Improvement in Caterpillar’s underlying end markets is driving its performance, and management took the opportunity following a solid showing in the first quarter of 2018 to raise its bottom-line guidance for the full year. The market, however, did not look favorably on management’s comments that the first quarter should be expected to be the “high-water mark” for the year in terms of margin performance. We’ve updated our fair value estimate of shares.
By Kris Rosemann
It may seem like an eternity ago, but as recently as 2016, Caterpillar (CAT) was at the tail end of its only stretch of four years of consecutive annual sales declines in more than 90 years of business. The demand environment for the heavy machinery giant’s products has improved drastically since then, and the company’s shares initially jumped following its April 24 earnings report, which was full of positive developments surrounding demand and a significant profit guidance hike. The rally, however, was short-lived after management’s commentary on first-quarter margin performance not being sustained throughout the full year 2018 hit the wires.
Caterpillar reported 31% revenue growth on a year-over-year basis in the first quarter of 2018, driven by strength across its three major segments. Adjusted profit per share more than doubled from the year-ago period to $2.82, and operating profit exploded to $2.1 billion from $380 million in the comparable period of 2017. However, cash flow from operations was pressured in the quarter, due in part to a significant decrease in accrued wages, salaries, and employee benefits. Nevertheless, free cash flow came in positive in the quarter, but at $178 million, it compared unfavorably to cash dividends paid of $467 million.
Caterpillar’s strong first-quarter results stemming from higher demand across all regions and most end markets led management to raise its 2018 profit outlook range to $9.75-$10.75 from previous guidance of $7.75-$8.75. Better-than-previously-expected sales volume is the key driver of the increased outlook, but any potential impact from geopolitical risks and increased trade disruptions have not been factored in the outlook, which have a real possibility to provide headwinds.
Improved price realization is expected to be partially offset over the course of the year by growing material costs largely due to higher commodity prices, which is also a key driver of demand for its own products, the latter of which did not have as meaningful of an impact on Caterpillar’s performance in the first quarter of the year. As a result, the first quarter is expected to be the strongest period of 2018, and management acknowledging as much sent shares tumbling during the April 24 trading session.
In its ‘Construction Industries’ segment in 2018, the company expects growth across all regions to be led by construction activity in North America and infrastructure development in China. The EAME (Europe, Africa, and Middle East) region is expected to continue growing in 2018 alongside business confidence and stability in oil-producing countries, while the ongoing recovery in Latin America is expected to continue.
Caterpillar expects mining companies to increase capital spending in 2018 for both equipment replacement cycles and expansions as global economic conditions and favorable commodity prices allow for larger budgets. Global demand for commodities should also help drive a positive operating environment for heavy construction, quarry, and aggregate customers, and higher machine utilization levels from customers across its ‘Resource Industries’ segment is expected to push aftermarket parts growth.
The company’s ‘Energy & Transportation’ segment continues to benefit from the improvements in the energy resource pricing markets, and positive demand for reciprocating engines in the North American oil & gas market is expected to lead segment growth in 2018. The midstream space continues to support Caterpillar’s backlog of turbines, and an increase in rail traffic in North America has reduced the number of idle locomotives and railcars, which should translate into an increase in rail services revenue at Caterpillar. 2018 is also expected to mark the turnaround in its Power Generation sales after multiple challenging years.
Though it may not be an immediate concern, we’re keeping an eye on Caterpillar’s debt load, which includes more than $27.3 billion in Financial Products debt as of the end of the first quarter. A tightening credit cycle alone may not be cause for concern, but should rising borrowing rates be accompanied by a material disruption in Caterpillar’s end markets, which we saw in record-length fashion as recently as the period 2013-2016, such a debt load could spell trouble for the firm. It is worth noting, however, that total debt related to its Machinery, Energy, and Transportation businesses (i.e. non-financial related) came in just under $8 billion at the end of the first quarter, which is only slightly higher than its cash balance of nearly $7.9 billion.
Caterpillar’s near-term demand outlook is undoubtedly stronger, and its profit guidance hike for 2018 was encouraging, even if it may not repeat the margin performance turned in in the first quarter. Relatively weak free cash flow generation is not a significant cause for concern on the basis of one quarter, and we would expect it to more or less catch up to the relative strength of management’s other performance expectations over the course of the year. We’ve raised our fair value estimate to $137 per share, and Caterpillar’s Dividend Cushion ratio currently sits at 2.3 (adjusted for Financial Products debt) as shares yield just over 2% as of this writing.
Agricultural Machinery: AGCO, CAT, CNHI, DE, HEES, MTW, RBA, TEX
Metals & Mining – Diversified: AG, BHP, CLF, FCX, RIO, SCCO, VALE, WPM
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.