Caterpillar - 3 Warnings In A Row Says It All

Oct.23.13 | About: Caterpillar Inc. (CAT)

Caterpillar (NYSE:CAT) reported yet another set of weak quarterly results on Wednesday before the market open.

The manufacturer of construction and mining equipment continues to be hurt by a tough operational environment; notably in mining equipment. These tough conditions prompt Caterpillar to negatively revise its full year outlook for the third time in as many quarters.

I remain on the sidelines. While I feel that initiating a short position at these levels might be risky given the fact that Caterpillar aims to please shareholders, it is still far too early to initiate a long position at this point in time.

I continue to be very cautious for the short term and wouldn't be surprised to see shares dip below $80 in the coming weeks.

Third Quarter Results

Caterpillar generated third quarter revenues of $13.42 billion, down 18.4% on the year before. Revenues fell over a billion short compared to consensus estimates of $14.5 billion.

Net earnings fell by some 44% to $946 million. Earnings per share fell by similar percentages to $1.45 per share, badly missing consensus estimates of $1.66 per share.

CEO and Chairman Doug Oberhelman commented on the poor performance, "This year has proven to be difficult, with expected sales and revenues nearly $11 billion lower than last year."

Looking Into The Results

Caterpillar continues to struggle and there are no signs of improvement yet, with third quarter negative sales growth accelerating to minus 18.4%.

Note that Caterpillar's income statement is based on production, so a $500 million sequential decline in inventories, and a $2.2 billion reduction in inventories compared to a year earlier takes a toll on reported numbers.

The construction and power systems business performed relatively solid, each posting a 7% drop in revenues to $4.55 billion and $4.92 billion, respectively. The Resource Industries business took the hardest hit with a 42% drop in revenues to just $3.00 billion. Note that revenues were weak across all continents.

These dramatic revenue numbers took a toll on profits. The construction business and the troubled resource industries reported operating profit declines of 43% and 63%, respectively. The power system business, which is by far most profitable at the moment, fared relatively well. The unit reported a modest 6% fall in operating profits.

In the light of negative revenue growth of over 18%, the reported 46% fall in operating earnings is not even that bad. The flexibility in the business model, and pro-active cost cuts in manufacturing, as well as selling, general & administrative costs are to thank for that.

Outlook

The continued weak environment prompted Caterpillar to lower the full year outlook again. Full year sales are now seen around $55 billion, compared to a previous revenue guidance of $56-$58 billion.

Earnings per share are now seen around $5.50 per share, down a buck compared to the previous guidance.

Note that analysts were looking for full year earnings of around $6.19 per share on revenues of $56.8 billion.

Even more disappointing is the preliminary outlook for 2014. Despite improvements in economic indicators, Caterpillar is cautious and guided for flat revenues in 2014 compared to 2013, plus or minus 5%.

The performance so far implies that you fourth quarter revenues are seen around $13.7 billion, while earnings are seen around $1.30 per share. The guidance implies that fourth quarter revenues are seen down about 15% on the year.

Valuation

Caterpillar ended the third quarter with $6.36 billion in cash and equivalents. Caterpillar operates with $9.35 billion in debt for its machinery business. The financial unit holds another $30.19 billion in debt, for a net debt position of around $33.2 billion.

Note that revenues for the first nine months of this year came in at $41.25 billion, down 17.2% on the year before. Net earnings fell by 44.1% to $2.79 billion in the meantime.

Factoring in losses of 5% in pre-market trading, with shares trading around $85 per share, the market values Caterpillar at $55 billion. This values the company at 1.0 times annual revenues and 15-16 times annual earnings.

Caterpillar pays a quarterly dividend of $0.60 per share, for an annual dividend yield of 2.8%.

Some Historical Perspective

Shareholders in Caterpillar have long been tied to the fate of notably the global mining sector. Shares rose from levels in their thirties by 2004 to highs of $80 by 2007, to fall back to just $25 during the financial crisis.

Shares did rebound to levels around $115 per share in 2011 and 2012, but have seen a 25% correction ever since.

In recent years Caterpillar has demonstrated rapid growth, as the firm more than doubled annual revenues to $65.9 billion between 2009 and 2012. Note that earnings peaked at $5.7 billion last year, or at $8.48 per diluted share.

Investment Thesis

Investors in Caterpillar had to deal with yet another weak earnings report, as the company continues to cut costs and its guidance. The guidance cut for 2013 is bad enough as it is, yet Caterpillar does not even see any improvements into 2014.

To please shareholders somewhat, Caterpillar repurchased another $1 billion of its stock during the third quarter. This brings year to date repurchases to some $2 billion, or 3.5% of the outstanding share base. Note that the company still has $1.7 billion under its current authorization until this expires in 2015. Investors also recently received a dividend hike to $0.60 per share, for a yield of around 2.8%.

Yet these payouts cannot eliminate the entire pain as the underlying business continues to struggle, prompting Caterpillar to further rationalize production and staff levels. I must see that I am still positively surprised by the operating leverage in the business model. Note that operating profits nearly being cut in half is a terrible result, but also take note that this happened while nearly a fifth of total sales fell away.

The much anticipated pick up in order rates for mining equipment has not materialized despite strong production levels this year. This makes the acquisition of Bucyrus International in 2011 and ERA Mining Machinery last year extra painful.

Back in July of this year, I last took a look at Caterpillar's prospects. I concluded that shares offer little appeal on valuation and leverage concerns, amidst a terrible year so far. This company has been cutting its forecast the third time in a row now after previously warning in April and July.

In all honesty, Caterpillar's management itself is having little visibility on the business prospects, but it provides a lot of good information in its quarterly reports, which are extremely interesting to read. Again, operating performance remains lackluster but is partially driven by the nature how Caterpillar works. In good times, revenues are hit extra hard as inventories fall on top of ailing demand. Of course this works both ways.

Cost cuts remains necessary to keep reporting some profit and generate some cash flows, as Caterpillar has been returning cash to investors rather aggressively this year. While I applaud the dividend hikes, I am still not greatly enthusiastic about share repurchases at these fairly high levels in the stock.

I reiterate my stance. The very long term prospects continue to look rosy, but it might be 2015, or later, before a really recovery will materialize. Shares are no obvious short as comparables should get easier and the mining industry can't delay investments forever. These actions, combined with shareholder friendly initiatives make a short trade risky, but a long position remains quite risky as well, given the still fairly high valuation and the implicit leverage of the financing division.

I remain on the sidelines, but Wednesday's sell-off is again well-deserved amidst yet another very disappointing quarter. For now the short to medium term risks remain to the downsides.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.