Flattening Dealer Inventories Doesn't Change Our Long-Term Thesis for Caterpillar

Equity Analyst

Dawit Woldemariam

Revenue segments as reported by the company.

Sales of Machinery, Energy & Transportation

Revenues of Financial Products

Revenue Segments

Revenue is the money generated from normal business operations. Gross Profit is revenue minus cost of goods sold. Operating Income is revenue minus cost of goods sold and other operating expenses.

Revenue

Gross Profit

Operating Income

Revenue & Operating Income

Net Income, also called net earnings, is calculated as revenue minus cost of goods sold, operating expenses, depreciation, interest, taxes, and other expenses.

Net Income

Gross Profit, Operating Income, and Net Income as a percentage of Revenue

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Operating Margin

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Margins

An operating expense is an expense a business incurs through its normal business operations. Often abbreviated as OPEX.

Selling, general and administrative

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Year over year growth in Revenue and Operating Expenses.

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Shares outstanding refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company's officers and insiders.

Outstanding Shares

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Also known as Price/Sales Ratio. Calculated using Average market cap for the quarter / Annualized quarterly revenue.

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We believe Caterpillar will continue to be the leader in the global heavy machinery market, providing customers an extensive product portfolio consisting of construction, mining, energy, and transportation products. For nearly a century, the company has been a trusted manufacturer of mission-critical heavy machinery, which has led to its position as one of the world’s most valuable brands. Caterpillar’s strong brand is underpinned by its high-quality, extremely reliable, and efficient products. Customers also value Caterpillar’s ability to lower the total cost of ownership. 

The company’s strategy focuses on employing operational excellence in its production process, expanding customer offerings, and providing value-added services to customers. Since 2014, Caterpillar has taken steps to reduce structural costs and its fixed asset base by implementing cost management initiatives and by either closing or consolidating numerous facilities, reducing its manufacturing floorspace considerably. Over the past decade, the company has continually released new products and upgraded existing product models to drive greater machine efficiency. Customers also rely on the services that Caterpillar provides, for example, machine maintenance and access to its proprietary aftermarket parts. Furthermore, its digital applications help customers interact with dealers, manage their fleet, and track machine performance to determine when maintenance is needed. 

Caterpillar has exposure to end markets that have attractive tailwinds. On the construction side, we believe the company will benefit from the $1.2 trillion infrastructure deal in the U.S. The country’s road conditions are in poor condition, which has led to pent-up road construction demand. In energy, we think the improvement in the price of oil since COVID-19 lows will encourage exploration and production companies to increase oil and gas capital expenditures, leading to increased sales of Caterpillar’s oil-well-servicing products. That said, we believe mining markets will have limited upside, as fixed-asset investment growth in China starts to slow, likely capping commodity price upside.

Business Strategy & Outlook

We assign Caterpillar a wide economic moat rating, underpinned by intangible assets and switching costs. Throughout its history, the company has consistently provided customers with reliable, high-quality products, while offering the lowest total cost of ownership. These factors have led to Caterpillar becoming one of the world’s most valuable brands. The strength of its brand and extensive dealer network has solidified Caterpillar as the market leader for heavy machinery equipment. The global heavy machinery market is led by large players like Caterpillar that can deliver world-class products, in addition to value-added services to customers through its global dealer network. It is a leading player in many of its end markets with particular strength in construction and mining products. We believe smaller local and regional competitors will struggle to win market share in these end markets globally, allowing Caterpillar to maintain its strong market share positions. 

Looking across the heavy machinery industry, Caterpillar offers some of the most reliable, high-quality, and efficient products. The company’s products can be categorized in three groups: lifecycle performance (medium- to heavy-duty applications), lifecycle value (light- to medium-duty applications), and utility (light-duty applications). These products provide a wide range of value propositions based on customer type. Lifecycle performance customers value premium products (high specifications and features) that can withstand high utilization, operate around the clock, provide the lowest total cost of ownership, and ultimately measure machine success by cost per work completed. Lifecycle value customers gravitate toward simpler products for less extreme operating conditions that hold up on performance and quality. These customers tend to be more price conscious than lifecycle performance customers and have been a challenge to serve in the past. Caterpillar has since changed its approach in recent years to develop products that address customer-specific performance needs in this customer segment. 

