Schrödinger's CAT: Is It Dead Or Alive?

Aug. 6.14 | About: Caterpillar Inc. (CAT)


DuPont Analysis is used to break down the ROE.

Leverage over several periods is compared using market value of equity.

Trends in cash and book value of equity are used to assess the share buyback.

Caterpillar (NYSE:CAT) missed analyst projections on gross revenues, reporting only $14.15 billion compared to the projection of $14.5 billion. However, they beat the earnings estimates of $1.52 per share, coming in at $1.69 per share. I've heard people attributing this performance in part to their share buyback program. The share buyback deserves part of the credit for beating EPS estimates in the first quarter, when weighted average shares dropped from 658.6 million in 2013 to 639.3 million in 2014 Q1. In the second quarter, it only dropped to 638.3 million. That reduction of one million shares in the weighted average is about 0.16% of the float. Caterpillar had to do something else to beat the earnings projections.

The following DuPont analysis should help explain the performance of the company:

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Tax Burden

In a DuPont Analysis, tax burden is the inverse of the effective tax rate. In short, a higher number means taxes are taking less. The effective tax rate was higher in the first two quarters of 2014 than in 2013. They average out to about the tax rate for 2012, which was the year with the highest effective taxes. CAT's performance was not caused by better tax planning.

Interest Burden

The interest burden is calculated in a similar way to the tax burden. The higher the percentage, the more income was able to make it from EBIT to earnings before taxes. Interest costs are down, but the change is tied improvements in "other income". CAT uses the "other income" line to bring in translation adjustments relating to their exposure to foreign currency. I considered excluding translation adjustments, but the foreign currency exposure could be very effectively hedged between the major currencies. Under covered interest rate parity, the foreign currency gains or loss should be largely predictable based on the forward exchange rates. Therefore, maintaining the exposure rather than hedging it is implicitly similar to paying or receiving interest based on the spread between the risk free rates in each country. Simple version: Translations gains and losses can be considered a form of interest, therefore they were included. CAT did benefit significantly from a reduction in effective interest expense.

Operating Margin

The operating margins are up from last year, but down from previous years. Still, given the importance of operating margins the change compared to 2013 is quite meaningful to earnings per share. Given the drop off in sales that CAT experienced, their ability to maintain operating margins is very impressive.

Asset turnover

Assets are up and sales are down. The ratio was hit from both sides and it's a limiting factor for the company. However, when sales pick up this ratio will be adjusted quickly and CAT will be looking very good.

Leverage Ratio

The leverage ratio is the most concerning part of the DuPont Analysis. Based on book values, it appears that the company is financing dramatically more of its operations with equity rather than debt. That can be one of the weaknesses of the return on equity measure though. It is susceptible to being distorted by differences between market value of debt and book value of debt. I'll address that in more depth later in the article.

The takeaway, so far, is that small improvements in the Interest Burden and Operating Margin have done most of the lifting in allowing CAT to beat analyst projections.

The company is buying back shares

The company recently announced it was accelerating the share repurchase program. That shouldn't be too surprising given the trend in cash and book value of equity. The following chart breaks down cash and book value of equity. To account for significant share repurchases that took place during the period, the weighted average number of shares outstanding is included:

Book value of equity can be distorted relative to market values

The book value of equity for the company is not tied to the market value. To really understand the level of leverage in the business we would need to compare the market values of debt to the market values of equity. Unfortunately, finding reliable quotes on all the company's debt issues is impractical. Most analysts use the book value of debt and the market value of equity. Unfortunately, the market value of equity can also change dramatically. To control for the variance, the opening and closing share prices are pulled from the first business day after the end of each fiscal period. The prices are averaged and multiplied by the number shares outstanding on the balance sheet date.

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Note that the share values are different in each table because Table 2 used the diluted weighted average and Table 3 used the actual number of shares outstanding on the date of the Balance Sheet. Total Liabilities is being used rather than long term debt.

Based on the percentage of the company financed with debt, the company has not been increasing its leverage. Instead, leverage has been decreasing and cash has been increasing. Based on those trends, it appears management is making a very solid decision to return funds to shareholders through a share repurchase plan.


CAT has a solid history of stable margins and has done an excellent job maintaining their operating margins in a challenging environment. The environment for the business neither looks great nor terrible, so I expect the company to continue performing at about the same level. Between share buybacks and dividends, management is returning substantial amounts of funds to shareholders. The combination allows the stock to be held for dividends while having a growing ownership stake as more shares are retired.

I am bullish on CAT as part of a highly diversified long term portfolio.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. The analyst holds a diversified portfolio including mutual funds or index funds with long exposure to the stock. Values for Assets and Equity used ending values rather than averaged.