Caterpillar seen turning around despite investigation

A Caterpillar 349E hydraulic excavator at E Lower Wacker Dr, Chicago.
A Caterpillar 349E hydraulic excavator at E Lower Wacker Dr, Chicago.

By Mengjie (Jessie) Jiang

Caterpillar Inc. is projected to turn around in 2017, boosted by improving global end markets and effective cost management, despite the overhanging cloud of an alleged tax fraud.

Analysts anticipate the heavy-equipment maker this year will post net income of $1.54 billion, or $2.60 per diluted share, swinging from a $67 million net loss, or 11 cents per diluted share, in 2016. Revenue is estimated to be $37.69 billion in 2017, slightly lower than $38.54 billion in 2016.

A government-commissioned report, viewed and reported by The New York Times on March 7, accused the manufacturer of bringing home billions of dollars from offshore affiliates while avoiding federal income taxes on those earnings.

The Internal Revenue Service, Federal Deposit Insurance Corp. and Commerce Department on March 2 raided three Caterpillar facilities, including the corporate headquarters in Peoria, according to a company press release. The company advised it believes this action pertains to export filings of Caterpillar SARL in Switzerland. Shares declined about 4 percent on the news, and the next day Morningstar Inc. decreased its fair value estimate for Caterpillar shares to $64 from $67, deducting an estimated $3 billion exposure from share value.

However, the market looks positive in the long term. The 12-month average target price on Caterpillar’s shares compiled by Bloomberg stands at $97.39, 6 percent higher than its latest closing price of $91.86. Out of 29 analysts covering Caterpillar, nine call the stock a buy, 14 call it a hold, four say sell.

“I’ve really never seen anything like this really impact the longer term in any of these stocks, so for example, we’ve seen fines happen from the EPA, we’ve seen other companies have SEC investigations and taxes and so forth, the market seems to treat them all as one-time items,” Jefferies LLC analyst Stephen Volkmann said in a phone interview. “I would be surprised if anything happened anytime soon and I would be surprised if the market deemed that material.”

What’s hampering the manufacturing giant is the sluggish global economic environment. Caterpillar’s monthly sales have been declining for 49 consecutive months, most recently an 8 percent global machines retail decline in January and an average 15 percent decline in 2016.

Asia Pacific is the only region delivering positive growth; it registered a 10 percent rise in the fourth quarter ended December 31, and will continue modest advancement owing to increased infrastructure and residential investment in China, the company anticipates. North America and Europe-Africa-Middle East sales will remain deterrent due to the availability of used equipment. Also, sales in Africa and Middle East will be down because of overall economic weakness and continued pressure on economies that rely on oil revenues to drive economic growth. The Brexit poses uncertainty for Caterpillar’s access to the European markets as U.K. is one of the largest bases for Caterpillar outside the U.S. and almost 25 percent of the company’s sales come from its European business.

Volkmann said Caterpillar is heavily-levered to global commodity markets, and those oversupplied markets make it hard for commodity prices to rally very much, plus almost all the end markets the company relies on have been in a downturn.

“We’ve seen as the oil and gas and mining related cutbacks have come down, that has a negative impact on construction equipment as well, so I think this is sort of classic cyclical weakness,” Volkmann said.

Citing the challenging economic environment and the strengthening of the U.S. dollar, Caterpillar estimates revenue in 2017 in a range between $36 billion and $39 billion, with a midpoint of $37.5 billion, a 3 percent drop from 2016 and just a hair below the analysts’ estimate.

Some analysts believe the economy is getting better as the market bottomed.

John Eade, president and senior analyst at Argus Research Co., said the earnings outlook is actually going to improve for Caterpillar.

“Orders start to pick up, the economy is getting better in Brazil now, and in China, housing market is kicking up then and there is an outlook for quite a bit of infrastructure expanding here in the U.S.,” Eade said in a phone interview. He recommends buy with a target price of $115.

The construction industry can be anticipated to see moderate gains through 2017 and beyond. The U.S. Architecture Billing Index, an economic indicator for nonresidential construction activity for the next approximately nine to 12 months, has been at 50 or better for 20 of the last 24 months, signaling robust conditions ahead for the construction industry. And construction research firm Dodge Date & Analytics Inc. predicted that total U.S. construction starts for 2017 will advance 5 percent to $713 billion.

Caterpillar is still the dominant global player with huge skills and scope in global construction equipment, phenomenonal global distribution network, and large and well-capitalized dealers, Volkmann points out.

“They tend to gain a little bit of market share in each cycle, each downturn. If the downturns are tough for everybody, they are tougher for the small guys with limited resources,” said Volkmann, adding that Caterpillar has built balanced external production lines to avoid having huge swings when there are currency changes.

As sales remain weak, Caterpillar’s goal is to reduce costs. It’s now the third year of the company’s four-year restructuring and cost reduction initiative aiming to lower its annual operating costs by about $1.5 billion.

The cost-reduction plan, according to Zacks Investment Research, is accompanied by the closure of more than 20 facilities decreasing manufacturing square footage by more than 10 percent and reducing the workforce by more than 10,000 people.

Caterpillar said the around 12,300 workforce decrease in 2016, consisting of 7,700 U.S. workforce and 4,600 non-U.S., was primarily the result of restructuring programs and lower production volumes. (Mengjie Jiang/MEDILL)
Caterpillar said the around 12,300 workforce decrease in 2016, consisting of 7,700 U.S. workforce and 4,600 non-U.S., was primarily the result of restructuring programs and lower production volumes. (Mengjie Jiang/MEDILL)

The latest action in the initiative was related to the company’s European manufacturing footprint as it announced in September 2016 that it’s considering to reallocate the production of the Gosselies plant, in Belgium, a move that could lead to a layoff of about 2,000 employees. And again in January 2017, Caterpillar announced that it’s contemplating the closure of its Aurora manufacturing facilities.

In 2017, Caterpillar is expecting about $750 million of additional cost reduction, mainly deriving from restructuring actions taken in recent years, the companies continued focus on cost management and lower period costs.

Bloomberg analyst Karen Ubelhart said in a phone interview that lower costs will help Caterpillar receive a higher profit once the revenue comes back. “In the past, they would have decremental margins of like 40 to 45 percent, and in this downturn, it’s been more like 25 to 30 percent, they’ve done a very good job. It’s the top line,” Ubelhart said. Decremental margin is a measure of the degree to which each dollar of incremental income adds to profits.

Caterpillar’s financial portfolio remains healthy with $7.2 billion cash and short-term investments and 41 percent debt-to-capital ratio, within its target range of 30 percent to 45 percent. In the fourth quarter, past-dues were 2.38 percent compared with 2.14 percent in the prior-year quarter, still remaining lower than historical averages, and write-offs in the quarter were $30 million, or 0.45 percent of the average retail portfolio, lower than the $36 million, or 0.55 percent, in the prior-year quarter. The company paid dividends of $1.8 billion in 2016.

Although Caterpillar has a strong balance sheet, Volkmann said, the company is not expected to make any share repurchases now due to the risks of further downgrade. In December 2016, Moody’s Investors Service downgraded Caterpillar Inc., Caterpillar Financial Services Corp. and various supported affiliates to A3 from A2, and to Prime-2 from Prime-1, citing the effects of the enduring end-markets softness on the company’s operating performance and credit metrics.

Caterpillar will release its first-quarter results on Apr. 25.

Photo at top: A Caterpillar 349E hydraulic excavator on East Wacker Drive, Chicago. (Mengjie Jiang/MEDILL)