Is Caterpillar a Buy?

Caterpillar

The world of investing is full of choices. Selecting those areas which can provide above average returns requires focusing on corporations with: strong management, balance sheets and business models. These elements allow firms to increase its earnings, dividends and shareholder value. This is what some of the most successful corporations do to achieve these objectives.

Since 1926, Caterpillar has been focused on providing tractors, construction equipment and other machinery to a variety of industries. The most notable include: oil / gas, construction and locomotives. Over the years, its business model has been continuing to evolve to meet the changing needs of customers. The result is that the firm is selling a variety of products in numerous countries around the world to include: the U.S., Canada, Brazil, China, the EU and Russia. (Standards and Poor's, 2014)

Caterpillar is organized into a number of different segments (i.e. Construction, Resources, Power Systems and Financial Products). Each one of them will cover the customer's specific needs and ensure that they have the financing to purchase different machinery and equipment. Construction is focusing on meeting the needs of the construction industry. The merchandise they sell include: backhoes, small wheels, skid steers, multi-terrain, medium wheel, compact track, compact wheel, track-type loaders; mini excavators, wheel excavators, small / medium / large track excavators, motor graders and pipe layers (for heavy construction). (Standards and Poor's, 2014)

Resource Industries sells materials that are utilized in the exploration and extraction of various natural resources (i.e. gold, oil and silver). The different products they sell include: electric rope, hydraulic shovels, draglines, drills, high wall / long wall miners, hard rock vehicles, large track-type tractors, trucks, large wheel loaders, wheel tractor scrapers; wheel dozers, machinery components, electronics and control systems. Power Systems is manufacturing / distributing generators, engines and integrated systems. The equipment they sell include: reciprocating engines, turbines, turbine-related services, diesel-electric locomotives / components, rail-related products and services. (Standards and Poor's, 2014)

The Financial Products division provides retail and wholesale financing alternatives for customers. It focuses on addressing the different issues they will face on the job. The most notable include: loans, property / casualty / life / accident / health insurance and short-term receivables. These areas give customers greater amounts of flexibility and it helps Caterpillar to meet these needs. (Standards and Poor's, 2014)

The result is that Caterpillar has become one the largest construction firms in the world. However, the stock is trading nears its 52-week high and the developing economies slowing. This is creating concerns about its valuations moving forward. (Standards and Poor's, 2014)

To determine if the company is a good long-term buy requires focusing on its strengths and weaknesses. This will be accomplished by conducting a financial review, providing a pro forma balance sheet, ratio analysis, return on equity, asset management performance, its financial policies and a synapses of the findings. Together, these elements will determine if now is the right time to purchase Caterpillar.

A financial statement review

The different financial statements are demonstrating how the company is in strong fiscal shape. For instance, the annual report is indicating that Caterpillar has diversified their business model to provide customers with an array of services through their 16, 200 dealerships. They sell them various products / services and provide continuing support. This is something that helps the brand to receive a larger following in developed and developing countries.

The result is that the earnings per share and the dividend have been steadily increasing. The case of earnings the firm is realized $5.75 in 2013. This is up from $1.43 in 2009. However, the earnings are down from 2012 which was $8.48. While the dividends, have been steadily increasing from $1.68 (in 2009) to $2.23 (in 2013). This is indicating that the company's strategy is working to increase the bottom line numbers and shareholder value. Yet, it is also illustrating a certain amount of volatility directly related to shifts in the economy. This is because the company sells its products to firms that are involved in the manufacturing of specific products. If there is a decline, it will adversely impact the firm's earnings. The drop from 2012 to 2013 is indicative of this.

According to Graham (1976), those companies that are cyclical will have a direct impact on: the price of the stock, dividends and earnings. When the economy is shifting, there is the potential to realize higher returns at the end of recession. This is when the earnings and the balance sheet will improve. However, at certain times, the company will become volatile from shifts in the economy. (Graham, 1976) This occurred from 2008 to 2009 when the stock fell to $24.52 (down from the all time of $82.63). The key to buying the stock over the long-term is to purchase at the time when the economy and earnings are steadily improving. ("Caterpillar," 2014) This increases the chances of seeing higher total returns from the growth and dividends.

These trends are confirmed by the different figures from the balance sheet. In this case, the company has been seeing increasing and declines in certain areas with them saying, "We reported revenues of $2.78 billion for 2013, an increase of $90 million, or 3%, compared with 2012. Profit after tax was $530 million, a $98 million, or 23%, increase from 2012. The increase in revenues was primarily due to a $229 million favorable impact from higher average earning assets, partially offset by a $123 million unfavorable impact from lower average financing rates on new and existing finance receivables and operating leases and a $14 million unfavorable impact from returned or repossessed equipment. Profit before income taxes was $718 million for 2013, compared with $591 million for 2012. The increase was primarily due to a $97 million favorable impact from higher average earning assets and a $67 million decrease in the provision for credit losses. These increases were partially offset by a $14 million unfavorable impact from returned or repossessed equipment." ("Caterpillar Form 10K," 2014) These insights are showing how the company is increasing earnings through various shifts in accounting practices vs. A sharp improvement in demand.

