Weak Manufacturing Sector, High Costs to Hurt Caterpillar

On Nov 28, we issued an updated research report on Caterpillar Inc. CAT. The company’s global machine sales growth has been declining for the past few months, hitting the lowest point in October, which is concerning. Lower backlog, inventory reduction at its dealers and low end-user demand due to the global economic uncertainty are headwinds. Also, raw material-cost inflation, thanks to the imposition of tariffs, is likely to continue to weigh on Caterpillar’s margins.

Retail Sales Declining

For the three-month period ended October 2019, Caterpillar reported a global retail sales increase of 3% — the lowest so far this year. Sales growth is currently confined in the single-digit territory, at levels last witnessed in 2017.  The company has logged an average growth rate of 5.8% during the January-October 2019 period, marking a sharp decline from the prior-year figure of 25.6%.

Lower Backlog & Demand to Hurt 2019 Results

Caterpillar’s order backlog came in at $14.6 billion, reflecting a sequential drop of $400 million. Order backlog decreased mostly in Construction Industries and Resource Industries. This decline reflects dealers’ expectations for lower demand from end markets in the fourth quarter and their desire to reduce inventory levels. This does not bode well for the fourth-quarter 2019 top-line results. For the ongoing quarter, Caterpillar expects end-user demand to remain flat and dealers to make further inventory reductions owing to the global economic uncertainty.

For 2019, Caterpillar’s adjusted EPS guidance for 2019 is pegged at $10.59-$11.09. The mid-pint of the guided range reflects a decline of 3% from the $11.22 reported in 2018. This guidance reflects lower end-user demand as well as dealer reducing their inventory. The company anticipates dealer inventory will be up about $500 million at the end of this year compared with the prior year. Caterpillar expects modestly lower sales for the year, in contrast to its prior expectation of modest sales growth.

Weak Manufacturing Sector to be a Deterrent

The U.S.-China trade tensions and waning global demand seem to have taken a toll on the U.S manufacturing sector. Per the Institute for Supply Management’s latest report, the U.S Purchasing Managers’ Index (PMI) was 48.3% in October 2019 — marking the third month of contraction in the sector. Moreover, industrial production edged down 0.8% in October following a 0.3% fall in September and a 0.7% rise in August. This indicates a contraction in the manufacturing sector, which is likely to impact Caterpillar’s performance.

China Market Continues to be a Drag

Persistent pressure from competitive pricing in China remains a headwind. Given that China represents about 10% to 15% of the construction industry segment’s sales and about 5-10% of Caterpillar’s overall sales, it is likely to weigh on the company’s results.

Higher Costs to Dent Margins

Material cost inflation will continue to dampen Caterpillar’s margins due to the implementation of tariffs last year. Further, SG&A and R&D spending will keep flaring up due to investments in growth areas, including services and expanded offerings, and some corporate level items.

Price Performance

Caterpillar’s shares have gained 7.4% in a year’s time compared with the industry’s growth of 6.1%.

Zacks Rank & Stocks to Consider

Caterpillar currently carries a Zacks Rank #4 (Sell).

Some better-ranked stocks in the Industrial Products sector are Northwest Pipe Company NWPX, Tennant Company TNC and Sharps Compliance Corp SMED. All of these stocks sport a Zacks Rank #1 (Strong Buy), at present. You can see the complete list of today's Zacks #1 Rank stocks here.

Northwest Pipe has an expected earnings growth rate of 15.8% for the current year. The stock has appreciated 46% over the past year.

Tennant has a projected earnings growth rate of 29.8% for 2019. The company’s shares have rallied 25% so far this year.

Sharps Compliance has an estimated earnings growth rate of a whopping 500% for the ongoing year. Year to date, the company’s shares have gained 26%.

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