This note was originally published October 17, 2013 at 18:49 in Industrials
Editor’s Note: Shares of Caterpillar (CAT) are getting bulldozed around 6% today after a weak earnings report. Take a look at this earning preview note from last week where Hedgeye Industrials Sector Head Jay Van Sciver predicted this. Jay’s been out front, trumpeting CAT as a top short idea since the middle of 2012 when he joined the firm.
Investors do not seem very negative on the outlook for CAT’s 3Q earnings for an odd reason. They tend to think that everyone else thinks that CAT will miss, limiting the relevance. Investors are also looking for an announcement on structural cost actions at Resource Industries, which may cloud the 2H outlook. Our view is that CAT has an end-market demand problem, not a cost problem.
CAT is also expected to issue preliminary sales and revenue guidance for 2014. Many expect that it will be the Industrials guide of the quarter. We think not – few analysts take guidance from CAT seriously anymore. Remember “steady as she goes” for the 2013 outlook given in 3Q 2012? Sales and revenues were supposed to be “roughly the same as 2012, in a band of about plus-or-minus 5%.” Recall that 1Q 2013 sales and revenue were actually down 17.3%. Following some short-term reaction, the market is likely to take a 2014 outlook with an excavator full of salt.
We generally do not bet on quarters – it is a tough game. A change in assumptions for warranty or accounts receivable allowances could leave even the best estimate off target. A simultaneously announced buyback or acquisition could render the reported results old news before they are even read. That said, there are a number of reasons why we expect weaker results this quarter.
While we will be ‘surprised’ if results do not disappoint, we are not ‘in’ CAT for this quarter’s results. Rather we are focused on the long-term down-cycle in resources-related capital spending. In the long run, resources-related capital spending requires rising commodity prices to remain far above maintenance-type levels. Currently, resource-related capital spending is well above the levels needed to support long-term demand growth.
CAT Inventories: CAT has guided flat company level inventories for 2H 2013, meaning that inventory levels at year end should be roughly the same as at the end of 2Q 2013, as we understand it. However, in the third quarter “inventory could come down some as we have many of our Northern Hemisphere facilities take vacation shutdowns during the months of July and August.” The company level inventory headwind should have continued into 3Q 2013, but consensus doesn’t seem to reflect it. Dealer inventories are also expected to decline through 2H 2013.
Can CAT Get To $6.50? That inventory outlook intersects poorly with the implied margin in current guidance. Here is what we wrote on 8/9/2013 - our view is unchanged:
To hit guidance, CAT’s margins in 2H would need to improve ~30% vs. 1H with NEGATIVE MIX and NEGATIVE PRICING in Construction Industries and Resource Industries. Sure, that might happen – and 795F Trucks might fly. As we have written repeatedly – CAT is letting us down easy (gradually) and we have a tough time getting to $6.00 in 2013 EPS. This is just a rough sketch of guidance - not what we expect, which we published here.
Current consensus has margins at about 11.5% in the back half of the year, which would also represent a substantial and unlikely improvement in profitability from 1H. Given the expectation of continued inventory reduction in 3Q, we are not sure why consensus expects margins to expand. A guide down seems quite likely.
Not Just Resource Industries: CAT management admonished us not to hyper focus on mining capital spending, shifting investor attention instead to Power Systems. That may not be a great plan. We have long expected the resource-related capital equipment portions of Power Systems to also experience meaningful pressure. The most recent dealer statistics (below) show declining sales in Power Systems. That seems consistent with our broader definition of resource-related capital spending. It is also not a great set-up for 2014 sales and margins.
Construction Industries: In a noticeable omission, CAT does not fully discuss the >500 basis point drop in Construction Industries margin in 2Q 2013 YoY. It apparently relates to dealer inventory reductions, too, but that explanation does not fit the ‘it’s just a mining equipment demand drop’ narrative. CAT’s construction equipment division participates in an intensively competitive business, but we are a bit surprised by the recent weakness. As we understand it, lower capacity utilization in Resource Industries impacts the other divisions as well, given shared platforms, and that is a very hard problem to isolate or correct.
3Q and 4Q Expectations: Forecasting quarterly earnings for CAT is challenging, in no small part because we do not know how much revenue will come out of the backlog. Last quarter, CAT emphasized inventory headwinds, but not the draw on backlog and the likely favorable pricing in it.
