“Again, we get down to low $70s, a lot of bets are going to change on a lot of things. And there's no doubt that would be impacted to some degree. I would agree with that.”
– Doug Oberhelman 3Q 2014 Earnings Call
We have long referred to CAT as exposed to ‘resources-related capital spending’, not just mining, because we have expected a decline in energy-related capital spending. Given the decline in crude oil prices, it seems likely that CAT’s 2015 will show stress from reduced oil & gas capital spending. CAT’s Energy & Transportation (E&T) segment was already facing 2015 challenges from Tier IV Final.
We also expect 2015 to bring some credit challenges to CAT Financial. With the further declines in mined commodities, as well as Mercury Air Toxics regulations, receivables backed by mining equipment collateral may be less secure than some investors expect. Higher provisions for credit losses seem likely, as mining equipment values (and liquidity) are likely to decline just when collateral value matters most. CAT has had some “material weaknesses” relating to its Allowance for credit losses, but the allowance magnitude looks like a pressing problem.
We view 2015 consensus as too high, with our expected range in the $4.50-$6.70 reasonable range for next year (an EPS decline) vs. a consensus $7.05, ex charges. There is a meaningful upcoming catalyst in the initial 2015 EPS guide with CAT’s 4Q earnings report in January.
*See Sept 2012 CAT 10 minute thesis call here, slides: CAT's Deep Cycle or our March 2013 Mining & Construction Equipment presentation for a full review. We also held a call with the former head of Finning Power Systems titled Understanding CAT Power Systems. On excess capital investment in energy, see links here.
Oil & Gas Capital Spending
The shale boom and high energy prices significantly increased capital investment in crude oil and natural gas production. This chart ends in 2013, but conveys the idea reasonably well. In our view, there is significant potential downside to oil and gas capital investment.
CAT sells large engines and turbines into oil & gas applications, with much of the equipment fetching high margins. The list below is from a call with Jeff Leigh, former head of Finning Power Systems.
CAT in the Last Energy Downturn
Looking at CAT’s 1983 annual report, it is interesting to note that lower oil prices caused a meaningful drop in turbine and engine shipments, among other difficulties, particularly in emerging markets. We have often compared the current resources capital spending downturn to that of the 1980s (see Party Like Its 1979). Truck engines, which benefited from lower oil and deregulation, will not be an offset for CAT in this cycle.
Large Gensets & Locomotives: 2015 Tier 4 Final
Power generation is divided between prime power and standby power. Lucrative prime power sales are often made to off-grid users, like mine sites and shale oil plays, or in emerging markets. We assume sophisticated purchasers of larger gensets are pre-buying ahead of Tier 4 Final in 2015. A prebuy seems evident from CAT’s E&T results, as sales are likely increasing in a pull forward from 2015.
Locomotive sales have been more formally disclosed as a T4F pre-buy, but management suggested the post-pre-buy bust will only trim about 2% off of E&T next year. Given our understanding that something like 70% of CATs locomotive sales are in the U.S., maybe half of that is OE, and that EMD will make up a bit over 10% of E&T sales this year, the decline will be a bit larger, we think.
Taking the guided 2% decline for locomotives and what is likely to be lower genset sales post-Tier 4 Final and lower resources spending, it is not easy for to see how E&T revenues can increase in 2015.
CAT often describes natural gas compression as the “majority” of the oil & gas exposure in the Energy & Transportation segment. It is not entirely clear if that is of sales or installed base, but it would be very helpful if they simply provided the numbers instead of leaving investors to speculate. We assume that if it were favorable, it would be presented more clearly.
Still, USA Compression (USAC) is the second largest outsourced compression services provider in the US, and they appear to have been fairly aggressive in 2014. Street capex forecasts for Exterran, the largest provider, and USAC capital spending currently project a 6% and 20% decline in 2015 capital spending, respectively. While it is challenging to get insight into the broader compression market, it does not appear to us that gas compression will drive E&T growth in 2015.
Caterpillar Financial: Investors Have Yet To Scrutinize This
Is CAT paying more attention to collateral value and equipment sales than to the creditworthiness of its counterparties? As a manufacturer, providing favorable customer financing to sell more equipment is a common pitfall. In addition, we see a lack of diversification in CAT Financials credit exposure, since much of it appears mining-related. If miners start to (or rather, continue to) go bust in coal, iron ore and the like, CAT may be left with mining equipment collateral that is challenging to remarket at assumed valuations.
Note: “Mining” as defined in Caterpillar Financial’s filings include only large miners, not all mining exposure.
Despite lending to some really interesting characters (see below) the allowance for loan losses seems low to us, both in absolute level and relative to historical norms. While Caterpillar Financial is not a big part of CAT’s earnings, Industrials investors usually react poorly to unexpected losses at financial subsidiaries. They often view it as having fluffed up prior equipment sales. Remarketed used equipment can compete with new equipment sales at the same time that credit becomes less available for new equipment sales.
As we understand it, portions of the deals below typically remain on CAT’s balance sheet. Financing is often provided in pre-production (project finance), increasing the risk, as we see it. CAT should provide more disclosure, we think. Discovery Metals’ Boseto project, a Botswana copper mine with $2.86/lb cash costs, sounds like a tough credit to us.
And, financing can be greater than CAT equipment value…
We do not think that E&T will generate organic sales growth or a profit gain in 2015, given an anticipated decline in oil & gas capital investment and impact of Tier 4 Final. We could, of course, be wrong, but we take the lead-off quote on the oil price as an indication of trouble ahead. Mined commodity prices are meaningfully lower as we head into 2015, and we expect pricing pressure to intensify in mining equipment and MATS regulations to hurt coal mining. Construction Industries should do well, but faces very tough margin comps in 1H 2015. CAT Financial also looks challenged amid lower mined minerals prices.
If we were to pencil out a really favorable scenario for 2015, we would suggest E&T revenue flat at a margin comparable to 2014, and the same for Resource Industries. We could grow Construction Industries at a mid-single digit rate and repeat the 2014 record margins. We could grow Caterpillar Financial operating income by a low single digit percentage, too. Even in that highly optimistic scenario, which is unlikely given the set-up outlined above, we would model a 2015 EPS (with buybacks) at around $6.70, below the $7.05 consensus. In a more base-case outlook, we wouldn’t be surprised to see CAT at <$6.00 per share.
We don’t see Caterpillar escaping the downcycle in resources capital spending, with the long-awaited decline in energy capital spending now at hand. The outlook for mining has deteriorated, with dealers inventories unlikely to make up the difference. Increasingly, it seems investors are recognizing that the Caterpillar dealer network receives much of the service revenue. We also expect price declines in various mined commodities to start to pressure Caterpillar Financial. We suspect most investors have not scrutinized that subsidiary closely, yet.