Weak demand for mining machinery and equipment weighed on the second quarter results of Caterpillar (NYSE:CAT). The maker of construction, mining and power equipment saw its sales fall by $2.8 billion or 16% annually to $14.6 billion in the second quarter due to a combination of soft end-user demand and reduction in Caterpillar (CAT) dealer inventories in anticipation of sustained soft end-user demand. 
As CAT sells its products to its dealers who in-turn sell them to end-users, which include mining and construction companies, it is open to impact from fluctuations in its dealer inventories. In the second quarter, nearly half of the company’s top line drop came from reduction in its dealer machine inventories, which fell by $1 billion during the quarter as opposed to a rise of $300 million in the year ago period. 
The remaining top line decline was driven by weak end-user demand, particularly from the mining industry. CAT dealer’s sales volumes to the mining sector fell significantly in the second quarter as mining companies cut capital expenditures in light of the weak demand for many metals and commodities. This impact from softness in the global mining markets on CAT’s sales volume was enhanced by some issues surrounding mining companies, that included an increased focus of mining companies on cost and capital control after incurring several write-offs in the recent past. Some mining companies also underwent recent management changes, which also contributed to the decline in capital spending from the sector.
On its part, CAT responded to this decline in sales volume with cost cuts, which included temporary factory shutdowns, rolling layoffs and significant reductions to flexible workforce. On a year-over-year basis, the company slashed its total workforce – full-time and flexible – by over 20,000 employees to around 138,000 employees at the end of the second quarter. However, in spite of such steps, earnings of the company fell by 43% annually to $1.45 per share in the second quarter. 
CAT’s profits, in addition to the impact from lower sales volume were also impacted by a $1.2 billion decline in its own product inventory.  The decline in CAT inventory meant that the company produced less than it what it sold to its dealers in the quarter. Now, this improved its cash flow for the quarter, however, impacted its profits by way of increased costs from manufacturing inefficiencies.
Separately, the decline in dealer inventory during the second quarter exceeded CAT’s expectations and accordingly it was forced to lower outlook for 2013. The company now expects its 2013 top line to lie in a range of $56-58 billion, down from $57-61 billion guided in April, and its 2013 earnings to fall around $6.50 per share, compared to $7 per share, announced earlier. 
We currently have a stock price estimate of $86 for CAT, around 5% ahead of its current market price. We are in the process of incorporating second quarter earnings and shall update our analysis shortly.
CAT’s Mining Exposure And Outlook
Manufacture and sale of mining trucks, loaders, bulldozers, underground roof support equipment and other mining machinery constitute around a third of CAT’s total business. The company’s exposure to this sector increased in 2011 following the $8.8 billion acquisition of Bucyrus, at which time the outlook for mining industry was positive.  However, at the end of the second quarter, CAT anticipates the current weakness in the global mining industry to persist through 2013. Surveys, which the company cited in its earnings filing, suggested that the global mining capital expenditure could decline further in 2014. If this were to happen, then CAT’s mining equipment sales and its overall performance would remain under pressure for many months.
CAT also said in its earnings release that it anticipates dealer inventory reductions to continue through 2013 with around $1.5-2 billion reductions in the second half.  Thereafter, it believes further dealer inventory reductions would be unlikely as large scale reductions would have already taken place in 2013.
Construction And Power Segments Fare Better
On the bright side, the remaining two-third of CAT’s business – construction and power – posted relatively better results. Sales at both these segments declined in single-digits, compared to the 34% annual decline in sales at the company’s mining segment.  Specifically, CAT’s sales from China continued to rise despite the slower economic growth of the country.
Looking ahead, CAT will take additional cost reduction measures in the second half of 2013 to counter the weak demand environment across its businesses. At the same time, in order to maintain its shareholder returns, the company will repurchase shares worth $1 billion in the third quarter. Last month, CAT had also announced a 15% hike in its quarterly dividend citing a strong balance sheet and likely in an attempt to soothe investor concerns arising from the current challenging macro environment. Notes: