Stealing Time

This note was originally published at 8am on July 09, 2013 for Hedgeye subscribers.

“I want to use the time it takes.”

-Per Peterson


As opposed to what I usually do when I’m reading non-fiction, I don’t dog-ear many pages when I read a novel. The aforementioned quote is a simple one for type-A types in this profession. It comes from Peterson’s acclaimed novel, Out Stealing Horses.


Time is important to me now, I tell myself. Not that it should pass quickly or slowly, but be only time, be something I live inside and fill with physical things and activities that I can divided it up by, so that it grows distinct to me and does not vanish when I am not looking.” (Out Stealing Horses)


That is all. I just wanted to share it with you. It’s a blessing to be able to work with my teammates and produce something distinct every morning. Thank you for taking the time to read our thoughts.


Back to the Global Macro Grind


Three consecutive up days for the SP500 (taking it to within 1.7% of her all-time high of 1669) as the Russell 2000 powers forward to make its 2nd consecutive all-time high in as many trading days (+18.8% YTD to 1,009). That’s progress.


So are US employment growth expectations rising alongside:


A)     Rising Bond Yields

B)      Falling Equity Volatility


In Hedgeye quant-speak, that means:

  1. SP500 is back in a Bullish Formation (bullish on all 3 of our core risk management durations, TRADE/TREND/TAIL)
  2. US Equity Volatility (VIX) is back in a Bearish Formation with immediate-term TRADE resistance = 16.39
  3. US Treasury 10yr Bond Yields remain in a Bullish Formation (with immediate-term TRADE support 2.33%)

As growth expectations rise, slow-growth securities (Bonds, MLPs, Utilities, etc.) fall:

  1. US Consumer Discretionary stocks (XLY) = +3.39% July-to-date
  2. US Financials (XLF) = +2.67% July-to-date
  3. US Utilities (XLU) = -0.53% July-to-date

In other words, one of these things (XLU) is not like the others. #StrongDollar and #RatesRising gets the consumer paid, not the banker and/or ETF manufacturer who is pushing you Yield-Chaser product.


*Key Word Score in 2013 = #expectations


Mr Market couldn’t care less what Captain Valuation thinks about a mining security. Mr Market is all about the rate of change in expectations. And right now, expectations are rising that #GrowthSlowing is still yesterday’s war.


From a US stock market factoring perspective, here’s another way to look at that relative to the SP500’s +15.0% YTD gain:

  1. Low Yield Stocks = +22.9% YTD
  2. Top 25% EPS Growth Stocks = +19.4% YTD
  3. High Beta stocks = +17.5% YTD

High Yield Stocks (i.e. slow growth) are only +11.2% YTD. Whether you are long Tesla (TSLA) (which is replacing Oracle (ORCL) in the Nasdaq 100 today), or you’re short sketchy MLP companies, you are just loving this expectations shift versus the consensus.


Don’t let jimmy pundit confuse you  - for the entire year the #OldWall hasn’t been Bullish Enough on the US Dollar, Bond Yields, and Growth Expectations. At the beginning of 2013, the sell-side’s average “year-end target” for the SP500 was only 1531.


Today, the SP500 is obviously 109 handles higher than that, and the VIX is -18.0% for the YTD. Only 43.8% of investors surveyed in the most recent II Bullish/Bearish Survey admitted they are bullish.


Are we discounting too much growth too fast? Or are we just normalizing a pervasively bearish growth expectation in the political economy? I don’t know. All I know is that I will not let consensus’ bearish baggage get me down.


Life is too short to not enjoy the up moves. If I can steal more of the good times, I’ll take them.


Our immediate-term Risk Ranges are now:


UST 10yr 2.56-2.74%

SPX 1619-1650

VIX 14.12-16.36

USD 83.47-84.83

Yen 99.59-101.98

Brent Oil 104.93-108.36


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Stealing Time - Chart of the Day


Stealing Time - Virtual Portfolio


“The greatest barrier to success is the fear of failure.”

-Sven Goran Eriksson


I was in Kansas City, Missouri then Denver, Colorado yesterday before flying into Aspen last night for the 2013 Fortune Brainstorm Tech Conference (ping me if you are here!). Cabs, planes, and bad coffee - just another busy day in the life of building a business.  


