Will Caterpillar Continue Rising With Low Growth in U.S Construction?
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Caterpillar (NYSE: CAT) continues to rally despite the little growth in the U.S housing market – one of the main business sectors of the company. Further, the U.S housing market is part of Caterpillar's construction segment, a segment that is a key driver for Caterpillar’s sales. During last year the construction segment’s sum of revenues reached a total of $19.7 billion, which is the second largest segment in terms of sales – the largest segment was the power sector with $20.1 billion in revenues. In North America, sales from construction segment reached $5.9 billion; this figure puts the construction segment in North America as the second largest segment, in terms of sales, among all other segments in other regions. Thus, U.S construction is one of the most important businesses for Caterpillar. When it comes to construction, it's heavily dependent on government spending; both federal and state.
During the second quarter of 2012, the financial reports of Caterpillar were positive: the company’s net earnings reached $1.7 billion compared to $1.58 billion during the first quarter of 2012 and $1 billion during Q2 2011. In terms of operational profitability it reached 9.8% during Q2 2012 which is very similar to the previous quarter – back then it was 9.9% – and nearly 7.1% during Q2 2011.
But the construction industry continues to show little growth and without a rally it could continue to impede Caterpillar’s sales growth. In terms of construction there are several segments: public buildings, such as hospitals, roads, bridges, private homes, etc. Let’s consider two issues: the U.S housing market and government spending.
In regards to the housing market there are some signs of recovery: housing starts in the U.S have increased during the year, but is still very low compared to the pre-2008 era; U.S building permits also didn’t rise by much; new and pending home sales also rose during the year but they are still very low relative to the pre-2008 recession. So there isn't much progress in the housing market. What about government spending?
There are some mixed signals in this issue: on the one hand, during the second quarter, State and local government consumption expenses and gross investment declined by 2.1%. The low growth in the U.S – according to the recent GDP report for Q2 2012 the GDP expanded by only 1.5% - along with huge debts that many of the states currently have, lowers the chances of additional growth in investment to infrastructure and dwellings.
On the other hand, there are some signs of growth mainly on the federal level: during the second quarter, real non-residential fixed investment rose by 5.3%; real residential fixed investment increased by 9.7%. Nonetheless the federal government consumption and gross investment still declined by 0.4% in Q2 2012.
The decline in government debt during recent months may also suggest there is a drop in government spending including investments. In regards to infrastructure, during the fiscal year of 2012, the federal government spent only $490 million on transportation infrastructure compared to $1,063 million during the parallel time last year. Nevertheless, the federal government deficit will still reach above one billion dollar during the fiscal year of 2012.
And since the U.S is in election year there will be little movement in any direction in terms of increasing investment towards contractions.
The economic growth of the U.S is plausibly among the key factors for the rise of Caterpillar. One the basic and straight forward index that could be used to analyze the effect of the economic growth of the U.S on the company’s stock is the S&P500 index. During August, the S&P500 index rose by 2.8%, while the company’s stock rose by 6.9%. The linear correlation between the S&P500 index and Caterpillar stock price reached 0.67 during July and August. This means that nearly 45% of the company’s stock rally could be explained by the recent rise in S&P500. This also implies that most of the growth in the company’s stock was due to its good performance in the recent financial reports.
The low growth in the U.S may have also curbed the rally of other heavy machinery companies such as Deere & Company (NYSE: DE) and Joy Global, Inc. (NYSE: JOY); the former provides products and services primarily for agriculture and forestry and the latter in provides services and products in mining equipment. But much like Caterpillar, these companies have also performed well in recent weeks: Deere & Company's operational profitability in Q3 2012 reached 17.9%; Joy's third quarter operational profitability reached 21.6%; during August Deere & Company stock edged down by 0.8%; Joy's stock rose by 12.8%.
The chart below shows the developments of S&P500 index and Caterpillar stock during 2012. It shows how the relation between the two is very strong and robust. Despite the recent rise in Caterpillar it still hasn’t recovered from its tumble at the beginning of the second quarter of 2012; the company’s stock has still underperformed the S&P500.
The bottom line is that there are several macro-economic issues – both on a federal and state level – that will probably continue to impede the progress of the American construction segment, which, in turn, could adversely affect one the prime businesses of Caterpillar. In particular, this could mean that in the months to come Caterpillar will be adversely affected by the low growth in the U.S which could curb the progress of Caterpillar's stocks.
For further Reading: Why Caterpillar isn’t pulling up? Just blame it on the Oil
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