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How Caterpillar Makes Its Money

Analyzing how Caterpillar Inc. (NYSE: CAT) makes money is a useful exercise for investors because it sheds light on what investors need to know before buying the stock right now. In a nutshell, the stock's near-40% rise in the past year has been propelled by its positive earnings momentum, which is largely due to an improvement in its end markets. So in order to take a view on whether this can continue, it's useful to know how Caterpillar makes money. 

A gas compression engine. Image source: Caterpillar Inc.

Cyclical, but which cycle?

It's long been known as a cyclical stock, but not all economic cycles are equal. Caterpillar's main end-market exposures -- construction, mining (referred to by Caterpillar as "Resource Industries") , oil & gas power generation, and transportation -- make it unsuited as a catch-all stock to be bought as a proxy for economic growth. In fact, buying the stock is, whether intentional or not, an expression on the growth prospects of its end markets.

The following table shows the percentage contribution of each segment and region to 2016 equipment machinery sales. As you can see below, Caterpillar's most highly visible activity is also the biggest generator of revenue. So buying Caterpillar is largely a play on global construction.

Segment 

North America

Europe and the Middle East

Asia Pacific

Latin America

Total

Construction industries

21%

9.1%

10.5%

3%

43.6%

Resource industries

5.8%

3.3%

4.1%

2.8%

16%

Energy & transportation

18.7%

11.7%

6.8%

3.1%

40.3%

Total

45.5%

24.2%

21.4%

8.8%

 

Data source: Caterpillar Inc. presentations.

Unfortunately, investing is rarely as simple as that. Although construction markets are obviously a huge consideration in investing in Caterpillar, it's not the crux of the company's future profitability. Here are three important factors to consider. 

Much more than construction 

First, here is a chart of segment operating profit in recent years. As you can see below, energy & transportation has contributed more to profits than construction in recent years.

Data source: Caterpillar Inc. presentations. In 2012 the energy & transportation segment was within a segment called power systems.

Second, the variance in capital spending in energy and mining is larger than that in the global construction industry. You can see this in the operating-profit performance of the relative segments in the chart above. This means that, from an investment perspective, the swing factor in the company's earnings will be generated by demand condition in the energy and mining, which plays out mainly in the resource and energy & transportation industries. In addition, the construction segment also has some exposure to oil & gas spending.

Third, oil & gas and mining spending have a tendency to be correlated, at least it has been in the last few decades (see the chart below). Essentially, capital spending is tied to price movements as production ramps in order to meet demand. In this sense, you can think of energy and mining spending as effectively moving in tandem.

Brent Crude Oil Spot Price data by YCharts.

Of course, there is an important caveat to be made here. Specifically, there is no reason why energy and mining capital spending has to be correlated because of commodity prices, in this case oil & gas and metals, are not necessarily correlated -- they have their own demand and supply dynamics. Nonetheless, those dynamics -- things like emerging market demand for resources to support economic growth and the ability of production to meet demand -- have moved together in recent times.

What does it all mean for investors?

All told, if Caterpillar's biggest, most important end-market drivers are energy (oil prices) and mining commodity prices, then buying the stock is effectively manifesting a viewpoint on those prices. In other words, if you are buying the stock for the long term, that's the consideration you need to make. Caterpillar is not a stock for those nervous about long-term trends in commodity trends, but if you are looking for energy spending exposure backed by underlying earnings from construction activity, then Caterpillar is worth a look.

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Lee Samaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.