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Caterpillar (CAT)

Table of contents Executive Summary ..page 3 Who Caterpillar is and where they do business ..page 4 Corporate Strategy ........page 5 Caterpillars past financial performance...page 7 Caterpillar versus the competition ...page 8 Caterpillars recent return on investment for investors page 9 Future outlook for Caterpillar ..page 10 Biography .................................................................................................page 12 Exhibits 1-6page13-18

Executive Summary Caterpillar is the worlds largest producer of mining and earthmoving equipment. The major markets where they conduct business are North America, Asia/Pacific, Europe/Africa/Middle East, and Latin America which accounts for 36%, 25%, 25% and 14% of sales respectively. Basically, Caterpillar operates anywhere infrastructure is being created or improved, wherever mining is being done, and wherever large scale construction project are being developed. Their goal is to become the global leader everywhere we do business: Our customers will make more money with us than with our competitors (trefis.com, 2012). Caterpillars business model is intial sale of high quality equipment and aftermarket services on that same equipment over its life cycle. We call it seed, grow, harvest. High-quality machines seed it; parts are the harvest, and growth is the aftermarket down the road. This is really what makes us tick (Thomson Reuters Streetevents, 2012). The keys to their continued success as a company and as investment for shareholders and potential shareholders are: to reduce their costs per unit by better managing their inventory, to continue reducing selling & administrative costs, and to extract the most value from their recent acquisitions. First, the company plans on reducing its inventory holding period, which they plan on doing through the standardization of parts used to assemble the equipment they make and repair it in aftermarket services. Second, the company has implemented a leadership development program for nonmanufacturing employees with the goal of making dealers and management into leaders that are on the same page strategically with Caterpillars corporate. Third, Caterpillar needs to use recent acquisitions to increase in market presence and product line, while at the same time sell off the parts of these full owned subsidiaries that do not match their business model. For example, Caterpillar is presently selling off Bucyruss distribution network to its dealers in order to reduce overall selling and administrative cost while at the same time generating nonoperating revenue. In conclusion, Caterpillars business model is quite simple as the population of the world increases the need for infrastructure and the demand to for fossil fuels will

4 increases in all markets of the world, and this is especially true of developing markets, and this is what Caterpillar is betting on to fuel continued growth in sales--both intial sales and aftermarket services.

Who Caterpillar is and where they do business. Caterpillar Inc.s (CAT) corporate headquarters are located in Peoria, Illinois. Caterpillar has been in business for 85 years under one name or another. Caterpillar Inc. is the world's largest producer of earthmoving equipment. Major global markets include road building, mining, logging, agriculture, petroleum, and general construction (Value line, 2012). In 2011 the company began financial reporting in the following five segments in order to better get a handle on costs: Construction Industries, Resources Industries, Power Systems, CAT financial and other operations which respectively accounted for 33%, 26%, 33%, 5% and 3% of total sales. Construction Industries is responsible for supporting customers using machinery in infrastructure and building construction applications. Resource Industries is responsible for supporting customers using machinery in mining and quarrying applications. Power Systems is responsible for supporting customers using reciprocating engines, turbines and related parts across industries serving electric power, industrial, petroleum and marine applications as well as railrelated businesses. Financial Products Segment provides financing to customers and dealers for the purchase and lease of Caterpillar and other equipment, as well as some financing for Caterpillar sales to dealers (Forbes.com LLC, 2012) Caterpillars products include trackers, scrapers, graders, compactors, loaders, off-highway truck engines and pipe layers. Caterpillar also makes the parts that make up these machines from diesel & turbine engines to the air filters these engines use. Looking at Caterpillars resent acquisition of Bucyrus you get a sense of all the products the corporation actually makes. The first step in integrating the company into the Caterpillar family is to use Caterpillar engines, air filters, and bucket teeth in machines and equipment assembled in their manufacturing facilities to produce their finished products. Once this is done the finished products will be painted with iconic yellow and black and have the Caterpillar name written on them. This is very important to Caterpillars business model since after market service of

