CAT: Why Consensus Is Coming Our Way

Takeaway: Looking for slower growth or small declines in resources-related capex is inconsistent with history and logic. That may be bad news for CAT.

CAT: Why Consensus Is Coming Our Way



Resource-related Capital Investment Cycle:  When commodities rise sharply, resources-related capital spending ramps quickly to bring on additional supply.  A subsequent flattening or decline in commodity prices can bring resource-related capital spending back to trend levels – typically not far above maintenance levels, since the industries are generally mature.  Currently, resources-related capital spending is very high following 100+ year outlier gains in many commodity prices, like iron ore, copper and gold.


CAT: Why Consensus Is Coming Our Way - 1qq



Expect Very Large Declines:  Some are looking for slower growth or small declines in resources-related capital spending.  That expectation is inconsistent with history and logic.  As the chart above shows, resources-related capital spending declined 80% over a five year period following peak orders in the late 1970s.  CAT posted very large losses in the early/mid 1980s, in part as a result of this readjustment.  As the chart below shows, a return to slow output growth levels of capital spending (approximated by depreciation and amortization) would bring a ~70% decline in capital spending at large miners.  Mining is not a growth industry.  In the long-run, capital spending should be expected to approximate DD&A.


CAT: Why Consensus Is Coming Our Way - 2qq



Resources Capital Equipment Is Where CAT Makes Money:  Approximately three-quarters of CAT’s 2012 operating income was derived from Resource Industries and Power Systems.  Both of those divisions are heavily exposed to resource-related capital spending.  Resource Industries counts sales of mining equipment to coal, copper, iron ore and gold mines as its largest end-markets.  Power Systems sells locomotives to mines and railroads, power generation systems to mines/resource companies and power plants, turbines to gas compression and energy extraction sites, and other end markets.  Picturing the impact of a 50% decline in resources-related capital spending (not at all unlikely in our view) on the operating income of CAT does not require much imagination.


CAT: Why Consensus Is Coming Our Way - 3qq



Value Traps:  CAT, Komatsu and other diversified resource-equipment suppliers are likely to look cheap on multiples for years to come.  They will go down and investors will buy them thinking they are values, only to find that results weaken yet further.  Beware the low PE in cyclicals – it is frequently a sign of a cycle peak or decline. 



To listen to the Q2 2013 Macro Themes Conference Call hosted yesterday afternoon by the Hedgeye Macro Team, led by CEO Keith McCullough, please CLICK HERE (in order to access the replay you will need your login information.) To view the presentation that accompanied the call CLICK HERE.


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#GrowthAccelerating: After a positive growth inflection in the U.S. macro data to start the year, the key risk management consideration from here is whether domestic growth can accelerate in the face of seasonal and fiscal policy headwinds. Alongside strong dollar benefits to discretionary demand, labor market, housing, and birth trends should remain supportive of consumption over the intermediate term. 


#StrongDollar: It all starts and ends with the Buck. We see a stronger U.S. dollar deflating Bernanke's commodity bubbles which should boost U.S. consumption. In particular, we highlight a bullish set-up for the USD versus the EUR and JPY.


#EmergingOutflows: Consistent with our call for continued U.S. dollar strength and commodity deflation, we think the very early innings of the next round of emerging market crises is upon us. Sustained USD appreciation exposes EMEs to a variety of economic risks that asset allocators have not had to appropriately discount for over a decade.

Consumption Is The Name Of The Game

What drives global growth? An uptick in consumption. What drives consumption? Downward pricing pressure in commodities. Commodities have been overbought for some time but this week, they came screeching to a halt as investors around the world sold off things like corn, wheat and gold. The Consumer Discretionary SPDR (XLY) and Consumer Staples SPDR (XLP) ETFs are having a ball, up 11.8% and 11.2%, respectively, over the last six months. These ETFs will benefit from the breakdown in commodity prices which helps drive global growth. Definitely worth paying attention to.


Consumption Is The Name Of The Game - XLYXPLY


Early Look

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In preparation for PENN's F1Q 2013 earnings release tomorrow, we’ve put together the recent pertinent forward looking company commentary.




  • "March was clearly better than January and February, and we can talk about weather, we can talk about timing and tax returns, we can talk about the payroll tax. January and February clearly were not good months for our industry as a whole. And March, we saw a bit of recovery. Now, there couldn't have been pent-up demand from weather. Weather and timing of tax returns are two things that you would think would be just a timing issue and would come back in March. So I don't know that we're prepared to call March a consumer recovery, but it was certainly nice to see at the very least that some of the lost business from the first half of the quarter came back in March. From what I hear, we're not alone in saying that."
  • "One thing that you notice is if you start in either Sioux City or in Kansas City area and start to work yourself east, as some of the snowstorms start there in the middle of the country and move their way across, we have a little bit of a weather exposure issue there. We've talked about that in February. But when we get a snowstorm, it doesn't affect one property. It tends to come across and affect 8 to 10."
  • "The acquisition there of Harrah's St. Louis I talked about earlier, that closed in November. We've decided to invest about $60 million in that property (this year); some new slot machines, some new carpets, facelift."
  • [Youngstown/Dayton tracks] "Racing Commission has decided that they think we need more seats for the racing section of those businesses. So the process is a little bit on hold at this point. We're not changing the opening date from 2014, while we seek a resolution there."
  • [Jamul agreement]  "Important to note, we are a manager-developer for that property. The $360 million, the tribe is going to seek to finance that separately from us. We have agreed to backstop it. Assuming that the tribe can finance it at better rates than what we've offered them, then they will do so and that will reduce our risk of course. But we will backstop if they can't, and we think that we have a reasonable management agreement in place and we think that it could be a good business for us."
    • "We could cross market with our M Resort, which gets a lot of drive-in business from California. The steps there, the NIGC is reviewing the management agreement right now. We need to get approval on that and then we have some other agreements with Caltrans and some utilities type agreements to work on. We hope to be under construction there towards the end of this year."
    • "Any investment that we would make upfront, it would not be in the form of equity; it would strictly be debt. There is a structure in place that Lakes was involved in this process before and they have in the neighborhood of $60 million of debt. And any debt that we put in would come before theirs and so we get paid back from free cash flow."
  • "With Columbus, I'm not spending any time worrying about where Columbus is going to end up. It's going to be fine. It's showing sequential growth. It's showing increased visitation. It's showing improvements in the slot customer base. Clearly the fact that Scioto was out first in the market with very aggressive marketing upfront was not ideal. The reality is, over the long term – and I don't mean years, I mean a few more months, I think you'll see the Columbus property really come into its own in terms of getting an appropriate level of market share."
  • "One of the things right now is, people need to keep in mind, is that when they look at the numbers that we're seeing in St. Louis, we've probably got almost 500 or 600 machines out of commission currently and the fact that there is a good amount of construction noise going on. It's not that disruptive, at least for now, but it does have some kind of an impact."



