heavy equipment & trucks

Industry SurveysHeavy Equipment & Trucks Adrian Compton, Heavy Equipment & Trucks Analyst

April 9, 2009

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Current Environment.............................................................................................. 1

Industry Profile ....................................................................................................... 9

Industry Trends .................................................................................................... 10

How the Industry Operates ................................................................................ 17

Key Industry Ratios and Statistics .................................................................... 22

How to Analyze a Capital Goods Company ..................................................... 23

Industry References ............................................................................................ 26

Comparative Company Analysis...........................................................Appendix

This issue updates the one dated May 22, 2008. The next update of this Survey is scheduled for October 2009.

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INDUSTRY SURVEYS HEAVY EQUIPMENT & TRUCKS / APRIL 9, 2009 1

CURRENT ENVIRONMENT

What is down must go up

The US economy has been in recession since December 2007, according to the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), an organization that provides economic research. Standard & Poor’s Economics believes that this will be the longest recession in post-war history.

In 2008, payrolls registered 12 consecutive months of declines. Job losses totaled 2.589 million, just below the record of 2.75 million set in 1945. The unemployment rate reached 7.2%, the highest in 16 years. The US housing and auto markets have been among the worst affected areas of the economy during this period. Business and consumer confidence readings have also been weak, with the University of Michigan’s US consumer sentiment index plunging to a low of 55.3 in November, the lowest reading in 28 years. The index moved up to 61.2 in January 2009, but then fell to 56.2 in mid-February 2009.

All of the industrial companies in the heavy equipment sectors have felt the chill of the recessionary headwinds. In 2008, they struggled with negative economic growth in the US in combination with surging manufacturing input costs from raw materials, labor, and energy. Caterpillar Inc., a major bellwether for the heavy equipment sector, noted recessionary conditions in the US in the first quarter of 2008, but saw continued pockets of strength, notably in emerging markets and in mining and energy demand. By year-end 2008, however, the perfect economic storm had formed. Arriving all at once were a sharp pullback in energy and mining commodity prices, the global credit crunch, the European Union in recession, and a slowing of growth in the previously strong emerging markets of the BRIC countries (Brazil, Russia, India, and China), and other emerging market economies.

According to data released by the US Department of Agriculture (USDA) in its 2009 Farm Sector Income Forecast, record-high agricultural commodity prices allowed farmers in the US to build the strongest balance sheets ever recorded, with farm equity of $2.134 trillion in 2008, up from $1.998 trillion in 2007. Farm equity is forecast to rise further in 2009 to $2.171 trillion. This created unprecedented demand for farm equipment globally, and manufacturers such as Deere & Co., CNH Global NV, and AGCO Corp. had record earnings in 2008. However, in the final quarter of 2008, we saw a sharp pullback in agriculture commodities prices and, subsequently, weakening demand for agricultural equipment, which we expect to continue through 2009. We do not believe that this drop in demand will be as severe as construction equipment manufacturers will experience, since we have a more positive outlook for the farming industry.

Although manufacturers of heavy trucks saw anemic sales in the US, they benefited from exposure to emerging markets in 2008; however, by year end, even this market had experienced a pullback in demand. China’s heavy truck market continued to maintain its global No. 1 position (as measured by unit sales), with 540,448 units sold in 2008 (up 27.2% year-on-year), compared with a slow North American market with 207,199 units sold. China’s market is very difficult for foreign manufacturers to compete in, since Chinese manufacturers enjoy a price advantage of almost 66% over US manufacturers. By year-end 2008, emerging market demand had also waned significantly. A further pullback in global demand is expected in 2009 as the global downturn gains momentum. Both the Chinese and North American heavy truck industry are simultaneously undergoing a sharp pullback in demand. Comparing January 2009 with the same month of 2008, sales in China dropped by 72%, to 10,851 units, while North American sales dropped 23% to 13,669 units. However, we expect an uptick in activity in late 2009 from the replacement of aging fleets and a pre-buy of trucks before the revised US emission standards take effect in 2010.

Although heavy equipment manufacturers are currently in a recessionary global economic environment, it is important to remember that the industry is coming off several years of strong results. During the economic expansion of the past several years, many heavy machinery companies experienced improved sales and profits as a result of increased demand. In the five years through 2008, sales at three bellwether heavy equipment

2 HEAVY EQUIPMENT & TRUCKS / APRIL 9, 2009 INDUSTRY SURVEYS

companies—Caterpillar Inc., Deere & Co., and Paccar Inc.—grew at an average compound annual growth rate (CAGR) of 14%. During the same period, earnings grew at an average CAGR of 20%, reflecting the significant manufacturing operating leverage inherent in these companies’ business models.

MIDDLE OF THE PERFECT STORM, LIGHT AT THE END OF THE TUNNEL

In March 2009, Standard & Poor’s estimated that real US gross domestic product (GDP) had slowed from growth of 2.0% in 2007 to a decline of 6.2% by the fourth quarter of 2008. Looking ahead, we expect the recession to be long and deep. We see real US GDP continuing to contract through the first three quarters of 2009, but then beginning to grow as a result of the aggressive actions taken by the US government in collaboration with members of the European Union and China. As of this writing, Standard & Poor’s expected the US economy to continue to grow through 2010 as the global economy recovers.

According to McGraw-Hill Construction (a unit of The McGraw-Hill Companies Inc., which is the parent company of Standard & Poor’s), the overall level of construction starts will contract a further 7% in 2009, after a 12% decline in 2008, driven by weak economic conditions. This will continue to hurt sales at construction equipment makers. We believe reduced farm incomes in 2009 will lead to decreased demand for agricultural equipment of between 5% and 10%. In the heavy trucks segment, we forecast that replacement of aging fleets will be the major driver of demand, with modest pre-buying of trucks helping to stimulate demand starting in the second half of 2009.

The heavy machinery industry encompasses a wide range of industrial businesses. In this Survey, we focus primarily on the largest segments: construction equipment, heavy trucks, and farm machinery. The overall health of the global economy drives demand in each sector to varying degrees. However, because sector-specific factors also drive demand for these products, we discuss each area separately.

CONSTRUCTION EQUIPMENT: STABILITY IN HOUSING CONSTRUCTION MARKET KEY

The upheaval in the financial markets, which began in September 2008, has compounded the issues facing the construction industry on top of sharply decreasing demand in both residential and nonresidential construction. The lingering freeze in credit markets has only added to the construction industry’s anguish, as financial institutions have had to absorb mounting losses from real estate asset-backed securities. The decline in the construction industry continues, despite the continuing government intervention, and we note that it will take time for these efforts to have an effect.

Residential construction spending continues to be very weak. According to a news release by the US Department of Commerce on March 2, 2009, residential construction spending declined 27.4% in the 12 months ended January 31, 2009. Residential construction remains depressed: housing starts totaled just 583,000 in February 2009 (seasonally adjusted annual rate, or SAAR). Although this is up from 477,000 starts in January 2009, it is down from 2.1 million new starts in 2005. Housing prices are down as well: in November 2008, the S&P/Case-Shiller Home Price index for 20 major US metropolitan areas was 25% below its peak in July 2006. We believe an economic recovery will not gain traction until the residential housing market stabilizes.

In the near term, through the first half of 2009, we believe the economy will show continued weakness. After 1.1% real GDP growth in 2008, Standard & Poor’s economists expect the US economy to shrink 3.0% in 2009 as the economy continues to battle a recession that is being drawn out by the continuing credit crunch. Standard & Poor’s, in March 2009, estimated that GDP growth would be a negative 5.6% in the first quarter of 2009, before beginning to grow again in the fourth quarter at a positive rate of 1.6%, and 1.8% for 2010, as the aggressive policy action by the US government begins to benefit the economy.

We believe that there will be a gradual thawing of the financial markets in 2009, which will present a challenging funding environment for commercial buildings, especially for developers seeking to refinance short-term debt. We also see state and local governments being hurt by the constrained funding environment and, in some cases, deferring construction projects. However, we do expect that the stimulus


packages passed by governments worldwide—a major beneficiary of which will be infrastructure projects—will greatly assist the construction industry to regain growth. Against this backdrop, McGraw-Hill Construction has forecast, in its annual Construction Outlook 2009, that the overall level of construction starts in 2009 will slide another 7% to $515 billion, after a 12% decline in 2008. For the 12 months ended January 2009, total construction declined 9.1%: residential construction declined 27.4%, but was offset slightly by growth of 2.1% in nonresidential construction. We expect these conditions to continue through late 2009, as the economy struggles with a very weak employment market and the credit freeze. Funding continues to be difficult, as construction loans and commercial mortgages become pricier and harder to get. Declining US payrolls are reducing demand for offices.

Private residential construction, which typically represents roughly half of total construction outlays, came in at $291.5 billion (SAAR) in January 2009—a decline of 28% from the $404.9 billion in January 2008.

Public construction outlays—generally about 30% of total construction spending—showed a gain in January 2009; at $303.7 billion (SAAR), this total was 4.4% higher than the year-earlier level. The year-over-year increase reflected increased government spending on infrastructure projects such as bridges, highways, and water supply projects. However, on a monthly basis, spending declined 2.3%. We expect public construction outlays to grow substantially as a result of the stimulus package—the American Recovery and Reinvestment Act of 2009—with its focus on public infrastructure projects.

Nonresidential private construction (roughly 40% of total construction outlays) rose to an annualized rate of $391.0 billion in January 2009. This represented a 4.3% decrease from December 2008, and a 0.3% increase from January 2008.

Additionally, we see slowing equipment spending as companies delay fleet additions due to an economy in recession and hard-to-obtain and expensive financing. Capital equipment spending will fall 14.8% in 2009, after rising 1.5% in 2007, according to Standard & Poor’s forecasts. While the balance sheets of many large US corporations are pretty sound, with low debt and record cash levels, smaller companies are less well positioned, with higher debt levels.

