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Our Bear Call on Cat Gets Some Company

Editor's note: The following research note on Caterpillar (CAT) by Hedgeye Industrials Analyst Jay Van Sciver was originally published June 24, 2013, which also happens to be the date we added CAT to Hedgeye's "Best Idea" list. As you may have heard, earlier today famed short-seller Jim Chanos outlined why he's now shorting Caterpillar which sent the stock tumbling over 2%. We have a great deal of respect for Mr. Chanos. We welcome him to the bear camp on CAT.


Our Bear Call on Cat Gets Some Company - jimbo


Takeaway: Emerging market turmoil should accelerate the downside in CAT, likely leading investors to reassess inflated 2014 expectations.




We have published a number of reports outlining the bear case on CAT (for example, see herehere 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.


Our Bear Call on Cat Gets Some Company - cat1


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.


Our Bear Call on Cat Gets Some Company - CHART2

Bullish: SP500 Levels, Refreshed

Best news of the day is that Bernanke wasn’t dovish enough to satisfy the begging from Gold Bond bulls. #StrongDollar is holding support, and that, ultimately, is a good thing for what’s been working for 6 months – long US Growth.


Across our core risk management durations that matter, here are the lines that matter to me most:

  1. Immediate-term TRADE resistance = 1701
  2. Immediate-term TRADE support = 1661
  3. Intermediate-term TREND support = 1602

Higher-lows of support and higher-all-time-highs of resistance will continue to be bullish until they are not.

  1. We want to be buying growth on red days (bought TSLA and NKE on red yesterday)
  2. We want to be shorting bounces in bearish growth trades (Gold, Bonds, etc) on green days

Staying with our 2013 process because it’s still working,



Keith R. McCullough
Chief Executive Officer




Bullish: SP500 Levels, Refreshed  - SPX

Sharks, Vampires & Central Planners

This shark – swallow you whole.

- Quint, “Jaws”


Sharks, Vampires & Central Planners - quint


We often hear government economists and policy makers express concern that market turmoil might “spill over and affect the real economy,” an Orwellian locution where the price of oil spiking over $110 is seen as a “market dislocation,” and not as a multi-billion dollar tax on America’s middle class.


There have been measurable benefits from government programs going back to the first responses to the crisis under Treasury Secretary Paulson, though largely of dubious value.  The fact that we spent a trillion dollars to keep a bunch of bankers employed, while technically a win for the nation’s employment statistics, was arguably not the application that would have attained the utilitarian goal of the Greatest Good for the Greatest Number.


Last week saw a convergence of data points that all point to the likelihood that Chairman Bernanke wants to retain Friends in High Places, assuming that his legacy will be set not by those who write history – and especially not by those who live it – but by those who decide what gets published.  (Quoth the Duke of Gloucester, patron of historian Edward Gibbon, upon being presented with the completed Decline and Fall of the Roman Empire, “Another damned thick, square book!  Always scribble, scribble, scribble, eh?”)


We don’t mean to scoff at the very real suffering caused by economic collapse, but Hedgeye holds firm to the view that government meddling in the economy is generally not a good thing, and that a long-term program of persistent government meddling in the economy is a decidedly harmful thing. 


Government intervention has the predictable effect of shortening economic cycles, while also increasing volatility – perhaps two sides of the same coin of time compression.  In consequence, it also has the predictable effect of generally not really fixing anything and of battering the middle class, edging them nearer to the abyss with each new policy nudge.


By the Fed’s own reckoning, each successive round of QE has a diminishing impact on the markets.  Mind you, that impact is measured in basis points – one-hundredths of a percent – and the twenty-five basis point impact looked for from any future round of QE is not predicted to last.  The banks are still not lending, largely because of uncertainty over government policy.  But don’t blame the banks.  People aren’t borrowing, for much the same reason: no one wants to take a loan to expand a business that might be shot execution style by the Fed suddenly reversing its interest rate policy.


Sharks, Vampires & Central Planners - qe2


So, if the Fed’s easy money policy is not supporting the “real economy,” who is benefitting from it?


Most excess liquidity seems to be supporting the short-term trading of major financial houses – which helps explain the furor over the Volcker Rule, designed with the sole purpose of walling off risk trading from deposit taking (a proposition that a tenth-grader could clearly articulate in a single sentence – do you know a tenth grader who wants to be President?)


Wealthy folks are going to get wealthier through this artificial inflation in asset prices.  This has been the effect of each previous round of money printing, and is likely to continue.  But each successive round of QE also takes a moral chunk out of the nation’s Middle Class, not to mention shredding American credibility in the global marketplace.  Our markets used to be the gleaming city on the hill.  Now they are just the Best House in a Bad Neighborhood.  How long before they turn into a slum? 


Hedgeye’s institutional clients were treated last week to an exclusive conference call with George Friedman, founder and chairman of Stratfor, the global intelligence and strategic risk assessment consultancy.  Friedman says the decimation of the middle class brought about by government neglect and economic malaise has historically been a key indicator of pending social unrest. 


