Moody's Lowers Outlook on Caterpillar (CAT) to Negative; Sees Weak Demand in Resource Industries Segment

April 20, 2016 3:22 PM

Moody's Investors Service changed the rating outlook of Caterpillar, Inc. (NYSE: CAT) and Caterpillar Financial Services Corp. (CFSC) to negative from stable, and affirmed the A2 long-term and Prime-1 short-term ratings of both companies.

RATINGS RATIONALE

Moody's revised the rating outlook to negative because of the challenges CAT faces from weak demand in its Resource Industries segment that we believe will extend at least into 2017, and the additional pressure this will place on the company's credit metrics. The Resource Industries segment had generated 31% of sales and 53% of Machinery, Engine & Transportation (ME&T) operating profits at the last peak. CAT has a long history of successfully contending with cyclical downturns, but the current falloff will be the longest and most severe in the company's history. Moreover, Moody's sees little evidence of a near-term recovery, and expects that when demand begins to improve the recovery will be more modest and protracted than during past upturns.

Despite these pressures, CAT will retain significant operational strengths that underpin the A2 rating, and should preserve its position as the most formidable competitor in the construction and mining equipment sectors. These strengths include: reputation for the industry's highest-quality equipment; most extensive product array; broadest geographic footprint; and, most formidable dealer network.

"The question is not whether CAT will remain profitable, or sustain its position as the world's preeminent supplier of construction and mining equipment" said Bruce Clark, senior vice president with Moody's. "The core question is whether CAT's various operational and restructuring initiatives can strengthen its returns despite a deep and prolonged downturn, so that its risk profile and credit metrics are consistent with an A2 long-term rating."

Moody's believes that CAT recognizes it cannot rely on a recovery in demand in the mining sector to restore competitive returns for shareholders, or to generate credit metrics that more solidly support the A2 long-term and Prime-1 short-term ratings. Consequently, the company has been implementing three major operating initiatives to improve its performance and returns independent of a market recovery. These initiatives include: 1) the LEAN operating system; 2) the Across The Table dealer program; and 3) the OPACC (operating profit after capital charge) investment and return metric. The potential benefits these initiatives can provide are reflected in CAT's Construction Industries segment where operating margins improved over 200 basis points (to 11.6% in 2015) despite a nearly 15% drop in sales (from $19.5 billion in 2012 to $16.6 billion in 2015).

During 2016, CAT's ME&T sales are expected to decline by about 10% as the downturn in its major end markets continues. This would represent a 38% cumulative decline from the last peak of $63 billion in 2012. To stabilize the rating outlook CAT will need to show clear evidence that it is continuing to harvest benefits from the implementation of its operational initiatives in its three primary segments (Construction Industries, Resource Industries, and Energy & Transportation), with improvement coming in three areas: 1) inventory days (147 days at year-end 2015 reflecting Moody's standard adjustments); 2) decremental margins (20% for 2015); and 3) EBITA margin (7.3% for 2015 reflecting Moody's standard adjustments). Decremental and incremental margins refer to the ratio of the change in operating profits excluding restructuring costs to the change in sales, and is becoming an increasingly important measure used by CAT to track its operating efficiency.

It is also important that the operational initiatives being undertaken by CAT lay a foundation for the company to maintain stronger credit metrics throughout all phases of the business cycle. CAT's fundamental strengths and its relative competitive advantage versus peers have generally increased as business cycles have occurred. However, at the peak of the cycle the company's key credit metrics (EBITA margin, debt/EBITDA and EBITA/interest) have been reflective of strong "single-A" metrics, while at the bottom of the cycle these metrics have fallen to the "Ba" level. In order to better support an A2 rating level it will be critical for CAT to generate more robust performance during cyclical peaks and moderate the degree of erosion during downturns.

CFSC, which benefits from a support agreement from CAT and provides vital retail and wholesale financing for CAT operations globally, continues to incorporate prudent underwriting standards. It also maintains adequate capitalization and reserve levels, and adequate liquidity.

CAT's gross liquidity position of $17.0 billion at December 31, 2015 consists of $6.5 billion of cash and short-term investments and $10.5 billion of committed credit facilities. These liquidity sources provide adequate coverage of the combined $12.8 billion of ME&T and CFSC debt maturing during the coming twelve months.

CAT's rating could be downgraded if: 1) there is a lack of evidence that it is making clear progress in implementing its three operational initiatives (LEAN, Across The Table, and OPACC); 2) the cyclical downturn extends into 2017 and dims prospects for a meaningful improvement in sales and earnings; or 3) there is any erosion in its liquidity position. The rating could also be lowered if the company is unable to achieve the credit metrics and performance characteristics (identified below) that will be necessary to stabilize the outlook.

In order for CAT's outlook to be stabilized the company will have to show that it is on track to achieve the following metrics: 1) EBITA margin that is solidly in the high single-digits range; 2) debt/EBITDA that is moving toward the mid-2 times area; and 3) EBITA/interest approximating 5 times. A stable outlook will also have to reflect the expectation that CAT is laying the groundwork to generate further improvement in these metrics through 2017, and that the company has the capacity to generate more robust peak-cycle and trough-cycle performance.

Affirmations:

..Issuer: Caterpillar Finance Corporation

....Senior Unsecured Commercial Paper, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Short Term Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: Caterpillar Financial Australia Ltd.

....Senior Unsecured Commercial Paper, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Short Term Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

..Issuer: Caterpillar Financial Services Corporation

.... Commercial Paper, Affirmed P-1

.... Issuer Rating, Affirmed A2

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Short Term Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....Senior Unsecured Regular Bond/Debenture, Affirmed A2

....Senior Unsecured Shelf, Affirmed (P)A2

..Issuer: Caterpillar Financial Services GmbH & Co KG

....Senior Unsecured Commercial Paper, Affirmed P-1

..Issuer: Caterpillar Financial Services Ltd.

.... Commercial Paper, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Short Term Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: Caterpillar Inc.

.... Commercial Paper, Affirmed P-1

.... Issuer Rating, Affirmed A2

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Senior Unsecured Regular Bond/Debenture, Affirmed A2

....Senior Unsecured Shelf, Affirmed (P)A2

..Issuer: Caterpillar International Finance Limited

....Senior Unsecured Commercial Paper, Affirmed P-1

....Senior Unsecured Medium-Term Note Program, Affirmed (P)A2

....Short Term Senior Unsecured Medium-Term Note Program, Affirmed (P)P-1

....Senior Unsecured Regular Bond/Debenture, Affirmed A2

..Issuer: Desoto (City of) Ind. Dev. Authority, Inc.

....Senior Unsecured Revenue Bonds, Affirmed A2

....Short Term Senior Unsecured Revenue Bonds, Affirmed P-1

..Issuer: Peoria (County of) IL

....Senior Unsecured Revenue Bonds, Affirmed A2

....Short Term Senior Unsecured Revenue Bonds, Affirmed P-1

..Issuer: Stephens County Development Authority, GA

....Senior Unsecured Revenue Bonds, Affirmed A2

....Short Term Senior Unsecured Revenue Bonds, Affirmed P-1

Outlook Actions:

..Issuer: Caterpillar Finance Corporation