4 Reasons Caterpillar Could Trend Lower in the Near Future

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

Caterpillar’s (NYSE: CAT) fortunes depend more on the economy than its own internal doings, something that was evidenced in its recent quarterly report. Challenges are aplenty, and there are signs that suggest that the weakness in Caterpillar’s shares is here to stay. So before you decide to dive in, here are four things you should consider.

Weakness ahead?

Caterpillar’s first-quarter numbers were disastrous. Earnings per share slumped 45% year-on-year on 17% lower revenue. A slow construction market in the U.S., weak demand from global markets, especially China, and dwindling commodity prices were behind the fall. Caterpillar has been struggling for several quarters now because of these factors, reflected in its weak operational performance over the past one year. 

CAT Net Income TTM data by YCharts

With the equipment maker lowering its outlook for 2013, the downward trajectory is likely to continue. Caterpillar expects its full-year revenue to be down by anything between 7% and 13% from the 2012 level. Its earnings of $7 per share for 2013 are down from the $8.50 a share it earned last year. It’s hard to see Caterpillar’s shares stage a comeback this year as a weak outlook and macro concerns could weigh heavily on them.

No takers for its equipment

With top-line growth hard to come by, inventory is turning out to be a huge problem for Caterpillar. The situation has worsened over the past few years. Caterpillar’s inventory turnover ratio, which tells us how fast the company is selling its inventory, is discouraging. A lower ratio means the company is sitting on piling inventories that don’t earn anything. From 5.8 times in 2004, Caterpillar’s inventory turnover ratio slipped to 3.8 times by the end of 2010. Caterpillar ended 2012 with a turnover of just about 3 times.

Let’s check another important metric, days inventory, also known as inventory outstanding. This measure indicates how quickly the company can convert its inventory to sales, or simply how many days it takes to sell inventory. The quicker it does, the better, because the company can then free up its working capital for other uses. Caterpillar used to take 63 days to sell its inventory in 2004. It went up to 95 days by 2010 and hit 116 days last year.

How does Caterpillar’s inventory stack against peers? I’ll compare statistics with one company from each of Caterpillar’s businesses. Deere (NYSE: DE) is better known for its tractors, but is a close competitor to Caterpillar because it gets 20% of its revenue from its construction-equipment business, which has a good global presence. Deere’s inventory turnover also slid downwards over the past few years. From 8.4 times in 2004, it is down to 4.3 times for the trailing twelve months. Yet, Deere’s equipment doesn’t take much time to fly off shelves, unlike Caterpillar. Deere’s TTM inventory outstanding is at 36 days only, a sharp contrast to Caterpillar’s three-digit figure.

Moving on to mining, Caterpillar took over the crown of the largest mining-equipment maker from Joy Global (NYSE: JOY) when it acquired Bucyrus in 2011. Joy’s 2012 inventory turnover of 2.5 times was weaker than Caterpillar’s, but it has remained range-bound for several years. Again, Joy scores higher on days inventory -- It took 72 days to sell off its inventory in 2012. That’s up from 58 days in 2004, but the rise isn’t as steep as Caterpillar’s. Overall, both Deere and Joy are on firmer grounds than the equipment king.

Internally weak

What’s worrisome is that Caterpillar’s inventory situation worsened in the first quarter -- In contrast to the 18% fall in its revenue, Caterpillar’s inventory reduced by a meager 3%, both sequentially. Cat’s inventory outstanding for the quarter was at a whopping 143 days, which means Cat’s equipment are lying around in the warehouses for nearly four and a half months before getting sold. Caterpillar is having a really hard time moving its inventory. Naturally, scaling back production is the only option left until demand picks.

Lower production and sales are bound to hurt Caterpillar’s bottom line, making it difficult for the company to improve its cash flows, which presents a dismal picture currently. For record profits of $5.7 billion earned last year, Caterpillar generated a measly $165 million in free cash flow. This is another yellow flag for the company, something investors should keep in mind. Comparatively, Joy generated $305 million as FCF on net income of $762 million for the trailing twelve months.

The mining malaise

The markets are pinning hopes on the recovery of the U.S. construction market, but as long as the mining industry is in doldrums, Caterpillar’s growth will be limited for two reasons. One, its resources industries segment, which is essentially mining, is where it earned higher profits. Two, mining is also where Caterpillar made huge investments in recent times.

In fact, the persistent weakness in mining markets also puts a question mark to Caterpillar’s Bucyrus acquisition, which was also its largest-ever deal. Caterpillar is yet to see the kind of gains it would have expected from the acquisition. Given the way mining majors are thinking right now, it could take a lot of time. Cat expects mining equipment sales to fall 50% this year.

The Foolish bottom line

Investors should ideally not expect great profits or good returns from Caterpillar in the near future. Those who cannot handle short-term volatility should particularly stay away. That’s not to say that those who hold the stock should panic. While it is prudent to step back and weigh the cons of an investment, Caterpillar could still make a good long-term bet for value investors. Stay tuned.


Neha Chamaria has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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