Has Caterpillar Peaked?
- CAT's Q4 revenue grew by double-digits. Energy & Transportation growth was a pleasant surprise.
- Profit margins for Construction and Financial Services ticked down. This could be the canary in the coal mine.
- In my opinion, the global economy is not strong enough to warrant an investment in CAT.
- Sell CAT.
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Caterpillar equipment. Source: Caterpillar
The U.S. economy has been on an upward trajectory for over a decade. At some point what goes up must come down. However, President Trump believes the economy is strong and has more room to run. Sans more government stimulus, I believe the economy will begin to show cracks. That's why the earnings of cyclical names like Caterpillar (NYSE:CAT) are so important. They arguably could give an indication on just how strong (or weak) the economy truly is.
Caterpillar manufactures everything from earth-moving equipment to equipment to oil and gas equipment. At some point its revenue and income streams could be impacted by the vagaries of the global economy.
Caterpillar's Top Line Growth Remains Impressive
Despite my prognostications about the global economy, Caterpillar's revenue growth has been impressive. Q4 2018 revenue of $14.3 billion was up 11% Y/Y. This was less than the 18% growth reported in Q3 2018. With Caterpillar's sizable revenue base, one would expect its revenue growth to slow. On a sequential basis, revenue growth was only 6%. I expect Caterpillar's revenue growth to eventually slow into the single digits over the next few quarters.
Construction is Caterpillar's largest segment at about 39% of total revenue. Its revenue grew in the high single-digit range while the other two operating segments both grew by double-digits. The lion's share of Construction's revenue growth was derived from North America, which was up 17% Y/Y. North America was driven by higher demand for new equipment, of which about half was due to an increase in dealer inventories. Oil and gas activities and non-residential building construction were catalysts during the quarter. They could remain catalysts until the market realizes there may not be enough demand to justify such business fixed investment.
Construction's sales in Europe, Africa and Middle East ("EAME") rose 9% on infrastructure and non-residential building activities. Revenue from Asia/Pacific (about 25% of Construction sales) fell 4% due to lower demand in China. The trade war with the U.S. may have impacted Caterpillar this quarter. However, whenever China's economy appears to crack the country props it up with infrastructure spending and stimulus to support the property market. These measures have helped keep Caterpillar's equipment sales afloat. How many shovel-ready projects does China have left? At some point it will have to cut off certain stimulus measures, which implies Construction's Asia/Pacific sales could fall further.
Resources revenue was driven by sales of mining and heavy construction equipment. Management believes commodity prices support continued investment in the mining sector. Energy & Transportation revenue rose 11%; in my opinion, this was the biggest surprise during the quarter. Oil & Gas revenue was up 15%, despite the fact that Schlumberger (SLB) and other oil services firms were bearish on the North America land drilling segment. Power Generation revenue was also up by double-digits, though General Electric (GE) and Siemens (OTCPK:SIEGY) have been bearish on the power market. I found the sector's performance mind-boggling, but it could be the catalyst Caterpillar needs if Construction falters.
Profit Margins Are Expanding
Caterpillar achieved operating profit of $1.9 billion up 36% Y/Y. The increase was due to higher sales and higher prices, offset by higher manufacturing costs. Profit margin for Construction ticked down about 100 basis points as higher price realization was offset by higher material and freight costs. The company expects to pass through price increases in Q1 2019 and reset incentive compensation. This should improve Construction's profit margins going forward. However, this assumes the segment can maintain its top line long term. That may not be the case.
Profit margins for Financial Services also fell. It was partially due to (1) an unfavorable impact from equity securities in Insurance Services and (2) an increase in provision for credit losses as the Cat Power Finance portfolio weakens. One would expect the credit quality of the loan portfolio to weaken as the economy appears to have peaked. Though Caterpillar's overall profit margin expanded, the declining margins for Construction and Financial Services could be the canary in the coal mine.
As central bankers around the world continue to remove the punch bowl, it could pressure equipment sales and margins. What happens if the company can no longer pass through price increases? The fallout could be lower revenue and declining margins.
Dealer Inventories Are Rising
Of note is that dealer inventories also increased during the quarter. The increase in dealer inventories followed a few quarters of tight dealer inventory levels. Management believes such inventory levels are warranted by demand. In my opinion, this seems rather odd. I would imagine that since we are nearing peak economy that dealers would want to carry less inventory. The RV industry is going through a similar phenomenon. Inventories at RV dealers are at elevated levels while demand has fallen. RV dealers did not want to miss out on expected robust sales, and are now stuck with unsold units.
Dealer inventory for the Construction segment may not mean that inventory is slow moving. It could be due to the fact that dealers wanted to stuff the channel to ensure they would not be left without enough product to meet demand. If dealers overestimated demand then they could reduce new orders, which could hurt future sales for Caterpillar. The company is utilizing technology to better management equipment, help customers monitor fleet data, request parts and service, and connect with dealers remotely. This technology could potentially help Caterpillar determine the utilization levels of its equipment in the field and potentially better project new sales data from the dealer to the end-user.
If inventories are not sold down quickly it could portend slowing unit sales in the future or a potential need to reduce prices in order to move equipment. Either one of these events could weigh on the Construction segment going forward.
Caterpillar is exposed to the vagaries of the global economy. I do not think economies of China or the U.S. are strong enough to warrant an investment in CAT at this time. The stock is off by about 15% Y/Y and could fall further. Sell CAT.
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