CAT - Caterpillar: Tailwinds Headwinds And Q2 Earnings

2023-07-28 14:30:57 ET

Summary

• Caterpillar will report Q2 2023 earnings on Aug. 1.
• Construction equipment use and demand are expected to increase due to infrastructure spending and the clean energy transition.
• The US Manufacturing PMI Index shows a contraction in the manufacturing sector, which may pose challenges for Caterpillar.
• I want to share the main data I will be focusing on as the report is released.

Introduction

Caterpillar ( CAT ) will report its 2Q 2023 earnings on Tuesday, Aug. 1, before market open. After sharing my 1Q 2023 earnings preview , I will now spend a few words on what I will be looking at once the upcoming report will be released.

Tailwinds

I have often highlighted the main three macro trends that are true tailwinds for Caterpillar:

1. The Infrastructure Investment and Jobs Act passed in late 2021 is going to boost construction equipment use and demand.
2. Revitalization of American Manufacturing has become a political priority for the U.S.
3. The role of critical minerals in the clean energy transition will lead to increasing mining activity, boosting the need for highly-technological and competitive equipment.

Headwinds

However, the overall picture may not seem totally on the bulls' side. In fact, if we look at the US Manufacturing PMI Index, we see that we are at the lows of the last decade, apart from the COVID-related plunge.

In fact, the index in the United States fell to 46 in June 2023, below forecasts of 47. In other words, we see a faster rate of contraction in the manufacturing sector, with companies managing outputs down as demand weakens and production is slowing because of a decrease of incoming orders.

Key metrics to look at

With a company such as Caterpillar, I look particularly at three main points:

1. Margins. Just like Deere ( DE ), Caterpillar enjoyed very easy comps in Q1 2023 because in the first quarter of the prior year the company was still delivering equipment sold with 2021 prices due to the well-known supply chain bottlenecks. In Q1 2023, Caterpillar's operating margin came in at 17% before a quarterly revenue of $15.9 billion. As long as the operating margin stays above 16% we are in positive territory.
2. Inventory level. Caterpillar has been able, in the past six months, to complete its unfinished products and get them quick to its dealers and to end customers. Therefore, dealer inventories are increasing and are now back to their normal range of 3–4 months of projected sales.
3. Backlog is still strong at $30.4 billion. However, last quarter we saw no difference with Q4 2022. This goes along with other data showing a slowing economic activity.

Key segments to monitor

Even those who don't read Caterpillar's reports can expect the construction segment to be the most important one for the company. Below, we can take a look at a nice page where we see the whole product portfolio of the segment combines with its results over the past six fiscal years. From this segment, Caterpillar receives 42% of its total revenue. Therefore, it's a key segment to monitor. Some investors also may be worried about the weakening residential construction business. Yet, globally, about 75% of Caterpillar's construction industries revenue is from nonresidential, while the remaining 25% is residential. This insulates rather well the company from a deteriorating housing market.

However, what I think is one of the most promising business lines for Caterpillar is the resource industries one. In fact, as I pointed out earlier, the need for minerals is growing significantly. In addition, Caterpillar has been investing heavily for more than a decade to develop autonomous solutions that are meeting more and more the needs of mining customers.

Let me quote a few words from Jim Umpleby, Caterpillar's CEO, at Bernstein's Annual Strategic Decision Conference.

There are two promising aspects of this business. The first one is the increasing need for minerals, which, as Mr. Umpleby said, is driving a transitioning to mining, which...

If you look at the projections by the automobile manufacturers for the amount of EVs that need to be built and government policymakers, there's no way around the fact that, that will increase commodities that are required for those electric vehicles. The average EV take 6 times as many minerals versus an internal combustion engine car. And of course, our mining customers use our products to produce the commodities to meet that demand.

