Why Caterpillar Inc’s Q2 Results Could Be a Mixed Bag?

In June we heard good news and bad news about Caterpillar (NYSE: CAT  ) , the world's largest equipment manufacturer. Bad news first -- the company for the first time during the year reported an 8% decline in construction sales in Asia-Pacific (read China) in May. With mining awfully down, this was a terrible blow. Now for the good news -- in a recent survey of Cat dealers in the U.S. by Credit Suisse, it was revealed, "For 2014, 95% of the dealers we surveyed are exceeding their forecasts, with the year now expected to be up 8-12% y/y versus 5-7% initially forecasted."

Against this backdrop, the equipment major will report its second quarter earnings on July 24. Let's find out how Cat is set up.


A Caterpillar dumper sitting at a construction site in New York, Source: Fool, Flickr

U.S. construction could be the brightest spot
Construction activity is picking up in the U.S. CEO Doug Oberhelman is optimistic on the segment's growth momentum and at the first quarter earnings call, he said that they are hearing "positive stories about new projects" from dealers and customers. This was corroborated in the survey of Cat dealers that Credit Suisse conducted. The dealers said that they are seeing improvements in multi-family housing, automotive, hospitals, schools, and data centres. The reports about non-residential was 'mixed', but it remains a high-margin business.

Cat has not yet posted its June retail sales numbers, but the dealers' retail construction machinery sales are showing double digit growth in North America, having shot up by 17% in May on a three-month rolling basis. 

In contrast, signs of weakness are still evident in Europe and the sales contraction in the Asia Pacific region in May is a cause for concern. In China, excavator sales fell by 31% in May (the worst decline since February 2013) after government spending was hit, threatening new-equipment demand. Cat's excavator sales were down by 5.7% in the same month.

No signs of recovery in mining
Major mining companies, including Rio Tinto and Vale have reduced their capex budget for this year, which means that global mining demand could stay depressed. Mining companies have restricted their capital expenditure since mid-2012 due to lingering weak metal and commodity prices. Consequently, Cat has reported depressed sales in the resources segment for the past eight quarters, with a contraction of over 37% in 2013. Cat's management predicts another 20% decline in the segment sales in this fiscal year. 

In the global mining sector, the worst hit region remains the Asia Pacific where Cat posted 69% sales decline in May, as miners cut costs to boost their profits, followed by EMEA and Latin America that posted double digit declines of 47% and 62%, respectively. However, mining sales have recovered modestly in North America as thermal coal stabilized in the U.S.

Coal production in the U.S. had fallen below 1 billion short tons for the first time in 20 years in 2013, but the U.S. Energy Information Administration (EIA) expects production to increase to 1.01 billion short tons in 2014. Cat's retail sales in the resource industries segment in North America were up 7% in May.

Energy and transportation sector in temporary lull
Cat's energy and transportation segment reported strong growth till the first quarter of this fiscal year, but May's retail sales data revealed a 3% drop in worldwide sales. This sudden slump could slow down Cat's sales growth in the quarter.

On the positive side, the company's huge order backlog of $19.3 billion was mainly for locomotives. This could aid segment sales growth in the coming quarters. From a more long-term perspective, we find that the EIA has forecasted that global energy demand would rise by 56% over 2010-2040. So, the weakness could be temporary, but it would help to keep an eye on the performance of this segment and its backlog position.

Earnings could remain firm, and rewards for investors to continue
As the mining slump continues and energy sector shows some negative signals, Cat is reducing pressure on sales through inventory management and better dealership performance, aiming to improve earnings by 15% a year. Cat expects the annual earnings per share to be around $6.10, excluding restructuring costs, in 2014, which is more conservative than analysts' prediction of $6.22 per share.

The company is incessantly trying to keep operating costs low through lean manufacturing initiatives and cost-cutting strategies, like employee layoffs and plant consolidations. Cat expects restructuring costs to be around $400 million-$500 million this year. Some of the savings could be visible this year, though the full impact will be felt in 2015.

Cat declared a 17% hike in dividend in June this year, which means that it's confident of generating solid cash flows in the coming months. The company will also buy back $1.7 billion of its common stock under an accelerated stock repurchase program.

Wrapping up
Cat's Q2 performance could be a mixed bag as far as sales growth is concerned. Apart from North America, there may not be much to look forward to. However, restructuring and cost-cutting could help maintain the company's earnings momentum. Let's stay tuned. 

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