Slow Innovation Will Hurt Revenue Growth in Global Markets

Company Catalysts

Shrinking Buybacks Will Spook The Market

Caterpillar's stock buybacks have declined by 51% YoY. The great Warren Buffet is a personal fan of share buybacks and labelled anyone who criticised them “either an economic illiterate or a silver-tongued demagogue”. Generally, stock buybacks are an indicator of a company’s strong cash position or belief that their share is undervalued, hence buying it back. So what does the inverse imply? While a decline in buybacks isn’t necessarily a red flag, as it may be done to increase investment back into the company to spur growth, it may indicate that the company’s cash flow forecasts can’t support it, or that they believe their stock price is too expensive.

Caterpillar’s decision to cut stock buy backs could have a negative impact on market sentiment and potentially harm the current share price, despite the fact that it could provide more value in the long term if the company reinvests the money that would otherwise be distributed.

Technological developments from competitors could see Caterpillar fall behind.

The trend towards automation, remote operation and electrification of heavy equipment could invite competitors willing to operate on lower margins. Companies such as Oshkosh, Komatsu, Cummins, Volvo and Westinghouse Airbrake Technologies might put pressure on Caterpillar's business model and profitability.

Heavy Macchinery carbon footprint - CityLogistics

Electrification has already caught the automotive world by storm (just take a look at Tesla’s valuation) and the reverberations are already making their way to the heavy equipment sector. The likes of Komatsu already have 7 battery electric mining haulage trucks available on their website and therein could lay the problem for Caterpillar. They may have missed the bus. Caterpillar announced its first successful demonstration of a battery electric prototype back in November 2022 with commercial scale production timelines not mentioned. Caterpillar lagging behind competitors with technological advancements like electrification could be the impetus behind a rapid loss of market share. Besides helping mining companies meet sustainability metrics, battery electric heavy machinery also offer instant torque, greater maneuverability, independent wheel control and an easier adoption of automated driving capabilities. The benefits electric heavy vehicles provide could be incentive enough for end-customers to overlook Caterpillar in favour of an electrified competitor.

The heavy machinery business has reached a new frontier of sorts. Many of the business operating here have done so for decades, but innovations in machine learning, artificial intelligence have paved the way for a new race to secure market share. Utility to the end customer will become an important determinant on which consumers will head. For example, if Komatsu can provide a front-end loader to a customer with the same horsepower, bucket capacity and operational weight but it’s more economical and is able to automate some workflows, it’s a no-brainer that a customer would choose that at an appreciable premium over a similar offering from Caterpillar that may fail to comply with future sustainability regulations and lacks future-proofing if automated work-sites become more commonplace.

Regional and Competitive Dynamics

Caterpillar's future performance could be hampered if competitors with regional advantages or more affordable contract terms gain momentum. The company has relied on the technological superiority and longevity of their machinery to deliver above-average returns, but this edge could diminish over time. Sany Heavy Industry Co is one prime example of a Chinese multinational heavy equipment manufacturing company that has arisen to form viable competition against Caterpillar. Sany is no small fish either, it is the fourth-largest heavy equipment manufacturer in the world, and the first in its industry in China to enter the FT Global 500 and the Forbes Global 2000 rankings.

Construction Equipment manufacturer market share - BigRentz

Sany’s arrival on the scene has effectively crushed Caterpillar’s ability to achieve any meaningful market share gains in the developing Asia-Pacific region for the construction and mining segments, with this being evident in the most recent earnings report detailing lower sales volume in the region, despite industry picking up post-COVID. Caterpillar’s Asia-Pacific operations saw a 21% decline in revenues, 17% of which was purely from a decline in sales. The Asia-Pacific region is such a key market for Caterpillar to try and make ground in, considering the likes of India announcing that under the National Infrastructure Pipeline (NIP), projects, Rs. 108 trillion (US$ 1.3 trillion) of projects are currently underway. This would be a super valuable opportunity for Caterpillar, but Asiatic competitors will undoubtedly have the upper hand in securing sales in this region and thus threatens to hamper Caterpillar’s growth in the Asia-Pacific market even further.

