All of Caterpillar’s Segments Are Hurting -- Here Are the Details

Caterpillar's (CAT +3.07%) second-quarter results added to last quarter's struggles as the company continues its bumpy ride through 2020.

Considering that all three of Caterpillar's key segments suffered their lowest revenue in years, now is a good time to take a cold hard look at Caterpillar and determine the effect of COVID-19 on its business.

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Construction industries

Revenue for construction industries fell over 37% for the quarter as Caterpillar cited decreased end-use demand across the world. Generating $2.5 billion fewer sales from what was its highest revenue segment is one thing, but what really hurt Caterpillar was the shortfall in construction profit, which fell a whopping 58% compared to a year ago. 

Data Source: Caterpillar. Table by Author. PP = percentage point.

The main region to blame was, unsurprisingly, North America, where machine sales for its construction and resource industries fell 40% and overall revenue decreased 54% "driven by lower pipeline and road construction activities." Commercial construction has been hitting Caterpillar the hardest. CEO Jim Umpleby said commercial construction would be "hard to call" but expects to see residential construction improve toward its normal seasonal pattern. 

Resource industries

Despite higher copper and iron prices, mining revenue and margins were down this quarter. The company noted that third-quarter demand is probably going to remain soft from natural seasonality and weaker non-resident construction. 

Data Source: Caterpillar. Table by Author. PP = percentage point.

In terms of a hit to overall profit and profit margins, this was Caterpillar's worst segment.

For context, Caterpillar's business has a high degree of operating leverage, meaning small changes to revenue can have a big impact on profitability. The reason for that is because Caterpillar has a lot of fixed costs that come with the territory of producing heavy equipment at scale and selling it around the world. The R&D required to invent new products, operate manufacturing facilities, manage a complicated and bulky supply chain, and pay salaried employees are a given whether sales are high or low. The advantage of this structure is that profit can grow at a faster rate than revenue when there's a lot of demand for Caterpillar's products because everything is already set up to produce more. The flip side is happening now, where lower sales mean profit is declining faster than the rate of revenue decline because Caterpillar is structured to produce more than the market is demanding.

The mining industry has a particularly high degree of operating leverage because there are several fixed costs that are incurred despite commodity prices or demand volumes. According to Caterpillar, volume in its resource segment fell because customers are cautious about how much copper and iron they want to produce -- despite reasonable prices on those commodities -- which is one reason why profit declined nearly 70% even though revenue declined just 35%. Caterpillar noted that lower volume really affected its resource and construction industries the most, which is why profit margins fell substantially for both segments. In sum, Caterpillar is attributing the profit decline to lower sales volume because this segment has an acutely high degree operating leverage.

Another key takeaway is that management remains bullish on the long-term prospects of mining. Umpleby noted that there haven't been a meaningful number of project cancellations, and newer projects are moving forward. 

Given the severity of the decline with this quarter's resource profitability, and the nearly 50% decline in profitability that the segment faced in the first quarter, this could remain a challenging segment for a while.

Energy and transportation

Despite everything that is happening with the energy industry, it can be hard to imagine that Caterpillar's energy and transportation segment was actually its highest revenue, highest profit, and least affected segment this quarter.

Data Source: Caterpillar. Table by Author. PP = percentage point.

Part of that success came from China, which led end-user demand in the Asia Pacific region to increase by 7%. 

Contrary to full-year overall guidance, Caterpillar did give us some insight for energy and transportation -- citing that it expects the same usual seasonal uptick in the fourth quarter as normal. According to management, it's rare that Caterpillar's energy and transportation sales fall in the back half of the year. 

What to do now?

Caterpillar's business is in a tough spot. It expects at least a $2 billion decrease in dealer inventory levels for the year -- proving its reliance on several struggling end markets. Caterpillar has proven its longevity by surviving several challenging economic cycles in the past -- but it's hard to justify any sort of short-term upside for the industrial company until the situation improves. That being said, Caterpillar's track record, 3.1% dividend yield, and 11% decline since the beginning of the year could make it a reasonably attractive long-term investment if you don't mind waiting for a few years.