Image Source: Caterpillar Inc – Third quarter 2019 IR presentation
By Callum Turcan
On October 23, Caterpillar Inc (CAT) posted third-quarter 2019 earnings with both its top- and bottom-line performance falling well short of consensus expectations. Furthermore, management revised the firm’s adjusted (non-GAAP) EPS guidance for 2019 down to $10.90-$11.40 from $12.06-$13.06 previously, quite the reduction. Please note this represents Caterpillar’s second earnings guidance reduction so far this year. Caterpillar’s weak performance is about much more than just the industrial equipment supplier, it speaks unfavorably to the state of the global industrial economy. Our fair value estimate for Caterpillar stands at $156 per share, and shares of CAT yield 2.9% as of this writing.
Revenue Growth Disappearing
Management has adjusted Caterpillar’s production schedules and inventory management systems to better match demand expectations as dealers are winding down their own inventories in the face of slowing demand. Dealer inventories decreased by $0.4 billion in the third quarter of 2019, hurting Caterpillar’s top line performance, versus the $0.8 billion inventory build in the same quarter last quarter. Caterpillar’s CEO Jim Umpleby noted in the earnings press release:
“Our volumes declined as dealers reduced their inventories, and end-user demand, while positive, was lower than our expectations.”
During the third quarter of 2019, Caterpillar’s consolidated GAAP revenues declined by almost 6% year-over-year, hitting $12.8 billion. When looking at just its ‘Machinery, Energy & Transportation’ (or ‘MET’) segment, Caterpillar’s sales dropped by over 6% year-over-year. The firm recorded modest revenue growth at its ‘Financial Products’ segment last quarter on a year-over-year basis.
During the first three quarters of 2019, Caterpillar’s consolidated GAAP revenues were up just a fraction of a percent on a year-over-year basis, with both its ‘MET’ and ‘Financial Products’ segments reporting growth. To provide some contrast, Caterpillar’s consolidated GAAP revenues surged by 42% from 2016 to 2018, with the vast majority of that coming from its ‘MET’ segment.
The slowdown in 2019 signals a stark change in Caterpillar’s growth trajectory, as the tailwinds from a rebound in mining activity post-2016 and bustling North American construction activity are being overwhelmed by trade war disruptions and ultimately a synchronized global slowdown in economic activity. Demand softness from Caterpillar’s core end customers (construction, raw energy resource extraction, agriculture, etc.) is feeding directly into subdued sales expectations, and when management eventually provides 2020 guidance, that outlook will likely reflect this softness. Confidence is also key as dealers are reducing inventories over expectations of weaker future demand.
Furthermore, we caution that demand from the oil & gas industry will likely be very subdued going forward given consistently low raw energy resource prices and the need for upstream operators to scale back capital expenditures to live within their operating cash flows. Caterpillar sells the oil & gas industry various types of industrial equipment including compression, pumping, power, and transmission systems.
Due to dealers reducing their inventories and in light of weak demand expectations, management now sees Caterpillar’s 2019 revenues falling short of its 2018 performance. Previously, Caterpillar was guiding for modest revenue growth this year versus 2018 levels. Caterpillar’s CEO had this to say on the issue during the firm’s third quarter 2019 conference call (emphasis added):
“…based on input from dealers and customers, we now expect fourth quarter end user demand to be about flat compared to the fourth quarter of 2018. Based on our revised expectations for dealer inventory and end user demand, we now expect sales and revenues to be modestly lower for the full year versus our prior expectation of modest sales and revenue growth in 2019. The global economic situation is very fluid due to a variety of factors. The decline in dealer inventory, along with our improved lead times, will position us to react quickly to positive or negative developments in the global economy during 2020.”
We view Caterpillar’s production schedule and inventory management changes as largely defense maneuvers.
Maintaining Margins
Caterpillar is fighting back in the ways it can, namely by controlling expenses, and we really like management’s commitment to preserving the firm’s operating margins. While keeping in mind Caterpillar’s financial statements can be a messy read given its large financial wing, the firm’s consolidated GAAP operating margins were broadly flat in both the third quarter of 2019 and first three quarters of 2019 versus the same periods last year, respectively. However, when looking at Caterpillar’s non-GAAP ‘MET’ gross margins (‘MET’ revenues less cost of goods sold), the company has been experiencing pressure here. Cost of goods sold as a percent of revenue climbed by ~100 basis points from the first three quarters of 2018 to the first three quarters of 2019, indicating Caterpillar’s “core” gross margins are weakening somewhat in order to prop up its industrial equipment sales.
