Attaining global leadership in three diverse businesses is no mean feat. Caterpillar (CAT 0.20%) has been the frontrunner in global construction equipment, mining equipment, and engines and turbines markets for several years now. Today, the heavyweight boasts a product line that spans more than 300 products and 3 million units of machinery across the globe.
Source: Caterpillar
Of course, running a business of this scale comes with its own challenges. For example, Caterpillar has to keep its key assets, primarily property, plant, and equipment, up and running in perfect condition, irrespective of how business conditions are. That entails massive amount of spending even when the company's top and bottom lines are under pressure, like they've been over the past year or two.
At the same time, investors wouldn't be too happy if their company is spending only just as much to maintain its assets, and not investing in growth. It's all about striking a balance between maintenance expenditure and growth spending, even when the going gets tough. How does Caterpillar fare in this area? Is it channeling money in the right direction to secure a strong future? Let's dig deeper.
Is Caterpillar really growing?
Every asset depreciates over time, and a company needs to maintain, and even replace, them as their useful life wears out. Ideally, the company should be spending enough to cover those depreciation costs and keep its assets and operations running. Any capital spending that overruns depreciation expenses indicates investment in growth; where growth could be in any form, from research and development to acquisitions.
That might sound confusing, but believe me, it's easy to figure out whether the company you've invested in is actually pumping money into growth or not. So if you're a Caterpillar investor, all you need to do is adjust its total capital expenditures (which include R&D and acquisition spending, if any) for depreciation expenses to find that out.
I've done that for you: I pulled out the numbers from Caterpillar's financials, calculated its adjusted net capital expenditures, as explained above, for each of the past five financial years, and plotted them against depreciation to give you a complete picture. The result is pretty interesting.
Figures in billions of U.S.$
As you can see, Caterpillar is clearly a growth-oriented company, having consistently spent a lot more than it needs to simply maintain its assets.
2011 was an exceptional year for Caterpillar as it acquired mining-equipment manufacturer, Bucyrus International in its largest deal ever. While that meant huge headway in the global mining-equipment industry, Caterpillar also made great progress in its engines business the same year by acquiring alternative fuel and natural-gas engine supplier, MWM Holding GmbH. So roughly $8.2 billion of the $12.11 billion capex for 2011 that you see in the graph above pertains to these acquisitions.
Beyond 2011, bulk of Caterpillar's growth spending went into R&D. Caterpillar has always been the frontrunner in innovation, which is also a major reason why the company is a global leader in each of its business segments today.
So was that good use of money?
By now, it's clear that Caterpillar has channeled its money heavily into growth over the years. The question is: Are those investments paying off, or was the company better off giving away all that money to shareholders? Caterpillar's return on invested capital and return on equity should give you an answer. Here's what these metrics look like over the past five years.
CAT Return on Invested Capital (Annual) data by YCharts
Caterpillar was doing exceedingly well until 2012 – churning out more than 10% and 35% ROIC and ROE, respectively -- when the commodities boom ended and global mining markets slumped. Things worsened last year, sending the company's sales, profits, and returns plunging. That explains why the lines in above graph are trending downward.
In hindsight, Caterpillar's move to buy Bucyrus near the peak of commodities boom looks questionable. Not only did Caterpillar time its acquisition wrong, it also paid a hefty premium for the deal.
Caterpillar probably had a valid reason back then: It was eyeing an acquisition to expand its mining business much before the 2008 financial crisis. With commodities leading global recovery thereafter, with prices even hitting pre-crisis peaks by 2010, Caterpillar had an even bigger reason to go bullish about the mining industry. Not one to take any chances, Caterpillar sealed its position as the largest mining-equipment company in the world by taking over Bucyrus. And then the mining markets plunged.
I wouldn't say betting on the high-potential mining industry was a wrong decision. A couple of years ago, General Electric also announced intentions to double revenue from its mining business by 2016 via acquisitions. Caterpillar just went overboard by paying a huge premium for Bucyrus that's costing the company heavily now.
Don't panic yet
With the mining industry showing no signs of recovery yet, Caterpillar clearly needs to squeeze more out of its construction and energy & transportation businesses to win back investor confidence. The company is already trying hard through aggressive cost cutting and restructuring of operations.
More importantly, Caterpillar may not be creating much value at current ROIC of 6.5%; but investors needn't panic, for two reasons. First, a return of equity of 20% in such challenging times is worth a pat on the back. Second, a strong balance sheet is helping Caterpillar fight the storm.
The company is flush with cash, having gone a little easy on growth programs over the past year in the wake of a slowdown in key markets; and much of that cash is going into shareholders' pockets as dividends and buybacks. For perspective, Caterpillar announced a share repurchase program worth $10 billion last year, and raised its dividends by 15%, marking it the 20th consecutive year of dividend increase.
Source: Caterpillar Year in Review 2013 report
The trend is here to stay -- Caterpillar already increased its quarterly dividend by 17% this past June.
What this means for you
Caterpillar is a fine example of what efficient capital allocation is all about. From upkeep of its key assets to investing in growth to rewarding shareholders, the company isn't leaving out any aspect.
Caterpillar aims to generate strong cash flows over the next five years to support growth and shareholder returns. The company may be facing headwinds currently, but it looks like investors are in safe hands in the longer run.
