Caterpillar Company Overview Caterpillar Began

Caterpillar

Company Overview

Caterpillar began in 1890 as two different manufacturers of steam tractors. By 1915, the Caterpillar brand had been launched and in 1925 the two antecedents of the Caterpillar Tractor Company had merged. By the early 1940s, the product lines were being expanded and by 1950 the company had grown large enough to expand overseas, first moving into the British market. Over time, Caterpillar began to separate its engine business from its tractor and farm business. A financial arm was founded in 1983 and by 1986 the firm had changed its name to Caterpillar Inc. To reflect the diversity of its product lines as the number of product offered tripled in just a few years at the beginning of the decade (Cat.com, 2009)

Over the years, Caterpillar has primarily expanded organically, only adding a handful of acquisitions, mainly to its diesel engine business. Recent initiatives have been focused on the production side. Caterpillar initiated 6 Sigma and has been focused on the development of clean engine technology. The business has continued to expand both in terms of service offerings (logistics) and geographically.

Today, Caterpillar operates three main product lines -- Machinery, Engines and Financial Products. The company sells to a number of different industries including oil & gas, mining, farming, construction and forestry. Cat is one of the most dominant firms in the industry, with $48.75 billion in sales worldwide. Both revenues and profits have grown steadily over the past several years, despite a wide range of competitive and economic threats. There are indications now, however, that the global economic crisis is beginning to have an impact on Cat.

Caterpillar's revenues have grown 69% since 2004 and its profits have grown 78% in that span. The company is very profitable. It booked a record profit of $3.52 billion last year on revenues of $51.32 billion. The company has strong gross margins of 22.9% and an operating margin of 8.6%. This compares to 24% gross margin and 8.8% operating margin in 2004. Their margins exceed the industry average.

Because of their profitability, Caterpillar has been able to maintain a strong balance sheet. Cat's liquidity ratios are healthy, with a 1.22 current ratio and 0.81 quick ratio. This compares with 1.22 and

0.82 five years ago, indicating exceptional balance sheet consistency. The company has a fairly high degree of leverage, with a debt-equity ratio of 10.13, compared with 4.77 five years ago. This has in part resulted from an erosion in equity. Retained earnings have increased steadily, but the company has removed substantial amounts of treasury stock from its books.

Free cash flow over the past four years has been strong, ranging from $3.1 billion to $7.9 billion. In recent years, Caterpillar has retired nearly $8 billion worth of stock, a significant amount considering that the market cap is only $19.33 billion today. Despite the long history of strong performance, investor confidence in the economic outlook is poor, and this is reflected in Caterpillar's stock price, which at around $32 is much closer to its 52-week low than its high. For a company that last year earned $4.03 per share and has seen 5-year profit growth averaging 26.5% per year, a price/earnings ratio of just 8.10 is curiously low. Certainly, the economic outlook has dampened earnings expectations, which now sit at just $1.77 for 2009 and $1.92 for 2010, but Caterpillar is a strong company with a dominant market position. However, in order to better determine if it is worthwhile to purchase Caterpillar stock, we must analyze the company's performance with respect to the economic downturn. Is the general investor pessimism warranted, given that the company is still expected to be profitable?

How the Economy Affects Caterpillar

Caterpillar is less a bellwether for the entire economy than it is for certain sectors. This is evident in its beta, which at 1.75 reveals that Caterpillar is a volatile firm in terms of its stock price (MSN Moneycentral, 2009). This strong movement belies to a certain extent the steady pace at which Cat's earnings and profits have grown. Despite operating in several highly cyclical industries, Caterpillar has been able to maintain its growth trajectory by way of careful expansion into ancillary businesses like finance, insurance and logistics.

Geographic expansion helps diversify some of the risk associated with the U.S. housing market but because geographic diversification is driven by the regional availability of natural resources, the move is more one of necessity than risk mitigation. Caterpillar entered foreign markets to follow their customers, particularly once its industry became subject to competition from foreign firms like Komatsu and Mitsubishi.

That said, the overall health of the economy does impact Caterpillar. Among the most important macroeconomic indicators to Caterpillar are housing starts, interest rates, exchange rates and fuel prices. Housing starts are critical to Caterpillar's construction business. When construction of the housing markets dries up, Caterpillar sells fewer vehicles and engines, and leases fewer as well. Light construction accounts for 15% of Caterpillar's sales, with heavy construction accounting for a further 28% (Caterpillar Inc. 2008 Annual Report).

Interest rates are a component of demand in the housing sector, but they are a component of demand in a number of other sectors as well. The impact of high interest rates is that firms are less likely to undertake certain projects. This reduces demand for Caterpillar products. The company has built in an operating hedge with respect to interest rates through its financial arm, which can charge higher rates when interest rates increase.