But what is it that gives us the confidence in building our own businesses? With all of the politics, fear-mongering, and central planning, why do we care to carry on? In moments of weakness, I admit to asking myself these questions every once in a while. Then something inspires me to rise above all of that. It’s either in your gut, or it is not.


There’s a great passage in a novel I just finished (Out Stealing Horses, by Per Peterson) that reminded me of who taught me to be this way (my Dad): “he had so much self-confidence he could take on almost anything and believe he would succeed” (pg 51). But don’t kid yourself; having role models in your life isn’t enough – you have to be the change, and break confidence barriers yourself.


Back to the Global Macro Grind


How many people have been confident enough to be invested in US growth stocks in 2013? Of the non-consensus bulls you know, how many of them are bullish because of #RatesRising?


I won’t hear it at this innovator’s conference in Colorado today, but I hear it a ton in institutional investor meetings - lots of doubt, fear, and concern. The lack of self-confidence out there is born out of a lot of 2008 baggage. I don’t get bogged down by that.


Both the SP500 and Russell2000 clocked fresh all-time highs again yesterday of +18.9% and +24%, respectively for 2013 YTD. #StrongDollar and #RatesRising isn’t something to be feared; it’s a pro-growth signal that needs to be understood.


By our risk management process scorecard, this morning is almost perfect for US stocks. Here’s the big 3 things to have confidence in:


1.   #StrongDollar – after correcting -0.5% last week (Bernanke wasn’t giving anyone anything but things to fear, which is just a shame at this point) and falling again yesterday, today the US Dollar Index holds both our immediate-term TRADE ($82.07) and intermediate-term TREND ($81.53) lines of support


2.   #RatesRising – after falling 10 basis points last week to 2.48% (Bernanke policy to have you fear failure), the 10yr yield held our immediate-term TRADE line of 2.45% support yesterday (TREND support underpins that at 2.21%) and is backing up again this morning to 2.51%; higher-lows and higher-highs for bond yields is a bullish growth signal supported by employment gains


3.   #CommodityDeflation – with the USD -0.5% last week, Commodities were +1.5% (CRB Index) – that’s not new; the intermediate-term correlation between USD and Commodities = -0.71. Why? That’s simple – the entire base of futures/options buyers in Gold, Oil, Food, etc. is still trying to front-run Bernanke’s “tone” on tapering


Like they were in the summer of 2008 (when Bernanke was whispering to the #OldWall that he was going to cut to 0%, too early), Oil prices are once again the biggest threat to US Consumption.  


If you want fear, I’ll give you something to fear – it’s called Dollar Devaluation. Just reverse all of the aforementioned 3 things and the USD will weaken, interest rates will fall, and commodity reflation will slow growth.


Who wants that? And, moreover, if 95-99% of Americans don’t want that, who stands in the way of tapping Bernanke on the shoulder and telling him to taper?


If Reagan or Clinton were in office, they’d be perfectly fine with that. Bush and Obama have been so scared of their own economic shadow that it’s their fears that have manifested into the conflicted power of Bernanke’s Bubbles (Commodities, Gold, Treasuries, etc.).


I don’t fear the politicized not liking my advice. I fear that a lot of Americans are going to get blown up by this bond bubble. I also fear that the only fear left, is a fear-mongering anti-growth government policy itself.


The greatest barrier to #StrongDollar and #RatesRising is self-evident. It’s time to get this old-boy, crony-whispering, and un-elected policy out of our way. It’s time to let free-market prices clear. The inability to evolve is as very credible threat. Confidence is the answer.


Our immediate-term Risk Ranges are now:


UST 10yr 2.45-2.70%


VIX 11.57-14.16

USD 82.07-83.46

Brent Oil 107.11-109.08

Gold 1


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


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TODAY’S S&P 500 SET-UP – July 23, 2013

As we look at today's setup for the S&P 500, the range is 24 points or 0.86% downside to 1681 and 0.56% upside to 1705.    










