in the 2012 Form 10-K:

Fourth-quarter 2012 profit was negatively impacted by a goodwill impairment charge of $580 million, or $0.87 per share, related to Siwei. Lower sales and revenues and the cost impact from sharply lower production and the $2 billion decline in Caterpillar inventory also had a negative impact on fourth-quarter profit. Those impacts were partially offset by a $300 million positive impact related to the settlement of prior-year tax returns.

Chart 7 shows trends in net income and net profit margin for the past eight quarters.

(click to enlarge)

Sources: Prior 10-Qs, 2012 10-K, and Independent Calculations.

Declining Segment Operating Margins - Concerns: A significant decline in the three major segments' operating margins indicates pervasive earnings pressure in CAT's business.

Declining Segment Operating Margins - Background: Operating margins in the Construction Industries, Resource Industries and Power Systems segments declined significantly year-over-year in Q4 2012.

Chart 8 shows trends in segment operating profit margins for the past eight quarters.

(click to enlarge)

Sources: Prior 10-Qs, 2012 10-K, and Independent Calculations.

Valuation: CAT shares trade at a slight premium to peers identified below, and its shares are about 20% below its 52-week high. The shares may continue to be pressured, given the issues identified in this report.

(click to enlarge)

Sources: Stock market data, company filings.

Peers used are: Deere & Company (NYSE:DE), CNH Global NV (NYSE:CNH) and Cummins Inc. (NYSE:CMI)

Additional Key Information

  • Industry: Construction Machinery
  • Last Reporting Period: Q4 FY12
  • FYE:Dec. 31
  • Auditor: PwC
  • Market Cap (billions): $59.8
  • P/E (NYSE:TTM): 10.6x
  • EPS: $8.48

TTM Financial Metrics - Dec. 31, 2012 (billions)

  • Revenue: $65.9
  • Operating Income: $8.7
  • Net Income: $5.7
  • Operating Cash Flows: $5.2
  • Total Assets: $89.4
  • Total Debt: $40.2
  • Total Equity: $17.6

  • Close: $89.77
  • 52-Week High: $113.73
  • 52-Week Low: $79.64

  • Close: 2.9%
Source: Caterpillar's Revenue And Inventory Still Reasons For Concern