Caterpillar (CAT -0.55%) released quarterly earnings before market open Thursday. An initial positive reaction sent the stock up close to 2% in premarket trading. But shares finished the day down 2% and were down as much as 4% intraday.
Investors may think that Caterpillar stock would be trending higher after notching adjusted EPS of $2.87 ($1.93 expected) and revenue of $11.9 billion ($11.05 billion expected). Here are some key takeaways from Caterpillar's earnings to help you understand why the stock could be falling, as well as what to look for in the year ahead.
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High expectations
Despite having arguably its worst earnings year since the Great Recession, Caterpillar was a surprising value stock that reached an all-time high in 2020. It has then proceeded to be one of the best performers in the Dow Jones Industrial Average so far this year. Needless to say, expectations were high heading into earnings.
As a cyclical stock, Caterpillar should be a key beneficiary of a global economic expansion, and the market knows it. Its energy and transportation division is poised to benefit from increased oil and gas consumption and industrial production.
Basic materials form the bedrock of economic expansion. Global mining activity is improving as demand for basic materials grows. Caterpillar's resources division -- led by mining -- directly benefits from this uptrend.
Last but not least, its construction division is a natural winner from the booming U.S. housing market. Over the mid to long term, an expected rebound in commercial real estate paired with global construction trends in emerging economies like China should be a key driver for Caterpillar.
Aside from company-specific expectations, low-interest rates paired with falling unemployment, economic stimulus, and increased spending bode well for the economy as a whole. U.S. Federal Reserve chair Jerome Powell made it clear Wednesday that the Fed intends to keep interest rates low even as the economy recovers. In sum, Caterpillar is poised to benefit from industry-specific tailwinds, as well as macro tailwinds.
Positives
Strong top and bottom lines
There was a lot to like from Caterpillar's report. Its top and bottom lines marked the highest quarterly results since the onset of the pandemic. Another standout was free cash flow (FCF) from machinery, energy, and transportation (ME&T), which came in at $1.7 billion. For comparison, Caterpillar's full-year 2020 ME&T FCF was just $3.1 billion.
Paying down debt and raising the dividend
Despite earnings being down last year, Caterpillar was able to support $2.24 billion in dividend payments from ME&T FCF. Although it retained a strong balance sheet throughout the pandemic, Caterpillar could benefit from decreasing its leverage. Generating high FCF supports Caterpillar's dividend, share repurchases, and can help pay down debt as well. Caterpillar hinted that its goal is to raise the dividend for the 27th consecutive year -- retaining its spot on the list of Dividend Aristocrats.
Rising dealer inventories
Caterpillar generates the majority of its sales through an independent dealer network. Dealers tend to decrease their inventories when they expect customers to spend less and increase inventories in preparation for customers to spend more. 2020 saw a sharp $2.9 billion reduction in dealer inventories, the largest annual decline in seven years.However, dealer inventories rose $700 million in the first quarter compared to the fourth quarter of 2020 -- a positive sign that business is picking up. Given the severity of last year's drawdown, dealers could simply be restocking back to normal levels. We'll need to see a sustained increase in dealer inventories for a true boom to take shape.
Operating margin improvement
Operating margin is a metric that illustrates the profitability of Caterpillar's business. Its Q1 adjusted operating margins improved across all three business lines for a companywide average of 15.3% -- above the 11.8% average in 2020.
Concerns
China construction sales could slow
China, and the Asia-Pacific region in general, was Caterpillar's biggest growth market in 2020. Management noted that infrastructure spending in China is leading to a sustained boom in construction activities. However, growth could slow later in the year seeing as China is ahead of the U.S. and other regions in the growth cycle.
Operating margin could decline
Caterpillar said that operating margin could fall in the second quarter compared to the first quarter. Caterpillar's Q2 2021 results will lap its worst quarter from the pandemic, which will make its year-over-year results look incredible on paper. As the year progresses, it could serve investors well to take Caterpillar's year-over-year comparisons with a grain of salt, focusing instead on how each quarter folds into the narrative of a multi-year economic recovery.
Supply chain challenges
One reason management could be hinting at profitability concerns has to do with supply chain challenges. CEO Jim Umpleby said that Caterpillar "has been developing contingency plans including workarounds in our factories that may lead to increased costs. We're working very hard to avoid or minimize supply chain issues that [could] lead to production shortfalls that might impact our ability to fully meet improving customer demand." The company also cited raw material challenges and the global chip shortage as primary supply chain concerns. If Caterpillar is unable to meet consumer demand or does so at a higher cost, it would likely impact its bottom line.
Lack of full-year guidance
Once again, Caterpillar refrained from giving full-year guidance. This uncertainty, paired with the fact it has yet to reinstate share buybacks could be met with scrutiny. However, it seems management is taking a cautious approach given 2020's lackluster performance.
Takeaways
Caterpillar had a great quarter, but uncertainty regarding sustained growth in China and its ability to meet customer demand are real concerns. Given these concerns, and that Caterpillar's stock was up big heading into earnings, a pullback seems reasonable. However, its strong FCF, industry-leading position, and expected dividend raise align with the thesis of what makes Caterpillar a stable long-term buy.
