Caterpillar is a bellwether in the industry sector and, in many ways, a proxy for the global economy. Their outstanding results today are not simply unique to one company but also illuminate many long-term trends impacting the world as a whole, highlighted below.
Caterpillar produces machinery that helps in every segment of urbanization such as construction, mining, energy, electric power generation, and transportation. For Caterpillar to say we had our best year of sales growth since 1947 during last year – a year many companies found to be one of the most difficult to navigate – that’s speaking volumes for both Caterpillar and the economies it serves; namely the U.S. (36%), developing countries (China 9.12%, Brazil 7.67%, and India 6.11%), and other foreign countries (29.47%). With its A+ earnings release today, Caterpillar’s earnings and guidance have sent a vibe that global economic analysts haven’t felt in months: optimism.
Caterpillar beat Wall Street estimates for earnings by $0.55 cents. They also beat on top line revenues with 17.24 billion versus the consensus for 16.02 billion. The beat was mainly due to higher sales of $2.646 billion. Order backlog at the end of 2011 was $29.8 billion – an all-time record. Beyond the earnings and revenue surprises, the company guided revenues higher for the full year, 2012 to $68-72 billion from the 10-20% growth they projected at the end of their third quarter results (which was a range of 63.8-69.6 billion).
Caterpillar and many other global industrial companies have some tailwinds at their back due to long-lasting factors. I see namely three that are easily identifiable and which are already quite well known by investors. They are:
- Population Growth
- Urbanization
- Low Interest Rates
World population is forecasted to grow to 7.6 billion people in 2020 (from 6.9 billion in 2011) based on Caterpillar’s projections. Infrastructure to meet the needs of that many people will need to be put in place in addition to renovation of existing infrastructure to maintain services. In addition to population growth, a mass exodus from agriculturally driven economies in Brazil, China, and many others towards urban centers has been a global growth story for the last three decades. The more the world population expands, the more infrastructure and commodities that will be needed. That means equipment, machinery, and energy production. These are long-lasting economic growth drivers that aren’t going away due to a flood, twister, tsunami, or banking crisis.
However widely known the growth drivers may be, it’s always good to review them in the face of economic headwinds. That’s because we had quite a few last year that affected the economy, including:
- Weather related devastation:
- Japanese earthquake and tsunami knocking out production, consumption, and power generation
- Twisters and flooding in central U.S. destroying property and farming
- Flooding in Thailand knocking out hardware manufacturing and farming (rice)
- Eurozone debt crisis shaking consumer and corporate sentiment causing uncertainty and subsequent austerity measures
- The secondary effects of weather and debt crisis halted global economic growth in its tracks with economists calling for a new bear market and a hard landing in developing economies
Just as the leading components of a manufacturing survey helps forecast economic activity at the macro level, sales and new orders for industrial companies are the leading component of economic activity at the micro level. When looking at leading economic indicators, like the regional manufacturing survey, you want to focus on leading components like new orders. If new orders increase, then that’s production you can expect in the months and quarter ahead. As new orders increase, you might need to hire more employees or invest in capital to increase capacity. In the same way, we can look at huge expenditures in capital intensive industries like Caterpillar’s as a leading indicator on growth, at the micro level.
In finance, you weigh the value earned from a project versus your expenditures on a net present value basis. In laymen’s terms, you don’t buy something you can’t afford based on projected revenue over the expected life of the project/product. In addition, you measure that value against another alternative, called opportunity cost. To make a long-story short, when you buy a large CAT 797F mining truck to haul 400 tons of ore, you are doing it only if you have the forecasted revenue to be able to afford it.
