CAT: Blinded by the Sun

Overview

A traditional sell side firm upgraded CAT today in a lengthy report that we suspect most longs won’t read in its entirety.  Rather than respond to a boring write-up with another boring write-up, we will mostly focus on what is missing from that report: all the bad stuff. 

Calling the bottom in CAT is a strategy that is not working.  Investors and sell siders have been making that call since before Resource Industries had even reported a down quarter (See It Hasn’t Started, So It Isn’t Over).  CAT is the 3rd worst performing Industrial YTD in the S&P 500, so arguing that the bottom is in because the shares are holding 80 as the market rips to all-time highs is a bit facile.  Why even bother trying to call a bottom when being long CAT is not working? 

CAT: Blinded by the Sun - bh1

Of course, we were not born yesterday.  Management provides special access to a sell sider and select clients.  Shortly after, said analyst upgrades the stock and writes a glowing report.  We are sure that the SOLAR/dealer visit trip was great.  We’ll leave the rest to the reader’s imagination.

 

Leaving Aside the Bad Stuff, CAT Is Great!

 

Trough Earnings

 

We see the $4.50 2014 EPS figure is a straw man.  We agree that CAT should produce more than $4.50 in 2014 EPS, excluding charges and any issues at CAT Financial, but why does that matter?  2014 was last interesting six months ago.  The battleground has moved to 2015 and later, where we see little hope of a rebound.  It has also moved to the CAT boardroom and CAT Financial.  The assumption that Power Systems is a stable source of profitability is deeply flawed, as is the assumption that Resource Industries cannot operate at a loss, in our view.

Multiple of Trough Not Useful For Generating Alpha

 

CAT underperformed the market nearly continuously from the late 1970s until 1992.  The peak/trough multiple analysis is unrelated to generating Alpha, so it is worthless.  It gives a buy signal in ’82-’83, ’84-’85, ’87, then finally successfully in ’91-’92.  Alternatively, our process – understanding the cycle, the industry structure and the valuation – has worked well and we have published real-time write-ups demonstrating it for the past year and a half (when we joined Hedgeye).

CAT: Blinded by the Sun - bh2

Cyclical Industries Can Lose Money

 

The Armageddon scenarios presented are really not that bad in the context of a deep cyclical like CAT.  Why exactly can’t Resource Industries operate at a loss?  Resource Industries margins are collapsing amid vast industry overcapacity.  Pricing is increasingly competitive, with the decline slow to hit the Income Statement as the company works off better priced orders in backlog.  Resource Industries revenues have only declined for three quarters, so it is still very early in the adjustment process.  What would Resource Industries profitability look like with industry capacity utilization at, say, 30%?   Mining capital spending is likely to remain at around maintenance levels, i.e. normal levels, for something like the next decade, as we see it. 

Where Is CAT Financial?

The recent credit metrics have looked questionable at CAT Financial, so we guess it was probably easier just to leave it out.  It is just the leveraged division which comprises about 40% of the firm’s assets and is a key focus for bears and short sellers.  Given the endless focus on the comparatively tiny (in terms of assets and risks) SOLAR turbine business, a few sentences might have been in order.

Mining Exposure Outside of Resource Industries

Part of the reason for weakness at Construction Industries is that larger pieces of equipment were often sold to the mining industries at high margins.  Locomotives at Power Systems are also sold to mines on occasion (see EMD website).  Mine site power is also a factor at PS.

Acquisitions & Capital Allocation

Comparing old CAT to current CAT is not exactly apples for apples.  CAT has gone through a period of terrible capital allocation, in our view, with vastly overpriced acquisitions and soon-to-be-unutilized capacity additions.  The misallocated capital is likely >$10 billion in the last few years and has yet to be recognized, by our estimates.

 

Management Credibility & Strategy

Given what has happened at CAT in the last year or two, some discussion of management strategy or credibility should probably have been included, right?  We expect a management change at CAT in the next year or two, with a new team coming in to lower the performance bar.  How do you write a 47 page report about a company that needs a turnaround without mentioning the name of the CEO or discussing strategy?

Competitors Missing

Komatsu, Hitachi and other competitors seem to be conspicuously absent from the discussion, which is an important omission for both Resource Industries and Construction Industries.  As mining equipment demand dries up, these competitors are refocusing on construction equipment, negatively impacting price.  In the instance where Komatsu is mentioned, it is about their coal commentary, not their competitive response to an evaporating mining equipment market.

Top Down View of Energy Capital Spending

We discussed the long-term outlook for Energy-related capital spending in our Industrials Fishfinder note this morning.  Energy-related capital spending boomed along with other resources-related capital spending and has since started to decline.  We see some risk that Power Systems is in fact the next shoe to drop.

CAT: Blinded by the Sun - BH3

Dealer Inventories

Dealer inventories should be looked at on a dollar basis, not as a % of sales.  Finning has about 2x the value of inventories of Westrac and Toromont combined, by our estimates.  Finning still has a lot of inventory to work off as we see it.  CAT provides inadequate transparency on this issue, we think.

We’ll Stop Here…

If CAT were composed exclusively of the SOLAR turbine business, the company’s outlook might be rosier.  Unfortunately, SOLAR is a small part of total CAT.  Of course, if the sell side were composed entirely of analysts actually trying to make good calls, markets might function better.

Instead, we think there is little reason to expect that this is the inflection point for CAT or that all of the bad news is priced in.  Multiple of peak/trough work would be interesting if it generated useful predictions – it just doesn’t.  We see a scenario for CAT much more like the 1980s, where the boom in resource-related capital spending drops over a long period of time amid tough competitive pressures.  We also see serious strategy and management deficits at CAT, the eventual resolution of which may result in a greater capitulation in the shares.  Maybe then we join the search for a CAT inflection….