5 Caterpillars products is such a big part of their business. This is our aftermarket and business model. We call it seed, grow, harvest. High-quality machines seed it, parts are the harvest, and growth is the aftermarket down the road. This is really what makes us tick (Thomson Reuters Streetevents, 2012). Caterpillar manufactures the majority of their products in the United States, but they have acquired numerous competitors in the United States and internationally. Additionally, foreign sales account for 70% percent of total sales (Value line, 2012), which makes Caterpillar a truly global corporation. The markets that Caterpillar operates in include the United State, Europe, Russia, China, India, Asia, Brazil, and Southern Asia. Basically Caterpillar operates anywhere infrastructure is being created or improved, wherever mining is being done, and wherever large scale construction projects are being developed. Caterpillar focuses on developing markets where they believe they can gain market share, and China is considered the largest developing market and they have worked to establish a footprint to get that done, 16 factories in Asia -- in China today, 11,000 employees and another 11,000 or 12,000 dealer employees(Thomson Reuters Streetevents, 2012). Further the acquisition of ERA/Siwei gave Caterpillar a manufacturing facility within China in the mining industry, which can be used as a platform to expand their other business segments within the country. However, their market share in China declined from 10% to 7% in 2011, according to trefis.com.

Corporate Strategy Caterpillars corporate strategy is called Vision 2020, and was initiated in 2005 and consists of 5 year forecasts in sales growth. First, the company plans on being a superior long-term investment for shareholders through being in the upper quartile of the S&P 500, which they have accomplished for the last 20 years, and maintaining a 25% pull through rate. This means that the corporation plans on their stock appreciation plus their dividend payout to put them in the top 25% of all firms for yearly holding period return. Additionally, the company plans on always paying a consistently growing dividend to their shareholders. Second, the company plans on reducing its inventory holding period, which they plan on doing through the standardization of parts used to assemble the equipment they make and repair in after

6 market service. This will increase their inventory turnover ratio by reducing the number of items they need to keep in inventory and at the same time increase inventory turnover by being used in more finished products. Third, the company has implemented a leadership development program for nonmanufacturing employees with the goal of making dealers and management into leaders that are the same page strategically with Caterpillars corporate goals. Lastly, Caterpillar plans on becoming the global leader everywhere we do business: Our customers will make more money with us than with our competitors (trefis.com, 2012). Caterpillar believes it will create value by positioning itself to become the leader in market share in developing markets, by developing its workforce into leaders through its leadership development program, and strategic acquisitions of competitors to gain access to new markets or increase market share. First, as the population of the world increases the need for infrastructure and the demand to for fossil fuels increases in all markets of the world, this is especially true of developing markets, and this is what Caterpillar is betting on to fuel continued growth in sales in both intial sales and aftermarket services. Second, Caterpillar believes investing in their workforce will position it to benefit from the continuing global growth in GDP. This includes developing their dealers knowledge of products and understanding the business needs of its consumers. Third, strategic acquisitions help Caterpillar to increase its product line and increase their exposure in developing markets and mature markets. This can be best seen through the acquisitions of ERA/Siwei and MWH. The MWH acquisition increased Caterpillars product line to include natural gas reciprocating engines and 600 engineers that specialize in designing and developing natural gas engines, and this is huge since the fracking of the Marcus Shale formation begin in the eastern United States. Further, this technology can also be used to increase Caterpillars presence in other markets such as Europe where landfill gas and waste gas are readily available. Also, the ERA/Siwei acquisition gave Caterpillar an increased presence in China in the coal mining industry, and coal is the most abundant fossil fuel in the world so ignore all the news about the decreased demand for coal right now, think longterm, coal mining will definitely increase in the long-term. In conclusion, Caterpillar Inc. recently affirmed its 2011 profit outlook and offered a rosy forecast for the years ahead because growth in the

