Tariff Impact on Heavy Equipment Makers Likely Modest

It appears that heavy equipment investors are in for a first-quarter 2018 earnings season even more stellar than we previously expected. In our view, first-quarter performance for companies within the heavy-equipment industry was already likely to be strong, particularly given recent U.S. tax reform, which we believe incentivized both customers and manufacturers to move orders from the fourth quarter of 2017 to the first quarter of 2018 to take advantage of immediate depreciation allowance and lower tax rates. But with the latest news on tariffs, we believe heavy-equipment companies will witness even stronger demand in the first quarter as customers who were contemplating orders become even more likely to pull the trigger.

While we are still assessing potential tariff-related effects, we note that both wide-moat Caterpillar and Deere have adequate inventory on hand to last for a few months before tariffs have an impact. Thereafter, we estimate that these companies will be exposed to rising steel prices, which account for around 10% of their total operating expenses (raw materials account for 50%-75% of cost of goods sold). We view it as unlikely that many companies will meaningfully pass along their increased raw material costs to customers, as foreign competitors stand ready to take advantage. Moreover, companies in our coverage list operate without hedges and are thus exposed to steel price fluctuations.

Steel tariffs enacted by the George W. Bush administration lasted for 18 months. If we assume 24 months of tariff-related impacts and an inability for manufacturers to pass the increased steel prices along to customers, then we would expect to see operating margins decline over 200 basis points, resulting in fair value estimates declining less than 5%. Thus, assuming no other retaliatory measures taken by other countries in response to products manufactured by our coverage list, we currently don’t expect material impacts to our fair value estimates.

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