Caterpillar: CATting it short

By | April 25, 2016

It didn’t take too long since my last post for Caterpillar’s management to lower its EPS guidance and keep the tradition of doing so alive. Light to Friday morning, the company unceremoniously said that “the profit outlook at the midpoint of the sales and revenues range is now $3.00 per share.” I shall remind you that these $3 include $0.5 benefit due to a favorable change to the pension accounting method. So in reality, we are talking about an EPS of $2.5 and a PE ratio north of 30.

Unsurprisingly, the magic number of $3.5/share is mentioned again “ex-restructuring costs”. Warren Buffett likes to say that we should always look at how much the other guy is making if he is trying to sell us something, so let’s look at Caterpillar’s compensation policy:

ESTIP design provided that a bonus pool would only be funded if the Company achieved a minimum profit per share-diluted (PPS) performance “trigger” of $3.50

Aha! Buffett is on to something…

Screen Shot 2016-04-25 at 12.04.41 AM

Before discussing this, let’s look at two more nuggets from that earnings release:

We continue to see competitive pressure that started in the last half of 2015 driven by excess industry capacity, unfavorable currency pressure and an overall weak economic environment.

While oil prices have improved since the beginning of 2016, it is not clear at this time that the current price level is either sustainable or sufficient to drive increased demand for equipment.

You would expect such an announcement, coupled with the change in pension accounting at such an inauspicious time,  to generate a selloff in the shares that are now traded at a PE of 26. Yet, nothing much happened and the stock price barely moved.

Now, it seems like the management’s strategy is to stay around and live to fight another day. Once again, the company sells the market that the future will be better, in this case, the second half of the year:

This year, that’s going to be a little bit more skewed to the second half; we’re thinking maybe 47.5% or so in the first half, 52% in the second half, and that represents about $600 million more in the second half of the year than kind of our historical average would lead you to expect.

Yeah, right. The second half.

And once again about CAT Financial:

Just a quick comment on Cat Financial. Nothing really obvious to report there…

Nothing? Really?? Wells Fargo, JP Morgan and Bank of America all have significantly stepped up their bad-loan provisions for loans to the energy and resource sectors, which happen to be Caterpillar’s main sectors. But for Caterpillar there is “nothing obvious to report.”

I’m really puzzled at how the market keeps on buying on these empty promises and consistently rewards the company with PE multiples that would make other, much better business, jealous.

To me, it is as simple as that:

  1. The resource industry is going through a painful  capacity adjustment process as the end of the Chinese commodity super cycle is coming to its inevitable end. All the big miners are reducing capacity and slashing Capex with no mercy. Due to this adjustment process that will probably take many years to play out, the market is flooded with second-hand equipment which even further reduces the demand for new equipment. This double whammy of lower demand and a lot of second-hand equipment in the market doesn’t bode well for that segment in the years to come.
  2. The energy industry is also in the end of a decade of over investment and any hopes for sales to suddenly jump are misplaced. Those of you who are interested, can read an excellent analysis of the cycle in the energy markets from the chairman of Spectrum Geo in his well-written annual letter. It is full of insights and a frank discussion of the industry and the cycle. Because he is honest and doesn’t lie, his company doesn’t get a PE of 26. For the time being.
  3. The whole deal with CAT Financial being so resilient doesn’t smell good to me. As Warren Buffett once said: “if it seems too good to be true, it probably is.” As we’ve already seen in this post, Buffett is usually right…

One more thing…

The market is probably hanging on CAT’s dividend yield (c. 4%) to price the stock. However, EPS of $3 isn’t enough to cover the $3.08 in dividend payout, not to mention that $0.5 out of that $3 is coming from an accounting change. That means that to maintain the dividend, Caterpillar will have to either underinvest in the business and jeopardize its future earning power or increase leverage to maintain the payout. There is, of course, the option to cut the dividend, but that will probably be done only when all other options are exhausted because of how the management is compensated and how promotional the management team is.

To be continued.




Category: CAT

5 thoughts on “Caterpillar: CATting it short

  1. avi

    great post yaniv,as always:)
    how long you think they can keep paying div >gains?

  2. Itay

    Great thinking shared here. 10x.
    What do you think would be the catalyst for $CAT to drop? We do not see any major volatility in the share price since. It could happen, though, hence, I’d be happy to hear your thoughts…

    1. Yaniv Uliel Post author

      The sentiment in the market might change and it is impossible to know what would trigger it or when will it happen. During the market panic in January the stock dipped below $59 in the next stock market panic this can happen again so an opportunity will show itself but I have no idea when.

  3. ofir

    Enjoyed reading your post. CAT just came all the way back to $80 and the question is if Q2 results can be surprisingly better than expected. According to the retail sales reported by the company it doesn’t seem to be the case, yet shares are up 15% from June 26th low… Amazing.

    1. Yaniv Uliel Post author

      Ofir, thank you for your comment. I don’t think that there can be a big positive surprise in Q2 sales and it will mainly be the outlook that will determine the stock market’s reaction. The market is still pricing CAT as if we are in a low part of the cycle and the tide in the mining markets will resume sooner or later. It will take some time, but the market will eventually realize that the China driven commodity super cycle is a thing of the past that will not be repeated in our lifetime.


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