Utility customers are the most price sensitive—success is measured by cost per hour—and operate primarily in emerging markets. Caterpillar serves utility customers through its SEM brand, with low-feature products that are specifically designed with the cost-conscious customer in mind. Caterpillar’s strategy to launch new offerings focused on customer needs by segment has led to the development of high-quality products customers value, strengthening its brand and competitive positioning. We believe Caterpillar benefits from pricing power, manifested from its brand familiarity of more than 90 years and complex customer needs. Customers come to Caterpillar not only for the best products in the industry but also for its ability to provide aftermarket parts on-demand and services to keep their machines running to get projects completed. 

Caterpillar is focused on offering products with the lowest total cost of ownership, which takes into consideration both purchase and future costs. In addition to the initial purchase price, owners weigh how much it will cost to operate and maintain a machine. Future costs include labor costs, maintenance and repair costs, costs for spare parts, fuel costs, and insurance costs, to name a few. Customers in developed markets typically look for machines that help minimize future costs and are not necessarily looking for the cheapest up-front equipment (primarily a focus for customers in developing markets). Cheaper equipment can increase the likelihood of machine failure during operation, leading to lost productivity that cuts into an operator’s profitability (mission-critical equipment). Many of Caterpillar’s competitors talk about providing customers the lowest total cost of ownership, but we think Caterpillar is the market leader. Its products employ better efficiency and output (measured by cost per work completed or cost per ton) for customers compared with competitors, allowing them to spread costs over the lifetime of equipment (operating leverage as work output increases). This dynamic supports its brand value in the eyes of customers looking to optimize their operations. 

Fuel consumption costs are another lever that operators can focus on to drive down total ownership costs. Caterpillar offers a wide range of products that enhance fuel efficiency, specifically through its diesel-electric and electric drivetrains offerings. These products also help the company address carbon emissions concerns, which is increasingly a point of focus for government authorities. We think Caterpillar’s risk to increased emissions regulation is moderate given its continued focus on producing next generation products that reduce machine emissions. 

When it comes to labor costs, Caterpillar helps customers reduce labor costs through improved product efficiency (new features help customers complete jobs faster). For example, new product models continually introduce better operator control, comfort, and visibility through the machine cab (in addition to cameras that offer 360-view of a job site). Caterpillar has also benefited from its ability to bring down maintenance costs for customers by increasing machine connectivity over the past decade. More than 1 million of its assets are connected to its digital platform (out of 2 million assets in the field). Newly assembled machines are equipped with technology (the company is also working to retrofit machines in the field) helping both customers and the company track data (machine utilization rates and productivity) to inform future service needs. Caterpillar’s large parts distribution network and product support offering through its dealer network keep service intervals reasonable, increasing machine up-time and optimizing the total cost of ownership.

Caterpillar’s exclusive dealer network is a key tenet to its strong competitive positioning across multiple geographies. The breadth of Caterpillar’s dealer network is unmatched, with 160 dealers operating about 2,700 branches globally. The company has significant presence on every continent and sells most of its products through its dealer network (turbines and locomotives are sold directly by Caterpillar). These dealers are often very large organizations that exclusively sell Caterpillar products. We think it’s very difficult for existing competitors and new entrants to replicate the size and coverage of Caterpillar’s dealers. Fully stocking a branch is challenging without similar product breadth to Caterpillar, hence, why many competitors’ products are sold at dealerships that carry multiple product lines. Caterpillar’s value proposition not only consists of its high-quality products, but it also includes the reliable product support provided by dealers. When customers need parts or machine servicing, they can rely on the dealer network to reduce their machine down-time. 

Caterpillar’s increased focus on its installed base through aftermarket and service offerings keeps customers from switching. The company’s machines and engines perform mission-critical functions for large construction, mining, and oil drilling projects. Caterpillar’s products are known for their durability and quality, despite operating in extreme conditions. For customers, switching to an alternative product poses significant risk to their operations, with the potential for project disruptions from machine failures and long lead times to service equipment. Caterpillar’s service agreements give customers priority on proprietary aftermarket parts and services from dealers, making it easy to understand what the total cost of a machine will be throughout its operating life. We also believe the high cost of failure associated with switching away from Caterpillar’s products increases the likelihood of elevated projects costs, ultimately cutting into a customer’s profitability. 

