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CAT: Feeling Managed?

Takeaway: Commentary that does not match the numbers is not a good sign. We expect pressure on 2014 estimates and the 2015 target to be dropped.

CAT: Feeling Managed?

 

Investors frequently like names that respond well to disappointments.  However, CAT’s report is just the latest in a series of guidance cuts driven by a multi-year decline in resources-related capital investment, in our view.  Resources-related capital equipment dominates CAT’s operating profit picture and it is not likely to rebound in 2013, 2014 or 2015, in our view.  Buying cyclicals that are just past peak results is unlikely to work out well.  We still think investors should avoid the long side and look to opportunistically enter short positions.

 

  • Sandbagged Quarter?  CAT’s earnings release read very weak today - almost too weak.  CAT could presumably have drained backlogs to improve sales, as it has done in other recent quarters, but instead allowed backlogs to build slightly.  It seems almost intended to reset expectations lower and make people feel like this quarter was the ‘bottom’.  CAT also apparently took an unquantified charge for an unspecified Power Systems project that has yet to be delivered.  That seems odd to us, since our recollection of multiple deliverables accounting would have had the negative impact recognized over the remainder of the project through delivery.  Not that we are challenging the GAAP-ness of it being in a single quarter, but it suggests to us, at the margin, that management wanted to bring expectations down.  They have been letting us down easy, as we previously noted here, but today was a bigger chop.
  • What It Means For 2013:  Ballpark annualized 1Q performance comes out to roughly $52-$56 billion in sales, by our estimates.  CAT can probably hit its new $57-$61 billion guidance range by resuming the draw on its backlog. 
  • Not Sure About $7:  It is not clear to us that CAT can earn $7 with the expected declines in high margin Resource Industries revenue, and the margin compression across Construction Industries and Power Systems.  Higher order rates in Construction Industries are negative for mix.  We get a likely range solidly below $6/share, with some wiggle room on the tax rate and other assumptions.  An $87 million tax benefit this quarter (related to a prior period) helped cushion the decline in operating income and should really be backed out.
  • Focus Now 2014:  Can CAT earn the current consensus of $9 in 2014?  We think not.  Consensus seems to be expecting a bounce back in mining and resources-related capital spending.  We expect end-market demand to actually worsen in these markets in 2014, as discussed in our recent black book on Mining & Construction Equipment.  Ping us if you expect a different outcome – we love the debate.
  • 2015 Guidance Off the Table?  This may end up being a record for a major company to ditch a long-term profit goal – it was put out only about 7 months ago.  It is no doubt embarrassing for management and we do not want to pick on them, aside from noting that the large and expensive mining-related acquisitions will now benefit the “next generation” of management, according to today’s call.  Also on the earnings call, management said “I mean, certainly, we don't have an outlook for 2014.”  If you do not have an outlook for 2014, how can you have one for 2015?

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Source: CAT Mine Expo Analyst Presentation

 

  • Recent Decline in Commodities:  Resource Industries and Power Systems sell to resource-related industries, like energy and mining.  They also account for about three-quarters of CAT’s operating income.  The recent broad decline in commodity prices is likely to impact orders negatively in coming quarters.  So far, US coal has been a key driver of weakness, but recent broader declines should catch-up with implied orders in coming quarters. Our March Mining & Construction Equipment black book focused heavily on the commodity capex outlook.

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  • Inventories Still A Problem:  The headwind to production and margins from the inventory correction is likely to last a while, as we have discussed before.  CAT may have lowered the level of inventory, but sales declined more.  We’ll learn more about the dealer situation as they report in coming weeks.

