Caterpillar's Numbers Look Ugly, But That Was Expected

By Stephen D. Simpson, CFA | July 24, 2013 AAA

Even though the mining and construction markets stubbornly refuse to get better as quickly as analysts want them to, there's still a “want to believe” trade alive and well in Caterpillar (NYSE:CAT) shares. In other words, investors know that this company is built to withstand the ups and downs of the very cyclical construction, mining, and energy markets, and there's a definite interest in trying to buy low ahead of the recovery. Although the recovery looks a little further away now after the second quarter and Caterpillar shares aren't exactly cheap, they are a quality vehicle for playing those eventual recoveries in construction, energy, and mining.

Tough Conditions Lead To A Miss
Caterpillar's quarter was quite as bad as the financial media blurbs may suggest, but it was definitely a tough quarter, and one where results were below expectations even though sell-side analysts get frequent data points (dealer surveys, etc.) with which to fine-tune estimates.

Consolidated revenue declined 16%, but the number that everybody follows, machinery revenue, declined 17% and missed the average sell-side estimate by about 2%. Weakness was widespread, as resources (mining, mostly) led the way with a 34% decline, while construction fell 9% and power declined almost 5%. Every reporting region was down, with North American sales down the least (10%, with 1% growth in construction), LatAm and Europe down in the teens (-15% and -19%, respectively), and Asia-Pacific down 26%.

SEE: 5 Earnings Season Investing Tips

For what good it does, I'd point out that machinery revenue was actually up 11% sequentially, with construction up 15% and power up 19%, while resources declined another 3%.

Margins were also weaker than expected, with mining driving a lot of the underperformance. Gross margin declined four points from last year and 40bp from the prior quarter, while manufacturing profits declined 45% (and margin declined about six points) on much lower margins in resources and a significant decline in construction margins as well.

No Joy In Mine-ville
I found it interesting that management said that declines in aftermarket revenues were not a major factor in the performance. Given the recent comments from Sandvik, I would have thought a larger than expected drop in aftermarket business would have explained some of the shortfalls in the margins of the resource business. And to be fair, just because management says that aftermarket business wasn't a big factor that doesn't mean that the sell-side wasn't expecting more.

In any case, it's hard to feel good about the mining business right now, and the prospects for companies like Joy Global (NYSE: JOY), Komatsu (Nasdaq:KMTUY), and Atlas Copco (Nasdaq:ATLKY). That said, Komatsu's management has been pretty upfront with its expectations of lousy unit/volume demand in mining, and I would think investors in stocks like Joy Global are more or less hoping for results that “are less bad” as opposed to “good”.

SEE: Komatsu Looks Like A Winner, But Valuation Is Tricky

Construction Getting Better Slowly
Although Illinois Tool Works (NYSE:ITW) and Caterpillar are in very different businesses, both companies are seeing very sluggish performance in global construction. The U.S. market does seem to be getting better, but progress has been very slow. Likewise, while Caterpillar seems to be gaining share in China from the likes of Sany and perhaps Volvo and Komatsu, it's still a tough market right now. It's also worth noting that investors looking to play a North American/European construction recovery might do better with stocks like Deere (NYSE:DE) or Terex (NYSE:TEX), given that CAT's exposure is a little smaller than you might imagine.

The Bottom Line
The best near-term recovery prospect for Caterpillar might be in the energy sector, where demand for Caterpillar power sources drives about 40% of the Power business. In any case, these results and management's guidance suggest that a full-blown recovery is still some ways away.

Long term, I'm looking for mid single-digit revenue and free cash flow growth from Caterpillar, which is worth about $80 in fair value today. On the other hand, the stock is trading at a price/book value multiple about one-third of the long-term norm, so there is certainly reason to think that there's upside in the shares – it's really more of a question of how long the wait will be before underlying conditions start improving. While I'm more inclined to own stocks like Komatsu, Atlas Copco, or Cummins (NYSE:CMI), Caterpillar is a respectable play on an eventual mining and construction recovery for patient investors.

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