  • YIELD CURVE: 2.21 from 2.18
  • VIX closed at 12.29 1 day percent change of -1.99%

MACRO DATA POINTS (Bloomberg Estimates):

  • 7:45am: ICSC retail sales
  • 8:55am: Redbook weekly retail sales
  • 9am: FHFA House Price Index, May, est. 0.8% (prior 0.7%)
  • 10am: Richmond Fed Manuf Index, July, est. 9 (prior 8)
  • 11am: Fed to purchase $3-$3.75b notes in 2019-2020 sector
  • 11:30am: U.S. to sell 4W bills, $25b 52W bills
  • 1pm: U.S. to sell $35b 2Y notes
  • 4:30pm: API crude, oil product inventories


    • House, Senate in session
    • Senate Banking subcmte holds hearing, “Examining Financial Holding Companies: Should Banks Control Power Plants, Warehouses, and Oil Refineries?” 10am
    • House Agriculture panel hears from CFTC members Scott O’Malia and Mark Wetjen on the future of the commission, 10am
    • House Financial Services Cmte votes on Chairman Jeb Hensarling’s bill that would wind down Fannie and Freddie, marking for concrete congressional action on legislative proposals to revamp U.S. housing finance system, 10:15am
    • Senate Health, Education and Labor Cmte hears from National Labor Relations Board nominees Kent Hirozawa and Nancy Schiffer at confirmation hearing, 10am
    • House Judiciary panel holds hearing on legal status of undocumented immigrants brought to U.S. as children, 2pm
    • House Education and Workforce panel hears from OMB official Howard Shelanski on delaying the health-care law’s employer mandate, 10am
    • McAfee CTO Phyllis Schneck joins panel of witnesses for House Foreign Affairs Subcmte on Asia and the Pacific hearing on cybersecurity, 2pm


  • Biggest Banks Face Fed Restoring Barriers in Commods Review
  • Netflix 2Q EPS beats, domestic streaming subs miss
  • Pentagon’s spectrum compromise benefits wireless carriers: WSJ
  • Verizon raising speed of its internet to 500 megabits/second
  • Nokia said to prepare rollout of new Lumia-based smarthone
  • Oracle raising China investment, Shanghai Daily says, cites CEO
  • Aereo seeking to reach 25% of U.S. population, CEO says
  • Ebay projects cross-border shipping at $307b in 2018
  • SouthWest jet has nose gear failure at LaGuardia airport
  • Obama said to consider Raskin for dep. Treasury Secretary
  • Chinese Premier said to have placed 7% growth as 2013 minimum


    • DuPont (DD) 6am, $1.27
    • Air Products & Chemicals (APD) 6am, $1.36
    • CIT Group (CIT) 6am, $0.91
    • Polaris Industries (PII) 6am, $1.10
    • Sensata Technologies Holding (ST) 6am, $0.53
    • Carlisle Cos (CSL) 6am, $1.34
    • Centene (CNC) 6am, $0.65
    • RadioShack (RSH) 6am, ($0.24)
    • Travelers (TRV) 6:57am, $1.59
    • Altria Group (MO) 6:58am, $0.63 - Preview
    • United Technologies (UTX) 6:59am, $1.58 - Preview
    • Lexmark International (LXK) 6:59am, $0.87
    • Regions Financial (RF) 7am, $0.21
    • Pentair (PNR) 7am, $0.90
    • Forest Laboratories (FRX) 7am, $0.08
    • Waters (WAT) 7am, $1.21
    • Idexx Laboratories (IDXX) 7am, $0.97
    • Penn National Gaming (PENN) 7am, $0.63
    • Wendy’s (WEN) 7am, $0.06
    • MGIC Investment (MTG) 7am, ($0.13)
    • Ironwood Pharmaceuticals (IRWD) 7:07am, ($0.68)
    • Lockheed Martin (LMT) 7:25am, $2.20 - Preview
    • TDAmeritrade Holding (AMTD) 7:30am, $0.31
    • Domino’s Pizza (DPZ) 7:30am, $0.56
    • FirstMerit (FMER) 7:30am, $0.31
    • Exact Sciences (EXAS) 7:30am, ($0.18)
    • Avery Dennison (AVY) 7:35am, $0.70
    • Valero Energy (VLO) 7:43am, $0.96
    • United Parcel Service (UPS) 7:45am, $1.13 - Preview
    • Ryder System (R) 7:55am, $1.23
    • Illinois Tool Works (ITW) 8am, $1.10
    • Freeport-McMoRan Copper & Gold (FCX) 8am, $0.45 - Preview
    • PACCAR (PCAR) 8am, $0.75
    • Sigma-Aldrich (SIAL) 8am, $1.04
    • Peabody Energy (BTU) 8am, ($0.05) - Preview
    • TCF Financial (TCB) 8am, $0.21
    • Discover Financial Services (DFS) 8:30am, $1.15
    • FMC Technologies (FTI) 4pm, $0.47
    • Panera Bread (PNRA) 4pm, $1.77
    • Robert Half International (RHI) 4pm, $0.43
    • RF Micro Devices (RFMD) 4pm, $0.07
    • AT&T (T) 4:01pm, $0.68 - Preview
    • ACE (ACE) 4:01pm, $1.94
    • VMware (VMW) 4:01pm, $0.77
    • Electronic Arts (EA) 4:01pm, ($0.60)
    • Total System Services (TSS) 4:01pm, $0.33
    • Nabors Industries (NBR) 4:01pm, $0.09
    • American Campus Communities (ACC) 4:02pm, $0.56
    • Waste Connections (WCN) 4:04pm, $0.43
    • Norfolk Southern (NSC) 4:05pm, $1.49
    • Broadcom (BRCM) 4:05pm, $0.69
    • Juniper Networks (JNPR) 4:05pm, $0.25 - Preview
    • Illumina (ILMN) 4:05pm, $0.39
    • CR Bard (BCR) 4:05pm, $1.38
    • Everest Re Group (RE) 4:05pm, $4.25
    • Compuware (CPWR) 4:05pm, $0.04
    • Polycom (PLCM) 4:05pm, $0.14
    • Altera (ALTR) 4:15pm, $0.31
    • International Game Technology (IGT) 4:15pm, $0.31
    • KKR Financial Holdings (KFN) 4:15pm, $0.37
    • Apple (AAPL) 4:30pm, $7.30 - Preview
    • Unisys (UIS) 4:30pm, $0.90
    • Rock Tenn (RKT) 5pm, $1.66       


