- Caterpillar's earnings will lag its share price growth in next few quarters. Earnings will bottom out soon and grow in 2017 and 2018.
- Management kept its construction equipment top line rolling year guidance flat which is a first in years.
- Caterpillar reported an adjustment upwards in China which could be a huge growth market for Caterpillar in the years to come.
Caterpillar (NYSE:CAT) slightly missed earnings per share estimates ($0.67 compared to $0.68) but revenues came in better than expected ($9.5 million as opposed to $9.4 million predicted). This meant that industrial operating margins came in weaker than expected (6.2%) which prompted the management to reduce its 2016 sales outlook by around $2 billion and earnings per share by $0.3 to $3.70. As always it was forward-looking guidance that moved the stock although the stock pared back most of the losses (2%) to finally end the trading day on the 22nd at $78.33 when earnings were announced. In saying this, Caterpillar's industrial cash flow came in at an ugly $138 million which would have worried income investors about the viability of the dividend.
However as I pointed out in my earnings preview, the company's debt to capital ratio is crucial and fortunately, it fell to 37.7% which illustrates the strength of its balance sheet. It would suffice to say that I don't see Caterpillar's dividend coming under pressure in the near term especially when you consider the $5.9 billion cash balance it still has on its books. I still maintain Caterpillar stock is not overvalued at these levels despite its continued sales slump. Here is why.
Firstly, investors have to remember that the market is forward looking. First comes share price growth, then comes earnings growth. Caterpillar stock has rocketed by 28%+ since the end of January (see chart) but its earnings this quarter dropped from $2.07 a year ago to $0.67 in Q1-2016. Is this sustainable is the question?
Well, we just have to go back to 2009 to see how Caterpillar behaved in a similar fashion. Oil and equities bottomed out in the early parts of 2009 and oil went from around $40 a barrel to around $110 in early 2011. Caterpillar stock followed suit as it went from around $25 a share to over $115 a share in the same time period. Now what investors should remember is that Caterpillar's earnings actually went down in this period. EPS went from $5.66 in 2008 to $4.15 in 2010. It wasn't until 2011 and 2012 did we see valuations and earnings come back to historic averages. The same is happening here in my view. The market knows Caterpillar will do better as commodity prices rise but it may take another year or two for earnings to catch up.
This is why its segment-wise figures should not come as a major surprise to investors considering where the machine manufacturer is in its cycle. It's worst performing segment was transportation which declined a whopping 33% on a rolling year basis. Oil rallied by more than $15 a share over the past few months which convinces me that sooner or later oil and gas customers will start to increase their buying. Furthermore, mining fell by 26% and construction fell by 19% but I expect these numbers to come down in the forthcoming quarters as demand starts to perk up.
Furthermore, mining fell by 26% and construction fell by 19% but I expect these declines to reduce in the forthcoming quarters as demand starts to perk up. In fact, when the company was dialing down its 2016 top line guidance it decided to not alter its construction equipment business top line from 2015 which is a positive sign in my book and a sign that a bottom in this earnings cycle is imminent. Construction equipment will be the first to bottom, then mining and energy, etc will follow suit.
Thirdly, it will be interesting to see whether Caterpillar can make bigger inroads into China where Komatsu is the indisputable market leader. The management stated that it saw nice growth in China during the first quarter as a result of the ongoing stimulus measures the government is implementing. Now if present restructuring could pave the way for a larger market share in China, I have no doubt the market would price the stock higher. Restructuring charges (which will come in higher this year than predicted) will eventually subside but will undoubtedly benefit the company.
Restructuring charges (which will come in higher this year than predicted) will eventually subside but will undoubtedly benefit the company. Furthermore, the company's recent exit from the vocational truck business will also lower costs and help the company compete better over the long term. Investors have to be patient. Once restructuring starts to wind down, we should see meaningful earnings and margin growth.
To sum up, Caterpillar may have missed on earnings but long term, I still don't see much downside risk in this stock. Why? Well, I believe the commodity cycle has bottomed and we should see higher energy and commodity prices from here. I acknowledge that a portion of earnings growth may be already priced into the stock but Caterpillar's yearly earnings should bottom this year or next which is bullish for its share price going forward.