The decline during the first quarter wasn’t much of a surprised as the outlook for mining capital expenditures declined precipitously as commodity prices tumbled. In fact, Cat’s revised outlook accounts of a 50% year-over-year decline in sales of the firm’s traditional mining equipment and a 15% decline in sales of the equipment sold by Bucyrus.
Sales fell 23% in the resource segment for the quarter, and with most of the global mining giants like Rio Tinto plc (NYSE:RIO), BHP Billiton Limited (NYSE:BHP), and Anglo American dealing with new supply coming on-line, prices remain weak. Naturally, we at Valuentum think this news looks bearish for competitor Joy Global Inc. (NYSE:JOY) which relies mostly on mining activity to generate revenue. Although we think Joy Global looks overvalued, we believe the company could be an acquisition target, so there are some real risks to a short position. On the other hand, Cat’s bearish outlook for mining sales could be bullish for the diversified miners because the firms may slash capital expenditures at a more aggressive rate than anticipated. This could result in a positive impact to free cash flow.
Supply remains the largest threat to industry profitability and cash flow because significant mining supply is coming on-line at Rio, Vale, and Anglo American’s Minas Rio project. In effect, large amounts of iron ore supply could come to market at the same time demand growth moderates to reflect less robust demand from China. While certainly a valid concern, Valuentum believes these fears may be slightly overblown and underestimate other emerging markets’ role in consumption. Further, Chinese real estate steel demand growth may decelerate, but the country will still add several million cars to the road over the next decade.
Caterpillar Inc. (NYSE:CAT)’s construction business was also weak, as sales fell 17% year-over-year to $4.2 billion. Sales in North America declined 14% to $1.5 billion, which was stronger than the 17% decline in Asia-Pacific and the 23% decline in EAME. We think continued strength in the US housing market could provide a positive catalyst, but it is important to recall that the company boosted dealer inventories last year, so sales growth might not translate immediately. Nevertheless, we do not feel as bullish about a recovery in Chinese construction; another key lever for Cat’s growth.
With regards to China, management provided what we believe was fairly bearish commentary, saying:
“I am pleased to report this morning that we along with our dealers have made quite significant progress in lower inventory. Dealer machine inventories declined throughout 2012 and are currently at reasonable levels relatively to sales.
In terms of our inventory, that’s Caterpillar finished inventory in China, as expected it declined during the first quarter. While inventory reduction is expected to continue into the second quarter, we do expect to begin increasing production in China during Q2.”
We tend to agree with this outlook, and in our view, the read-through seems to suggest current demand remains sluggish. If China remains weak, the impact on Caterpillar Inc. (NYSE:CAT) could be disastrous. Not only does China account for a significant amount of revenue directly, but the country also accounts for a large portion of resource consumption growth. When China doesn’t buy resources, mining firms don’t need to purchase new mining equipment, which clearly would have a negative impact on Cat.
