CAT's Slowdown No Longer If Or When, But How Long?

By Stephen D. Simpson, CFA | October 24, 2012 AAA

The slowdown that has hit industrial companies ranging from Cummins (NYSE:CMI) to Dover (NYSE:DOV) to Honeywell (NYSE:HON) and Caterpillar (NYSE:CAT) has been long in coming and pretty well telegraphed. The economic malaise in Europe and slowdown in China has pressured demand for commodities and slowed the pace of construction - basically a one-two punch to Caterpillar's core businesses. Although the Street responded to CAT's third quarter earnings pretty calmly, I don't think today's valuation is close to washout levels and there could be further downside if the fiscal cliff bites into the U.S. economy and further slows the global economy.

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Good Margins as Sales Start to Soften
Caterpillar's numbers had been declining for a while, so it's not like the idea of worsening conditions was news to the analyst community. That said, this wasn't a terrible quarter for this large industrial company. Manufacturing revenue rose 5% from last year, while falling about 6% from the second quarter. All three segments saw sequential declines, ranging from 3% in resources (mining equipment) and 4% in power systems to 8% in construction. All were positive on a year-on-year constant currency basis, however, with resources up nearly 13%, construction up about barely 1%, and power systems up almost 5%.

Caterpillar did surprisingly well on margins. Gross margin did worsen by about 40 basis points (BPs) from the second quarter, but improved more than two points from levels a year ago. Manufacturing operating income was also surprisingly strong, with a 1% sequential decline showing more resiliency that many expected.

SEE: Analyzing Operating Margins

The Slowdown Is Here
There's little question that slower end-market conditions are starting to bite into the company's outlook. Although North American sales were up 9% this quarter and sales to the Asia-Pacific region climbed 8%, orders dropped 25% from the second quarter (and more than half from last year) and the backlog dropped almost 20% on a sequential basis. The reasons behind these declines are pretty well known in the market. Weak commodity prices and rising operating costs have led many major miners such as BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) to curtail new expansion plans, and Caterpillar and Joy Global (NYSE:JOY) both have elevated exposure to the feeble North American coal market relative to other mining equipment companies such as Atlas Copco (OTC:ATLKY) and Sandvik (OTC:SDVKY).

Caterpillar is also facing slowdowns in construction and its power systems business. While the outlook for construction in 2013 is arguably better, there has been a huge slowdown in China and competition between Caterpillar, Komatsu (OTC:KMTUY), Volvo (OTC:VOLVY) and local players such as Sany is intense. On the power systems side, General Electric (NYSE:GE) was generally supportive of the conditions in the locomotive market, but the oil and gas markets have clearly slowed.

A Pause in a New Cycle, or the Same Old Same Old?
Investors who once argued that it was different this time and that companies such as Caterpillar, Cummins and Joy Global were no longer cyclical industrials have pretty much been discredited at this point. Nevertheless, it's worth asking whether we've seen a once-in-a-generation spike in equipment demand, or whether 2012/2013 is just another pause in an ongoing supercycle. On the bullish side, countries such as China, India and Brazil still have major development/infrastructure needs; I think some Americans underestimate just how large these countries are and how different the levels of development are between the "showcase" cities and the hinterlands. That would argue for ongoing demand for commodities (fueling demand for mining and oil/gas equipment) and construction. What's more, let's not forget that the United States still has some infrastructure needs of its own.

On the bearish side is the argument that these countries have overbuilt and outspent their needs, and that the worldwide rush to bring on new mining projects has closed the gap between commodity demand and supply. Along similar lines, a lot of new equipment has gone into service in recent years and pulled forward many years' worth of demand.

The Bottom Line
I lean more towards the bullish side of the argument; Caterpillar is always going to be cyclical and the 2013 global economy may be weaker than currently assumed, but I think the long-term demand picture is solid. The only problem is that a lot of other investors seem to lean bullish on these shares. Even if Caterpillar can continue to grow at a healthy clip (10% free cash flow (FCF) growth), these shares aren't tremendously cheap, with a fair value around $100. A faster recovery and/or ongoing margin improvements could push that to $120, but investors should be wary of overly optimistic forecasts for the next year. While Caterpillar remains a well-run industrial company, the next few quarters could be startlingly weak.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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