7 worlds population and expansion of its cities will create demand for its mining and construction equipment (Construction Safety Dispatch Articles, 2012). Caterpillars past financial performance. Caterpillars financial health by financial ratio analysis, statement of cash flow review and common size financial statement analysis leads one to believe the company is well positioned to grow as a business and as an investment for shareholders or potential shareholders. Starting with a management by exception analysis of the financial ratios for liquidity, asset utilization, and profitability from 2009s stock market low point to the third quarter of 2012 (see exhibit 1). First, Caterpillars liquidity seems stable as the company has the ability to pay their current debts as seen by having a current ratio of about 1.4, but their cash ratio has dropped from .25 to .11, which may indicate that they are having trouble having enough cash on hand to pay present obligations, without liquidating short-term investments. Second, their long-term financing position has improved as both debt to equity and debt to capital have declined. This is also shown through the decomposition of return on equity by the Du Pont identity, which shows the company is deleveraging its capital structure during this time period. This means the company is better positioned to withstand a possible global recession. Third, asset utilization shows a troubling trend in 2012 with inventory and receivables turnover ratios declining and the total operating cycle in days reaching 226 days. This means that Caterpillar overestimated demand for their products and will have scale back production for the time being, till they burn off this excess inventory. It is worth noting that their mining products may be dragging this number down as natural gas is replacing coal as source of fuel for power plants in the United States, and in China demand for coal for steel production has fallen off. Yet, coal is the most abundant fossil fuel in the world so in the long-run the demand for coal mining equipment will increase. Fourth, the profitability of Caterpillar has been increasing since 2009 to the present as shown by the fact that all ratios in this category have been improving. In summary the financial ratio analysis as a company and as an investment, the bottom line is Caterpillar is growing more and more profitable, yet at the same time they will need to slow production in order to burn off their excess inventory.

8 The review of the statement of cash flows and common size analysis of the balance sheet and income statement also shows that Caterpillar is a healthy company that is positioning itself for growth in sales and market share. First, the statement of cash flows (exhibit 4) reveals that the company is generating more revenue from operating activates, specifically that net cash provided from operating activities has increased to $7.01 billion in 2011 from $6.343 in 2009. This shows that companys sales of its product lines are the driving force behind the companys profitability, as opposed to selling off investments in order to temporally boost profits. Next the analysis of the common size balance sheet (exhibit 5) and income statement (exhibit 3) shows the same trends as the financial ratio analysis, but with more detail. The balance sheet also shows the troubling growth of inventory to 17.86% in 2011 up from 10.59% in 2009. Also, short-term and long-term receivables are up, which highlights that Caterpillars customers are taking longer to pay their bills, and the chances of the account being uncollectable are increasing the longer the accounts are outstanding. Also, intangible assets and goodwill has notably increased, but this was caused by their recent acquisitions such as Bucyrus and MWH. On the liabilities side of the balance sheet accounts payable have increased to 10.02% in 2011 from 4.99% in 2009, which shows that the company is having a harder time paying its short-term debts and may face a cash shortage. Yet, the long-term debt has decreased showing the company is deleveraging its self, which will be good for the company and the shareholders if the global economy continues to slow down and goes into a recession. The most important financial from the Income statement is that selling and administrative expense are down. In conclusion, year over year, Caterpillar Inc. has been able to grow revenues from $39.9B to $57.4B. Most impressively, the company has been able to reduce the percentage of sales devoted to selling, general and administrative costs have dropped from 10.66% to 9.07%. This was a driver that led to a bottom line growth from $2.7B to $4.9B (Bloomberg Businessweek, 2012). Caterpillar versus the competition Caterpillars competitive analysis verses industry (exhibit 2) and Volvo, Komatsu, and CHH Global shows that in Caterpillar has annual sales of $60.1billion and a market cap of 58.67 billion, which is substantial greater than their closest competitors. Therefore, only a ratio analysis of the industry and