  • "In both Toledo and in Columbus we do expect in January to show sequential growth month-over-month in our slot volumes. So we are making progress."
  • "As we look at the 18 properties that were showing year-over-year results, half of those properties are now experiencing the effect of new supply. As we look at that effect, as we expected, we are losing trips to this new supply in various markets. But the average quality of the player that has stayed with us has actually improved a bit, and we're able to respond to the newer business volumes and the newer and updated trip frequencies."
  • "The one thing on the first quarter assessment of where we are, we looked last year, and we were fortunate to have just tremendous winter weather in our markets. So I think we factored in more of a normal winter going through the first quarter, and we also obviously factored in the fact that we don't have 29 days in February like we had last year."
  • "I think in central Ohio the primary issue is market penetration and getting into new households. We have to do a better job of introducing our new facility on the west side of town to more and more customers. I don't think it's saturation, clearly not in central Ohio. And I don't think it's saturation in northwest Ohio either, because you look at the Detroit market in the fourth quarter, they were only down 3%. Our numbers in the Toledo market really represented regional growth for that part of the Midwest."
  • "I would expect corporate overhead to come back to a more normal level, probably on a normalized basis somewhere around $80 million would be our expectations."
  • "Regarding what we're seeing in terms of reinvestment, it was noticed that our competitor in Columbus outspent us four to one in the month of December with promotional slot play. And we are going to respond and have responded in the fight zones we think are there for those customers. But I don't think you're going to see that have a material effect on margins in the Columbus market. And in Toledo, we're a little bit more by ourselves there; Detroit is an hour away north, and Cleveland is a couple hours to the east. We are looking at, again, the fight zones, but any increase in reinvestment will be done very thoughtfully with a disciplined test and control process to make sure that it is going to enhance EBITDA."
  • "Looking at 2013, we're expecting $275 million of project CapEx and roughly $97.9 million worth of maintenance CapEx for next year. Looking at the first quarter, I would break that down that we expect to spend roughly $49.4 million on project CapEx in the first quarter and $27.2 million of maintenance CapEx."
  • "There's been some tough markets down in the Gulf Coast; and obviously Baton Rouge is under pressure due to the competition in Baton Rouge, which is very – Baton Rouge historically has very high margins, which when you're under severe revenue pressures, are difficult to maintain. We're certainly doing a, I think, an incredible admirable job. It doesn't mean we don't have some more room for improvement. And then Tunica has been a bit of a rough market as well especially in the fourth quarter."
  • [Softness in market] "It certainly is more at the lower end with less trips, the retail consumers.  We are seeing some trip decline throughout all the segments of the business.  Some of that is due to cannibalization. But generally the big issue and the majority of our loss of business volumes have been at the retail end."
  • "Given the locations of the Horseshoe downtown Cincinnati facility and the Northville facility up in the Cleveland market, we do not think in our modeling and in our guidance, in our expectations that that's going to affect the business in central Ohio, which is a couple hours away drive time. Our expectations and our thoughts around central Ohio really are focusing in on the 1.8 million people in the Columbus MSA."

Tough Spot: SP500 Levels, Refreshed

Takeaway: Sometimes my risk management signals front-run what will become my fundamental research views. Sometimes they are head-fakes.



The research reasons for taking down my gross long exposure into last week’s highs, and not ramping that up (yet) again here on red aren’t there. The risk management signals are. Sometimes my signals front-run what will become my research. Sometimes they are head-fakes.


That’s what makes this 1557 level a tough spot. It’s my immediate-term TRADE line – is it support (Friday and Tuesday) or is it resistance (Monday and Wednesday)? Inquiring stock market operating minds want to know (including my own). I don’t know.


Away from 1557, across my core risk management durations here are the lines that matter to me most:


  1. Immediate-term TRADE resistance = 1601
  2. Immediate-term TRADE support = 1540
  3. Intermediate-term TREND support = 1515


In other words, even if 1557 snaps, we have a big landing area of support (where I wrote a note titled “Buyem” at 1540 a few Friday’s ago). So what to do now? Just wait and watch – I think the market does a pretty good job telling us where to make the big moves.


#StrongDollar, Down Gold/Oil/Copper is a fantastic pro-growth research signal for Consumption assets. Our Q2 Global Macro Themes deck goes through the research views on that. This note is all about the risk management levels, what I am thinking right now, and why.




Keith R. McCullough

Chief Executive Officer


Tough Spot: SP500 Levels, Refreshed - SPX

Morning Reads From Our Sector Heads

Keith McCullough (CEO):


Carney to Leave Canada Policy Unchanged in Final Forecast (via Bloomberg)


Josh Steiner (Financials):


Bond Hedge Fund 5:15 Capital to Close Down, Return Money (via Bloomberg)


Fed doves stand by stimulus, though one has bright outlook (via Reuters)


Rob Campagnino (Consumer Staples):


Hedge funds' gloom on ags reaches record high (via Agrimoney)


Todd Jordan (GLL):


Carnival to spend millions to make ships more reliable (via USA Today)


Brian McGough (Retail):


Target’s Pricing Strategy: One Penny Higher Than Wal-Mart (via Sourcing Journal Online)


Macy's Appeals Martha Decision (via WWD)


Howard Penney (Restaurants):


New Salads and Cool Wraps at Chick-fil-A Starting April 29th (via GrubGrade)


Analyst's upbeat on Buffalo Wild Wings (via Nation's Restaurant News)


Kevin Kaiser (Energy):


Commodities Traders Brace for Transparency While Staying Private (via Bloomberg)


Matthew Hedrick (Europe):


Brazil inflation: Surging tomato prices create political headache (via BBC News)



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