Impact of Chinese slowdown On Caterpillar’s Construction Equipment Revenues

China can no longer be considered as the flag bearer of global GDP growth. This is because its last recorded double digit GDP growth rate was 10.4% and that was back in 2010. Since then, the Chinese economy growth rate has decelerated around 30% over five years to roughly 7%. The same has affected US multinationals like Caterpillar, which is heavily dependent on emerging market revenues to drive earnings growth. In this article, we will analyze the magnitude of the Chinese real estate downturn and how this impacts the valuation of Caterpillar, which has a formidable international segment and has been a major supplier of construction equipment, courtesy the construction boom.

Reasons for Chinese slowdown

One of the primary reasons for the Chinese slowdown has been a sharp decline in the real estate sector and a precipitous fall in residential investment. From 2012 to 2014, China significantly ramped up and overbuilt its residential real estate sector. At times, the country was increasing national floor space at a rate approaching 50 percent a year. Spending on residential construction reached an unsustainable 10.4 percent of the country’s gross domestic product (GDP). That is the second-highest figure on record for any country. Only Spain, which took such spending to 12.5 percent of GDP in 2006, surpassed it.

However, starting 2014, the real estate sector started to nosedive owing to oversupply on account of cheap credit issued to home builders by their respective local governments. The only way to arrest this decline is to liquidate the excess inventory so that housing prices fall further, which, in turn, will have different consequences on the different segments of society. The Chinese affluent will stand to lose because they have already bought multiple properties, which will increase speculation on guaranteed increase in prices. However, if price declines are substantial, the same will bring in greater demand from the middle class, which might lend a vital lifeline to the Chinese housing sector.

Impact on Caterpillar

This decrease in residential and commercial investment, because of the sudden slowdown, is bound to impact Caterpillar’s revenues since a downturn in construction will drive down demand for construction equipment. The decline in GDP growth will decrease the demand for commodities worldwide, and commodity-export-dependent countries like Brazil will also go through periods of slow GDP growth, which will lead to layoffs, and hence less demand for housing, which will also impact the construction sector negatively.

Here, we are mainly considering the impact of a slowdown in construction growth on emerging markets because infrastructure building activities are an integral part of almost all developing economies, which provides attractive growth options for manufacturers like Caterpillar.

However, we are not entirely downbeat on the prospects of revenue growth for Caterpillar’s construction equipment sector. We believe the company will suffer from declining revenues for a while before a gradual upturn in real estate sector. This is because the Chinese government authorities are relaxing their stringent rule of one property per family, and this is expected to drive demand. Also, the decline in prices will see the emergence of middle class buyers in the market, which should prop up real estate prices. In addition, China has also devalued the yuan which will increase Chinese exports, and this, in turn, will translate into greater disposable income, allowing the average Chinese consumer to spend on residential investment. The same is evident when we look at the increase/decrease in prices of newly built homes in China; we see after months of decrease, prices have started rising again, albeit gradually. Our current price estimate for Caterpillar is $76 per share, higher than the current market price of $67. This is because we expect Caterpillar’s revenues to decline in the next two years but gradually rebound thereafter.

The fear of a Chinese crisis due to the sudden burst of the real estate bubble is highly unlikely. This is because China does not have the problem of zero-bound interest rates; the interest rates are still higher compared to other developing countries. Hence, the Chinese authorities do have the option of lowering interest rates further, which will make mortgages cheaper and spur demand for housing. Besides, the average Chinese buyer is required to make an upfront payment of 30% of the total property value. Hence, the chances of a mortgage crisis as that in the US is also lower.

Hence, we believe it is only a matter of time before Chinese GDP growth rebounds, which, in turn, should boost Caterpillar’s revenues.