Furthermore, customers invest a significant amount of time and money into machinery, creating additional friction to switch products. The purchase price of heavy machinery can run up into the hundreds of thousands (can get into the low-million-dollar range for new mining trucks), in addition to the time it takes machine operators to fully train on a machine to reach optimal productivity to complete projects on time. Caterpillar also benefits from long product upgrade cycles, particularly in mining, where mining trucks have a useful life of over 10 years. In our view, these factors alone keep customers from switching, but the strongest reason keeping customers put is Caterpillar’s aftermarket offering. The company’s parts distribution and extensive dealer network provide customers with aftermarket parts and reliable services to ensure their equipment operate efficiently, saving them from the headache of machine down-time and from having to search for parts independently. 

We do not believe Caterpillar’s wide economic moat faces any substantial threats from environmental, social, and governance risks. Caterpillar has exposure to product safety issues and carbon emissions regulation, but we do not view them as material enough to include in our valuation. Product safety issues include both customer injuries while operating Caterpillar machinery and injuries suffered by Caterpillar employees in the production of products. Carbon emissions regulation is increasingly a topic of discussion, but we think Caterpillar is already hedging against this risk through the development of next-generation products that reduce the carbon emissions of its products, namely its diesel-electric and electric drivetrains. Additionally, we think the effect from climate change initiatives will likely be incremental rather than immediate. In our view, the immediate threat is to new oil wells on federal lands, rather than the private lands that shale firms operate on. The increase in renewables, electric vehicles, and cleaner internal combustion engine vehicles will likely have a modest impact on fossil fuel demand in the next 10 years.

Wide

Economic Moat

Caterpillar

Solar Turbines is a designer and manufacturerer of industrial gas turbines for onshore and offshore electrical power generation, for marine propulsion and for producing, processing and transporting natural gas and oil. Solar Turbines is one of the world's leading producers of industrial gas turbines up to 30,000 horsepower (22,000 kW). There are more than 15,000 Solar Turbines gas turbine systems installed in over 100 countries worldwide that have collectively logged more than 2 billion hours of use.

Solar Turbines

Perkins Engines is primarily a diesel engine manufacturer for several markets including Agricultural, Construction, Material Handling, Power Generation and Industrial. Over the years Perkins has expanded its engine ranges and produces thousands of different engine specifications including diesel and gas engines.

Perkins Engines

Progress Rail Services is a supplier of railroad and transit system products and services and has become one of the largest integrated and diversified suppliers of railroad and transit system products and services in North America. Progress Rail markets products and services worldwide and maintains 110 facilities in the United States, 34 in Mexico, four in Canada, two in Brazil, five in UK, one in Italy, and one in Germany. Progress Rail is organized into two divisions: Engineering & Track Services and Locomotive & Railcar Services.

Progress Rail Services

Caterpillar, Inc. engages in the manufacture of construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. It operates through the following segments: Construction Industries, Resource Industries, Energy and Transportation, Financial Products, and All Other. The Construction Industries segment supports customers using machinery in infrastructure and building construction applications. The Resource Industries segment is responsible for supporting customers using machinery in mining and quarrying applications and it includes business strategy, product design, product management and development, manufacturing, marketing, and sales and product support. The Energy and Transportation segment supports customers in oil and gas, power generation, marine, rail, and industrial applications. The Financial Products segment offers a range of financing alternatives to customers and dealers for caterpillar machinery and engines, solar gas turbines, as well as other equipment and marine vessels. The All Other segment includes activities such as the business strategy, product management and development, and manufacturing of filters and fluids, undercarriage, tires and rims, engaging tools, and fluid transfers. The company was founded on April 15, 1925, and is headquartered in Irving, TX.

Earnings data Q2 2023

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We see those iconic yellow machines at nearly every construction site.

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