As these brands penetrate deeper into their home market, their recognition begins to grow and Caterpillar faces the possibility of even losing out in other essential markets like Latin America and Europe. While Europe-Africa-Middle East grew 5% in the most recent quarter, Latin America declined by 4% much like Asia-Pacific.

Edging closer to market saturation

Caterpillar operates in a mature and highly competitive market with limited opportunities for significant growth. Caterpillar is already the largest manufacturer in the construction industry when it comes to heavy machinery sales, but with competition heating up, the likelihood here is that Caterpillar loses market share to other companies in the segment as they may already be reaching saturation. The global construction industry is set to reach $334 Billion by 2030, representative of an equivalent growth of 7.9% annual growth and up from $183.4 Billion in 2022, but this growth may not even be enough to support the market’s cur current growth expectations for Caterpillar. To put it simply, even if Caterpillar wasn’t to lose market share to competitors, the anticipated growth of the construction industry may not be enough to support the current valuation for the company.

Industry Catalysts

Cyclical industries aren’t great for consistent long-term growth

Mining and Construction are very cyclical industries, there are periods of booms and busts. Timing the market here could be just as, if not more important than new product innovations. Irrespective of R&D spend, marketing, reputation or product quality, if the economic cycle isn’t conducive to growth in a given period, then declines will be common. Given the cyclical nature of the economy, surpassing its previous peak in sales ($55.7B in Q2’19) may prove challenging.

Right now, global economic conditions are uncertain. Inflation and interest rates are running red hot and, although expenditure on infrastructure projects have still been high, there’s no guarantee this will continue over the course of 5-10 years, let alone the next 12 months. The longer economies endure this tough economic conditions, the more likely it is that infrastructure spending slows and newer mining projects struggle to achieve funding. The outcome for this would be a significant decline in sales growth for the likes of Caterpillar and its competitors.

Input Material Scarcity

Machine and Equipment manufacturers compete for the same chips used in electrical vehicle manufacturing, an uptick in demand for EVs could mean that companies like Caterpillar experience a shortage in materials needed to produce their products. Productions levels decline and so too does new equipment sales, despite the demand being present. While chip shortages are being resolved, there are still grave political concerns with securing Taiwanese made semiconductors for the long-term. Should anything happen which interrupts the flow of new chips heavy machinery manufacturers, margins could see a sharp decline as the companies scramble to secure higher-priced American made chips.

Increasing operational costs

Operational costs in the heavy machinery segment are rising due to increased raw material costs and labor costs. These higher costs may reduce the company's profitability unless they can be passed on to customers through higher prices, which may not always be possible given the competitive nature of the industry.

Regulatory Changes

Increasing focus on environmental regulations and policies favoring cleaner, renewable energy sources could lead to reduced demand for traditional diesel-powered equipment. While some manufacturers already offer electrified machinery in their product line-up, the ones that don’t (like Caterpillar) will have to incur significant development costs and CAPEX costs to prepare production lines for offering these new battery-electric vehicles. This is particularly relevant as more countries adopt stringent emission standards.

Caterpillar has saturated its market penetration and will be slow to react to changing technology.

As an industry leader, Caterpillar has reached the saturation point of its market, and has already achieved global coverage with its products. Although there is the possibility for new found growth through technical innovations like automation and electrification, I am going to operate off of the assumption that Caterpillar is not first to market with these innovations and misses out on the tailwinds of a technological advantage. We’ve already seen that Caterpillar is lagging behind when it comes to battery powered vehicles and so it’s a fair assumption to make that they’ll likewise be late to implement automation and machine learning capabilities into their products. I’m assuming that In the coming years any growth Caterpillar experiences is more reliant on industry trends rather than new product expansions.

