Cat Sinks Its Claws Into Services

Dirty, greasy work could help Caterpillar thrive during the next downturn

Jennifer South aims her needle gun at a busted-down engine and blasts away. The giant 12-cylinder motor had powered a mining truck until a few weeks earlier, when it was carted off to Caterpillar Inc.'s (CAT ) remanufacturing plant in Corinth, Miss., to be salvaged. Over its brutal life, the engine had become caked with dust that had hardened like concrete. Now, wearing safety glasses, earplugs, gloves, and a protective apron, South must chisel away the years of buildup to unearth a bolt so she can further dismantle the 17,800-pound carcass of iron and steel. The air-driven gun pecks, with rods that look like knitting needles, until the calcification is gone.

"It's oily, greasy, heavy work," says South, who joined the company nine years ago as a 19-year-old college student. And progress is slow. The plant's 600 employees disassemble and rebuild an average of just two diesel engines per eight-hour shift, cleaning, inspecting, and repairing 20,000 parts along the way. But multiply that output by Caterpillar's other remanufacturing plants -- the company will start up its 14th, in Shanghai, in early 2006 -- and then multiply that by the five-figure price of these reclaimed products, and it gets easier to see why the division has become Caterpillar's fastest-growing unit this decade. Annual revenue tops $1 billion and is estimated to grow 20% a year.

This type of unglamorous, quintessentially Old Economy dirty work is how Chief Executive James W. Owens is planning to make Caterpillar a $50 billion company. His strategy: have service businesses refill the bucket when the current manufacturing gusher inevitably begins to slow.

A 33-year Caterpillar veteran, Owens, 59, ascended to the top job in early 2004. Since then his biggest problem has been simply keeping pace with the upsurge in demand for earthmoving equipment and heavy-duty engines. That "yellow iron," as Owens calls it, helped Cat place No. 23 on the BusinessWeek 50 tally of last year's best corporate performers. This year is shaping up even better: Owens says Caterpillar's 2005 revenue will increase 20%, to a record $36.4 billion, with profits climbing at least 37%, to $2.7 billion -- an all-time high. The stock, which closed at $58.76 on Nov. 22, is up 21% this year, near its record high of $59.88 in mid-September.


But Caterpillar's basic business is extraordinarily cyclical, as Owens, a PhD economist, knows all too well. Behind today's turbocharged results, another industrial bust may already be in the offing. Owens foresees the domestic market for big-rig truck engines peaking in 2006. The mining sector will top out in 2009 if not sooner, he adds, with an outright recession possible as soon as 2011.

To offset the slowdown, Owens wants to make more acquisitions, particularly in fast-rising markets such as China, and to double the pace of new rollouts to grab market share. He's also pushing dealers to cut inventories. That would reduce orders now, but should keep factories busier when retail sales slacken. And for as long as demand holds up, he's hiking prices.

Services, however, are the key to Cat's strategic shift. The Peoria (Ill.) company has three service divisions today -- Financial Services, Logistics, and Remanufacturing -- which account for 15% of Caterpillar's revenues and perhaps 20% of its net income. Because of their fast growth, Owens says, they should generate 20% of sales by 2010, which would put the troika's combined revenues at $10 billion. Since these also are higher-margin businesses, their bottom-line contribution should increase even more, to as much as 30% by the end of the decade, calculates Ann Duignan, an analyst with Bear, Stearns & Co. (BSC ).

Cat Financial extends credit for three-quarters of all Caterpillar sales, so it has soared right alongside the equipment business. The division, which averages 95,000 customers a year, opened its first office in China earlier in 2005. No surprise, then, that it's having a record year, with expected revenues of $2.3 billion and a $350 million profit. Cat Logistics, meanwhile, is prized for its steady income stream. The unit warehouses and delivers replacement parts for 60 industrial customers, including Bombardier Inc. and Harley-Davidson Inc. (HDI ). In October it signed a $100 million contract with General Motors Europe (GM ) that will pay out over a decade.

The remanufacturing division is the newest of the service units. Caterpillar got into the business almost by accident: It dates back to a favor Cat reluctantly did for Ford Motor Co. (F ) in 1973. To lower its own costs, Ford's truckmaking subsidiary wanted a source of rebuilt engines, which generally sell for half the price of new ones. As Caterpillar executives tell it, management saw Ford's demand as a chore. But because supplying Ford with new engines would be such a money-maker, the company consented and opened a repair shop in Bettendorf, Iowa. By 1982 the business had grown enough that Caterpillar bought a vacant factory in Corinth, Miss., to reclaim used crankshafts. Still, even into the late 1990s, after Caterpillar built a second plant in Nuevo Laredo, Mexico, and a third in Prentiss, Miss., remanufacturing was considered a sideline. "It was something we had to do," recalls Steven L. Fisher, president of the division.

In 2000 management realized that this handful of ancillary factories represented a hidden opportunity. The business had become reliably profitable, and the marketplace was full of mom-and-pop outfits, making it easy for the company to pick up business through acquisitions. Caterpillar's own numbers argued for expansion, too. As new-equipment orders were falling amid a plunge in the industrial economy, revenues and profits from Caterpillar services continued to climb. Since then, as the company has built and acquired more facilities, Cat Remanufacturing's results have doubled.

The division's flagship plant in Corinth, about 100 miles east of Memphis, extracts every last bit of value from used parts. The facility, which is the size of six football fields, is a cacophony of industrial clangs and whirs as workers strip old engines down to their individual components and then, after salvaging whatever they can, put them all back together. No piece is too inconsequential for recycling. In the area where Jennifer South works, employees fill wire bins with bolts, nuts, and washers sorted by stock-keeping unit number. The parts are then cleansed in a bath of molten salt to come out like new.

Nor are damaged goods automatically tossed aside as scrap. Down the line, a computerized machine builds up a worn-down engine block by spraying it with a fine mist of liquefied metal. When it's done, the surface has been raised by the width of a dime. Other workers dust engine blocks, crankshafts, and other major components with a metal powder that, when magnetized and viewed under ultraviolet light, can expose otherwise invisible cracks. Like dentistry on a large scale, cracks then are dug out, and the cavities filled by hand with iron and machine-polished to original product specifications.


Analysts praise the unit because it also allows Caterpillar to profit again and again from the same goods. By selling rebuilt products at discount prices, it keeps makers of knockoff parts out of the lucrative aftermarket. And the business seems to have room to grow: Its Shanghai plant will let it offer rebuilt parts in China, a market that could be big, since few customers there can afford new equipment. Remanufacturing, says Owens, "has the highest growth and earnings potential of any of our businesses in the next five years."

Owens is confident of maximizing that potential. During the next contraction, he's promising that earnings won't drop below $2.50 a share, as they did in 2001 and 2002. The only way he can meet that commitment, says Bear Stearns' Duignan, is if his services strategy pans out as planned.

Corrections and Clarifications In "Cat sinks its claws into services" (Corporation, Dec. 5), the value of a 10-year contract that a Caterpillar Inc. division, Cat Logistics, signed recently with General Motors Europe was incorrect. The contract will pay out nearly $100 million a year over 10 years, not a total of $100 million over that span.

By Michael Arndt

    Before it's here, it's on the Bloomberg Terminal.