Why This Dow Stock Could End up Surprising You

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

Profits cut by half, recent acquisition raising questions, less-than-upbeat 2013 outlook: You’d think it’s time to look elsewhere when this is what a company offers to investors on its earnings report platter. Thankfully, Caterpillar (NYSE: CAT) investors know better. The stock gained 2% on an otherwise dull day, because among other lessons, Caterpillar loyalists have learned how to look beyond what meets the eye.

Deft handling

As much as investors trust their company, Caterpillar also makes sure it doesn’t catch them off guard, giving them enough time to prepare for any red-faced event. I call it mutual affection. It is this silent bonding that saved Caterpillar’s stock on a day the company reported 55% lower quarterly profits.  After all, it had already warned investors this was coming. Just days ago, Caterpillar announced how it had “uncovered deliberate, multi-year, coordinated accounting misconduct concealed” at China-based ERA Mining Machinery, which it acquired last year. The fraud cost Caterpillar more than half a million, denting its bottom line deep in the last quarter.

Many are wondering how such a huge misdoing could miss management’s eye when they weighed the pros and cons of taking over ERA. That’s a question I don’t have an answer to, but I know two things: One, the company has come out pretty open about the whole issue. I mean, it could have easily held back the information till earnings release, but chose to let the world know what’s going on inside. Caterpillar could have also dodged the blame, but CEO Douglas Oberhelman has sportingly taken it all upon himself. He says, “I recognize the decision to acquire Siwei happened on my watch and the buck stops at my desk. I’m accountable for that acquisition.” My respect for Caterpillar’s management has just scored a point.

Two, and more importantly, this unfortunate incident should serve a handy lesson, not only for Caterpillar but for every other company pumping money into China. Joy Global (NYSE: JOY) upped its ante in the market by taking over International Mining Machinery last year. No untoward news from Joy yet, but it pays to know that Joy is currently in the midst of integrating IMM into its business, and is still drilling deeper to know how it can capitalize on IMM. General Electric (NYSE: GE) is taking its healthcare, electric, locomotives, and almost every other business to China. Last December, it finalized plans to purchase mining-equipment maker Industrea, which has a strong foothold in China. Both Joy and GE should prudently absorb every bit of detail they can about Caterpillar’s ERA fiasco to help them tread safe waters as they synergize or buy out any company based in the Middle Kingdom.

A lesson well learned

I wouldn’t say Caterpillar itself started off on the wrong foot. Sure, an internal fraud is the last thing a company would want to see when it’s embarking on a major expansion plan. But given the innumerable number of Chinese companies caught involved in shady accounting practices, it could have come at a later stage, in a future deal. Since ERA was Caterpillar’s first step up the Chinese mining market ladder, I see it this way: with a hard lesson coming off the very first move, Caterpillar will watch every step hence. More prudence would become a priority now, which should go a long way in enabling the company to achieve its goal of ruling the Chinese market in the years to come.

Wind at its back?

What investors need to know is that this event won’t deter their favorite company from its path of growth. Huge inventory continues to plague companies in China with dealers holding back fresh orders. Yet, an uptick is visible, and can only be expected to gather steam as the government rolls out stimulus packages to boost infrastructural activities.

Joy sees an uptick in electricity demand to fuel coal consumption in China this year. GE had all good things to say about China after revenue from its industrial segment climbed 9% last quarter on improving demand. So did Alcoa (NYSE: AA), which pegs the Chinese economy to grow over 8% this year. That’s in line with Caterpillar’s forecasts. After announcing a new facility for its wheel and transportation business in China last month, Alcoa has just struck a deal with Commercial Aircraft of China, indicating some movement in the sluggish market. Two of Alcoa’s predictions particularly bode well for Caterpillar -- demand for aluminum from China’s heavy-truck industry to grow as much as 19% and that from commercial construction to grow 8% to 10%.

The optimism will be easier to digest once mining companies, who serve as critical customers for equipment makers like Caterpillar, ring in the hope bell. We’ve already got some in line, though. After Rio Tinto (NYSE: RIO) reported 4% higher production for 2012 with record iron ore shipments, BHP Billiton surprised many by citing China as the reason behind the 3% bump up in its last quarter iron ore production. The top two mining giants are hopeful of a rebound in the Chinese market this year, with Rio even suggesting that the worst in China could be already over. That Rio is staying put with its plans to pump billions in the Australian mining market over the next few years instills further confidence.

The Foolish bottom line

While the year has kicked off on an excellent note, how China treats Caterpillar and others will only be revealed some months down the line. Meanwhile, housing in the U.S. is in a sharp recovery mode, and industries like aerospace and automotive are picking up.

Caterpillar took off nearly $2 billion worth of inventory last quarter, and sounds stiffly low on its full-year guidance. Don’t panic, because Caterpillar isn’t trying to be an ‘alarmist,’ it’s just being ‘cautious.’ That’s exactly the Caterpillar we’ve all known for years – it likes to surprise rather than shock. Stay invested, and stay tuned. Click here to add Caterpillar to your stock watchlist for all updates, news, and analysis. 

Neha Chamaria has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company and Joy Global. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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