  • Biggest Banks Face Fed Restoring Barriers in Commodities Review
  • Sugar Glut Easing as Bear Market Spurs Supply Cuts: Commodities
  • Goldman Pares Its 12-Month Commodity Outlook After Crude’s Rally
  • WTI Drops a Second Day; Goldman Predicts Wider Discount to Brent
  • Gold Imports by India May Slump as Purchases Linked to Exports
  • Copper Falls as Some Investors Sell on Demand-Outlook Concern
  • Corn Falls to Two-Week Low as Cooler Weather Boosts U.S. Outlook
  • Arabica Coffee Gains Before Brazil Cold Weather; Cocoa Advances
  • MillerCoors Sees Metal-Warehouse Delay Costing Buyers $3 Billion
  • Crude Supplies Drop to Six-Month Low in Survey: Energy Markets
  • Rebar Advances Amid Steel Price Increase, China Speculation
  • Japanese LNG Profit Premium Over U.K. Falls to Eight-Month Low
  • Gold’s 50-Day Moving Average Signals Advance: Technical Analysis
  • Gold Falls From One-Month High After Rally Spurs Investor Sales


























The Hedgeye Macro Team













In preparation for IGT's F2Q 2013 earnings release tomorrow, we’ve put together the recent pertinent forward looking company commentary.




  • [International] "There are systemic issues that have impeded participation in some markets, which we are working to overcome. And the economic headwinds in certain regions continue. However, we remain committed to harvesting the investments that we have made in this business particularly in expanding our portfolio of localized content. Long-term, we still expect international markets to outpace the growth of our North American business."
  • "We now expect that our objective of achieving flat year-over-year yield by the fourth quarter will be more challenging than previously anticipated. However, we remain focused on improving yields, confident that we can continue to offset a portion of yield pressures by managing costs."
  • "Looking forward, we expect to see a decrease year-over-year in our gaming operations capital expenditures, driven by a decline in installations."
  • [Doubledown] "As we develop these markets, we expect that the number of daily active users will grow, but the average revenue per daily active user could decline slightly...we continue to expect the transaction to be GAAP accretive by 2014."
  • [Product Sales margins] "Traditionally, we're in kind of the low 51% to 53% range and that's where I would expect it to stay over the remainder of the year."
  • "We do need some cooperation from GGR trends. And I would say, over the first two quarters of our fiscal year, we haven't seen anything to indicate that we're going to get some positive tailwind in that area."
  • [Operating expenses] "We expect it to retrench back to where it was in the first quarter, say, for costs associated with marketing and promoting DoubleDown, where we do engage in some direct – marketing expenses. We'll be in line or probably grow less than the revenue growth that we experienced, as is the case this quarter."
  • [Canadian VLTs] "We expect at the moment that we should see the vast majority of the remaining units ship in the year. But keep in mind these are large bulk orders and depending on either customer needs or other impacts, you could see swings and sometimes those swings border on a quarter. Right now I would say that we believe the vast majority of the remaining shipments will occur in the year. And then there may be some follow on activity as locations top off their floors in 2014."
  • [Doubledown] "We think we have the right product in place complemented by the IGT content to continue to grow those numbers. I mentioned we're penetrating a couple of different markets with new language offerings and we expect that will drive DAU though it may slightly impact bookings per daily active user. As you get into a market you need to build familiarity before you can convert to paying users. It's incredibly difficult to precisely identify which metric is going to go up. Lately we've seen them all rise and we continue to expect to make forward progress in all and we will continue to balance that which will provide us the greatest long-term return. So I think you can expect to see them move north."
  • [International systemic issues] "Europe tend to be more macro. The other two (Latin/South America, Asia Pacific) as we look at them probably have more of a systemic issue within the structure of how they allow the business to operate.


