CAT viewed favorably despite acquisition: Stellar fourth quarter encourages optimism

January 31st, 2013

On Monday morning, the Dow Jones Industrial Average continued to climb in what began a six consecutive day gain.  The advance could be considered minor, but could largely be attributed to Caterpillar Inc., a blue chip construction and mining-equipment manufacturer.

The major reasons that CAT performed so well lie within its fourth quarter. The firm produced earnings and revenues numbers that surprisingly exceeded analyst benchmarks.  Macroeconomic trends also amplified the markets in favor to CAT as orders for durable goods (goods lasting three years or longer) rose 4.6 percent from November.

Even though CAT is performing well, things arguably could be better for them. Last year, CAT purchased the Chinese-owned ERA Mining Machinery, a $700 million dollar transaction.

The hope was that this play would aid CAT in its position in China, allowing them to tap into demand stemming from the myriad of infrastructure and construction projects that the nation has to offer. It seemed like a smart investment in the long run, but it would not be until after the acquisition that CAT would actually suffer from the mistakes in its rationale.

In any sort of merger or acquisition, due diligence is extremely important. Even as individuals, we would like to know what we are buying before we spend a large sum of money. CAT missed several red flags that indicated that ERA may not have been such a great buy after all.

For starters, accounts receivable between 2010 and 2011 jumped 37 percent. This was not in line with the 10 percent sales growth over the same time period, and could be interpreted as evidence that people were not paying for ERA’s goods.

Another major oddity was that inventory that had not been delivered to customers rose 234 percent, implying that many of their sales were not even being delivered.

The problems compounded as the company’s directors began to loan money to the firm as a means of avoiding expensive financing. The financing would be unfavorable by management and could mean trouble for overall investor and executive satisfaction.

ERA was in serious trouble and found itself in an unsustainable business model. The only way the company would have any chance for survival was through a takeover by a company with superior financial muscle, or in this scenario CAT. Under the wing of a strong company, the hope was that ERA could further sustain its fast growth, relationship building and channel building. In the immediate term, it is hard to say that the outcome will have a happy ending. CAT just had to bear a $580 million write down for accounting misconduct at ERA.  This plunged CAT’s fourth quarter net profit by 55 percent and likely left a bitter taste in the mouth of executives. Yet despite all the trouble that came from the acquisition, life still goes on for Caterpillar and their investors.

The company is making smart moves elsewhere in the business by slimming down unnecessary production and inventory. For instance, CAT is moving away from less profitable regions, such as Europe, which is currently in the midst of financial struggle across the continent.

CAT, despite the major hit, remains resilient and continues to please Wall Street and those invested in the consturction and mining equipment company. Look for Caterpillar to continue with a slow but steady share appreciation and to bounce back in its first quarter of 2013.

Information from The Wall Street Journal and Yahoo Finance was used in this report.