For those investors who believed a year ago that Caterpillar (NYSE:CAT) had somehow outgrown its cyclicality, the past twelve months have been a painful reminder that it's never “different this time”. The real question now, though, is what the new normal will look like. Although there's good reason to believe that Caterpillar's power and construction businesses can do better, the longer-term outlook for mining isn't as robust anymore. There is certainly the risk that estimates head even lower, but Caterpillar shares are starting to look a little interesting in terms of value.
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Business Continues To Erode In The First Quarter
Business went from bad to worse in the first quarter, as Caterpillar continues to absorb global weakness in both construction and mining spending. If there was good news to the quarter, it was in that investors had already prepared themselves for an ugly report.
Revenue fell 17% as reported, with machinery sales down 18% in the quarter. All of Caterpillar's units had double-digit declines, with the mining (resources) business pacing the decline at 23%, while construction sales fell 17% and power fell 12%.
Caterpillar's margin performance was also quite lackluster, as lower volumes and inventory adjustments worked against the company. Gross margin actually improved from the fourth quarter (by 30bp), but fell almost four points from the year-ago level. Operating income dropped nearly by half, though, with machinery profits down 54% on a greater than six-point decline in operating margin. While income from the power business declined about one-quarter, the construction and resources businesses each fell about 60%.
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Signs Of Life In Construction, But Mining May Be Changing For The Worse
U.S. commercial construction activity has been pretty stagnant, and Europe is likewise in tough shape. China, though, seems to be getting a little better. Although Caterpillar has only single-digit share in most categories of construction equipment in China and trails rivals like Sany, Komatsu (OTC:KMTUY) and Volvo (Nasdaq:VOLVY), industry-wide sales declines seem to be shrinking and Cat may be picking up a bit of share.
The bigger worry may be in mining. Rio Tinto (NYSE:RIO) management has commented more than once recently that they believe that the industry is past the point of peak capital expenditures, and there's going to be a much greater focus on maximizing utilization of existing equipment and canceling/delaying projects with unattractive returns on capital.
Along these lines, I'd take note of the fact that Vale (NYSE:VALE) has recently chosen to go with coveyors at its Serra Sul iron ore mine, a move that will replace around 100 mining trucks. Caterpillar's European mining rivals Atlas Copco (OTC:ATLKY), Sandvik, and Metso are also shifting their emphasis to automation and process equipment in mining in attempt to offer better operating efficiency and replace lost equipment sales. I don't want to suggest that Joy Global (NYSE:JOY) and Caterpillar can't or don't compete in products like mining conveyor systems, but I do question whether they can do as well as these markets as their rivals.
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The Bottom Line
I do expect Caterpillar to see a recovery in construction equipment, and the decision of rivals like Terex (NYSE:TEX) to exit certain markets could work in the company's long-term favor. Likewise, I think a recovery in North American oilfield and industrial activity should help the power business. That mining business worries me, though, as we have now seen several major miners trim their long-term capital expenditure (CAPEX) plans pretty significantly.
If Caterpillar can muster low single-digit revenue growth and regain mid single-digit free cash flow (FCF) margins, these shares look relatively attractive at these levels. Importantly, I don't believe that Caterpillar is losing share in its core markets or products, though I do have some concerns about the company's ability to change with the environment in mining. Even so, investors looking for a way to play a recovery in construction and mining could certainly consider Caterpillar shares at today's prices.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.