CAT: Bull Thesis Review & 2Q Expectations



We received a number of responses from more positive investors challenging our CAT thesis following last Thursday’s presentation.  The three key bullish themes that emerged were:


  1. Buyback: Better capital allocation for CAT going forward in the form of share repurchases
  2. Segment Models: The downside may look minor when modeled by segment, particularly when inventory reductions are factored in.
  3. Mining Cycle Already Well Known: The stock is hated already – how much downside could there be?  Investors should ‘look through’ the downturn.


CAT has already underperformed and we have been negative on the name for over a year.  However, we still see significant downside.  While we could always be wrong and will change views as appropriate, data and experience suggest these cycles go on for much longer than most investors expect and frequently overshoot.  This one seems to be just getting started.


Argument 1:  Better Capital Allocation/Buyback


Overvalued:   CAT announced a $1 billion buyback with its disappointing 1Q 2013 earnings.  That shift in capital allocation has generated some optimism – particularly on the day it was announced.  However, CAT’s equity appears overvalued.  Buying overvalued equity is not a great way to create value.


Good Acquisitions:  If anything, issuing overvalued equity to make acquisitions of cheap, good businesses might add some value, even providing a short-term reporting boost from some of the purchase allocation flexibility.  Following the challenges of ERA and Bucyrus, additional large acquisitions seem unlikely. 


Buyback Valuation Discussion Cringe-Worthy: On the call following 1Q earnings CFO Bradley Halverson said with respect to the buyback:


“So the question is why now. And our balance sheet is very strong. We think with the drop in stock price recently and where our PE is, the fact that we believe we have a slow growing economy but one that's stable…. We had a good cash flow quarter.  We have plans for a good cash flow year and we think, again, this is an opportunistic time here in the short term to reward our shareholders with $1 billion stock buyback.” - Bradley Halverson 4/22/13 (Bloomberg Transcript)


First, low multiple cyclicals tend to be overvalued - P/Es do not work as a valuation metric (cyclical investing 101).  Cyclicals tend to be cheapest when earnings are negative and they have no P/E.  Second, CAT already has plenty of leverage.  Does anyone really think CAT is underleveraged? Finally, CAT has not been generating all that much free cash flow recently.  If the cash flow impact of receivables growth and rental equipment purchases are included, CAT had negative free cash flow in 2012 (cash from operating activities less capital spending and investment in receivables).


CAT: Bull Thesis Review & 2Q Expectations - cv1

CAT: Bull Thesis Review & 2Q Expectations - cv22




Buy Backs & Performance:  Buybacks tend to be a last resort for companies that do not have anything better to do with cash.  They are also frequently used to manage investor sentiment by mingling the announced buybacks with poor financial results (like CAT’s 1Q 2013).  Large buybacks are often associated with underperformance (see RRD or RSH, for example).  When CAT was outperforming in the past decade, it was adding capacity and doing deals amid a robust market outlook.  Now, aggressive internal investment appears less attractive.  


Magnitude Insufficient:  The announced buyback adds back cents to EPS, while the down-cycle in mining capital investment is likely to remove dollars.



