1 Reason Alcoa's Earnings Report Paints a Bleak Picture for Caterpillar, Inc.

If Alcoa's guidance is anything to go by, Caterpillar's largest and highest-margin business may be at risk.

Neha Chamaria
Neha Chamaria
Apr 11, 2014 at 1:35PM

As an aluminum major, Alcoa's numbers and outlook provide great insight into some of the key sectors of the economy. Alhough Alcoa (NYSE:AA) isn't a member of the Dow Jones Industrials anymore, its earnings report continues to be much awaited by investors in many of the Dow companies. Caterpillar (NYSE:CAT) is one of them.

Alcoa's growth projections about various end markets can provide key insights into where Caterpillar is headed, especially considering that both companies serve several common markets. While Alcoa's latest report presents a decent picture for Caterpillar's construction equipment business, one of its projections spell trouble for the equipment maker's highest-margin business.

Before I get to where Caterpillar can stumble this year, I'll give you the good news first.

On the right track
Alcoa remains optimistic about the North American construction market, projecting it to grow by 3%-4% this year. Alcoa emphasized two leading indicators that have shown strength in recent months -- the architectural billing index and non-residential contracts.

The American Institute of Architects' Architecture Billings Index, or ABI, gives an idea about where non-residential construction spending activity could be headed over the next nine to 12 months. A score above 50 indicates a rise in billings (for design services) at U.S. architecture firms, thereby reflecting greater construction activity. The ABI scored 50.7 in February, up slightly from January's 50.4 mark and considerably higher from its December score of 48.5, indicating steady recovery in the construction market.

Source: McGraw Hill Construction.

The McGraw Hill Construction's Dodge Momentum Index, another barometer for non-residential construction, also remains in a broader uptrend (see graph on the right). Though the Index slipped slightly in February and March, the weakness was largely because of cold weather and hence appears temporary.

The extreme winter may have also slowed down residential construction activity, with U.S. housing starts falling for three straight months through February. Nevertheless, permits for new homes jumped nearly 8% in February. Furthermore, average home prices across the U.S., as reported by the S&P/Case-Shiller Home Price Index, hit 2004 levels in January, indicating strong recovery.

In short, Alcoa confirmed the ongoing strength in the U.S. construction market, which is excellent news for Caterpillar, and its investors. In fact, Caterpillar is already reaping the benefits -- its construction equipment retail sales from North America for the three months through February jumped 13% year over year.

Brighter days ahead?
If news from the U.S. construction market is positive, Alcoa is equally upbeat about the Chinese construction market. During its latest earnings call, Alcoa reaffirmed its projections for the market, expecting it to grow between 7% and 9% this year. In other words, the Chinese economy may not have improved much in recent months, but it may have left the worst behind. So why is that important for Caterpillar?

A Caterpillar machine in China's Sichuan-Yunnan provinces. Source: Caterpillar

China contributed roughly 6% to Caterpillar's total sales in 2013. While that isn't a big number, it's important to note that the company's 2013 sales from China jumped 20% over 2012. So if Caterpillar could generate higher sales from the market even when it was at its weakest, investors can hope to see even better numbers from the company this year as the Chinese economy strengthens.

More importantly, China is at the top of Caterpillar's expansion list so any uptick in sales from the market could encourage the company to put its growth plans back on track.

But while Caterpillar's construction business may have entered the growth trajectory, its energy and transportation (erstwhile power systems) division, which is also currently its largest and most profitable business, could be in rough waters.

Impending slowdown?
Alcoa projects the market for industrial gas turbines to fall between 8% and 12% this year. Gas turbines and reciprocating engines are among the key products offered by Caterpillar's energy and transportation business, which contributed nearly 37% to the company's total revenue in 2013.

Gas turbines are primarily used by players in the oil and gas and power generation sectors, both of which are key end markets for Caterpillar. With prices of natural gas bouncing back in recent months, coal has managed to draw the market's attention. Alcoa also highlighted how some of the utilities in Europe are "mothballing" the gas-fired plants in the wake of higher gas prices. That could hurt the demand for Caterpillar's turbines and engines.

In fact, Caterpillar's last released retail sales data provided a glimpse into the weakness -- equipment sales from the oil and gas market slipped 10% year over year for the three months through February. With the marine and rail locomotive markets already on a softer patch, generating sales could become a bigger challenge for Caterpillar's energy and transportation business this year.

Foolish takeaway
As a cyclical company, Caterpillar is still in a vulnerable position, and may have to wait a little longer to chart its turnaround story. The construction market may be heating up, but Caterpillar has a lot more at stake, thanks to its mining-equipment and engines and turbines businesses. And Alcoa's projections aren't the kind that should excite a Caterpillar investor much. You'll perhaps get more clarity when Caterpillar reports its earnings in a couple of weeks. Stay tuned.