In what's becoming a familiar refrain during earnings season, Caterpillar's (CAT 0.83%) fourth-quarter earnings were pressured by soaring supply chain costs that will extend into 2022. However, on a more positive note, underlying demand remains strong. In addition, management is taking pricing action to offset cost increases and believes that profit margin headwinds will disappear when the supply chain pressures ease. Does it all add up to make a Caterpillar a stock to buy on a dip? Here's the lowdown.
Caterpillar's margin pressure
The margin pressures impacting Caterpillar right now are in the table below. Whereas full-year reported operating profit margin increased year over year from 10.9% to 13.5%, Caterpillar's fourth-quarter operating margin declined to 11.7% from 12.3%.
Image source: Getty Images.
In fact, management conceded that the margin was lower than it had previously expected. CEO Jim Umpleby put it down to two things. First, freight costs were higher than expected due to inflationary pressures and management's decision to use premium freight to meet customer demand.
Second, management referred to "production inefficiencies." In a nutshell, Caterpillar faced up to supply chain constraints by keeping "our plants open and fully staffed to best serve our customers and meet as much demand as possible," according to Umpleby. Unfortunately, these actions came at the cost of near-term margin.
Management's rationale is that when the supply chain issues ease, Caterpillar will increase production and then generate margin expansion through volume improvement.
| Metric | Fourth Quarter 2021 | Fourth Quarter 2020 | Full-Year 2021 | Full-Year 2020 |
|---|---|---|---|---|
|
Sales |
$13.8 billion |
$11.2 billion |
$51 billion |
$41.7 billion |
|
Cost of goods sold |
$10 billion |
$7.8 billion |
$35.5 billion |
$29.1 billion |
|
Operating profit |
$1.6 billion |
$1.4 billion |
$6.9 billion |
$4.6 billion |
|
Operating profit margin |
11.7% |
12.3% |
13.5% |
10.9% |
Data source: Caterpillar presentations.
What about pricing actions?
After supply chain costs hit profitability in the fourth quarter, industrial investors want to know whether price increases can offset the cost increases in 2022. CFO Andrew Bonfield believes they can. Discussing the matter during the earnings call, he noted, "we intend price increases to more than offset manufacturing cost increases in 2022, assuming the current level of supply chain disruption does not deteriorate."
More positive news
In addition to the pricing action, Caterpillar should see some margin benefit from ongoing growth in its services sales. In fact, its services sales of $19 billion in 2021 were higher than the $18 billion in 2019, even as overall sales are $2.8 billion lower. As such, management believes it's on track to double its services sales from $14 billion in 2016 to $28 billion in 2026. Moreover, investors have more reason for positivity, given the possibility of a pick-up in demand from a boost to infrastructure spending.
In addition, Caterpillar continues to meet its investor day targets outlined in 2019. The key point from the investor day in 2019 is that management was trying to raise its operating margin and free cash flow generation through the cycle. For reference, Caterpillar's construction, mining, energy, and transportation machinery are tied to cyclical markets, so its revenue, profit margins, and cash flow are also cyclical.
Image source: Getty Images.
Management aimed to improve its operating margin range through the cycle to 10%-21%. Similarly, management aimed to generate free cash flow (FCF) (cash flow excluding its finance arm) of $4 billion to $8 billion rather than the historical range of $3 billion to $6 billion through the cycle. The first aim has been achieved (see table above), and even though Caterpillar's FCF of $3.1 billion in 2020 fell below target (in exceptional circumstances), the $6 billion in 2021 was right in the middle of the fairway.
Headwinds in 2022
On the other hand, there are some questions about Caterpillar in 2022.
It's not the only company trading on the belief that supply chain issues will ease through 2022 and margin expansion will follow. Moreover, there's no guarantee that its end markets will remain as strong at the end of 2022 as they were at the end of 2021.
For example, China's construction market is slowing, and housing starts in the U.S are expected to decline through 2022. Both events could negatively impact Caterpillar's sales.
In addition, it's worth noting that many of the self-same issues driving the soaring raw material costs (high mining and energy commodity prices) also drive sales of Caterpillar's mining, construction, and oil and gas equipment sales. In other words, if commodity prices fall, Caterpillar's demand could be negatively impacted.
A stock to buy?
There's a lot to like about Caterpillar, but potential headwinds are also coming in 2022. That's an additional risk to take on board, and there are plenty of other reopening stocks and infrastructure stocks to buy that have better-looking end markets in 2022 and beyond.