We think America still has a way to go before chaos strikes, but we remember that Secretary Paulson got Congress to trigger TARP by predicting there would be marshal law within a matter of days – a dire prediction that this nation’s leaders bought into.  TARP was passed with a large number of legislators never having even read the bill.


If you were worried that Washington might actually get some control over Bad Actors in the financial sector, you can breathe easy.  All that posturing and crying “Sh*t!” in a crowded Senate hearing made for mildly engaging reality TV, but in the end Business As Usual remains the mantra in the City of the Perpetual Extended Palm.  (For colorful commentary on the Senate financial crisis hearings, and other Washington-to-Wall-Street low points, see the Hedgeye e-book Fixing A Broken Wall Street). 


Sharks, Vampires & Central Planners - doll5


Bernanke’s fiddling in the system has the effect of trashing the Dollar, and of spiking asset prices – the value of stocks in your 401(K) just went up, but so did the price of gas, effectively an instantaneous tax hike.  By creating waves of volatility in the markets, Bernanke is doing his utmost to keep the bankers banking and the traders trading. 


To return to scary summer movie metaphors, while you are out frolicking in the surf, why are the Central Planners avoiding the sunlight?  Are they vampires, or do they just not like being around We The People?  Be careful out there: even at low tide you won’t see the shark until it’s upon you.

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Morning Reads on Our Radar Screen

Takeaway: A quick look at stories on Hedgeye's radar screen.

Keith McCullough – CEO

Live, From Congress, It's "Delivering Beta" With Ben Bernanke (via Zero Hedge)

China Won’t Have Large Stimulus This Year, Finance Minister Says (via Bloomberg … KM note: Hedgeye's call, precisely)

Barclays, Traders Fined $487.9 Million by U.S. Regulator (via Bloomberg … KM note: What's 1/2 a billion, amongst #OldWall friends?)

Seized N Korean ship: Cuban weapons on board (via BBC)

Olbermann Will Return To ESPN (via New York Times)


Morning Reads on Our Radar Screen - bbo


Christian Drake – Macro

Bernanke: Bond-Buying Plans Not 'A Preset Course' (via WSJ)


Todd Jordan – Gaming

Bally Sees Winning Hand In $1.3 Bil SHFL Buyout (via IBD)


Tom Tobin – Healthcare

Health Plan Cost for New Yorkers Set to Fall 50% (via New York Times)

Man battles health insurer for drug that could save his life (via Today Show)


Howard Penney – Restaurants

Janney Montgomery Scott Slashes Rating, Target on McDonald’s (via Dividend.com)

McDonald’s and Visa Conjure Fantasy Budget for Low-Wage Employees (via Daily Beast)

Teenager Wears Dirty Trousers as Late British Open Qualifier (via Bloomberg)


Kevin Kaiser – Energy

Linn Energy (LINE) and LinnCo (LNCO) upgraded to Buy at Goldman Sachs (via Business Insider … KK note: We reiterate Sell.)


Josh Steiner – Financials

BofA Beats Estimates as Profit Rises 63% on Expense Controls (via Bloomberg)

Housing starts fall to ten-month low (via Reuters)


Matt Hedrick – Macro

'Romanian gypsy ghettos. Schools filled with children who do not speak our language. A surge in crime. Social benefits abused': Now GERMANY admits mass immigration threatens 'social peace' (via Daily Mail)


Caribbean still a tough pricing environment but Europe is holding its ground.



RCL will likely report earnings next week.  We expect management to comment on the bookings environment improving since the Grandeur of the Seas fire.  However, based on our findings, Caribbean pricing has not improved since the incident.  The pivot variable in its FY2013 guidance is once again determined by the outlook on Europe, which we believe continues to trend better than the company’s conservative forecast.  Better than expected performance in Europe coupled with a weaker Caribbean leads us to forecast FY 2013 yield guidance narrow to 2.5%-3.5% from 2.0-4.0%.  However, there remains risk to the downside, particularly on F3Q.  FY 2013 expectations on the buy-side and sell-side have been lowered in the past month.   2013 FY net yield Street consensus is at 3.1% (Hedgeye: 3.0%).


While it has only been two weeks, pricing seems to be under even more pressure since management issued guidance – not only for the rest of the year but also for 1H 2014.  Management indicated on their conference call that they do not expect the Carnival brand to show yield improvement until 2H 2014.  However, unless Europe shows tangible growth, 2014 consensus for 2.5% net yield growth looks aggressive right now.  It is early but we’re seeing no signs of regaining pricing power in the Caribbean and Mexico.