TABLE B01—CONSTRUCTION PUT IN PLACE IN

CONSTRUCTION PUT IN PLACE IN THE UNITED STATES (Annual value, in millions of current dollars)

TYPE OF CONSTRUCTION 1995 2000 2005 2006 2007 2008TOTAL CONSTRUCTION 548,666 802,756 1,102,703 1,167,554 1,137,152 1,078,858

Total private construction 408,655 621,431 868,543 912,169 850,009 770,392Residential 228,121 346,138 611,899 613,731 492,499 358,351Lodging 7,131 16,304 12,666 17,624 27,503 36,663Office 22,996 52,407 37,276 45,680 53,377 57,911Commercial 44,096 64,055 66,584 73,368 84,999 82,272Health care 15,259 19,455 28,495 32,016 34,776 37,827Educational 5,699 11,683 12,788 13,839 17,071 18,771Religious 4,348 8,030 7,715 7,740 7,429 7,107Public safety 185 423 408 419 495 686Amusement and recreation 5,886 8,768 7,507 9,326 10,352 11,041Transportation 4,759 6,879 7,124 8,654 9,444 10,208Communication 11,112 18,799 18,846 22,187 26,947 24,726Power 22,006 29,344 26,304 31,164 41,481 59,432Sewage and waste disposal 576 508 240 305 383 605Water supply 670 714 326 477 460 712Manufacturing 35,364 37,583 29,886 35,086 42,229 63,817

Total public construction 140,011 181,325 234,160 255,385 287,143 308,465Note: All data revised. Figures may not add to totals due to rounding.Source: US Department of Commerce.


HEAVY-DUTY TRUCKS: MARKET REBOUND EXPECTED IN LATE 2009

We see a rebound in the heavy truck market starting in the second half of 2009. We think that demand will be driven by fleet owner replacement of older vehicles and the positioning of fleets ahead of a more stringent set of US emission standards scheduled to take effect in 2010. We also expect continued economic growth from emerging markets and a rebound in US economic growth in 2009 to help boost sales.

North American sales of Class 8 (over 33,000 pounds) commercial vehicles totaled 207,070 units in 2008, a 13% decline from 237,614 units in 2007. We expect retail sales of Class 8 vehicles in the US and Canada to decline to around 130,000 vehicles in 2009, but project an increase in 2010 as the North American economies see a resumption of growth.

In 2008, Paccar and Scania AB (38%-owned by Volkswagen SKG) were the industry leaders in terms of profitability: they posted operating margins of 6.8% and 10.0%, respectively, versus 8.1% and 10.1% in 2007, and 6.4% and 6.0% in 2003, at the early stage of the cycle. AB Volvo (which includes Mack and Volvo Trucks) reported operating margins of 3.3% in 2008, and 5.2% in 2007, versus 0.2% in 2003.

By comparison, for the 10 years through 2008, operating margins for the truck manufacturing sector averaged approximately 4.3%. During the trough of the cycle, cutthroat price discounting of Class 8 trucks (historically the most profitable segment of the overall truck industry) took a toll on truck makers’ profitability. In 2003, operating margins averaged 1.6%. Volume gains, productivity gains and price increases aided the group’s significant profitability improvement in the five years through 2008.

Operating margins narrowed to 4.5% in 2008, as unit volume continued to decline following the pre-buy of 2006 and because the US economy was in recession. We expect margins to widen in 2009, aided by lower manufacturing input costs (raw materials, labor, and fuel), offset somewhat by lower manufacturing volumes. We see 2009 as being the bottom of the cycle for the heavy truck industry, before growth begins again in late 2009.

Impact of 2010 EPA emission regulations on truck sales In December 2000, the US Environmental Protection Agency (EPA) established its Clean Diesel Trucks, Buses, and Fuel: Heavy-Duty Engine and Vehicle Standards and Highway Diesel Fuel Sulfur Control Requirements (the “2007 Heavy-Duty Highway Rule,” or HD 2007), an emissions-control program for heavy-duty highway vehicles and the diesel fuel they use. HD 2007 mandated lower emissions levels: lower by 90% versus 2004 levels for particulate matter (PM) and by 50% for nitrogen oxides (NOx), according to the EPA.

The new standards, which are intended to significantly reduce emissions of PM and NOx, will be phased in beginning with the 2007 model year; full compliance is required in 2010. By 2010, engines are required to emit no more than 0.2 grams per brake horsepower hour (g/bhp-hr) of NOx and 0.14 g/bhp-hr of non-methane hydrocarbons (NMHC).

Depending on certain factors, a change in emissions standards often increases demand for noncompliant engines before the new regulations take effect. This process—called a pre-buy—can significantly affect the replacement cycle by reducing demand in the year when regulations go into effect.

Table B05: 'RETAIL SALES OF MEDIUM- & HEAVY-DUTY TRUCKS, BY WEIGHT CLASS

RETAIL SALES OF MEDIUM- & HEAVY-DUTY TRUCKS, BY WEIGHT CLASS

--------------------------------- UNITS -------------------------------- ------------------ % OF TOTAL ------------------GROSS VEHICLE WEIGHT 2004 2005 2006 2007 2008 2004 2005 2006 2007 2008

Medium-duty trucks, total 148,994 169,117 184,454 148,874 119,133 36.4 34.1 33.3 38.5 36.516,001–19,500 lbs. 40,053 49,845 53,200 50,245 47,556 9.8 10.1 9.6 13.0 14.619,501–33,000 lbs. 108,941 119,272 131,254 98,629 71,577 26.6 24.1 23.7 25.5 21.9

Heavy-duty trucks(over 33,000 lbs.) 260,553 326,211 368,791 237,614 207,070 63.6 65.9 66.7 61.5 63.5

Total North American Med. & heavy truck sales 409,547 495,328 553,245 386,488 326,203 100.0 100.0 100.0 100.0 100.0

Source: ACT Research.


Pre-buying occurs for two main reasons: cost and uncertainty. The newer engines tend to be more expensive (Paccar estimates from $5,000 to $10,000 more, depending on horsepower and application) than the ones they replace: manufacturers need to recoup the incremental engineering, development, and production costs associated with the new emissions-compliant engines. Additionally, because users have not extensively tested the new engines, the information available regarding fuel efficiency, maintenance costs, and reliability is usually limited. Much of the expected price increase will result from the cost of the new emissions-reduction components.

Fuel economy has a big impact on truck operators’ purchasing decisions, since fuel represents approximately 25% to 30% of business costs. Maintenance costs are also a large portion of a vehicle’s total cost of ownership. However, truck operators also increasingly value vehicle reliability: businesses that have moved toward a just-in-time (JIT) inventory model (which aims to minimize inventory costs by shipping parts or products when they are needed) increase the pressure on truckers to meet tight shipping deadlines.

The number and length of carriers’ tests of new engines and the results of those tests will also have a large influence on pre-buying activity. The more time that truckers have to test the engines, the less uncertainty there is likely to be with respect to incremental fuel and maintenance costs associated with the new engines. The results of the tests will also influence how much pre-buying activity occurs: if the new engines exhibit unappealing aspects such as reduced fuel efficiency and/or higher maintenance costs, more operators would be expected to pre-buy trucks ahead of the introduction of the new EPA emission standards in 2010. These factors lead us to expect pre-buying of Class 8 trucks in 2009 before the new emissions standards take effect with the 2010 model engines. While it is difficult to estimate the exact portion of purchases that will be related to pre-buying, with some purchase activity that is expected as a result of replacement demand and expectations of an economic pick-up in 2009, we think that pre-buy activity will represent a significant portion of demand.

Updated budget from the DOT In 2005, President Bush signed the Safe, Accountable, Flexible, and Efficient Transportation Equity Act: A Legacy for Users (SAFETEA-LU), a $286.4 billion, six-year highway bill. It provides funding for states through September 30, 2009, and represents about a 31% increase over the $218 billion in funding provided by the Transportation Equity Act for the 21st Century (TEA-21).

As a result of SAFETEA-LU, we expect state spending to increase through 2009, as federal funding will likely allow highway-related projects to move forward. The fiscal 2009 budget request proposes $41.9 billion in federal highway funding for that year (up slightly from $41.2 billion in 2008), the amount called for under the 2005 highway law (PL 109-59). However, the Administration’s fiscal 2008 budget proposal had decreased funding for certain parts of SAFETEA-LU. Transit funding, as part of SAFETEA-LU, set spending at $9.7 billion, but the DOT budget provides only $9.4 billion for transit programs. SAFETEA-LU established the Revenue Aligned Budget Authority (RABA) funding program, which allowed highway funding to exceed the authorization if gas tax revenues surpassed projections. Based on these gas tax revenues, the states were guaranteed an additional $631 million RABA adjustment in fiscal 2008, but this amount was not part of the president’s budget.

GLOBAL ECONOMIC STIMULUS PACKAGES—GOOD FOR INFRASTRUCTURE

We anticipate a surge in global stimulus spending in 2009 by world governments, of which infrastructure construction will be a major component. According to recent reports in the media, the major stimulus packages proposed, as of mid-February 2009, were US ($875 billion), Canada ($5 billion), China ($586 billion), Australia ($3.2 billion), and Europe ($280 billion). In addition to the stimulus packages, required infrastructure spending in emerging markets will also continue: China is proposing to spent $1.46 trillion over 5 years, Australia $13.6 billion, and Argentina $21 billion. We view Caterpillar as a major beneficiary of the forthcoming global infrastructure boom, with its unprecedented global reach. The Associated Equipment Distributors, an industry organization, estimates that 6.4 cents of every dollar spent on highway construction, or on major repair and maintenance, is used toward the purchase or lease of equipment. In


regard to water infrastructure, 12 cents of every dollar spent on sewer and drinking water projects is for construction equipment.

COMMODITY PRICES PROVIDE WEAKENING SUPPORT FOR AGRICULTURAL EQUIPMENT SALES

Net farm incomes are projected by the USDA to decline in 2009 to $71.2 billion, as the sharp pullback in agricultural commodity prices from historical highs set in mid-2008 impact farmers’ income. This will slow the demand for agricultural equipment, as farm income is the primary driver of farm tractor, harvester, and

combine sales. According to the USDA, farm income was an estimated $89.3 billion in 2008, up slightly from $86.8 billion in 2007, but 37% above the 10-year average of $65.3 billion. Farm income benefited from record increases in agricultural commodity prices that more than offset rising production costs for the farm sector. (For more details, see the “Farm income projections” table.)

The value of crop production was $181.1 billion in 2008, according to USDA estimates, exceeding the previous record set in 2007 by $34.1 billion, or 21%. The expansion in farm income in 2008 benefited from increasing

prices of foods and beverages, as well as continued demand for corn-based ethanol, aided by historically high crude oil prices. It is believed that these higher prices were driven by a number of factors, including financial market speculation and increased demand for commodities in emerging markets.

Looking ahead, the USDA expects net farm income to decrease about 20% in 2009. The current forecast of $71.2 billion, though down from 2008, represents a level that is 9% above the 10-year average of $65.3 billion. We attribute this high level of expected farm income to continued strong crop receipts, reflecting higher crop prices, increased international demand, and support from government payments. Total expenses are also forecast to decline in 2009 for the first time since 2002, after record increases of $20.5 billion in 2007 and

$36.2 billion in 2008.

