Caterpillar reported excellent third-quarter results Monday that showed the best quarterly sales in history and an all-time record high backlog. This is probably the best report we’ve seen out of third-quarter earnings season thus far. We think the strong results support our view that the global economy is not headed south in a hurry, and our $110 fair value estimate for Caterpillar remains unchanged at this time.
Revenue advanced over 40% (in part due to the acquisition of Bucyrus), but on an ex-Bucyrus basis, sales still jumped an impressive 30%+. Machinery and power system sales jumped 44% from the same period a year ago led primarily by sales volume in new equipment, though aftermarket, price realization and currency were notable tailwinds, as well. The firm indicated the volume increases were broad-based, occurring across all geographies, as mining and construction activity remained healthy. We view this as a positive data point for Europe and the Asian economies—both arising as potential concerns regarding the global economy. Importantly, however, it noted that China was an exception, as construction machine sales to end users actually fell from levels reached in the same period a year ago, with economic tightening by the Chinese government to combat inflation listed as the primary explanation for weakness. The firm’s power systems saw increased demand as energy prices remain conducive for continued investment.
Caterpillar’s profit was equally as impressive as its top-line expansion. Earnings per share jumped 40% to $1.71 in the quarter, while profit jumped 44%. The achievements in this quarter, excluding Bucyrus, were absolutely remarkable: 1) best quarter in sales in history, 2) order backlog is at an all-time high, 3) year-to-date operating margins were the best in three decades, 4) industrial operating cash flows through the first nine-months were better than any number registered during a fiscal year (12 months). Perhaps expected based on the performance in the quarter, the company raised its revenue and earnings outlook for this year (2011), excluding Bucyrus, to the high end of its previous range, $56 billion and $7.25 per share, respectively. Given the wide ranges offered previously as guidance, moving to the high end is a material positive.
Management indicated that it also expects momentum to continue through 2012 and noted that it is not seeing the impact of the political and economic uncertainty in its business. Caterpillar expects sales growth of 10% to 20% for 2012 based on slow growth in the developed world and continued strength in orders from developing countries. Specifically, the firm’s massive order backlog (over $28 billion, up from about $17 billion from the third quarter of last year) and future orders from the developed countries to replacing aging tractor fleets are two sources of demand supporting growth.
As a supplemental to our note, we have included an excerpt from Caterpillar’s press release that covers its views on the economy for 2011 and 2012 and the assumptions backing its optimistic forecasts. We think Caterpillar’s management team is among the best in disclosing its views about the global economic environment, which is all too important for its business. From management’s third-quarter press release:
2011 Economic Outlook
Eurozone government debt problems, U.S. difficulties in raising the federal debt limit and signs of slowing economic growth caused stock markets and confidence indicators to decline in the third quarter of 2011. While concerning, we do not believe these developments signal the onset of recession. The indicators that we track suggest slow growth the rest of the year. We expect the world economy will grow about 3 percent in 2011, down from 4 percent in 2010. Metals prices softened in response to economic concerns, but production continued to increase, and mining companies appear to be continuing with investments. While commodity prices are off their highs, we expect that they will remain favorable for mining investment and production.
Key points related to our economic outlook include:
- The U.S. economy averaged 0.8 percent annual growth in the first half of 2011 as federal, state and local governments reduced spending at over a 3 percent annual rate. We anticipate the U.S. economy will improve its growth rate in the second half of 2011, allowing full-year growth of about 1.7 percent. We expect capital investment to continue to grow faster than the overall economy.
- The Eurozone’s difficulties in addressing its government debt crisis and policy tightening slowed economic growth and weakened confidence. The European Central Bank (ECB) began increasing bank liquidity during the third quarter of 2011 and announced additional actions in October. We anticipate the ECB will start reversing recent interest rate increases in the fourth quarter of 2011. Economic growth is expected to be about 1.5 percent in 2011 with capital investment growing even faster.
- Japan‘s economy has declined for three quarters, in large part due to natural disasters. We expect increased government spending and near-record banking liquidity will allow a recovery in the second half of 2011. As a result, we expect economic output in 2011 to be about even with last year. Capital spending is expected to improve in the second half of 2011.