SG&A expenses fell by over 3% year-over-year, R&D expenses dropped by almost 6% year-over-year, and other operating expenses dropped by about 8% year-over-year during the first nine months of 2019. Declining profit at its subsidiaries and a modestly higher effective corporate income tax rate saw Caterpillar’s consolidated GAAP net profit margin shift lower by over 30 basis points year-over-year during the first three quarters of 2019. Caterpillar’s diluted GAAP EPS still marched higher by almost 4% year-over-year to $8.75 during the first nine months of 2019 due to the company reducing its outstanding diluted share count by over 5% year-over-year, a product of substantial share buybacks. During Caterpillar’s third quarter 2019 conference call the firm’s CEO noted:
“We maintained our operating profit margin percent despite lower volume and some continued pressure on manufacturing costs. We anticipate meeting the full year operating margin targets communicated during our Investor Day last May.”
Dividend Strength
At the end of September 2019, Caterpillar was sitting on $7.9 billion in cash and cash equivalents while its ‘MET’ segment carried a negligible amount of short-term debt along with $9.1 billion in long-term debt. Keep in mind Caterpillar’s ‘Financial Products’ segment carries a substantial amount of total debt. When removing the noise from its balance sheet, Caterpillar’s financial position is quite strong and that’s a key reason why its adjusted (keeping its ‘Financial Products’ segment in mind) Dividend Cushion ratio stands at 2.8x. However, unlike most firms that would normally earn a Dividend Safety ratio of EXCELLENT when carrying a Dividend Cushion ratio north of 2.75x, we give Caterpillar a GOOD Dividend Safety ratio given the risks its ‘Financial Products’ segment poses in the event of a downturn.
We define Caterpillar’s free cash flows as net operating cash flows less ‘capital expenditures – excluding equipment leased to others’ and please note we value the firm’s financial wing separately from its industrial operations. During the first nine months of 2019, Caterpillar’s industrial division generated $3.8 billion in free cash flows, fully covering $1.6 billion in dividend payments. Additionally, the company spent $3.3 billion repurchasing its shares, but given rising exogenous headwinds, we think it would be best for Caterpillar to bulk up its balance sheet heading into 2020. That’s unlikely to be the case, with Caterpillar’s CEO noting this during the firm’s third quarter 2019 conference call:
“During our Investor Day in May, we shared our intention to drive long-term shareholder value by returning substantially all of our Machinery, Energy & Transportation free cash flow to shareholders through a competitive dividend and a more consistent share repurchase plan…
We also repurchased $1.2 billion of common stock in the third quarter. We continue to expect share repurchases during the second half of the year will be similar to the first half, which will reduce our total quarterly average diluted shares outstanding by about 9% since the first quarter of 2018.”
Some of Our Thoughts
Here’s a summary of our thoughts on Caterpillar and the structure of its business model from our recently updated 16-page Stock Report covering the firm (can be accessed here):
Caterpillar makes construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company also owns Caterpillar Financial Services (Cat Financial). The machinery giant’s operations are tied to cyclical end markets, and results are not immune to geopolitical risks either. It is based in Deerfield, Illinois.Caterpillar’s dealer network is a significant competitive advantage. Its reach is phenomenal, with ~50 dealers in the US and 120+ outside the US (serving ~190 countries).
Mining equipment sales remain tied to expectations of commodity prices, and the period 2013-2016 is exemplary of the pain this can cause. Drivers of demand at Caterpillar of late include continued strength in the North American construction market, new equipment sales momentum in resource industries, and demand for rebuilds of well-serving equipment in the energy space. Higher material and freight costs have the potential to weigh on bottom-line results in the near term, but it expects to mitigate the impact of tariff-related costs.
Caterpillar is quite effective at managing costs through the course of the economic cycle. 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. We also like the focus on driving strong inventory turns.Caterpillar Financial’s exposure to weak credits in the mining and energy arenas will always have us concerned. The hidden captive finance arms across the broader machinery group may put surprising pressure on performance in the event of a downturn.
We would like to stress that while Caterpillar is generally regarded as a maker of industrial equipment, its reliance on Cat Financial needs to always be taken into account.
Concluding Thoughts
Should the global economy show signs of stabilizing, particularly as it relates to industrial activity, Caterpillar would appear relatively cheap at ~$141 per share as of the end of the October 29 trading session. Recent signs have not been promising. Exports out of South Korea, a barometer for the global economy, continue to plummet while macroeconomic readings in the EU and North America are showing signs of a major slowdown materializing as we speak (particularly in the Eurozone, but that appears to be spreading to the US economy as well). China’s economy continues to feel the heat from the US-China trade war. The low end of our fair value estimate range stands at $125 per share of CAT, meaning that under more pessimistic assumptions, Caterpillar appears fairly valued as of this writing.
Agricultural (and Industrial) Equipment Industry – AGCO CAT CNHI DE MTW
Diversified Mining Industry – BHP FCX NEM RIO SCCO VALE WPM
Conglomerates Industry – MMM DHR GE HON UTX
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.