Why Lower Iron Ore Prices Could Hit Caterpillar Stock Hard

By Markets Fool.com

If Caterpillar investors are betting on recovery in the mining industry to push the stock higher, they're in for some bad news. Industry experts peg prices of key commodities including iron ore to hit multiyear lows in the near future as supply continues to exceed demand. That could deal a big blow to Caterpillar's revenue and profits, and its stock price. Here's why.

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Why Caterpillar is suffering, and where the real problem lies
The world's largest manufacturer of heavy construction and mining equipment was rolling in cash until the global commodities boom hit a roadblock three years ago. At this point, resources industries(Caterpillar's mining-equipment division) fell from being the company's most profitable division to a major drag on the top and bottom lines.

Data source: Caterpillar financials. Chart by author.

Caterpillar's woes were exacerbated because the commodities markets slowed right after the company paid a hefty $8.8 billion to acquire mining-equipment maker Bucyrus International in 2011. The unfortunate timing of the deal and the prolonged weakness in mining sent markets into panic mode, and Caterpillar's stock soon lost favor with investors: it's down about 10% over the past three years.

Needless to say, recovery in the mining industry is imperative for Caterpillar, not only to grow but also to unlock value from its Bucyrus acquisition. But mining activity cannot take off until consumption and prices of commodities improve. That's where the problem lies: prices are only heading lower.

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Worst yet to come?
The price of iron ore -- a key raw material for steel and thus a vital commodity -- crashed to a decade low of near $46 per tonne last month. While it has rebounded sharply since, it's still trading near 50% lower from last year. If that wasn't enough, prices appear to be headed lower again: UBS forecast iron ore to hit April lows again during the second half of this year and to remain under pressure through 2016, Credit Suisse estimatedthe price to tumble to $45 a tonne this year.

BHP Billiton , the world's third-largest iron ore miner, confirmed the fears. During a recent conference, BHP's vice president for marketing, Alan Chirgwin projected global iron ore demand to grow by only 30 million-40 million tonnes this year even as supply increases by 100 million-110 million tonnes. Meanwhile, the construction industry in the world's largest steel-consuming market, China, remains in the dumps, leaving little hope for iron ore producers.

Given this backdrop, commodities prices are bound to fall in the absence of enough demand to mop up the extra supply. And as prices decline, so will spending by mining majors as they desperately cut costs to survive. While outlining BHP's growth plans earlier this month, CEO Andrew Mackenzie said"the iron ore and metallurgical coal markets are currently well supplied," and that the company doesn't "expect to invest significantly more in these businesses at this time."Overall, BHP has slashed its capital and exploration expenditure forecast to $9 billion for 2016 from $12.6 billion for this year.

All this could further reduce demand for Caterpillar's beleaguered mining-equipment division. The company's mining backlog is already depleting at a rapid pace. Without sufficient orders to refill the backlog, Caterpillar's resource industries' revenue could soon dry up.

What you should watch
That Caterpillar is already feeling the heat of the recent drop in commodities prices was evident last month when it increasedits restructuring cost estimates for 2015 by about $100 million, saying the incremental costs will relate to its mining-equipment facilities.

Simply put, the pain is far from over, and there's only so much the company can do by way of restructuring and cost-cutting. If commodities prices continue to remain in the doldrums, Caterpillar could be in deep trouble, particularly as its other businesses -- energy and transportation and construction -- are battling headwinds as well.

So keep an eye on commodities prices, which could give you a good idea about what the future holds for Caterpillar and its stock.

The article Why Lower Iron Ore Prices Could Hit Caterpillar Stock Hard originally appeared on Fool.com.

Neha Chamaria has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.