Will Caterpillar’s cost cutting strategy be significant?

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Caterpillar

Caterpillar (NYSE: CAT) announced its restructuring and cost reduction plans in September 2015. The move comes in the wake of declining revenues in three of the past four years. Caterpillar has already cut about 16000 jobs, and expects facility consolidations and closures to impact about 20 of its facilities and 10% of its manufacturing square footage. Will this help increase the company’s profits and EPS in the near term? We believe the positive impact is likely to be offset by a couple of factors. First, given continued weak commodity prices, customers in the mining sector unlikely to pick up purchases in the year ahead.  Nor is there a clear sign of recovery in Chinese economy. In the long run, however, these steps will improve Caterpillar’s margins by an estimated 60 basis points. The company expects to reduce operating costs by about $1.5 billion annually, once the measures are fully implemented.  This is likely to increase company’s EBITDA by about 20% annually. We have priced in these expectations in our estimates. If, however, the program is unsuccessful and margins don’t improve, there can be a downside of around 12% to our price estimate.

 

What prompted Caterpillar to undertake massive restructuring effort?

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Caterpillar’s attempt to reduce costs resulted from the recent decline in sales driven by low commodity prices and slowdown in Chinese economy. Resources segment accounted for about 73% of overall revenue decline for Caterpillar between 2013 and 2015. The segment was affected by decline in crude oil prices and suppressed purchase activity from Caterpillar dealers in an attempt to lower their inventories in-line with the weak global demand for mining equipment and machinery.

Caterpillar responded to declining profit by implementing cost cutting measures. The company initially planned to reduce its workforce by 10,000 by 2018 but, about it has already cut around 16,000 jobs as of September 2016. It also plans to lower SG&A expenses and cut about $0.7 billion costs by the end of 2016. Caterpillar expects long term cost reductions from lower period manufacturing costs, including savings from additional contemplated facility consolidations and closures.

What will be the impact on margins and EPS?

Caterpillar’s EBITDA has declined by 27.5% since 2013 and stood at $6.7 billion in 2015. If the company executes its cost reduction plan effectively, we estimate $0.7 billion reduction in costs by the end of 2016.We further expect $0.6 billion reduction in direct costs by 2017 as a result of lower SG&A and lower workforce expenditures. We expect Caterpillar’s EPS decline in 2016 but believe the figure can rise by about 5% in 2017 due to cost reductions. We expect company’s overall EBITDA margin to decline from 14.3% in 2015 to 13.6% by 2017, but recover thereafter to reach 14.0% by 2020 due to combination of revenue revival and cost rationalization.

 

Notes:

1) The purpose of these analyses is to help readers focus on a few important things. We hope such lean communication sparks thinking, and encourages readers to comment and ask questions on the comment section, or email content@trefis.com

2) Figures mentioned are approximate values to help our readers remember the key concepts more intuitively. For precise figures, please refer to our complete analysis of Caterpillar

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