By Meribah Knight, Crain News Service
CHICAGO (Nov. 3, 2014) — As the price of oil plunges, so are the prospects for the division generating most of the profit at giant equipment manufacturer Caterpillar Inc.
Cat's energy and transportation segment, a grouping of engine products and generators used for things like oil rigs, locomotives and wind turbines, has been a bright spot in recent quarters, with high margins and hefty sales thanks to a booming oil industry. But the company's recent earnings call came on a day when oil futures were trading at $82.09, 21 percent lower than four months earlier. Cat tacitly acknowledged that if prices keep heading south, so will the segment's outlook.
The low price of oil is “not a significant negative,” said Mike DeWalt, Cat's vice president of strategic services. “At least not where it's at now.”
Three days later, New York's Goldman Sachs Group Inc. slashed its forecast for crude oil to $75 a barrel, $15 lower than its previous estimate. The reason: a glut of oil caused by overproduction and slow global growth.
“If the new reality is oil in the mid-70s, Caterpillar definitely needs to do some cost re-engineering,” said Kwame Webb, an analyst at Chicago-based Morningstar Inc.
Cat already has been aggressively recalibrating expenditures because of a mining industry in freefall. The shift came after the company spent more than $8 billion in 2011 for South Milwaukee, Wisconsin-based mining equipment manufacturer Bucyrus International Inc., the biggest acquisition in the company's history. Cat shelled out $700 million for a Chinese mining company, ERA Mining Machinery Ltd., in 2012. To add to its troubles, Cat was the worst-performing stock on the Dow Jones industrial average last year. Its stock closed at $101.41 on Oct. 31, down 9 percent from a high of $111.40 in July.
The Peoria, Ill.-based company has managed to stay profitable thanks in large part to its energy and transportation segment, where sales rose 13 percent in the third quarter and operating profit jumped 29 percent year-over-year. Compared with the company's mining and construction segments, where third-quarter revenue dropped by 19 and 2 percent, respectively, its performance is nothing short of spectacular.
‘Victim of their own success'
Today, the segment's sales provided 38 percent of Cat's revenue in the first three quarters. (For the same period, mining came in with 16 percent of revenue and construction was 36 percent.) But most notable are the division's high margins, hovering around 20 percent and contributing nearly two-thirds of Caterpillar's third-quarter operating profit. But now, as oil prices drop, the one sector buoying the balance sheet of the world's manufacturing heavyweight is at risk.
“The market that is performing best is things related to oil and gas,” said Larry De Maria, a New York-based analyst at Chicago's William Blair & Co. But Caterpillar “could be a victim of their own success.” On Oct. 31, oil futures were trading at $80.68.
In a statement from Cat, spokeswoman Barbara Cox said the company does “not expect the recent decline in oil prices to have a significant impact on our segments in the near term.”
Despite its stellar performance, the energy and transportation division also leaves the company exposed to the price and demand for oil. “They have exposure upstream, but they also have pretty good exposure midstream,” said Mircea Dobre, a senior analyst at Milwaukee-based Robert W. Baird & Co.
What's more, analysts say sales in Cat's construction sector also could be pinched if the glut of oil continues and companies stop building rigs and investing in infrastructure.
Mr. De Maria estimates that oil and gas make up 30 percent of Cat's revenue in the energy and transportation segment and 40 percent of engine retail sales. “Oil and gas represents the biggest risk now,” he wrote in a recent report.
“It could be a very real headwind, and it's going to make it hard to grow earnings next year on what the company said is already going to be a flattish environment,” Mr. Dobre adds.
But there also are a lot of moving pieces, including how low the price of oil goes, how long it stays there and how the varying industries within the segment respond.
“Whoever gets the answer to this question gets the stock right,” Mr. Dobre said. “This is where the debate lines are drawn between the bulls and the bears.”
This report appeared on the website of Crain's Chicago Business magazine, a sister publication of Tire Business.