Given the leading nature of farm income, we expect equipment sales to show signs of softening demand in 2009, as farm input costs of fertilizers, seed, labor, and land remain relatively high and prices for agricultural commodities remain below the peaks set during 2008, thus narrowing margins for farmers. Consequently, we anticipate that end-market conditions for farm equipment manufacturers will decline from the growth rate set in 2008. We still expect to see continued strength in the global farm sector, which we believe will benefit on a recovery in agricultural commodity prices from the sharp pullback in late 2008 and through 2009.

TABLE B04– FARM INCOME PROJECTIONS

FARM INCOME PROJECTIONS(In billions of dollars)

2007 E2008 F2009 F2010 F2015

Cash receipts 301.5 339.2 321.1 322.3 351.5Government payments 11.9 12.4 10.0 10.8 9.3

Gross cash income 313.4 351.6 331.1 333.2 360.8Value of inventory change 3.7 0.1 (1.5) 0.5 1.7Non-money income 24.0 25.4 27.2 27.4 30.0

Gross farm income 341.1 377.2 356.7 361.0 392.5Cash expenses 226.0 261.1 250.1 250.2 274.5

Net cash income 87.4 90.5 81.0 82.9 86.3Total production expenses 254.4 290.9 281.0 282.9 309.0

Net farm income 86.8 89.3 71.2 78.1 83.6E-Estimated. F-Forecast.Source: Food and Agricultural Policy Research Institute.

Table B02: FARM INCOME AND FARM EQUIPMENT EXPENDITURES

FARM INCOME AND FARM EQUIPMENT EXPENDITURES(In billions of dollars)

NET TOTAL REALIZED ---------- EQUIPMENT EXPENDITURES ----------CASH FARM OTHER

YEAR RECEIPTS INCOME TRACTORS TRUCKS MACHINERY TOTAL2009F 324.1 71.2 4.9 4.3 7.0 16.22008E 354.3 89.3 5.0 4.4 7.1 16.52007 313.4 86.8 5.0 3.6 7.1 15.72006 274.1 58.5 4.7 3.6 6.2 14.42005 281.5 79.3 5.1 4.3 7.1 16.62004 267.4 85.8 6.0 4.5 7.0 17.52003 249.5 60.5 5.0 4.2 5.9 15.22002 221.0 39.6 4.0 3.9 5.8 13.62001 235.6 54.9 3.7 4.0 6.0 13.82000 228.6 50.6 3.3 3.7 5.3 12.41999 224.0 47.7 3.3 3.5 5.3 12.11998 222.5 47.1 3.5 3.9 5.5 12.91997 227.5 51.3 3.3 3.7 5.2 12.2E-Estimate. F-Forecast.Source: US Department of Agriculture.


The three biggest global manufacturers of farm equipment, Deere & Co., AGCO Corp. and CNH Global NV (the Netherlands–based maker of Case and New Holland tractors), collectively posted an increase of 15.0% in agriculture equipment revenues in 2008, year-over-year. Together, these firms control about 55% of the global farm equipment market. Sales of farm equipment in 2008 were aided by continued positive farm conditions globally; however, we do see pockets of weakening demand in Latin America, Eastern Europe, Russia, and Asia/Pacific from continued credit constraints. Farms benefited from historically strong commodity prices in 2008, aided by global demand for food and energy crops and a weak US dollar.

In 2009, the global landscape has shifted dramatically, with a sharp pullback in agricultural commodity prices as the global recession has hurt demand, notably for food and energy crops. Competing with energy crops are fossil fuels, which have fallen even more sharply since the global downturn began. The price per barrel of oil (as measured by West Texas Intermediate/Light Crude) has dropped from a high of $147 in July 2008 to an expected average of $42 per barrel in 2009, according to forecasts from the US Energy Information Administration (EIA). Should fossil fuel prices remain low, demand for energy crops will also be subdued and, therefore, hurt agricultural equipment demand. Global grain stocks for wheat and corn are forecast to be at or near 30-year lows relative to consumption.

Biomass fuels’ legislation contributing to farm equipment demand The updated rulemaking for the Renewable Fuel Program of the Energy Policy Act of 2005 provided a comprehensive program for 2007 through 2012 and beyond. The policy mandates a rise in renewable fuel use in gasoline to 7.5 billion gallons by 2012, nearly double the estimated four billion gallons of fuel ethanol consumed in the US in 2005.

The Energy Independence and Security Act of 2007 expanded the Renewable Fuels Standard to require that 36 billion gallons of ethanol and other fuels be blended into gasoline, diesel, and jet fuel by 2022. Ethanol production in the US has continued to increase over the past several years, from less than 3 billion gallons in 2003 to over 9 billion gallons in 2008. The USDA estimates that about 25% to 33% of all corn grown will be used to manufacture ethanol in the 2008-09 crop year. A total of 3,026 million bushels is expected to be used for fuel consumption out of a total production of 12,774 million bushels.

Additionally, the economic stimulus bill has a number of provisions aiding renew-able biomass fuels (algae fuel, bagasse, babassu oil, biobutanol, biodiesel, biogas, biogasoline, cellulosic ethanol, ethanol fuel and vegetable oil), which are derived from crop farming. The legislation extends tax credits through 2009–10 depending on

CHART H07– Oil vs. Agriculture

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S&P GSCI Agriculture Index (left scale)Crude oil price (West Texas Intermediate, right scale)

OIL VS. AGRICULTURE

Source: Standard & Poor's.

(Index, Jan. 1, 1970=100) (Price, $/barrel)

Chart H04: US CORN USED IN FUEL PRODUCTION

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Other corn usage (left scale)Fuel alcohol use (left scale)% of corn production used for fuel (right scale)

US CORN USED IN FUEL PRODUCTION (Millions of bushels)

Source: US Economic Research Service.


the type of biomass fuel or renewable diesel (except foreign-produced fuel) including regular fuels that incorporate biomass gas, energy-efficient biomass fuel stoves, and energy efficiency improvements at the residential level. We see these tax credits as directly benefiting agricultural machinery demand for energy crop production. Energy crops are Chinese tallow, hemp, maize, rapeseed, sorghum bicolor, soybean, stover, straw, sugarcane and sunflower.

According to the Annual Energy Outlook 2009 from the US Energy Information Administration, renewable fuel will comprise 5% of total fuel usage in the US in 2009, rising gradually to 9% of total usage in 2030, aided by legislative support. The EIA assumed a growth factor of 3.3% per annum. Although fuel ethanol can be produced from different feedstock—including corn, milo, barley, sugar, starch, and others—in the US, it is produced primarily from corn. Based on statistics provided by the USDA’s Economic Research Service, corn used for fuel production is expected to account for 31% of total US corn production in 2016–17, up from an estimated 20% in 2006 (see chart entitled “US corn used in fuel production”). The amount of corn used for ethanol has already gone up dramatically, and is projected to have accounted for 27% of production in the 2007–08 crop year, up from only 7% as recently as 2001, and less than 1% back in 1980. Ethanol represents the third largest market for US corn, after livestock feed and exports.

Until the end of 2006, corn and ethanol prices moved independently; however, this changed in 2007, when their prices became highly correlated. For example, in June 2008, corn was $7.50 a bushel and ethanol was $3 per gallon; by October 2008, corn was $3.73 per bushel and ethanol was $1.65 per gallon. A fundamental economic relationship of 2.8 gallons of ethanol to a bushel of corn—the amount of corn it takes to produce the 2.8 gallons of ethanol—exists because the ethanol industry is the marginal consumer in the corn market.

In our view, long-term energy demand will continue to drive the growing of corn and other energy crops, raising demand for those crops and, ultimately, cash receipts for farmers, giving them more money to spend on agricultural machinery.


INDUSTRY PROFILE

Heavy equipment trends vary by market

The heavy machinery industry is large and diverse. For purposes of this Survey, Standard & Poor’s focuses on three main sectors: heavy trucks, construction equipment, and agricultural equipment.

HEAVY TRUCKS

The heavy truck industry is comprised of the design, manufacture, distribution, service, and spare parts sectors, and related financing activities. Based on the combined revenues of the world’s five-largest truck makers, the heavy truck industry contracted slightly in 2008 from 2007, hurt by anemic global end-markets. We expect this contraction to continue in 2009 as the global economy continues to face a challenging operating environment. However, we do expect a pick-up in activity in late 2009, aided by key replacement cyclical requirements from aging fleets.

Heavy trucks, known as Class 8 trucks, are primary haulers of freight in North America and are a beneficiary of economic demand. Economic activity generates haulage, which increases demand for heavy trucks; as a general rule, freight haulage expands or contracts in conjunction with the economy. The

majority of demand (about 75% in a typical year) is from replacement or the scrapping of worn-out equipment, while the remaining 25% of demand is driven by regional population growth (i.e., the fractional rate at which the number of individuals in a population increases or decreases). The current demand for the heavy truck industry in North America is still suffering from a case of supply overhang from the overbuying that occurred in 2006 ahead of an EPA emission standard change in 2007. We see this overhang of heavy trucks, in combination with a contracting economy, continuing to hurt manufacturers in 2009. We do not expect any pick-up in heavy truck purchase activity until the second half of 2009, when we see economic growth beginning.

The heavy equipment manufacturers that participate in the truck industry experienced an overall decline in segment revenues of about 4% from 2007 to 2008, which translated to a segment operating

income decline of 16%, as the industry was hurt by a spike in raw material costs from historically high commodity prices. For 2009, we expect a further decline in revenues of between 20% to 25%, as the global recession continues to hurt the truck manufacturers. Due to the manufacturing leverage inherent in financial results of the heavy truck companies, we expect earning to be down around 50% to 60% year-over-year in the first half of 2009, before a recovery is evident late in the second half of 2009. This will lead to further production cuts through 2009 as inventories of trucks continue to be downsized. We expect the heavy truck manufacturing industry could shrink to activity levels not seen since 2002.

