Caterpillar (CAT) has yet to breach the low end of our fair value estimate range, despite releasing a dismal third-quarter report. Revenue dropped 18% on a year-over-year basis, while earnings per share tumbled more than 40% (both below consensus expectations). The firm also issued a revised 2013 outlook and now expects sales to be about $55 billion (was $56-$58 billion) with profit per share of $5.50 (was $6.50 per share in the middle of the range). As we outlined after the firm's second-quarter report, released July 25:
"It appears that neither Cat nor its dealer network, which plans to reduce inventories even further, expects a robust recovery in demand anytime soon. 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. 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…mining equipment demand trends and dealer inventory reductions indicate that caution may be in order…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."
Though we nailed this third-quarter miss in our previous note, Caterpillar suggested in its third-quarter release that "order rates have not picked up despite continuing strong commodity production." This is not good. We previously outlined recovering iron ore prices and record production at Rio Tinto (RIO). Also, BHP (BHP) posted a 23% year-over-year increase in iron-ore output during its September quarter and indicated that copper and petroleum production also increased. Caterpillar is still struggling even though its mining end market has stabilized. Its outlook for 2014 bears these concerns:
From an economic standpoint, the company expects better world growth in 2014. However, significant risks and uncertainties remain that could temper global economic growth. The direction of U.S. fiscal and monetary policy remains uncertain; Eurozone economies are far from healthy and China continues to transition to a more consumer-demand led economy. In addition, despite higher mine production around the world, new orders for mining equipment remain very low. As a result, the company is holding its outlook for 2014 sales and revenues flat with 2013 in a plus or minus 5 percent range. The company expects sales growth in Construction Industries, relatively flat sales in Power Systems and a decline in Resource Industries' sales.
Probably the first question on readers' minds is how safe is Caterpillar's dividend given the firm's terrible third-quarter results and ominous future fundamental trajectory. The reality is that Caterpillar is still a healthy free-cash-flow generator. The company's net cash from operations totaled $7.61 billion through the first nine months of 2013, and it has only shelled out $1.86 billion in capital expenditures or $3.16 billion (including expenditures for equipment leased to others). Traditional free cash flow is roughly $5.7 billion (or $4.4 billion) during this time frame, which compares to only $730 million in cash payments for dividends during the first nine months of 2013. Though this is certainly very healthy dividend coverage, we still have to pay close attention to Cat's financial operations, which represent more than $18 billion of its $26 billion debt load on the balance sheet. In any case, we have no interest in shares in our actively-managed portfolios.
Additional disclosure: RIO is included in the portfolio of our Best Ideas Newsletter.