We Were Mostly Right, But Too Optimistic On Restructuring
We’ve been “short” CAT for about the past year and a half, but this is the first quarter where we were not bearish enough. We had expected management to present the strong corrective measures hinted at on the 2Q 2013 call. Instead of a restructuring program, CAT management sounded a bit helpless – revenue was just dropping too fast. As the totality of the miss and lack of credible response sink in, we expect continued pressure on CAT shares. CAT’s 2014 outlook implies an earnings decline from an already weaker than expected 2013. CAT sell-siders are going to need to cut 2014 to ~$5.50 from ~$7, give or take, which will be hard for even the 13 analysts with Buys to spin as positive. CAT is not in a good way with the Street.
Troubled Industrial companies usually have a “go to” playbook. They trash a quarter or two with one-time impairment charges and accruals, boosting future earnings with a current profit hit that gets written off as one-time. Analysts may complain that those future higher earnings are just the result of previous charges, but the market usually gives a partial pass. Then that troubled company does some sort of “portfolio reshaping”, with a few small divestitures and a few large acquisitions with generous acquisition accounting. As the charges/accruals run out, they just rinse and repeat. We’ve all seen variations on this before, with some companies achieving greater success than others. It gets the management teams through the down-cycles with a bit less pain and bad press.
We had assumed CAT would adopt a version of this playbook in 3Q, finally recognizing that the market for resources-related capital equipment is going to grind lower, not turn higher. Even if CAT management truly believes that mining capital spending will come back, a series of charges would make it look like they were doing something – even if it was only protecting headline EPS. They could then do a few acquisitions (looking at you MTW – mining shovels and cranes scream synergies, right?). Acquisitions could stem the nasty revenue decline, allow CAT to stop repurchasing overvalued shares and, most importantly, give management something less gloomy to talk about.
On the earnings call, CAT oddly disavowed much of this strategy. We are “short” and even we had expected more positive news on this front.
“And in terms of physical capacity, it doesn't make any sense to close down an assembly line or get rid of machining equipment that you've put in place. So I think just from taking out physical capacity standpoint, there's just not a lot of scope to do that... But we're going to need the physical capacity.” – CAT 3Q 2013 Earnings Call
As we read that, our response is “actually, no, you are not going to need that capacity.” While we could be wrong, that expectation lies at the core of our CAT thesis and rests on pretty solid data and reasoning. Nonetheless, CAT should be telling us that it is rationalizing capacity and will take a bunch of charges – that is the playbook. It will be harder to do that convincingly with the comments above.
Why Can’t CAT Follow The Playbook?
Perhaps management is unwilling to accept an implied mea culpa on billions in bad investments in mining equipment. Action to reduce capacity or focus acquisitions elsewhere might be perceived as an admission of bad choices.
The lack of M&A is less of a surprise; the current management team’s track record on acquisitions is poor. The Board would probably be very skeptical of any proposed transaction. Given the publicity around the Siwei fraud and the BUCY purchase price allocation, transaction execution would probably not be much fun, either.
Why not ‘kitchen sink’ 3Q and then do a deal? Maybe CAT is waiting for 4Q 2013 to combine it with goodwill impairment testing. Maybe they are just responding really, really slowly – even though they responded very quickly in 2009. Maybe Kynikos’ “accounting issues”, the Siwei fraud and the huge dealer inventory problem have attracted the attention of regulators and management is distracted or wants to stop digging. Maybe senior management is about to turn over and the Board wants to leave the restructuring to the next team. The last one seems a good guess.
If the market hates uncertainty, CAT’s lack of a reasonable playbook is likely to foster continued share price weakness. We may be reading this all completely wrong, but the lack of a clear response to CAT’s challenges struck us as a key aspect of CAT’s release. What, exactly, are the longs looking forward to? Are they just going to wait for resource-related capital spending to turn up (think 2025)? As the charts below show, mining capital spending is already cyclically inflated and likely on its way lower. Please do not email that now earnings expectations are low enough – we get that every quarter. 2013 is low enough now, excluding a possible 4Q goodwill impairment charge, but 2013 is almost over. Expectations for the out years are still too high in our view.
We have held three “black book” calls and written numerous notes outlining our bear case for CAT. Our thesis has played out well so far, but all the while we had assumed that CAT would go to the playbook. While it may be interesting to see what CAT does instead, we do not see alternatives that are likely to benefit the share price anytime soon.