Home > Short Ideas > Caterpillar (NYSE:CAT) : An Economic Bellwether

Caterpillar (NYSE:CAT) : An Economic Bellwether


Introduction

In the 1976 movie classic All the President’s Men, secret informant Deep Throat guides Washington Post reporter Bob Woodward by telling him to "follow the money."  After the past decade(s) of reckless credit expansion, Deep Throat’s message should be resonating in the minds of security analysts.

Future sales, earnings, and overall business valuations largely rely on the efficacy of continuous credit growth.  Credit availability and credit growth directly or indirectly affect all businesses.  However, the effects are not spread uniformly.  One company that serves as a bellwether for global economic activity and as a barometer for global credit growth is Caterpillar Inc. 



The Business

Caterpillar Inc. (NYSE:CAT):

 

 

Business Description (From Google Finance):

Caterpillar Inc. (Caterpillar) is a manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The Company also is a service provider through Caterpillar Financial Services, Caterpillar Remanufacturing Services, Caterpillar Logistics Services and Progress Rail Services.

  
Discussion and Analysis

Succinctly, Caterpillar is an industrial company that has benefited handsomely from the global credit boom.  According to The Economist, global public debt increased from $18.4T in 2000 to $43.6T in 2011.  Statistics that include total credit market debt show a much bigger and faster growing number.  Effectively, credit expansion has been growing 2x faster than the underlying global economy and much of the new credit has been directed towards fixed asset investments that use products manufactured and financed by Caterpillar.

Following the dot com bubble, the United States lowered interest rates and proceeded to rapidly pump credit into its economy.  Accordingly, asset prices inflated and its economy enjoyed a brief boom.  At the peak of the boom, year-over-year credit growth nearly eclipsed 10% and the US was running a $2B per day trade deficit.  Credit flowed into US based fixed assets (houses, office buildings, condos, etc) and into the pockets of foreigners selling goods to US consumers.  The deluge of new credit was globally stimulative and it impacted the price of industrial commodities and the demand for industrial equipment. 

The following figures illustrate the impacts:

As shown above, Caterpillar has not sustainably increased revenue inside the US over the past two decades and it now generates roughly 70% of its revenues outside the US.  The main source of these non-US revenues is either directly or indirectly China.  China is now using the dollars it accumulated from its US trade imbalance to fund its own fixed asset investment boom.  Dollars are now flowing from China into Australia, Brazil, Canada, and other resource rich countries in exchange for iron ore, coal, copper, etc.  These forces are a boon for Caterpillar since China needs equipment to build and the supplier nations need equipment to extract their natural resources.

The following figure provided by GMO illustrates China’s share of world commodity consumption:
 
 

 

Conclusion

The basic thesis is that China’s economy and its banking system cannot continue to expand at a double digit pace.  When China’s economic activity tapers, even modestly, Caterpillar’s revenues will decline.  If non-US revenues decline to $15B and US revenues hover around $15B, then Caterpillar will generate $30B in total revenues.  Using historic multiples of price to revenue, $30B in total revenue values Caterpillar somewhere around $30B or about 50% less than the current $60B market capitalization.

The aforementioned scenario may happen in the distant future or not too distant future – the exact timing is unknown.  However, cracks in the global credit system are spreading and property prices inside of China may have peaked.  Owing a few CAT shares may be a good hedge against a global economic slowdown.
 

Disclosure: Short CAT
 

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