1 Marc Igneri

Caterpillar Inc. Exchange: NYSE Ticker: CAT Market Capitalization: $56.73 billion December 3, 2010 closing price: $89.38 52wk Range: $50.50-89.49

For the sake of highlighting Caterpillars most recent achievements, quarterly financial statements are replicated. Throughout the paper, comparisons to previous annual reports will be encompassed. It is important to recognize that Caterpillar has only recently started to reshape positive financial statements.

Established in 1925, Caterpillar is arguably the worlds largest supplier of machinery equipment for various outputs including mining, construction and agriculture. Caterpillar dominates its industry and has the largest manufacturing capability in the production of gas turbines, diesel and natural gas engines, tractors, excavators, and components for various locomotive, marine and petroleum applications. Major competitors include Deere & Co, Joy Global Inc., and Komatsu Ltd. Caterpillar Inc. ranks number one in its industry with a market capitalization of $56.73 billion. The Dow Jones industrial average includes Caterpillar in its 30 companies. Caterpillar also has subsidiary units including Caterpillar Financial and Caterpillar Insurance. The corporation is known for their aggressive acquisition schedule and since 2008 Caterpillar has bought over 15 companies. Its most recent acquisition deal was reached with Bucyrus International, Inc. The Bucyrus acquisition will provide Caterpillar with significant resources in surface and underground mining equipment allowing them to further undermine competitors such as Joy Global. With this in mind, the objective of the report is to investigate Caterpillars strength as a global competitor. The corporation is an American icon and it remains one of the strongest multinationals in terms of export operations. The report will aim to support Caterpillars short and long term positions. Growth prospects and effects on operations will

3 also be examined. All ratios and calculations will be based on the latest financial statements as of 9/30/2010. By default, Caterpillar follows GATT regulations. The fiscal year is January 1December 31. Caterpillar has been known for aggressive accounting practices by which investors consider a level of risk. The accounting and governance-rating ratio, currently measured at 5, has been declining steadily since levels of about 35 in 2008. An important aspect to take into account when considering this decline is the corporations stance on acquisitions. It was in 2008 when the company began ramping up its buying schedule. Caterpillar took significant hits to financial statements because of massive goodwill payments that were to be made on its acquisitions. However, when analyzing this company it is important to understand the growth factor in its fundamentals. Caterpillar took a hit during the global crisis because infrastructure and construction progress in many areas of the world came to a halt. The corporation, having a great deal of cash on hand, decided to grow operations organically. The payoff proved to be tremendous and in 2010 the company recently altered its accounting practices so that goodwill expenses are not paid. This will generate $80 million plus in earnings and will translate to an annual earnings per share increase of 18 cents. Investors may find Caterpillars fundamentals more appealing after this notion to hide such expenses. Investors have no doubt that the amount of resources from both internal growth and acquisitions will allow for Caterpillar to enter an entirely new level of operations in the upcoming years. Equity investors have confirmed this notion with Caterpillars stock price up 56.8% year-to-date. Getting down to the fundamentals, Caterpillars short-term liquidity is on par with its industry levels. The current ratio is 1.42, indicating that Caterpillar has $1.42 of current

4 assets for every $1 of current liabilities. Taking in to account high inventory levels, an acid test of 0.97 shows the effect of Caterpillars inventory on liquidity. This could indicate that Caterpillar has a long turnover time for inventory, which is not ideal. It should be noted that the quick ratio has been declining and is down from 1.06 on 12/30/2009. Caterpillar most likely transferred a great deal of their acquisition inventories to their own balance sheet, so this may not be the most accurate measure of liquidity. Until Caterpillar can work out its stale inventory, investors should pay closer attention to the current ratio so as to not penalize Caterpillar for its acquisition inventories. Caterpillar has a solvency ratio of 1.17 revealing that it has $1.17 of total assets for every dollar of total liabilities. This number is decreased slightly from the current ratio, showing the effect that the high long-term debt has on its solvency. Looking further into the corporations solvency, the total debt to assets is 0.46. This means that for every $1 of assets, $0.46 was financed by debt. Even when using the long-term debt to assets ratio, the number is still 0.33. Thus it can be said that the company has a high level of long-term debt. This is significantly higher than Joy Global but still lower than Deere & Co. Caterpillar has always been known to have massive debt multiples to cash balances. Its use of debt is righteous however, as it can be seen that the long-term debt peaked on the 2008 balance sheet and has been declining since then. Again, this is a consequence of the bold acquisition plan. The long-term debt to equity ratio truly shows Caterpillars inclination towards debt financing. The LTD/equity ratio is currently 2.07 meaning that Caterpillars debt financing is 2.07x the amount of financing received from shareholders equity. Analyzing the total debt to equity ratio of 2.91 shows a strong similarity to the relationship between the total debt to assets and long-term debt to assets. Finally, the startling amount

