According to an interesting update from The Wall Street Journal, Caterpillar (NYSE:CAT) may have just passed on a high-potential growth opportunity, and a chance to acquire valuable share in an upcoming market, to General Electric (NYSE:GE).
Caterpillar's Electro-Motive Diesel, or EMD unit, which is a part of its energy and transportation, or E&T, business, will reportedly take another two to three years to get its freight locomotives ready even as General Electric gears up to roll out its offerings next year. That could be a big setback for Caterpillar's E&T division, which is gradually emerging as its largest and most profitable business.
Why is this a big deal?
The U.S. EPA Tier 4 emissions standards for diesel locomotives, which call for 70% and 76% lower particulate matter and nitrogen oxide emissions, respectively, will come into force from Jan. 1 next year. Accordingly, U.S. railroads will need to upgrade their fleets as the standards kick in. It's a big business opportunity for locomotive makers, and the first mover will naturally enjoy a significant competitive advantage. Unfortunately for Caterpillar investors, it looks like GE will take the cake.
While Caterpillar may not start producing its Tier-4 compliant freight locomotives until 2017, GE already began testing its Evolution Series Advance Power 4 locomotives last year, and expects to start full production by the middle of next year. Considering that GE already dominates nearly 70% of the locomotive market in the U.S. as per WSJ estimates, this could have been a golden opportunity for Caterpillar to strengthen its foothold in the rail industry and take its E&T business to new heights.
Investors who follow may already know that E&T contributed a major portion to Caterpillar's sales and operating profits last year, and it has also proven to be its most resilient business in recent years. More notably, the division derives a major portion of its revenue from transportation -- which comprises of rail and marine -- as shown below.
So, headway in freight locomotives could have given Caterpillar's rail, and hence its E&T business, a good thrust.
So, what's ailing Caterpillar...
Not many know that Electro-Motive Diesel has always been one of GE's closest and toughest competitor in the transportation space, even before it was acquired by Caterpillar in 2010. So, it's unnerving to see a well-established company like EMD delay its launches.
While there's not much clarity about the reasons behind the delay, an unprecedented labor dispute that forced Caterpillar to close down its primary locomotive-assembling plant in 2012 could have been one of the factors. Ironically, at around the same time, GE struck peace and renewed contracts with its union workers at its locomotive plant even as it worked on setting up new locomotive facilities. So, while GE was ramping up production capacity in anticipation of an upswing in locomotives demand, Caterpillar was dealing with operational disruptions.
...and why isn't it worried?
Caterpillar isn't too worried about its delayed Tier 4 freight locomotives, though. In its defense, Caterpillar believes that railroads may not switch to the advanced locomotives until the technology is proven. In other words, railroads will try to delay the transition, thus allowing the company enough time to get its act together.
While it's true that transition to such advanced technologies is a drawn-out process, every railroad company will eventually have to meet the emission standards. More importantly, with the U.S. economy picking up steam, railroads are doing brisk business and churning higher profits, thus leaving them with more cash to upgrade their fleets. For instance, Union Pacific has outlined 8% higher capital spending for the year, and it plans to use 60% of that projected expenditure of $3.9 billion to "replace and improve existing capital assets." Purchasing 200 locomotives and upgrading existing ones count among its priorities.
Does Caterpillar know a secret?
Interestingly, Union Pacific had partnered with EMD in 2012 and invested $20 million to test advanced emission-reducing technologies in line with Tier 4 standards for freight locomotives. In fact, the two companies enjoy a long-standing relationship.
Could it be a possibility, then, that Union Pacific is one of those railroads that want to go slow on Tier 4 -- something Caterpillar is aware of and that explains its laid-back attitude to freight locomotives? I'm not ruling that out, because it's hard to believe that an innovative leader like Caterpillar will let an opportunity slip away without any premise, especially when it was the first in the world to launch a Tier 4 passenger locomotive.
This delay could prove costly
That said, any railroad buying even a few Tier 4 locomotives will end up in GE's backyard if it's the only compliant product available in the market. And even a small initial success could prove a game-changer for GE, leaving Caterpillar in the lurch. GE has another ace up its sleeve: Its Evolution Series locomotives do not require exhaust gas treatment, which could be a big crowd puller among railroads. Caterpillar hasn't divulged details about its freight locomotives yet.
I'd expect Caterpillar to pull up its socks, because anything to do with EPA emissions standards presents a long-term growth opportunity that cannot be ignored.