Caterpillar Reports Moderating Declines in Mining, Rebounding Results in Construction, and Solid Free Cash Flow

With a strong dealer network and economies of scale as the largest global construction and mining equipment manufacturer,  Caterpillar (CAT) has carved a wide economic moat, in our opinion. Following the company’s fourth-quarter results, we plan to maintain our $94 per share fair value estimate. The firm continued to see sharply declining mining markets, but increasing Construction and Power Systems revenue. While these gains weren’t enough to prevent total revenue from falling (down 11% in the quarter), the firm drove solid operating margins in both Construction and Power Systems, helping increase consolidated machinery profitability from a year ago.

In addition, the firm believes the dealer inventory reductions that have plagued its top line in recent quarters are now largely past. Management held its sales outlook for next year, a range of negative 5% to 5%, and estimated about $5.85 in 2014 earnings per share before expected restructuring expense. We will revisit our near-term EPS projection (currently $5.97), but broadly we believe Caterpillar’s performance is tracking our forecast of moderating declines in mining, rebounding results in construction and engines, and solid free cash flow due to lower capital spending needs and better internal inventory management.

The company has also sharply reduced its inventory overhang, greatly improving free cash flow, but still faces heightened acquisition integration requirements, continued competition in China, and further mining equipment headwinds. In all, Caterpillar's near-term business prospects look challenging, given global economic concerns, and the firm remains heavily leveraged to high commodity prices through its substantial mining equipment exposure. We still think its long-run trajectory is solid, but we believe the firm will face even more severe short-run difficulty than we previously anticipated, from challenged mining prospects, European weakness, and continued tepid Chinese demand.

Construction sales jumped more than 20% in the quarter, with a 26% volume increase more than offsetting negative price and currency impacts. This was the first year-over-year increase in volumes since the third quarter of 2012, led by less dealer inventory reduction as well as end-user demand expansion in Latin America, Asia-Pacific (China in particular), and North America. Power Systems also saw its first positive volume performance in several quarters, with expansion in all areas except Asia. Resource continued to be a drag on sales, with a 48% revenue decline stemming about half from lower end-user demand and half from dealer inventory reductions. Management expects the Construction and Power Systems segments to grow about 5% next year--much healthier than the negative results posted in 2013--but Resource to decline another 10%.

Operating margins for Construction and Power Systems both climbed from a year ago, helping offset continued declines in Resource. For the full year, we calculate total operating margins at about 9.6% (excluding restructuring costs), down from 13.4% in 2012. Although we expect sales to climb in 2014, alongside better cost absorption stemming from limited internal inventory reductions, the negative mix effect of falling mining sales and increasing construction volume will probably constrain margin expansion. That said, we’re encouraged that Caterpillar plans to increase its investment in R&D during the upcoming year--a good long-term strategic move, in our view.

The firm will also spend about $400 million to $500 million on restructuring in 2014 (roughly 0.5% to 1.0% of sales), following about $200 million of 2013 investment. The bulk of this (about $300 million) will go toward improving European operations at Caterpillar’s plant in Gosselies, Belgium, and the firm expects total restructuring to begin to pay back in earnest in 2015. As such, we remain comfortable with our long-term forecast for improved profitability versus current levels.

Caterpillar’s free cash flow performance also improved materially in 2013. The company generated nearly $6.5 billion of free cash in its nonfinancial services segments for the full year, or 170% of net income. This result was greatly improved from 2012, when a buildup of inventory led to free cash flow of just $1 billion, or 18% of net income. With the improved cash generation, the company announced a $1.7 billion share repurchase for the first quarter of 2014, and a new $10 billion buyback authorization that runs until 2018. We applaud this move, given that the current share price sits below our fair value estimate and Caterpillar has faced difficulty with other uses of cash (specifically acquisition integration). We expect some inventory build following sharp declines in 2013, but with earnings forecast to grow in 2014 and capital expenditures expected to again decline, we expect another solid year of free cash generation.