CAT: Feeling Managed? - www3

 

 

  • Commentary Didn’t Match Numbers:  Construction Industries was the worst performing segment in many ways, with sales down 17% and operating income down 61%.  Sales were down in every geographic region.  That is ugly – yet management implied that Construction Industries was doing well with backlogs up a bit.  Power Systems also showed margin declines, apparently partly related to a project problem and its own significant sales decline.  Every segment showed sales declines in every geographic region – oddly except mining-heavy Resource Industries in Latin America (+10%!).  The weakness was surprisingly broad-based but the commentary fixated on mining equipment.  Commentary that does not match the numbers is not a good sign for investors, in our view, as it suggests management is weaving narratives instead of reporting results, essentially managing investors instead of just the business. Today’s proxy, however, suggests that managing investors remains quite lucrative.  We are looking forward CAT dealer reports and the CAT 10-Q.  

 

 

 


TRADE OF THE DAY: EEM

Today we shorted the iShares MSCI Emerging Markets Index ETF (EEM) at $41.59 a share at 10:02 AM EDT in our Real-Time Alerts. #EmergingOutflows is one of our Top 3 Global Macro Themes for Q213, so we'll put this position on in conjunction with that.

 

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VIDEO: Positive Notes

 

Hedgeye Director of Research Daryl Jones appeared on CNBC’s Closing Bell this afternoon to discuss the US stock market and earnings season. Jones noted that with lower volatility and the Federal Reserve taking a more subdued approach to market participation, the climate for US stocks is undoubtedly bullish. As more companies report in the S&P 500, chances are that the majority of earnings will come in at or above expectations.

 

You can watch the full clip of Daryl discussing the markets in the clip posted above. Skip ahead to 1:15 to go straight to Daryl. 

 


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HOUSING: The Inflection Point

This morning's housing data was existing home sales, which came in at 4.92 million for the month of March. That's a 0.6% decline month-over-month (March vs February), which came in below consensus expectations. In general, the housing market is encountering seasonal headwinds which has lowered investor confidence in housing. Hedgeye Financials Sector Head Josh Steiner explains the current paradox plaguing the housing market:

 

"On the one hand, low inventory precipitates rising prices, while on the other hand low inventory marginally constrains volume growth. All things equal, low inventory helps the housing market far more than it hurts."

 

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Our expectation is that over time, both volume and inventory will rise. As mortgage demand increases and more homes come out of being "underwater," the market will continue to placate investors. We remain bullish on housing and think that any near-term hurdles will be overcome.

 

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China Catches Its Breath

Takeaway: China’s new environmental policies might actually fix one of the world’s worst air pollution problems.

How Do You Say “Parts Per Million” In Chinese? – China’s New Environmental Policies

This week Hedgeye Risk Management hosted a conference call with Dr. Melanie Hart, head of the China Energy and Climate Policy program at the Center for American Progress.  Dr. Hart is a recognized expert on Chinese technology and regulatory matters and a Mandarin speaker who resides part time in China.

 

China is prominent on the world economic radar for a large number of reasons.  1.4 billion reasons, to be exact.  A lot of people who consume lots of everything.  When China’s economy strengthens, much of the rest of the world benefits.  A major policy shift affecting Chinese manufacturing and transportation would have a global impact.  Dr. Hart says we are witnessing that shift right now as new regulations issued in 2012 will dramatically change Chinese industry as they are implemented on a schedule set to run through 2015.

 

The Problem

China’s official environmental policy used to consist of trying to convince the world that things were going well.  The global public relations blitz surrounding the 2008 summer Olympics in Beijing highlighted “Blue Sky Days,” a metric the government continued to track through most of 2011 as they kept telling their citizens “the air is getting better, the air is getting better.” 

 

But the air wasn’t getting better, the air wasn’t getting better.  In the face of the official “Blue Sky” count, ordinary Chinese were blogging photographs of distinctly Nasty Sky Days.  While official figures counted most of the year as being “Blue Sky Days,” bloggers tracked fewer than 100 acceptable days a year.