Argument 2: Segment Models


Hard to Normalize: CAT changed its segment definitions, so gathering segment level history before 2009 is challenging.  Add in acquisitions, and it is really difficult to look back at how changes in resources-related capital spending impacted the different businesses.  Even management thinks so:


“In terms of what's normal, man, as I look back over the last few years in mining, it's a little tough to decide actually what's normal.” – Michael DeWalt, 4/22/13


CAT: Bull Thesis Review & 2Q Expectations - cv3



Our Forecast Range for a Flat/Declining Commodity Price Environment


Deep cyclicals like CAT tend not to have gentle changes in results over time.  Many analysts nonetheless model gradual change, even when the evidence suggests otherwise.  The table below assumes that the move higher in commodity prices is largely over – principally that metal and energy prices will not rise much faster than inflation in the forecast period.  Our March 2013 Mining & Construction Equipment presentation supports that outlook, but it is a key assumption for the forecast.  When commodity prices stall, resource-related capital spending reverts to maintenance-type levels in our analysis.


We don’t do point estimates, especially in cyclical names where long-term forecasts are likely to be significantly off.  If an investor is on the right side of the cycle, industry structure and valuation, we have found that performance follows.  That said, we were asked for specifics on our outlook for CAT segments.  We provide the table below to give a sense of our views, with supporting discussion underneath. If the estimates for Resource Industries look extreme, just look up the volatility in results at Bucyrus, or in the shipbuilding industry or housing construction market.  When the demand cycle moves, revenue and margin swing hard in the same direction.


CAT: Bull Thesis Review & 2Q Expectations - cv444




Resource Industries


The decline in mining capital spending is not a deviation from normal levels, but a return to them.  Resource Industries is dominated by mining capital spending, with coal, iron ore, copper, gold and other minerals as key end-markets. 


Aftermarket Sales:  Many investors seem to believe that Resource Industries sales are more than half parts and service.  We think the actual number is a lower, perhaps only 25%-40% depending on the year.  (If it were half of sales, CAT would open every presentation with it, and rightly so.)  We see CAT’s dealer network as a liability in the mining equipment space, where there are only a couple hundred relevant customers globally.  For example, JOY does derive slightly more than half of its sales from aftermarket products – but it does not have a dealer network to support.  Dealers take a sizeable cut of the aftermarket revenue, as CAT dealers typically focus on service and support.  As another indication, CAT reports total Bucyrus revenue (excluding divestitures) as $4.76 bil in 2012.  Finning bought its distributorship for $465 million and reports that in the ~half year that it owned it, the distributorship generated $233 million in revenue.  If we assume the same service-to-new-products revenue mix for the Bucyrus distributorship as Finning and assume a similar sales multiple for the other divestitures, we get an aftermarket share of around 30%-35%.  It is also worth noting that if mining activity weakens significantly, existing equipment may be parted out, reducing aftermarket sales.  CAT should simply disclose the number in an unambiguous, wink-free way.


Scale & Duration of Decline:  We expect to see a 70% decline, give or take about 10 percentage points, in mining capital spending in total over something like four to seven years.  That is derived from an expectation that mining capital spending will return to maintenance levels (see slides 7 & 8 in our recent CAT slide deck for how we get there).  Near maintenance levels of capex is what miners normally spend.  That is because mining is a sub-GDP growth industry that tends to add its capacity in huge lumps (like in the ‘00s and the ‘70s).  That capex decline includes a portion of parts and service, since those are often capitalized expenses.  Importantly, CAT’s backlog already contains orders stretching out quarters and years, so investors can look ahead further than the reported topline. 


Margin Pressure:  Mining equipment companies added significant manufacturing capacity over the past decade.  If our view of the pending market decline is correct, it would be internally inconsistent not to model significant margin pressure.  CAT, Komatsu, Hitachi, Liebherr and others are likely to be more price competitive when backlog duration is short and capacity is available.  JOY’s operating margins ranged from slightly negative to a high single digit from 1.  In the resources-related capital spending boom, JOY’s operating margin nearly tripled.  Given the topline outlook for mining capital spending, the margin assumptions presented could prove generous.  In the early 1980s, following the last resource-related capital investment boom, competition from Komatsu helped drive very significant losses at CAT.


So Much Hasn’t Hit Yet:  Of course, dealer inventory adjustments are a major factor in the 1Q sales decline and CAT’s own inventory adjustments also negatively impacted margins.  However, Resource Industries has only reported one quarter of YoY revenue declines.  It seems a bit premature to call the end of a likely multi-year reversal in this segment after just one quarter.  Resource Industries pricing was still up in 1Q.  Pricing can hold for a little while as the industry works on backlog – like in 2009 – but a sustained downturn amid industry overcapacity is likely to produce intense price competition.