The second promising aspect is linked to the autonomous solutions and how they have been welcomed by mining customers, as Mr. Umpleby explained:

We've had mining customers publicly state that they've seen up to 30% productivity increase against their best manned sites. And you just happen to think about a mine that operates 24 hours a day, seven days a week, it's all about how much you can produce, and obviously do it safely and environmentally responsibly. So if a customer can get a 30% productivity increase with our autonomous solution, that is a game changer. Now by working with our suppliers by getting better ourselves, we've gotten that down such that if a mine only has 15 to 20 trucks, it can pencil out to make it worthwhile to put autonomy in their operation. [...] By reducing the amount of trucks required to make it feasible economically, we've gone from about 10% of the mines around the world to 50% or more, which expands that opportunity.

I think things are clear: Increasing demand for minerals is driving demand for new mining equipment. This demand will not diminish as the energy transition takes place. Secondly, autonomous solutions create tangible value for big customers. As Caterpillar improves their cost structure, these solutions will be sought for by smaller customers, increasing the total addressable market.

But there is one last business I'm monitoring closely: Services.

Back in 2017, Caterpillar took many aback, declaring that it would double in 10 years its services revenue. Well, at the end of 2022 the company was more than halfway through this task.

As Mr. Umpleby recently explained, the focus on services was a major area of efforts for the company:

Another major area of focus was services. And I can talk a lot about that, we invested heavily in services. That's something -- services represents everything we do for our customer after that initial sale. And done right, it's good for the customer, it increases their productivity and efficiency, it's good for our Caterpillar dealers, and it's good for us.

Services revenue is recurring, and it is a high margin revenue. Increasing it and making it easier for the company to have this influx of cash coming, it is crucial to offset any cyclical downturn.

Therefore, I think it is interesting for investors to know how Caterpillar has been working on making it easier for its customers to order new parts and ask for assistance, as Mr. Umpleby explained:

One of the things we're doing is making it easier for customers to do business with us and our dealers by having an app on your phone. We're putting serialized QR codes on machines now. So when those small contractors can take their phone, scan that QR code, and they can pull up an app, and they'll know exactly what part to purchase to get the right part for their machine. That saves time. They don't have to make the call. They don't have to do any checking, it's all right there. They can have that part delivered to them or they can push a button and have the dealer come and help install that part for them. [...] Because we have 1.4 million connected assets, we know the number of hours those assets have. We know if they're running or not, if in some cases, we're actually monitoring more features than that. So we can actually give our dealer leads and our dealer can go to our customers proactively to sell them parts to give them service to make sure they know when maintenance is coming up.

Expectation

Thanks to government-related infrastructure spending and the other tailwinds we talked about, Caterpillar should see another big quarter in terms of sales. I personally expect sales to be above $16.3 billion. As said, operating margins should be around 16%-17%.

We should still see strong demand for mining equipment thanks to high commodity prices and increasing need for minerals.

But this second quarter will be, as far as I see, the last quarter with strong bottom-line growth. As things normalize, YoY comparisons will weaken in the second half of the year and margins will come down a bit. I think Caterpillar could finish the year with an operating margin around 14%-15%, which would be very good.

For sure, Caterpillar keeps on being a free cash flow generating machine, which fosters big shareholder returns. In addition to a good return on capital employed (13%), Caterpillar has been able to increase its dividend in any economic condition (even during the Great Recession) and repurchasing its outstanding shares aggressively.

Investors, in fact, welcomed the most recent 8% dividend hike.

But what matters the most is what makes Caterpillar able to generate such returns and this has to do with the economics of the company which we have seen above.

As far as Caterpillar's valuation is concerned, I stick to my recent rating and the explanation I gave in my past review. As far as Caterpillar is in the $220-$240 range, it's trading around what I think is its fair value. Therefore, I see the company trading at a little premium, which I can understand well, as I have tried to explain. I personally don't yet have initiated a position, having missed a big opportunity some months ago. With the stock trading at all-time highs near $260, I would rather wait for another pullback before buying. In fact, this stock usually goes through some downturns which offer more compelling entry points. Overall, Caterpillar keeps on being on my watchlist, waiting to become part of my dividend growth portfolio.

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