Embattled heavy-equipment maker Caterpillar (CAT 1.62%) reported on Friday that global sales of its machines fell for the ninth consecutive month, tumbling 10% in the three months through August compared to 2012. The culprit is a worldwide slowdown in mining, an industry that Caterpillar made its top focus in 2010 after the collapse of the U.S. construction industry.
But Caterpillar is a business with a long strategic vision. The company is using the current period of weakness as an opportunity to consolidate its operations and reduce costs, biding its time for an upswing of the cyclical mining business, whether that be three, five, or 10 years away. I want to own Caterpillar when that happens — and I'm happy to hold it while I wait.
As the world's largest manufacturer of heavy equipment for construction and mining, Caterpillar has global exposure, and the slowing economy in China is behind much of the company's current struggle. During the last decade, the foundation of China's rapid economic growth has been heavy investment in infrastructure, most notably transportation, energy, and residential. That building boom has benefited equipment manufacturers such as Caterpillar in two ways: Not only does construction equipment get purchased, used, maintained, and replaced to build the infrastructure in the first place, but the need for the raw materials that go into infrastructure boosts commodity prices, leading miners to purchase more equipment.
More recently, however, observers from the Wall Street Journal and researchers at the International Monetary Fund (PDF) are expressing concern that China's massive investments are yielding lower and lower returns. A move away from an investment-led model to a consumption-led model will hit Caterpillar in the same two areas that initially benefited it: As infrastructure investment dwindles, there will be both less demand for construction equipment to build infrastructure and less demand for the mining equipment to produce commodities for infrastructure. That means Caterpillar's dealers and distributors in China have been running out their inventories, ordering less equipment, and, ultimately, dragging down Caterpillar's Asia-Pacific sales by 30%. That is the primary factor in the company's worldwide 10% sales slip.
Still, there are certainly bright spots for the near term. On the heels of a stronger economic and residential recovery in the United States, North American retail sales actually increased for the first time in 2013. While the uptick was a modest 1%, North America remains Caterpillar's largest and most dominant market, so any tailwinds there will help the company, particularly in the housing sector.
But an investment in Caterpillar doesn't really rest on an imminent strong housing recovery in the U.S. Instead, the company's thesis is that in the very long term, a global population that is growing and urbanizing will require infrastructure, and Caterpillar products will be needed to provide that infrastructure.
Caterpillar estimates that worldwide demand for electricity, for example, will rise 90% over the next 30 years, with a third of electricity coming from coal — coal that could be mined by Caterpillar products. As the global population adds another nearly three billion people over the next four decades, the demand for housing, roads, power, water, and other infrastructure will rise ever faster. Caterpillar, as the largest and most trusted name in heavy equipment, is ideally suited to provide the tools the growing global population will need.
And in the mean time? Caterpillar's not sitting still.
The company is aggressively cutting costs and consolidating its supply chain, even as it continues to return cash to investors. Caterpillar has entered into share-buyback programs recently to the tune of about $1 billion every quarter, indicating management's belief that shares, currently selling for under 11 times forward earnings, are undervalued.
The company is also committed to its dividend. Caterpillar's nearly 3% yield is already high relative to the S&P 500 following a 15% dividend boost last quarter, and the company has both the ability and the intent to raise dividends yet further. Caterpillar's payout ratio, the proportion of earnings paid out as dividends, is only about 25%, leaving room for more dividend increases even if earnings stagnate or fall. CEO Doug Oberhelman reiterated Caterpillar's commitment to its dividend in 2012, saying, "We will never, ever cut a dividend, and we'll grow dividends modestly as we have been."
Add to that the rock-solid reliability of Caterpillar's business model. Thanks to its reduced cost structure, pricing discipline, and the indispensability of the products it sells, the company weathered the recession with high profitability, pre-recession highs as early as 2011.
Putting it all together, you have a company that is poised to benefit enormously from seemingly inevitable macro trends, such as population growth, urbanization, and industrialization, that pay investors handsomely while they wait.
Caterpillar is a low-risk, high-reward investment that pays to hang on to.
