Should You Buy Caterpillar After Its Mixed Second Quarter?

Paul J. Richards/AFP/Getty Images

Source: Paul J. Richards/AFP/Getty Images

On Thursday morning Caterpillar (NYSE:CAT)—the world’s leading supplier of construction and mining machinery—reported its second quarter earnings results. The numbers were largely mixed, and the stock fell 3 percent. On the one hand the company’s sales fell by about 3 percent. On the other hand the company’s profits rose by 4 percent, or 8 percent on a per-share basis thanks to stock buybacks, and this reflects operational efficiencies resulting from a declining workforce. Thus the quarter is largely mixed.

This becomes even more apparent as we look at the company’s individual segments. The company’s construction machinery segment performed extremely well, with sales rising 11 percent. But its natural resource segment saw a sharp decline of 29 percent. These data points have implications not just for Caterpillar, but for the global economy as well, and I should note that Caterpillar’s performance is highly sensitive to global economic activity.

The fact that the company’s mining equipment sales fell so sharply reflects a falling demand for natural resources.   The company’s rise in construction machinery sales reflects strong global economic activity. Now this disparity is highly counterintuitive given that construction requires the use of natural resources, and if there is declining demand for natural resource mining equipment with rising demand for construction equipment eventually something has to give. Either construction is going to eat up natural resources and force prices higher, which in turn will drive sales of mining equipment. Or the increase in construction spending is temporary while the decline in resource demand reflects the true state of the economy, and as natural resource production precedes construction in the production chain we should expect to see a decline in construction and economic weakness.

I suspect that the answer to this dilemma is largely dependent on interest rates. So long as interest rates remain low and companies have easy access to money and credit then they should continue to spend on construction, which should drive natural resource demand. This would benefit Caterpillar’s business substantially. On the other hand if interest rates rise then businesses will be forced to borrow less, and this will curtail construction spending and Caterpillar’s business.

With this in mind, it seems that Caterpillar is a risky business at this juncture. At the very least it has little control over its own fate since its management cannot control interest rates. Thus I think investors should err on the side of caution given that the Federal Reserve is planning on ceasing its quantitative easing program in October. This will eliminate demand for long-term bonds and force interest rates higher.

But even if this doesn’t happen, I think that there are better options out there for investors. For instance, on a price to earnings basis John Deere (NYSE:DE) is far less expensive than Caterpillar given its exposure to the floundering agricultural machinery business. Long term agricultural machinery demand has outperformed demand for construction machinery—Caterpillar’s largest business—and Deere trades at less than 10-times earnings or half of Caterpillar’s valuation.

Investors who believe that economic activity will pick up may also consider investing in a company with more resource exposure given that this business has been weak. Caterpillar’s mining equipment business has been weak due to weak demand for resources such as iron ore, but its construction business has levitated the stock price. Meanwhile there are companies that produce iron ore whose stocks have performed miserably [e.g. Vale (NYSE:VALE)]. For investors who like to look for contrarian opportunities, these stocks provide a better opportunity than Caterpillar.

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Disclosure: Ben Kramer-Miller has no position in Caterpillar or in any of the stocks mentioned in this article.

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