Caterpillar (NYSE:CAT) will announce its third quarter earnings Wednesday, October 23. The maker of construction, mining and power equipment will likely post a sharp fall in sales and profits due to a combination of weak end-user demand from mining companies and reduction in Caterpillar (CAT) dealer inventories in anticipation of sustained weak 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 its last quarter earnings release, the company said that it expected its dealer inventories to fall by $1.5-2 billion in the second half of 2013 due to largely soft end-user demand from mining companies.  We figure that these large dealer inventory reductions will impact CAT’s third quarter top line.
Mining companies are slashing their capital spending on equipment and machines due to weak demand for many metals and commodities. The recent asset write-offs and management changes at some major mining companies are also contributing to the decline in capital spending from the sector. This softness in demand is weighing on CAT dealer sales and through them on CAT’s sales. In the first six months of this year, due to these trends, CAT’s sales fell by nearly 17% annually to $27.8 billion.  On its part, CAT is responding to this decline in sales volume with cost cuts, which include employee layoffs and temporary factory shutdowns. However, despite these steps the company’s earnings are falling. In the first half of this year, CAT’s earnings fell by 44% annually to $2.76 per share, and we anticipate the trend to persist in the third quarter.
We currently have a stock price estimate of $86.41 for Caterpillar, marginally below its current market price.
CAT’s Mining Exposure
The 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 a time when the outlook for the mining industry was positive.  However, the company currently expects the present downturn in mining demand to persist through 2013. Some surveys cited by CAT at its previous earnings announcement suggested that global mining capital spending could decline further in 2014. Thus, we figure that CAT’s third quarter sales and profits will see a significant fall.
Construction And Power Segment Results To Be Relatively Better
In comparison, the remaining two-third of CAT’s business – construction and power – is doing better. In the first half, sales at both these segments declined in single digits year-over-year, compared to the over 30% year-over-year fall in sales seen at CAT’s mining segment.  In the third quarter, we anticipate these segments to continue to post relatively better results driven by China where CAT’s sales have continued to rise.
A Strong Balance Sheet
Separately, we figure that despite industry weakness, Caterpillar’s strong balance sheet supports its current outlook. At the end of the last quarter, its machinery and power system segment – which basically refers to its construction, mining and power businesses – had a debt-to-capital ratio of around 35%, well below the upper limit of 45%, of the company’s targeted range.  The company also maintained its quarterly dividend rate at 60 cents a share in a recent announcement. This dividend rate represents a 15% hike from the company’s dividend rate of a couple of quarters back.
CAT is also accelerating its share repurchases. The company is expected to report share repurchases worth $1 billion in the third quarter which follows repurchases of an equal amount in the previous quarter. Post these repurchases, CAT will still be left with $2.7 billion in its share repurchase authorization.  We figure these active share repurchases soothe investor concerns arising from the current mining sector weakness. More importantly, these share repurchases indicate that the company has already allocated sufficient capital to fund its growth, and fulfilled its pension and other obligations, as share repurchases as a priority follow these other heads in the company’s capital deployment strategy.Notes: