Capital Goods: Caterpillar and CNH Industrial Constructive with a Mix of Optimism

Excerpt from Footnotes and Flashbacks: Week Ending Feb 3, 2023

The 4Q22 earnings and guidance released by CAT and CNHI this past week offer a good view into customers across a range of key end markets including construction, mining, energy, and agriculture among others. Along with Deere (who is a 10/30 fiscal year with a Jan 1Q23 quarter release ahead), CAT and CNHI rank as the global cap goods bellwethers with Komatsu of Japan. CAT and DE are by far the largest and most valuable with CAT the dominant player in construction and earth moving equipment and Deere the undisputed King of agricultural equipment.

CNHI is more geared to farm equipment as its lead business. Like CAT, CNHI has a concentration more in North America with its history of acquired companies (JI Case with its Tenneco and International Harvester legacy and New Holland with its Ford history). CNHI had spun of its Iveco truck unit in mid-2022. CNHI’s US focus is reflected in its news last week that it will delist from the Milan exchange and list only on the NYSE.

CAT generates more than twice the annual revenue of CNHI and is valued at almost 6X the equity market cap across a more diversified mix by end markets and geographic regions. CAT thus gets more focus for a read on global market conditions. With any recession talk inherently casting doubt on the cyclical Machinery and Equipment markets, CAT in particular can serve as a good bellwether and proxy for what lies ahead. CAT is so big and wide in product reach it is hard to sum up.  The results sure did not signal signs of material weakness.

 From the chart above, one can see the stock action across capital goods names are not flashing red by any stretch even if last week was a tough one for the equities of CAT and CNHI alike. The lack of bullish guidance was enough for a sell-off, but anyone who has watched CAT’s stock on earnings day over the years gets used to it.  The revenue growth of 20% ended on a very strong note, margins expanded for the full year and ended with a 4Q22 best, volume variances were materially favorable, and the financial services unit had very solid credit quality metrics.

CAT sounds no cyclical alarms at all, but 2022 is a tough act to follow…

For CAT, the story lines around where capex cycles could go from here in commodities markets is in the optimist’s camp. That is where inflation has a silver lining for those who want to expand commodity capacity. Margin expansion proves CAT’s ability to deal with inflation in its expense base and supplier chain.

Very healthy free cash flow allowed for a hefty base of shareholder rewards in buybacks and dividends, so CAT’s performance in an inflation-tainted market set the company apart. The margin expansion proves CAT’s pricing power with price realization broken out in its information as the leading driver of their operating profit.

The main takeaway looking back was that 2022 was a great year for CAT with respect to growth and margins. The 4Q22 adjusted operating margins were the highest ever, so the idea of there being not much upside in profit performance is the downside of such a good year. Guidance was tepid in the sense that CAT could not get too bullish on volume when dealers went into inventory building mode during 4Q22.  That would be a long shot to replicate.

The tone overall was one of guarded expectations with some optimism around what can unfold in commodity markets with Mining and Oil & Gas wildcards to the upside in the often-unpredictable metals and energy markets. Volume will be hard to exceed in 2023, but pricing will be favorable. Supply chains are more supportive now also.

Nonresidential construction has generated a lot of views since it has so many subsegments from commercial to industrial to energy and mining. Many hear “nonresidential” and they think Office Buildings and Retail. As we covered in last week’s issue, United Rentals gave a constructive view on why a base case can be made for stability and sustained high demand. CAT’s nonresidential markets cover a wide swath where the climate initiatives (from mining to battery factories to chip factories) and infrastructure spending can play a key secular role outside the usual cyclical forces. Nonresidential markets are 75% of revenues for the Construction Industries segment.  

The segment top line numbers saw +19% in Construction and +19% in Energy and Transportation in 4Q22. Those two largest segments drive just under 80% of segment revenue (before eliminations). Resource Industries is smaller at around 20% but grew by 26% in sales. That level of economic activity is hard to match in 2023. If the midstream expansion programs pick up pace even faster (pipelines are always a challenge) in the push for more LNG exports, CAT will be a winner there also.  Power Gen equipment demand serves such markets as Data Centers as well as Industrial and Energy markets.

The good news for the broader capital goods cycle with all of its diverse end markets is that CAT guided to higher revenue and profits in 2023 vs. 2022. The upside is in North American construction markets. The non-China Asia Pacific markets were called out for growth, but China could remain soft. Latin America is expected to be flat. Middle East will be strong and Europe “uncertain.”

The China X-factor has upside potential on reopening themes and could promise some upside in the regional market but more importantly in mining customers serving China. That said, COVID handicapping is more about the dark arts than reality. Infrastructure bills, energy transition investment, questions around Upstream and Midstream expansion all tend to favor stability or upside for CAT. CAT’s financial services activities also came in strong with the delinquency and charge-off data putting up good numbers.  Past due percentages at quarter end were the lowest in 15 years. Write-offs in 2022 were down by 77% vs. 2021. The allowance cushion ticked up modestly at year end at a 1% handle.

The CNHI Ag connection…

CNHI results are more tied to Ag Equipment, and they are much smaller in construction. The CNHI results were quite strong for 4Q22 and the full year. The sell-off in the stock was more linked to guidance. Some theories indicated the planned delisting from Milan exchange prompted some selling, but the fact is that a range of sell-offs last week included Deere and AGCO in the direct peer group serving similar markets. As indicated, CAT also saw stock pressure last week despite a great quarter.  

The guidance was underwhelming and caught some grief in the equity markets for being overly conservative, but Deere should help give more clarity to the ag sector market outlook when it reports in two weeks. The product and geographic guidance by unit was heavy on the use of the word “flat” teamed up with negatives and that sent the CNHI equity into a bad day. Net sales guidance targeted at +6% to +10% for Industrial Net Sales with free cash flow +$1.3 bn to $1.5 bn. It is hard to find a good reason for a sharp sell-off even in an off week for cap goods names.

The 4Q22 and FY 2022 numbers were very favorable.  Industrial sales overall were +27% in 4Q22 and +21% for FY 2022. For 4Q22, CNH posted a material increase in sales and EBIT margins. Ag sales rose by 29% and EBIT margins widened by over 3 points.  Ag EBIT featured the “highest profit in more than a decade.” The growth was 2/3 organic and the remainder deal related.

Construction sales were up by 17% and EBIT margin widened by 110 bps on the quarter. CNHI is not competitive with CAT in profitability metrics, but CNHI is also a free cash flow generator with ~$1.6 bn in FY 2022. The net debt position at year end 2021 swung to a net cash position at year end 2022. Solid sales and margins with healthy free cash flow and net cash position is not a bad way to enter a period of uncertainty. The global food challenge is supposed to set the stage for more investment in the customer base.