Interest rates contribute to the exchange rate fluctuations as well. In any global company, exchange rate fluctuations expose the firm to both transactional and translational risk. The former can be hedged in any number of different ways but the latter cannot be hedged. As a result, if the U.S. dollar increases in value significantly, the value of overseas revenues and profits to the U.S. income statement diminishes.

Lastly, fuel prices are another macroeconomic variable that impacts on Caterpillar's operations. High fuel prices can result in increased sales in certain regions where fuel extraction is expensive and therefore fluctuates with fuel prices (Canada, for example). Caterpillar derives 36% of its engine business from the petroleum industry, giving the company a meaningful direct stake in fuel prices (Ibid). In addition, higher fuel prices suppress economic activity to Caterpillar's detriment.

In addition to the general macroeconomic impacts, Caterpillar is subject to fluctuations in commodity prices. The mining industry is cyclical in nature, with activity rising and falling in response to fluctuations in commodity prices. When prices are high, demand for Cat's mining equipment increases but when prices are low, mining activity falls off, bringing demand for Cat's products with it. A significant portion of the volatility of Caterpillar's stock price can be attributed to volatility in commodities markets, as mining accounts for 25% of machinery sales (Ibid).

Given their economic drivers, Caterpillar has been remarkably resilient to the economic downturn. The housing market has been down for a couple of years, but Caterpillar still grew profits. The spike in oil prices in the first half of 2008 did not slow down Cat's growth either. Only in the first quarter of 2009 has Caterpillar seen any struggles. Some of this strength can be accounted for by Caterpillar's geographic diversification -- the downturn was confined mainly to the United States last year and did not take hold on world economies until the end of 2008. By 2009, even strong economies like Canada were starting to shed jobs, and Caterpillar was left with no real strong growth.

Caterpillar's delayed suffering can be attributed as well to its recognition of the downturn as early as October 2007 (Garza, 2009). This allowed the company to prepare for the downturn. The decline in profitability only hit in 2009 when it became apparent that the recession was going to be significantly worse than expected.

Caterpillar's earnings in the first quarter of 2009 were a loss of $112 million on revenues of $9.225 billion. In the first quarter of 2008 the company made a profit of $921 million on revenues of $11.796 billion. Profits grew in Q2 last year but have declined in each of the three quarters since (MSN Moneycentral, 2009).

Caterpillar's dependence on construction and other primary industries is reflected in their assessment of the recent stimulus package. The company noted that China has invested three times as much on infrastructure, despite having an economy one-third the size. While many have criticized the stimulus package as being too expensive, Caterpillar would prefer to see more money spent. Naturally, they would be among the greatest beneficiaries of such largesse, given their stake in the construction industry. The company has said they expect to see some benefit from China's infrastructure package (Garza, 2009). The implications of this are clear -- Caterpillar is dependent on infrastructure spending and capital investment.

While the former may be at a disappointing level, the latter must be in a terrible state for Caterpillar. The credit crunch has significantly reduced the level of capital investment in the economy. While Caterpillar has its own financing arm, firms are not only dependent on Caterpillar to provide financing. Moreover, with interest rates at historic lows and capital investment low, the financing arm cannot be counted on to deliver strong top or bottom line growth.

The present economic situation is a perfect storm for Caterpillar. Commodities prices have dropped dramatically over the past nine months. Credit is unavailable and when Caterpillar offers credit the rates are low. Economic activity is down, suppressing capital investment. The housing market is still stagnant. The economic malaise has spread to the four corners of the globe. Only countries with distorted, artificial economies and freedom from the constraints of democracy can justify a level of infrastructure spending that would make Caterpillar happy. In a nutshell, there are no real bright spots for Caterpillar right now. The company still expects to make money this year, but their estimates of those earnings are constantly dropping (Ibid).

Key Drivers

Caterpillar has adopted a differentiated strategy. The firm produces high-performance products in industries where high performance is demanded and often necessary. The strategy has a few key elements, including innovation, financial strength and supply chain excellence.

Innovation has long been a key driver for Caterpillar. The company was at the fore of tractor technology development, such that co-founder Benjamin Holt has been inducted into the Inventors Hall of Fame (Cat.com, 2009). The company has been working on greener technology for a decade and has moved to the front of the curve in that subcategory. Caterpillar has invested over $1 billion in research and development in each of the past four years. This is in addition to $2.4 billion in facilities upgrades and other infrastructure investments. The organizational structure was altered to facilitate a more customer-centric R&D approach.

