This note was originally published June 24, 2013 at 15:31 in Industrials
We have published a number of reports outlining the bear case on CAT (for example, see here, here and even here). We do not want to rehash the whole thesis, but we do think the current issues in emerging markets will accelerate the readjustment in expectations for CAT. As a result, we are adding CAT to the Best Ideas list.
CAT has been an underperformer over the past year as commodity prices stalled. After a decade of being a primary beneficiary of the boom in commodity prices through increased resource-related capital spending, CAT appears very vulnerable. Emerging-market growth, particularly the fixed asset investment bubble in China, has been a major driver of commodity demand.
The real bite will come to 2014 expectations, we think, as investors realize that the decline in resources-related capital spending is a return to normal levels, not a decline from them.
Resources-Related Capital Spending Falls Substantially When Commodity Price Flatten
The decline in mining capital spending in coming years is likely to be on the order of 60%-80% from peak, by our estimates. Such a decline will lead to overcapacity, competitive pricing and (obviously) lower volumes for OEMs like CAT supplying mining capital equipment. CAT has also made many peak-of-cycle acquisitions in resource-related capital equipment.
EM Crisis Accelerates Our Thesis
“The recent developments in China are clearly not positive for sentiment among EM investors; nor are they supportive of EM economic fundamentals, particularly given that so much of EM growth was perpetuated by China’s fixed asset investment bubble – which we clearly view as in the process of popping.” – Darius Dale, Hedgeye Macro Team (i.e. the guy who got the current EM situation right)
China’s fixed asset investment bubble has been a major driver of physical commodity demand over the past decade. It isn’t as though European, US or Japanese steel demand growth led the tripling of iron ore output in the last decade. Emerging market demand has. The financial stress currently underway is likely to crimp fixed asset investment for quite a while, and with it resources-related capital spending. If the emerging market challenges continue, expect those CAT order delays to turn into cancellations.
Resources-Related Capital Investment Is Where CAT Makes Its Money
As the chart below shows, when you take out Resource Industries and Power Systems, there is not much left of CAT’s operating income. Those two segments are dominated by energy, mining and other resource-related products, in our view. CAT dealers own much of the service and parts revenue from the existing installed base, a meaningful difference from JOY, Sandvik and other equipment suppliers. Construction Industries competes in a more fragmented, lower margin industry that has its own emerging market exposures. For CAT, commodity-related capital spending, and with it the emerging market growth story, are critical. The declines that are likely to evolve from the current EM crisis are a very serious issue.