- Difficulties in developed economies prompted most developing countries to halt policy tightening, with several countries reducing interest rates. Our outlook assumes developing countries will grow about 6 percent in 2011, about a percentage point slower than in 2010.
- Asia/Pacific countries tightened economic policies in 2011, which we expect will slow economic growth to less than 7 percent. We believe that rate of growth would be sufficient for both construction and commodity demand to increase.
- China‘s economy averaged 9.4 percent growth in the first three quarters of 2011, and we expect past policy tightening will slow full-year growth to 9.3 percent. Inflation appears to have peaked, and liquidity growth has slowed to a rate consistent with past easing. We expect no further policy tightening this year.
- Our outlook assumes Latin American economic growth will slow to about 4.5 percent in 2011, the result of prior interest rate increases. Brazil recently cut interest rates, and other countries appear near the end of policy tightening.
- Africa/Middle East economies are benefiting from low interest rates and favorable commodity prices. We expect economic growth will exceed 4.5 percent in 2011.
- Countries in the CIS have maintained low interest rates and are benefiting from favorable commodity prices. Our outlook assumes economic growth will improve to over 5 percent this year.
2012 Preliminary Economic Outlook
We expect the world economy will continue to recover in 2012, with growth improving to about 3.5 percent. The United States and Japan should account for much of the improvement.
- Economic uncertainty over the past quarter has caused many countries to reconsider policy tightening, and several countries have already cut interest rates. Overall, we expect interest rates will trend lower in 2012.
- An expanding world economy will likely increase demand for most commodities. We expect producers will continue to struggle to meet this demand, and most commodity prices should average higher than in 2011.
- The U.S. Federal Reserve announced it would hold interest rates in a zero to twenty-five basis point range well into 2013, and we expect additional actions to maintain liquidity growth. Our outlook assumes the U.S. economy will grow about 2.5 percent in 2012, and we expect business investment to grow even faster.
- We expect economic growth will improve employment and household formations in the United States—the major driver of housing demand. Housing starts will likely improve somewhat with multi-unit starts increasing the most. While we expect housing starts in the United States to improve modestly, they will likely remain below what is needed to support a rate of household formations consistent with ongoing population growth.
- Our outlook assumes nonresidential building construction in the United States will improve due to lower vacancy rates, increased building prices and easier credit terms. Infrastructure-related construction will remain constrained by government budget restrictions and the lack of a new federal highway program.
- We expect the ECB will reverse its two 2011 rate increases by the end of first quarter 2012 and that bank liquidity will continue to improve. These actions will help offset tighter government budgets. We expect the Eurozone economy will grow about 1 percent in 2012, but capital spending should increase faster.
- Other European economies will likely continue to outperform the Eurozone, and we expect economic growth in all of Europe will average less than 1.5 percent.
- We anticipate the Bank of Japan will hold interest rates near zero and increase bank liquidity. Favorable economic policies, along with reconstruction spending, will likely lead to about 4 percent economic growth.
- Our outlook assumes Asia/Pacific economies will grow more than 7 percent in 2012, a slight improvement over 2011. Although we expect China will relax economic policies, growth will ease to about 9 percent. Growth in the other large regional economies, India and Indonesia, should improve slightly.
- Continued economic growth in Asia will likely improve construction activity and commodity demand, and we expect mining production to increase.
- Interest rates in several of the key Latin American economies will likely decline in 2012. We expect economic growth of more than 4 percent, with further increases in both mining and construction.
- Africa/Middle East and CIS regions were slower to recover, and interest rates are not much higher than a year ago. Continued favorable commodity prices should provide additional help, and we expect economic growth close to 5.5 percent in 2012.
Economic Risks
- The large developed economies of the United States, Eurozone and Japan pose the most significant risks to our outlook. A decade of weak growth has left these economies with high unemployment, governments struggling to fund operations and depressed construction spending.
- Economic policies of developed countries have not been up to the task of securing sustained, stronger economic growth. Governments have too often engaged in confidence-destroying battles over budgets, and central banks have too often overestimated the stimulus provided by their policies.
- Our forecast of improved growth in these economies rests on the assumption that central banks will continue recent efforts to provide more liquidity, allowing modest recoveries to continue. Should they prematurely tighten these policies, recessions could develop.