What Heavy Machine Stocks Are Best Bets

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Weak investment sentiment in the industry has affected the demand for construction equipment. Deere & Company (NYSE: DE), Caterpillar (NYSE: CAT) and CNH Global (NYSE: CNH) are combating lower demand cycles by boosting their agricultural equipment sales.

In the following article, I aim to analyze how John Deere, banking on its strong agriculture equipment wing, is sustaining the lows in this dynamic industry.

Recent events

John Deere has performed pretty well in its second quarter with sales soaring by 9% resulting in an increase in net income of 2.7%. Financial crisis in the European Union, cold and wet weather in UK will affect the demand for its farm machinery, but demand remains strong in South America. The situation remains the same in the Common Wealth of Independent States, where a surge in import duties in Russia, Kazakhstan and Belarus are expected to negatively impact demand for Deere’s equipment.

However, good management decisions still outweigh market downturns. Deere is aggressively pursuing growth opportunities in emerging markets especially China, Brazil and India. It has recently opened up seven factories in the above mentioned countries, to cater to their demand while keeping costs low. Deere has also set up its engine manufacturing facility in China, which is attracting the hottest investments all over the world. To top it off, China has announced agricultural subsidies which will greatly enhance the demand for Deere’s agricultural equipment in the country.

Caterpillar has taken a huge hit in its second quarter, revenues dropped by 16% due to weak investment sentiment in the construction business. Earnings dropped 43% in its second quarter, which again is not a healthy indicator. Most recently, Caterpillar faced a reduction in its dealer inventory, which has led to the above mentioned results for this quarter. Forecasts will remain unchanged for some time and caterpillar will struggle to offset the declines due to dealer inventory reduction.

To the brighter side, increase in construction related spending in United States might help Caterpillar, and will enhance its heavy equipment sales in the United States. Mining Equipment is Caterpillar’s most profitable business; further scrutiny leads us to the fact that due to higher commodity prices miners have become conservative in capital spending. To worsen the situation coal prices have also dropped which shall translate into a further deterioration in its mining equipment demand. However, a surge in gas prices is shifting the demand to coal which could straighten out the complexities Caterpillar is facing. Lastly, in my opinion, sales for spare parts will increase while sales for new equipment may fall.

Market demand conditions paint a similar picture for CNH Global as well. Sales from construction business have declined by as much as 26%, though agricultural equipment sales are up by 9%. According to careful estimates CNH might face over production, since it anticipates a strong market demand in the third quarter, contrary to market condition, should the demands not materialize the company shall face a tough inventory correction as in the case of Caterpillar.

A recent important event is the announcement of a merger between CNH global and Fiat Industrials, under which a new company shall be renamed as CNH Industrials. The merger is anticipated to be the beginning of a new era for both companies in terms of global and comprehensive reach. However, construction equipment business has retarded the revenue growth. Moreover, growth in tractor demand in Latin American will also help CNH to boost its future sales of agriculture equipment.

Dividends and free cash flow

While analyzing dividends and free cash flows we notice that dividends for CNH global have been increasing since 2008 at a high rate, where as John Deere and Caterpillar have been providing constant returns, due to stable and well diversified operations. However, CNH global has an unrealistically high payout ratio of 204%, which means the company is not retaining anything to fuel long-term growth. However, to the other side John Deere and Caterpillar have modest payout ratios 23% and 33% respectively, a low payout ratio helps the company increase its dividends.

Free Cash Flow presents an entirely different picture, though CNH global has a high payout ratio but its free cash flow is negative and is declining sharply. John Deere’s free cash flow despite being negative is recovering at a high growth rate. Caterpillar on the other hand has positive free cash flow which is increasing at a constant rate.

Final thought

In the past few quarters, construction related spending has slowed down. As a result companies providing heavy construction equipment like Caterpillar are facing headwinds from lower demand. Moreover, Caterpillar’s most profitable mining equipment business also struggles with lower demand cycles. Coal companies are cutting back on their capital expenditure, where the machinery and equipment expenditure also has declined rapidly. Market conditions are expected to remains the same for a few quarters for Caterpillar, only after when the sales would start to pick up.

John Deere has been doing pretty well, since globally agriculture sector is growing rapidly. High commodity prices and strong farm incomes are continuing to support a favorable level of demand for Deere’s farm machinery in much of the world. John Deere also continues to increase its exposure in the high growth markets, which paints bright prospects for the company. Need for efficient technology and increasing commodity prices have helped increase demand for John Deere’s agriculture equipment. In the light of above argument, John Deere seems to be a better option among all. 

Zain Raza 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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