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The Key Takeaway From Caterpillar's Earnings

By Lee Samaha - Feb 23, 2018 at 10:15AM

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One sector holds the key to the stock's upside in 2018.

The recent volatility with Caterpillar Inc.'s (CAT -1.81%) share price can cause fears that the highly cyclical stock's run is over. That may well be true, but if so, it's unlikely to be because Caterpillar's end markets have weakened. On the contrary, the industrial equipment manufacturer's fourth-quarter earnings showed a company preparing for another strong year of growth. Let's look at how and why Caterpillar is set to benefit.

Caterpillar's cycles

The investment case behind buying Caterpillar stock in 2018 is based on the idea of an upturn in each of its three main reporting segments.

A man wearing a hard hat and looking up at mining equipment

The outlook for capital spending on mining equipment is positive for Caterpillar. Image source: Getty Images.

For the construction industries segment, an improvement in U.S. GDP should help encourage ongoing strength in residential, nonresidential, and infrastructure spending. Meanwhile, Caterpillar expects "strong" growth in China in the first half but "gradual tightening to impact the second half."

In the energy and transportation segment, the ongoing recovery in oil prices should help oil and gas capital spending. To be clear, Caterpillar expects "oil prices to remain volatile" but also anticipates "continued strength in oil and gas in 2018, led by demand for onshore oil and gas equipment in North America," according to CFO Brad Halverson on the earnings call. Meanwhile, a bounce in power generation spending is expected to help even though the segment's industrial sales are expected to be flat.

Mining holds the key

However, it's the resource industries (mining) segment that's the swing factor for 2018. Caterpillar outperformed in 2017 largely on strength in North American onshore oil and gas spending and strong construction markets in North America and Asia. Now it's time for the resource industries segment to start to significantly contribute again.

Because of declining mining commodity prices, resource industries' share of equipment segment profit has been very low in recent years. It's a far cry from several years ago when mining used to be Caterpillar's most important end market. For example, in 2011, the segment contributed nearly 40% of total equipment segment profit.

a bar chart of Caterpillar's segment profit from 2015 through 2017.

Data source: Caterpillar presentations. Amounts in millions of U.S. dollars.

Mining outlook

The good news is that following a few years of dramatic falls in mining capital expenditures, the outlook is a lot better. Prices of industrial metals have been in recovery mode since the start of 2016 -- and in such cases, increased capital spending usually follows.

BHP Capital Expenditures (TTM) Chart

BHP Capital Expenditures (TTM) data by YCharts.

Consequently, some of the largest mining companies in the world already have plans to increase capital expenditures. For example, Rio Tinto plc plans to increase capex to $5.5 billion in 2018 from $4.5 billion in 2017. BHP Billiton plans to increase spending to $6.9 billion in its fiscal 2018, compared with just over $5 billion in its fiscal 2017. Similarly, Russia's Nornickel plans to spend $2 billion in 2018 and then increase it an average of $2.3 billion to $2.5 billion for 2019-2020.

In addition, mining stocks like Rio Tinto, BHP Billiton, and Vale have surged lately as the market prices in expected improvements in U.S. GDP growth. 

Caterpillar's outlook

As for management's commentary, Halverson stated: "We believe most miners have returned to profitability, and we expect their capital spending to increase in 2018, with a growing share spent on sustaining capital expenditures."

In fact, conditions are already starting to improve, with resource industries reporting "the strongest quarter for sales to users in over two years." Meanwhile, "Aftermarket parts demand remained high" and "dealer inventory was about flat" -- bullish for Caterpillar's sales, as end-user demand is increasing and Halverson says dealer inventories are "lean."

Unfortunately, management didn't break out guidance in terms of segment, but you can bet that a large part of the increase is expected to come from the mining industry.

The bottom line

All told, Caterpillar expects full-year adjusted profit per share in the range of $8.25-$9.25. Analysts have a consensus of $9.03 for 2018 and $10.50 for 2019, putting it on a forward P/E ratio of 17.3 and 14.9. If you believe we're heading for a long-term commodity upcycle, then the valuation looks favorable, and mining is the key for 2018.

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