Summary
Thursday’s earnings report should shift attention to 2015 expectations, with the market likely to focus on backlog and preliminary 2015 revenue guidance. While we expect management to provide a very wide guidance range for the segments, we also expect 2015 EPS to eventually come in near or below 2014 EPS. Last year's initial 2014 revenue guidance took a significant bite out of both consensus sales and EPS estimates. CAT will be giving initial 2015 guidance following a period of weakness in key energy, mining, and construction end-markets. As a result, we think there is a heightened likelihood that 2015 estimates resume their march lower in the near-term.
Key Points
Wind Changing Directions? Dealer inventory builds, a short-lived surge in coal production, and Tier 4 pre-buy activity supported 1H 2014 results, but the environment going forward looks far less supportive. Commodity prices, particularly in iron ore, oil and gas, and coal are generally much lower than 1H 2014 or 2H 2013. Dealers are expected to reduce inventories in 2H 2014 at a similar painful pace to that of 2H 2013, with guidance for drawdowns of ~$1.6 bil vs. ~$1.3 bil in 2H 2013. Construction equipment demand may also have slowed, as preannouncements from TEX and MTW suggest. It is hard to see order rates improving sequentially, pointing to either weak revenues or, more likely, further draws on the order backlog into 2015.
Expect Wide Guidance Range: While we do not know where management will place 2015 revenue guidance, we do expect that guidance will provide plenty of flexibility. A wide guide would likely allow management to avoid another 2013-esque series of credibility damaging guidance cuts. CAT’s markets have weakened in an increasingly uncertain global economy and recent growth concerns should provide a good pretext for incorporating ‘wide-ness’ into the 2015 outlook. Of course, a wide guidance range may be interpreted as the market as ‘we don’t know, but it doesn’t look all that good’, anyway.
Energy & Transportation Exposed: Increasingly, we expect the ‘action’ to shift into the Energy & Transportation (E&T) segment. Of course, mining capital spending has declined to more normal levels, and may worsen a bit given commodity price weakness and equipment pricing trends. Over time, we would look to the credit side of CAT for incremental interesting negatives in mining equipment. With oil prices near the lows of recent years and Tier 4 Final implementation in large engine in 2015, we expect to see pressure on E&T order rates and margins.
Tier 4F Beyond Locomotives: While gas compression is likely to remain robust, the other energy end-markets may be less so into 2015. CAT does not have a Tier 4 compliant US locomotive offering, and does not expect one, last we checked, until about 2017. Prime power gensets frequently go into off-grid applications like mining, oil production, rail, coal, steel, and agriculture. Reciprocating engine sales to other oil and gas applications, like rig engines, may also soften amid lower energy prices.
Source: Hedgeye Call with Jeff Leigh, Former Head of Finning Power Systems April 11, 2014
Our Expectations: We think a more reasonable 2015 EPS and E&T revenue expectation is at or below 2014. We expect an E&T downshift leading the decline on a softer energy market and Tier 4 Final implementation. We also see pricing in mining equipment continuing to weaken, with credit developing into a more relevant factor. Construction Industries may continue to perform on the top line, but faces record margin compares in 1H 2015. That doesn’t sound to us like a recipe for the 5% ($55.1 bil to $57.8 bil) sales growth or 13% 2015 EPS growth ($6.26 for 2014 to $7.08) implied by consensus estimates.
Where We Could Be Wrong: CAT could have a larger cost reduction program than we currently expect. Share repurchases boost EPS, and large or numerous acquisitions can impact reported sales and EPS. Significant stimulus, particularly in China, could help re-inflate commodity prices. Dealer inventory changes can also be a bit of a wild card, and may help 2015 after years of mostly destocking.
Some Questions on the Quarter and Guidance
- What oil price is baked into the 2015 outlook? Crude oil prices may be down on the Saudi’s trying to disrupt U.S. shale oil, or in an effort to pressure Russia over Ukraine, or steeply lower Chinese demand, or some combination of those factors, or none of those factors. In any case, 2015 end use demand by ‘petroleum’ has a less clear outlook than it did a few months ago.
- How much impact will Tier 4 Final have on E&T in 2015? Interestingly, the company took a pass on a version of this question in the last conference call, with the analyst confessing that he “should have sent it before”. Staged conference calls aside, the T4F standards matter for other high horsepower engines beyond locomotives.
- Given the recent pressure in iron ore and coal, how are you managing the credit risk at CAT financial and are there any noteworthy trends? It seems widely expected now that many coal and iron ore miners will be forced to exit.
- What is happening with mining equipment pricing in the market today relative to what is being recognized from backlogged orders in revenue? Last we heard, pricing was slipping at a slow rate.
- How much of change in Construction Industries sales related to changes in dealer inventories (destock) vs. so-called end user demand? The company has been doing a much better job with the disclosures around dealer inventory changes. Destock may overstate end-market weakness.