A 23 foot and 9 inch Cat 797F mining truck, hauling 400 tons of stuff, will cost you a cool million (varies according to spec). Not to mention the gallon of gas…per minute…you burn while moving from point A to point B as you move mother earth. With 1,000 gallons in the tank, you can move rock for 16.6 hours before spending ,550 to fill up at the local Chevron station. Oh yeah, don’t forget to penny up for the largest tires in the world (63 inch diameter) that cost 0 per tire. Wait, I forgot a couple more zeroes…I meant ,000 per tire! So when you do the financial alchemy of the cost and benefit analysis of a new 797F truck, and the costs to operate and service it, you’re not going to make an investment like that unless you deem it economical and profitable for your company or government. There’s a lot of planning involved with large capital expenditures.
So as macro investors, when we’re all worried about black swan events and Eurozone debt crisis, you can bet John “Infrastructure” Doe at the government board who’s deciding how many trucks to order for the new desalinization plant or Jan “Norwegian” Doe who’s deciding to buy 100 Boeing 737 MAX airliners are doing the cost and benefit analysis when they place high capital investment orders. You don’t order a million truck or a million dollar plane because you think you’ll have a single good sales quarter ahead. High cost capital investments are factored over a longer time span. As such, capital investments are leading indicators of projected growth at the micro level, and 21 of 24 industrials just reported positive growth from a quarter ago so far in the S&P 500.
The Global Growth or Global Correction Story of 2012
When Caterpillar, Textron, Boeing, Raytheon and 21 other industrial companies surprise us on a difficult quarter amidst a difficult macro environment, we should take notice. The long-term nature of the cost and benefit analysis attributed to capital intensive equipment and machinery from Boeing and Caterpillar’s products make their earnings announcements and guidance all the more important in a murky macro environment. Sure, China is a centrally managed economy. In effect, they don’t need to care about the cost of equipment, as long as it produces jobs to keep the populace busy and happy; but I think that by now, we have learned the Chinese are long-term planners who don’t care about a quarterly earnings estimate. They see the long-term projections for urbanization and population growth and know they will need to continue to invest in their infrastructure and technology to catch up to the West. You might be saying, what about their falling factory utilization rates?
Urbanization isn’t just about factory capacity, it’s about phone networks, sewage systems, energy production and distribution, transportation, food distribution, and shopping malls – things that many developed nations take for granted because we have these things already. Caterpillar sees a major gap here between developed nations and developing nations in the access to paved roads, energy use, mobile phones, motor vehicles, and access to sanitary facilities based on the chart below.
Source: Caterpillar’s BofA/Merrill Lynch Global Industries Conference 12/6/2011, p14
I saw an interview between CNBC and Freeport-McMoRan in which the contributor asked Richard Adkerson whether a China hard landing was off the table after FCX announced a 13% earnings surprise. He didn’t say much about China, but he said the copper market is tight and global copper market demand is improving. He also stated they’re planning an exploration budget increase of $275 million. He might not have said much on China specifically, but he’s definitely putting his money where his mouth is on global growth with a larger exploration budget and triple the mill output at Cerro Verde.
European headwinds are dying down. The charts I look at show a falling Euro Ted spread, falling sovereign yields due to improved auction results on short-term to 3/year paper, and falling interbank rates. An interesting test will come next Monday when Italy auctions off 5 and 10/year paper – durations that are longer than the ECB’s 36m tenders. I think that will be an important hurdle to gauge sentiment in the credit markets.
There are many headwinds still facing the global growth story due to a slowdown in Europe and China. We’re all connected in a global economy and we’re all affected by the central bank policies of one economic region or another. We’ve had 17 straight weeks of stronger U.S. economic news, and the news this week continues to show economic improvement, with the leading economic indicators (LEIs) today suggesting that trend will continue. There are some long-standing tailwinds however that haven’t gone away just because of a housing crisis in the U.S. or a sovereign debt crisis in Europe. The population is still growing, and urbanization of developing nations continues to narrow the gap with developed economies. Central Bank intervention is working to turn things around. The only question is how much inflation will be needed to prop the global economy to combat deflationary effects from contracting credit in Europe. I think gold’s trying to answer that question now, but I’ll save that for another wrap up.
