Why was Caterpillar's operating cash flow negative in 2004 when profit was strong?

Consolidated operating cash flow of -$3.99 billion reflects growth in trade receivables held at Cat Financial, which rose sharply with record dealer deliveries. In the fourth quarter of 2004 the company reclassified certain securitized receivables and wholesale inventory receivables from investing to operating activities after SEC staff raised concerns, and restated 2003 and 2002 accordingly. Investors should focus on Machinery and Engines operating cash flow of $1.92 billion and on the combined sources of funds, which included $5.72 billion of collections on retained interests in securitized receivables.

Did Cat Financial violate its debt covenants, and is there a risk to the company?

Yes, Cat Financial's debt-to-equity ratio was 8.23 to 1 at December 31, 2004, above the 8.00 to 1 year-end limit under its global credit facilities. The company attributes the breach to record fourth-quarter financing activity. The banks granted a waiver, and no borrowings were outstanding under those facilities at year-end. Management expects compliance throughout 2005, but the episode highlights that Financial Products leverage is high and growth-dependent.

What are the main risks to the 2005 outlook?

The filing cites several: a sharp rise in interest rates by central banks, which would hurt both economic growth and debt costs; a collapse in commodity prices, which would hit mining and energy demand; continued steel and material cost increases in the first half of 2005; currency movements, where a 10% dollar weakening would reduce Machinery and Engines cash flow by about $200 million; the phase-out of extraterritorial income tax benefits; and possible dealer inventory tightening. Management also flagged competitive price discounting and the risk that delayed price realization from the record backlog could persist.

How significant are the pending legal matters?

Management believes none of the pending matters will have a materially adverse effect on financial position, results, or cash flows. The largest is Caterpillar's suit against Navistar, which seeks about $139 million in past-due receivables plus claims tied to fuel injector pricing and alleged misappropriation of technology. A separate suit by International Truck and Engine Corporation over a long-term engine pricing term sheet is scheduled for trial in June 2005. The EPA also proposed a civil penalty of about $641,000 related to a sold Kansas facility.

What drove the improvement in margins and what might change in 2005?

Operating profit rose to $2.73 billion from $1.69 billion, mainly on volume (a $1.81 billion favorable impact), price realization of $512 million, and the absence of $153 million in NCPs. Offsetting these were $1.11 billion of higher core operating costs, largely steel and commodity inflation and freight costs, plus $139 million of higher retirement benefits. For 2005, management expects retirement costs to rise about $100 million, with material cost pressure concentrated in the first half and price increases effective January 3, 2005 intended to offset it.

CAT 10-K FY2005 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 24, 2005. Cited figures are marked; the original filing is the authoritative source.

Caterpillar's 2004 Form 10-K shows a year of record performance: sales and revenues rose 33% to $30.25 billion^a, the first time the company crossed the $30 billion milestone it had targeted in 1997, and profit more than doubled to $2.035 billion ($5.75 diluted EPS, up from $3.13).

Machinery sales jumped 38%^b and engine sales 29%, driven by a sharp industry upturn, record North American and Latin American demand, and strong pricing. Management was candid that bottom-line results lagged its own expectations: steel and commodity costs, supply-chain inefficiencies from material shortages, and a record backlog that delayed price realization all compressed incremental margins. Balance sheet and cash flow need careful reading.

Consolidated operating cash flow was negative $3.99 billion^c, largely because Cat Financial's receivables growth and trade receivables are classified in operating and investing activities, and the company restated 2002-2003 cash flows after SEC staff concerns about captive-finance classifications. Machinery and Engines operating cash flow improved to $1.92 billion. Total debt rose to $23.5 billion, almost all of it at Financial Products, and Cat Financial breached its debt-to-equity covenant at 8.23:1 (versus an 8.00:1 limit) and obtained a bank waiver.