 

The US embassy in Beijing installed an air quality monitor in 2009 to test for “PM 2.5 particulates” within the embassy compound.  PM 2.5 measures “Particulate Matter,” which can be made up of a nearly infinite range of substances, chemicals and gases – in a heavily industrialized region, most of them are either bad for you, very bad for you, or really seriously extremely bad for you.  Says the EPA:

 

Particle pollution includes “inhalable coarse particles,” with diameters larger than 2.5 micrometers, and “fine particles,” with diameters that are 2.5 micrometers and smaller.  How small is 2.5 micrometers?  Think about a single hair from your head.  The average human hair is about 70 micrometers in diameter – making it 30 times larger than the largest fine particle.

 


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Take a look at the graphic and decide how much of this you want your family breathing in every day.  All right, then.  Neither do the Chinese.


Beijing residents figured out how to access the Twitter feed on the air quality monitor at the US embassy.  Ordinary citizens started re-blogging embassy Twitter messages to places where others could read them.  By 2011 a crisis erupted: here was proof that the authorities’ “Blue Sky” statistics were false.  The embassy readings indicated “extremely hazardous” levels of PM 2.5 particles and other pollutants.

 

So the Chinese government did something few Western observers would have anticipated: they acknowledged that air quality was dangerous and committed to new policies to aggressively clean up the environment.

 

Dr. Hart says this was a simple political reality driven by the average middle-class Chinese urban resident – a group comprising over 300 million people – a sizeable constituency even in a country where “One Citizen, One Vote” is considered a quaint notion.  Most of them are not English speakers and get their information primarily from the state-run media.  But they are well aware of the environmental situation and are sophisticated about monitoring air pollution levels.  They are plugged into blog networks and other sources of news about the environment.  They all know exactly what “PM 2.5” means and use the term routinely in their conversation.

 

The Party Takes The Clean Air Pledge

Once they acknowledged that there was a problem, Dr. Hart says the Party swung into action, to tremendous effect.

 

Starting in early 2012, Beijing started publishing accurate air quality readings, urging citizens to monitor the government’s progress.  In early 2012 the Ministry of Environmental Protection rolled out new air quality standards and a set of directives covering residential areas.  Under a formal 5-Year Plan, emission targets are set for 2015, and again for 2020.

 

The 2012 national standards for coal plants set emissions control standards comparable to, or better than those in the US and the EU.  New plants must be 100% in compliance, while existing plants have only until the end of the initial five-year stage, in 2015.  This may strike us as odd here in America where the worst polluters can get a court order allowing them to continue to run their plants, or simply violate federal rules and pay a fine much smaller than the profits they earn from their improper behavior.  Something to be said for central planning?

 

This unprecedented plan is focused on residential centers.  Dr. Hart says the Party recognizes they can’t clamp down on all emissions nationwide without disrupting economic growth, so they developed a 12-year plan covering 13 broad regions and 117 cities, with urban pollution reduction targets of up to 10%.  Each city must develop its own plan for emissions reduction and in the next phase, cities and regions will be linked to ensure air quality improvement along broad geographical corridors. 

 

Beijing itself has all but completely eliminated coal consumption, replacing it with natural gas.  Five remaining coal plants are all marked for closure and Beijing will soon be the world’s largest all-gas powered city.  The city has also imposed rigid vehicle restrictions, making it exceedingly difficult to get a new vehicle permit, and permitting drivers to go out only every second day, using odd / even license plate numbers. 

 

The central government is absolutely serious about this, says Dr. Hart, but they want the cooperation of the citizenry.  The government acknowledges this is a problem that took many years to develop, and which will therefore take time to clean up.  At last November’s Party congress, outgoing general secretary Hu Jinao coined the expression “ecological civilization,” an expression that has taken root as a key political concept.  Dr. Hart says this is a highly significant development, signaling a deep commitment at the highest levels of government, one that is being brought forward under the current general secretary Xi Jinping.   

 

Steps this year include a reassignment of high Party officials to key regulatory posts where they will have the authority to implement change.  The national electricity regulator has been moved under the authority of the national reform commission, for example, and there are rumors that the once-powerful monopoly will be broken up into more manageable units. 

 

What Will Change Look Like?