5 of total debt to cash shows just how levered Caterpillar is. The total debt is currently $28.61 billion compared to the 9/30/2010 cash balance of $835 million. The amount of long-term debt compared to current cash levels is absurd. If Caterpillar were to lose say, 15% of its operating level, the company would struggle to survive and bankruptcy would become a real threat. Caterpillars capital structure is highly levered towards debt relative to equity. Given the recent commodity boom and the continuation of this trend, combined with the huge rebound from emerging markets, Caterpillar remains in a dominant stance and will almost surely experience large growth in its operating levels as opposed to the risk of any decline. Caterpillars products are in high demand and the company has added over $1 billion in receivables since 6/30/2010. This shows the very promising road lying ahead of Caterpillar as a worldwide supplier. If sales contracts have increased so much over one quarter and continue to do so, the effects will benefit for years to come. To gain a quantitative measure of Caterpillars risk of bankruptcy, the z-score is calculated to reveal the chance of default. The z-score is calculated as: Z-score = (EBIT/Total Assets)x3.3 + (Net Sales/Total Assets)x0.99 + (Market capitalization/total liabilities)x0.6 + (Working Capital/Total Assets)x1.2 + (Retained Earnings/Total Assets)x1.4 = .0639 + .1788 + .6570 + .1635 + .4759 Caterpillars z-score = 1.5391 A z-score lower than 1.8 generally indicates a high risk of financial distress. However, the z-score in the situation of Caterpillar is a poor generalization of bankruptcy risk. The corporation carries a high level of debt, much of which was generated for the financing of acquisition purchases over recent years. Caterpillar has no reason to continue

6 increasing debt levels and the z-score should work itself out to normal ranges of 3.0 as Caterpillar continues paying down debt by generating massive cash from operations. Caterpillar has a trailing 12-month return on investment of 4.81%. This number should continue to rise as Caterpillar becomes more efficient in using resources gained from takeover operations. The return on assets shows similar performance at 3.14%. Comparing this to the return on equity at 22.05% shows that Caterpillar is not yet able to maximize production capacity from operations. Capital from assets and investments will continue to rise year-on-year as the company ramps up operating efficiency. Caterpillars turnover ratios and income statement will be examined next. The total asset turnover is measured at 0.6x. For every $1 of assets, Caterpillar generates $0.60 in revenue. Once again this is a consequence of not maximizing efficiency on newly acquired resources and should continue to improve. The accounts receivable turnover is 5.3x indicating that the company collects its receivables 5.3x annually. This is a very impressive number and shows the high demand in Caterpillars products. Caterpillars current inventory turnover is 3.4x, which means they replenish inventories 3.4x annually. This is already a strong number and as Caterpillars operations grow year-on-year, the inventory turnover should rise considerably to keep up with demand. Caterpillar posted $10.45 billion of revenue in Q3 2010 ended 9/30/2010. Compared to one year earlier, the company was reporting revenue of $6.6 billion representing a 58.33% increase year-on-year. Beating on the top line indicates strong demand for products and should benefit many of the areas in which Caterpillar is fundamentally lacking. Another important figure was Caterpillars reduction in cost of goods sold year-on-year. In Q3 2009, COGS was 83.72% and as of Q3 9/30/2010, the number is 76.34%. Most impressively, Caterpillar has more than quadrupled

7 operating income from Q3 2009 from $236 million to $1.19 billion. Caterpillar has also been reporting considerable increases on bottom line strength and posted a net income of $792 million as of 9/30/2010. As of 9/30/2009, the net income was $404 million

representing a 96% increase year-on-year. Caterpillars strong income statements will eventually correct the balance sheet issues that weigh down the financials. In Q3 2009, Caterpillar had a gross profit of $3.16 billion and a gross margin of 28.34%. The gross margin level has been steadily increasing and is up from 23.04% year-on-year. This is a strong figure, as global inflation has been pushing up the cost of supplier goods. Many manufacturers at this time are struggling to increase margins due to these cost increases, so investors should consider Caterpillars strength in this area. Recent earnings per share levels also support Caterpillars bottom line growth. Caterpillar reported Q3 2010 EPS at $1.22. In Q3 2009, Caterpillar posted a $0.64 EPS for a year-on-year growth of 90.63%. In 2009 the annual EPS was $2.18 and forecasts for 2010 are pointing to an annual EPS of $3.91. This is a 79.36% increase annually. Currently, Caterpillar trades at a price-toearnings ratio of 29.48. This is 112.64% higher than the industrys average but is justified by the growth of Caterpillars EBITDA. Investors value Caterpillar to trade at 17.5x enterprise value/EBITDA. Judging by the massive growth of operating income, the company should have no problem maintaining this investor projection and value should increase as Caterpillar continues to beat on EBITDA estimates. The book value per share for Caterpillar is $15.50, which equates to a book value of $9.84 billion. Caterpillars book value is significantly higher than any of its competitors and reinforces its strength as number one in its industry. Caterpillar also has appealing operating cash flow figures. The company has

8 increased its cash flow from operations steadily year-on-year and in Q3 2009 was $6.34 billion. While the number has not grown massively, it will take time for operations to reach max capacity. Investors should note that this important figure will continue to grow yearon-year and operating cash flow also reveals just how competent the company is on supplydemand level. In comparison, the Q3 2009 figure for cash flow from investing was $-995 million. Cash flow from financing is $-1.49 billion. These vast differences in the statement of cash flow show the reliance of Caterpillar on its manufacturing capacity and operations. To offset the increasingly negative cash flow from investment and financing, Caterpillar has no other choice but to expand its operating levels. Caterpillar currently has an under-funded pension plan. For the fiscal year 2009, Caterpillar had $11.83 billion in total pension assets. Pension obligations for the same period were $855 million. The pension plan return on assets is $-958 million. Caterpillar has 67% of its pension plan in equity so this number should improve as global equity markets continue their bullish sentiments. For 2009 the pension plan was under-funded by $3.78 billion showing that liabilities exceed assets considerably. Although the effects of the under-funding suppress the effect of strong earnings, investors should not pay much attention to these obligations when considering operations growth. However, by correcting the pension obligations, Caterpillar can eliminate this negative earnings weight. One of Caterpillars competitive advantages is its overwhelming international presence. Over the past decade, the US dollar has continued to decline. Combined with a huge growth of emerging market economies, Caterpillar has experienced huge amounts of demand. The falling dollar and the steady increase in mining, construction and agricultural operations has led to Caterpillar placing most of its operations overseas. In fact, the U.S.

9 only represents roughly 33% of sales. This is one of the reasons for Caterpillars huge success and establishment as a global brand over the past years. On top of this, many of Caterpillars acquisitions since 2008 have been overseas companies. Caterpillar buyouts include companies from Brazil, Canada, China, Germany, Japan, and South Korea. Operations in Japan, China, and South Korea have represented much of Caterpillars sales during recent years. It is apparent that Caterpillar seeks to capitalize on the growth opportunity in the infrastructure and economies of these emerging nations. A definitive assumption would be that Caterpillars revenues would increase from the effect of a weaker dollar. Investors consider this effect in their projections and a weak dollar will prove to be a catalyst for massive future growth. The effect of a weak dollar also increases as foreign currencies continue to appreciate. The yen is trading at an all time high and Chinas yuan is significantly undervalued. Caterpillar receives the highest demand from Japan, which is in line with the appreciation of the yen to the dollar. Komatsu Ltd., a Japanese domestic competitor of Caterpillar, has been less than desirable and has experienced decreasing demand as Caterpillar increases operations. In 2010, Caterpillar is one of the strongest manufacturing corporations with an international presence. The corporation has taken many risky actions, especially through its acquisitions, but continues to outperform its segment and will grow accordingly. There is no doubt that Caterpillars stern moves to grow organically when other companies were struggling to survive proves that the future is promising. Even though the company has a less than desirable balance sheet and cash flow statement, the true strength of its income statement offsets any worries. The corporation is poised to grow operations at a rate that dwarfs industry averages in the five-year spectrum. With this being said, a prospective

10 investor must consider whether Caterpillar can offer desirable returns. Caterpillar is saturated with debt and most investors should probably avoid purchasing bonds in this situation. Although Moodys carries an investment-grade rating of A2 for Caterpillar, yields are less than attractive when compared to an equity investment. Just two weeks ago, CAT Financial made a $150 million bond offering to Hong Kong investors. The coupon rate is a mere 2%, but is reinforced by the anticipated growth of Caterpillars EBTIDA. Similarly, a short-term creditor should not shy away from lending to Caterpillar. Any notes that Caterpillar carries have a very slim chance of default and thus short-term creditors will find Caterpillar to be a quick return on investment. The corporation should have no problem paying off these new bonds or any debt financing for that matter given the level of cash on hand and future growth. This is surely the much less risky route of investment, but investors must consider investing in CAT stock to seek higher returns. Caterpillars stock is currently up 56.8% year-to-date. Prior to the forced sell-offs and diminished product demand of 2008, the stock was trading at a high of about $82. Investors seem to be recognizing the underlying potential for demand growth of Caterpillar. When trading the stock, it is important to favor technical analysis over fundamentals. Caterpillar has a long road before its financial statements become ideal and so investors should seek bullish indicators on the behavior of the stock price.

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The above charts help to break down investor sentiment on the stock of Caterpillar. First and foremost investors should take attention to the simple moving average, represented by the yellow line in the price chart. The simple moving average is currently sitting well above its 200-day moving average, and also the 50-day moving average. This immediately indicates that the stock is trading in a new range and the steady increase of the simple moving average shows that the upside potential is still strong. The money flow index currently shows that Caterpillar is overbought, which is in line with recent news

12 releases and insider transactions. Following a strong Q3 earnings report, investors have converged quickly on the earnings growth of the company and have began to factor this in to the price. However, it should be noted that investors sold-off on the companys earning report in October and although the stock quickly moved to an oversold position, it held its stock price. The momentum shows the nature behind the money flow in that there is significant buying momentum. Typically this would mean that there is a much higher ratio of buyers than sellers. It can be said that for every share sold of Caterpillar, there is more than one buyer who will enter a new position. This behavior shows the buying pressure on the stock and indicates that selling is drying up. This drives the price up due to investor demand on the purchase of new shares. Institutional and retail investors looking to enter into a Caterpillar position will be inclined to place money in the stock rather than bonds. The equity return potential outperforms bond yields with the anticipated upside from both internal operations and technical stock indicators. With solid receivables and inventory turnover, Caterpillar can offer high sales potential to suppliers and users of goods and services, but the extent of Caterpillars internal operations allows for little reliance on external suppliers of goods and services. In conclusion, Caterpillar holds a top spot in its industry and will maintain its dominance as it continues to expand internal operating capacity through global expansion and organic growth. I would certainly consider Caterpillar as a potential career choice. The company has strong management and the benefit potential is high due to increasing growth. With such promising future demand, career prospects should pay mind to Caterpillars raw competence. For myself, I consider CAT Financial to be attractive in that they do a great job in supporting internal financing and investment positions. Ultimately, I would favor a

13 position on a sales team in Caterpillar to capitalize on my heavy global interest and my skill set. I believe that I would excel as a member of Caterpillars sales team. I am confident in Caterpillars products and its ability to outperform competitors and for this I have potential as a great sales asset supported by my applicable skill set.