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…
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:
- 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.
- 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.
- 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.