Caterpillar Inc. (NYSE:CAT) shares opened nearly 3% higher this morning as the market applauded the heavyweight's first-quarter earnings report. And why not? A surprisingly good set of numbers and improved full-year profit guidance isn't something investors expect to see when business conditions remain challenging.
The world's largest construction and mining equipment maker beat Street estimates on both the top and bottom lines. But we need to find out what pushed the company's Q1 profits higher, and why it projects greater earnings despite higher potential costs.
What's keeping revenue decline in check
Caterpillar's Q1 revenue came in at $12.7 billion, down 4% year over year but exceeding analyst estimates of a 6% decline. However, the real story lies in the details. Here's what revenue by segment looks like:
|Business Segment||Q1 2014 Revenue (in billions)||Q1 2015 Revenue (in billions)||% Change|
|Energy & Transportation||$4.78||$4.76||unchanged|
There are two key takeaways from these numbers: Demand for Caterpillar's construction equipment continues to remain weak, and its energy and transportation division is showing signs of stress, as evidenced by flat Q1 sales compared to 11% higher year-over-year sales reported in the fourth quarter.
Except North America, where sales climbed 9% year over year, every other geographic region exhibited weakness in construction. Asia-Pacific and Latin America each reported a more than 20% drop in sales. While Latin America had an especially strong first quarter in 2014 thanks to a large order from Brazil, ongoing weakness in China is hurting Caterpillar's prospects in the Asia-Pacific region. The company expects lower construction-equipment sales from China this year, which doesn't bode well considering the market is among its key growth drivers.
Pressure on top line as year progresses?
Flattish Q1 energy and transportation revenue is far more relevant in today's discussion because Caterpillar's top line could take a heavy blow if E&T slows down, since this business has significantly helped offset weakness in mining and construction over the past couple of years.
But as Chairman and CEO Doug Oberhelman pointed out during the earnings release, "Energy & Transportation turned in another great quarter, although we don't expect this to continue due to the oil-related portion of the business." In other words, as the company had already hinted in its previous earnings call, E&T revenue will decelerate from the second quarter onward because of weak demand for engines from oil and gas companies in the wake of lower oil prices.
The secret behind improved profits and outlook
What's notable is that despite lower revenue, Caterpillar's Q1 earnings per share jumped sharply to $1.81 from $1.44 in the year-ago quarter. It's worth noting that nearly $0.14 of it came from a one-time gain that the company booked for selling a stake in its logistics business, part of which was sold off in 2012. Nevertheless, excluding that still results in a substantial earnings improvement, which Caterpillar attributed to better pricing and lower restructuring costs.
Strong Q1 profits encouraged Caterpillar to improve its 2015 profit outlook to $4.70 per share, versus an earlier projected EPS of $4.60, including restructuring costs. Interestingly, Caterpillar kept its revenue outlook unchanged at $50 billion, or roughly 10% lower from 2014. At the same time, it increased its restructuring cost projections, expecting to incur about $100 million more than the earlier projected $150 million this year.
So, what does that mean? With no potential improvement in revenue and higher restructuring costs, Caterpillar perhaps expects other factors affecting its profits to turn in its favor as the year progresses. That could include lower operating costs as a result of cost-reduction efforts and favorable currency movements since Caterpillar gets a good portion of its sales from international markets. Since currency movements are unpredictable, I believe the company is banking on its cost-control initiatives to boost profits, which is certainly an encouraging sign.
Why this could be the bottom
What impressed me most is that Caterpillar improved its profit guidance despite major headwinds like low oil prices and a recent decline in key commodities, which hurts its resource industries or mining business. In fact, the higher restructuring costs Caterpillar expects to incur this year are primarily related to its mining-equipment facilities, indicating that plant shutdowns or layoffs could be on their way.
Remember, Caterpillar is also traditionally known to be conservative when it comes to projections. So, the fact that it raised its guidance perhaps indicates that it doesn't see further downside in the business, suggesting better days ahead for the company and its stock. That's exactly what patient investors who kept faith in the stock during the downturn have waited to hear.