- We expect charges in 3Q for the structural capacity reductions at Resource Industries. We also think a goodwill impairment charge is likely in 4Q for BUCY goodwill, as impairment testing should come at year-end.
- Excluding those factors, we would expect a 3Q result in the neighborhood of $1.30-$1.50 vs. consensus of $1.67. We could be wrong for several reasons beyond backlog, including currency and cost controls, but that is what we get. Once a company gets into identifying restructuring charges, as CAT seems likely to do this quarter, lots of interesting items can be called special. That said, we think current guidance is a long-shot and expect CAT to struggle to earn $6.00 this year.
- Instead of a buyback, we expect a miss to be paired off with a cost reduction plan targeted at Resource Industries. Of course, the cost impact of low volume at Resource Industries is not easily isolated, so that is where we will be interested to see some detail. We could obviously be wrong in this expectation.
- We expect comments about 2014 to be positive and focus on the eventual end of dealer inventory draw downs. We note that JOY and Sandvik have seen large mining order and revenue drops without a dealer network.
Other Indicators: While we do not rely on these sort of tea leaves, secondary indicators for CAT are do not suggest an approaching inflection point:
- Insiders Selling: In the last couple of years, insiders have only bought 2,000 shares in the open market while selling hundreds of thousands. Selling may have slowed down in recent months, but we do not see the open market purchases that might accompany an inflection for CAT.
- Sell Side Estimate Revision Trends: Since the first week of October there have been a number of downward revisions to estimates. Quiet period or not, we all should have a sense of how this ‘revision’ process works.
We continue to see CAT as exposed to a significant, multi-year decline resources-related capital spending through both its Resource Industries and Power Systems segments. Investors appear to be hoping for a cost reduction plan capable of resolving a lack of demand/cyclical downturn problem. We continue to expect CAT shares to underperform through the down-cycle.
Takeaway: Get the dollar right, and you’ll get a lot of other things right.
The U.S. Dollar is getting pulverized. Why? Because the United States doesn’t have a monetary policy to protect it. Euros and Pounds love this. The world will even buy Yens if Bernanke doesn’t buck up to the bar.
With our long-term Hedgeye TAIL risk line of $79.21 USD Index under attack, we went to net short in #RealTimeAlerts yesterday (6 LONGS, 9 SHORTS).
Click image to enlarge.
Get the dollar right, and you’ll get a lot of other things right.
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Takeaway: If 1728 breaks, 1671 is in play.
POSITION: 4 LONGS, 10 SHORTS @Hedgeye
I moved to net short yesterday and sold the open today too. The reasons are twofold:
- Burning Buck
We have zero monetary policy in this country to defend against those two bond bull lobby factors. So, congrats – now we are all hostage to their combined implication = #GrowthSlowing. That’s why slow growth Utilities (XLU) are +0.9% and the Financials (XLF) are -0.9% today.
Across our core risk management durations, here are the lines that matter to me most:
- Immediate-term TRADE resistance = 1754 (the all-time closing high)
- Immediate-term TRADE support = 1728
- Intermediate-term TREND support = 1671
In other words, the fundamental case for Bernanke messing this up (not tapering) is in. The only question that remains now in my model is when (and if) the quantitative levels that matter to this epic bullish stock market momentum break. If 1728 breaks, 1671 is in play.
It’s really sad to watch. The Fed has never understood why Down Dollar Inflation expectations = slow growth. And I don’t suspect they will until it is too late. Gold, Bond, and Utilities bulls, Unite!
Keith R. McCullough
Chief Executive Officer
Takeaway: CCL looks washed out (as are the bathrooms on the Triumph, finally) while RCL may be the stock at risk.
This is indeed a pivot for us - we’ve been crapping on Carnival (CCL) all year. But with most of the issues flushed out, the stock may be bottoming out.
In our latest pricing survey, Europe looks stable and with easy upcoming comps, CCL’s large European exposure should be an asset. Moreover, CCL is doing better than the competition in Alaska and while the Caribbean outlook is still somewhat cloudy, our pricing survey did not indicate any further deterioration for early 2014 itineraries. Could we be early? It’s happened before but the hedge of Royal Caribbean (RCL) on the other side might be the solution, for those so inclined to a pair trade.