9 Volvo will be explored using liquidity, asset utilization, profitability, and market values in 2011 numbers. First, in liquidity Caterpillar is below the industry averages, but in line with Volvos numbers. The exception is that Caterpillar has a higher debt to equity ratio, which shows Caterpillars capital structure is more depended on debt financing than Volvo or the industry average. This reliance on debt will increase EPS in times of global growth in GDP, but will hurt the value of shareholder investment if the global economy slips into a recession. Second, Caterpillars asset utilization is better than the industry, but worse than Volvos numbers. Yet, this does not include Caterpillars troubling growth in inventory in 2012, which compared to the industry and Volvos 2011 numbers shows that Caterpillar has too much capital tied up in inventory. Third, the profitability ratios are where Caterpillar really stands out specifically their return on equity which is 38.25% versus Volvos 17.97% and the industrys 26.24% average. This is the effect of relying on more debt financing then the competition and is further shown by their leverage ratio from the decomposition of ROE through the DuPont identity. Fourth, the market value ratios show that as a stock Caterpillar is a much better investment than Volvo or the industry average with Caterpillar having a much lower market-to-book ratio and a lower price to earnings ratio. In summary, Caterpillar is a better investment if the global economy is growing since 70% of their sales are international. Additionally when you take into account their recent acquisitions of Bucyrus, MWH, and ERA/Siwei Caterpillar is really increasing their global market share and product line.

Caterpillars recent return on investment for investors Caterpillar is a blue chip stock that has paid out a consistent dividend since 2002, yet at the same time the companys stock is undervalue according to most investment analysiss which on average claim Caterpillars stock is worth at least $100 dollars per share. If an investor had purchased the stock at some point in 2003 they would have earned a 134.5% return their 10yr investment, when one considers dividend payout and capital gain on the stock price. Additionally, if you look at a the 10yr and 5yr return on investment both are distorted due to market lows; i.e. the credit crisis in 2008, and the combined effect of the 9/11 terrorist attack and the bursting of the dot.com bubble in 2002. Therefore, as an analyst my

10 advice to possible investors in Caterpillar is that you cannot count on stock appreciation because the company stock is sensitive to overall stock market volatility as seen since 2002, yet at the same time the company is paying a consistent dividend. Therefore, overall Caterpillars stock is a solid investment since it is undervalued and has paid a consistent dividend, and if you are lucky enough to buy in when the market is down they have a consistent record of recovering their stocks value.

Future outlook for Caterpillar The future outlook for Caterpillars stock is bright according to Seeking Alpha who projects Caterpillars target stock price by looking at EPS growth and forecasting future earnings, starting with the fact that Caterpillars stock is trading at discount today when one looks at multiples of market to book ratios versus their competition, as seen in exhibit 2. Further, the author uses consensus estimates to predict that EPS will reach $17.49 and stock value of $244.88 in 2016 and then discounts it to the present using a 10% discount rate (WACC), which yields a target price of $152.05 in 2013. This target price seems too high in my estimation because Caterpillars 36-month growth rate is 9.35%, yet all that really matters is what the future numbers will be, and Caterpillars 12-month growth rate in EPS was 78.31% in 2011, according to Hoovers.com. Next, the author calculates the target stock price using a risk enhanced discount rate of 21% and calculates a $124 per share target price for 2013. In summary, Caterpillars target stock price in 2013 is between $100 to $124 per share and therefore is selling at a discount since its present market prices is $85.45, and most analyst value it at about $90 per share (see trefis.com). Additionally, Investors who are looking to invest in construction and equipment industry should choose Caterpillar for the stocks likely appreciation and the fact that the company is paying a dividend with a yield of 2.4%. Whether Caterpillar can reach it projected $80 to $100 billion in sales by 2015 and its goal of $12 to $18 EPS depends on the global economy not slipping into a recession. However, Caterpillar has adjusted its EPS outlook to $12 to $15 and if they focus on the following they can reach this goal by: focusing on shortening how long they hold inventory, continuing to trim their in selling and