Power Systems


Resources Exposed:  We have generally referenced “resource-related” capital investment as opposed to “mining” capital investment.  That is so we could also reference energy-related capital investment at Power Systems.  While CAT has not done a great job at breaking down end market exposures for Power Systems, it is no stretch to suggest that the division is heavily exposed to oil & gas capital investment.  The division also has some exposure to mining capital spending, such as mine site power and locomotives.


Not As Big Of A Drop, But It Could Be:  Oil & gas capital spending also boomed in the past decade.  That helped growth in some of CAT’s highest margin Power Systems product lines.  We assume that Power Systems is half ‘resources’ exposed, with much of that exposure from oil & gas.  Even though oil prices, for instance, have held reasonably firm, they have still appeared to stall since 2010/2011, or even 2007.  Historically, stable commodity prices drive capital spending back toward maintenance levels.  Critically, large energy companies appear to have started cutting capital spending.  We have assumed drops in line with 1Q 2013 actuals, but oil & gas capital spending may well be the next shoe to drop for CAT if energy prices remain stagnant.


CAT: Bull Thesis Review & 2Q Expectations - cv5




Locomotives & Other:  Locomotive demand is exposed to commodity volumes. Sales should see slowing demand growth following a long period of significant investment by railroads (including mining railroads).  New locomotive emissions regulations ~2015 are a factor.  We assume the balance grows at a mid-single digit rate.




Construction Industries


Rebound Likely, Industry Competitive:  We expect a delayed but significant cyclical upswing in construction equipment.  We prefer developed market exposure in less competitive niche products to CAT’s broad product portfolio.  As a whole, the industry tends to be fragmented and competitive.  Even in a demand upswing, we do not expect Construction Industries to deliver margins comparable to those of Resource Industries near its peak. 


A Better Idea:  If an investor wants exposure to the rebound in construction equipment demand, they should buy a construction equipment company.  CAT’s profit outlook is not dominated by the outlook for construction equipment demand, in our view.  Even estimates that are above street expectations fail to deliver upside for CAT EPS.



Argument 3:  Mining Cycle Already Well Known


Not In Consensus:  From what we can see of consensus expectations, the “well known” impact seems limited to 2013, with remarkable improvement thereafter in 2014 and 2015.  If forecasters are looking for a one year speed bump, then the cycle is not known, or at least not well understood.


Not Unusual for Recognition:  In our launch deck last year, we included a table showing the up-cycle in Transmission & Distribution (T&D) equipment.  T&D stocks outperformed handily even after the huge northeast blackout in 2003, a demand sign that was hard for anyone investing in NYC, Boston or CT to miss.  That cycle was well recognized, but it still worked.  CAT has so far, too.  Mostly analysts hesitate to show how long and positive an up-cycle can be.  The opposite tends to hold true on the downside.


CAT: Bull Thesis Review & 2Q Expectations - cv6



Investors Are Not Going To Look Through It:  We do not know many analysts or PMs with the patience to ride out a four to seven year down-cycle. We expect resources-related capital spending to go down and stay down for decades.  There is no other side to see. 




2Q Outlook


1Q Weakness vs. 2Q Expectations:  Given how spectacularly weak 1Q 2013 headline results were, 2Q may well improve sequentially.  Inventory destocking is supposed to slow from 1Q 2013’s pace and production is guided to improve along with it.  However, just as in 1Q, we do not expect the market to respond much to headline results.  We also think there is a small chance that management drops the increasing unattainable $12-$18 2015 EPS guidance.


Implied Orders Matter More:  Implied orders are likely to matter more than the headline number (implied orders = period revenues – change in backlog).  These stabilized in 1Q amid a short-lived rebound in key commodity prices.  Weakness in iron ore, copper and coal is likely to generate a renewed decline in implied order rates this quarter.  For all of the focus on dealer retail sales, they lag.  Orders tend to lead.  This is where we expect CAT to struggle in 2Q and in 2H 2013.  Declines in implied orders are important for our short thesis.  If we are correct, those declines should start to push 2014 expectations lower, along with normalized profit expectations.



CAT: Bull Thesis Review & 2Q Expectations - cv7



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