Can the Caterpillar Bloom Into a Butterfly

By Shailendra Raghav - May 29, 2012 | Tickers: BHP, CAT, RIO | 0 Comments

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Caterpillar (NYSE: CAT) had a fantastic run in the past three years from 2009 to early 2012. The stock price made a spectacular turnaround from the mid-20s to $116 in March 2012. But from the day the 1QF12 results were announced, the stock has fallen from $107 to $90 closing yesterday, almost a 20% fall.

What did the company do in the past 3 years - grew sales from $32 billion in 2009 to $60 billion in 2011, its lifetime best, at a time when the macroeconomic environment was less than ideal.

Then why did the price fall ~20% - despite the fact that company posted its highest ever quarterly net profits, the investors were spooked by the fall in sales of CAT products in China.

Instead of focusing on whether the stock is a buy or sell, let’s focus on what has been going on in Caterpillar for the past few years.

What have they done right?

1. In 2009 CAT had one of its worst years. The infrastructure related stocks were getting slaughtered world over, but CAT managed to sneak out a profit. And after that within 3 years they doubled their revenues and delivered their highest ever revenue numbers, $60 billion in 2011 with mediocre macroeconomic conditions in its major markets – US and Europe (where it gets its 60% revenues). It was able to deliver these revenues due to a rebound in the emerging markets.
2. It has a capex plan of $4 billion till 2015. So what? Well if you look at CATs history, it has always been late in either increasing capacity, or R&D or M&A during the business cycle. This was one of the major reasons why competitors like Komatsu, Doosan could take away market share from Caterpillar as it was not able to cater to the expanding demand due to capacity constraints. But this time, CAT has realized their mistakes, and is making amends by investing in capacity and technology earlier in the cycle. They have made huge investment plans all over the world.
3. Smart Acquisitions – CAT bought Bucyrus for $8 billion last year. And with that they got a good portfolio of products in the Mining area, which was one of their weaker areas. If you look at the mining figures for the just concluded quarter – revenue grew by 73% and half of that growth was due to Bucyrus. Also Bucyrus products complement CAT in many areas like that of electric motor trucks, which is being increasingly preferred by miners throughout the world, and which CAT lacked in its portfolio.
4. Increasing focus on higher margin products – Caterpillar has been increasing focus on higher margin products. They are slowing down production of smaller machineries, focusing on mining which is a high-margin business etc.  This has immensely improved their profitability.

What are the risks?

1. Capex plans of Miners don’t go as planned – This might come out to be true sooner rather than later. Just a few days ago Rio Tinto (NYSE: RIO) and BHP Billiton (NYSE: BHP), world’s largest miners, informed the investors that they will be going slow in their capex plans. The commodity prices do not support the mining of the commodities. Demand fall from China forms a major factor in the overall price drop of commodities. Which brings us to the next big risk
2. China slowdown – China forms only 3% of CATs revenues, but why is China so important?  Well China consumes almost half the commodities produced throughout the world. So all the mining plans goes for a toss if there is a slowdown in China, as the demand for metals and minerals will reduce which will results in a fall in commodity prices. Hence the whole world is focusing on China.The demand for equipment has already slowed down in China. The on ground inventory of excavators was quite high.
3. Non recovery of US and Europe markets – The lower sales in China and Brazil in Q1 were offset by the surprising rise in sales in USA. The sales in US for the past couple of years have been due to replacement demand as the on ground fleet is getting older. US and Europe form major portion of Caterpillar’s revenues and their non-recovery will be painful for CAT.

Although the current economic and business scenario looks weak, but the down cycle will pass and up cycle will start. And at these times we must stick to companies which can withstand these circumstances and make the right decisions to take advantage of the oncoming up cycle. Caterpillar has a healthy balance sheet which will help it get through the tough times, and it is making investments which will reap rich dividends when the cycle turns. With its global reach, diversified product portfolio, impeccable brand name and a smart management Caterpillar should be considered for your Buy and Hold portfolio.

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