Financial strength is a key drive for Caterpillar. In good times, this is less in evidence but today we can see the importance of maintaining a strong balance sheet and healthy margins. Caterpillar is well-positioned for this economic downturn. It will be able to maintain dividend payments throughout the downturn. Moreover, Caterpillar is able to position itself to take advantage of the inevitable market upswing. The company is continuing to make capital investments so that it has the capacity and capability to meet market demands when the economy beings to recover.

A third driver of success for Caterpillar is supply chain excellence. The firm has manufacturing facilities spread across the globe. Not only does this bring them closer to their customers but it provides an element of geographic diversification as well. They also have committed to Six Sigma production, which aims to reduce errors improve quality. Six Sigma is typically applied throughout the supply chain. The company's competency in supply chain management has led to the development of another business line, Caterpillar Logistics Services. Efficient production and transportation flows enable the company to market to meet the needs of even the most demanding customers.

Competition

Caterpillar faces competition from a number of different firms. The most direct competitor is Komatsu, which entered into direct competition in 1967 when it arrived in the U.S. market with a specific mandate to take over Caterpillar's dominant industry position. There are several other competitors as well. These include John Deere, Mitsubishi, Liebherr, and CNH. John Deere operates primarily in farm equipment, Liebherr mainly in mining while Mitsubishi and CNH are competitive with Caterpillar in multiple businesses. Of this the biggest threat remains Komatsu, which dominates the construction and mining equipment industry in Asia and has made substantial inroads into Caterpillar's business in North America.

The arrival of Komatsu signaled a seismic shift in the nature of competition within the mining and construction equipment industry. First, it signaled that the industry was truly becoming global. Cat had international operations at the time, but had not made a major push into Asia. Komatsu's arrival marked the first time these major competitors had gone head-to-head. As the Japanese firm made inroads, the intensity of rivalry increased significantly. Caterpillar -- having gotten fat on monopoly riches -- suffered badly during the 1970s. By the 1980s, a turnaround was needed to salvage Caterpillar. Management and union leaders both had failed to recognize the competitive threat and suffered the consequences. Caterpillar revived itself, and the rivalry between the two firms has been intense ever since (Eckley, 1989).

Today Caterpillar operates in a highly competitive environment. The firm's dominant market position allowed it to weather the storm of Komatsu's arrival. As more firms have entered the marketplace, Caterpillar has benefited from the competition. It forced them to adopt a discernable strategy take the steps necessary to align their tactics with that strategy.

Competition is characterized by high intensity. Machine quality, service levels and cost are all factors in which firms in the industry compete. Products are segmented by task, with any given task having only a handful of different products available. The costs in the industry are high and many firms do not have other businesses.

For Caterpillar the intensity of competition has been defrayed somewhat by two factors. One is Cat's overall strength and sustainable competitive advantages. These have allowed the company to continue to grow despite intense competition. The industry overall has also grown, in response to growth in global commodity demand. This has helped Cat and other industry firms grow, as their core markets are not yet mature.

Employment, Production, Income

On the surface, the current economic crisis affects just the construction business directly. Yet, the ways in which employment, production and income are linked will inextricably impact all of Caterpillar's businesses. Of these three, income is the most volatile variable. Firms' income can rise and fall based on any number of variables. Earlier in this paper some of the key macroeconomic variables affecting Caterpillar were outlined.

A period of sustained income reduction will affect production. This is because as income is reduced, inventories build up. As inventories increase the need for production decreases. Eventually, the production is reduced to the point where it affects employment. Employment levels are typically a lagging indicator in the economy. Firms seldom eliminate workers incrementally -- they are dismissed in batches. Additionally, there are costs associated with eliminating workers, relative to the costs of temporary production shutdowns. As a result, by the time workers are laid off, the economy has already deteriorated for several months. Caterpillar's annual report is evidence of this, as the company has stated they are just going to start laying off workers this year, despite the fact that the housing market has been down for a couple of years and commodities prices falling for nine months.

When employment drops, the money available in the economy for consumer spending drops as well. This reduces demand, which results in even more inventory increases. Another round of production declines and layoffs ensues. Eventually, the cycle is broken and the economy begins to recover, following the same cycle in reverse.

Income, production and employment are all down at present. There is little indication that the economy is truly headed for recovery. Some pundits are estimated that the world economy will continue to contract this year before starting recovery in 2010. The IMF has said that the economy in China is showing signs of recovery already, mainly as a consequence of short-term support (Channel News Asia, 2009). Given the relative debt positions of China and the United States, it is reasonable that China would be in a position to lead the economic recovery.

This reality is significant for Caterpillar for a couple of reasons. One is that the recovery may begin sooner that expected if China can spur the recovery. China is a major consumer of commodities, so if demand there picks up, commodities prices will improve. This will drive a resurgence in the mining industry. The oil industry will see a similar uptick with strong growth coming from China.