Caterpillar (CAT 0.53%) investors were in for a pleasant surprise on Thanksgiving week, as Bank of America upgraded the heavy-equipment maker's shares to "buy" from "neutral." This provided investors a much-needed breather in an otherwise turbulent year that saw Caterpillar's sales and profits dwindle as things worsened in the mining industry.
Mining markets are still in a rut, and demand from key geographic regions like China continues to remain soft. A dour outlook from Caterpillar doesn't help much, either. So what has suddenly excited analysts at Bank of America enough to raise their price target on Caterpillar stock to $100? That's a neat 18% upside from the current share price of around $85. Is Caterpillar hiding something that will push its stock to the three-digit mark soon?
Inside Bank of America's mind
Instead of mining or construction, Bank of America is betting on Caterpillar's lesser-known business, power systems. In analysts Ross Gilardi's and Michael Feniger's words, "While the mining and construction equipment outlooks remain murky, the Power Systems business should put a floor under earnings, in our view." The analysts do not expect Caterpillar's 2014 earnings to fall below $4.50 per share.
In a recent post, I had discussed how Caterpillar is underplaying its power systems business. So yes, I think Bank of America is rightly optimistic about the business. But believing that this business alone is enough to propel Caterpillar's growth or support its share price doesn't make much sense.
The power within
The power systems division, which include gas engines, turbines, and rail locomotives, has emerged as Caterpillar's highest revenue generator and most profitable business this year. These charts, which break down Caterpillar's revenue and operating profit by segment, will give you the full picture.
| Business segment | Revenue for nine months ended Sept 30, 2013 | Revenue for nine months ended Sept 30, 2012 | % change |
|---|---|---|---|
| Construction Industries | 13.6 | 15.3 | -11% |
| Resource Industries | 10.3 | 15.4 | -33% |
| Power Systems | 14.6 | 15.8 | -8% |
Figures in billions. Source: Company financials
| Business segment | Operating profit for nine months ended Sept 30, 2013 | Operating profit for nine months ended Sept 30, 2012 | % change |
|---|---|---|---|
| Construction Industries | 0.8 | 1.8 | -51% |
| Resource Industries | 1.4 | 3.7 | -61% |
| Power Systems | 2.4 | 2.7 | -11% |
Figures in billions. Source: Company financials
Despite all three segments reporting lower revenue and profits year over year, it's clear that Caterpillar's power systems held up the best. That explains Bank of America's optimistic outlook about the business.
But will this last?
The question is whether this growth is sustainable, especially when demand for electric power equipment remains weak. That's a major reason why Caterpillar's revenue from the power systems business slipped 7%, year over year during the third quarter.
There's more evidence that all's not right. Rival Cummins (CMI +0.58%) also reported 1% and 11% drops in engine sales for the third quarter and first nine months, respectively, as demand from mining and electric power industries fell. Likewise, key competitor General Electric's (GE +0.80%) revenue from its power & water division slipped 10% and 17% during the last quarter and the nine months ended Sept. 30, respectively.
But unlike Cummins, which has the stronger truck engine market to fall back on, and General Electric, which can offset the weakness in power by strength in its oil & gas business, Caterpillar is more at the mercy of demand for power equipment and locomotives. Though oil and gas is a key category within Caterpillar's power systems business, its exposure is nowhere near to that of General Electric's.
Moreover, General Electric is going places, having recently bagged a massive $2.7 billion contract to power Algeria with its gas turbines. While the benefits of this order should start reflecting in General Electric's numbers next year, Caterpillar doesn't really have much to look forward to.
No visible catalysts here
In fact, Caterpillar expects "flat sales" from its power systems business for 2014.
Cummins recently sounded the warning bell, too: When asked about its 2014 outlook for engines, management's answer was: "we don't see a big win behind us on economic conditions."
That's certainly a concern, especially when you know that Caterpillar's mining-equipment business is unlikely to stage a comeback next year, and its construction-equipment side isn't doing too well either. While Caterpillar expects sales from construction industries to improve slightly in 2014, it projects revenue from resource industries, or mining equipment, to further decline.
Growth catalysts are clearly lacking, and I can hardly see any signs that could trigger a reversal in Caterpillar's stock price. 2013 has been a disastrous year for the equipment maker, and chances are that Caterpillar will end the financial year with big drops in revenue and profits. With half of the company's sales coming from mining and construction equipment, any deterioration in those end markets going forward could deliver a huge blow to its top and bottom lines.
Foolish takeaway
Had Caterpillar's power systems business recorded greater year-over-year sales and profits, investors could have safely bet on it and remained hopeful. Sadly, that's not the case. Investors should also remember that the resource industries has historically been the highest-margin business for Caterpillar. With the better part of Caterpillar's growth plans targeted at mining, not much will happen until that industry recovers.
Meanwhile, if there's anything that will fuel Caterpillar's stock price in near months, it'll probably be positive news from China, because the market tops the company's expansion list. Again, that trigger will have nothing to do with Caterpillar's power systems business.