Here is what we’re seeing from our proprietary pricing survey of >12,000 itineraries for mid-July.  We analyze YoY trends, as well as relative trends, which are determined by pricing compared to the last earnings/guidance date for a cruise operator i.e. RCL: 4/25, CCL: 6/25, NCLH: 5/6





  • Royal Caribbean
    • RC brand pricing for F3Q and F4Q has not recovered from the Grandeur of the Seas (5/27) incident.  For example, Oasis of the Seas which had averaged over $1,000 per itinerary in early June had fallen close to $800 by mid-July (in the respective year ago periods, prices averaged close to $1,000).  Yes, most of the cabins are filled but the lack of pricing stickiness is concerning.  F1Q 2014 RC pricing was also moderately lower while F2Q 2014 pricing was moderately higher and trend was stable.
    • Celebrity’s pricing trend for F4Q and F1Q 2014 was lower with lower YoY pricing.
    • Pullmantur F3Q pricing fell in the mid-digits in early July and remained there in mid-July.  Its F4Q 2013 and F1Q 2014 pricing trend was flat to slightly negative.
  • Carnival brand
    • While it’s only been two weeks since Carnival’s last guidance, pricing is losing ground fast.  FQ4 2013, FQ1 2014, and FQ2 2014 pricing were all lower by double digits YoY.  Pricing trend for FQ4 2013 and FQ1 2014 particularly weakened in the last two weeks.  The Carnival brand accounts for 83% of CCL’s total capacity in the Caribbean.   
  • Norwegian
    • Norwegian's Caribbean pricing trend declined for Q3 2013, mainly due to a 16% tumble in Breakaway prices.  Breakaway prices, which had been resilient in June, finally cracked under a tough pricing environment.  Overall, NCLH Q4 2013 and Q1 2014 pricing trend was flat.  Meanwhile, Getaway’s pricing for February/March 2014 itineraries remained steady, though 12% lower than that seen in May.


  • Royal Caribbean
    • Very close-in F3Q RC pricing was moderately weak.  However, F4Q RC pricing crept into positive territory.
    • Celebrity YoY pricing remained nicely higher in the double digits for F3Q and F4Q. 
    • Pullmantur Mediterranean very close-in F3Q pricing was stronger in the two weeks ago but F4Q pricing trend deteriorated.
    • European capacity accounts for 49% and 25% of total capacity in F3Q and F4Q, respectively. Celebrity accounts for 33% of capacity in F3Q and F4Q, respectively, while the RC brand accounts for 48% and 35% of capacity in F3Q and F4Q, respectively.
  • Carnival
    • Costa F3Q pricing, which continued to fall since June, was unchanged relative to the beginning of July.  Costa’s FQ4 pricing remained strong at double digit growth.  Costa’s early FQ1/FQ2 2014 pricing did not change much.  Princess, Cunard, and AIDA F3Q/F4Q pricing trend were fairly stable, while Holland America pricing declined slightly in the last two weeks.
    • We estimate Costa accounts for 40-50% of total European capacity in F3Q and F4Q
  • Norwegian
    • F3Q prices continued its downward trend since May. F1Q 2014 pricing improved slightly. 





Not many itineraries left.  Holland America continued to discount aggressively in F3Q and F4Q.  Norwegian and the RC brand also slashed F3Q prices.  On the brighter side, Princess pricing was impressively higher YoY.



Carnival brand’s pricing struggles in Mexico remain for F3Q, partially due to hard comps.  Carnival brand’s F4Q 2013 and F1Q 2014 pricing both took a heavy hit in July and trend is declining.  



1Q 2014 RC brand pricing strengthened in mid-July.  Costa’s F4Q 2013 and F1Q 2014 pricing remained robust.


Client Talking Points


So, China’s Finance Minister says they “won’t use large scale stimulus.” Take his word for it. Shanghai Composite led losers down -1% in Asia overnight. Meawhile, Singapore put up a nasty (ex-Oil) Export print of -8.8% year-over-year in June. What that says is ex-Japan Asia #GrowthSlowing.


Everyone and their brother are trying to front-run Ben Bernanke breathing appointments at this point. It's sad, but that’s the reality. CRB Index up +0.6% yesterday with Gold, Oil, etc chasing higher on a -0.7% US Dollar day. Will Bernanke be dovish enough? We shall see. But this is a certified central planning expectations circus; EUR/USD TAIL risk line is 1.31. That could go either way.


Copper down -1.1% on the China reality-check (short CAT again on that too). But Brent is still pinning her hopes on Benny. $109.40 last is above our long-term TAIL line of $107.86. That's important. The net long position in futures/options for everything crude oil has gone hog wild; over 325,000 net longs! (biggest long lean of the year).

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.


Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016. 


Health Care sector head Tom Tobin has identified a number of tailwinds in the near and longer term that act as tailwinds to the hospital industry, and HCA in particular. This includes: Utilization, Maternity Trends as well as Pent-Up Demand and Acuity. The demographic shift towards more health care – driven by a gradually improving economy, improving employment trends, and accelerating new household formation and births – is a meaningful Macro factor and likely to lead to improving revenue and volume trends moving forward.  Near-term market mayhem should not hamper this  trend, even if it means slightly higher borrowing costs for hospitals down the road. 

Three for the Road


Goldman upgrades $LINE $LNCO to Buy. We reiterate Sell.



"We keep kicking the can down the road. But maybe now we're at the point where the can is kicking back"

- Jim Chanos


$487.9 Million: The total amount in fines and penalties Barclays and four former traders must pay in an order tied to an investigation of alleged manipulation of energy markets. (Bloomberg)

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