On its 2Q earnings call, CAT hinted at potential new cost actions to be specified in coming weeks. While we do not know exactly what they might be, we discuss some expectations below. More aggressive cost reductions may make for a good press release, but the new cost cuts are unlikely to represent a meaningful acceleration from the actions already taken. As we see it, high costs are not the issue for CAT; rather, a deflating bubble in resources-related capital equipment, increasing price competition and overpriced/poorly-timed investments are the problems. In addition, deep cost actions could further undermining the 2009 downturn comparison we hear so much about from CAT longs. The shares may rally on a headline cost cut announcement, but we would look to fade that optimism.
This Is Not 2009: CAT Out of Cost Flexibility?
The current downturn for CAT bears little resemblance to the one during the financial crisis. For starters, the drop in demand is specific to CAT’s end markets, not broader economic conditions. Mining equipment prices increased in 2009, while they have started to fall as of 2Q 2013. CAT apparently had “trough plans” ready in the last downturn, while frequent guidance cuts suggest that CAT has been caught off guard by recent weakness. Notably, the inventory situation was much more favorable in 2008/2009. To quote Jim Owens, “I think our ability to do a better job on the pricing front than you might have expected goes back to inventory management and not overstocking dealer inventories with product that was in the wrong product in the wrong place…” (James W. Owens, not Doug Oberhelman, 8/3/2009)
To the extent upcoming actions require a costly restructuring, it would add an additional difference between the current downturn and CAT’s performance through the financial crisis. In 2009, CAT was impressively able to rely on its flexible cost base until Chinese stimulus, among other factors, buoyed both commodity prices and CAT’s resources-related capital equipment end markets. In the current downturn, CAT has already been flexing that flexible cost base. We suspect that recent acquisitions and capacity additions have reduced CAT’s cost flexibility. A deeper restructuring may suggest that CAT is running short of cost flexibility.
What to Cut: Labor, Assets, Capital Spending?
Headcount Reductions: Been There, Done That
CAT has already reduced headcount, with a YoY decline of about 13,500 employees worldwide, net of divestitures and including declines in its ‘flexible’ workforce. Full-time employment was 122,402 at the end of the second quarter and we estimate that ‘flexible’ employment adds 15,000-20,000 more.
Excess headcount does not appear to be CAT’s key problem. Revenue per full-time employee compares favorably with historical averages, especially considering that Bucyrus registered lower values than CAT prior to acquisition. While growth in flexible labor reduces comparability with earlier periods, flexible labor should not represent a cost action challenge. While we think headcount was implied as a cost target on the 2Q 2013 earnings call, we do not expect cuts to extend beyond a single-digit thousand number. In so far as that is the case, the new actions could be smaller than those already taken over the past year. They may just be more expensive. The headcount actions taken so far have not boosted CAT’s results relative to expectations, in part because they do not solve the key problem, which is declining demand for resource-related capital equipment.
Assets: Facility Rationalizations and Asset Impairments
As we see it, CAT overinvested in resources-related capital equipment assets. It significantly overpaid for acquisitions and added production capacity at the peak of the cycle. Receivables growth amid falling equipment revenue suggests that recent sales might have been even lower without the extension of credit. A BUCY goodwill impairment would probably be greeted as good news, if for no other reason than it could stop being a question on earnings calls. Unfortunately, that testing will likely have to wait until year-end.
Downscaling or closing facilities beyond the current rolling plant shutdowns and reduced schedules may prove messy and time consuming. CAT’s facilities are frequently integrated among the different segments and serve different steps in the production process, potentially making it challenging to isolate Resource Industries and weaker areas of Power Systems. Facilities that can be isolated have already had layoffs in some instances. Problematically, CAT has added capacity at many mining exposed plants in the last few years, potentially leaving lightly depreciated assets on the chopping block. Challenges aside, we suspect that this is an area where CAT could use more aggressive actions.
CAT’s guidance for capital spending in 2013 is for less than $3 billion, matching consensus at just under $3 billion. It is odd that CAT has continued to add PP&E in Machinery and Power Systems amid a downturn. This may be a desire to complete “in flight” capital projects, but capital spending slowed relative to depreciation and amortization in 2Q 2013. CAT may well take capital spending down more aggressively in the back half of the year, which we would generally view as a good idea amid excess capacity in many product areas.
Charges and Guidance
To the extent CAT management takes charges in an announced restructuring, it could provide an opportunity to revise guidance. CAT’s management is likely under significant pressure to meet its current $6.50 guidance mid-point, which we think is it is not likely to reach (as discussed in When 795F’s Fly). If CAT uses charges to redefine guidance or back out operating expenses as special, it could backfire. Investors may well be tired of having their expectations managed (see Feeling Managed?). While it might boost the stock for a day, we think it would be a bad move for a company increasingly under short-seller scrutiny for its reporting.
How Worried Should Shorts Be?
While a significant cost reduction headline could squeeze short sellers (short interest has increased this summer to nearly 5% of the float), we would view that squeeze as an exit opportunity for longs stuck in the CAT value trap. CAT does not really have a cost problem; it has an end-market demand problem, a historical capital allocation problem and an industry overcapacity problem. CAT’s flexible cost structure has been delivering, but cost actions cannot correct those broader challenges. To the extent that CAT management again tries to manage investor expectations, those maneuvers may meet increased investor skepticism. Given what significant restructuring actions might imply for CAT’s market outlook and cost flexibility, CAT could even decline on such an announcement.