Macro Risks Threaten to Derail Caterpillar’s Impressive Growth This Year

Caterpillar (NYSE:CAT) recently reported record sales as demand for Caterpillar’s machinery and engines was spurred by commodity-hungry emerging markets. Emerging markets have helped extend the boom for commodity prices in recent years and are driving mining investment globally. Developed markets experienced some growth in machinery and engines sales earlier this year as well, as dealers increased inventories and industrial clients refurbished aging fleets in anticipation of continued economic growth. However, amid heightened uncertainty around the European debt crisis and sluggish U.S. growth, we believe we could see a meaningful slowing in Caterpillar’s business in the second half of the year despite our bullish view on the company’s prospects longer term. Caterpillar’s machinery and engines businesses compete with Deere and Co. (NYSE:DE), Komatsu (TYO:6301), Terex (NYSE:TEX), Hitachi Construction Machinery (TYO:6305), Cummins (NYSE:CMI), GE Energy (NYSE:GE), Wartsila (HEL:WRTBV), etc.

Our $116 price estimate for Caterpillar stock is about 40% above market price.

Global Growth is Slowing

In the three-month rolling period ended April 2011, Caterpillar’s global retail deliveries of machines climbed over 60% year over year (yoy). Since April this growth has been steadily decelerating and stood around 34% yoy growth in the three-month rolling period ended August 2011. ^[1]

The increase early on was driven by commodity demand in emerging markets, which in turn drove investment in mining and machinery globally. Also a moderate level of investment among developed countries led to sales as industrial clients refurbished their machinery fleets and invested on the anticipation of a recovery in demand.

Warning Signs Could Signal Trouble Ahead

Macro concerns relating to the European debt crisis has worsened recently which weighs on business sentiment and has led to lower sales growth. European nations have so far been unable to effectively contain the debt crisis, which is now threatening to spread to other major economies within Euro zone such as Spain and Italy. More importantly, many businesses and market participants are not satisfied with the U.S.’s handling of its economy and efforts to stimulate the economy.

Construction and farm machinery sales are closely correlated to the health of economy. Therefore in the medium-term while construction and other machinery sales will continue growing along with the global GDP, its rate of growth will likely moderate until further evidence of a recovery in demand surfaces.

Although Caterpillar is focused upon controlling costs, we believe that margins will suffer due to increasing cost pressures in the medium term as Caterpillar has been experiencing an increase in freight and material costs. Moreover, to fund its expansion, Caterpillar plans to invest about $3 billion in 2011. The company will also have to increase investment in R&D to remain competitive with other players.

Though we highlight these concerns, we have an overall constructive view of the company’s fundamentals that support our valuation. However, if the global economy slows greater than markets currently anticipate, or if there are major shocks that would curtail further spending, we will need to revise our estimates.

See our complete analysis for Caterpillar.

1. Caterpillar: Dealer Statistics [↩]