Filing a 10-Q at 4:30PM on a Friday is a mistake for a company that has recently been said to have “accounting issues” by one of the world’s best known and most diligent short sellers. Regardless of the content, a Monday morning filing would have been less provocative. We have looked through to see what CAT may have been hoping to deemphasize.
The disclosure that jumps out is that CAT had “incorrectly” reported impaired loans and finance leases at CAT Financial. Even the most ardent CAT optimist has to acknowledge that there have been issues with due diligence at CAT (e.g. Siwei). “Incorrectly” disclosing impaired loans and finance leases may add to the perceived lack of management attention. Having investors focused on a new red flag at CAT Financial is unlikely to be positive; cash has poured into receivables in recent years to support equipment sales, growing the unit’s infrequently discussed $35 billion in assets.
We also note additional language that disagrees with the history of resources related capital spending. When commodity prices stall or decline, resources-related capital spending should return to maintenance-like levels over time. CAT’s language suggests that they do not believe that the decline in Resource Industries sales is part of a return to normal levels of demand, not a departure from them.
There are other odds and ends, the key aspects of which we think can be gleaned from the quarter’s press release and earnings call. It is not as though CAT reported an unexpectedly strong quarter.
Incorrectly Reported Impairments
Here is the new disclosure:
“During the second quarter of 2013, we changed the classification of certain loans and finance leases previously reported as impaired. While these loans and finance leases had been incorrectly reported as impaired, the related allowance for these loans and finance leases was appropriately measured; therefore, this change had no impact on the Allowance for credit losses. The impact of incorrectly reporting these loans and finance leases as impaired was not considered material to previously issued financial statements; however, prior period impaired loan and finance lease balances reported in Notes 4 and 8 have been revised.” – CAT and CAT Financials’ 2Q 2013 10-Qs
At first, the disclosure does not look all that interesting. The impaired items were previously overstated and the accruals are reported to have been accurate. However, the magnitude of the incorrect reporting and the lack of corrected historical replacement financials are of some interest. Consider the table below:
This new disclosure raises questions, at least for us. Did CAT’s management not realize that the disclosed Recorded Investment In Impaired Loans and Finance Leases With An Allowance was being incorrectly reported by ~30%-50% for at least a year? Did CAT change the methodology to identify impaired loans to reduce the current reported balance and, presumably, those going forward? Is this a red flag indicating further incorrect disclosures at CAT Financial or efforts to manage something? We are pretty sure that CAT management does not want to be asked those kinds of questions following Siwei, Chanos and recent guidance cuts.
We do not want to make a mountain out of a mole hill, but context usually matters and these issues are often not isolated to a single item. At the very least, we would have preferred some background on the cause of the incorrectly reported values.
What is “Normal”
We continue to think that the boom in resources-related capital spending was a deviation from historical norms and that recent declines are just a step back toward them. CAT disagrees, judging by other comments and this disclosure on an anticipated cyclical recovery.
“Due to the substantial decline in Resource Industries' sales and the uncertainty around when cyclical recovery will resume, we have taken substantial action to adjust production levels and to reduce costs.” – CAT 2Q 2013 10-Q
This differing view may matter going forward in Power Systems, where many expect the stall in energy prices to have a different impact on energy-related capital spending (Power Systems) from that of stalled metals prices on mining capital spending (Resource Industries). But we note that Power Systems is also under pressure:
“The lower sales were mainly due to decreases in electric power and industrial petroleum applications.” – CAT 2Q 2013 10-Q