CAT: Downtrend Resumed?

Takeaway: CAT’s bounce may be over.

Is CAT the new GE?


We see CAT as caught in a multi-year downswing in resources-related capital spending. Since mid-2012, CAT shares have lagged the index by 23%, but have outperformed YTD amid large dealer inventory builds, easing comps for Resource Industries, and pre-buy activity in Energy & Transportation.  In context, however, the outperformance from late 2013 to mid-May looks like a bounce within a longer-term downtrend.


CAT: Downtrend Resumed? - cater1



CAT shares have resumed their relative underperformance since mid-year.  In 2H 2014, dealer inventory drawdowns and challenging markets outside of the U.S. should pressure Construction Industries margins.  At Resource Industries, price declines in key commodities signal ongoing challenges that can be worse than weak mining capital spending.  Energy & Transportation may suffer in 2015, after benefiting in 2014, from new emissions standards.  In many ways, what we are suggesting is that CAT may be a new GE: a large index constituent poised to underperform over a long period…occasional painful bounces aside.



Resource Industries (RI)


No Rebound Coming:  While investors may want to write-off Resource Industries, management does not.  CAT remains positioned for a mining investment rebound, with significant capacity still in place.  We believe that there is no meaningful rebound pending, as declines in resources-related capital spending represent a return to normal levels, not a decline from them.  Equipment pricing is likely to continue lower as better priced orders exit the backlog.


It Can Be Worse Than Lower Mining CapEx: When Phelps Dodge was struggling, their plan to manage low copper prices included: “suspended stripping in a higher cost portion of the mine and will allow for the redistribution of a variety of mining equipment…” High prices yield declining ore grades; low prices improve ore grades.  Equipment from curtailed or shuttered mine sites can find its way to would-be buyers of new equipment, pushing new equipment demand well below normalized levels.  That is pretty typical for a severe capital equipment downturn.  Credit risk is another significant exposure.


Iron Ore, Copper , Coal: Key End-Markets Weakening


Iron Ore: With iron ore prices back on the decline amid ongoing massive supply increases, it is widely expected that higher cost iron ore mines will close.  ‘Low’ prices generally result in mine closures after some pain, although it wouldn’t be shocking to see Chinese mines receive some sort of support to maintain local economic statistics.  Struggling or shuttered high cost mines create challenges for CAT and other makers of mining equipment beyond weak orders and deferred maintenance.  Financed equipment can lead to credit losses; does anyone really want to go pick-up a rope shovel at a bankrupt Australian mine?  The iron ore downturn may well be in its early stages.


CAT: Downtrend Resumed? - cater2


The idea that iron ore prices are ‘low’ is also a bit fanciful.  Less than a decade ago, iron ore sold below $20/ton and often below $15/ton. Our read is that the marginal cash costs for 2015 production, a level at which prices would be ‘low’ or near a ‘bottom’, are well below current spot prices.


Copper:  We reviewed the long-term dynamics of copper in our Mining & Construction Black Book last year.  Copper supply growth is, by our estimates, set to expand rapidly in 2015 and 2016.  Prices have weakened from $3.73/lb at the beginning of the year to $3.07/lb.  While not as serious as iron ore, supply growth may further pressure prices.


Coal:   U.S. coal and natural gas prices received a boost from last winter’s ‘polar vortex’.  Prices for both have since weakened.  With the EPA’s MATS rules set to take effect in April 2015, the outlook for U.S. demand appears negative.  Coal companies have already shown some credit issues (JRCC, for example).  The EIA expects coal consumption “to fall by 2.6% in 2015, as retirements of coal power plants rise in response to the implementation of the Mercury and Air Toxics Standards[MATS]…”. Continued pressure on coal mine investment seems likely.


RI Dealer Inventory:  Declines in dealer inventory were a major headwind in 2013, adding to the broader collapse in mining equipment demand.  Recent dealer sales have been slightly less terrible, likely due to easing comps and a brief period of higher coal prices.  CAT’s North American Resource Industries dealer sales popped up as US coal prices increased following the ‘polar vortex’ last winter.  We expect dealer inventories to decline in 2H 2014, but at a slower rate than 2H 2013.  


CAT: Downtrend Resumed? - cater3



Construction Industries (CI)


Dealer inventory builds combined with stronger end markets helped Construction Industries report record 1H 2014 margins.  However, CI dealer sales growth slowed noticeably in recent months.  Slowing demand and dealer inventory reductions in the back half of the year should depress margins from recent highs. 


