Caterpillar: the guide for the perplexed

By | March 17, 2016

Caterpillar’s CEO, Doug Oberhelman, is known to be extremely promotional. I always failed to understand how the market keeps on taking his word at face value given such a poor track record of forecasting and torturing the numbers. To get everybody up to speed, let’s see what has been been happening at Caterpillar since 2013:

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Take a minute to read through the table (click on the picture to see it more clearly). One thing that catches the eye is the earnings beat in 2014, a year that started with an initial EPS outlook of $5.3 and ended with an EPS of $5.88. Since sales can be pushed and pulled easily–usually tempting the customer to do so by extending a discount–it will be more useful to look at a 3-year average. For 2013, I used the mid-point of the guidance, $8 per share. Take a look at that:

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I have nothing against promotional management teams. Mike Fries, Liberty Global’s CEO is highly promotional, but, he promises and then over delivers. At Caterpillar the opposite is the norm: over promise, then promise a bit less over time and finally, under deliver, by almost 25%!

This pattern has been going on for over three years and as shown by the table above, 2016 seems to be no different.

JP Morgan’s equity research team has almost always been overly optimistic when it comes to Caterpillar as can be seen by the price targets they set:

Screen Shot 2016-03-17 at 12.30.39 PM

They are still very optimistic as in their analysis they peg a PE multiple of 20 to Caterpillar and still, they arrive at a price target of $60. Caterpillar currently trades slightly above $74 and I’m really puzzled by this. And so should you be.

Here are some thoughts that disturb the optimistic PE ratio of 20 that JPM pegged to the stock:

  • The end of the commodity super-cycle is not just a cyclical shift, it is here to stay
  • There is no growth in sight for Caterpillar
  • Mike DeWalt, VP of finance, on his last conference said that there’s no need to talk about Caterpillar’s huge financing operation so the sell side didn’t say a thing. I wonder how could it be that while Caterpillar end customers are suffering and some of them are going bust, this financing operation shouldn’t be discussed in more detail.

Raping the pension plan’s numbers to squeeze another $0.5 for the 2016-guided EPS is a new low for the company. Such a company doesn’t deserve a PE of 20. I’m sure most of you can think of better-managed companies, with secular tailwinds, nice growth prospects and decent management teams that get lower multiples.

Charline Munger once said “never underestimate a person who overestimates himself.” I feel like that truly applies to Caterpillar’s management team, who by exuding confidence and misleading investors and analysts manages to keep the price of the shares above even the most optimistic sell side analysts’ target price.

However, with earnings of $3 per share (if we take the previous guidance at face value), a dividend of $3.08 per share and such a poor forecasting track record, it seems to me that a dividend cut is in the cards.

Perplexed, indeed.

5 thoughts on “Caterpillar: the guide for the perplexed

  1. Barak Herzman

    Hi Yaniv, thanks for the following up on this idea.
    Let me play the devil’s advocate and offer a few explanations for the current valuation:
    1. Free Cash flow, adjusted to changed in working capital is $3.1B, implying FCF multiple of 14.
    2. The company’s net margin is low. If you consider revenue guidance of $42B and assume net margin of 7% EPS can go up to 5$, making the multiple more reasonable (2015 margin was 4.5%).
    3. Using EV/EBITDA, the current multiple is ~11 which is OK for an industrial company.
    4. P/E is in line with S&P 500 companies (weak argument)

    I am also short CAT, however, I don’t know if revenue will go down much more than $40B.

    Reply
    1. Yaniv Uliel Post author

      Barak, thank you for your comment, I’ll reply by order:

      1. If we look at 2015’s CF statement, we start with (all amounts are $’bn) 2.1 then add another 3 for depreciation which takes us to 5.1, next we need to deduct 1.4 for Capex (which is probably too low for that level of revenue but lets ignore it for now) and we are at 3.7 then we need to deduct 1.9 for leasing of equipment that CAT leases to others and that brings us to 1.8. I didn’t make any adjustment to WC because that isn’t a part of the business’ earning power. That takes to a multiple of more than 20 based on a market cap of 45.

      2. With the pricing pressure from both weaker demand and a lot of second-hand equipment flooding the market I really can’t see a scenario of margin expansion.

      3. EV/EBITDA of 11, in my opinion, if suitable for a solid and stable industrial with good growth prospects, not for an industrial that two of its main segment are subject to end of almost a decade of super cycle.

      4. Currently (guided EPS $3), the PE on this year’s projected earnings is north of 25, this is way more than the typical S&P multiple.

      5. Not a word about the financing operations. WFC, BAC and JPM all saw higher provisions for the energy and mining sectors but miraculously, that hasn’t been the case for CAT. Yet.

      Reply
  2. avi

    hey yaniv,great post,keep writinig 🙂
    its amazing to see how reports after reprots with all the tricks of the managment they miss again and again by the buttom line and the stock still alive.
    i dont have any good explain but ther div (lets see when they cut him).
    maybe investors can think that india can replace china demand?!

    I have the patience to see the stock fall back to 60.
    happy passover.

    Reply
  3. Barak Herzman

    Hi Yaniv,

    I completely agree on 2-5, I am also perplexed how they are not incurring higher provisions.
    Regarding #1, assuming changes in working capital are ignored, I would consider increasing free cash flow by “Proceeds from disposals of leased assets and property”, which is another +$0.7B to FCF.
    This brings us to owner earnings of $2.5B.

    Reply

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