11 administrative costs, and maximizing value that they can extract from their latest acquisitions. First, when looking at Caterpillars inventory the thing that stands out is that their inventory turnover ratio is 2.8 (see exhibit 2), yet this is somewhat deceptive since Caterpillar not only has finished goods inventory but also parts inventory, which is used in production of finished products and after market servicing of their products. At the their analyst exposition the CEO mentioned that in the long-term the company is attempting to standardize parts used in production and aftermarket in order reduce the amount of parts that they need to hold inventory, which will create value as their inventory will turnover faster if this initiative is successful. Additionally, in the short-term the company has slow down production of its product line, while at the same time keeping enough inventory on hand in anticipation of markets such as China bouncing back quicker than some people think. Second, the largest gain profits in 2011 came from reducing the cost of selling and administrative cost, which the company credits their leadership program with these gains. Also, at the analyst exposition it was mentioned that the program had only been completed by half of their dealers and employees, so Caterpillar is counting on further reducing selling and administrative costs. Third, the company needs to maximize the value of their latest acquisitions. Take for example, MWH which owns patents on natural gas reciprocating engines, and employs 600 engineers who are creating more products. In the U.S. market this is huge as natural gas has become more abundant and cheaper with the fracking of the Marcus Share formation. Next, look at the Bucyrus acquisition which clearly made Caterpillar the largest supplier of mining equipment. Think about that for a second, and yes for the moment the mining industry is having it trouble with the reduction in coal demand in the United States and China. Yet, in the long-run this is acquisition is going to pay huge dividends, since coal is the most abundant fossil fuel in the world and will be used by the majority of power plants to generate electricity throughout the world in the future. In conclusion, Caterpillars business model is quite simpleas the population of the world increases the need for infrastructure and the demand to for fossil fuels increases in all markets of the world, this is especially true of developing markets, and this is what Caterpillar is betting on to fuel continued growth in sales, both intial sales and aftermarket services.

12 Biography

Bloomberg Businessweek. (2012). Financial statements for caterpillar Inc (CAT). Retrieved from http://investing.businessweek.com/research/stocks/financials/financials.asp?ticker=CAT Construction Safety Dispatch Articles (2012, November 27). Construction equipment manufacturer caterpillar forecasts healthy demand for mining machinery. Retrieved from http://www.dispatchmarketinginc.com/eNewsletters/ConstructionSafetyDispatch/Constru ctionSafetyDispatchArticles/tabid/4859/ID/1442/Construction-equipment-manufacturerCaterpillar-forecasts-healthy-demand-for-mining-machinery.aspx Forbes.com LLC. (2012). Caterpillar Inc (NYSE: Cat) | buy/hold/sell analysis. Forbes.com, Retrieved from http://finapps.forbes.com/finapps/BuyHoldSellAnalysis.do?tkr=CAT
Hoover Inc. (2012). Caterpillar inc. company information. Retrieved from http://www.hoovers.com/industry-facts.investmehttp://www.hoovers.com/companyinformation/cs/company-profile.Caterpillar_Inc.7f9fd7e5b8cf194c.htmlnt-firms.1312.html Seekingalpha.com. (2012, July 5). Buy caterpillar now, 100% margin of safety that stock will double. Retrieved from http://seekingalpha.com/article/703451-buy-caterpillar-now-100-margin-ofsafety-that-stock-will-double

Stock-analysis-on.net. (2012). Caterpillar inc. (CAT), research and analysis. Retrieved from http://www.stock-analysis-on.net/NYSE/Company/Caterpillar-Inc/CommonSize/Income-Statement Thomson Reuters Streetevents. (2012, September). In Doug Oberhelman (Chair) MINExpo Caterpillar Inc. 2012 analyst meeting, Las Vegas. Trefis.com. (2012, February 27). Caterpillar looks on track with vision 2020 strategy. Retrieved from http://www.trefis.com/stock/cat/articles/105132/caterpillars-vision-2020-is-it-ontrack/2012-02-27 Value line. (2012, 11). Change profile display custom report - Caterpillar Inc. Value line investment survey, retrieved from http://www3.valueline.com/secure/vlispdf/stk1700/profile.aspx?ticker=CAT