The slowdown in the Chinese economy has impacted Caterpillar‘s (NYSE:CAT) top-line growth year-to-date. Growth has been particularly hit hard at its Construction Industries division in China where sales have declined compared to the mid-2011 levels. The efforts by the Chinese government to cool its rising real estate prices and control high inflation by maintaining high interest rates have caused this decline. This is also one of the primary reasons for the company’s stock price decline, which is down nearly 25% from its peak levels of $115-$116 in February earlier this year to $86-$90 at present. However, we anticipate the stock to move upward again as the interest rates in China ease with lower inflation levels. The country has been a major growth market for Caterpillar over the past decade and its increasing urbanization is expected to continue to drive its top-line growth over the coming years.
In addition, the long-term growth factors for Caterpillar remain intact as rising world population, prosperity and urbanization will increase demand for energy and resources, promoting growth across its industrial businesses: construction, mining and power systems.
We currently have a stock price estimate of $97 for the company, approximately 7% above its current market price.
The Slowdown in Growth of the Chinese Economy
China’s GDP expanded 7.6% year-over-year in the second quarter of 2012, its lowest in three years and its sixth consecutive quarterly decline. The slowdown in growth is the result of high interest rates, which have been maintained in order to control inflation which exceeded 6% in July last year, well above the government targeted 4%. Only recently have the inflation levels eased below 4%, prompting the Chinese central bank to cut its key lending rate in June. At present, the benchmark lending rate stands at 6%, which is still very high compared to the rates in the U.S. and other developed countries.  As a result, the consistently high interest rate regime has impacted the growth of companies operating in China, particularly in the construction industry.
Companies Reel Under High Interest Rates
Caterpillar witnessed a y-o-y decline in sales for its construction business division in China in the second quarter. The division manufactures and sells machinery used in infrastructure and construction applications. In addition, at the Bank of Amercia Meryll Lynch New China Conference held in November last year, the company had indicated that it expects the interest rates in China to ease in 2012.  However, as that did not happen in the first half of 2012, the company ended up overestimating construction equipment demand in China, and hence it is now planning to export the extra inventory in the country to other developing countries.
Other companies operating in the Chinese construction industry have also been impacted. Japan’s Komatsu Ltd., which is the second-largest maker of construction equipment in the world after Caterpillar, reported a 42% decline in its last quarter earnings on lower sales in China, forcing it to cut its profit outlook by 17%.  Sany Heavy Industry Co. Ltd., China’s largest construction equipment manufacturer, also lowered its sales forecast for 2012.
Lower Inflation Rates Augur Well for Companies
However, inflation rates have now come below the government targeted 4%. The Consumer Price Index (CPI) inflation touched a 30-month low of 1.8% in July. This augurs well for the industry as People’s Bank of China, which is China’s central bank, now has more room for growth revival. And if interest rates are cut sufficiently, we could see higher sales for Caterpillar’s Construction Industries division in China in 2013, and a corresponding increase in our price estimate for the stock.Notes:
- China inflation rate dips to a 30-month low in July, August 9, 2012, www.bbc.co.uk [↩]
- BofAML New China Conference Presentation, November 2 2011, www.caterpillar.com [↩]
- Komatsu Cuts Full-Year Profit Outlook 17% as China Sales Slump, July 31 2012, www.businessweek.com [↩]