Our pricing survey actually presented a more uncertain 2014 for RCL. Given RCL’s newfound position as the Cruise bellwether and recent stock appreciation to match, the risks look greater for that stock. RCL won’t feel the Europe tailwind (“Europe tailwind”? it’s no longer an oxymoron) to the extent of CCL.
Regionally, RCL faces pressure in all of its markets – potentially from CCL’s aggressive marketing strategy. Pricing is way down in Alaska and Europe and RCL is overexposed to the Caribbean (highest since 2007) where visibility is the lowest. Sell-side sentiment seems the most bullish in over 2 years. While valuation is in-line with historical levels, RCL's earnings are at risk.
Here are some of the differentiating factors between CCL and RCL:
Editor's note: This is a brief excerpt from a recent report written by Hedgeye Managing Director Todd Jordan. For more information on how you can access Hedgeye Research click here.
In preparation for RCL's FQ3 2013 earnings release tomorrow, we’ve put together the recent pertinent forward looking company commentary.
- "In the second half of the year, we have lowered our revenue forecast by just under one percentage point due to lower expectations in China and some impact from the pricing environment in the Caribbean. In aggregate, our booked load factors and pricing are both up slightly for the full year. Since our last call, bookings have been slightly higher than last year after adjusting for capacity."
- "Europe is developing about as we anticipated and we are expecting net yield increases in the mid-single digits for the year."
- "The Caribbean, which represents about a quarter of our deployment in Q3 and almost half in Q4, is holding up pretty well. We are aware there has been a lot of focus in the investment community on the overall health of the Caribbean in light of some of the competitive pressures. And we would be naive to say that this has not affected us to some degree. But at a macro level, consumers seem to be recognizing the value of our brands and our pricing in the region continues to show improvement for the year."
- "Asia is the only product in our portfolio that we are forecasting to have lower yields for the year."
- "The territorial island dispute between China and Japan has forced us to drop Japanese ports-of-call from our itineraries, and in total we have had to modify 30 sailings. These modifications have resulted in some churn in our book-of-business as well as some volatility in the booking behaviors in the region."
- "Our Pullmantur brand is one exception here (positive growth) and as Richard noticed, the brand will be putting much more emphasis on developing its business in Latin America."
COMPETITIVE PRICING/PROMOTIONAL ACTIVITY
- "In recent weeks competitive pricing has gotten more intense.
- "Throughout recent months, there has been a lot of promotional activity. We've discussed in the past that you can basically expect to see promotional activity throughout the revenue cycle."
- "Bookings for both 2013 and 2014 are ahead of where we were at the same time last year, both in terms of load factor and pricing."
- "Our objective for next year is to at least achieve flat net cruise costs excluding fuel. And while we don't forecast what the price of oil will do, we do work aggressively to reduce our energy consumption."
- "Onboard spending was much stronger. Onboard revenues increased 8.2% for APCD in the quarter and generated about $0.04 per share of favorability to our April's expectations. Overall, we are generally seeing better spending behaviors out of the North American guests, but we are also enjoying very favorable results from our revitalization project. Gaming, beverage, specialty restaurants and shore excursions all out-performed."
- "Current estimates indicate that we will reduce our year-end net debt balance by about $270 million versus prior year, which in combination with improved operating cash flows will help improve our credit measures as we continue to strive for investment-grade metric."
QUANTUM OF THE SEAS
- "Quantum of the Seas will enter the fleet just over 15 months from now. We are very pleased with her initial bookings since we opened for sail at the end of May. Quantum has already reached the projected load factor for her 2014/2015 winter season that we have set as a target for the end of this year. And the demand for her suite and new stateroom types such as the studios are particularly encouraging."
- "We're feeling pretty good about the first quarter. We had very strong load factors; our pricing is up slightly. As we look out beyond Q2 the numbers are really too small to extrapolate, but I will say that in all our quarters in 2014 our load factors and APDs are running ahead of where they were a year ago."
- "I think we anticipated that Alaska had a terrific beginning of the year and it was unlikely to continue at that trajectory."
- "Australia is a very attractive southern summer market for us. We have a strong presence there with both Royal Caribbean and Celebrity. We did expect pressure on yields this year from the capacity increases and we're looking forward to be – playing a prominent role in that market going forward in the future."
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