Yesterday, Baird Equity Research issued a report on Caterpillar Inc. (NYSE:CAT), covering the stance of Finning International and Seven Group Holdings - the company’s two largest dealers. The research firm retained a Neutral stance on the company's stock, with a price target of $80.
Take away from Finning International
Finning International Inc. is the largest distributor of Caterpillar machinery. It operates in Canada, Chile, Argentina, Bolivia, UK, and Ireland. The distributor disclosed that the orders continued to decline year-over-year (YoY) in its coverage areas. As a result, the backlog remained flat over the past two-quarters on declining revenue. The aftermarket product support revenue also observed a 10% YoY decline, amid lower demand from South American mining and oil sands, 7% YoY decline in Canada, and 12% YoY decline in Latin America, which sequentially recovered 4%.
Take away from Seven Group Holdings
Seven Group Holdings Ltd is a diversified holding company that operates two large Caterpillar dealerships. WesTrac Australia is considered the largest dealer in Western Australia, whereas its subsidiary WesTrac China is considered among leading Caterpillar dealer in five provinces of Northeast China.
For WesTrac Australia, Seven Group Holdings stated that the aftermarket competition in the region is high. Even though the company had observed 2% YoY increase in shipped, its revenue slipped down 5% on price compression. Moreover, customer-part destocking also continued.
The distributor also disclosed that of 5,597 machine fleet, 1192 mining machines are still idle (21% of the fleet). The customers are accustomed to park older machines and use the recently-bought equipment. Utilized machine average age was eight years, while idle machine average age came to be 11.5 years. On the brighter side, the company observed a significant pickup in New South Wales-based heavy and general construction markets, in both new and used equipment unit sales.
For WesTrac China, Seven Group Holdings stated that Caterpillar’s lifecycle value proposition is gaining traction in the mainland. Its market share has increased, with growth observed in used equipment and part sales. Product support sales surged 13% YoY, as the service business has matured. The underlying activities in China, such as the One Belt One Road Program and new Beijing Airport, are showing signs of stabilization.
Caterpillar’s Performance Review
On July 26, 2016, Caterpillar announced its second-quarter financial results of fiscal 2016 (2QFY16). The result surprised the market, beating both revenue and earnings estimate. Against $10.128 billion consensus expectations, it reported $10.342 billion revenue. Furthermore, its $644.176 million (EPS: $1.09) net income also beat the Street’s $562 million (EPS: $0.96) estimate. This increment was attributed to Chinese commodity demand, oil & gas prices, Bucyrus integration, and execution of machinery transition to Lane Strategy.
Bucyrus Operation’s Sale Decision
Caterpillar’s management has lately decided to sell off its Bucyrus International’s service operations to its dealers. This step is likely to promote faster aftermarket penetration while reducing Caterpillar's net investment and streamlining acquired overhead costs. Recall that Caterpillar had acquired this mining machinery maker back in July 2011 for $9 billion. This transaction was Caterpillar’s largest but was under constant fire from market experts amid much higher payment.
Improved dealer performance
Caterpillar started its Across the Table initiative in March 2014, which was designed to improve dealer performance through better customer service and efficiency. Caterpillar highlighted that this opportunity promises $9 billion incremental revenue if bottom quartile dealers become mid-quartile performers along with an $18 billion incremental revenue opportunity if all dealers become top-quartile performers. The Initiative embeds 10 work streams, which includes Parts Logistics Transformation, Distribution Aspects of Technology-Enabled Solutions, and eBusiness Transformation.
Large late-cycle exposure
Beyond machinery demand tied to non-residential construction activity, other major later-cycle markets include oil & gas, energy infrastructure, power generation, and commercial marine. The mining segment is traditionally the latest cycle machinery market, challenged by the EMD locomotive business.
Increased Exposure in Emerging Markets
Global macroeconomic outlook is increasingly dependent on sustained growth in developing markets. Latin America and Asia Pacific regions generated 35% of sales in 2014, with total emerging market direct exposure likely exceeding 25% of sales. Chinese share is anticipated to grow with the increased investment. Realizing the opportunity, Caterpillar has added incremental capacity in China, India, and Brazil.
Dependency over Commodity Prices
Historically, high prices for commodities like coal and copper have driven significant demand for associated capital equipment, and also support has increased investment in energy and transportation infrastructure and building construction in developing economies. Caterpillar's stock price performance is highly correlated with oil prices. Investors consider it a demand proxy for not just petroleum products, but also for coal and other commodities.
Dealer inventory management
Dealers' management of inventory can leverage the impact of changing retail user demand on Caterpillar's sales and production levels. The Caterpillar Production System is designed to improve manufacturing flexibility, reduce lead-times, and enable Caterpillar dealers to reduce inventory investment. Further control of dealer inventories to be enabled by Caterpillar's Lane Strategy involves increasing its own finished goods inventories of popular machine configurations at centrally located Product Distribution Centers. The demand for construction machinery is correlated with Caterpillar dealers' capital expenditure for rental fleet replacement and is influenced by rental fleet utilization, rental rates, used equipment values, and access to capital.
Cyclical Swings and its Mitigation
Despite significant consolidation over the last 30 years, the excess global capacity in the construction machinery industry seems to have resulted in a persistently difficult competitive pricing environment following downturns. However, these swings have been offset by Caterpillar’s integrated services that generated nearly half of the company’s revenue in 2009. These include CAT Financial, aftermarket parts and services, re-manufacturing, and OEM components.
The company in its earnings call also disclosed that it expects revenue to fall in $40-42 billion range; hence it revised the guidance to $40-40.5 billion. The reason behind it is the persisting economic risk faced during the quarter and the continuation of the same. The company also expects the earnings per share (EPS) to be around $3.55 per share, excluding the restructuring expenses. As for the restructuring, its anticipation is increased from $550 million to $700 million, or $0.80 per share.
Research Firms’ Stance
As per Bloomberg statistics, 23 research firms covered Caterpillar Inc. Out of these, two suggest Buy and 18 advise Hold. The 12-month average price target from these firms was calculated $71.50.