Does This Caterpillar Have 9 Lives To Survive The Industry Downturn?

On July 24, 2013, Caterpillar (CAT) declared its second quarter results for fiscal year 2013. It posted a disappointing 16% year-over-year revenue decline. Caterpillar blames falling commodity prices since this affects its mining business directly. China's economic slowdown also impacted the company as this region has a significant market share in the mining industry.

What steps will Caterpillar take to overcome, or at least lessen, the impact of the declining mining industry?

Mining business still a huge headwind

In the second quarter this year, the overall global mining results were negative. It was mainly due to the falling commodity prices and rising operating cost, which grew faster than production. This includes the 13% rise in employee cost, while the number of employees grew by only 2%.

In order to reduce the cost structure, Caterpillar has taken cost-cutting measures to dampen the negative effects of its mining business. In the past two months, Caterpillar has laid off over 700 employees, increasing total global layoffs to 10,000 in the past 12 months. Additionally, it will be closing its tunnel-boring machine plant in Toronto, Canada, initiating another 330 job cuts by the first half of 2014.

On the other side, mining companies are reducing their capital expenditure, or capex, due to the overall slowdown. In this scenario, the demand for aftermarket parts and services tends to increase since companies use existing equipment rather than purchasing it new. This trend will help Caterpillar offset declining original equipment sales since it provides quality services for its sold equipment. These services provide higher margins compared to the equipment sold, which will play a large role in mitigating the negative impact from the declining capex of mining companies. Caterpillar is anticipated to experience a reduced-decline in its construction business of just 2% to $18.8 billion in this year on the year-over-year basis.

Declining backlog

In the! second quarter this year, Caterpillar's backlog declined $1.3 billion to $19.1 billion on the quarter-over-quarter basis. The resource industries and the power system segment contributed to this decline, but it was offset by the increase in the construction segment. Orders declined by 11% year-over-year.

The company's book-to-bill ratio stood at 0.91 in the second quarter, which is not a good sign. A ratio below 1.0 implies that fewer orders were received than filled. This also means a decline in the number of future orders, indirectly indicating less business in the coming quarters.

One of the major reasons for the decline in the sales is that dealers, or retailers, are de-stocking. To offset this, the company under produced in the second quarter in order to reduce the dealers' high level of inventory and existing stock. Unlike companies such as Joy Global (JOY), which also manufactures machinery for extraction of minerals like coal, iron ore, and copper, Caterpillar sells its products through a separately owned dealer network.

Joy Global will continue benefiting from legacy-mining orders turning into shipments in the first half of its fiscal year. However, despite this tailwind opportunity, Joy Global is expected to post EPS at $5.60-$5.80 in this fiscal, which is significant reduction from its previous year's EPS of $7.13. It too will be highly impacted from this whole industry downturn.

Peer Comparison

Based on the highest market cap companies in the machinery equipment industry, I am comparing Deere (DE) with Caterpillar in order to gain a better understanding from a valuation standpoint. Deere is also engaged in manufacturing construction equipment, and has a market cap of $32.7 billion. The enterprise value of Caterpillar stays at high levels of $90.29 billion, due t to its large market cap, while Deere's enterprise value is only $61.64 billion. Caterpillar also stands strong when compared on the EV to revenue basis, as it has a ratio of 1.50 times, which is lower t! han Deere! 's 1.63 times. This ratio helps investors understand how much it would cost to buy the company's sales.

Caterpillar also has a better EV to EBITDA ratio, which is 9.50 times compared to Deere's 10.02 times. Through this ratio, it is easy to find out the approximate fair market value of a company and the lower number is considered better. It is surprising that despite high enterprise value, Caterpillar has better ratios than Deere, since Caterpillar has revenue double the level of Deere, and it has 50% higher EBITDA also. Additionally, considering the price to book ratio, the industry standard is 4.9 times, while Caterpillar and Deere have a ratio of 3.17 times and 3.90 times respectively. By comparing the price to book ratio of the industry with its individual companies, we learn whether the company is undervalued or overvalued. The former shows growth prospects in the future, and the latter reflects the overpricing of a stock. This indicates that both the companies are fairly undervalued. Therefore, on valuation basis, Deere is not as an attractive investment when compared to its peer company, Caterpillar.

Conclusion

Presently, Caterpillar isn't doing great business. Nevertheless, on the valuation point-of-view, it stays an attractive investment. To boost investor confidence, the company will buy back shares worth $1 billion, part of its $7.5 billion share repurchase authorization, in this quarter of the year. These aspects give me confidence to recommend this stock as a hold in order to gain long-term gains.

Source: Does This Caterpillar Have 9 Lives To Survive The Industry Downturn?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Market Holds Rally, Investors Don’t Show Up

Is it just your clients who missed the huge stock market rally?

Apparently not, judging from a fund research round table that included top Morningstar analysts Scott Burns, Russel Kinnel, Laura Lutton and John Rekenthaler.

In a free-flowing discussion that is a highlight of each year’s Morningstar Investment Conference, the Chicago-based research firm’s top analysts answered questions from PBS business journalist Consuelo Mack.

Self-defeating behavior on the part of investors was a theme that came up early and often on the late Wednesday panel.

Burns (left) called it “confounding” that a huge segment of investors have not participated in the stock market rally, describing the heavy flow into fixed income as a “retroactive fix” of a bad asset allocation that overweighted stocks prior to the financial crisis.

Rekenthaler’s formulation packed more pain:

“You don’t get too many chances to get over 100% gain without inflation after only four years,” he said, adding that huge numbers of investors compounded the woe of missing the rally by heading for the exits after locking in portfolio losses in 2008 and 2009.

Conversely, Lutton worried about latecomers to the rally, saying “investors chasing performance doesn’t end well historically. Those who see bonds as safe investment are going to be unhappy.”

And Kinnel noted the danger in the investor quest for yield.

“Whether you’re looking at funds, bonds or stocks…the highest yielding areas…are a little scary right now.”

Missing the rally and coming to it late, with all the dangers that entails, made investment strategy another dominant theme in the discussion.

“This fall it will be five years since [the collapse of] Lehman Brothers,” Burns noted, “but people talk about it as if it were five weeks ago. The scars are still so deep.”

For that reason, he said financial advisors should give serious consideration to strategies that might not be optimal from a return perspective, such as target-date or low-volatility funds.

“If at the end of the day they make the investor behave better, they’re better off [with these strategies]. So many did the wrong thing after 2008-09,” he said.

“The two surest ways to not reach your goals are to not save and leave it all in cash,” he added. For advisors, therefore, the challenge is to “keep in the game but in a way that the client can tolerate.”

For Kinnel’s part, “cost and stewardship are the biggest factors FAs should consider in investing clients’ dollars.”

Stewardship, which looks at things such as the culture of the fund firm and whether managers invest in their own fund, was also emphasized by Lutton.

“Is this fund firm a good caretaker of your capital?" she said. "Studies have shown a relationship between these softer [factors] and performance.”

In that regard, Kinnel noted that “some of the big publicly traded fund firms are less careful” stewards of shareholder capital, but he said boutique firms could be found on either extreme, noting that the boutique firm Strong Funds got caught in scandal whereas Vanguard got to where it is through its fund stewardship.

And Burns steered away from large vs. small, saying [bond giant] “PIMCO, at end of the day, is one big boutique—they’re not all things to all people.”

When asked by Mack to name names, Kinnel cited FPA Capital, Primecap and TFS as excellent fund companies.

---

Check out complete coverage of the Morningstar Investment Conference at AdvisorOne.