Caterpillar Reloaded

A summary digestion of Caterpillar's recent 1Q09 earnings and conference call. For those who want to get an understanding for what is happening, but using less time.

The result in brief

Caterpillar (CAT) earned $0.39 per share, excluding redundancy costs of $0.58 per share, down from an adjusted US$1.44 per share in 1Q08. Revenue fell 22% to US$9.225bn. Nevertheless, operating cash flow was actually up, to $895m vs. $706m in 1Q08, due to substantial inventory reductions of US$764m vs. an inventory gain of US$864m in 1Q08. Research Reloaded Free cash flow for 1Q09 was $450m vs. only US$61m in 1Q08. Thus on a cash flow basis, CAT remained strong due to effective management into the down cycle.

Guidance was for 2009 revenue of US$35bn +/- 10% and 2009 profit of $1.25 per share excluding redundancy costs expected to be $0.75 per share.

Operating profit

Op profit was -$175m, or US$463m before redundancy costs as shown below. This was down significantly from op profit of US$1.29bn in 1Q08.

Key Segments Revenue and Operating Profit

Machinery Sales

In the latest conference call management said they expect end-user demand for machines in the US to fall 70% from its quarterly peak in early 2006, and sees a similar trend for the US and Japan. Sales down 29%YoY due to cancellation of some major projects due to higher credit spreads for customers, housing industry declines, mining industry demand falling with lower commodity prices, and Caterpillar’s dealers reducing inventory. By region, North America was down 30%, EAME was down 46%, Latin America was down 16%, and Asia/Pacific was down only 2%. Thus Caterpillar has seen substantial relative strength for the Asia/Pacific market.

Also, interestingly the Machinery segment as a whole was able to increase prices. Thus Caterpillar seems to be defending its pricing and sacrificing on volume in a disciplined fashion. Op loss was -$508m, or -$173m before redundancy costs. Op profit in 1Q08 was $626m. Margin thus obviously went negative due to the negative side of operating leverage, despite Caterpillar’s ability to increase prices. Helping dealers reduce inventories, to prevent excess inventory in the system, has been part of Caterpillar’s pricing strategy.

Engine Sales

Sales down 8% YoY due to currency effects and sales volume decline. Caterpillar was nevertheless able to increase its prices, as it did with Machinery. By region, North America was down 13%, EAME 7%, Latin America 20%, and Asia/Pacific 10%. Thus less relative strength evident for Asia/Pacific in this segment. Op profit was $297m, down 46% YoY.

Financial Products

These days, these kind of segments can be scary, being potential land mines for investors, such as what happened with General Electric. Nevertheless, Caterpillar is much different, and has no where near the financial complexity of GE. CAT finances its customers and dealers, with loans backed by its own products, where it can understand the collateral value very well. In 1Q09 Caterpillar’s financial segment saw revenue declines of only 12% and still registered an op profit of $99m.

CAT's Employment

Worldwide employment was 103,000, and the company reduced their full-time employees by 10,000 since end 2008, though also added 6,400 people due to acquisitions and their Japanese business consolidation. Part-time employment fell by 15,000 since end 2008.

Actions to Deal with a Tough Environment

Caterpillar expects the world to be in recession for 2009, but sees the US as the first developed country to emerge perhaps in end 2009, early 2010. It also expects certain developing countries such as China to lead and rebound.

Nevertheless, the company is managing itself for the downturn, lowering its production levels even below its lower demand forecasts in order to let dealers bring down their inventory levels. Of course they are also reducing their own costs, bringing down their own inventory and increasing their liquidity.

They are reducing employee costs by lowering the amount of overtime paid, which is can result in significant savings since the company reported that in 2008 a high level of overtime was paid. The company uses overtime in order to have volume flexibility. They are also implementing full or partial shut-downs for some facilities.

US Stimulus Package and Its Effects

CAT expects the impact to be limited, and expressed discontent with the meager infrastructure spending in the US plan. It says that China is spending three times as much on infrastructure despite having one third the economy, but this is a bit of an unfair comparison given China is a developing country.

Liquidity

The company claims to have excellent access to capital, pointing to its recent February $3.5bn bond issuance and demand for Caterpillar commercial paper. In the earnings conference call management indicated that they would not likely need to issue any further debt in 2009.

They are also carrying more cash than normal on their balance sheet. Inventory management will also help here, and they plan to reduce inventory by $3bn in 2009. Dividend suspension or cuts could be implemented depending on the economic situation, in order to support liquidity. CAT is also eligible to participate in the US government’s Commercial Paper Funding Facility. In their recent conference call, in response to a UBS analyst question, management nevertheless indicated that using this facility is merely an option on the table and it is unlikely to be a substantial part of funding. In simple terms, they probably don’t need it, which is a good thing.

1Q09 interest coverage ratio was reported at 1.24 to 1, vs. its minimum covenant 1.15 to 1 and financial leverage was 7.70 to 1, vs. its minimum covenant of 10 to 1.

Conclusion

CAT has rebounded substantially to $38 from its $22 52-week lows earlier this year, but is still well below its $82 highs from 2008. Good news from the earnings was that CAT was still expecting to make money in 2009, has little concern in terms of liquidity, generated healthy free cash flow despite much lower earnings due to strong inventory management, and actually has been able to increase prices in the weak environment. Management stated that the strong can get stronger in a downturn, and we believe that CAT is on its way to accomplishing this. Still, as pointed out in our previous manufacturing piece, a turn around for sales could be more than a year away.