Stockholders' equity reached $7.47 billion^d, and the company repurchased 6.9 million shares. Looking ahead, management guided to another record 2005, with sales and revenues up 12-15%, profit per share up about 25%, and material cost pressure concentrated in the first half. Key risks include commodity price reversals, interest rate increases, currency moves (a 10% dollar weakening would cost roughly $200 million in 2005 cash flow), the phase-out of extraterritorial income tax benefits, and the outcome of the Navistar and International Truck litigation.

02—Key points

Key Highlights

Record sales and revenues of $30.25 billion (up 33%), with profit of $2.035 billion and diluted EPS of $5.75 versus $3.13 in 2003.
Machinery sales rose 38% to $18.84 billion on 33% volume growth; engine sales rose 29% to $9.49 billion.
Operating profit of $2.73 billion, up 62%, helped by the absence of $153 million in 2003 Non-Conformance Penalties, though higher steel and commodity costs and supply-chain issues weighed on margins.
Consolidated operating cash flow was negative $3.99 billion after the restated classification of Cat Financial receivables; Machinery and Engines operating cash flow improved to $1.92 billion.
Total debt rose to $23.5 billion, with Financial Products debt up $3.19 billion; Cat Financial breached its 8.00:1 debt-to-equity covenant (8.23:1) and received a waiver.
Year-end backlog of $9.1 billion versus $4.9 billion a year earlier, supporting 2005 volume growth.
2005 outlook: sales up 12-15%, profit per share up about 25%, with a new six-year UAW labor agreement and ETI tax phase-out raising the effective tax rate about two points.

03—Questions

Frequently Asked Questions

Why was Caterpillar's operating cash flow negative in 2004 when profit was strong?
Consolidated operating cash flow of -$3.99 billion reflects growth in trade receivables held at Cat Financial, which rose sharply with record dealer deliveries. In the fourth quarter of 2004 the company reclassified certain securitized receivables and wholesale inventory receivables from investing to operating activities after SEC staff raised concerns, and restated 2003 and 2002 accordingly. Investors should focus on Machinery and Engines operating cash flow of $1.92 billion and on the combined sources of funds, which included $5.72 billion of collections on retained interests in securitized receivables.
Did Cat Financial violate its debt covenants, and is there a risk to the company?
Yes, Cat Financial's debt-to-equity ratio was 8.23 to 1 at December 31, 2004, above the 8.00 to 1 year-end limit under its global credit facilities. The company attributes the breach to record fourth-quarter financing activity. The banks granted a waiver, and no borrowings were outstanding under those facilities at year-end. Management expects compliance throughout 2005, but the episode highlights that Financial Products leverage is high and growth-dependent.
What are the main risks to the 2005 outlook?
The filing cites several: a sharp rise in interest rates by central banks, which would hurt both economic growth and debt costs; a collapse in commodity prices, which would hit mining and energy demand; continued steel and material cost increases in the first half of 2005; currency movements, where a 10% dollar weakening would reduce Machinery and Engines cash flow by about $200 million; the phase-out of extraterritorial income tax benefits; and possible dealer inventory tightening. Management also flagged competitive price discounting and the risk that delayed price realization from the record backlog could persist.
How significant are the pending legal matters?
Management believes none of the pending matters will have a materially adverse effect on financial position, results, or cash flows. The largest is Caterpillar's suit against Navistar, which seeks about $139 million in past-due receivables plus claims tied to fuel injector pricing and alleged misappropriation of technology. A separate suit by International Truck and Engine Corporation over a long-term engine pricing term sheet is scheduled for trial in June 2005. The EPA also proposed a civil penalty of about $641,000 related to a sold Kansas facility.
What drove the improvement in margins and what might change in 2005?
Operating profit rose to $2.73 billion from $1.69 billion, mainly on volume (a $1.81 billion favorable impact), price realization of $512 million, and the absence of $153 million in NCPs. Offsetting these were $1.11 billion of higher core operating costs, largely steel and commodity inflation and freight costs, plus $139 million of higher retirement benefits. For 2005, management expects retirement costs to rise about $100 million, with material cost pressure concentrated in the first half and price increases effective January 3, 2005 intended to offset it.

04—Continue

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