Caterpillar: The Strong Will Get Stronger

Regarding the state of manufacturing in a downturn, Caterpillar (CAT) had a striking quote in their last earnings call:

And generally speaking, if you go back to the '80s, close to half the world's manufacturers didn't make it through that downturn successfully. And the strongest got stronger, and we were one of those. I would expect that we will strengthen our position going through this downturn.

The state of the ISM

The ISM's PMI hit some nasty lows in the 80's downturn, which were recently hit again in January during the current downturn before seeing a rebound to the recent level of 42.8%, which still implies contraction, just less than before. Now, is the above Caterpillar quote correct, were almost half of manufacturers really in serious trouble? It would seem that this time around, things haven't been so bad. But feel free to enlighten me.

Interesting inflection point for New Orders

Most recently, if we look at the latest ISM report released June 1st, we see that there has been an interesting inflection point. New Orders growth went positive, continuing its improvement since December 2008, but rather shrinking by smaller amounts, it is now growing. Customer inventories have also continued a 2-month drop, which is a positive for future manufacturing orders.

While employment and inventories continue to decline at a rapid rate and the sector continued to contract during the month, there are signs of improvement. May is the first month of growth in the New Orders Index since November 2007, with nine of 18 industries reporting growth. New orders are considered a leading indicator, and the index has risen rapidly after bottoming at 23.1 percent in December 2008. Also, the Customers’ Inventories Index remained below 50 percent for the second consecutive month, offering encouragement that supply chains are starting to free themselves of excess inventories.

Anecdotal evidence

For some anecdotal evidence, here are some of ISM's quotes from different industries. I find the one from Machinery most interesting, implying that they might be last to rebound if indeed the US economy is starting to turn.

"Some amount of havoc is about to erupt, with companies pushing for increased capacity when suppliers have taken capacity offline." (Computer & Electronic Products)

"Business is actually better than plan." (Food, Beverage & Tobacco Products)

"Realistically, we don't see any of our major customers looking to place business until mid-2010 at the earliest." (Machinery)

"April was flat on sales. May looking better." (Primary Metals)

"Business still trending downward, but not as fast." (Chemical Products)

The strong will get stronger. The weak, well, will get weaker or die off (notwithstanding bailouts of course).

Let's at the very least hope things don't unfold as they did in the 80's. Either way, as Caterpillar management said, strong players are likely to get (relatively) stronger in the current environment.

A summary digestion of Caterpillar's recent 1Q09 earnings and conference call. For those who want to get an understanding for what is happening, but using less time.

The result in brief

Caterpillar (CAT) earned $0.39 per share, excluding redundancy costs of $0.58 per share, down from an adjusted US$1.44 per share in 1Q08. Revenue fell 22% to US$9.225bn. Nevertheless, operating cash flow was actually up, to $895m vs. $706m in 1Q08, due to substantial inventory reductions of US$764m vs. an inventory gain of US$864m in 1Q08. Research Reloaded Free cash flow for 1Q09 was $450m vs. only US$61m in 1Q08. Thus on a cash flow basis, CAT remained strong due to effective management into the down cycle.

Guidance was for 2009 revenue of US$35bn +/- 10% and 2009 profit of $1.25 per share excluding redundancy costs expected to be $0.75 per share.

Operating profit

Op profit was -$175m, or US$463m before redundancy costs as shown below. This was down significantly from op profit of US$1.29bn in 1Q08.

Key Segments Revenue and Operating Profit

Machinery Sales

In the latest conference call, management said they expect end-user demand for machines in the US to fall 70% from its quarterly peak in early 2006, and sees a similar trend for the US and Japan. Sales down 29%YoY due to cancellation of some major projects due to higher credit spreads for customers, housing industry declines, mining industry demand falling with lower commodity prices, and Caterpillar’s dealers reducing inventory. By region, North America was down 30%, EAME was down 46%, Latin America was down 16%, and Asia/Pacific was down only 2%. Thus Caterpillar has seen substantial relative strength for the Asia/Pacific market.

Also, interestingly, the Machinery segment as a whole was able to increase prices. Thus Caterpillar seems to be defending its pricing and sacrificing on volume in a disciplined fashion. Op loss was -$508m, or -$173m before redundancy costs. Op profit in 1Q08 was $626m. Margin thus obviously went negative due to the negative side of operating leverage, despite Caterpillar’s ability to increase prices. Helping dealers reduce inventories, to prevent excess inventory in the system, has been part of Caterpillar’s pricing strategy.

Engine Sales

Sales down 8% YoY due to currency effects and sales volume decline. Caterpillar was nevertheless able to increase its prices, as it did with Machinery. By region, North America was down 13%, EAME 7%, Latin America 20%, and Asia/Pacific 10%. Thus less relative strength evident for Asia/Pacific in this segment. Op profit was $297m, down 46% YoY.

Financial Products

These days, these kind of segments can be scary potential land mines for investors (look at what happened with General Electric). Nevertheless, Caterpillar is much different, and has nowhere near the financial complexity of GE. CAT finances its customers and dealers, with loans backed by its own products, where it can understand the collateral value very well. In 1Q09 Caterpillar’s financial segment saw revenue declines of only 12% and still registered an op profit of $99m.

CAT's Employment

Worldwide employment was 103,000, and the company reduced their full-time employees by 10,000 since end 2008, though also added 6,400 people due to acquisitions and their Japanese business consolidation. Part-time employment fell by 15,000 since end 2008.

Actions to Deal with a Tough Environment

Caterpillar expects the world to be in recession for 2009, but sees the US as the first developed country to emerge perhaps in the end of 2009, or early 2010. It also expects certain developing countries such as China to lead and rebound.

