Industrial bellwether Caterpillar (CAT) reported relatively disappointing second-quarter results, as both its top and bottom lines fell below consensus estimates. Revenue dropped 16% to $14.6 billion, as sales declined in all geographic regions, with the steepest reduction in Asia/Pacific (though we note sales in China increased). Profit per share plunged over 40% to $1.45 due to lower volumes, an unfavorable mix of products, and sales deleveraging (reduced cost absorption). Management acknowledged the difficult market environment by reducing inventories $1.2 billion in the quarter, trumping that of its dealer supply chain, which cut channel inventories by $1 billion (more than expected).
It appears that neither Cat nor its dealer network, which plans to reduce inventories even further, expects a robust recovery in demand anytime soon. In fact, Cat believes dealer inventories will end 2013 about $3.5 billion lower than year-end 2012. Though cleaning out channel inventories by under-selling end-user demand may help when the pace of equipment orders turns, we don't think Cat and its dealer network are making such decisions on a whim, indicating demand may be subdued for some time. We think the massive 25% and 52% declines in 'Resource Industries' revenue in its North America and Asia/Pacific regions caught management a bit off guard-'Resource Industries' profit also fell a staggering 61% from the year-ago period.
Perhaps unsurprisingly, Cat cut its 2013 revenue and earnings per share outlook to the range of $56-$58 billion (was $57-$61 billion) and to $6.50 (was $7), reflecting the deteriorating demand situation. The sharp decline in dealer inventory and reduced capital expenditures in the mining sector ('Resource Industries') are two particular hurdles Cat must overcome to turn the corner on the trajectory of both revenue and earnings in the next few years. Industry surveys indicate that total mining capital expenditures will fall another 20% in 2014 from 2013 levels, which will be roughly 5%-10% below 2012 spending. We'll be monitoring Cat's productivity initiatives and cost-reduction measures through the remainder of 2013 to ascertain whether the firm has positioned itself well for an even steeper drop in demand. Free cash flow in coming periods will be cushioned by an ongoing reduction in capital expenditures, which are expected to be $400 million less in 2013 than in 2012.
Caterpillar is one of the most shareholder-friendly firms in the industrial arena. The company plans to continue buying back stock and recently upped its quarterly dividend. However, mining equipment demand trends and dealer inventory reductions indicate that caution may be in order. We've seen strong performance from industrial bellwethers General Electric (GE) and Honeywell (HON) in their respective second quarters, so we're more concerned about the health of Cat's mining-construction peers than any abrupt slowdown in general industrial demand. Still, financial performance at Cat is definitely heading lower in coming periods, revealing the firm's relatively severe degree of inherent cyclicality. Even though the long-term at Cat looks bright (given inevitable global economic expansion and rising standards of living in the decades ahead), we're not compelled to own shares at current levels.