Caterpillar Down to Neutral - Analyst Blog

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We have recently downgraded our recommendation on Caterpillar Inc. ( CAT ) from Outperform to Neutral due to the recent loss of momentum in sales growth, margin headwinds, negative impact of the European debt crisis and a slowing Chinese economy. The quantitative Zacks #3 Rank (short-term Hold rating) for the company indicates no clear directional pressure on the shares over the near term.

In 2011, Caterpillar recorded an impressive 88% surge in profits to $7.79 per share (excluding the impact of acquisition of Bucyrus), driven by record sales. Total revenue increased 35% to $57.6 billion, excluding the impact of acquisition of Bucyrus. After accounting for the Bucyrus acquisition, Caterpillar witnessed an all time record sales of $60.1 billion, up 41% from 2010, driven by increased sales volume (particularly new equipment) on higher end-user demand. Including the effect of Bucyrus, profit per share was $7.40, up 78% from $4.15 in 2010.

The Caterpillar-Bucyrus merger will position Caterpillar as the leading global mining original equipment manufacturer and will dwarf Joy Global Inc. ( JOY ), the only U.S.-based manufacturer of surface and underground mining equipment. Caterpillar expects Bucyrus to be accretive to its operating profit by at least $450 million in fiscal 2012. Caterpillar has a narrow product line compared to Bucyrus, which has a broad product portfolio. The Bucyrus acquisition will also help Caterpillar to gain a strong foothold in China and India, both of which are major mining markets.

Caterpillar's financial position strengthened through fiscal 2011. The company's Machinery and Power Systems (M&PS) operating cash flow was $8 billion, an improvement of 43% over 2010 and an all time record. The positive cash flow resulted from continued strong performance and a significant focus on asset management. This, in turn, has facilitated Caterpillar to fund acquisitions of around $10 billion without diluting shareholder value. Even with the acquisitions, Caterpillar had more than $3 billion in cash on its balance sheet with Machinery and Power Systems debt-to-capital ratio of 42.7%, as of fiscal 2011 end.

Despite the relatively weak economic growth in 2011, Caterpillar's order backlog increased steadily throughout the year and was at a record level, which holds promise for the year ahead. Backlog (excluding Bucyrus) stood at $29.8 billion, up 59% from $18.7 billion at the end of 2010 and 4% above the third-quarter end. Besides, many products have long lead times, with some slated for 2014. This bodes well for Caterpillar's future performance.

The company is doggedly adding production capacity for many of its products. Caterpillar's recent string of investments include expansion in Tosno, Russia for off-highway trucks, a new mining truck facility in Indonesia and expansion of existing facility, capacity expansion of mining trucks produced in Illinois, expansion of mining truck capacity and a new small engine facility in India, and also a new small excavator and tractor facility in Georgia. A new parts distribution center in California and expansion of an R&D center in Wuxi, China are in the pipeline.

Caterpillar recently announced the expansion of its manufacturing facility in Xuzhou, China, which would augment hydraulic excavator production by a substantial 80%. Furthermore, it is adding another product line and expanding its wholly owned Chinese construction equipment company, Shandong Engineering Machinery. In a bid to expand its parts distribution network, Caterpillar is building a new parts distribution center in San Luis Potosi, Mexico. We believe the top line at the company will continue to grow on the back of increasing demand for construction and mining equipment. Caterpillar's expansion plans of opening new facilities and furthering existing operations, particularly in the emerging markets, will boost its long-term potential.

On the flipside, Caterpillar machines sales growth of 21% for the three months ending February 29, 2012, dipped further from the lowest growth rate of 30% last year and from the 27% clip recorded in January 2012. Even though Caterpillar has seen sales ramping in the last 22 months, the rate of increase has of late been tempered by tougher year-on-year comparisons and weakening economic conditions, especially in Europe. Sales growth is now less than one-third of the highest level of 66% recorded in 2011.

Margins at Caterpillar may come under pressure from various quarters. These include higher manufacturing costs, steeper selling, general and administrative expenses, and spiraling research and development expenses to meet stringent emission requirements. Besides, the Bucyrus inventory step-up and costs associated with integration would burden margins.

In addition to the European debt crisis, signs of a slowdown in China have triggered concerns. China has slashed its 2012 growth target to an eight-year low of 7.5%. A slowing Chinese economy will have a negative effect on infrastructure and construction spending with an immediate impact on Caterpillar's sales in the near term.

Peoria, Illinois-based Caterpillar Inc. is the manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. The company is one of the few leading U.S. companies in an industry that competes globally from a principally domestic manufacturing base. Caterpillar operates two divisions - Machinery and Power Systems and Financial Products. Caterpillar competes with the likes of CNH Global NV ( CNH ), Komatsu Ltd. ( KMTUY ) and Volvo AB ( VOLVY ).

CATERPILLAR INC ( CAT ): Free Stock Analysis Report
CNH GLOBAL NV ( CNH ): Free Stock Analysis Report
JOY GLOBAL INC ( JOY ): Free Stock Analysis Report
VOLVO AB ADR B ( VOLVY ): Free Stock Analysis Report
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Business , Stocks
Referenced Symbols: CAT , CNH , JOY , VOLVY

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