Caterpillar Is Cutting Costs & Relying On Construction & Energy Businesses To Combat Mining Weakness

For over an year now Caterpillar (NYSE:CAT) has battled weak demand for machinery and equipment from the global mining sector. With mining companies cutting their costs and capital spending in an attempt to boost their profits and cash flows, sales of mining equipment manufactured by CAT have tanked. Last year, the company’s mining segment sales contracted by over 37% annually and in the recently concluded March quarter, they fell by over 33% annually. ^{[1] [2]} Additionally, many mining companies in the recent past incurred large asset write-offs which forced them to cut back on investment in new mines and and equipment. Instead, currently most mining companies are focusing on increasing productivity at their existing mines. This is weighing on demand for new mining machinery and equipment such as mining trucks, wheel loaders, shovels and boring equipment. Major mining companies including BHP Billiton, Rio Tinto and Vale that constitute a significant chunk of global spending on mining machinery have indicated that they will reduce their capital spending in the current year. Accordingly, CAT in its first quarter earnings announcement said that it does not anticipate the demand for new mining equipment to recover in 2014. Thus we figure, 2014 like 2013, will be a tough year for CAT’s mining business. So, how is CAT combating this sustained weakness in its mining business?

We figure the company is relying on growth from its other segments namely construction and energy & transportation (E&T) to balance the decline from its mining segment. This is also evident from the company’s first quarter results where despite a 33% year-over-year decline in mining segment sales, its top line was flat on a year-over-year basis as growth from construction and E&T segments balanced mining segment decline. Additionally, we also anticipate large scale cost reduction measures initiated by CAT in the wake of this severe mining sector weakness to also benefit its results in 2014.

We currently have a stock price estimate of $109 for CAT, marginally ahead of its current market price.

See our complete analysis of CAT here

Growth From Construction & E&T Businesses Will Neutralize The Decline From Mining

In the current year, CAT anticipates its construction segment sales to rise by 10% annually, driven by continued strong growth from China and a steady recovery in sales from the U.S. and Europe. The company also anticipates its E&T segment sales to rise by 5% annually driven by higher demand for engines and turbines from global oil & gas and power generation sectors. Additionally, as these two segments constitute around three-fourth of CAT’s overall sales, this anticipated growth in their sales will likely offset the 20% year-over-year decline in sales anticipated by the company in its mining segment. ^{[2] [2]}

In the first quarter, CAT’s construction segment sales rose by 20% annually driven by higher purchases by CAT dealers in anticipation of higher end user demand in the second quarter. ^[2] More importantly this growth in dealer purchases was spread across all major geographic regions including North America, Europe, Africa & the Middle-East (EAME) and China. This clearly suggests that in the coming months sales of construction equipment to end users like construction companies will likely rise across all these major markets. Thus, CAT could fulfill its 10% year-over-year sales growth target for its construction segment.

Results from CAT’s energy & transportation (E&T) segment, which makes reciprocating engines, gas turbines and diesel/electric locomotives, will also likely post healthy growth in the current year. In the recent past, this segment has been the most consistent performing segment among all CAT segments. Sales from the E&T segment increased steadily from $15.5 billion in 2010 to $20.2 billion in 2014. ^[3] And, in the current year, CAT anticipates sales from this segment to rise by 5% annually. We figure this consistent performance at CAT’s E&T segment is a result of its sales being spread across multiple sectors which include oil & gas, transportation and power generation. Thus, a temporary decline from one sector does not sink the overall segment sales. Additionally, over the long-term, this segment will likely post strong growth as global demand for energy continues to rise, especially from the emerging countries. As a result, demand for engines and turbines that enable oil/gas extraction and power generation will also rise growing results at CAT’s E&T segment. According to EIA forecasts cited by CAT, global energy demand will likely rise by 56% over 2010-2040. ^[3] In our view, driven by this growing global energy demand, CAT’s E&T segment will post strong growth not only in 2014 but also over the long-term.

Cost Cutting Is Also Expanding Profits Through Higher Operating Margins

Separately, CAT is also lowering its costs to combat the decline from the global mining sector. The company is consolidating plants to ensure greater sharing of common resources and lowering its headcount to save on salaries. In the first quarter, these measure enabled the company to lower its SG&A and R&D expenses by $152 million on a year-over-year basis. As a result, despite a flat top line, CAT’s first quarter profits rose by 5% annually to $922 million. ^[2] In our view, in the remaining months of 2014, gains from these cost reduction activities will continue to more than offset the impact from mining sector weakness. So, on the whole in 2014, we anticipate CAT to successfully combat the negative impact from global mining sector weakness on gains from its cost reduction activities and growth from its construction and E&T segments.

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1. CAT’s 2014 10-K, February 18 2014, www.caterpillar.com [↩]
2. CAT’s 2014 Q1 earnings form 8-K, April 24 2014, www.caterpillar.com [↩] [↩] [↩] [↩] [↩]
3. CAT’s presentation at J.P. Morgan Aviation, Transportation & Industrials Conference , March 11 2014, www.caterpillar.com [↩] [↩]