TABLE B06: HEAVY EQUIPMENT REVENUES AND NET INCOME, BY SEGMENT

HEAVY EQUIPMENT REVENUES AND NET INCOME, BY SEGMENT(Ranked by 2008 revenues)

OPERATING REVENUES PROFIT*

--------- (MIL. $) --------- -------- (MIL. $) --------COMPANY 2007 2008 2007 2008HEAVY TRUCKSDaimler AG 41,569 39,925 3,097 2,246Volvo AB 29,045 25,906 2,349 1,551Paccar Inc. 14,296 14,143 1,353 1,157Scania AB 13,060 11,342 1,798 1,542Navistar International 7,809 10,317 141 818CONSTRUCTION EQUIPMENTCaterpillar Inc. 20,678 23,089 3,006 2,834Volvo AB 13,515 19,294 1,878 3,053Deere & Co. 8,016 9,986 1,250 1,486Komatsu Ltd. 7,157 7,568 765 127CNH Global NV 8,291 7,148 652 230Kubota Corp. 5,035 4,818 571 466Terex Corp. 5,023 4,464 321 26AGRICULTURAL EQUIPMENTDeere & Co. 12,121 16,572 1,443 2,224CNH Global NV 9,948 12,902 656 1,234AGCO Corp. 6,828 8,425 395 565*Before taxes.Source: Company reports.


CONSTRUCTION EQUIPMENT

The construction equipment manufacturers make and sell construction equipment, including track and wheel tractors, track and wheel loaders, pipe layers, motor graders, wheel tractor–scrapers, track and wheel excavators, backhoe loaders, log skidders, log loaders, off-highway trucks, articulated trucks, paving products, skid steer loaders, and related parts. These manufacturers also produce machinery for other industries, such as agriculture equipment, and energy and mining equipment; and they provide other services, such as logistics, remanufacturing, part manufacturing, and maintenance services. The largest companies in this sector also have financial-service subsidiaries that can provide financing solutions to both the client company and its customers. The largest manufacturers are true global conglomerates, operating in virtually every country on the planet.

Investors have perceived that the era of automatically generating profits has come to an end. Construction equipment manufacturers have all entered the global recession, as demand for construction equipment softens substantially. CNH Global NV, in February 2009, stated in a presentation that companies are restructuring and cutting costs as the recession deepens.

The global heavy machinery manufacturers posted segment revenue growth for construction equipment sectors of about 13% in 2008, although segment operating income overall declined 2.6% as manufacturers were hurt by escalating raw material costs. Additionally results were impacted by non-cash charges in the fourth quarter of 2008 from goodwill write-down and asset impairment charges. We expect revenues to decline about 25% in 2009, and earnings by around 50%, as the construction industry struggles with a lack of demand across the industry. We see some pockets of strength, notably in certain sectors of the mining and energy industry stemming from pent-up demand for specialty equipment that was not previously supplied due to manufacturing volume constraints. We expect heavy construction equipment demand to remain soft through the end of 2009, when we expect these companies to become beneficiaries of global stimulus packages with a focus on infrastructure development.

AGRICULTURAL EQUIPMENT

The agricultural equipment manufacturers manufacture and distribute agricultural equipment and related replacement parts worldwide. The group produces tractors, combines, planters, tractor-pulled implements and other specialty farm equipment used in farms and in specialty agricultural industries. They also offer related services such as precision farming technologies that enable farmers to gather information, such as yield data, by utilizing satellite global positioning systems; and have divisions which provide financing to customers.

The agricultural equipment manufacturers all had a record year in 2008, with segment revenue growth of 34% and segment operating income growth of about 57%. The agricultural equipment manufacturers benefitted from record agricultural commodity prices, which translated to record farm income, allowing farmers to spend more on farming equipment. Additionally, emerging markets such as Brazil, Argentina and Eastern Europe continued to be strong growth markets for agricultural equipment manufacturers. For 2009, we expect a softening of demand, resulting in an overall revenue decline of about 15% and, subsequently, net income declining 30%, from lower agricultural commodities prices through 2009.

INDUSTRY TRENDS

In the heavy machinery industry, demand drivers and business economics can vary from one sector to another. Nonetheless, industry sectors also share a number of trends and themes: consolidation, expanding use of captive finance subsidiaries, focus on productivity, customers’ ever-growing demands for improved value and service, and e-commerce initiatives. We talk about the common trends first and then describe those affecting individual sectors.


HEAVY EQUIPMENT MANUFACTURERS CONTRACT

Consolidation remains a long-term trend in many heavy machinery sectors. With a high fixed-cost business model based on manufacturing-volume leverage and marginal cost of production, bigger is better. Although markets for the largest categories are already highly concentrated, opportunities remain for smaller acquisitions that would allow leading manufacturers to expand their product lines or sales territories through dealer networks.

Many large participants in these industries consider their operating subsidiaries to be components of a business portfolio and have begun evaluating these businesses from a portfolio-management perspective. They actively manage their portfolios to optimize capital resources and to provide the most favorable returns to investors. Such companies often make acquisitions to round out product lines or to deepen market penetration, and restructure or divest lagging units that cannot provide acceptable returns.

The economic downturn has hurt construction and farm machinery and heavy trucks to varying degrees. The heavy equipment manufacturing industry is highly cyclical in nature, systemic from a number of demand-driven factors, including the cost of raw materials, the high cost of production, research, and development, and demand activity in end-markets. For example, during the recent global economic expansion from 2002 to 2007, demand for heavy machinery grew strongly with demand from a robust residential and commercial construction industry, record energy and mining commodities prices, and record agricultural commodities prices. End-markets of heavy construction, agricultural and heavy trucks all experienced a period of strong growth, which in turn allowed more expenditures on heavy machinery and trucks, thus driving profits of manufacturers. However, as global business cycle growth turned negative, construction and farm machinery and heavy trucks started to experience a weakening of demand for products and services.

A growing trend among the heavy machinery conglomerates is to increasingly offer integrated related services, from spare parts manufacturing, financial products such as leasing or hire purchase agreements, remanufacturing services, service and parts facilities, logistical services, and consultancy services, Companies are increasing shifting their proportion of revenues to integrated services to exploit an already captive customer base, thus lowering the cost of obtaining additional revenue streams and to smooth the earnings cycle. Integrated services generally are higher margins business than normal product manufacturing, have a lower fixed-cost basis and are less prone to economic cyclicals. In our view, Caterpillar Inc. is an example of this business structure evolution. In 2008, Caterpillar generated $16 billion in integrated services, or 36% of its total revenue from service-related revenue streams. Service-related businesses include Caterpillar Financial Services, Caterpillar Remanufacturing Services, Caterpillar Logistics Services, Progress Rail Services, Solar Customer Services, and Genuine Cat Replacement Parts.

As of January 2009, each segment of the heavy machinery manufacturing industry was in contraction. We saw this contraction in growth begin in the second half of 2008 as end-markets were hurt by global frozen credit markets. We outline below how each segment was affected and where we believe they are in each respective stage of the business cycle.

Heavy truck manufacturers The heavy truck industry started to see signs of contraction in growth in 2007, after the EPA emissions pre-buy of 2006 caused an overhang of supply of trucks and trailers in the US. By mid-2007, the heavy truck manufacturers began seeing an additional slowdown in demand as freight haulers carried less freight, which in turn caused them to cut their fleet size and delay purchases of new vehicles. Heavy truck manufacturers continued to see pockets of strength in world demand, as the global economy continued to grow strongly. By the second half of 2008, demand in the rest of the world also showed signs of slowing, hurt by frozen credit markets. These underlying economic demand factors still remain in place as the global economy remains in recession. In the US we expect a pick-up in demand as key replacement cycles are hit in the second half of 2009, in combination with some pre-buying ahead of the EPA emission standards in 2010.


Fleet operators typically have 30 days visibility on haulage demand. They continue to be hurt by a sharp drop in haulage volume since November 2008, which has continued through February 2009. This drop in haulage volume has led to idle fleet capacity and a further cut back in fleet size by fleet operators. Generally, fleet operators have no plans to purchase heavy trucks for haulage other than the replacement cycle. The drop in fuel costs since mid-2008 has provided working capital benefits.

The BRIC countries have extended their global positions through heavy-duty truck manufacturers such as KAMAZ Inc. of Russia (of which Daimler AG acquired 10% in December 2008), Sinotruk Ltd of China, and Tata Motors Ltd. of India (the world’s fourth-largest truck manufacturer). The Chinese heavy truck market is now the largest in the world, with key market positions held by local manufacturers.

Brazil, on the other hand, does not have its own heavy-duty truck industry and, as a result, has been divided up by developed-world manufacturers. The Brazilian market is continuing to grow as an important source of sales for heavy duty truck manufacturers. The market is expected to grow in 2009, albeit substantially slower than in 2008. We do not foresee any significant Brazilian players entering into the industry at this stage.

We see further consolidation of the heavy truck manufacturers when the credit markets unfreeze and credit begins to flow again for mergers and acquisitions. Volkswagen (VW) is the largest shareholder in both Scania AB and MAN AG (MAN). In January 2009, MAN bought VW’s Brazilian truck business. MAN’s CEO, Hakan Samuelsson, has indicated that he is still eager to unite with Scania after having failed in a hostile bid in 2006. We believe smaller manufacturers, such as Navistar and Freightliner in the US, are also potential take-over targets. We see the number of developed-world major heavy truck manufacturers being just six in the near future (from 10 in 2008): Cummins Inc., Daimler AG, Hino Motors Ltd (owned by Toyota), MAN, Paccar Inc., and Volvo AB.

Heavy construction manufacturers The heavy construction industry was hurt from the sharp decline in construction activity. It has also suffered from the pullback in mining and energy activity. In 2009, we still see pockets of strength in some emerging market economies, such as China and Brazil, although sharply down from 2008 levels. There is still some pent-up demand for certain mining equipment. We do not see these demand factors changing until, at the earliest, the second half of 2009, when we believe demand will begin to return to the market as central governments spend aggressively to stimulate economies with a large focus on infrastructure development.

Agricultural equipment manufacturers The agriculture equipment manufacturers segment left 2008 and moved into 2009 with a better outlook than the other heavy equipment manufacturers, as farms continue to produce agricultural commodities at

healthy profit levels. However, through February 2009, we have seen a softening in demand for agriculture equipment as farmers remain cautious of the economic outlook and current climate. Demand for agriculture equipment is strongly correlated to agricultural commodity prices, which have held up better than mining and energy commodity prices, although they have still fallen considerably from mid-2008 peaks. Agriculture commodity prices are still considerably higher than they were at the beginning of 2007, due to a secular shift in demand as emerging markets become more affluent and drive agricultural prices up. In 2009, farm balance sheets remain historically

CHART H06—COMMODITIES FUTURES INDEX VS. AGRICULTURE EQUIPMENT REVENUES

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S&P GSCI Agriculture Index (left scale)Agriculture equipment manufacturing revenues* (right scale)

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COMMODITIES FUTURES INDEX VS. AGRICULTURE EQUIPMENT REVENUES

(Index, Jan. 1, 1970=100) (Billions of dollars)


strong, with the US Department of Agriculture (USDA) expecting the farm sector to continue its upward trend, reaching $2.2 trillion in value, driven by substantially increased farmland values. The USDA also expects debt to continue its downward trend, expected to reach 9.1% of farm assets financed by debt. However, the USDA does expect average net cash incomes from specialty crops to decline.

CAPTIVE FINANCE SUBSIDIARIES: THE RISK/REWARD TRADEOFF

The highly cyclical nature of the heavy equipment and truck markets is forcing many manufacturers to look to other areas for profit growth. Many of the larger companies within the heavy machinery universe have expanded their operations to include captive finance subsidiaries—divisions that provide financing to dealers and customers, intended to facilitate the purchase and/or lease of a company’s equipment. Consequently, the big manufacturers now offer service-related operations, such as leasing, financing, and maintenance service offerings (as discussed above). Industry observers believe that trucking companies’ increasing reluctance to own trucks, which rapidly depreciate, should accelerate demand for truck leasing in the future.

Because a significant portion of a heavy machinery company’s earnings may be derived from its finance unit, especially during periods of general weakness in the industry, we think it is important to consider some of the risks associated with these operations, as well as their potential impact on consolidated earnings. Given the cyclical nature of both trucking and farming, equipment companies must manage their risk exposure wisely.

Risks Heavy machinery companies with a financial services division tend to bear certain risks, in addition to the risks already inherent in the highly cyclical environment in which they operate. Among these risks, we think that credit and residual value risk merit special attention. With respect to the latter, we view residual value guarantees (RVGs) as an aggressive type of financing arrangement, where the finance company retains the majority of the risk.

Credit risk. The possibility of incurring a financial loss due to a borrower’s failure to meet a contractual debt obligation, or credit risk, is a significant consideration for captive finance subsidiaries, in our view. Within the highly cyclical heavy machinery industry, suppliers and customers tend to be affected by similar macroeconomic conditions, and both usually face a certain degree of financial stress at or near the trough of the cycle. Therefore, in order to reduce the likelihood of incurring a significant financial loss, it is important that a heavy machinery company maintain disciplined underwriting standards on its loan and lease agreements throughout the entire cycle.

Residual value risk. Broadly defined, residual value risk is the risk that, at the end of a contract, the fair market value of the equipment that is sold or leased will be less than the residual value that the finance company estimated at the time the contract originated. In the event that the equipment is worth less than the calculated residual value, the finance company may be forced to record a write-down for the difference. Residual value risk relates primarily to contracts involving buy-back or trade-in commitments, RVGs, or operational lease contracts.

Residual value guarantees (RVGs). A fairly aggressive kind of financing arrangement, RVGs essentially provide the dealer/customer with a put option on the equipment, while the finance company retains the majority of the risk. In general, when equipment is sold subject to an RVG, the finance company receives the full amount of the sales price from the dealer/customer. The finance company then establishes a liability for the amount of the RVG obligation, and the rest of the proceeds are recorded as deferred lease revenue on a straight-line basis over the life of the RVG contract. At the end of the contract period, if the dealer/customer decides to return the equipment to the finance company, the finance company is obligated to purchase the used equipment at the guaranteed value. If the RVG exceeds the current fair market value of the equipment, the finance company may be forced to dispose of the used equipment at a loss.

During the late 1990s, aggressive use of RVG contracts by certain heavy-duty truck makers and dealers, largely in an attempt to gain market share, resulted in a flood of used vehicles on the market a few years


later. This rapid increase in supply depressed the prices of used vehicles in the market and ultimately led to a significant number of lessors incurring substantial residual value write-downs.

Impact on earnings As mentioned above, heavy equipment manufacturers are counting on service revenues from areas such as leasing and financing to generate reliable earnings streams, greater sustainable income growth, and higher returns. Although leasing and financing are generally much more profitable businesses than manufacturing,

they also shift more of the financial risk from the dealer/customer to the equipment manufacturer, as previously discussed. Moreover, leasing and financing operations generally require heavy machinery makers to take on large amounts of debt, primarily to finance the purchase of equipment that is going to be leased or sold. Other financing activities may include using various types of hedging instruments and off–balance-sheet arrangements; these, too, can raise equipment makers’ financial risk profiles.

Individual companies’ earnings contributions from financing activities are shown in the table entitled “Estimated percentage of consolidated net income derived from financial services divisions.” One of the key takeaways from this table, we believe, is that the finance subsidiaries appear to represent an increasingly important source of earnings and cash flow during periods of weakness in the manufacturing side of the business.

For example, many of the companies listed in the table experienced weak demand for their products in 2001 and 2002 as the overall economy slowed, while 2004 until mid-2008 marked significantly improved conditions for both the industry and the economy. In the previous period, companies tended to derive a greater proportion of net income from their finance divisions, while starting around 2004 and continuing through mid-2008, the proportion of net income derived from the finance division was much smaller. All else being equal, we view this is as a positive relationship and one of the benefits of operating a financial services division.

FOCUS ON PRODUCTIVITY

Standard & Poor’s believes that a common characteristic among many of the more successful heavy machinery companies is a relentless focus on enhancing productivity. While there are many ways of achieving increased productivity, many corporations have embraced a philosophy known as Six Sigma.

The term Six Sigma can mean different things to different companies. However, we view it simply as a disciplined approach to process improvement. Six Sigma uses a five-step model known as DMAIC (define, measure, analyze, improve, control) for improving a process. In the define stage, the problem is defined and an improvement goal is established. The measure stage uses various data analysis techniques to measure the existing process (i.e., to establish a baseline) and to identify quantitative metrics for measuring progress toward the goal. During the analyze stage, potential ways of achieving the desired goal are explored. In the improve phase, the new process is implemented. Finally, in the control stage, systems designed to control the new process are institutionalized.

While many companies have embraced Six Sigma to varying degrees within their own organizations, some companies, such as Caterpillar Inc., are looking beyond their own facilities and have begun working with suppliers to identify ways of doing things better, in an effort to improve the productivity of the entire supply chain. In a recent Caterpillar 10-K, the company stated: “At Caterpillar, Six Sigma goes beyond mere process improvement; it has become the way we work as teams to process business information, solve problems and manage our business successfully.”

TABLE B03— FINANCIAL SERVICES OPERATING PROFIT—2008

FINANCIAL SERVICES OPERATING PROFIT — 2008

FINANCIALTOTAL SERVICES FINANCIAL

OPERATING OPERATING SERVICESPROFIT PROFIT AS A %

COMPANY ----------- MIL. $ ----------- OF TOTALCaterpillar 7,876.0 545.0 6.92CNH Global N.V. 1,650.0 390.0 23.64Deere & Co. 3,420.0 478.0 13.98Paccar 1,464.0 216.9 14.82Volvo 2,020.5 178.1 8.81Source: Company reports.


MAXIMIZING VALUE FOR THE CUSTOMER

Like makers of consumer goods, heavy machinery firms are hearing more customers demand value for their money. For buyers of capital goods, value is measured in terms of return on investment (ROI). Maximizing ROI is not simply a matter of paying low prices for purchased equipment; it involves the efficiency of the equipment as well. Customers often will pay higher prices for equipment that has fewer breakdowns, provides more output per day, or requires less downtime for routine maintenance than competing brands. Again, it all comes down to productivity.

Heavy machinery makers have undertaken a number of strategies to meet customers’ demands. For instance, they have applied sophisticated electronics to mechanical systems in order to enhance productivity, increase precision, facilitate maintenance, and provide operators with more complete information on the equipment’s operating status.

Simpler can be better Another way to satisfy customers is to do more with less—that is, to reduce the complexity of the heavy machinery. This often improves the equipment’s quality and reliability, while cutting the cost to buy and operate it.

Simplification can take several forms. It usually involves minimizing the number of parts or components used in assembling a piece of equipment. The fewer the number of parts, the greater the likelihood that the equipment will be built right the first time, and the less likelihood that it might break. Simplification also can involve limiting the variations and types of equipment produced on individual assembly lines, which has been shown to improve efficiency and lower the incidence of defects in the output.

THE TRUCK REPLACEMENT CYCLE

Fleet operators typically order new trucks after taking into account both their financial strength and the demand outlook for their services. The cyclical nature of demand is clearly visible in the annualized unit sales results of Class 8 heavy-duty trucks (more than 33,000 pounds) since 1988, as shown in the chart entitled “Class 8 truck retail sales.” Annualized demand in the US for heavy-duty trucks hit bottom at about 93,000 units in early 1992. Volume then climbed to about 268,000 trucks in 1995 and peaked at approximately 341,000 trucks in 1999, according to statistics provided by Americas Commercial Transportation Research Co. (ACT Research), an independent commercial vehicle research organization.

Most recently, sales of Class 8 trucks in North America were 207,070 vehicles in 2008, down from 237,614 vehicles in 2007, about a 13% drop, following a drop of 36% on sales of 368,791 vehicles in 2006. Moreover, annualized sales reached an all-time record in December 2006, at 409,000. This weakening in

sales reflects the recessionary operating environment. The large sales of Class 8 trucks in 2006 was accounted for by a combination of improving carrier profitability, ongoing replacement demand for heavy-duty trucks because of an aging motor fleet, and a significant amount of pre-buying activity ahead of 2007 changes to emission regulations. Partly due to demand that was pulled forward into 2006, sales of Class 8 trucks declined sharply in 2007 and further in 2008; we see another decline in 2009 caused by the ongoing global recession.

As mentioned previously, we see a pick-up in activity in late 2009 and into 2010 as the

Chart H03: Class 8 truck retail sales

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business cycle once again turns up for the heavy truck industry. We think the sales bottom of 93,000 vehicles in 1992 could be tested again in 2009; February 2009 sales were only 8,864 vehicles, a 20% drop from January 2009 and 47% lower than February 2008.The North American truck replacement cycle at the end of 2008 was 7.5 years, the highest in more than 20 years, which we see as a key to stimulating demand. Another positive indication is the global emphasis on infrastructure spending in many of the national stimulus packages. Large construction projects stimulate demand for heavy trucks because of the need to cart large quantities of building products. Over the long term, we expect truck and truck engine sales to continue to show dramatic swings, with underlying growth averaging 4% to 5% annually.

VARIED TRENDS IN CONSTRUCTION SPENDING

In 2004, growth in nonresidential construction spending turned positive for the first time in several years, as the economy expanded by 3.9%, in real terms. As of October 2008, McGraw-Hill Construction (a unit of the McGraw-Hill Companies Inc., which is the parent company of Standard & Poor’s), in its annual Construction Outlook 2009, was forecasting that construction starts would slide a further 7% in 2009, following an slide of 12% in 2008. Real residential construction spending is expected to fall a further 3% in

2009, following a 35% drop in 2008.

We expect companies manufacturing infrastructure equipment to benefit from an expected $90 billion in direct spending on Department of Transportation (DOT) projects in the U.S. included under the American Recovery and Reinvestment Act of 2009. Additionally, a further $32 billion will be spent on an electrical “smart” grid. Other international countries are still in a state of flux on determining final amounts to be spent.

During the last 10 years when global growth was robust, a general theme among developed countries was to “balance their books” by cutting back on public works programs. This has now created a strong need to update, maintain and build infrastructure. CIBC World Markets Inc. (the investment banking subsidiary of Canadian Imperial Bank of Commerce) released a study in January 2009, which estimated that updating the world’s infrastructure could cost between $25 and $30 trillion over the next 20 years. Canada, for example, has eliminated its budget deficit; however, it has built up an infrastructure spending need of $120 billion in the process. The report forecasts that, annually, the US will need to spend $180 billion, Europe $205 billion, Asia $400 billion, and Africa $10 billion.

The American Recovery and Reinvestment Act has infrastructure and public building investment provisions totaling $134.8 billion to be spent on infrastructure projects in addition to already-scheduled spending of $66.6 billion. Additionally, upgrading

Chart H02: PRIVATE CONSTRUCTION SPENDING

Chart H01: FARM EQUIPMENT EXPENDITURES & FARM INCOME

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PRIVATE CONSTRUCTION SPENDING(Year-to-year percent change)


the nation’s aging power grid could total $1.5 trillion over 20 years, according to the Brattle Group, Inc., a business consulting group.

China and Russia both spend about 6% of GDP on infrastructure, versus 2% in Europe and 1% in the US.

Over the long term, we believe that total private spending on US construction will likely increase about 3% to 4% per year, on average, in line with historical growth in GDP.

IMPROVING OUTLOOK FOR FARM EQUIPMENT

Historically, a tough competitive landscape and tepid demand drivers have made it difficult for farm equipment makers such as Deere & Co., CNH Global NV, and AGCO Corp. to generate outsized long-term earnings growth and profitability. Mature markets and plentiful manufacturing capacity for farm equipment had resulted in fierce competition, and kept a tight lid on pricing. Net farm incomes rose to record levels in 2008; however, they are expected to decline in 2009 as a result of lower crop prices. This recent demand driven causing agricultural commodities to spike in 2007-2008 is largely associated with increased demand for commodities from India, China, and other expanding economies in Asia, which is outpacing the increases in supply.

Looking ahead, we expect a softer-demand environment for farm equipment manufacturers, as we believe that reduced crop prices will continue to translate into reduced demand for large tractors and combines. As of February 2009, the USDA was projecting a 20% drop in net farm income for 2009. The anticipated decline largely reflects higher expected crop receipts due to decreased commodity prices.

HOW THE INDUSTRY OPERATES

Manufacturers in the heavy-duty machinery industry rely on their technological expertise and market reputations for survival. Their products are crucial to their customers, often determining the customers’ business success or failure.

To manufacture heavy-duty machinery typically requires months. Selling it can take many months—sometimes years. Before purchasing such equipment, customers usually undertake detailed analyses of such factors as price, reliability, quality, productivity, life-cycle operating costs, in-service performance, and aftermarket service. The purchase decision will be reviewed by several layers of management within a firm and sometimes by its board of directors. Ultimately, the customer’s decision to purchase this capital-intensive equipment from a specific manufacturer involves a long-term commitment that can generate a lucrative revenue stream for the manufacturer.

Riding the cycles The heavy-duty machinery industry comprises highly cyclical businesses whose fortunes tend to lag those of the global economy. Typically, increases in heavy-duty machinery spending stem from customers’ decisions to replace aging equipment or to add capacity. Among the factors involved in the decision to replace aging equipment are an overall cost/benefit analysis of maintaining the old equipment versus buying new, the outlook for markets served, and the impact of government regulations.

Capacity increases or decreases in industries that buy heavy equipment are driven primarily by capacity utilization rates and projections of future demand and profits. When capacity utilization rates are high and demand growth is anticipated, companies will typically purchase additional machinery and equipment. Conversely, when capacity utilization rates are low and management expects little or no long-term pick-up in demand levels, companies will forgo purchases of heavy-duty machinery. Within this general context, however, the various segments of the heavy-duty machinery industry (which includes heavy trucks, farm equipment, and construction equipment) exhibit differences and particularities.


HEAVY TRUCKS

The heavy truck category comprises medium-duty trucks (Class 5–7; 14,001 pounds to 33,000 pounds) and heavy-duty trucks (Class 8; more than 33,000 pounds). Leading heavy-duty truck manufacturers model their operations around the industry’s cyclicality and the need to customize products. They focus on the design and assembly of truck platforms, and they rely on suppliers of parts and components to design and produce the various mechanical, electronic, interior, and exterior systems that are assembled to make a vehicle. This practice lets the truck manufacturer or assembler maintain the lowest possible fixed-cost base, and it gives customers greater flexibility to outfit vehicles as they desire.

What customers want Heavy trucks are highly customized vehicles, manufactured to suit the end user. Buyers have traditionally selected the “hard parts”—engines and transmissions (power trains), axles, suspensions, wheels, tires, brake systems, seating, and other interior and exterior features—based on the purpose and route the truck is to serve. Considerations include the distance traveled per trip, geographical region, road topography, and cargo type. For example, for long-haul shipments where speed of delivery is a priority, carriers may prefer a comfortable truck with a large fuel tank. In the case of heavy-load shipments where weight limitations are a consideration, a carrier may choose to go with a lighter truck and a smaller fuel tank.

Today, customizing extends to sophisticated electronics systems, such as antilock brakes, crash avoidance warning systems, and tracking and communications devices enabled by the global positioning satellite (GPS) system. A customer may decide to add these electronic features to boost the operating efficiency of its fleet, to improve safety and reliability, or to satisfy regulatory mandates.

Despite the high degree of customization, the product life cycle of heavy trucks is quite long. Basic vehicle redesigns occur as infrequently as once a decade; when they happen, they are primarily the result of breakthroughs that permit more efficient truck design through improvements in aerodynamics or weight reductions in components made by assemblers. Interim efficiency improvements come primarily from gains achieved by component suppliers, especially in the power train and axle categories.

Concentration and competition The heavy truck industry is a concentrated field, with just four major competitors in the Class 5–8 segment of the North American truck market: Freightliner (a division of DaimlerChrysler AG), Volvo Trucks North America Inc., Paccar Inc., and Navistar International Corp. Industry concentration also extends to the component level. Currently, there are just three domestic heavy truck diesel engine makers, two axle makers, and two transmission producers.

Despite this concentration, price competition tends to be intense over the course of the industry’s business cycle. This is partly because customers closely compare competing trucks and the combinations of components on competing vehicles. Price competition varies in intensity, depending upon the desirability of a particular order. Customers gain bargaining power by virtue of the size of their potential orders and their own financial soundness.

Unlike the domestic automobile industry, the heavy truck industry has not faced significant foreign competition. Some foreign manufacturers, such as DaimlerChrysler and Volvo, have acquired US heavy truck manufacturers rather than establish completely new truck brands.

Due to different geographical terrain and local needs, Class 8 trucks are not manufactured in many foreign countries. Outside the US, two factors favor the use of smaller trucks: goods typically move relatively short distances, and narrow city streets cannot accommodate large trucks. Thus, import competition in North America has not been a factor in the Class 8 market. In the medium-duty trucks segment (Class 5–7), however, foreign truck producers have made inroads into the US market.


Orders and distribution Customer orders are the lifeblood of the truck industry, helping to determine manufacturers’ production plans and profit outlook. Most production is customer-specified—that is, it consists of trucks made to order. Thus, a manufacturer’s order backlog is critical in determining its production line rates and employment levels. Given the high level of training that workers need to produce these specialized vehicles, advanced planning is required. Truck manufacturers monitor the backlog to determine how many workers are needed and how many will need to be trained.

During periods of economic weakness, truck orders slow as fleet operators usually find themselves with excess capacity—that is, idle trucks. In the transportation business, this is called unused equipment. During such periods of excess capacity, fleet operators often cancel or defer pending truck orders. Instead of replacing aging trucks, fleet operators repair them, thus extending their useful lives. To conserve cash during prolonged financial crunches, fleet operators sometimes cannibalize idled trucks for spare parts.

Truck makers establish and support networks of independently owned dealers. These dealers stock sample vehicles and maintain inventories for sale to independent truck operators—individuals who typically operate a single vehicle at a time, which they buy out of inventory. Dealers are also responsible for gathering orders and passing them through to the manufacturer.

Most dealers are affiliated with a single manufacturer. The manufacturer typically supports the dealer’s sales and marketing efforts (with cash payments, marketing strategies and materials, and the like), provides wholesale financing of dealers’ inventory, and offers sales and lease financing to retail customers. Manufacturers also give discounts, rebates, and other marketing subsidies to stimulate sales when necessary.

Regulation The US government regulates the truck industry through its safety and emissions laws. Truck manufacturers must comply with its mandates, and parts and components suppliers are often concerned as well. Regulations concerning such items as brake systems usually force a truck maker and its systems producers to work closely together to achieve compliance. Emissions regulations are primarily the province of the engine manufacturers, which often keep truck makers apprised of regulatory and production developments.


Producers of agricultural equipment manufacture the machinery farmers use to cultivate land and to plant and harvest crops. This equipment includes tractors, plows, cultivators, sprayers, spreaders, combine harvesters, balers, and assorted implements attached to the tractors and combines for tending crops. Most producers of motorized agricultural equipment also manufacture construction and industrial machinery, such as logging equipment and general-purpose tractors.

As with heavy trucks, the most important segments of the agricultural equipment sector have become concentrated after much consolidation in the 1980s. Today, the remaining large players are looking overseas to extend their reach into new markets. Many are entering developing areas of the world and the recently opened markets in Eastern Europe via acquisitions and joint ventures. In addition, over the past decade, a new market has begun to emerge for these companies in the under–40-horsepower tractor market. Purchasers of these smaller tractors include homeowners, turf and land caretakers, commercial contractors, public agencies, rental businesses, golf courses, hobby and part-time farmers, and industrial plants. The Association of Equipment Manufacturers (AEM), a trade organization, estimated that sales of units of under-40-horsepower tractors (used by the AEM as a proxy for overall agriculture equipment demand) will decline about 11% in 2009 from 2008.