Nevertheless, the company is managing itself for the downturn, and lowering its production levels even below its lower demand forecasts in order to let dealers bring down their inventory levels. Of course they are also reducing their own costs, bringing down their own inventory and increasing their liquidity.

They are reducing employee costs by lowering the amount of overtime paid, which can result in significant savings, since the company reported that in 2008 a high level of overtime was paid. The company uses overtime in order to have volume flexibility. They are also implementing full or partial shut-downs for some facilities.

US Stimulus Package and Its Effects

CAT expects the impact to be limited, and expressed discontent with the meager infrastructure spending in the US plan. It says that China is spending three times as much on infrastructure in spite of having one third the economy, but this is a bit of an unfair comparison given that China is a developing country.

Liquidity

The company claims to have excellent access to capital, pointing to its recent February $3.5bn bond issuance and demand for Caterpillar commercial paper. In the earnings conference call, management indicated that they would not likely need to issue any further debt in 2009.

They are also carrying more cash than normal on their balance sheet. Inventory management will also help here, and they plan to reduce inventory by $3bn in 2009. Dividend suspension or cuts could be implemented depending on the economic situation, in order to support liquidity. CAT is also eligible to participate in the US government’s Commercial Paper Funding Facility. In their recent conference call, in response to a UBS analyst question, management nevertheless indicated that using this facility is merely an option on the table and it is unlikely to be a substantial part of funding. In simple terms, they probably don’t need it, which is a good thing.

1Q09 interest coverage ratio was reported at 1.24 to 1, vs. its minimum covenant 1.15 to 1 and financial leverage was 7.70 to 1, vs. its minimum covenant of 10 to 1.

Conclusion

CAT has rebounded substantially to $38 from its $22 52-week lows earlier this year, but is still well below its $82 highs from 2008. Good news from the earnings was that CAT was still expecting to make money in 2009, has little concern in terms of liquidity, generated healthy free cash flow despite much lower earnings due to strong inventory management, and actually has been able to increase prices in the weak environment. Management stated that the strong can get stronger in a downturn, and we believe that CAT is on its way to accomplishing this. Still, as pointed out in our previous manufacturing piece, a turn around for sales could be more than a year away.

Comments

[john1940:]

An excellent post. Few people recognize the change in manufacturing that has occurred among well managed companies. Inventory reduction is a major component and has been accomplished by new technologies and not accounting changes. It takes a large capital investment but can keep a company in a competitive position. Contrast with the auto companies; they tried and knew what to do, but were stonewalled by the unions.

Jun 10 11:21 AM

[mbkelly75:]

Well done - the only thing that bothers me about CAT is that they have a really large debt that may cause problems later. In general - I have liked the stock for a long time - but the debt bothers me in today's problem world.

Jun 10 11:53 AM

[TinyTim:]

No mention of the UAW & Cat's long history of labor problems

Jun 10 12:46 PM

[Vincent Fer...:]

FYI no mention in regards to labor issues in the latest conference call with analysts.

Jun 10 05:53 PM

[icandoitdon:]

i believe cat's debt relates to their financing of sales, not its operations. ditto with deere.


On Jun 10 11:53 AM mbkelly75 wrote:

> Well done - the only thing that bothers me about CAT is that they
> have a really large debt that may cause problems later. In general
> - I have liked the stock for a long time - but the debt bothers me
> in today's problem world.

Jun 10 08:58 PM

[Moon Kil Woong:]

Thanks for the post. I have been a holder and fan of this stock. It is one of the few stocks that has a bright long term future in a traditional area. It is not overly hyped. It's valuation seems fair. It is top of its class. Recent developments in its industry only encompass some benefits from bio-fuels and a rise in food commodities.

All in all, a stock Graham types value investors would be proud holding at this price. It is true sales will turn around later but when it does you will probably have missed the boat on its ride back to the $60-70 range.

Jun 11 01:57 AM

[User 429632:]

This article seems to miss important news that were released back in January where more than 20,000 workers had been laid off :

"Jan. 30: Caterpillar (nyse: CAT - news - people ) increases previous layoffs from 20,000 to 22,110, and share price hits 52-week low. " Forbes

Jun 11 04:53 AM

[Graham and ...:]

I am a Graham and Dodd investor, and I am also proud to own this stock (bought at 31) for a doubling (or more).


On Jun 11 01:57 AM Moon Kil Woong wrote:

> Thanks for the post. I have been a holder and fan of this stock.
> It is one of the few stocks that has a bright long term future in
> a traditional area. It is not overly hyped. It's valuation seems
> fair. It is top of its class. Recent developments in its industry
> only encompass some benefits from bio-fuels and a rise in food commodities.
>
>
> All in all, a stock Graham types value investors would be proud holding
> at this price. It is true sales will turn around later but when it
> does you will probably have missed the boat on its ride back to the
> $60-70 range.

Jun 11 11:14 AM

[morris kool:]

Part of the recovery strategy is investment in infrastructure, like roads, power generation, and the like.
CAT equipment will play a large role in this.
Morris Kool

Jun 11 11:42 AM

[TLassen:]

Great analysis, in general I agree with most commentators regarding positive outlook. Will wait for the pull back following the inevitable dividend cuts next qtr.
2009 EPS estimate from CAT 1.20, S&P 1.60, current dividends will be reduced sharply.

Jun 11 12:09 PM

[bbowen7:]

Most impressive is CAT's discipline - raising prices and helping distributors to reduced inventories (e.g. reduce CAT sales) during a major downtrend. This discipline is what leads periodically to labor unrest - would that GM had had the courage at appropriate points.

Jun 11 01:42 PM