Caterpillar continues to report modest revenue declines.
Earnings are up on cost cutting, continued and accelerated share repurchases.
The increase in leverage resulting form repurchases, premium valuation and lack of growth is a worry.
Investors in Caterpillar (NYSE:CAT) were not happy with the company's second-quarter earnings report. Revenues for the quarter and full year are softer than anticipated. This is as the earnings beat and increased guidance is driven by financial engineering, through massive share repurchases.
The increase in leverage, premium valuation and continued pressure on top-line results makes me cautious.
Highlights For The Second Quarter
Caterpillar reported second-quarter revenues of $14.15 billion, down 3.2% compared to last year. The extent of the revenue shortfall came as a surprise to analysts which were looking for revenues of close to $14.5 billion.
Despite the shortfall in revenues, Caterpillar managed to expand earnings to $999 million which was up by 4.1% compared to last year. Thanks to a reduction of the outstanding share base, Caterpillar managed to grow earnings per share by 8.3% to $1.57 per share on a diluted basis.
Excluding restructuring costs which totaled $0.12 per share, non-GAAP earnings came in at $1.69 per share. Investors and analysts were looking for earnings of $1.52 per share.
Looking Into The Operational Segments
Total machinery, energy and transportation sales were down by 3.7% to $13.39 billion. Total operating earnings were down by 5.0% to $1.32 billion.
The smaller resource industries segment reported a massive 29% drop in sales to $2.24 billion with weakness seen in all geographical segments. Consequently, operating earnings dropped by 75% in the normally very lucrative business, coming in at just $133 million. The very poor performance is of course attributed to continued weakness in the global mining sector.
Energy & transportation sales were down by 2% to $5.18 billion. Despite the fall in sales, operating earnings saw a further improvement and surpassed the billion mark.
The construction segment was the bright spot and posted an 11% jump in sales to $5.41 billion to become Caterpillar's biggest segment. Operating earnings advanced by 83% thanks to very strong sales leverage, coming in at $674 million.
Notably North America drove the results amidst the continued economic growth in the country. Sales rose by 6% to $5.88 billion on Caterpillar's home turf. EAME posted a 3% drop in sales to $3.31 billion while the performance of Asia and Latin America was weak in particular with the continents posting a 13 and 15% drop in sales, respectively.
Total financing revenues worldwide were up by 3% to $759 million for the quarter. Despite the revenue growth operating earnings were down by 4% to $232 million.
Halfway through the year Caterpillar is updating the outlook for this year. Full-year sales are now seen between $54 and $56 billion which is a downwards revision from the earlier guidance of annual sales of $56 billion plus or minus 5%.
Despite sluggish sales, Caterpillar is more optimistic about annual earnings. Restructuring costs are now seen around $400 million at the low end of the previous guidance for costs of $400 to $500 million.
GAAP earnings are now seen around $5.75 per share, about twenty cents more than previously anticipated. Non-GAAP earnings are seen at $6.20 per share, ten cents more than previously anticipated. Analysts had already anticipated full-year adjusted earnings of $6.23 per share, while they were looking for revenues to come in at $56.3 billion.
Valuing The Business
Caterpillar ended the quarter with $7.9 billion in cash and equivalents, while its industrial operations had about $10 billion in debt outstanding. This results in a very modest net debt position, but note that total liabilities from the financing business came in at $24.7 billion.
With roughly 638 million diluted share outstanding, and shares trading at $104 per share, equity in Caterpillar is valued at roughly $66 billion. Given the full-year outlook, equity is valued at 1.2 times annual sales and roughly 18 times GAAP earnings.
Struggling From The Continued Slump In Commodities
Being a supplier to global construction and mining markets, Caterpillar remains a very much cyclical stock. Top-line sales have been very volatile over the past decade increasing from roughly $30 billion to $51 billion by 2008. Sales fell to just $32 billion the year thereafter and recovered to nearly $66 billion by 2012 before falling again.
Despite the volatile top-line sales results, Caterpillar managed to remain profitable in every year, with earnings ranging from about $900 million in the difficult 2009, to $5.7 billion by 2012. Despite the volatile earnings, Caterpillar managed to reduce its total share count by about a tenth over this total time frame. Of course this has resulted in a relative increase in leverage on the balance sheet over this time period.
With sales continuing to disappoint, Caterpillar has done a good job at continuing to cut the cost base, allowing the company to still report earnings of $3.5-$4.0 billion. This is despite the outright weak circumstances in the mining industry which has the potential to be very profitable.
As CEO Doug Oberhelman often comments, Caterpillar unfortunately cannot control the environment in which it is operating. As such the company has made substantial cost cuts to create lean operations which remain profitable even when sales drop by double-digit percentages on an annual basis.
Given that Caterpillar has quite a capital-intensive business, the lower sales free up working capital as well as fixed capital which the company has used in order to please investors. Therefore the company aims to repurchase $2.5 billion worth of stock during the third quarter, as part of its large $10 billion share repurchase program. The program is very aggressive, and implies that Caterpillar is repurchasing its outstanding share base at a rate of 15% per annum in the coming quarter.
This is accompanied by a quarterly dividend of $0.70 per share, providing investors with another 2.7% yield per annum.
While all of this seems great, large part of the earnings per share growth is the result of financial engineering. As such shares trade at 18 times earnings, although amidst very difficult mining circumstances. Yet Caterpillar is rapidly increasing leverage, even during the relative good times in its construction and energy business. While the hike in annual earnings per share seem good, this is the result of the accelerated and huge share repurchase program, and not so much growth of revenues or improved operating performance.
As such the earnings report is of a very low quality, driven by a built up in debt. For this reason alone I continue to avoid shares. A mining rebound does not appear to be imminent, potential for further cost cuts appears limited, while the valuation is high amidst an increase in leverage.
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