Bulldozer: how Caterpillar rode over the Asian currency collapse.
Record sales and near-record profits were Caterpillar's take-away from the Year of the Asia Crisis. Who'd a thunk it? The Peoria powerhouse merely shrugged off what analysts at the Federal Reserve Bank of New York and other brain trusts had identified as the direst economic-competitive threat to American industry in over a decade.
Last year's steady stream of press releases blaming bad earnings news on Asia indicates the economists weren't off base when they predicted difficult times for American manufacturers. But Cat's immunity to the Asian Contagion was the fruit of carefully laid plans. Battered by the cheap yen in the early 1980s, Cat took radical action to eliminate the threat, and its record sales in the teeth of Pacific turbulence prove the strategy worked.
Cast an eye backward. The year: 1979. New Fed Chairman Paul Volcker bites the hand of the peanut-farmer-president who appointed him and sets the central bank on an inflation-busting course that will send the Fed funds rate into double digits, bring on a full-fledged recession and usher Ronald Reagan into the White House. The Reagan Revolution cuts taxes but not spending. Interest rates ratchet higher. And global investors eager to earn those eye-popping rates bid the dollar up, up, up.
The effects are felt in the oddest places - cold, desolate Tumbler Ridge, in British Columbia mining country, for example. This is Cat country. So much so that the chairman of local Cat dealer Finning Tractor & Equipment Co. used to joke, "You have to be an absolute genius to lose money as a Caterpillar dealer." During the late 1970s, Finning had grown at 22 percent per year. But the dollar's surge gave Japan-based rival Komatsu a 40-percent price advantage in the early 1980s. Thanks to the dollar-yen exchange rate shift, you could buy almost two Komatsus for the price of one Cat. Suddenly, Finning's chairman looked like Einstein.
The Earth Moved
British Columbia was no anomaly. The competition was hitting Caterpillar everywhere. Lynn McPheeters, who stepped into the CFO slot in November 1998, was treasurer of Caterpillar's Far East unit in 1983. "We had to be competitive, and we tried to be competitive by lowering our dollar prices," he recalls. "As you can imagine, we had to get down to some very low price levels that weren't attractive to us. But it was the only thing we could do at the time to counter the undervalued yen, because our Japanese competitors were coming in with some very low prices."
Caterpillar's then-chairman, Lee Morgan, kept a high profile, criticizing Fed policy and demanding that the government bring the dollar down. But to some, Cat and its corporate peers looked like industrial dinosaurs, out of touch with a new world in which governments in fact had limited power to influence capital flows and currency rates.
"The early '80s were a wake-up call. All American manufacturers really had their bells rung," says Douglas R. Oberhelman, who in November 1998 moved from Cat's CFO position to head worldwide engine sales and marketing in the engine products division. "We recognized that our company was exposed to currency movements and embarked on a long-term, detailed strategy to become less currency-sensitive."
Cat assembled a task force with representatives from treasury, manufacturing, sales and other areas to study the problem and recommend solutions. The task force identified several issues. First, Cat manufactured most of its machines in the United States, incurring costs in dollars. But dealers like British Columbia's Finning had to compete in local currency prices. The devil was in the mismatch. When the dollar strengthened, it took more Canadian dollars, French francs, German marks, Japanese yen or Brazilian cruzeiros to buy a dollar, or a machine priced in dollars. Of course, when the dollar weakened, those local currencies bought more dollars, so Cat had a competitive advantage. But if recent history was any guide, betting the company's future on the foreign exchange markets looked to be a high-risk wager.
Komatsu had been, if not a negligible player, something less than a threat until the dollar-yen rate handed it market share on a plate. But there was no reason to expect that the fall of the dollar that began in 1985 would eliminate competition from Japan. Cat's task force also found its big Japanese competitor had relied on its dominance of the Japanese market to subsidize its global export drive. Japanese corporations that earned high margins on domestic sales could afford to take lower margins on international sales, and thereby sustain a long battle for global market share. Of course, when the Japanese established themselves as serious competitors, they crossed an important psychological threshold. Customers were now in the habit of checking out what Komatsu was offering before they bought.
Cat's strategic response hit all the competitive nails on the head. Cat would battle its Japanese competitors, eliminate currency risk and remake itself as the lowest-cost producer of the highest-volume machines on all four continents. Known internally as the "Four Continents Strategy," this plan would entail a thorough reorganization and restructuring, precipitate a bitter battle with Cat's unionized American workforce and inspire the unwelcome compliment of emulation by the competitor it was designed to thwart.
Declawing Exchange Risks
Oberhelman soon boarded a plane to Japan, where he would direct a new joint venture with Mitsubishi aimed squarely at Komatsu's dominance of the high-volume hydraulic excavator business. "By producing in Japan, we took away any advantage our Japanese competitor had over us," he says.
Meanwhile, Cat was implementing a strategy to put its manufacturing where the customers were. About 40 percent of Cat's production now is outside the United States, but that figure doesn't tell the whole story. "Three-quarters of the units sold in Europe are made right there," says Oberhelman. "The majority of units used in Asia are produced in Asia, the same in South America, including Brazil, and in the United States. Rather than shipping a bunch of iron around the world, we produce locally. This cuts shipping costs and puts us in the same currency zone as the customers, so we neutralize exchange risk."