Service Network Expands Market Share, Leading to Outsize ROICs
We estimate that Cat's service network has helped it expand its market share; preventing machine downtime is critical for customers, so the company's wide dealer network creates a sizable competitive advantage. As a result, the firm has enjoyed outsize returns on invested capital since 2010, and we forecast continued solid economic profitability. However, following the 2011 acquisition of mining equipment manufacturer Bucyrus, Caterpillar now garners a substantial portion of its operating profits from mining markets, where results will probably continue to suffer in the near term because of difficult year-over-year comparisons, economic slowing in China, and weaker mined commodity prices.

 

In the face of economic uncertainty, Cat's dealers have reduced their inventories in recent quarters, driving the company's sales below user demand in 2013. Nonetheless, the lack of such distributor fleet changes could lead to growth in 2014, even if end demand is stagnant. Moreover, we continue to expect improving construction markets in 2014 as U.S. nonresidential spending improves and Europe begins to thaw from its economic malaise.

Cat's Wide Moat Due to Strong Dealer Network and Economies of Scale
In both the construction equipment and mining machinery industries, a solid service reputation is critical--downtime at project sites and mines equates to lost revenue for customers. Like many competitors, Caterpillar works closely with its dealers to ensure financial health, but we believe its network has experienced less turnover than those of competitors such as  CNH Industrial (CNHI) and  Komatsu (KMTUY). Given Caterpillar's sizable market share and breadth of geographic coverage, we don't think this dealer base is replicable in the near term. Moreover, in the mining space (50% of Caterpillar's operating profit in 2012), the company generally enjoys oligopolistic markets that enjoy barriers to entry and rational pricing.

Caterpillar also enjoys economies of scale as the largest equipment manufacturer in the industry. We peg the firm's global construction and mining machinery market share near 30%, several percentage points higher than Komatsu, its next-largest competitor. We believe the company's geographic breadth and strong reputation provide a perceived product advantage that leads to higher-priced equipment and better resale values over time. The firm is unlikely to concede this advantage as its R&D budget dwarfs competitors' spending.

Encroachment of Peers Threatens Cat's Moat
Caterpillar remains the dominant player in the worldwide construction equipment market even as competitors have attempted to chip away at its armor. Still, we've become increasingly concerned that several peers, including emerging firms such as China's  Sany , have increased both their footprints and product quality in high-growth areas like China and Latin America.

We originally had believed these markets would prove large enough to include many global players at the expense of less-sophisticated offerings from local manufacturers, but domestic OEMs have rapidly increased the quality of their offerings while enjoying outsize growth. As evidence, Chinese manufacturers have substantially increased their share of hydraulic excavator sales (historically a product dominated by foreign producers because of its high level of complexity) and now sell nearly 50% of the country's volume. Caterpillar's entrenched dealer network in North America garners the firm a stranglehold on the region that is unlikely to waver in the near term. But we also caution that Sany,  Zoomlion (ZLIOY), and others have increased their foreign investments recently and could offer alternative products at lower prices in the next five to 10 years. Caterpillar's investment-grade financing arm remains a continuing competitive advantage compared with other sub-investment-grade captive subsidiaries (such as CNH) and challenged banks, but our moat trend rating is negative.

Large Acquisitions and Goodwill Write-Down Warrant Standard Stewardship Rating
We think Caterpillar has performed well over the past several years, as end-market growth, solid cost control, and good supplier management have pushed adjusted returns on invested capital back to the high teens from the low double digits during 2009. That said, the company has also recently completed several large acquisitions, a marked strategic shift from prior years, and faced a goodwill write-down in one of them (ERA Mining). We like that Caterpillar has continued to increase its sizable dividend, but we rate its stewardship as Standard, given the uncertainty surrounding these major purchases and the goodwill-impairment charge. CEO Doug Oberhelman took over when Jim Owens retired in 2010. Oberhelman joined Caterpillar in 1975 and was head of the engine division before taking the reins of the entire firm. Similarly, Ed Rapp ascended to the CFO position after years of service with Caterpillar, but recently took over as the firm's construction industries group president following the retirement of Rich Lavin. Brad Halverson, formerly vice president of finance services, is now CFO. The rest of management has similar levels of experience throughout many parts of the firm, and we like that performance metrics include return on assets and internal quality control.