We've all seen the headlines. China's growth is slowing down, and the only question is whether the landing will be hard or soft. Europe is fumbling its way toward collapse, with half-measure after half-measure failing to plug the holes in its members' budgets. And in the biggest unforced error of modern economic management, American lawmakers are set to preside over a "fiscal cliff" of steep tax increases and spending cuts that pundits predict will cut growth deeply. What's an investor to do? Don't panic: Find the companies that are built to be profitable even in the depths of a recession.
Caterpillar (NYSE:CAT) is the world's largest provider of heavy equipment for construction, mining, and infrastructure development. Operating as a vertically integrated provider that manufactures, distributes, markets, sells, and services heavy equipment, Caterpillar is often seen as a bellwether company whose track record predicts the pace of global economic growth. Therefore, when Caterpillar lowered its long-term earnings estimates last month, some analysts took it as yet another bad omen for global growth. The stock has tumbled nearly 10% since then, as other equipment suppliers like drivetrain producer BorgWarner (NYSE:BWA) and engine-maker Cummins (NYSE:CMI) have confirmed Caterpillar's caution by lowering their own estimates. But where others see a reason to despair, long-term investors should see a screaming "buy" opportunity.
At a mining industry conference, MINExpo in Las Vegas, Caterpillar CEO Doug Oberhelman lowered 2015 earnings-per-share estimates from $15-$20 to $12-$18, blaming weak global demand and predicting that 2013 would look a lot like 2012 economically. What might have spooked investors even more, however, was Oberhelman's detailed explanation of how the company might fare in a moderate or even severe recession.
Caterpillar has suffered revenue declines in only 16 of the 87 years the company has been in business, but even so, it has prepared for a contractionary sales environment. After the 2008 recession, Caterpillar aggressively targeted its cost structure, slashing its cost of goods sold as well as its selling, general, and administrative expenses. As a result, Caterpillar is now growing costs less than half as quickly as it is growing revenue. Before the recession, costs were growing at more than 100% the rate of sales.
In the event that a global recession strikes some time before 2015, Caterpillar has plans to delay capital expenditures so as to manage production to match weak demand. The company will also cut back on incentive pay for managers. These moves, combined with Caterpillar's existing cost-cutting moves, will allow the company to generate $6 in earnings per share even if sales drop 15%. That profit would be nearly 50% more than 2010's $4.15 per share and would allow Caterpillar to maintain critical research and development spending, not to mention preserve the company's high credit rating and robust dividend.
But what if a future recession is even worse than that? Caterpillar investors can look to history. The 2008-2009 fiscal year was the most severe recession in the company's history, with sales tumbling 37%. However, even then the company remained profitable, paid out its dividend on schedule and in full, and retained its mid-A credit rating. Oberhelman and other executives have prepared for an even worse revenue decline of 38.5%. That event, which would represent the single deepest recession in the company's history, would allow Caterpillar to still bring in $3.50 per share, easily covering the $1.80 dividend payment with room for increases. Oberhelman committed to that strategy, saying that "we will never, ever cut a dividend, and we'll grow dividends modestly as we have been."
Why is Caterpillar so robust? Some of its resilience comes from its vertical integration. When customers aren't buying new equipment because of a bad economy, that means they have to get more out of the equipment they do have. Caterpillar's network of parts resuppliers, repair operations, and services run up big profit margins and lots of revenue during recessions. The company calls this business model "seed, grow, harvest." Caterpillar "seeds" its market by making high-value equipment, "grows" the business through its extensive dealership network, and "harvests" the attractive aftermarket of parts, supplies, and services.
Caterpillar also simply makes products that people can't live without, and even in the depths of a recession, Caterpillar customers need heavy equipment to build and maintain infrastructure. The critical nature of its products allows Caterpillar to be healthy and profitable even in the depths of a recession, but to be clear, that company isn't anticipating the worst. In the event of even mild global growth, Caterpillar foresees great things in its own future. Oberhelman put it this way:
Global infrastructure development has been stopped in the developed world for a decade. At some point, that will recover somewhat and it may recover quite nicely. The developing world is still booming, and even China is still developing roads and bridges and all kinds of infrastructure.
But beyond that, think about Russia and Brazil and those 7 billion people [worldwide] wanting to live like us [citizens of the developed world], and we're right in the middle of every piece of infrastructure that needs to get developed anywhere in the world including reconstruction in this country and Europe, which will happen.
Fool contributor Daniel Ferry owns shares of Caterpillar. The Motley Fool owns shares of Cummins. Motley Fool newsletter services recommend BorgWarner and Cummins. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.