What makes Cat's strategy particularly noteworthy is that it was conceived and implemented when currency rates didn't seem much of a threat. The dollar hit its historic highs in 1985, then tumbled. The late 1980s were fat years for American manufacturers, plenty of whom were willing to write off the currency crisis of the Reagan years as an historic anomaly. In fact, Japanese corporations were themselves busy setting up global manufacturing networks.
Significantly, Komatsu adopted a mirror image of the Caterpillar strategy when the yen began to strengthen in the late 1980s. "Depending on the yen had helped us short term, but we had to have a long-term strategy that made more sense so we can compete into the next century," says a senior executive at Komatsu America International Co., headquartered in Vernon Hills, Ill., just up the road from Caterpillar. "When the yen got strong, it spurred us to get more aggressive on globalization."
Like Cat, Komatsu reduced its exposure to currency risk by manufacturing products as close to the customer as possible. Komatsu now boasts a diversified international manufacturing base that includes plants in Peoria, Ill., and Chattanooga, Tenn., as well as in Asia and Europe. On some products, only 15 percent of Komatsu's cost is yen-based.
Caterpillar's strategy got its first real test after the historic summer of 1997, when a speculative attack on the Thai baht succeeded, and the rest of the Asian currencies fell like dominoes. By February 1998, a Federal Reserve Bank of New York report showed the trade-weighted dollar at its highest levels in a decade and predicted a tougher competitive environment for American companies. The Institute for International Economics in Washington foresaw a $50 billion hike in the U.S. trade deficit.
A roster of American companies announced bad earnings news. Yet Caterpillar sailed through the storm all but unscathed. It set sales ($18.93 billion) and profitability ($1.67 billion) records in 1997, the year the crisis broke. More impressively, in 1998, even with the Asian market moribund, Caterpillar boosted sales by another 11 percent, to $20.98 billion. Profitability was 9 percent under the 1997 record, but currency wasn't to blame.
In its earnings release, the company noted, "The unfavorable impact of the stronger dollar on sales was mostly offset by a favorable impact on costs." In dollar terms, Caterpillar's Four Continents strategy operates as a natural hedge. Since costs are incurred in the same currencies as revenues, the kind of currency mismatch that killed the Cat in the early 1980s doesn't happen any more, at least not to any appreciable degree.
For example, CFO McPheeters says, "When the dollar strengthened against the European currencies, we had a disadvantage on the pricing side against European competition, because our European currency prices are lower in dollar terms. But because we manufacture in Europe, we benefit on the cost side. That is, our European currency costs are also lower in dollar terms."
Because Caterpillar has so neatly matched costs and revenues, it can dispense with most currency hedging. "We only put a hedge in place against a specific identifiable obligation, and our activity is relatively small, really," observes McPheeters. "From what I know of some of my counterparts at other companies, we're not even on the same radar screen in terms of hedging." Caterpillar monitors 35 currencies, and uses currency options, forwards, swaps and similar financial instruments, but all its hedges are short term, for a year or less. "We will protect a unit's business plan for them if they want to lock it in, so they're not subject to currency fluctuation," McPheeters says. "But we try to operate pretty much on fundamentals and don't get too cute with technical movements or try to market time. It's a strategic activity as much as anything."
A Cat With at Least Nine Lives
Caterpillar seems to have an open field ahead. Its main Japanese competitor faces some peculiar difficulties. The economic crisis in Japan has, paradoxically, strengthened the yen against the dollar, and given a market opportunity to possible competitors in Korea, whose won has dropped far beneath the yen. Korean manufacturers occupy a competitive position in the 1990s somewhat similar to Komatsu's in the 1970s, but Oberhelman offers three reasons the Koreans aren't likely to duplicate Komatsu's ride to glory.
First, Korea lacks the kind of big, captive domestic market that let Komatsu subsidize its export push. Second, Korean manufacturers of heavy equipment are relatively minor parts of the huge industrial groups, called chaebol; there's no Korean equivalent to a Komatsu or a Caterpillar. And third, competing effectively in the heavy equipment market now means maintaining a network of dealers able to provide spare parts and service. When a big shovel goes down, the opportunity cost is high, and few customers are willing to risk uncertain service. The shaky credit of the chaebol means it would be hard for Korean competitors to finance and build the necessary dealer and service infrastructure to compete on anything like equal terms with Caterpillar and Komatsu.
So, with currency competition all but eliminated as a competitive factor in Caterpillar's business, McPheeters' big challenge is a welcome one: managing growth. "We've done an awful lot in the past few years to position this company for growth," he explains. "Economic cycles are something we watch, but the beauty of what we've done in the last 10 years is that the diversity we've built into our product lines insulates against the wide economic swings in various regions." Although McPheeters says Caterpillar unquestionably operates in cyclical businesses, he argues that it's not a cyclical company, because its diverse products, services and markets balance cycle against countercycle to give it a smooth ride.
In Doug Oberhelman's four years as CFO, sales went from roughly $16 billion to $20.9 billion. McPheeters anticipates another sales and revenue leap. "We're pointing ourselves at being a $30-billion company in the next decade," he says. "So I guess the main thing we want to do is stay the course, keep up with the funding requirements for that growth and protect what is a very strong balance sheet."
Nice work, if you can get it.
New Jersey-based Gregory J. Millman's last article for Financial Executive was "Visionary CFOs."
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|Author:||Millman, Gregory J.|
|Date:||Mar 1, 1999|
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