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Summary

We continue to see evidence that CAT’s challenges extend beyond its Resource Industries segment.  CAT’s divisions do not form a true conglomerate, as we see it.  Construction Industries shares key competitors, components and end-markets with Resource Industries.  Similar resource-related capital spending trends drive sales at both Power Systems and Resource Industries.  CAT Financial has credit exposure across CAT’s manufacturing customers, with potential stress in mining appearing this quarter.  These businesses fall under a corporate structure that continues to show instances of poor governance.  Rather than address these structural challenges, CAT's management seems to cling to unrealistic financial targets and demand expectations.  Long-term, we expect CAT shares to continue to underperform as investors recognize that ongoing declines in resources-related capital spending are a return to normal levels, not a decline from them.  

Highlights

Progress Rail Subpoena & Criminal Investigation:   Progress Rail, part of CAT’s Power Systems segment, received a grand jury subpoena “relating to allegations that Progress Rail conducted improper or unnecessary railcar inspections and repairs and improperly disposed of parts, equipment, tools and other items.”  The company was also “informed by the U.S. Attorney for the Central District of California that it is a target of a criminal investigation into potential violations of environmental laws and alleged improper business practices.”  It doesn’t sound like a favorable development.

CAT acquired Progress Rail in mid-2006 from One Equity Partners, a JPM (which has had its own Federal investigations of late) PE fund.   It was formerly the rail services business of Progress Energy and, later, helped form a rationale for CAT’s 2010 Electromotive Diesel acquisition.  Progress Rail was a big acquisition for CAT at the time (“only the second that we've done at or above $1 billion”) and we know a lot about it circa 2006 because it filed an S-1 prior to being acquired by CAT.  Progress Rail has exposure to public transportation services and short lines in addition to the Class 1 rails.  Union Pacific has been litigating a complaint regarding derailments from improper remanufacturing work, but the claims are very small.  U.S. Attorneys usually have high win rates and do not, to our knowledge, engage in frivolous investigations.  We will wait for more information, but the investigation is another possible notch against the CAT’s internal controls.

Excess Inventory Not Isolated to Mining:  It has become increasingly clear that CAT is not just facing challenges in its mining heavy Resource Industries segment.  For example, excess inventory extends to Construction Industries and Power Systems, with even “changes in dealer inventories…unfavorable for electric power applications.”  Even part of the “decline in petroleum application sales was due to the impact of changes in dealer inventory.”  The broad dealer inventory problem should raise yellow-to-red flags for investors, in our view.  How can nearly every relevant product category have excess dealer inventory?  It would seem broader than the years-old flawed implementation of the "lane strategy", since CAT is similarly facing excess company inventory. 

Mining Not Isolated to Resource Industries:  While hinted to on the earnings call, Construction Industries sales to mining applications reached the 10-Q with “The unfavorable mix of products is primarily attributable to relatively higher sales of small and mid-size machines which generally have lower margins than larger size machines which are also sold into mining applications.”  Further, competitors in mining equipment, such as Komatsu and Hitachi, are refocusing on construction equipment because of weak mining equipment demand, depressing prices and margins for construction equipment.  Mine site power and locomotives are also exposed to mining investment, and Power Systems is broadly exposed to resources-related capital spending (e.g. petroleum), in our view.

No Capacity Reduction Cure:  While management hinted that Resource Industries was not planning a major capacity overhaul, additional disclosure puts it in writing: “We are expecting lower mining sales in 2014 and are continuing our efforts to lower structural costs. In order to be well-positioned when the industry improves, we are working to reduce costs, but are not expecting to make substantial changes in physical capacity”  (emphasis added). We expect CAT to eventually undertake more significant restructuring at Resource Industries, including the removal of excess capacity.

Increased CAT Financial TDRs/Impaired Assets:  While it is a long section (has its own 10-Q) and worth a read, CAT Financial showed meaningful increases in TDRs and Impaired Loans and Finance Leases.  When combined with the issues highlighted last quarter on “incorrectly reported” impairments, the increase may be of interest.  Total Troubled Debt Restructurings (where a debtor/lessee is in financial distress and the lender has granted relief as a result of that distress) increased to $195 million vs. $159 million in the year ago period.  What is more interesting is that the “Mining” TDRs went from (apparently) zero in the year ago period to $123 million in the three months ended September 2013.    Mining equipment sales may be down, but CAT Financial Mining segment assets increased 10.4% YoY, interesting given the credit dynamics there.  Investors may start to focus on this exposure, particularly if metal/mineral prices soften.  CAT Financial was the best performing CAT segment last quarter - the only one showing revenue and profit growth.  Under the hood, it may also prove mining/resources exposed.  CAT Financial is not exactly leverage and covenant free.

CAT: Is "It" Spreading? (10-Q Review) - bvc

Warranty Language Change:  The language describing warranty accrual rate switched from “are developed for each product build month” to each “are developed for each product shipment month” (emphasis added).  While it does not appear relevant in its impact on the quarter (warranty liability was not very interesting from what we see), warranty accruals are noteworthy as an area of flexibility for manufacturing companies.

Some Good Stuff, Too:  The yen impact should start to decrease over the next few quarters and currency in the third quarter “was unfavorable $188 million primarily due to the weaker Japanese yen, as sales in yen translated into fewer U.S. dollars.”  Pension remeasurement is likely to help 2014, as the use of a quarter-end discount rate would “result in a decrease in our Liability for postemployment benefits of approximately $2.6 billion.”  We expect these impacts to be well exceeded by the ongoing headwind from declining resources-related capital spending.  Nonetheless, these items are minor positives for reported EPS.

Long-term, we expect CAT shares to continue to underperform as investors recognize that ongoing declines in resources-related capital spending are a return to normal levels, not a decline from them.  CAT’s apparent control issues may limit management’s strategic flexibility (e.g. attention, limit M&A) as it responds to these challenges.  While 2014 expectations are now at more reasonable levels relative to our expectations, we expect further weakness, not a recovery, in 2015.