Before market open on Oct. 23, Caterpillar Inc. (CAT, Financial) posted its third-quarter earnings. With record-breaking profits, one would imagine that the stock would pop. But that was not the case. In fact, shares of Caterpillar fell sharply on the news. Let’s take a look at why that happened, and what we can expect from Caterpillar in the future.
Beating earnings but failing to impress
By any reasonable measure, the third quarter was good for Caterpillar. Total machine sales rose 21% globally in the three months of the quarter. Revenues grew in every single geographic region, even China, hitting $13.5 billion, up 18% compared to the same period last year.
Healthy revenues translated into even healthier earnings growth with adjusted earnings per share reaching $2.86, up 46% from the prior-year quarter. Caterpillar beat the analyst consensus on both the top line and bottom line, albeit narrowly. And it did so despite the headwind of tariff costs, which amounted to about $40 million.
While an earnings beat is usually met with positive market response, this was not the case for Caterpillar. Instead, the market drove the stock price down more harshly than any time since 2015. Shares fell nearly 8% in the premarket session, and they slid around that level for much of the morning.
At time of writing, the stock had recovered a hair from the morning lows, trading above $120 a share, down around 6%.
Causes of dismay
The principal cause of Caterpillar’s price drop was overly enthusiastic expectations. While it did beat the posted analyst consensus estimates on both revenue and earnings, the market was expecting even more from the company, which has been holding up so well despite growing trade tensions and rising tariff costs.
Another cause of fear was undoubtedly the apparent recent slowdown in equipment sales growth, especially in Asia. While total machines sales were up 21% for the full quarter, they had risen 24% and 23% in July and August. That indicates a marked slowdown in growth during September, the final month of the quarter. The fall in growth was even steeper in the Asian market.
We last discussed Caterpillar in an April research note, when shares were trading slightly above $150, up 50% from the previous year. At the time, we pointed out that, while strong economic growth was sustaining Caterpillar’s upward trajectory, there might be headwinds created by China trade tensions, which could prove troublesome for a company that saw 21% of its $45.5 billion in revenue come from the Asia Pacific market in 2017.
As it happened, China’s economy has indeed been slowing, reporting the weakest third-quarter growth since the Great Recession, but it was not until the third-quarter earnings report that we have seen such a violent downswing.
Looking ahead
Despite the doom-and-gloom response from the market, Caterpillar’s forward guidance remains quite optimistic. The company reaffirmed its earnings guidance for the full year of $11 to $12. It also foresees strong growth in China in the nonresidential construction and infrastructure. Furthermore, it now projects that the previous guidance on cost of tariffs for 2018 will come in at the low end, near $100 million.
While rising tariffs, escalating trade tensions and the potential for supply chain disruption continue to present potential headwinds for Caterpillar going forward, it has weathered the brunt of the storm so far with aplomb. The negative market reaction to the latest earnings report looks rather overdone, all things considered.
Verdict
Caterpillar is one of the titans of American industry. Its heavy machinery business is arguably the best in the world and its international footprint has made it one of the essential engines of the industrial growth of numerous emerging economies. And it has done so profitably, even in the face of tariffs and trade tensions.
Does that make Caterpillar a buy? Maybe. A cyclical business may trade at a low multiple, but still not be a bargain if it is trading at the top of an economic cycle. With so many headwinds facing the world economy, Caterpillar might get dinged further. But all in all, the current drop makes the heavy machinery maker look quite attractive for a long-term value player.
Disclosure: No positions.
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