Bad Times Ahead for Caterpillar? - Analyst Blog

Uncertainty looms over Caterpillar Inc. CAT as it faces a Senate probe for possible overseas tax evasions. It is alleged that the company evaded more than $2 billion of U.S. taxes by shifting profits abroad.

Caterpillar will be required to attend the hearing in April held by the U.S. Senate's Permanent Subcommittee on Investigations. The investigation dates back to 2009 when a Caterpillar employee working on the company's tax strategy alleged that the mining equipment maker resorted to a “Swiss structure” to siphon profits to offshore companies. He further alleged that Caterpillar used a “Bermuda structure,” which allows shell companies to return profits to the U.S. without paying obligatory taxes.

Caterpillar's revenues in 2013 declined 16% year over year to $55.6 billion. The company reported earnings per share of $5.75 in 2013, down 32% year over year. The company generated roughly 60% of its revenues in 2013 from international sales. In 2013, the company paid taxes of $1.32 billion, down from $2.5 billion paid in the prior year. According to the latest reports, the company made about $17 billion in profits overseas, on which the company is yet to pay taxes to the U.S. government.

This is the second setback for Caterpillar after it lost a major contract in February to Siemens AG SI and Cummins Inc. CMI in its home state of Illinois to produce locomotives for high-speed passenger-rail service. The loss of contract thwarted Caterpillar's plans of dominating the market for the next generation of passenger locomotives. Since 2006, Caterpillar has been making concerted efforts to grow its rail and transit business driven by a long-term bullish outlook on the rail sector. To this end, Caterpillar had acquired Electro-Motive Diesel in 2010 in a bid to expand its rail business from service to engine manufacturing.

Caterpillar is also worried about the Russia-Ukraine conflict. With an investment of over $1 billion in Russia since 2000, Caterpillar has much at stake. In the wake of Crimea voting to merge with Russia, bans on senior Russian officials and stricter trade embargos will impact American companies operating there. $38.2 billion worth of trade is at stake between the two countries and mining, banking, and manufacturing sectors will stand to suffer the most.

All this comes at a time when things were starting to look up for the mining and equipment behemoth. After a dismal run in 2013, it has been a good year so far for Caterpillar, with its shares prices holding up steadily above $90 since the fourth quarter earnings release on Jan 27. In fact, Caterpillar attained a 52-week high of $98.24 during intraday trading on Feb 24.

Caterpillar's fourth quarter results were phenomenal marking the first year-over-year earnings improvement in 2013. With this the company also broke the jinx of four consecutive negative earnings surprises. Even though revenues declined 10% in the quarter to $14.4 billion, Caterpillar delivered a 48% rise in its earnings to $1.54 per share helped by its focus on cost reduction.

Caterpillar expects revenues in 2014 to be flat with 2013 levels, up or down 5%. Excluding restructuring costs, earnings per share are expected at $5.85. Construction Industries and Power Systems are expected to deliver sales growth on the back of an economic recovery. However, sales at the Resource Industries segment will continue to be challenging, as mining companies keep cutting their pockets with lower capital expenditures allocated for 2014.

In spite of the issues plaguing the company at the moment, we believe Caterpillar will still reap the benefits of its cost reduction activities and benefit from a recovery in the construction sector. In the near term, Caterpillar shares could see some volatility given the negative market sentiment following reports of tax evasion and the Russia-Ukraine geopolitical tensions.

Caterpillar currently carries a Zacks Rank #3 (Hold). A better-ranked stock in the sector worth considering is The Manitowoc Company, Inc. MTW, with a Zacks Rank #2 (Buy).