Remain Cautious About Caterpillar

NEW YORK (TheStreet) -- About two weeks ago, after missing revenue and earnings estimates for four consecutive quarters, the world's largest mining and construction equipment company Caterpillar (CAT) surprised Wall Street by delivering better than expected quarterly results. Caterpillar reported strong demand for construction equipment, helped by aggressive cost-cutting measures. Moreover, the business also gave an optimistic forecast for 2014. Amid all this positivity, Caterpillar shares have risen by 11% since the earnings release, including yesterday's rally, and are currently hovering around $96.

However, I believe investors should think twice before buying into this optimism. Caterpillar's core operating area, resource industries, will likely struggle through 2014. This will be an extremely challenging year for Caterpillar, as it is targeting flat revenues in the current year, as compared to last year. This means that its other segments will have to show consistent improvements to offset the declines coming from mining equipment.

Caterpillar gets 95% of its revenue from the sale of machinery and power systems via three segments: resource industries, construction industries and power systems.

In the previous quarter, Caterpillar posted a 10.4% year-over-year drop in total sales and revenues to $14.4 billion, which was entirely due to the 11.1% drop in sales of machinery and power systems. On other hand, earnings soared 44%, to $1 billion or $1.54 per share, from just $697 million or $1.04 per share in the corresponding quarter of 2012. The company easily managed to surpass the market's expectations of a profit of $1.28 per share from revenues of $13.6 billion.

However, this massive jump in earnings is largely due to controversial write-down of a Chinese acquisition (Siwei) last year. Excluding the impact of that one-time item would bring down Caterpillar's earnings growth from 44% to just 5%.

Aggressive Cost Cutting

Some of this earnings growth can also be attributed to the firm's aggressive cost-cutting measures. Due to fewer sales, the cost of goods sales has naturally dropped. But the business has also been able to reduce its selling, general and administrative expenses by 11%, while the research and development expenditure has been cut by 24%. This was already anticipated, as Caterpillar has been scaling back operations in several regions, ranging from Minnesota to Belgium. The business also eliminated around 9,700 jobs, of which 40% were its U.S. workforce.

The ongoing cost cutting and restructuring efforts, which started in 2013, will continue through 2014. They will have a positive impact of nearly $200 million in 2014 and around $450 million each year after 2015.

This, I believe, will give a much needed support to Caterpillar's earnings, as it will offset some of the pressure coming from an unfavorable product mix.

Strength in Key Areas

However, the Chinese acquisition and cost-cutting measures aren't the only things that have driven Caterpillar's earnings. More importantly, the business has benefited from the accelerated recovery in the U.S. housing market. This led to an increase in demand for construction equipment and power systems, and had a positive impact on Caterpillar's earnings.

The business's revenues from the construction industries and power systems segments increased by 20% and 5% from last year to $4.8 billion and $5.5 billion, respectively.

I believe that this was the main positive in the latest earnings release. With improving macroeconomic fundamentals, the business could make up for some of last year's under-performance by posting increasing revenues from the construction industries and power systems segments.

Another positive was the 20% growth in sales in China. Caterpillar is expecting 7.5% economic growth in the country. This will translate into a "moderate" growth of the construction industry, which should translate into improving sales.

Struggling Core Business

Caterpillar has struggled in the past due to weakness in the mining industry. This was mainly due to the fall in metal prices. Furthermore, some unpopular takeovers, project delays and reduced capital spending by mining companies made things even more difficult for everyone in this industry. These factors severely hurt Caterpillar's sales of mining equipment, which are represented in its resource segment.

The resource segment has been the primary revenue drive for Caterpillar in the past several years. But in the previous quarter, the segment's revenues plunged 48% from last year, to $3 billion. This makes resource the smallest of the three main segments that make up its machinery and power systems unit, from which Caterpillar derives nearly all of its revenues.

Although there have been some positive signs, such as reduction in inventory, there is still no turnaround in sight. The order rates for new equipment remain extremely low.

Caterpillar's management is optimistic about its long-term prospects, since mining equipment sales could pick up in the coming years. But it is almost certain that the unit will remain under pressure throughout 2014. Therefore, Caterpillar is expecting a further 10% drop in revenues from its resource segment in 2014 from 2013.

Besides Caterpillar, other players in the industry are also struggling with declining sales. In its previous quarterly results, Joy Global (JOY) witnessed a 16% decline in underground mining equipment sales and a 36% decline in surface mining equipment sales. Meanwhile, Komatsu (KMTUY) the world's second-largest manufacturer of construction and mining equipment, significantly reduced its profit forecast in October and has reiterated its dim guidance, despite posting better results.

In short, amid persistent weakness in the mining sector and in the absence of any top line growth, Caterpillar has to rely on its cost-cutting measures to boost its earnings,. For 2014, the company is expecting annual revenue of around $56 billion and earnings of $5.85 per share, excluding the restructuring costs.

Caterpillar essentially thinks that its revenues in 2014 will be in line with last year's results. However, shareholders should take this guidance with caution.

Caterpillar has a history of over-promising and then revising down its outlook, and the company will incur substantial restructuring charges in 2014. According to its guidance, that will drag earnings down by 55 cents per share. Moreover, this profit forecast could also be revised downwards.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

Sarfaraz A. Khan is a capital market analyst and finance writer. Khan earned an MBA from the University of Aberdeen, located in the heart of the UK's oil and gas industry. Not surprisingly, his specialty lies in energy stocks. He also covers consumer goods, services sector, technology stocks, emerging markets and ETFs. His work appears on Seeking Alpha, Motley Fool and TheStreet.

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