Reading Caterpillar's (CAT) release and listening to the call, I get the sense of management basically shrugging its shoulders and saying "heck if we know" when it comes to the year ahead. I can't blame them in the least, as listening to all manner of conference calls this earnings season has turned up a wide array of feelings, impressions and outlooks for the economy both now and for the rest of 2013. For better or worse, the near-term outlook for Caterpillar is likely to be dominated by commodity price trends, while the long-term value seems only so-so right now.
A Messy Quarter, But Not So Bad On Balance
Caterpillar reported that revenue fell about 7% this quarter, with machinery revenue down a similar amount. While resource equipment revenue rose 14% (and 16% on an organic basis), power revenue fell 6% (down 9% organic), and construction revenue plunged 25% as dealers cut inventory by about $1 billion.
Earnings both above and below the line were messy. Gross margin eased off a bit from last year and pretty substantially (three and a half points) sequentially. Adjusted operating profit fell about 17%, with adjusted machinery profits down about 20%. Profits plunged in the construction business (with an operating margin below 1%), and power profits were down 15%, while resource profits were up about 20% on an adjusted basis.
While Caterpillar reported what looked like a sizable miss relative to estimates, it wasn't so bad. A goodwill charge of $580 million took out $0.87, while Caterpillar also recognized a $300 million tax benefit. Assign a tax rate closer to what the sell-side analysts were looking for and it looks like Caterpillar was just a penny or two below the target.
The Siwei Debacle Shows Even Big Companies Can Get Fooled In China
When Caterpillar announced its $700 million acquisition of ERA Mining, it made some sense at the time. The deal seemed pricey, but like Joy Global (NYSE: JOY), Caterpillar wants more exposure to the underground coal mining machinery market in China, and acquisitions are a logical way to go about it. Unfortunately, things got bad very quickly.
ERA Mining was basically a shell company that Siwei (the subsidiary that made the coal mining equipment) used to obtain a Hong Kong listing without launching an IPO. Although ERA Mining's reports were ostensibly audited, the auditors apparently did not notice issues with inventory accounting and cost allocation that significantly overstated profits. Caterpillar has since cleaned house after discovering the problems, but the $580 million writedown (more than 80% of the purchase price, 70% of which Caterpillar paid in cash) stings - even if accounting rules allow Caterpillar to call it a non-cash charge.
China Still Drives The Bus
For better or worse, China still wields considerable influence over Caterpillar's near-term fate. Total Asia-Pacific sales are only about a quarter of Caterpillar's total (and one-third of the resource-related sales), but China is "the" marginal consumer of most global commodities, and basically the price-setter. If Chinese companies start gobbling up iron, copper, alumina and so on as before, mining equipment demand should recover. Likewise, if China can find that sweet spot between stimulating the economy into over-building capacity and avoiding a politically disruptive recession, companies like Caterpillar, Volvo (OTCPK:VOLVY), Hitachi (HIT), and Komatsu (OTCQB:KMTUY) should be able to start moving more construction equipment as well.
All that said, it seems like the large global mining companies are getting more cautious. Vale (VALE) has scaled back its capex plans, and Rio Tinto (RIO) recently replaced its CEO - and the new man has built his reputation in part on an "on time, under budget" management approach that suggests Rio Tinto will be more careful with its capital in the coming years.
But Caterpillar Is Not Just A China Story
Outside of China, there are still ample reasons to have some concern over Caterpillar's near-term outlook. The budget wrangling in Washington, D.C. doesn't suggest any sizable federal largesse going in the direction of civil engineering and Deere (DE), Terex (TEX), Komatsu and the like will be competing hard for what business there is to get in commercial construction. At the same time, it looks like lower oilfield activity has reduced demand for portable power generators - also a threat to Cummins (CMI).
The Bottom Line
Back in August, I thought Atlas Copco (OTCPK:ATLKY) was the play that investors should consider if they wanted mining exposure. Since then, Atlas shares are up more than 20%, while Caterpillar is up 8% and Joy Global is up about 13%. Now admittedly such a short period of time proves nothing more than luck, but I feel the point stands that investors should think a little more broadly if they want exposure to the mining industry today.
As for Caterpillar, I see long-term revenue growth potential in the mid single-digits, with free cash flow growth potential in the high single digits. That's good for a fair value near $110, but that's not really enough potential reward for what I see as a potentially very volatile holding. The number of appealing cheap industrial companies is shrinking pretty fast in this post-election rally, but I'd be careful about making a big commitment to Caterpillar at these prices, as I think investors will get at least one more chance to buy shares at a lower level in the next six months.