Caterpillar’s (CAT) shares have taken a substantial hit following the firm’s restructuring and cost reduction announcement September 24. The slowing economy in China, the largest market for construction machinery in the world, has infected the export-dependent countries of Brazil, Canada, and Australia, resulting in severe weakness in mining activity and construction sales, almost everywhere on the globe. OPEC’s dedication to putting US producers out of business has wreaked havoc on the price of oil and orders for oil-related applications. Cat Financial’s exposure to increasingly weaker credits in the mining and energy arenas, however, has us most concerned. We’ve materially lowered our fair value estimate as a result.
Caterpillar’s cost reduction plans will begin in late 2015 and are indicative of recent, current, and expected market conditions across its cyclical end markets. The machinery giant plans to reduce annual costs by ~$1.5 billion, beginning in late 2015, and job cuts are expected to be in a range of 4,000-5,000 by the end of 2016, with the possibility for 10,000 jobs in all to be eliminated. Caterpillar is also contemplating the consolidation or closing of more than 20 manufacturing facilities through 2018, which has the potential to impact more than 10% of its manufacturing square footage. The firm also lowered its revenue guidance for 2015 by $1 billion, to $48 billion. 2016 revenue is expected to fall 5% from 2015 levels, but it’s more likely, in our view, that the pace of the decline may turn out to be greater.
The announcement is not the first round of expense cuts at Caterpillar since its most recent peak in sales, which occurred in 2012. The Peoria-based company has reduced its total workforce by more than 31,000 since mid-2012 and has closed or announced plans to shut or consolidate more than 20 facilities between 2013 and the date of its most recent announcement. Those cost-controlling actions were taken in anticipation of the recent and current weakness in the company’s commodity-based end markets, something it has been dealing with for some time. Part of Caterpillar’s strategy when faced with revenue declines is to manage the fall such that the decrease in operating profit is less than 30% of the decline in revenue, so when revenue drops, cost cuts are sure to follow.
However, it seems Caterpillar’s management wasn’t planning for yet another round of cost cuts during the ongoing downdraft of the current business cycle and certainly investors weren’t ready for the bad news, if its share price reaction is any indication in light of the broader equity markets just a few percentage points from all-time highs. What is now probable is that the current downward trajectory in the company’s fundamentals is much more prolonged than the duration previously anticipated by management. If the executive suite’s forecasts prove to be correct, 2016 will mark the first time in Caterpillar’s 90-year history that it will realize declining sales for four consecutive years, and concerns about global health haven’t been this serious since the Great Recession. There may be risks to organic revenue expansion 2017 as well.
We don’t expect prices for commodities like coal, iron ore and crude oil to sustainably rebound anytime soon, and the strengthening US dollar may continue to put pressure on dollar-denominated commodities as global supply remains robust in the wake of a potential sharp drop in demand, if not only from China, from its largest sovereign trading partners, too. Capital spending cuts at BHP (BHP) and Rio Tinto (RIO) and across the oil and gas arena, and the longest business trough in Caterpillar’s storied past is indicative of the current commodity bust that has left many reeling, others perhaps destined to default, as spreads on high-yielding commodity-linked credits widen. That Cat Financial may be left holding the bag in some cases is perhaps our biggest concern, accounting for the primary driver behind our downward fair value estimate revision in the form of a higher discount rate.
Caterpillar is preparing for weakness to last through 2016, but its cost reduction plan will not be in full effect until 2018. Though this doesn’t necessarily mean the company is expecting sales to decline through then, it does suggest the company anticipates sales pressure to continue for some time, and we posit that it might have something to do with not wanting to make yet another announcement of expense cuts next year. We’re viewing the news as the equivalent of management “ripping off the Baid-Aid” in anticipation of ongoing and prolonged weakness, but even management may not have a great handle on what may actually be in store in coming years. Right now, the executive team may be seeing troubling signs with respect to key customer defaults across its mining and energy end markets, which will likely only accelerate in 2016 and beyond.
As Caterpillar fights to maintain past profitability levels, its free cash flow and balance sheet are worth watching closely. In their current state, there is little reason to think the firm will not be able to weather the global commodity storm, but Cat Financial could expose the company to stresses not unlike those faced by General Electric (GE) or General Motors (GM) during the Financial Crisis, at least to some degree and in substance. The hidden captive finance arms across the broader machinery group may put surprising pressure on performance in coming years, and we think investors should be watching this dynamic closely, if they aren’t already. Of course we’re not expecting Cat’s demise, but we do think shares are worth less than before in light of the increasing risks and decidedly lower future free cash flow trajectory. Our new fair value is $60.
Agricultural Machinery: AGCO, CAT, CNHI, DE, HEES, JOY, MTW, RBA, TEX