1H 2014 Context and Estimates:  To give some context to the dealer inventory builds in 1H 2014 and the drawdowns expected for 2H 2014, we’ll throw out some of our guestimates and understandings.  CAT has previously indicated that “Dealer inventory, by and large, they have somewhere … around 3.25-3.5 months of inventory”. (DeWalt, 11/22/12)  Excluding parts, this suggests CI dealer inventory of roughly $4-$5 billion.  If that estimate is accurate, the 1H 2013 to 1H 2014 change in dealer inventories was a surprisingly large 20%-25%, or ~10%-11% of the segment’s 1H sales (dealer inventory drawdown of ~$400 million in 1H 2013 vs. build of ~$700 million in 1H 2014).  The gap between dealer sales growth and CAT Construction Industries sales growth matches the ~10%-11% estimate reasonably well in the chart below.


2H 2014 Tougher Comps:  In addition to slowing dealer sales, the inventory drawdown guided for 2H 2014 looks set to create difficult comparisons to 2H 2013.  We estimate inventory reductions in both periods, but 2H 2014 looks set to be about $1 billion larger.  Given the high incremental margins that CAT has been reporting for CI, it seems likely that margins will decline meaningfully.  If CAT reports the flattish CI revenue growth and significantly lower segment operating margins, as we expect, it seems likely that the recent CI optimism would fade.


CAT: Downtrend Resumed? - cayer4



Energy & Transportation (E&T)


2014 Prebuy Ahead of Big Engine Tier IV Final:  In 2H 2014, E&T may well continue to perform well.  2015 looks like a different story, however.  CAT has many strong attributes as a company, with its huge engines for gensets, mining/heavy construction equipment, and locomotives being among its most dominant.  Tier IV Final U.S. emissions standards go into effect for these large engines in 2015.  While a pre-buy is evident in locomotives, it is also a likely significant factor in certain other large engine markets. Cummins noted the following on power generation equipment:


Quarter-over-quarter increases were driven largely by increased power generation demand in North America and strong truck and construction demand in Europe ahead of the Tier IV Final and Euro VI emissions regulations.” – CMI Investor Presentation 2/6/14


Recent declines in natural gas/oil prices may prove an additional headwind.  Better orders from oil and gas end-markets helped in 1H 2014, partly due to an abnormally cold winter.  The disclosed dealer sales miss large parts of the E&T product portfolio, but a rough correlation to natural gas/oil prices seems likely (with a slight lag).


CAT: Downtrend Resumed? - cater5


Dealer sales growth has slowed in the last few months, which has corresponded to declining E&T segment topline growth.  It will be interesting to see how much E&T revenues and margins are impacted by Tier IV in 2015.  We think it may prove an underappreciated risk.



CAT: Downtrend Resumed? - cater6




It seems the combination of dealer inventory builds, higher N.A. coal demand, and a Tier IV Final pre-buy drove a sharp bounce in shares of CAT relative to the sector.  We did not anticipate those events effectively, but continue to improve our process and communication.  Nonetheless, it appears to us that CAT’s bounce is over and longer-term underperformance has resumed.  In the long-term, we think CAT may look like GE a decade ago: a large index constituent to underweight or short pair against better positioned machinery names.  


New Best Idea: Short SBUX

We are adding SBUX to the Hedgeye Best Ideas list as a short.


We are hosting a Black Book call next Thursday, September 18, 2014 at 11am EST to run through our thesis and field questions.  We will send out dial-in information and materials for the call next week.

SBUX: The Seven-Year Itch

It’s been seven years since Howard Schultz penned his now famous memo to management and employees, outlining where the company had gone wrong and what it needed to do to get back on track.  It has also been six years since I turned positive on Starbucks – but nothing lasts forever.


McDonald’s went on an eight-year corporate revival before it lost its luster and we fear Starbucks is nearing the end as well.  In this presentation, we will outline a number of concerns we have with the company leading us to believe that the street is overly optimistic about its future prospects.


I recently read that Harvard Business School Professor and Historian Nancy Koehn has studied Starbucks and its leader, Howard Schultz, for nearly 20 years.  She recently released a new HBS Case Study, “Starbucks Coffee Company: Transformation and Renewal,” which traces “the dramatic arc of the company’s past seven-plus years – a period that saw Starbucks teeter on the brink of insolvency, dig deep to renew its sense of purpose and direction, and launch itself in new, untested arenas that define the company as it exists today.”