Competitive pressures affect the fortunes of agricultural equipment makers. These pressures largely result from wide swings in crop prices and in farmers’ income, often caused by the impact of weather on the success or failure of crops. When crop prices and farm incomes decline, demand for agricultural equipment usually dips as well. During periods of weakness, prices deteriorate as equipment manufacturers attempt to maintain sales and output. Eventually, they slow production and lay off workers.


In North America, agricultural equipment is purchased or leased by individual farmers and farm cooperatives for use on the 2.1 million US farms in 2008 and 0.23 million Canadian farms in 2008. In the European Union (EU) countries, 9.9 million farms were in operation in 2003 (latest available), according to the European Commission. (Note: This EU total is not comparable with previous years because more countries are now included.)

Establishing a pipeline Agricultural equipment producers establish and support networks of dealers who maintain inventories of popular models and equipment. In addition, farm equipment makers finance sales and leases. Most agricultural equipment is sold out of inventory.

The variables for a tractor include engine size and power, the number of drive axles, the type of tires, and such amenities as air conditioning and audio equipment. Combines are somewhat more customized for each client, depending on the specific application and the combination of farm implements required to perform the tasks. Characteristics that help determine the way a tractor or combine is outfitted include the size and quality of the land farmed, the crop planted, and the climate of the region where the equipment will be used.

Government subsidies prop up farm income Demand for farm equipment closely reflects fluctuations in farmers’ incomes. In years that follow good harvests and favorable prices, farmers tend to reinvest their profits in new equipment. However, farmers’ incomes can fluctuate wildly, due to the vagaries of weather and volatile crop prices.

For decades, the US government and the EU countries have implemented various farmer aid programs, in an effort to try to stabilize volatile farm incomes. During leaner years, the level of government support can range from 30% to more than 50% of farmers’ annual income. These programs primarily consist of subsidies, which farmers receive if they cannot generate returns greater than production costs; price supports, which guarantee purchases of crops at preset prices; and set-aside programs, which essentially pay farmers not to grow crops.

The problem with subsidies and price supports is that they typically exacerbate supply and demand imbalances. These programs encourage farmers to plant more crops, even when prices are low, because the government guarantees payments. This scenario ultimately can lead to gluts in grain supply, dramatically increasing the likelihood of chronically weak grain prices and tepid long-term growth in farm income.

Domestically, in an effort to wean the farming industry from government payments, Congress eliminated most subsidy and set-aside programs in 1996, when farmers were enjoying a rare period of strong worldwide demand and crop prices. Subsequently, the farm depression in the late 1990s brought the subsidy issue back to the forefront. As a result, Congress and President George W. Bush resurrected these subsidy programs by passing the Farm Security and Rural Investment Act (known as the US Farm Bill) in May 2002. The Congressional Budget Office estimated that the program would cost approximately $171 billion over 10 years. The current farm bill, known as the Food, Conservation, and Energy Act of 2008, replaces the last farm bill that expired in September 2007. The current bill calls for farm subsidies totaling $307 billion over five years. According to the USDA, farmers are expected to receive $11.4 billion in farm subsidies in 2009, down from $12.4 billion in 2008 and $11.9 billion in 2007. We see this funding subject to change in view of the funding needed for the American Recovery and Reinvestment Act of 2009 passed by the Senate in February 2009.

In the European Union, subsidies have been commonplace for a number of years. Under the Common Agricultural Policy (CAP), the EU equivalent to the US Farm Bill, support payments total approximately $50 billion a year and account for over 40% of the European Union’s annual budget.

Government regulations have not been all bad Government regulation has not severely constrained the agricultural equipment market in terms of equipment design. For instance, the US Environmental Protection Agency (EPA) has not yet implemented emission regulations for agricultural and other off-highway vehicles, although such regulations have been contemplated from time to time and probably will be put in place eventually. They are not likely to raise


difficulties for the industry, however, in that they would mostly affect the diesel engines employed in farm equipment. Because farmers buy most of this equipment with government money, which is guaranteed, it is easier for manufacturers to pass along costs associated with developing compliant engines. In addition, the US Farm Bill allocated funds for farmers to buy cleaner-running engines.


Construction equipment manufacturers produce a broad line of heavy-duty off-road vehicles that are used in the construction of highways and buildings, as well as in mining, forestry, and landfill operations. These machines facilitate the recovery and movement of heavy payloads. Equipment typically produced by these manufacturers includes vehicles such as tractors, loaders, excavators, backhoe loaders, off-road trucks, scrapers, graders, pavers, log loaders, feller bunchers, skidders, and land compactors. These categories include some of the largest pieces of machinery in the world, designed to perform some of the most physically demanding tasks.

The particular segments that the industry serves influence demand for construction equipment. The largest factors are related to residential, nonresidential, and public construction, which comprise new housing, buildings, roads, highways, dams, and other major construction projects undertaken by both the government and private industry.

As with heavy trucks and agricultural equipment, distribution of construction equipment relies on dealer networks supported by the manufacturers, which finance sales and leases. Unique to the construction equipment sector, however, are dealer-owned rental fleets that have been recently established. This equipment is leased to construction and maintenance companies that need it for relatively brief periods.

Types of construction equipment Most construction equipment can be segmented into one of three broad categories.

Earth-moving machinery. This segment encompasses a broad range of equipment used to excavate and transport earth for purposes of building construction. It includes crawler dozers, loaders, wheel loaders and dozers, scrapers, graders, hydraulic excavators and backhoes, trenchers, pipe layers, and off-highway trucks.

Building construction (residential, commercial, industrial, and institutional) is by far the leading source of demand for earth-moving equipment. Road and dam building projects also have generated considerable demand historically, but with the interstate highway system virtually complete, that market will center on road repair and maintenance in the future. Domestic dam building has slowed, and a number of large projects are nearing completion in foreign countries.

Excavators and cranes. Used on virtually all types of construction projects, excavators range from small backhoes that can be mounted on a tractor or other prime mover to large walking draglines and power shovels used in major surface-mining projects. Because power shovels have relatively long, useful lives, replacement parts account for a significant portion of shovel makers’ total sales.

The major markets for cranes include bridge, highway, and large commercial and industrial construction projects. Heavy cranes are increasingly employed in offshore oil drilling and production platforms. As with power shovels, replacement parts are an important supplement to original equipment sales for the manufacturers. Most makers of heavy-lift cranes also produce hydraulic cranes.

Underground mining machinery. This category comprises essentially three types of machinery: conventional equipment, continuous miners, and longwall systems. The latter two are used primarily in the underground production of coal. Conventional equipment includes cutters, drills, loaders, shuttle cars, conveyors, and roof bolters. The continuous miner removes coal from the face of a seam and loads it into cars on conveyors, obviating the need for cutting machines, drills, or explosives. This system improves both mine productivity and worker safety.


Also efficient are longwall mining machines, which shear coal from the face of a seam in long slices and move it to the surface via conveyors. In mines where coal seams are thick enough and where the estimated mine life justifies the capital investment, this equipment can substantially improve productivity.

Other construction equipment. This category includes asphalt and concrete pavers; mixing, spreading, and finishing machines for asphalt and concrete; compactors, with both highway and landfill applications; air compressors and air tools; pumps; hoists; and rock-crushing and screening equipment. Many earth-moving equipment companies are also active in this area.

Heavy-duty machinery engines Engines for heavy-duty machinery are manufactured for a variety of applications. In general, however, they are classified as either on-highway (heavy- and medium-duty trucks) or off-highway (construction and farm equipment). The industry is highly concentrated, heavily regulated, and influenced by the same types of factors as the end markets that it serves. Primary participants in the on-highway segment include Caterpillar Inc., Cummins Inc. (formerly Cummins Engine Co.), Navistar International Corp., Volvo, and DaimlerChrysler. Manufacturers of off-highway engines include Caterpillar, Cummins, Deere & Co., Ford Power Products, General Electric Co., and Waukesha Engine (a division of Dresser Inc.).

KEY INDUSTRY RATIOS AND STATISTICS

Unit sales. For industries that sell discrete products such as heavy trucks, agricultural equipment, and construction equipment, the level of unit sales is a meaningful statistic. By tracking unit sales over time, volume demand for a particular product can be determined without having to adjust for inflation, as must be done with dollar revenues. One limitation of unit sales figures, however, is that they do not reveal whether a particular item sold is equivalent in terms of value and productivity to a unit sold earlier. Unit sales figures for capital goods industries are generally available from industry associations and individual companies on a monthly basis.


Construction spending. The US Census Bureau, a data-gathering agency within the US Department of Commerce, tracks construction spending on a monthly basis. It divides the data into residential, nonresidential, and public construction categories, and then into narrower categories that can be tracked for guidance on industry conditions. The Census Bureau disseminates statistics on construction spending 60 days after the close of each month.

Seasonally adjusted annualized spending for residential, nonresidential, and public construction fell 9.1% to $986.2 billion in January 2009, from $1,085.3 billion in January 2008.


Cash farm income. A key economic statistic for agricultural equipment makers is cash farm income: the aggregate net income from all individuals and companies engaged in agriculture. How much money farmers make has a direct influence on their equipment spending plans. Naturally, farmers tend to spend more to upgrade and replace farm equipment in prosperous times and to delay farm equipment purchases during lean times. Cash farm income statistics are provided on an annual basis by the Economic Research Service unit of the US Department of Agriculture (USDA).

Net farm income was an estimated $89.3 billion in 2008, up from $86.8 billion in 2007. It is projected to decrease to $71.2 billion in 2008. (For long-range cash farm income projections, see the table entitled “Farm income projections” in the “Current Environment” section of this Survey.)


Grain production and prices. Production levels of crops such as corn, soybeans, and wheat directly affect prices and, thus, farm income—the primary demand driver of farm equipment purchases. The USDA’s National Agricultural Statistics Service reports crop prices in its monthly Agricultural Prices publication.

HOW TO ANALYZE A CAPITAL GOODS COMPANY

Heavy-duty machinery companies derive the bulk of their revenues from the manufacture, sale, and servicing of productive equipment used in a variety of industries. Although each category in which they participate has its own particular nuances, there are many similarities in operations and in performance measures. The industry sectors covered by this publication are largely involved in the manufacture of products that are customer-specified to some degree. Many of the products are manufactured in batch or specific job orders. Customers typically order these products in a competitive bidding process, combined with detailed negotiations. Following, we discuss the analytical elements that are common to all of the capital goods industry groups, then the specific factors for each of the industry categories.

