Caterpillar’s Profits Increase Despite Flattish Revenue

Caterpillar‘s (NYSE:CAT) earnings rose by 8% year-on-year in the third quarter, despite sluggish revenues which grew 1%, driven by growth in its Energy & Transportation segment, which offset the decline in the Construction Industries and Resource Industries segments. ^[1] The maker of mining and construction equipment was able to grow its profits even as its top line remained flattish, as gains from the company’s cost cutbacks and its locomotives and oil & gas equipment growth outweighed the impact from mining and construction weakness. Caterpillar’s (CAT) earnings per share grew 12%, to reach $1.63, driven by the rise in profits and lower share count. In the third quarter, CAT repurchased $2.5 billion of common stock.

In its third quarter earnings release, CAT announced its revised earnings per share guidance for 2014. Citing continued improvement in cost control and operational execution, CAT raised its earnings per share guidance to $6.00 per share, from $5.75. It also narrowed its annual revenue guidance from $54-$56 billion to $55 billion, a decline from 2013 revenues.

See our complete analysis of CAT here

Cost cuts will likely continue

CAT’s higher earnings per share guidance leads us to believe that it will continue with its cost cutbacks. At the end of the third quarter, the company’s employee headcount was approximately 131,000, around 6,100 lower than that at the end of the third quarter of 2013. ^[1] Apart from headcount reduction, CAT is also consolidating plants, which will ensure greater sharing of common resources. We figure these cost reduction measures are essential for CAT to grow its profits in the current tough macro environment. Even over the long term, higher margins driven by these cost cutbacks will enable the company to boost its competitive position, as higher margins enable aggressive pricing.

Weak mining and construction sales temper Caterpillar’s revenue

In the third quarter, CAT’s Resource Industries and Construction Industries revenue declined 19% and 2% respectively. ^[1] 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 in 2013 after incurring large asset write-offs, sales of mining equipment manufactured by CAT have tanked. The after affects of the 2013 asset write-offs and low mined commodity prices have kept the demand for mining equipment and machinery suppressed in 2014, and could also temper growth in 2015.

The weak Brazilian economy and tough year-on-year comparison with Latin American markets negatively impacted CAT’s Construction Industries’ sales. In the previous year, CAT had received large orders from Brazil’s government which had significantly increased sales, leading to tough comparisons for this year’s third quarter. In addition, the economic condition in Brazil has been particularly troublesome in 2014 due to the recession brought on by declining investments in the country. Investments in Brazil contracted 5% due to the poor business environment and uncertainty ahead of the elections. ^[2] CAT seems optimistic about the future growth potential in Brazil since infrastructure spending has been key for development of the economy. ^[3]

Caterpillar’s long-term prospects look good

Along with its outlook for the remainder of 2014, CAT also announced its expectations for 2015, forecasting flat to slightly higher sales. ^[1] They expressed concerns regarding the macroeconomic environment which may continue to temper sales. Possible interest rates hikes in the U.S. following the tapering of the Quantitative Easing program and structural reforms in China may negatively impact CAT’s sales of equipment in 2015. However, growth in infrastructure spending in developing countries like India and demand for energy across the globe could drive CAT’s sales in the future.

• Growing urbanization, increasing disposable incomes and aging population in emerging markets such as China and India, should help drive spending on infrastructure sectors such as manufacturing, energy, water and transport. These factors are expected to drive global infrastructure spending to over $9 trillion per year by 2025, compared to $4 trillion in 2012. ^[4] An increase in infrastructure spending bodes well for CAT since rise in demand for construction equipment will in turn help boost sales of its Construction Industries segment.
• Global energy demand is expected to grow by 41% from 2012 to 2035, with 95% of the demand coming from emerging markets. ^[5] Growth in energy demand augurs well for CAT’s power generation equipment sales. It will also have a positive impact on sales of its mining equipment. Though renewable fuel will become popular in the long term, fossil fuels such as coal, oil and gas will remain dominant sources of energy generation, with market shares of around 26-27% each. ^[5] Extraction of oil and gas, and mining of coal, to support the energy demand, will help drive demand for mining equipment.
• Additionally, increased use of new machines may fuel recovery in the global mining sector. In order to keep short term operating costs low, mining companies are working their newer machines for longer durations. This is because older machines entail higher upkeep costs through frequent part replacements and repairs. Mining companies will eventually have to incur repair and maintenance costs, which include purchase of machine parts in order to avoid machinery breakdowns.  This will lead to a recovery in the mining equipment after-market.

We currently have a stock price estimate of $109 for CAT, around 10% above its current market price. We are in the process of incorporating CAT’s third quarter results and shall update our analysis shortly.

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1. Caterpillar Inc 3Q 2014 Earnings Release, October 23, 2014, www.caterpillar.com [↩] [↩] [↩] [↩]
2. Brazil Goes Into Recession for First Time in Over 5 Years, August 29, 2014, www.bloomberg.com [↩]
3. Caterpillar’s (CAT) CEO Doug Oberhelman on Q3 2014 Results – Earnings Call Transcript, October 23, 2014, www.seekingalpha.com [↩]
4. Capital project and infrastructure spending: Outlook to 2025, www.pwc.com [↩]
5. BP Energy Outlook 2035, January15 2014, www.bp.com [↩] [↩]