Given the estimates that the global construction industry was valued at $183.3 Billion in 2022 and is expected to grow at 7.5% annually, a reasonable assumption for the size of the global construction industry in 2028 would be $283 Billion. Caterpillar currently occupies about 13.7% of the global construction industry revenues according to the 2022 figures and with my assumption that Caterpillar will lose ground to competitors, I forecast that Caterpillar will have about 11% market share in 2028, which translates to $31.1 Billion in construction specific sales in 2028.

Mining will follow a similar trajectory to construction

Owing to similar mechanisms and end use cases in these cyclical industries, I’m assuming that Caterpillar’s mining segment will experience similar growth to 2028, which would translate to revenue growing from $12.91 Billion to $15.91 Billion in 2028. Roughly equivalent to a 4.26% per annum growth rate if you were to assume a linear growth in revenue.

Recent growth has been artificially achieved through inflationary mechanisms

The increases in earnings and revenue on a per-segment basis have been largely attributed to higher price realisation according to the most recent earnings report. This is not a sustainable way to achieve growth, improve margins or overall profit as the level of competition in the sector leads to relatively weak pricing power. I anticipate that inflation regulating itself will reveal that much of this growth was artificial.

Caterpillar will face tough competition in the transportation and energy segment

Much like the mining and construction, Caterpillar faces tough competition in the form of Rolls-Royce Power Systems, Deutz AG, Cummins Inc., INNIO, and Wärtsilä Corp, MAN Energy Solutions (VW), Siemens Power & Gas etc. when it comes to the energy and transportation segment. This segment relies heavily on buoyant oil and gas markets which require the generators Caterpillar produces to turn fossil fuels into energy. In the wake of the conflict between Russia and Ukraine, energy prices skyrocketed, to the benefit of Caterpillar and its competitors, which saw a rise in demand for their products in response to a need to quickly makeup a shortfall of supply. However, over the coming years, I’m conscious that many governments are pushing towards a “net-zero” energy landscape by 2050, which would require a steady phase out of fossil fuel generation capacity. As the new starts on fossil fuel projects likely to diminish in velocity, I forecast $28.3B in revenue for Caterpillar’s Energy & Transportation segment in 2028.

Negligible growth in the financial segment

Caterpillar’s financial arm is an often overlooked aspect of its business. Caterpillar Financial offers retail and wholesale financing solutions for customers and dealers. In this narrative, I am electing to attribute negligible growth to this part of the business, which is in line with past performance. I will assume revenues for this segment to be $3.5 Billion in 2028.

Net margins will remain consistent

I’m assuming that the company's net margins will remain consistent over the next 5 years. Over the preceding 12 months, the company was operating at a 15.4% net income margin, and I will carry forward an assumed margin of 15% over the next 5 years in my calculation, as I see there being less pricing pressure on CAT's input materials and any increased expenses will be passed on to the customer in order to maintain margins at around the current level.

Risks to my narrative

Biggest fish in the pond

As it stands now, Caterpillar is the biggest player in the heavy machinery space - particularly within the construction and mining segments. While my narrative points out they have lagged behind with some technical innovations, they certainly have the size, expertise and capital to commit to playing catch up and even exceeding competitors. One of the key risks to my narrative is that Caterpillar does just that and actually captures back market share in years to come by coming to market with the most polished and robust products that have implemented this new technology.

Infrastructure growth no matter the cost

Another component of my narrative is that I believe current economic conditions could stifle infrastructure growth and thus impact the sales for construction related machinery (be that directly with constructing machinery, or further up the supply line with mining equipment). The issue with this is that a lot of infrastructure growth might have to happen irrespective of costs. Take the India’s $1.3 Trillion National Infrastructure Pipeline for example. As India has now overtaken China as the world’s most populous country, this infrastructure growth isn’t a can that can be kicked down the road. It’s growth that absolutely must happen and will most likely happen even if the costs blow out due to inflation. Which is a positive for the likes of Caterpillar and other companies that would supply the equipment to make these infrastructure projects happen.