Can Caterpillar Protect Its Shareholders’ Interests?

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Caterpillar (NYSE:CAT) has been struggling due to weak demand for machinery and equipment in the global mining sector since the fourth quarter of 2012. Caterpillar’s (CAT’s) revenue from its Resource Industries segment, which primarily comprises of sales of mining equipment and machinery, has been declining due to profitability improvement programs at mining companies. Large asset write-offs in late 2012 and 2013, forced mining companies such as Vale, Rio Tinto and BHP Billiton, to cut costs and reduce capital spending. This significantly reduced demand for mining equipment and led to a 37.3% year-on-year decline in CAT’s Resource Industries’ revenue for 2013. [1] The after affects of the 2013 asset write-offs and low mined commodity prices have kept the demand for mining equipment and machinery suppressed in 2014. Declining prices of mined commodities such as coal and iron ore, driven by high production and slowing demand from China, have discouraged mining companies from investing in new mines or expanding operations. CAT’s Resource Industries’ revenue continued to suffer due to this trend in the first half of 2014. In the second quarter of 2014, Resource Industries revenue contracted by 28.5% year-on-year. [2]

CAT anticipates this weakness from the global mining sector to persist through the second half of the current year. CAT’s recent retail sales data seems to corroborate its expectations. In July 2014, retail sales for its Resource Industries products were down 33% globally, with only the North American markets showing positive growth. [3] For full year 2014, CAT forecasts its mining segment sales to contract by 20% annually. [4]

Due to the sharp decline in revenues of CAT’s Resource Industries and flattish overall revenue growth expectations for the full year, investors are concerned about CAT’s ability to support its dividend payments and share buybacks. But we believe that given its strong balance sheet and cash flows, growth prospects of end-markets and profitability improvement programs, CAT has sufficient capacity to return cash to its shareholders.

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We currently have a stock price estimate of $109 for CAT, approximately in line with its current market price.

See our complete analysis of CAT here

Strong Balance Sheet and Cash Flows to Support Dividend Payments

CAT’s Machinery, Energy & Transportation segment, which basically includes its construction, mining and power businesses, had a debt-to-capital ratio of about 32.5% at the end of the second quarter of 2014. [2] This falls at the lower end of the company’s targeted range of 30-45%, indicating that CAT can comfortably support its business through internally generated cash flows, despite the severe decline in its mining equipment sales.

Additionally, the segment’s current ratio (current assets/current liabilities), which is an indicator of a company’s ability to meet its short-term obligations, stood at 1.83. This indicates that even after making payments towards its short term obligations, CAT has sufficient resources to make payments to its shareholders.

The fact that Caterpillar had recently increased its quarterly dividend by 17%, amidst the declining mining revenues, is a positive reflection of the company’s financial position. [5] Caterpillar believes that its cash flows are not only sufficient to pay-off its obligations but also provide enough room to increase cash return to shareholders. The increase in dividends also indicates that the company anticipates its cash flows to remain strong through the coming months. Though CAT’s cash generated from operating activities contracted 10% year-on-year to cross $4.1 billion, it is the second highest in the past 10 years. This is a sign of strong performance given the weak demand for machinery and equipment in the global mining sector.

CAT also continues to actively buyback shares. During the first half of 2014, the company repurchased nearly $1.7 billion of its common stock. In its second quarter earnings release, CAT announced that it will repurchase shares worth $2.5 billion during the third quarter. [6] These repurchases are part of the $10 billion stock repurchase program that CAT finalized in the first quarter of this year. [6] This increase in cash return to shareholders through dividend hikes and active share repurchases indicates that CAT is confident about its long term prospects.

Growth in Infrastructure Spending and Energy Demand Will Drive CAT’s Growth

CAT based its positive outlook on growth prospects of its construction and power generation equipment sales. We also believe that CAT is well positioned to benefit from the rising global demand for energy and physical infrastructure. Growing urbanization, increasing disposable incomes and aging population in emerging markets such as China and India, should help drive spending on infrastructure sectors such as manufacturing, energy, water and transport. These factors are expected to drive global infrastructure spending to over $9 trillion per year by 2025, compared to $4 trillion in 2012. [7] An increase in infrastructure spending bodes well for CAT since rise in demand for construction equipment will in turn help boost sales of its Construction Industries segment.

Global energy demand is expected to grow by 41% from 2012 to 2035, with 95% of the demand coming from emerging markets. [8] Growth in energy demand augurs well for CAT’s power generation equipment sales. It will also have a positive impact on sales of its mining equipment. Though renewable fuel will become popular in the long term, fossil fuels such as coal, oil and gas will remain dominant sources of energy generation, with market shares of around 26-27% each. [8] Extraction of oil and gas, and mining of coal, to support the energy demand, will help drive demand for mining equipment.

Additionally, increased use of new machines may fuel recovery in the global mining sector. In order to keep short term operating costs low, mining companies are working their newer machines for longer durations. This is because older machines entail higher upkeep costs through frequent part replacements and repairs. Mining companies will eventually have to incur repair and maintenance costs, which include purchase of machine parts in order to avoid machinery breakdowns.  This will lead to a recovery in the mining equipment after-market.

We believe, long term growth trends in end-markets for CAT’s products should provide sufficient top line growth to further strengthen its financial position. Additionally, improvement in margins, driven by cost cuts should enhance cash flows and help provide solid returns to shareholders.

Cost Cuts Will Likely Raise CAT’s Profitability

CAT had to reduce production of its mining equipment in response to the softening global mining equipment demand in the fourth quarter of 2012. However, reduced production levels meant loss of efficiency which would lead to higher operating costs. In an attempt to lower its operating costs, CAT has been undertaking cost reduction measures since early 2013. These measures include plant consolidations, which ensure greater sharing of common resources, and headcount reductions, which save salary costs. This enabled CAT to lower its operating costs by $7 billion in 2013 and by $0.5 billion in the first half of 2014. [1] During the recent earnings meet, CAT announced that it will continue with its cost reduction measures in the coming months.

We believe that, given the headwinds presented by the declining Resource Industry revenues, these cost reduction measures are crucial for CAT’s profits. Over the long term, these cost reductions will help improve margins, which will help the company increase its cash flows and also give it a competitive edge, since higher margins enable aggressive pricing.

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Notes:
  1. CAT’s 2013 Q4 earnings form 8-K, January 28 2014, www.caterpillar.com [] []
  2. CAT’s 2014 Q2 10-Q SEC Filing, April 2014, www.sec.gov [] []
  3. CAT’s Monthly Retail Statistics, www.cat.com []
  4. CAT’s 2014 Q1 earnings form 8-K, April 24 2014, www.caterpillar.com []
  5. Caterpillar Inc. Announces 17 Percent Increase in Dividend Rate, June 11 2014, www.caterpillar.com []
  6. CAT’s 2014 Q2 earnings form 8-K, July 24 2014, www.caterpillar.com [] []
  7. Capital project and infrastructure spending: Outlook to 2025, www.pwc.com []
  8. BP Energy Outlook 2035, January15 2014, www.bp.com [] []