Moreover, Caterpillar is taking advantage of changes in the tax code to enhance their results with them saying, "The provision for income taxes reflects an annual tax rate of 25% for both 2013 and 2012. The 2013 annual tax rate of 25% excludes a benefit of $7 million, reflecting the impact of the American Taxpayer Relief Act. New retail financing for 2013 was $13.09 billion, a decrease of $868 million, or 6%, from 2012. New retail financing decreased across all operating segments with the exception of North America, which increased. At the end of 2013, past dues were 2.37%, compared with 2.45% at the end of the third quarter of 2013 and 2.26% at the end of 2012. Write-offs, net of recoveries, were $123 million for 2013, compared with $102 million for 2012. Full-year 2013 write-offs, net of recoveries, were 0.46% of average annual retail portfolio, compared with 0.42% in 2012. The increase in write-offs was primarily related to our European marine portfolio and was previously provided for in the Allowance for credit losses. At year-end 2013, our Allowance for credit losses totaled $378 million or 1.30% of net finance receivables, compared with $426 million or 1.49% of net finance receivables at year-end 2012. The overall decrease of $48 million in allowance for credit losses during the year reflects a $55 million decrease associated with the lower allowance rate, partially offset by a $7 million increase in allowance due to an increase in our net finance receivable portfolio." ("Caterpillar Form 10K," 2014)

These figures are significant, as they are demonstrating how the diversified business model is helping the firm to adjust to shifts in customer demand. This is one of the keys that are making them successful by providing quality and better support. This helps Caterpillar to remain the most dominate player in the marketplace with them saying, "Our value proposition is based on the belief that our customers will make more money with CAT equipment than they would with our competitors' equipment. Quality is a key component of that proposition because customers can only make money when their equipment is in operation. Our products tend to operate as part of a system -- an excavator loading a truck or a wheel loader loading a hopper. So if one CAT machine goes down, the customer's whole operation could potentially go down. There is no Caterpillar value proposition without quality products and quality service. No matter where our customers are located around the world, the expectation of quality is always the same. So for us, quality is the price of admission. The primary factor is the strength of the CAT product portfolio. The depth and breadth of that line is a key part of our strength -- from the smallest machines to the largest mining equipment, from generators to engines that power ocean-going vessels. It's a testament to the fact that building machinery at Caterpillar is a team sport -- a collaboration between product, component and service groups, coupled with feedback and engagement from customers. All of these players work jointly in terms of product development, and help us create solutions that meet customer requirements." ("Caterpillar," 2014)

The review of the financial statements is revealing that the firm is facing challenges from earnings slightly increasing. This is problematic, as decreasing demand in developing markets is becoming more pronounced. To make their results appear to be stronger, the firm has been using favorable accounting practices of select items. This is causing their top line numbers to be higher. However, it is not taking into account challenges associated with their current operating environment. In these situations, the company had under reported write offs. At the same time, they are seeing declining demand in the oil service and mining sectors. Yet, they are also realizing, improving earnings in the construction industry. This is causing the firm to state of how they expect their earnings to be flat year over year from these challenges.

Evidence of this can be seen with the CEO (Doug Oberhelman) saying, "Third-quarter net income rose to $1.63 a share from $1.45 a year earlier. Excluding one-time items, profit was $1.72, surpassing the $1.35 average of estimates compiled by Bloomberg. The per-share earnings excluding one-time items for this year are expected to be $6.50, 30 cents more than previously projected. We had higher sales of construction machinery in North America and of equipment for the oil and gas industry, in the third quarter. That outweighed another decline in mining equipment, in which the company is the largest player. Coal and metals producers have continued to cut spending in the face of lower commodity prices. Sales climbed 0.9% to $13.5 billion, more than average estimate of $13.2 billion. We expect 2015 sales to be flat to slightly up as growth-oriented monetary policies in developed countries should support continued modest economic improvement and it sees potential for higher investment in infrastructure in countries such as the U.S., India and Turkey." (Singh, 2014) These insights are illustrating how the sector is facing considerable challenges from the slowdown in mining and oil services. While at the same time, demand for construction equipment has been steadily improving North America. These differences mean that the firm will have trouble achieving significant year over year earnings growth in 2015.

