Over the last two weeks, all news about the Chinese construction sector has been marked with ambiguity. On one hand, Caterpillar's (CAT) CEO Doug Oberhelman was reported saying that his recent visit to China revealed a positive "attitude change" among CAT's customers. On the other hand, CAT's largest competitor in China, Sany Heavy Industry Co, reported a 59% decline in profits and attributed it to slow economic growth in the region.
Competitor's Point of View
China's largest machinery manufacturing firm according to market cap reported a 59 percent YoY decline in profits and an 18 percent decline in revenues. Net income declined from 1.73 billion Yuan to 714 million Yuan. Revenues fell from 10.85 billion Yuan to 8.9 billion Yuan. The company was wary of the decelerating economic growth in the region. Another sign of the economic slowdown was the fact that accounts receivable jumped up by 83 percent YoY to 20 billion Yuan. The company's excavator sales, its second biggest revenue contributor, plummeted by 27 percent.
The 11% decline in the company's margins shows that the company has brought down prices in order to attract demand.
Both Sany and Hitachi have cut production rates for this year. Hitachi, the second largest equipment manufacturer in Japan, also reported a 52 percent decline in earnings yesterday. A Tokyo-based analyst remarked that profits have taken a hit, due to the major restructuring taking place as well as the global economic slowdown. Though the company gets only 10% of its revenues from China, the slowdown in Chinese operations has hurt the profitability of the company.
Another Japanese equipments manufacturer to report earnings yesterday was Komatsu. Komatsu's shares were down 2.5% after it announced that it expects the demand for construction and mining equipment in Chinese markets to decline by 40 percent YoY for the quarter ending in December. A flat-20% decline is expected in the demand for the first quarter of next year, i.e. Jan - March 2013.
As already mentioned, in the earnings release held some 10 days back, CAT's CEO was bullish on the Chinese economic recovery. He was also optimistic with regards to the change in China's leadership to take place this November.
CAT earns 3% of its revenues from China. However, it expects to go big in China through incremental revenues in future from this region, which makes China an important growth avenue for the company. In our earlier article, we mentioned that CAT has managed to tackle the Chinese economic slowdown. At the start of the year, the company was anticipating 5-10% growth in overall revenue from incremental sales in China. Therefore, it expanded its manufacturing facilities. However, demand has been below expectations. The CEO has not cut down the workforce employed in China and is instead exporting the excess inventories to different parts of the world.
Since the sales of construction machinery are highly correlated with the economic growth in a region, it is necessary to discuss the movement in Chinese economic indicators. The important indicators include the Chinese GDP growth rate, electricity generation, exports, and fixed asset investment.
The GDP growth rate has decreased over the last seven quarters to 7.4%. However, the market often considers Chinese economic data to be manipulated and hence unauthentic. One of the most reliable data in China is considered to be that pertaining to electricity generation. According to Huaneng Power International, a Chinese firm that owns and operates coal-fired power plants in China, the YoY electricity generation growth rate was only 3%. The company itself produced 5.3% lesser electricity on a YoY basis. This indicates the current health of the economy. A 7.4% rise in GDP seems to be a doubtful number, especially considering the mere 3% growth in power generation.
The chart shows that the Fixed Asset Investment growth rate has picked up recently. However, what bulls do not take into consideration is the fact that fixed asset investment is still down 4.4% YoY for the first nine months of the year.
Exports have been on the rise as well. The following shows the pattern of exports in China:
It has now become evident that CAT's CEO was right when he said that there is a lot of economic uncertainty and it will take another 60-90 days for the cloud to clear and the future to become more visible. On one side, the rise in imports of iron ore by China has sent positive signals to the economy. On the other hand, no one is sure for how long the rise in demand will stay, as many think this is a temporary surge brought about by the recent approval of $156 billion worth of infrastructural development projects in China.
CAT is trading at a cheap price earnings multiple of 8x. It also provides a dividend yield of 2.5%. For the short-term, as already mentioned, the fiscal cliff has made the future of the economy obscure. However in the long-run, the stock's earnings are expected to rise as the global economy recovers. Therefore, the stock is recommended as a buy.