Apart from citizens enjoying an increasing number of Blue Sky Days, Dr. Hart says big changes will start to become apparent in 2014 as the 2015 deadline for full implementation approaches.  New regulations have been issued at the rate of one every month since February of 2012, and numerous industrial facilities have already been relocated or shut down.  A big push to complete the retooling should carry through 2014.

 

The message from the central government to the cadres is clear: “You can not mess this up.”  Implementation will be tracked at the local level, and meeting environmental targets will be the key to promotion through the party ranks.  In Chinese political culture, promotion within the Party hierarchy is the ultimate bottom line.

 

In terms of its economic impact, this has already led to consolidation in heavy industry.  Cities have made conscious policy changes to force small operators out of business, since larger facilities have greater economies of scale and are better equipped to adopt increased environmental controls.

 

Some industry has moved to Myanmar, a country with which China has a long commercial relationship, giving rise to concerns that Chine is merely shifting their pollution to Someone Else’s Back Yard.  Among the policy initiatives at the central government level are new rules that will require stiff pollution controls to be in place in all Chinese-owned facilities, even outside the national borders.

 

The government is installing monitoring equipment across the country that report air quality levels directly to Beijing.  Air quality is hard to certify and easy to fake.  And as the local cadres see their path to either advancement or ignominy dependent on improving local air quality, there is high incentive to lie.  Cameras on central government monitors have already caught local officials tampering with the devices, and the government is pursuing companies that keep shifting production just out of range of the monitoring posts. 

 

A significant international development is seen in complaints lodged by the Japanese, who say Chinese pollution is blowing across the open water and flowing into Japan.  The Chinese government, answering only to the political pressure from its own citizens, has basically told the Japanese, “if you buy us new technology, we’ll be happy to use it.”  This will bear watching over the next year or so as there may be increasing political pressure from China’s neighbors as the five-year plan advances and major polluters find themselves scrambling to meet a looming 2015 deadline.

 

Finally, a major wild card will be China’s domestic natural gas industry.  China has been watching the US shale gas business with great interest – observers estimate that China has substantially larger shale gas reserves than the US.  There are high hopes for a natural gas boom as the nation moves away from coal power – but there are a number of potential problems.

 

China’s shale gas deposits are much more difficult to access than those in the US, and their chemical makeup is harsher.  The highly corrosive output damages drilling equipment and will make refining more costly.  China also lacks an extensive pipeline infrastructure and has significantly less water resources for the fracking process.

 

Yet, with all these challenges, China’s leadership is dedicated to building a successful natural gas business and has put key experts in positions of authority to do everything possible to make this succeed.

 

Conclusion

Dr. Hart says the government will “absolutely not back away” from their air quality goals. 

 

First, the Party does not accept defeat.  The existence of a written five-year plan is a major commitment – indeed, an unshakeable one.  Having set the mechanism in place for ordinary citizens to monitor air quality, there will be no return to “Blue Sky Days.”

 

Secondly, Chinese are used to a High-Low society where the wealthy buy things the average citizen can’t afford.  European designer clothes and shoes.  Million-dollar luxury apartments.  Imported food and wine.  Bottled mineral water.  But clean air…?  There are some things money can’t buy.

 

It may prove difficult to attain all targets exactly on the projected schedule, and Dr. Hart says the next significant update should come from this autumn’s Party plenum.  She will be watching closely for any significant policy updates which could signal the level of success they are having in overcoming barriers along the path.


SLOW WEEK IN MACAU

Average table revenues slowed dramatically this past week, averaging only HK$775MM per day, still up 1% YoY.  Our full-month projection for April is now for GGR of HK$25.5-26.5 billion, which represents YoY growth of +5-9%, down from our previous estimate of +11-15%.  We heard that hold may have been low this past week.

 

In terms of market share, MPEL and Sands China continue to track above recent trend.  Despite the softness this past week, we remain positive on MPEL, given its likely strong Q1 earnings report, continued market share gains, and relatively low valuation. 

 

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