Why Caterpillar Desperately Needs to Prove John Deere and Joy Global Wrong


It's a critical week for Caterpillar investors. The closely watched heavy machinery bellwether is set to report its third-quarter numbers Wednesday, and the Street is not expecting much. While mining equipment rival Joy Global expects several rough quarters before China bottoms out, construction equipment competitor John Deere forecasts a weak North American market for the full year. Since both are critical markets, that's bad news for Caterpillar.

But with China's economy growing at an accelerated 7.8% in the third quarter, and Cat's machine sales from North America improving, are Joy Global's and Deere's concerns overblown? That's exactly what investors should look for in Caterpillar's upcoming report, because if the company can prove its peers wrong it may signal the much-awaited turnaround.

Is a slowdown in the making?
Caterpillar gets more than a third of its sales from North America, so any sluggishness in the market could hit the company hard. Deere projects its full-year construction equipment sales to drop 8% on a weak U.S. construction market. But Cat needs to worry more, because Deere has the more resilient farm equipment industry to fall back on -- Deere's farm-equipment sales are expected to climb 7% for the full year, offsetting sales weakness in its construction and forestry divisions.

Nevertheless, Cat's machine sales in North America grew 1% for the three months ended in August. That's a marked improvement from the 10% drop the company reported for the quarter ended in June. So Cat investors may not want to take Deere's dour projections too seriously. That said, Cat's upcoming earnings report will confirm whether the improvement in the U.S. market sales is temporary or the real thing.

Global woes could deepen
Weak numbers from Cat's other key markets, though, could dent investors' optimism. For the first time this year, Cat's machine sales in Latin America dropped 3% for the quarter ended in August. Latin America was among the two regions where Joy Global reported a drop in aftermarket bookings in its last quarter. Since aftermarket is a major business for Joy Global, falling orders suggest the Latin American market may be getting weaker.

Worse yet, Cat's business in the Asia-Pacific region is slowing down, as evidenced by the big 30% drop in sales for the three months ended in August. China, in particular, is a very important market for Caterpillar going forward, so investors must pay attention to the company's outlook about the market in its upcoming earnings call. One key metric to watch will be the inventory level.

The key to Cat's turnaround
Unlike Joy Global which sells directly to customers, Caterpillar relies on its global dealership network for sales. With the mining industry hitting a roadblock, the dealers were left with huge inventories, which hurt demand for Cat's equipment.

While Joy Global has to worry about its own inventory, Cat has to track its dealers' inventories and assess its own inventory and sales situation. So while Joy Global took down less than $200 million worth of inventory during the nine months ended in July, Caterpillar reduced its inventory by a whopping $1.2 billion during just the second quarter. Cat's dealers decreased inventory by $1 billion during the same period.

Joy Global believes its customers in China still have high inventories in hand, which could take time to deplete. Since the company gets 18% of its sales from the Chinese market, its outlook holds water. So investors may get to see further inventory reduction at Caterpillar's end this year. Cat had earlier projected its dealers' inventory to decline between $1.5 billion and $2 billion during the second half, with more than 50% reduction relating to mining equipment. At the same time, Cat expects to start some of its idled plants during the second half. If the company's upcoming earnings release reflects lower inventory and increased production, it could be a sign of better days ahead.

What investors should pay attention to
Joy Global expects the overall weakness in the mining industry to spill over to next year, hurting its top line by as much as 20% from the 2013 level. Even if Caterpillar's guidance reflects such uncertainty, investors can pin hopes on the company's other hugely profitable business to turn it around.

Since Caterpillar's growth is subject to the vagaries of the cyclical construction and mining markets, one quarter may not mean much for the company or its investors. Caterpillar's outlook for the full year and beyond, combined with its strategies to overcome challenges, will decide the company's fate in the years to come. Stay tuned -- after earnings are announced, I plan to take you through Caterpillar's numbers to help you make more informed investment decisions.

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The article Why Caterpillar Desperately Needs to Prove John Deere and Joy Global Wrong originally appeared on Fool.com.

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