1 Number Caterpillar Inc. Investors Need to Watch This Week

Whether Caterpillar has bottomed out can be gauged from one number in its upcoming fourth-quarter earnings report.

Neha Chamaria
Neha Chamaria
Jan 24, 2017 at 9:34AM

Caterpillar Inc.'s (NYSE:CAT) earnings releases are much-awaited events, but investors, perhaps, haven't been as jittery as now. Caterpillar's stock has jumped almost 12% since Nov. 8, taking its yearly gains to a staggering 56% as of this writing. That's mind-boggling for a Dow stock. Compare Caterpillar's performance with peer General Electric's (NYSE:GE) muted 10% gains in the past year, and you'll see what I mean.

The problem is that Caterpillar's sales and profits have deteriorated in recent quarters, and it's primarily the hopes of a recovery in commodities and an uptick in infrastructure spending under Donald Trump's presidency that's sending the stock higher. Is that even sustainable at a time when Caterpillar's key end markets are yet to show any signs of a revival? The answer to that, and whether the worst is over for Caterpillar, could be hidden in one particular number in Caterpillar's upcoming earnings release on Jan. 26. 

Image Source: Getty Images

Why Caterpillar could report "strong" Q4 profits

There's little to indicate "good" sales numbers from Caterpillar's fourth-quarter earnings report. Management called for $39 billion in revenue for the full year. Back of the hand calculation says the company will report Q4 revenue worth about $10 billion, which will mean a 9% drop year over year. That isn't really surprising, given Caterpillar's weak retail sales statistics for recent months: Its total machines three-month rolling sales were down 17% in November. Caterpillar's woes are, clearly, far from over.

The only bright spot could be Caterpillar's profit numbers. The company had an exceptionally painful fourth quarter in 2015 as it took aggressive restructuring actions that resulted in a loss of $0.15 per share for the quarter. This time around, Caterpillar expects to report a profit of around $0.46 per share in Q4. So if the headlines scream a sharp jump in Caterpillar's Q4 profits on January 26, you'd know where that came from. For the full year, though, Caterpillar's earnings per share could still be down about 30% from 2015.

But none of those numbers can tell you as much about Caterpillar's health as its backlog.

What to make of Caterpillar's Q4 backlog value

If you believe the worst is over for Caterpillar, you've probably missed its backlog trend. 

Data source: Caterpillar financials. Chart by author.

Caterpillar's backlog has declined rapidly in the past two years as new order rates slumped even as the company fulfilled orders in its backlog. There were no signs of a reversal yet, at least until the company's third quarter, when its backlog value declined 15% year over year to end at only about $11.6 billion. That's roughly the same percentage by which Caterpillar's revenue declined in Q3. You can see how Caterpillar's quarterly revenues have declined alongside backlog in the past couple of years:

CAT Revenue (Quarterly) Chart

CAT Revenue (Quarterly) data by YCharts

The logic is simple: As backlog is a key indicator of future potential revenue, a declining backlog indicates lower revenue going forward especially if end markets are weak. So if Caterpillar reports another decline in backlog for its fourth quarter, you know there's still time to call a bottom. 

In fact, Caterpillar management almost confirmed during its last earnings release that 2017 will be another weak year. Management specified that it hasn't seen any increase in mining-equipment orders yet and anticipates weak construction-equipment demand from North America for the second half of 2016 and 2017, along with weakness in power generation, marine, rail, and agricultural engines, all of which fall under the company's energy & transportation segment. General Electric just echoed some of Caterpillar's cautious sentiments by reporting 4% lower power orders (excluding the impact of its Alstom acquisition) and projecting a weaker year for its oil and gas segment.

In other words, with all of Caterpillar's important end markets under pressure, it may have to wait a little longer to see its order rates, and backlog, pick up. Until that happens, the company has no option but to continue banking on its restructuring and cost reduction efforts to prevent profits from falling off the cliff. But there's only so much it can do. With management also lowering its guidance twice last year and even calling analysts' estimates "too optimistic," investors may want to take Caterpillar's upcoming 2017 outlook with a grain of salt and focus on the crucial backlog number, instead, to know what lies ahead for the company.