To make matters worse, many of the emerging markets are experiencing decreases in economic growth. This is because these economies are overheating and begun moving closer to their historical rates of median growth. Furthermore, geo-political tensions in the Ukraine and Middle East are causing foreign direct investors to become more hesitant. The result is that they are cutting back on their projects and the overall amounts of development in numerous areas.

A good example of this can be seen with comments from Doug Oberhelman (the CEO) saying, "Caterpillar has trimmed costs over the last year to make up for a sustained drop in investment by global mining giants. Headcount of full-time workers is down nearly seven percent from a year ago. We understand we don't control the economy and have instead focused on what we can improve. We're lowering costs, improving cash flow and driving value for our customers through the continued deployment of our lean manufacturing initiatives. The continued risk that geopolitical events could negatively impact global GDP growth. The ambitious effort by China to transition its economy to a more sustainable-growth model, an enormous task that carries risks for the world economy. The continued acrimony over Russia's actions in Ukraine is also a threat. We are hoping for a peaceful resolution, but business confidence around the world could dampen, and trade and world GDP could slow should the situation deteriorate. The global economy remains fragile, and as such, one or two setbacks could create substantial downside risk for the global economic recovery." ("Caterpillar Reports Higher Profits," 2014) These insights are showing how geo-political concerns and slowing growth in developing countries could adversely impact earnings. This has the potential to create a situation where the company is experiencing declining earnings, if the world economy slows much further. Once this happens, is the point Caterpillar will have challenges in adjusting its business model and balance sheet with these challenges.

Pro Forma financial statements (Balance Sheet and Income Statement) for the next two fiscal years, assuming a 10% growth rate in sales and Cost of Goods Sold (COGS) for each of the next two years.

The financial statements are revealing that the company cannot maintain 10% growth rates. However, the instructions called for taking this assumption. In this case, these figures would be more accurate during stages when the global economy is rapidly expanding. The below tables (on the balance sheet and income statement) are reflecting these views.

Caterpillar's Pro Forma Balance Sheet (in billions)

Category

2015

2016

Cash

$6.08 billion

$6.76 billion

Net Receivables

$18.72 billion

$20.59 billion

Inventory

$12.62 billion

$13.88 billion

Total Current Assets

$37.42 billion

$41.62 billion

Long-Term Investments

$16.59 billion

$18.24 billion

Fixed Assets

$17.07 billion

$18.77 billion

Goodwill

$6.95 billion

$7.64 billion

Intangible Assets

$3.59 billion

$3.94 billion

Total Assets

$81.62 billion

$89.78 billion

Accounts Payable

$14.47 billion

$15.91 billion

Short-Term Debt

$11.03 billion

$12.16 billion

Total Current Liabilities

$25.50 billion

$28.05 billion

Long-Term Debt

$26.17 billion

$28.87 billion

Deferred Liability Charges

$10.00 billion

$11.00 billion

Total Liabilities

$61.67 billion

$67.83 billion

Stock Holders Equity

$20.81 billion

$22.89 billion

(Standards and Poor's, 2014)

These figures are showing how the firm's balance sheet will change based upon 10% growth in sales and the cost of goods sold. However, using the actual figures provided by Caterpillar, these amounts are closer to 3% annually. This means that these figures are overly optimistic.

Caterpillar's Income Statement (in Billions)

Category

2015

2016

Total Revenues

$55.65 billion

$61.30 billion

Cost of Revenues

$41.54 billion

$45.69 billion

Gross Profit

$14.20 billion

$15.62 billion

Research & Development

$2.04 billion

$2.24 billion

Sales, General and Admin.

$6.52 billion

$7.72 billion

Operating Expenses

$8.24 billion

$9.02 billion

Operating Income

$5.62 billion

$6.18 billion

Earnings Before Interest and Taxes

$5.59 billion

$6.14 billion

Income Taxes

$1.31 billion

$1.44 billion

Net Income Cont. Operations $3.78 billion

$4.15 billion

Net Income

$3.78 billion

$4.15 billion

(Standards and Poor's, 2014)

These figures are showing how the company will not experience an increase of 10% in growth and the rise in the cost of goods sold. This is because the economy is not seeing increasing demand and inflation. Instead, commodities prices are falling. This is having an adverse impact on demand in the developing markets. Whereas, other segments (i.e. North America) are experiencing numbers which are coming close to these projections. However, after the numbers from other divisions and regions are calculated, is the point they will decline. This is what is happening throughout most of the company.

A ratio analysis for the last fiscal year using at using liquidity and market value

The liquidity ratios are illustrating how the firm is steadily improving its balance sheet. The most obvious change can be seen with the current ratio. This is used to determine if a firm is able to pay off its short-term obligations. In general, a reading below 1.0 is indicating that the organization is facing considerable challenges paying its basic expenses. During the last year, this has risen from 1.42 to 1.44. This is illustrating how the company is using its cash to decrease its short-term obligations. In the future, this will help Caterpillar to be more prepared for the challenges they are facing. The quick ratio is indicating that the firm has considerable amounts of debt. These figures are coming in at .85 from .82 a year earlier. This is illustrating how Caterpillar is trying to deal with the issues impacting their balance sheet. However, these changes are taking a more long-term focus. (Standards and Poor's, 2014)

The financial ratios are confirming these moves with Caterpillar's fiscal position. In the last year, gross profit margins fell from 27% to 26%. This is indicating how the firm is facing challenges from shifting customer demand. At the same time, their operating margins are decreasing from 13% to 10% during the same timeframe. This is indicating how the organization is preparing for changes in the marketplace. The most effective strategy is to reduce expenses and pay down their debt. In the process, there will be a decline in their profit margins to achieve these larger objectives. (Standards and Poor's, 2014)

The asset management ratios are telling a similar story as the previous numbers. In this case, the asset turnover has decreased from .81 to .76. While, the return on assets is declining from 6.33 to 5.81. This is illustrating how Caterpillar is decreasing the total amounts of inventory they are holding and the rate of returns they are realizing. These numbers are highlighting how demand is starting to top out in some markets. To protect their assets, the management made a decision to decrease turnover and the returns they are realizing. This means that they are facing financial challenges and must engage in discounting to help reduce these levels. (Standards and Poor's, 2014)

From a profitability perspective, Caterpillar is experiencing decrease in profit margins from 9.01% to 7.19% in one year. The profit to stockholders is conforming this, with it decreasing from $5.61 billion to $3.78 billion. This is corroborating the findings from the previous ratios, by illustrating how the firm is facing considerable challenges moving forward. (Standards and Poor's, 2014)

In the last year, the price of the stock has continued to rise. The result is that valuations have been steadily increasing. For instance, the price earnings ratio (PE) has risen from 13.15 to 16.94. While the price to sales are falling from 4.39 to 3.26. These figures are indicating how the stock is becoming overvalued. This increases the likelihood of the company facing greater amounts of volatility moving forward. (Standards and Poor's, 2014)

The different ratios are indicating that Caterpillar is facing challenges from slowing earnings and trying to decrease their liabilities. The result is that a divergence is taking place with the price of the stock and the fundamentals. In this situation, they are showing how the company is losing the momentum it has built up over the last several years. This is indicating that the earnings might fall along with prices. These realities could occur, if the slowdown inside developing markets and key industries becomes more pronounced. (Standards and Poor's, 2014)

Calculate Return on Equity (ROE) using the DuPont system.

The return on equity has been declining since 2011 onward. This is when the ROE was reading 38.25%. These figures had increased from 10.24% in 2009. However, during the last two years, these changes have become more pronounced. In 2012 and 2013, these amounts have fallen to 18.21%. These figures are providing several conclusions about the company. The most notable include: operating efficiency, asset turnover are decreasing and debt is rising. To deal with these challenges, the management is cutting back on liabilities. This is causing the earnings to appear to be stronger than they really are.

According to Hagerty (2014), the company has engaged in a number of activities to deal with challenges impacting the company with him saying, "Caterpillar over the past year has closed some of its smaller plants and scaled back a large manufacturing complex in Gosselies, Belgium. The global workforce is down 4.5% from a year earlier to about 131,000. China remains a weak spot because of slumping construction-equipment sales there. For the first eight months of 2014, industry wide sales of construction machinery in China fell about 10% from a year earlier. It added that the Chinese market is likely to remain challenged in the near future. U.S. locomotive sales rose in advance of the stricter U.S. emissions that take effect next year. Customers are racing to avoid higher costs for the new railroad engines amid uncertainty over how well they will perform. Caterpillar's energy and transportation unit, which includes its Electro-Motive Diesel locomotive unit, logged a 33% increase in North America sales, contributing to a 13% rise in the energy unit's overall sales and a 29% increase in the unit's operating profit. Caterpillar has said it expects locomotive demand to fall sharply next year. The company also has warned that it may not have locomotives compliant with the new U.S. standards before 2017. Caterpillar is a big supplier of engines to the oil and gas industry, the recent drop in oil prices is a negative for the company, but it isn't a big problem, at least for now, company officials told analysts. If oil prices sink into the $70 to $75 range and stay there, that would put a chill on the oil industry, hurting demand for Caterpillar engines used in oil exploration and production. But if oil prices are in the mid-$80s, they can all live with that. "(Hagerty, 2014) This is confirming the challenges facing the company in the ROE. Over the last several years, the firm is adjusting with challenges from a slowing economy and increasing regulations. These issues have the potential to hurt their bottom line results. To address them, management is engaging in activities to improve their balance sheet and flexibility.