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Caterpillar: Mixed Earnings and Mixed Future


A new housing boom may not offset other headwinds as CAT tries to maintain growth.

Caterpillar (NYSE:CAT) recently reported disappointing quarterly results due to write down of its Chinese subsidiary and falling demand. The company's profit dropped 55% from $1.5 billion to $697 million as it undertook a massive $580 million write-down of a Chinese business that it acquired for approximately $780 million. Revenues also dropped by 7% to $16.08 billion while analysts were expecting $16.12 billion. One would expect revenue to be off slightly if one of your subsidiaries turned out to be a shell.

Caterpiller has predicted a recovery in the US housing market and expects Chinese economy to grow by 8.5% in 2013. And I am inclined to agree with its management thanks to a concerted effort by the Federal Reserve to blow up another bubble in housing. How long the credit expansion cycle will last, though, is anyone's guess. But the Fed is committed to doing whatever it takes to keep bond yields low to punish any form of savings even though there is a multi-month downtrend in the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). New money will disproportionately flow into interest rate-sensitive projects like construction.

The long end of the yield curve is rising despite the Fed's best efforts and the extreme move in the US savings rate in December 2012 -- a jump from 3.6% to 6.5% -- likely caused the QEIV announcement at the FOMC policy meeting that month. But, since nothing in Europe has been fixed and the recession there will continue as long as the ECB keeps contracting its balance sheet slightly, global growth will be sluggish at best.

Caterpillar's rival Komatsu Ltd (PINK:KMTUY) has also witnessed a 28% fall in quarterly profits to $275 million on the back of falling demand from China and Indonesia. Komatsu, now in its fourth quarter, is anticipating an overall 12% drop in profits to $1.49 billion (JPY 138 billion), especially with Japan's GDP contracting sharply in the fourth quarter. But, the extreme response to weaken the yen (NYSEARCA:FXE) by the new Abe government will put CAT at a severe price disadvantage to Komatsu worldwide as 2013 rolls on.

On the other hand, Caterpillar did report over FY 2012 a 15% increase in profits to $8.48 per share from revenues of $65.9 billion, a 10% increase from last year. But like Komatsu, its current-year profits could possibly fall by 5.7% if it touches the midpoint of its outlook of $7-$9 per share -- an unusally wide range given by Caterpillar, signaling management is as worried about the future as I am.

But the real story involves last summer's acquisition by CAT of Zhengzhou Siwei Mechanical & Electrical Manufacturing Co. in China, a subsidiary of Hong Kong-listed ERA Mining Machinery (HKG:8043), to gain greater access to the local subterranean mining market and the charge I discussed at this article's outset. Caterpillar's management was quick to blame "deliberate, multi-year, coordinated accounting misconduct" for the write-down, but the more important thing is why Caterpillar and its team of analysts failed to see this before the acquisition happened. CEO and Chairman Doug Oberhelman has accepted responsibility, but what does that mean?

While there is little he can do now, it is not like Caterpillar was new to the Chinese market. In fact, it's a primary business hub with 23 plants and a workforce of 15,000 where it competes with the local giants Zoomlion Heavy Industry Science and Technology Co (PINK:ZLIOY) and Sany Heavy Equipment International Holdings (PINK:SNYYF). It's a place which Caterpillar considers its primary revenue driver for the long term. One would assume that Caterpillar would be more aware of the mechanisms of fraud that are possible in China because of what a Jefferies' analyst calls its "opaque" accounting standards. Judging the value of one of the local firms should not have been too difficult. Did no one at Caterpiller visit the site? Yet it ended up paying a "premium" of around 480%.

Interestingly, since the write-down is on the "value" of the company, Caterpillar, much like Hewlett-Packard (NYSE:HPQ) and Autonomy, insists on calling it a "non-cash" loss, even though it paid the $700 million out of its wallet for the acquisition in the first place. If the company wants to play accounting games to keep its income sheet cleaner, that's its problem. Value investors, especially those focused on Return on Assets, should be cautious when valuing the quality of the firm's assets going forward.

Following the fraud, Caterpillar is doing what any other company would do: overhauling management at Siwei, and laying off of its executive Luis de Leon who played an active part in the deal and subsequent defrauding of its management and shareholders. For now, Siwei's managers, who, according to Caterpillar, are responsible for the fraud, have borne the brunt of the scandal.

Caterpillar sees a quarter of its revenue from Asia-Pacific and is well-positioned in China, the Siwei fiasco notwithstanding. Looking at the chart, it looks range-bound between $80 and $120 per share with a monthly bullish signal having been given after the earnings report. Right now the market likes the company enough to remain bullish. Outside of China, however, CAT may be looking at stiffer pricing competition from the aforementioned Komatsu as well as India's Mahindra (BOM:500520) due to foreign exchange issues. The real infrastructure growth will be around Southeast Asia over the next five to 10 years, and an American company like CAT may be at a disadvantage to those allied with the coming Asian Economic Community or who have free trade agreements in place. Like its board, I see too many headwinds to be long CAT at these prices.
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