Will Caterpillar Take a Hit on Its Largest Ever Deal?

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Disappointing third-quarter earnings from Caterpillar (NYSE: CAT  ) pushed the Dow component down 5.4% today and weighed on broader sentiment. Stocks finished down, breaking a four-day streak of record closing highs in the process: The S&P 500 and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) lost 0.5% and 0.4% on the day, respectively.

For Caterpillar, the hits keep coming
Talk about buying at the top of the market. Roughly three years ago, on Nov. 15, 2010, Caterpillar announced the largest acquisition in its history, that of mining equipment manufacturer Bucyrus International (now known as Caterpillar Global Mining) in a deal valued at $8.6 billion, including net debt. On that day, CEO Doug Oberhelman told Bloomberg Televsion:

The mining industry is very attractive to us for the long term. With all the things going on around the globe with globalization, urbanization and demand for minerals, things in the earth, we will be strong for a long period of time.

Make that the very long term; in the meantime, Caterpillar is suffering badly from its exposure to the mining industry, as the mining boom has deflated and miners cut back on capital expenditures. The hurt was apparent in the company's third-quarter results, which it released this morning.

Caterpillar missed the $1.67 earnings-per-share consensus estimate, posting $1.45 instead -- down from $2.54 in the year-ago period. That prompted the company to revise its full-year guidance lower (again) to $5.50 in earnings-per-share on sales of about $55 billion, down from $6.50 per share on sales of $56 billion to $58 billion.

The company's new revenue forecast for the full year represents a 17% decline from 2012, with Resource Industries (principally mining) accounting for three-fourths of the drop. What does that add up to when you look at Resource Industries in isolation? Caterpillar now expects revenues from the segment to shrink by 40% this year!

There was certainly an industrial logic to the Bucyrus acquisition, but some analysts and commentators (justifiably) expressed concern that the price tag looked a bit rich: The deal put an implied equity value on Bucyrus of nearly 28 times its trailing-12-months net income. You have to come up with an awful lot of synergies -- and growth -- to justify that kind of multiple. That growth simply hasn't materialized -- quite the opposite, in fact.

In the fourth quarter of last year, Caterpillar wrote down the goodwill linked to another mining-related acquisition, that of China's ERA Mining Machinery, by $580 million, citing accounting "misconduct." The Bucyrus acquisition added $4.6 billion in goodwill to Caterpillar's balance sheet (goodwill represents the amount paid for the target company in excess of the stated value of its net assets). It's not absurd to ask if -- or perhaps when -- Caterpillar intends to write some of that down, which would produce another hit to earnings (although it's a non-cash charge).

With IBM, Caterpillar is the only Dow component showing a negative return for the year. Given its exposure to the mining industry, there may be more disappointments in store for shareholders over the next several quarters -- and more volatility to boot.

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9/30/2016 5:01 PM
^DJI $18308.15 Up +164.70 +0.91%
CAT $88.77 Up +1.30 +1.49%
Caterpillar CAPS Rating: ***