Caterpillar on Top After Bet at Bottom: Riskless Return

Caterpillar Lands on Top After Bet at Bottom
Caterpillar Inc. diesel power generators sit outside at the Enercon Engineering Inc. facility in East Peoria, Illinois. Photographer: Daniel Acker/Bloomberg

Caterpillar Inc., the largest maker of construction and mining equipment, has provided the best risk-adjusted return among its peers since financial markets hit bottom in 2009 as it made acquisitions and expanded in emerging markets such as China.

Caterpillar’s risk-adjusted gain of 4.5 percent in the three years through June 26 topped that of 20 competitors with sales of more than $2 billion in the Bloomberg Industries Construction & Mining Machinery Index, the BLOOMBERG RISKLESS RANKING shows. The Peoria, Illinois-based company also had the highest total return in the index at 157 percent and volatility below 75 percent of stocks.

Doug Oberhelman has announced at least $10.3 billion of acquisitions since he became chief executive officer almost two years ago, adding mining shovels, drills and gas-driven engines while building and expanding factories from Brazil to China. Customers replacing used machinery in the U.S. and Europe have supported Caterpillar’s recovery after financial markets plunged in late 2008. Earnings will more than quadruple in the three years through 2012, according to analysts’ estimates compiled by Bloomberg.

“Over the past three years, their key end-markets have had stronger growth such as the U.S. and Europe,” Stephen Volkmann, a New York-based analyst for Jefferies & Co. who has a buy rating on the shares, said in a telephone interview. “Caterpillar’s been pushing a lot of levers to maintain diversity.”

Lehman Aftermath

The risk-adjusted return, which isn’t annualized, is calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. A higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.

Caterpillar’s risk-adjusted return was more than five times that of Tokyo-based Komatsu Ltd., its closest rival by size. Sweden’s Atlas Copco AB and China’s Sany Heavy Industry Co. provided the second- and third-highest gain with 3.2 percent and 3 percent respectively.

Caterpillar’s net income fell 75 percent to $895 million in 2009, while sales dropped 37 percent to $32 billion, the biggest decline since the Great Depression. That year, the Dow Jones Industrial Average fell to the lowest in almost 12 years and the 24-commodity Standard & Poor’s GSCI Spot Index dropped to a more than four-year low as the U.S. and euro area experienced recessions in the aftermath of Lehman Brothers Holdings Inc.’s bankruptcy.

‘Tough Times’

In response, the company raised its research and development spending to the second-highest in Caterpillar’s history, partly to meet new emission rules and also to position itself for an economic rebound, Chief Financial Officer Ed Rapp said in a June 15 interview. The company increased investment and did so earlier compared with previous business cycles while ensuring suppliers would be able to meet demand when an upturn came, he said.

“You really find out who you are in tough times,” Rapp said. “If we didn’t invest during the trough, we wouldn’t have been in a position to compete when we came out.”

Since the start of 2010, Caterpillar has posted year-over-year earnings growth and topped analysts’ profit estimates in every quarter except one, according to data compiled by Bloomberg. The company posted net income of $4.9 billion on $60 billion in sales in 2011. While demand for excavators, shovels and trucks has risen, Caterpillar has also boosted revenue with a string of acquisitions.

Bucyrus Acquisition

The company completed its $8.6 billion purchase of mining-equipment maker Bucyrus International Inc. in July, its largest acquisition, according to data compiled by Bloomberg. Caterpillar said June 6 it expects to complete the purchase of Hong Kong-based ERA Mining Machinery Ltd. in the third quarter, adding underground coal-mining equipment.

Caterpillar also bought assets in other industries. It acquired German engine manufacturer Motoren-Werke Mannheim Holding GmbH in November for 580 million euros ($724 million) and in August 2010 completed the $820 million purchase of locomotive manufacturer Electro-Motive Diesel Inc., a deal announced under Oberhelman’s predecessor Jim Owens.

The “depth and breadth” of Caterpillar’s product line, which now ranges from electricity generators for vacation homes to 100-ton trucks used at open-pit mines, helps keep sales steady, Rapp said.

Geographic Diversity

Following the string of acquisitions, revenue is spread more evenly on a geographical basis. North America was responsible for 36 percent of sales last year, down from more than half six years ago. A quarter of revenue came from the Asia-Pacific region and the same proportion from Europe, Africa and the Middle East last year.

In 2006, the company sold $1 worth of machines in the developing world for every $5 in the developed world, Rapp said. Revenue was split 50-50 last year, he said.

Caterpillar earned $7.40 a share in 2011, forecasts profit of about $9.50 this year and is targeting $15 to $20 in 2015. That’s based on “a non-recessionary, not great, but healing and modestly growing world,” Caterpillar Group President Rich Lavin said during a June 5 investor presentation.

