Caterpillar Rides the Rails with $820 Million Deal

Caterpillar's railroad products unit, Progress Rail Services, agreed Tuesday to purchase Electro-Motive Diesel (EMD), a maker of diesel-electric locomotives, for $820 million in cash. The move will increase the presence of the heavy-equipment maker in the railroad industry.

Caterpillar's (CAT) incoming CEO, Douglas Oberhelman, has wasted little time in shaking things up. In addition to this deal, the CFO and four other senior executives have departed this week. The top ranks will shrink from 39 to 35, as Oberhelman tries to streamline things.

A Pioneer in Diesel Power

Founded in 1922, EMD became a pioneer of the diesel locomotive. Eventually, General Motors saw the opportunity in this technology and purchased the company.

But in 2005, GM spun-off EMD to a group of private equity sponsors, which included Greenbriar Equity Group and Berkshire Partners. Since then, the company has gained traction -- despite the grueling recession. EMD has increased R&D, nearly tripled capital expenditures with next-generation equipment, and doubled revenues. As a testament to its capabilities, EMD's locomotives can deal with just about any type of environment -- whether it's the heights of the Andes or the sands of the Sahara.

Last year, EMD posted roughly $1.8 billion in revenues and has the largest base of diesel-electric locomotives in the world.

Things Looking Shaky for Caterpillar?

Since 2006, Caterpillar, the world's largest manufacturer of construction equipment, has invested about $2 billion in its rail business. This includes the deal for EMD.

All in all, the rail business is a cost-efficient way to move freight and people. What's more, it has strong barriers to entry and is expected to grow for the long run. As made evident by other railway deals -- like Warren Buffett's $44 billion mega-deal for Burlington Northern Santa Fe -- the industry continues to look attractive.

However, Caterpillar is facing some headwinds. The continued strength of the dollar is likely to be a drag on profits. Keep in mind that roughly 60% of Caterpillar's sales come from overseas.

Also, the sustainability of the economic recovery is still far from clear, especially with the recent debt troubles in Europe. So, it should be no surprise that Caterpillar's stock has taken a hit lately.

But this is no reason to avoid deals, especially ones for companies like EMD that will help diversify Caterpillar's business and should allow for more growth.
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