China growth picture may dim but for Caterpillar it's a bright spot

CHICAGO, July 24 Wed Jul 24, 2013 8:16pm EDT

CHICAGO, July 24 (Reuters) - Few U.S. companies have had a harder time in recent months defending their enthusiasm for China than Caterpillar Inc.

In January, executives acknowledged that accounting misconduct at a Chinese subsidiary would wipe out nearly half of Caterpillar's expected earnings in the fourth quarter of 2012. Last week, its China exposure was criticized by a top short-seller who warned China's economic growth was essentially a state-sponsored bubble that was about to burst.

But on Wednesday, executives at the Peoria, Illinois-based maker of earth-moving equipment were unapologetic, not only defending the long-term wisdom of their China strategy but highlighting how the country had been a bright spot in an otherwise disappointing quarter.

"I am not one in the camp of a China implosion - that China will implode and drag the world down into a massive black hole," Caterpillar Chairman and Chief Executive Officer Doug Oberhelman told analysts during a call to discuss the company's earnings miss in the latest quarter.

In an earlier appearance on CNBC, he was even more blunt: "We think China has bottomed" - referring to the moderation in that country's GDP, which grew at 7.5 percent rate in the second quarter, according to the country's National Bureau of Statistics, down from 7.7 percent in the first quarter and 7.9 percent in the last three months of 2012.

Not so long ago, Caterpillar's big exposure to China was welcomed by Wall Street, not questioned. Sales in that country, which remained largely unscathed during the recession that walloped the developed world, helped Caterpillar's sales snap back in 2010, 2011 and 2012 - even as many other companies continued to struggle with sluggish demand in the United States and Europe.

And on Wednesday, even as Caterpillar was cutting its full-year forecast, it was talking up China again. Sales in the country, excluding acquisitions, were up 20 percent year-on-year in the second quarter, Caterpillar said, driven by demand for construction equipment and power system products.

Caterpillar said the gains came even as overall industry sales were down, meaning its market share is growing

"We're quite happy with that," Oberhelman said.

Not everyone thinks Caterpillar investors should be happy - or that the Chinese slowdown is over. In recent weeks, signs of a continued strain in the world's second-largest economy have prompted some investors, including short-seller Jim Chanos, who argues China's economic miracle is a mirage, to predict that companies with strong China ties are facing major risks.

Caterpillar, which has benefited from the Chinese domestic construction boom as well as the global mining boom tied to China's demand for industrial commodities, is at the top of Chanos' list of such companies.

Chanos, who is perhaps best known for shorting energy giant Enron Corp before its collapse, says he believes that as China falters, it will curb the demand for raw materials that has driven demand for Caterpillar's earthmoving equipment. Last week, Chanos announced he was betting against Caterpillar because the company was "tied to the wrong products at the wrong part of the cycle" - a reference to the big investment Caterpillar has made in mining equipment in recent years.

On Wednesday, Oberhelman acknowledged - not for the first time - that the mining industry is in a slump and that this downturn is hurting Caterpillar's business. That was a major reason Caterpillar's profit dropped 43.5 percent in the second quarter and the company cut its outlook for the year in Wednesday's results announcement, sending its shares down more than 2 percent.

"Having been in this business 38 years and lived though cycle after cycle around the world, we're definitely in a cycle in mining," Oberhelman told CNBC. "There's no question there's a slowdown. But long term  mining is a great place to be."

The slowdown was illustrated by figures on Wednesday showing that activity in China's vast manufacturing sector slowed to an 11-month low in July.

In the conference call with analysts, Oberhelman embraced both areas that Chanos says make the company vulnerable: "Long term, China and mining, are appealing to us," Oberhelman said.

Caterpillar Controller Mike DeWalt pointed out that the country is continuing to grow despite the doomsayers and that, even at a reduced clip, that growth is impressive.

"We do not expect the significant economic growth rates that China experienced over the past 10 years will continue indefinitely," DeWalt said. "But we do believe that China will continue to grow at a much faster pace than the rest of the world."

He added that because China has grown so much over the past decade, economic growth rates of 7 to 7.5 percent have a greater impact today than a 10 percent growth rate would have had 10 years ago.

"It's a big economy that, relative to the world in total, is growing faster."

Alex Blanton, a senior analyst at Clear Harbor Asset Management in New York, says China's stated policy of accelerated urbanization - the government plans to move more than 20 million people a year from the farm to the cities in the coming decade - will drive growth. China will continue to require massive investments in infrastructure and other kinds of construction that will drive demand for the heavy machinery and other goods made by U.S. industrial companies like Caterpillar, he said.

"China's been slowing down for a couple of years now," Blanton said. "But it's still growing at more than a 7 percent rate - more than double what we're seeing in this country."

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

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