Caterpillar: An Attractive Infrastructure PlayAdrian Compton
We view Caterpillar (CAT) as well positioned to take advantage of an anticipated surge in global stimulus spending resulting from plans being finalized by world governments, of which infrastructure construction is a major component. The major stimulus packages proposed as of this writing, according to various reports, are: the U.S. ($850 billion), China ($586 billion), Europe ($280 billion), Canada ($5 billion), and Australia ($3.2 billion).
In addition to the planned stimulus packages, additional required infrastructure spending in emerging markets will likely continue. For example, over the next five years China is proposing to spend $1.46 trillion while Argentina plans $21 billion in outlays. Elsewhere, Australia expects to spend $13.6 billion over the same period. We expect Caterpillar to be a major beneficiary of the global infrastructure boom we see, with an estimated 6.4¢ of every dollar spent on highway construction used toward the purchase or lease of equipment or on major repair and maintenance, according to a recent report from Associated Equipment Distributors, an industry organization. In regard to water infrastructure, 12¢ of every dollar spent on sewer and drinking water projects is for construction equipment, according to Associated Equipment Distributors.
In the U.S., we believe Caterpillar is extremely well positioned in its chosen infrastructure equipment end markets. The company derived $17 billion (38%) of its 2007 revenues in the U.S. The National Governors Assn. estimated there are more than $136 billion of infrastructure projects ready to break ground.
Demand for Equipment ServicingWe expect revenues for Caterpillar to rise slightly in 2009 to more than $51 billion, supported by increased opportunities in emerging markets. While we anticipate slower growth in emerging-market economies, we see this helping to offset expected declines in developed economies.
We continue to see pockets of strength in global demand from the mining and energy sectors for more large machines, engines, and turbines, as production fell short of demand, indicated by Caterpillar's strong back order log. We also expect these sectors will need to replace aging mining equipment and use Caterpillar's services for mining equipment already purchased. We believe these factors will help support continuing demand for mining and energy-related products in 2009.
In its latest 10-Q for the period ending Sept. 30, 2008, Caterpillar said it is seeing most dealers report inventories that are appropriate for their deliveries, and therefore does not anticipate a need for dealers to sharply reduce inventories in 2009.
We expect growth to continue in Caterpillar's service-related areas as it continues to provide both services to a larger existing global customer base and access to strained credit markets. In our view, Caterpillar maintains a strong balance sheet and has maintained access to capital markets as needed to fund its business needs. We believe Caterpillar Financial's ability to access nearly frozen credit markets was evident in September 2008 at the height of the credit crunch, when it easily raised more than $1.3 billion in funding, allowing it to continue to provide funding options to its customers.
Strong Outlook in ChinaWe expect previously announced price increases to hold through 2009 in combination with lower manufacturing input costs of raw materials and energy, and a continued shift to lower manufacturing cost and tax jurisdictions.
With its February 2008 acquisition of Shandong SEM Machinery and its longtime relationship with the Chinese government, Caterpillar is well positioned in China, in our view. (Beijing traditionally blocks foreign companies from taking over equipment manufacturers.) The company now has 16 manufacturing facilities across China and is expecting $2 billion in sales there in 2008. It plans to spend $100 million in the next 12 months to triple SEM's output and open two additional plants. We believe sales should increase significantly, even if it maintains market share during the expected infrastructure stimulus spending of 2009-2013; however, we anticipate Caterpillar will be able to aggressively build market share as it has in other jurisdictions.
We see the company benefiting from its heavy machinery exposure amid an expected surge in global infrastructure spending and any rebound in mining, energy, and agricultural commodities, while service and parts income should continue to provide revenue and profitability support. Additionally, Caterpillar has consistently paid a dividend since 1938 and has increased its dividend since 1994. The stock, which carries S&P's highest investment ranking of 5 STARS (strong buy), currently yields approximately 3.6%.
Producing its distinctive yellow machines, Caterpillar has been in operation for more than 80 years and directly employs more than 112,000 people in 500 locations in 50 countries. Additionally, Caterpillar has a dealer network employing more than 120,000 people across 200 countries that provides its equipment and services. The company also provides rental services in 1,600 outlets globally.