While all of this may be true, I too have been following Howard Schultz and Starbucks for over 20 years.  Unlike Ms. Koehn, however, I did not go to Harvard and I am not a HBS Professor.  But I did release a Hedgeye Black Book in early 2009 detailing why I believed Starbucks was a great company and the stock was a great buy.


Today, while Starbucks is still a great company with a strong management team, the stock is far less attractive.  More specifically, and perhaps to the heart of the topic, I believe the company’s domestic business is maturing and management is rapidly attempting to stem this decline by deviating from its core.  Let us not forget that sentiment is near an all-time high.  To me, this HBS Case is simply another example of a Starbucks “top.”


Our call on SBUX will focus on:

  • Menu trends suggest increased complexity and slower throughput
  • Decelerating same-store sales and traffic
  • Rapid diversification away from the core business
  • Proprietary Hedgeye survey confirming new menu initiatives are not resonating with consumers
  • Significant and sustainable increase in coffee costs
  • Peak margins
  • Street optimism and overconfidence


Howard Penney

Managing Director



Fred Masotta


New Best Idea: Short SBUX

We are adding SBUX to the Hedgeye Best Ideas list as a short.

We are hosting a Black Book call next Thursday, September 18, 2014 at 11am EST to run through our thesis and field questions.  We will send out dial-in information and materials for the call next week.


Email if you would like access to the call.


Howard Penney

Managing Director



Fred Masotta


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
  • SHORT SIGNALS 78.35%

Hedgeye's Berger with the latest intel on Intel $INTC

athenahealth: Can You Afford to Be Short This Chart? | $ATHN

Takeaway: We don’t think you can be short this chart.

Update: The article below was posted on Bloomberg earlier today (see screenshot) after originally being published on Seeking Alpha here

athenahealth: Can You Afford to Be Short This Chart? | $ATHN - athn99


athenahealth: Can You Afford to Be Short This Chart? | $ATHN - athn2


By Tom Tobin


We recently developed a web-based survey tool to track the number of athenahealth (ATHN) clinical customers. Through today, the annualized trend is running near 20%. That’s good enough to stick with our “Best Idea” long thesis which we presented on August 14th.


The ATHN short thesis revolves around valuation and a negative outlook for athenahealth’s opportunity in the hospital market.  We think there remains a big opportunity in the physician office.  The data, so far, support our outlook.


We don’t think you can be short this chart. But with 20% short interest, clearly there are those who disagree with us.


Tom Tobin is the Healthcare sector head at Hedgeye. If you would like more information on his research, please email


HAIN: Margin Pressure Looming?

In case you missed the KR call today, we’d like to put out there part of the Q&A where management spoke about natural and organic products.  Importantly, KR said “we saw strong double digit unit and sales growth in Simple Truth and Simple Truth Organics.”  But, perhaps more importantly, the company went on to speak about margin pressure in the natural and organic segment.


See the interchange below:


<Q>:  I guess just following up on Kate's questions earlier on natural organic.  You mentioned innovation as a big part of the growth you're seeing in the channel of the response and the consumer.  Can you provide a little more detail on the number of SKUs you've added in these categories, the additional rollouts you plan and how many of the sales you think has been incremental?  And then as a corollary there, how you think about the margin associated with this category versus how you think about the rest of the store?


<A>: In terms of incremental, it's hard to say.  There is lot of switching that goes on today between natural and basic type of products.  As we have mentioned, we expect our Simple Truth brand to be a billion dollar brand this year.  So customers are as interested today and are as engaged in natural and organic as they've ever been.  Also, we don't talk a lot about organic produce, but that's a category that continues to grow. It could probably grow faster if supply was better, but we continue to enjoy large sales growth in that particular area.


<Q>: And just so, again, on I guess any additional SKUs that you're planning to roll-out on top of what you've done already and also how you think about the margin in these categories, I guess now and going forward.  Thank you.


<A>: Yeah, SKU count continues to increase, and the departments continue to grow in many cases, both on the private label side as well as the branded side. Margins, I tell you what, there's more margin pressure now on natural and organic than there's ever been.  It seems that it's becoming more and more of a competitive category, and so although margins tend to be better in natural and organic, I don't know if that's going to continue, you know, for the foreseeable future.

Our bearish bias on HAIN is in part based on the fact that they don’t have the margin structure to defend against an increasingly competitive environment.


So far we’ve been wrong with our call, but the evidence supporting our case continues to pile up.  If we continue to be on the wrong side of this trade it will be because the market thinks the company will be bought out.


Howard Penney

Managing Director


Fred Masotta


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