Financial Statement Analysis Blog #2 – in the context of a company’s industry
“If we do not discipline ourselves, the world will do it for us.”
No financial statement analysis on a particular company makes sense without a broader view of the company’s industry. On this front, a general analysis of the industry should cover the following aspects at the minimum:
What are the industry’s key characteristics?
How concentrated is this industry?
Are there unique customer or supplier characteristics?
What was the industry looks like 10 years ago?
What will the industry likely looks like in 10 years?
How does the global economy impact this industry?
Resources such as Hoovers, Yahoo Finance, Google Finance, Value Line Investment Survey, and Mergent Online can be used to answer these questions. In this blog post, we use Caterpillar (CAT) as an example in answering these questions.
Per Hoovers, CAT’s Construction Machinery Manufacturing industry’s major products are bulldozers, loaders, backhoes, power cranes, excavators, graders and rollers, crushers, mixers, pavers, concrete pumps, off-road trucks and trailers, and a wide variety of specialized machinery. This industry is characterized by a demand that is driven by construction activity, the need for efficient production and large capital investments, and exposure to construction downturns and greater import competition risks. This industry’s demand level fluctuates in a more volatile manner than the demand in the highly variable and cyclical construction industry. Production has to expand rapidly when construction activity increases, but buyers defer new purchases when construction activity slows. During recessions, production can decline significantly.
Because of the cyclicality in this industry, manufacturers are forced to adopt small production runs, which are relatively inefficient as each run requires twice as many production employees per sales dollar compared to car makers’ run. Large capital investments are also required as manufacturers emphasize research and development (R&D) to keep expensive machines running and to increase safety and efficiency. Product features developed include monitoring systems that identify operating problems, GPS, laser devices to help position steel beams, new hybrid diesel-electric engines increase fuel efficiency and GPS-guided bulldozers eliminate the need for survey sticks. The same technologies are used to automate plain cement concrete and hot mix asphalt-paving machinery.
To cope with large swings in demand, I would advise a construction machinery manufacturer to diversify – either through:
The geographical regions it operates in,
The products and services (lines of business) that it offers, and/or
Financial vehicles (securities, etc.) in industries with opposite business cycle to its own (such as dollar stores or discount retailers like WalMart who thrive during recessions).
Per Hoovers, because of the large capital investments needed to launch and grow a construction machinery manufacturing company, this industry is concentrated in a small number of major players such as: Caterpillar, Terex, and Deere (US), Atlas Copco and Volvo (Sweden), Doosan Infracore (South Korea), Hitachi and Komatsu (Japan), Liebherr Group (Germany), Sany Heavy Industry (China), and CNH Industrial (UK). In the US, construction machinery imports have grown rapidly and now account for 30% of the US market. The high value of machinery makes worldwide trade possible despite transportation costs. Some of the biggest manufacturers are foreign, such as Hitachi. Japan, Mexico, and Germany are the biggest sources of imports. Imports from China, though smaller, increase about 10% between 2012 and 2015.
Per Hoovers, large machinery buyers include equipment rental companies, homebuilders, construction companies, surface mining companies, the US Army Corps of Engineers, and the equipment leasing arms of financial services companies like Wells Fargo and Citibank. Manufacturers often sell to dealers using 3rd-party financing. Rental companies have become large buyers of new construction equipment, but also large sellers of used machinery – as such, they posed a competitive threat.
The most crucial suppliers to this industry are the steel companies. Steel is crucial to the construction machinery manufacturing industry because some of its products, such as loaders and bulldozers, are steel-intensive. Steep prices fluctuate according to world demand and when its prices rise, manufacturers’ production costs rise as well. Since steel producers want to keep prices high, manufacturers are vulnerable to market price fluctuations that adversely impact their profit margins.
It is worth mentioning that the S&P 500 Machinery Index has underperformed the main S&P 500 Index in the past five years. That said, per Hoovers, year-over-year changes in the US construction machinery manufacturing exceeded 20% four times between 2009 and 2015. Increase infrastructure development is predicted to drive global growth in demand for construction and mining equipment through 2021. Demand is expected to see a Compound Annual Growth Rate (CAGR) of 4.1%. The Asia Pacific region is expected to see the strongest growth. Spending on developing nations’ infrastructure is expected to increase. As a result, manufacturers of construction and mining equipment may see increased opportunities in Asia Pacific in the coming years.
In the US, efforts to promote infrastructure development are underway, especially in the area of credits and grants. The US government has acknowledged the aging of the nation’s highway infrastructure and the need to repair roads, bridges, and dams. In late 2015, President Obama signed the Fixing America’s Surface Transportation Act (FAST), the first long-term highway bill in a decade. FAST provides $205 billion for highways and $48 billion for transit projects over five years. A longer-term source of federal transportation spending may spur construction companies to invest in new equipment. Increasing media emphasis on the aging highways and bridges, including promises to expand infrastructure spending by President Trump, may affect demand for manufacturers’ products.
Per Hoovers, in developing markets, urbanization and the need for modern infrastructure are driving demand for US construction machinery. While its economy has slowed, China’s construction spending is forecast to rise nearly 8% per year through 2019. India’s construction spending is expected to grow nearly 9% per year through 2018. By 2018, India should overtake Japan as the world’s third-largest construction market.