Caterpillar’s Net Could Rise Despite Mining Weakness On Construction Sales Growth & Gains From Cost Cuts

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Caterpillar (NYSE:CAT) will announce its second quarter earnings Thursday, July 24. The maker of mining and construction machinery is coming off a good first quarter in which despite its flat top line, its profits rose on gains from cost reduction activities. In the second quarter, we anticipate the trend to continue. Caterpillar (CAT) will likely post a flattish top line (on a year-over-year basis) in the second quarter, as growth from its construction equipment and engine sales will likely get offset by decline in its mining machinery sales. The company’s second quarter profits will likely also rise driven by benefits from its cost reduction activities.

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

See our complete analysis of CAT here

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Weakness In The Global Mining Sector Will Likely Weigh On CAT’s Q2 Top Line

In the second quarter, we anticipate CAT’s mining equipment and machinery sales to continue to decline due to weakness in the global mining sector. For over a year now, CAT has battled weak demand for machinery and equipment from the global mining sector. As mining companies have slashed their costs and capital spending after incurring large asset write-offs, sales of mining equipment manufactured by CAT have tanked. In 2013, the company’s mining segment sales fell by 37% annually. [1] And, this trend continued in the first quarter of this year in which the company’s mining segment sales fell by 33% annually. [2] During its last quarter’s earnings presentation, CAT said that it does not anticipate the demand for new mining machinery to recover in 2014, and accordingly, forecast its mining segment sales to fall by 20% annually in 2014. [2] What is encouraging here is that the declines in CAT’s mining segment sales have progressively moderated. After falling by 37% annually last year, the decline in the company’s mining segment sales moderated to 33% (on a year-over-year basis) in the first quarter, and for full year 2014, CAT expects this decline to further moderate to about 20% (on a year-over-year basis).

What is however more important to determine is when the current mining sector weakness will end. In our opinion, till the time global mining companies such as Rio Tinto, Vale and BHP Billiton do not restart active purchases of new mining machinery and restart investments in new mines, CAT’s mining equipment sales will likely continue to fall. We will be watching CAT’s second quarter results for any assessment from the company of when it expects the current mining sector downturn to end.

Growing Construction Equipment Sales Will Help Balance Declining Mining Sales

On the bright side, the decline in CAT’s second quarter mining segment sales could be balanced by growth in its construction equipment, engine and turbine sales. The company is seeing increasing demand for its construction equipment from all major markets, including North America, Europe, Africa & the Middle-East (EAME) and China. In the first quarter, CAT dealers across all these markets increased their inventory of construction equipment indicating that sales of construction equipment to end users could pick up in the coming months. We figure recovering construction markets in Europe and North America, as well as strong construction spending in China will likely help grow CAT’s construction equipment sales in the second quarter and the remaining months of 2014. On its part, CAT anticipates its construction segment sales to rise by 10% annually in 2014. [2] Separately, the company is also seeing steady increase in its engine and turbine sales on higher demand from oil & gas and power generation sectors. We figure in the second quarter, CAT’s sales growth from construction equipment, engines and turbines will balance its sales decline from mining equipment. Thus, CAT’s second quarter top line will likely remain relatively flat on a year-over-year basis.

Cost Cuts Will Likely Raise CAT’s Second Quarter Profits Despite Its Flattish Top line

Additionally, we anticipate CAT’s profits to rise in the second quarter despite its flattish top line on gains from its cost cutbacks. The company has been taking large scale cost reduction measures since early 2013 in an attempt to lower its operating costs. These measures include plant consolidations, which ensure greater sharing of common resources, and headcount reductions, which save salary costs. These measures enabled CAT to lower its operating costs by $7 billion last year. [3] As these measures remain underway currently, we anticipate the company’s costs to decline further in the second quarter. In turn, higher margins driven by these cost cuts will likely enable the company to grow its second quarter profits. Additionally, in our opinion, over the long term, higher margins driven by these cost cuts will likely strengthen CAT’s competitive position, as higher margins enable aggressive pricing.

All in all, CAT looks set to post healthy profit growth in the second quarter, despite mining sector weakness, on gains from its cost cutbacks and construction equipment sales growth.

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Notes:
  1. CAT’s 2013 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 2013 Q4 earnings form 8-K, January 28 2014, www.caterpillar.com []