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Caterpillar Hit by Weak Manufacturing Sector & High Costs

Zacks Equity Research

On Oct 14, 2019, we issued an updated research report on Caterpillar Inc. CAT. The company’s global machine sales growth has been declining over the past few months and is currently at a trough, which is concerning. Lower backlog, a muted China market and the overall slowdown in the manufacturing sector remain headwinds. Raw material cost inflation, thanks to the imposition of tariffs, is likely to continue to weigh on Caterpillar’s margins.

Retail Sales Declining

Caterpillar reported an improvement of 4% in global retail sales for the three-month period ended August 2019 — the lowest so far this year. The company’s global machine sales growth rate chart has been moving south and is now in the single-digit territory — levels last witnessed in 2017. Caterpillar has an average growth rate of 6.1% during the January-August 2019 period, a sharp decline from the prior-year figure of 27.1%.

Moreover, sales growth in the Construction Industries segment dipped 1% in August, for two months in a row. Notably, the segment had last witnessed a decline in January 2017.

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Slowdown in the Manufacturing Sector to Impact Performance

At the end of the second quarter of 2019, Caterpillar’s backlog was at $15 billion, a sequential decline of $1.9 billion and a drop of $2.7 billion from the prior-year quarter. The company continues to expect modest sales growth in 2019 based on the fundamentals of its diverse end markets, and the macroeconomic and geopolitical environment.

The U.S.-China trade tensions and waning global demand seems to have taken its toll on the U.S manufacturing sector. Per the Institute for Supply Management’s latest report, the U.S Purchasing Managers’ Index (PMI) declined to 47.8% in September 2019 — the worst reading in a decade. Notably, the index had registered 46.3% in June 2009 — the last month of the Great Recession.

Moreover, the Industrial Production Index published by the Federal Reserve rose a meager 0.6% in August following a dip of 0.1% in July. This follows a decline of 1.2% in the second quarter — marking its second consecutive quarterly decrease. This indicates a contraction in the manufacturing sector, which is likely to impact Caterpillar’s performance.

China Market Continues to be a Drag

In Asia Pacific, regions barring China are expected to grow. Persistent pressure from competitive pricing in China remains a headwind. The overall China market is anticipated to be flat in 2019 following two years of significant growth. Given that China represents about 10% to 15% of the construction industry segment’s sales and about 5% to 10% of Caterpillar’s overall sales, it is likely to weigh on the company’s results.

Higher Costs to Dent Margins

Material cost inflation will continue to affect Caterpillar’s margins owing to the implementation of tariffs last year. The company estimates a total impact of $250 million-$350 million from tariffs in fiscal 2019. Moreover, sharp increase in demand has led to supply chain challenges. Further, SG&A and R&D spending will continue to escalate owing to investments in growth areas including services and expanded offerings, and some corporate level items.

Price Performance

Caterpillar’s shares have fallen 9.4% in a year’s time, compared with the industry’s decline of 11.2%.

Zacks Rank & Stocks to Consider

Caterpillar currently carries a Zacks Rank #5 (Strong Sell).

Some better-ranked stocks in the Industrial Products sector are Atkore International Group Inc. ATKR, Cintas Corporation CTAS and Sharps Compliance Corp SMED, each carrying a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Atkore International Group has a projected earnings growth rate of 19.8% for the current year. The stock has gained 58% so far this year.

Cintas has an estimated earnings growth rate of 12.74% for 2019. Shares of the company have rallied 59% year to date.

Sharps Compliance has an estimated earnings growth rate of 500% for 2019. The company’s shares have appreciated 25% so far this year.

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