Will China's Slowdown Hurt this Equipment Manufacturer?

Muhammad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It seems that Caterpillar’s (NYSE: CAT) impressive earnings growth has hit a roadblock that even their heavy machinery can’t get past. A global economic slowdown is finally taking its toll on the company. Caterpillar reported impressive earnings growth last year – between the third and fourth quarters Caterpillar posted an increase in earnings of about 35%. The party quickly came to a halt when earnings only rose seven cents per share between the fourth quarter of last year and the first quarter of 2012. Their 2nd quarter earnings report shows a continuation of positive earnings growth, but the current global economic slowdown isn’t helping matters.

Negative interest rates are helping Caterpillar’s earnings stay positive by giving other companies an incentive to borrow in order to purchase or rent heavy machinery. However, if industrial and residential construction markets remain as anemic as expected, no amount of cheap money is going to help. I see hard times ahead for Caterpillar.

The previous several quarters saw a boost from Caterpillar’s resource sales division. It appears that that well is drying up. Although the most recent report showed nearly seventy percent increase in revenues, mostly from Asia, iron ore prices have fallen to three year lows. Steel companies like Ternium (NYSE: TX) have seen shipments stagnate for the last two quarters and are anticipating lower prices in the third quarter of 2012.

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Revenue growth throughout the last several quarters is somewhat stagnant and expected to remain so, despite China’s $150 billion planned infrastructure investment.

The electricity generation division of Caterpillar is also expecting a slowdown of the revenue growth they experienced last quarter. Second quarter 2012 saw a rise of 12% in power generation revenues. Although less dismal than the resource sales division, Caterpillar’s power generator demand is expected to follow fellow industry leader Cummins who have also warned against weakness in demand for the second half of 2012.

Over the weekend Caterpillar’s President, Richard Lavin publicly anticipated their growth in Chinese markets to pick up again early next year. Notice he didn’t mention what he expected for the rest of the 2012. The President’s optimism for his company’s revenue growth in China has nothing to do with a reversal of the global economic slowdown that is putting the brakes on the entire capital goods sector. He was simply referring to the widely held belief that China will make good on their promise to invest billions on infrastructure upgrades to stimulate growth. The investment is substantial. China’s National Development and Reform Commission announced investments totaling roughly $150 billion in infrastructure developments.

He failed to mention that Caterpillar is facing heavy competition from Japanese rival Komatsu (TYO: 6301) and budding Chinese heavy machinery manufacturers. China’s heavy machinery companies, like China Yuchai International (NYSE: CYD) and their subsidiaries are capable of issuing one year bonds at interest rates lower than China’s current benchmark one-year rate of 6%. China may be the world’s largest construction site, but we can expect its reliance on foreign machinery to steadily recede as they concentrate their efforts to produce their own. The Chinese market for heavy machinery that represents a significant portion of Caterpillar’s top-line growth will become increasingly competitive in the years to come.

China’s economic slowdown is expected to continue despite their government’s efforts to boost its flagging growth with infrastructure investments. Even if Caterpillar’s market share in China remains unchanged throughout the first half of next year, it is unlikely that the revenue growth there will completely offset a slowdown in the rest of their global operations.

The European Central Bank’s move to expand their debt purchase program may be a step in the right direction, but it will be a very long time before European markets for heavy machinery bounce back. In North America, Lavin is optimistic about near future growth in the United States due to investment in roads and other infrastructure similar to China’s but on a much smaller scale. At best the Chinese stimulus will provide Caterpillar with a softer landing than some of their competitors, but I doubt that we will see the explosive revenue growth that fuelled Caterpillar’s run up in early 2012.

 If you’re already holding Caterpillar shares, I would suggest holding on until the current cycle reverses. Caterpillar is fundamentally sound and facing a slowdown, not impending doom. They are trading at just under 10 times earnings and revenues are expected to stagnate, not fall. Caterpillar increased their dividend yield by 6 cents a share to $0.52 from $0.46 and there is no indication that they will lower the yield next quarter. Overall I expect this stock to trade in a range between 90 and 80 until more economic data suggests the global economic slowdown is either a full blown recession or entirely finished.

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muhammadbazil owns shares of Caterpillar. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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