Caterpillar (NYSE:CAT) shares are on a tear this morning, having already gained 5%, as of this writing, after the heavy machinery giant's third-quarter numbers trumped estimates. Aside from strong earnings-per-share growth, Caterpillar also upped its full-year revenue and EPS guidance, giving investors enough reasons to get excited about.
But the headlines may not have given you the full picture. While an upgraded outlook is certainly a good sign, Caterpillar's earnings report revealed some disturbing trends that could hurt the company, and its stock, going forward.
Why aren't cost-cutting efforts showing up?
Despite flattish revenue of around $13.5 billion, Caterpillar's third-quarter earnings per share grew 12% year over year. Aside from favorable currency translation gains, much of the higher EPS was attributed to a lower outstanding share count thanks to the company's aggressive buyback program. Caterpillar repurchased shares worth $2.5 billion during the quarter.
So while buyback can boost EPS, that's not growth in real terms. The higher EPS would have made greater sense had it come on the back of lower costs. While Caterpillar did improve its gross margin by about two percentage points year over year, it ended up with nearly 10% higher selling, general, and administrative expenses. If you're wondering why that happened despite the company's aggressive lay-off programs in recent months, Caterpillar blamed higher "incentive compensation expense."
Digging deeper, I found out that under a short-term incentive plan, Caterpillar sets annual company performance targets and pays out an incentive, as measured against those targets, to its management and a section of employees. Accordingly, it paid $390 million during the third quarter compared to only $100 million in the comparable period last year. What's worth noting is that Caterpillar projects its full-year short-term incentive compensation to amount to nearly $1.3 billion versus only $545 million in 2013.
That makes me wonder whether Caterpillar's cost-cutting measures, which have been the company's focal point in recent months, will at all help boost its profits when incentives run so high. This is one area that needs to be watched closely going forward.
Everything's not right in China
In what isn't good news for Caterpillar, the Chinese construction market appears to have weakened further. During its earnings release, Caterpillar highlighted how the Chinese government's "push for structural reform" is actually "slowing growth", and that the construction industry in the nation is expected to "remain challenged in the near future."
China is among Caterpillar's priority growth markets, but slowdown has stalled the company's growth over the past couple of years. Unfortunately, Caterpillar's latest update suggests that the market could take longer to turn around.
In fact, the Asia-Pacific region, which ranks as Caterpillar's second-largest construction-equipment market after North America, has turned out to be the weak point in recent months. Caterpillar's third-quarter report confirmed this -- Sales for both, construction and resource industries (mining) divisions from the Asia Pacific region slipped 13% each during the quarter. Until this region, especially China, gathers steam, Caterpillar will continue to feel the heat.
Energy & Transportation is strong, but...
All eyes have been on Caterpillar's energy and transportation business ever since it emerged as its largest and most-profitable business last year. The third quarter was no different: Sales from E&T jumped 13% year over year even as Caterpillar's construction and resource industries divisions reported 2% and 19% lower revenue, respectively. But what caught my attention was when Caterpillar mentioned how a decline in its Q3 backlog for rail locomotives partially offset an increase in backlog for engines and rental machines.
With the Tier 4 emission standards set to roll in January next year, greater demand for locomotives could really set cash boxes ringing for companies like Caterpillar and General Electric (NYSE:GE). But since a declining backlog suggests lower orders, Caterpillar could be losing this race to General Electric. In fact, you may note that during its Q3 earnings release last week, General Electric specifically mentioned how it was "ahead of the competition" as it bagged orders for over 1,000 Tier-4 compliant locomotives during the quarter. General Electric further expects a 30% jump in its Q4 locomotive shipments.
In such a situation, it remains to be seen whether Caterpillar's transportation sales can continue to trend higher, or whether the division's good Q3 performance is just a one-quarter event.
Caterpillar now expects to generate revenue worth $55 billion this year versus its earlier projected ranges of $54-$56 billion. It also improved its earnings outlook by $0.25 to $6 per share. While that sounds great, the above mentioned factors could play a key role in deciding whether the company can really churn out greater profits and shareholder returns over the long term.
Neha Chamaria has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.