Chinese Slowdown

Lavin said his scenario also includes a “healthy China, a recovering Europe” and U.S. economic growth probably in a range of 3 percent or more.

First-quarter Chinese sales fell by as much as $300 million, Caterpillar said in April. Demand in developing markets will be lower than anticipated this year, it said.

Capital spending by mining companies, an indicator for equipment sales, will decline 3 percent in 2013 after increasing for three straight years, Goldman Sachs Group Inc. said in a June 1 report. Capital expenditures may decline as commodity prices drop, Goldman Sachs said.

The European debt crisis, global economic instability and the prospect of construction machines sales growth from replacement not continuing next year led Sameer Rathod, a San Francisco-based analyst at Macquarie Group Ltd., to lower his profit forecast for this year to $9.30 a share from $9.50.

Caterpillar’s economic assumptions are looking optimistic and “we think the market has already priced in a guidance cut,” Rathod, who has a buy rating on the shares, said in a June 13 report. The shares have fallen each month from March.

Commodities Drop

To those doubting Caterpillar’s underlying assumptions, Rapp points out that a target set back in 2009 to boost annual sales to $60 billion by 2012 was achieved last year. Also in 2009, the company set a profit goal for 2012 of $8 to $10 a share. Based on the $9.72 average of 22 analysts’ estimates compiled by Bloomberg, it’s on course to achieve that target, too.

Still, copper futures in New York have dropped 19 percent over the past year while the price of coal from Australia, the biggest exporter of the fuel, has dropped 31 percent. The economy in China, which is the largest coal and metals user, expanded 8.1 percent in the first quarter from a year earlier, the slowest pace in almost three years.

The country’s central bank last week cut borrowing costs for the first time since 2008 and loosened controls on banks’ ability to set lending and deposit rates, efforts to combat a domestic slowdown.

Joy Forecast

Joy Global Inc., a U.S. competitor of Caterpillar, on May 31 cut its earnings and sales forecasts because of a contracting U.S coal industry. It also said concerns about Europe and “tempered growth expectations” in China are affecting demand for mined commodities such as copper.

Growth in U.S. construction can help offset some weakness in the country’s coal industry, which used to be a bigger part of Caterpillar’s mining business, said Baltimore-based Russell Croft, co-portfolio manager of the Croft Value Fund.

“These cyclical slowdowns can come hard and heavy and the more shots you have on goal, the more chances you have out there,” said Croft, whose firm, Croft Leominster Inc., holds 153,000 Caterpillar shares. “It helps large global blue-chip companies like Caterpillar to ride through cycles.”

Industry-wide construction equipment sales in Europe increased in 2010 and 2011 after a two-year slump, data compiled by Bloomberg show. In North America, they have also gained in the last two years, after dropping for three-straight years, the data show.

Construction Growth

There may be room for further growth. North American sales in units are 45 percent below their 2006 peak and Europe is 42 percent below its 2007 peak, said Karen Ubelhart, an analyst at Bloomberg Industries in Skillman, New Jersey.

The average age of the U.S. rental construction-equipment fleet in April was 50.3 months, according to Rouse Asset Services.

“Equipment is still old so demand should hold up,” Ubelhart said.

While a bigger mix of larger, more profitable machinery such as mining trucks is helping to boost returns, Caterpillar also has benefited from increasing manufacturing efficiency, said Andy Kaplowitz, a New York-based analyst for Barclays Plc.

Even as Caterpillar’s sales rose 24 percent from 2006 through 2008, earnings were little changed. Efforts to improve productivity, profitability and market share started under Owens and continued under Oberhelman, Kaplowitz said.

‘Horrible Conditions’

Such moves are helping boost the bottom line, said Croft. He said his fund bought the stock in October 2008 amid “horrible market conditions” on expectations it would be a “winner” when the economy improved.

Twenty analysts recommend buying Caterpillar’s stock, five have a hold rating and none advise selling, according to data compiled by Bloomberg. The shares have gained 139 percent in the three years through June 26, the biggest increase of all companies in the Dow Jones Industrial Average.

Still, Caterpillar’s ranking for risk-adjusted returns has slipped over the last two years with competitors such as Chinese manufacturers Sany and Zoomlion Heavy Industry Science and Technology Co. taking the top spots.

“If the global economy holds up, Caterpillar can maintain its lead over global competitors,” Kaplowitz said. “Chinese competitors have a long way to go to catch up” in terms of quality, durability and technology, he said.

Caterpillar is in the third year of a roughly seven-year cycle of improving business, Mike DeWalt, director of investor relations, said during the same presentation at which Lavin made his remarks.

“It might be bumpy along the way but I do think the commodities and infrastructure build out in mining is a good longer-term place to be invested,” Croft said. “I’d want to own stocks like Caterpillar.”

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