Investors in Caterpillar, Inc. (NYSE: CAT) should closely monitor risks associated with economic cyclicality; participation in a competitive, mature industry; and operating a geographically diverse company. In September 2015, global macroeconomic weakness and a strong dollar are the most significant factors threatening operational performance. Caterpillar is a $43 billion manufacturer of construction equipment, mining equipment, turbines and engines. The company’s global operations serve construction, energy, mining, agricultural and industrial customers.
Cyclicality and Macro Pressures
Demand for Caterpillar’s products is highly cyclical. Caterpillar is the world’s largest manufacturer of construction and mining machinery, with operations spanning a diverse global footprint. When global construction spending falls and capital investment slows down, fewer pieces of industrial equipment are purchased. Caterpillar’s annual revenue fell 37% in 2009 amid recession conditions, illustrating its exposure to economic cycles. The company’s net income declined 75% in the same year. When demand for manufacturing products quickly dissipates, industry participants are usually stuck with excess inventory. Inventory overhangs often lead to decreased pricing power and asset write-downs, compounding the financial impacts of negative demand shocks. Suppliers of enterprise capital equipment are therefore disproportionately exposed to supply chain disruption risk.
Caterpillar is heavily exposed to the Chinese economy. Of Caterpillar's total revenues, 18% were generated in the Asia-Pacific region in the second quarter of 2015. The slowdown of the Chinese economy has been well documented, as economists’ gross domestic product (GDP) forecasts for 2016 have fallen below 7% as compared to recent historical growth rates consistently in excess of 10%. The slowdown is primarily attributed to a difficult real estate market and reduced investment in private business. Caterpillar’s sales in the Asia-Pacific region declined 21% year over year, while company-wide sales fell only 13% versus the prior year period.
Caterpillar is heavily exposed to energy and extraction industries. Its energy and transportation segment accounted for 37% of total revenue in the second quarter of 2015. As of September 2015, depressed oil and commodity prices have caused turmoil in related industries, reducing investment in capital machinery. Sustained low commodity prices could alter long-term capital expenditures and demand for CAT’s products.
The potential impacts of these macroeconomic risks are clearly evident in Caterpillar’s recent results. In late 2014, company management communicated early 2015 guidance and forecast flat revenue relative to 2014. In early 2015, this forecast was adjusted downward to a 9% year-over-year decline. Guidance was again reduced following the second quarter, with Caterpillar expecting revenue to fall 11% for the full year 2015.
Narrow Profit Margin
Caterpillar is a mature, diversified manufacturing company. It operates in a competitive industry, and the firm’s 10-K states that no single patent or group of patents is material to financial performance. These conditions are generally sufficient to ensure narrow margins, and Caterpillar’s recent results adhere to the pattern. Through June 2015, Caterpillar posted a 28.5% trailing 12-month gross margin, which is inferior to the 30.5% posted by competitor Deere & Company. Competitors Deere, Kubota Corporation and Komatsu Limited all have higher operating margins than CAT’s 9.7% mark. A narrow profit margin also contributes to CAT’s 19.0% return on equity, which trails Deere’s 24.1%.
Narrow margins indicate limited pricing power, forcing suppliers to maintain low price points to stay competitive. Firms with tight gross margins cannot invest as heavily in research and development or business model improvements as their more profitable peers. Moreover, research and development is often one of the first expense items that company management reduces when shareholders demand improved profitability, and this can affect long-term growth prospects. Wider profit margins also afford more stability in turbulent economic periods by allowing firms to absorb temporary hurdles. Tight margins also expose incumbents to potential disruptive pressures from innovative new market entrants.
High Leverage
As of June 2015, CAT held net debt of $23 billion; a long-term debt-to-equity (D/E) ratio of 1.6; and a total D/E ratio of 2.2. This is comparable to peers, though slightly higher. According to Morningstar, average long-term debt to equity for Caterpillar’s peer group is 2.1, while CSI Market estimates an average D/E ratio of 1.03 for the capital goods sector. Manufacturing firms and industrial goods providers typically carry high debt relative to nonfinancial industries. CAT’s debt is manageable and in line with industry standards, but its capital structure is still a noteworthy element of risk analysis. High leverage increases financial risk because cash must be used to repay debt obligations regardless of cash flows or profitability. In periods with poor operating income and cash flow, highly leveraged firms experience more severe net income fluctuations.
Currency
Caterpillar is exposed to currency exchange rate risk because the firm operates in numerous countries and conducts business in multiple currencies. The strong U.S. dollar has challenged year-over-year revenue growth as sales denominated in foreign currencies translate to fewer dollars than in the prior year. Caterpillar is an American company reporting results in dollars, so this translation is always necessary for investors. Deteriorating economic forecasts for Europe, the Asia-Pacific region and South America increase the likelihood the dollar continues to appreciate as central banks enact expansionary monetary policy. A significant portion of CAT’s expenses is also denominated in foreign currencies, which dampens the strong dollar’s impact on the bottom line and reduces currency risk.
Deceptive Valuation
Cyclical stocks often appear most attractively valued shortly before economic downturns. Sophisticated equity investors create forecasts that account for future operational volatility, so market price appreciation usually lags operational improvements as earnings approach a peak in the cycle. Strong operating performance at the peak of an economic cycle is frequently accompanied by low price to earnings (P/E) and cash flow multiples, giving cyclical stocks the appearance of attractive valuation.
In reality, financial performance is usually at its best before a rapid crash. Inexperienced investors may mistake cyclical peaks for sustainable growth, so market participants who fail to appropriately account for cyclicality can be fooled by these deceptive relative valuation metrics. Strong understandings of economic cycles and associated valuation dynamics are essential for mitigating the risk of investing in Caterpillar.