Caterpillar has become the world's largest manufacturer by revenue of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and integrated related services. Manufacturing products generated $29 billion of revenue in 2007, or 64% of the company's total revenue of about $45 billion. The company also provides related integrated services to support the manufacturing business, generating $16 billion of revenue, or 36% of the total, through Caterpillar Financial Services, Caterpillar Remanufacturing Services, Caterpillar Logistics Services, Progress Rail Services, Solar Customer Services, and Genuine Cat Replacement Parts.
Caterpillar's largest operating segment, the machinery unit (63% of revenues in 2007 and 9.7% operating margin), makes earthmoving equipment. Operations include the design, manufacture, marketing, and sales of construction, mining, and forestry machinery equipment. This segment also includes logistics services for other companies and the design, manufacture, remanufacture, maintenance, and servicing of rail-related products.
The division's products are used predominantly in heavy construction (including infrastructure), general construction, mining, and quarry/aggregates markets. End markets are very cyclical and competitive; demand for Caterpillar's earthmoving equipment is driven by volatile and cyclical factors, including economic cycles, commodity prices, and interest rates.
The engine segment (30% and 13.4%) makes diesel engines for both Caterpillar's own earthmoving equipment and third-party customers. Operations includes the design, manufacture, marketing, and sales of engines for Caterpillar machinery; electric power generation systems; on-highway vehicles and locomotives; marine, petroleum, construction, industrial, agricultural, and other applications; and related parts. This area also includes remanufacturing of Caterpillar engines and a variety of Caterpillar machine and engine components and remanufacturing services for other companies. The engine business's major end markets are petroleum, electric power generation, industrial, marine, and on-highway vehicles.
The financial products segment (7% and 23.0%) primarily provides equipment financing to Caterpillar dealers and customers. A principal line of business consists primarily of Caterpillar Financial Services Corporation (Cat Financial), Caterpillar Insurance Holdings (Cat Insurance), Caterpillar Power Ventures (Cat Power Ventures), and their respective subsidiaries. Cat Financial provides a wide range of financing alternatives, including loans to customers and dealers for Caterpillar products. Cat Insurance provides various forms of insurance to customers and dealers to help support the purchase and lease of equipment. Cat Power Ventures is an investor in independent power projects using Caterpillar power generation equipment and services.
Although the global economy is experiencing a period of weak economic growth, and the U.S. and the European Union are in recessions, we forecast revenue growth of 1.5% for Caterpillar in 2009.
We believe revenue growth will come from a number of factors, including global demand for construction equipment used in infrastructure projects, pockets of strength in energy, mining, and agriculture, and Caterpillar Financial's continued ability to access tight credit markets to provide financing options for customers.
We expect operating margins to expand as Caterpillar benefits from price hikes already in place for 2009, increased manufacturing efficiencies from its implemented Six Sigma program, lower manufacturing input costs for raw materials, energy, and labor, and a shift to lower manufacturing cost and tax jurisdictions. Additionally, we see the integrated services business comprising a greater proportion of revenues as Caterpillar leverages its existing customer base and increases market share in emerging markets.
Our EPS estimates are $5.99 in 2008 (12% growth) and $6.40 in 2009 (7% growth), vs. $5.37 in 2007.
Our 12-month target price of $55 is based on a blend of our price-earnings and discounted cash flow analysis (DCF) analyses. We apply a peer-premium p-e ratio of 9 times our 2009 operating EPS estimate to derive a $58 valuation. We think Caterpillar warrants a peer premium due to what we see as earnings growth above the industry average. Our DCF model yields an intrinsic value of $54. Weighing these two results, we arrive at our 12-month target price of $55.
We view Caterpillar's corporate governance policies favorably. Positives we see include a board-approved succession plan, that 90% of the board is independent outsiders, that the compensation and audit committees are comprised solely of independent outside directors, that the company has a policy limiting board members to five or fewer company boards, and that there were no "related party" transactions involving the CEO.
However, we believe that Caterpillar could strengthen its corporate governance policies by separating the positions of chairman and CEO, by requiring shareholder approval to change the size of the board, conducting performance reviews on individual directors, and by giving shareholders cumulative voting rights in director elections.
Risks to our recommendation and target price include the uncertainty of the current global economic environment and continuing sharp declines in industry demand in all developed economies—particularly in commercial and residential construction and their related construction-related sectors.
Additional risks include slower-than-expected economic growth, weaker nonresidential construction, volatility in agriculture, mining, and energy commodities, and/or power markets. We are also concerned that economic stimulus spending by the U.S. and governments internationally could be materially different than current proposals.