ANALYZING THE INCOME STATEMENT

Analysis of a company’s income statement provides the data needed to measure operating performance over a particular period. Analysis of longer-term results reveals trends in sales and profits over the course of a business cycle.

Sales and revenues Generally accepted accounting principles (GAAP) require that companies recognize a sale when a product is shipped or a service is rendered. Thus, in the case of heavy trucks and agricultural and construction equipment, manufacturers record sales when their products are shipped to independent dealers or to end users.

On occasion, manufacturers of large custom-built machinery or equipment will receive long-term contracts to manufacture highly specific equipment. These companies normally record sales on a percentage-of-completion basis, reflecting the portion of the sales contract that they have fulfilled. Among product categories, such contracts are typically used for the sale of mining equipment, material-handling equipment (such as the overhead cranes used in shipyards), and shipbuilding.

Recording revenues when products such as heavy trucks are shipped is a fairly straightforward process. However, accounting for percentage-of-completion contracts can be tricky because of the inherent flexibility in measuring the mileposts of a contract. Under the percentage-of-completion accounting method, sales and profits recognized on individual contracts or jobs are based on a project’s overall expected profitability. They are also subject to adjustment upon completion of the projects. For example, if a contract is expected to result in X dollars of income, when the job is Y% complete, Y% of X dollars would be recognized as profit.

The danger with this type of accounting is that it recognizes profits before they are realized. If cost overruns occur late in a project, a charge to earnings may be required to reflect the job’s lower actual profit. Thus, relying on conservative profit estimates can increase the likelihood that any adjustment will be a favorable one.

Another caveat is that companies have wider latitude to “manage” earnings under this type of accounting, by recognizing more or less profit in a given accounting period. In periods when overall profits are higher than expected, a company might recognize lower profit on individual contracts, which would hold earnings at a desired level. Conversely, when business is slow, profits that had been deferred might be recognized to increase reported earnings. This enables the company to report an orderly earnings increase that meets investors’ expectations.

Gross profit margin Gross profit margin (or gross margin) measures a company’s profitability before selling, general, and administrative (SG&A) expenses and interest expense. To calculate gross margin, subtract the cost of goods


and services sold from sales, and divide the result by sales. It is one of the clearest performance measures of a company’s operations because it excludes the impact that a company’s financial structure has on its ultimate profitability.

Gross profit margins can lend important insight into trends in market pricing, product mix, and costs of raw materials and labor. In addition, they can enable the analyst to discern the impact of raw material and labor costs on the business. Tracked over time, gross margins can provide a reliable read on a company’s productivity, particularly in the case of companies that disclose unit sales. If unit sales are known, the analyst can calculate per-unit revenue and gross profit by dividing sales and gross profit, respectively, by the number of units sold.

For heavy-duty machinery companies, trends in gross profit margin may vary widely from one sector to the next. For instance, heavy truck makers typically have a high level of fixed costs and, thus, a high break-even point. Once the break-even point is passed, they enjoy substantial profits per unit sold. They will therefore have wide swings in gross profit margin over the course of an economic cycle.

SG&A expense SG&A expense represents the selling costs and general and administrative expenses of a company. Companies with large direct sales forces and branch offices throughout their covered regions are likely to have higher SG&A expenses as a percentage of sales. However, in return, they are also more likely to have a knowledgeable sales force and greater penetration of their target markets, which could yield improved sales results. In contrast, companies that rely more upon independent dealers (who also sell competing products) tend to incur lower selling costs, with the potential trade-off of a less knowledgeable sales force and/or nonexclusive arrangements.

Other costs The remaining items in the income statement tend to be heavily influenced by a company’s particular financial and operating structure. Interest expense is a function of a company’s capital structure, while taxes can be heavily influenced by the geographic location of a company’s operating subsidiaries or the parent company’s state or country of domicile.

ANALYZING THE BALANCE SHEET

Analysts should look at a company’s balance sheet to determine its financial strength or potential weakness. Changes in the working capital ratio—the ratio of current assets to current liabilities—will show whether the company is using more or less cash than usual for normal operations and whether the business has potential liquidity issues. A build-up in accounts receivable as a percentage of sales may indicate problems with a customers’ bill payments, while growth in the inventory-to-sales ratio can foretell a slowdown in production levels or asset write-offs.

Most companies in the heavy-duty machinery universe will use some amount of debt to finance operations and capital expenditure requirements. However, too much debt can elevate the risk of investing in the shares of a company, as a greater proportion of cash that the company generates has to go toward interest payments, rather than being retained in the business for further growth. The debt-to-capital (D/C) ratio indicates the extent to which a company finances its operations and capital expenditures through borrowings that must be paid back in the future. In the heavy-duty machinery universe, most companies aim to achieve a D/C ratio in the range of 30% to 50%.

ANALYZING THE CASH FLOW STATEMENT: FREE CASH FLOW

Perhaps one of the most telling aspects of a company’s financial condition is the amount of free cash flow (FCF) that it is able to generate. For the purposes of this Survey, we define FCF as cash from operations, less net capital expenditures. FCF reflects the amount of money from normal operations that is available to fund acquisitions, pay down debt, repurchase shares, or distribute as dividends. Identifying a normalized


level of free cash flow for a company is one of the key steps in the discounted cash flow (DCF) approach that we use to value heavy-duty machinery companies.

KEY INDICATORS

Key indicators of a heavy-duty machinery company’s current health and future prospects include new orders and order backlogs, the book-to-bill ratio, and unit volume and production line rates.

New orders and order backlogs The two most important of the key indicators are new orders and order backlogs. New orders and order backlogs are among the most closely watched data for the heavy- and medium-duty truck, and the agricultural and construction equipment sectors.

When examining these figures, however, an analyst should be keenly aware of how a company calculates its data. When examining orders, it is necessary to know whether the company is disclosing gross, firm, or net orders, whether backlogs represent firm or funded backlogs, or if the company has increased the backlog’s worth by including the value of options or potential follow-on orders.

In its most general sense, the term “backlog” represents the accumulation of unshipped orders. However, there are different kinds of backlog. Gross orders represent the value of new orders that the firm has received. Net orders represent gross orders minus the value of any cancellations. Some orders are “firm and funded” (meaning that the customer has already made an initial deposit and will pay the balance upon shipment) and thus cannot be canceled. Others are unfunded, such as contracts with government bodies that must authorize funds for financing the purchases. While a higher backlog can be indicative of an upswing in demand, backlog should not be viewed in isolation; a higher backlog without a corresponding increase in new orders may indicate production problems.

Occasionally, a company will call its backlog a “total backlog” and include the value of all optional parts of a contract. In such cases, two figures are usually disclosed: the firm backlog and the total backlog. For example, if a heavy truck firm received orders for 300 trucks, of which 100 were firm orders and 200 were options on orders, the firm backlog would be 100 trucks, while the total backlog would be 300 trucks.

A company’s policy for recognizing orders often depends on the customer involved or the specifics of a contract. For instance, it is common for companies that receive multiyear government contracts to recognize in the backlog only the portion of the contract that is funded in the current government fiscal year. The portion of the order pertaining to future years may be recognized only when funds are appropriated by the government organization.

Book-to-bill ratio The book-to-bill ratio compares the value of a company’s new unfilled orders (bookings) with the value of its products sold or services provided (billings) typically on a quarterly or annual basis. This ratio can be calculated for durable goods orders and construction orders. A ratio above one indicates that the company has received more orders than it is able to fill out of current production. Conversely, a ratio less than one means that the company received fewer orders than it is able to fill. A ratio equal to one indicates that the orders received equal the amount that the company is able to fill.

Unit volume and production line rates Unit volume is a common measure of growth in the heavy- and medium-duty truck, agricultural equipment, and construction equipment industries. Tracking the number of units ordered, built, or sold makes comparisons easy over a long time period without having to adjust for inflation, as must be done when examining dollar values for these industries. Production line rates and, more directly, expected changes in line rates can be used to prepare an estimate of future revenues.


INDUSTRY REFERENCES

PERIODICALS Agricultural Outlook http://www.ers.usda.gov Monthly; focuses on the farm economy. Construction Equipment http://www.constructionequipment.com Monthly; covers the construction equipment industry. Engineering News-Record http://www.enr.com Weekly; covers engineering and construction. FAPRI-UMC Reports http://www.fapri.missouri.edu Series published monthly (or more frequently) by the Food and Agricultural Policy Research Institute (FAPRI) at the University of Missouri; provides various farm statistics and projections. Machinery Outlook http://www.manfredi.com Monthly; covers the diversified machinery group. Ward’s Automotive Reports Ward’s Automotive Yearbook http://www.wardsauto.com Weekly and annual publications, respectively, covering auto and truck manufacturing. World Agricultural Supply and Demand Estimates (WASDE) http://www.nass.usda.gov Monthly publication of the USDA’s National Agricultural Statistics Service; provides various agricultural statistics and forecasts. TRADE ASSOCIATIONS American Machine Tool Distributors’ Association http://www.amtda.org Trade association for US machine tool distributors. Association of Equipment Manufacturers (AEM) http://www.aem.org Trade organization representing manufacturers of agricultural, construction, mining, forestry, and utility equipment, plus suppliers of related products and services. It provides statistics and addresses safety, technical, and public policy issues.

RESEARCH FIRMS AND INSTITUTIONS Americas Commercial Transportation Research Co. LLC (ACT Research) http://www.actresearch.net Independent commercial vehicle research organization. Publishes five monthly reports covering the North American medium and heavy truck and trailer markets, and maintains supporting databases; also publishes special reports and white papers. Food and Agricultural Policy Research Institute (FAPRI) http://www.fapri.missouri.edu Independent, nonprofit agricultural forecasting organization at the University of Missouri. F.W. Dodge http://www.fwdodge.com Provides construction information, statistics, and news. GOVERNMENT AGENCIES Bureau of Labor Statistics (BLS) http://www.bls.gov/data The federal government’s principal fact-finding group in labor economics and statistics; part of the US Department of Labor. The Federal Reserve System http://www.federalreserve.gov Government organization that supervises and regulates banks, conducts US monetary policy, and provides services to the US government and the public. US Census Bureau http://www.census.gov Part of the US Department of Commerce; collects US population and economic data. US Department of Agriculture (USDA) http://www.usda.gov A cabinet-level department; performs agricultural research and economic analysis.

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rant

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HEA

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RU

CK

S IN

DU

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by S

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Com

pust

at —

A D

ivis

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of T

he M

cGra

w-H

ill C

ompa

nies

heavy equipment & trucks

Documents