How Caterpillar Inc. is Fighting Back Against a Bleak Mining Environment

Caterpillar's first quarter contained a pleasant surprise for investors as the company beat forecasts to register a healthy growth in earnings. The past year had been a tough one for the company, as mining companies' lowered capital expenditure hurt sales of mining equipment. What's going in Caterpillar's favor is its diversified portfolio; the company also makes construction equipment and gas turbines. These two product categories have been cushioning the fall.

Should we take the quarter as a trend for the whole year, or a flash in the pan? Let's dig in... but first, a quick quarter summary.

Quarter recap
Revenue in the three-month period went up just a tad, to $13.24 billion, compared with the $13.21 billion in the same quarter last year. However, profit per share increased a good 22.9% to $1.61, against the $1.31 registered in the year-ago period; analysts were only expecting $1.24 per share. Caterpillar's operating cash flow in the quarter also improved to $1.878 billion, up from $1.089 billion in the same period last year. Basically, the quarter was worth writing home about.

Source: Caterpillar

Down the hill and up the hill
For 2014, Caterpillar had forecast a 10% drop in sales for its resource industries business that serves the mining and quarrying companies. As it becomes clearer that the mining slump is deeper than expected, Caterpillar has revised the drop to 20%. In the quarter, sales from the segment went down 37%.

A 5% yearly uptick for construction industries business is now expected to be 10% since construction is showing up. Sales in the business were up 20% in the quarter as compared with the year-ago period. The forecast for the power business remains unchanged at a 5% rise, with sales rising 8% in the quarter.

The construction and power businesses numbers registered in the quarter were better than expected by the company. This prompted Caterpillar to increase its 2014 earnings per share expectations by $0.25 per share to $5.55.

Construction spending in the U.S. started showing up toward the end of 2013, and has been steadily rising ever since. The American Institute of Architects projects non-residential construction spending to go up to 7.2% in 2014. Spending on hotel construction will witness double-digit gains, with commercial facilities going up 11%. The harsh winter might have slowed activity in residential building, but the National Association of Homebuilders believes the uptrend in the economy, built-up demand, competitive mortgage rates, and in-reach home prices will push housing up.

Mining menace
Weak commodity prices have made miners cut capital spending, with investments in new projects and expansions being constrained and plants being closed temporarily. As the chart from Bloomberg shows below, the capital expenditure of the top miners that account for around 80% of the industry's spending is going to go down with each passing year.

Rio Tinto  has said that it will curb expenditures by 20% in 2014 and 2015. These companies are caught in a tight spot where they have to deal with low commodity prices on one hand and high mining costs on the other, which is impinging cash flow. Coal prices, for instance, are hovering at their lowest levels since 2007.

Source: Bloomberg

At the announcement of Komatsu's fourth quarter (ended March) results, CEO Tetsuji Ohashi said, "As far as we've heard regarding mining customers' appetites for investment, things are tough. Major miners are continuing to cut their capital expenditures."

Komatsu, the world's second-largest heavy machinery maker, expects its revenue to go down 3.8% for 2014. Sales of mining equipment could fall 17% after they dropped 18% past year.

Dealing with the menace
Caterpillar has come to terms with the mining scenario and has been taking damage control steps. It undertook an extensive restructuring plan in 2013 that encompassed shutting down small factories, cutting production in some others, and laying off staff. The efforts are going to continue in 2014.

What this has done is helped the company to rein in costs. That's precisely the reason why Cat could increase profits in the quarter in spite of sales being almost the same as year ago. The company is also going easy on capital expenditure, sliding down steadily from $3.4 billion in 2012 to $2.6 billion in 201. It is expected to be even lower in 2014.

Morningstar's Adam Fleck told Reuters that Caterpillar's "very solid cost control in construction in particular" is a pleasant surprise as it is the highest three-period level in the recent past. Caterpillar's even bought back $1.7 billion shares in the quarter, boosting investor confidence.

Signing off
The macro conditions are bogging down Caterpillar, but the company is doing well to make structural changes to better deal with the downturn. Support from construction and power is encouraging and will help Caterpillar weather the storm. Being a cyclical business, mining will turn the corner; when that happens, Cat will surely grab the opportunity with both hands.

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