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On July 24, 2013, Caterpillar (CAT) declared its second quarter results for fiscal year 2013. It posted a disappointing 16% year-over-year revenue decline. Caterpillar blames falling commodity prices since this affects its mining business directly. China's economic slowdown also impacted the company as this region has a significant market share in the mining industry.

What steps will Caterpillar take to overcome, or at least lessen, the impact of the declining mining industry?

Mining business still a huge headwind

In the second quarter this year, the overall global mining results were negative. It was mainly due to the falling commodity prices and rising operating cost, which grew faster than production. This includes the 13% rise in employee cost, while the number of employees grew by only 2%.

In order to reduce the cost structure, Caterpillar has taken cost-cutting measures to dampen the negative effects of its mining business. In the past two months, Caterpillar has laid off over 700 employees, increasing total global layoffs to 10,000 in the past 12 months. Additionally, it will be closing its tunnel-boring machine plant in Toronto, Canada, initiating another 330 job cuts by the first half of 2014.

On the other side, mining companies are reducing their capital expenditure, or capex, due to the overall slowdown. In this scenario, the demand for aftermarket parts and services tends to increase since companies use existing equipment rather than purchasing it new. This trend will help Caterpillar offset declining original equipment sales since it provides quality services for its sold equipment. These services provide higher margins compared to the equipment sold, which will play a large role in mitigating the negative impact from the declining capex of mining companies. Caterpillar is anticipated to experience a reduced-decline in its construction business of just 2% to $18.8 billion in this year on the year-over-year basis.

Declining backlog

In the second quarter this year, Caterpillar's backlog declined $1.3 billion to $19.1 billion on the quarter-over-quarter basis. The resource industries and the power system segment contributed to this decline, but it was offset by the increase in the construction segment. Orders declined by 11% year-over-year.

The company's book-to-bill ratio stood at 0.91 in the second quarter, which is not a good sign. A ratio below 1.0 implies that fewer orders were received than filled. This also means a decline in the number of future orders, indirectly indicating less business in the coming quarters.

One of the major reasons for the decline in the sales is that dealers, or retailers, are de-stocking. To offset this, the company under produced in the second quarter in order to reduce the dealers' high level of inventory and existing stock. Unlike companies such as Joy Global (JOY), which also manufactures machinery for extraction of minerals like coal, iron ore, and copper, Caterpillar sells its products through a separately owned dealer network.

Joy Global will continue benefiting from legacy-mining orders turning into shipments in the first half of its fiscal year. However, despite this tailwind opportunity, Joy Global is expected to post EPS at $5.60-$5.80 in this fiscal, which is significant reduction from its previous year's EPS of $7.13. It too will be highly impacted from this whole industry downturn.

Peer Comparison

Based on the highest market cap companies in the machinery equipment industry, I am comparing Deere (DE) with Caterpillar in order to gain a better understanding from a valuation standpoint. Deere is also engaged in manufacturing construction equipment, and has a market cap of $32.7 billion. The enterprise value of Caterpillar stays at high levels of $90.29 billion, due t to its large market cap, while Deere's enterprise value is only $61.64 billion. Caterpillar also stands strong when compared on the EV to revenue basis, as it has a ratio of 1.50 times, which is lower than Deere's 1.63 times. This ratio helps investors understand how much it would cost to buy the company's sales.

Caterpillar also has a better EV to EBITDA ratio, which is 9.50 times compared to Deere's 10.02 times. Through this ratio, it is easy to find out the approximate fair market value of a company and the lower number is considered better. It is surprising that despite high enterprise value, Caterpillar has better ratios than Deere, since Caterpillar has revenue double the level of Deere, and it has 50% higher EBITDA also. Additionally, considering the price to book ratio, the industry standard is 4.9 times, while Caterpillar and Deere have a ratio of 3.17 times and 3.90 times respectively. By comparing the price to book ratio of the industry with its individual companies, we learn whether the company is undervalued or overvalued. The former shows growth prospects in the future, and the latter reflects the overpricing of a stock. This indicates that both the companies are fairly undervalued. Therefore, on valuation basis, Deere is not as an attractive investment when compared to its peer company, Caterpillar.

Conclusion

Presently, Caterpillar isn't doing great business. Nevertheless, on the valuation point-of-view, it stays an attractive investment. To boost investor confidence, the company will buy back shares worth $1 billion, part of its $7.5 billion share repurchase authorization, in this quarter of the year. These aspects give me confidence to recommend this stock as a hold in order to gain long-term gains.

Source: Does This Caterpillar Have 9 Lives To Survive The Industry Downturn?