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CAT: A Short Christmas Come January 26th?


“Skeptical of Oil & Gas Capital Spending…Energy-related capital spending looks like ‘mining capital spending-lite’”


Hedgeye Industrials 4/21/2014 CAT: Defining Differences & The Segment Formerly Known As Power Systems





2015 is not shaping up well for CAT.  While some other industrials offer exposure to pending declines in upstream oil capital spending, we think CAT has greater exposure than the market appreciates.  We also believe CAT provides broader positives as a short/underweight, such as exposures to other resources-related capital equipment, likely credit losses, and problematic corporate controls.  We have been bearish on CAT since Hedgeye Industrials launched in 2012, and the tail of the thesis – declining energy-related capital spending and credit issues at its captive finance subsidiary – is finally coming into view. 


Consensus estimates for CAT’s 2015 EPS have hardly budged since late October.  This is odd, since expectations for 2015 upstream oil capital spending, a key CAT end-market, have certainly declined.  CAT provided its initial 2015 top-line guidance with its 3Q 2014 earnings report, calling for, give or take, zero growth.  Consensus just assumed margin expansion in 2015, translating that flattish top-line guidance into 8% EPS growth. 


Excluding a transaction or similar rabbit-out-of-the-hat solution, we expect both sales and EPS to be lower in 2015 vs. 2014.  We think something in the $5.00 -$6.50 range is a reasonable expectation for the initial guide in January vs. current consensus of $7.00.  Our guess is that management will want to set initial expectations low to avoid a repeat of the 2013 serial guidance cuts.


We really wonder if current holders have examined to whom CAT has provided financing in its quest to sell equipment.  CAT Financial has disclosed a “material weakness” relating to “Allowance for credit losses”, although the disclosed adjustments so far have been fairly small.  Caterpillar Financial has ~$35 billion in assets (although we do not hear much about it) and lends to mining and oil/gas companies, too.  There will be credit issues, in our view.  Losses at captive finance companies are typically greeted with a mix of confusion and disdain in the Industrials sector.


Here is a brief summary of why we expect the 2015 guide to come in well below consensus, and below anticipated 2014 results:


  • Resource Industries: We expect Resource Industries to show further modest revenue declines and a segment loss in 2015, as oil sands capital spending should weaken, MATS regulations should prove an incremental negative for coal demand, and many mined mineral prices, like iron ore, have fallen further.  Mining equipment prices should continue to be under pressure, as we understand it.  Financing also is likely to be less available/attractive.  Optimism around the cessation of the dealer destock seems misplaced in a market with slackening demand.
  • Energy & Transportation:  We have long expected a decline in oil & gas capital spending to follow the decline in mining capital spending, but the recent drop in oil prices locks that in for 2015.  We think the market actually underestimates the relevance of upstream oil and gas capital spending for CAT.  Gensets, drilling engines, fire pump engines, well service engines/pressure pumps, and transmissions add to the exposure, along with the aftermarket sales on these often overworked engine platforms.  While Tier 4 Final will have a disclosed negative impact on locomotive sales, it will also impact other categories of very large engines, like gensets.  The spike in North American E&T sales growth supports the view of a broader 2014 Tier 4 Final pre-buy.
  • Construction Industries:  While Construction Industries is largely insulated from the decline in resource-related capital spending, it faces very tough comps in 2015.  Dealer inventory builds supported record 1H 2014 margins.  Improving on 2014’s strong performance may prove challenging, particularly if dealer inventory actions are less supportive.  Emerging market demand may well continue to deteriorate, too.
  • Financial:  Caterpillar Financial has lent money to a number of mining projects, as discussed here.  While oil and gas financing exposure is difficult to quantify, it has presumably been a meaningful part of the portfolio.  Asset growth has slowed, and we expect higher allowances in 2015.


Are investors missing CAT’s upstream exposure?


We think that E&T has more upstream exposure than investors realize.  First, the margins correlate reasonably well to metrics like rig count, as best we can estimate.



CAT: A Short Christmas Come January 26th? - jkq1



Second, some oil and gas sales can get miscategorized.  For example, gensets may get categorized as electric power, even if the unit is for an oil and gas application.  Remote mines, offshore platforms, and onshore drilling sites tend not to have ready electricity grid access.  Consider this article - http://thebakken.com/articles/685/generators-evolving-with-the-bakken.


Consider Aggreko's end-market mix in North America, which shows about 1/3 of sales to oil & gas and mining.  Given CAT's product set and relationships, we would be surprised if it were a smaller part of the mix.


CAT: A Short Christmas Come January 26th? - adenew 2




Would You Want These Receivables?

And these are the ones that the company discloses in its mining finance pitch book…  We covered this in more detail a couple of weeks ago.


CAT: A Short Christmas Come January 26th? - jkq2




There is also likely to be credit exposure on the oil & gas side.  We do not know how big the exposure is today, but in 2009 it was expected to grow to several billion dollars.   We would guess that the growth has exceeded those earlier expectations.


CAT: A Short Christmas Come January 26th? - jkq3




In terms of exposures circa a few years ago, the drilling and well services names may be troubled, while the compression names look largely okay.


CAT: A Short Christmas Come January 26th? - jkq4



CAT is still advertising onshore financing, but we would bet credit standards have tightened just a bit this quarter.  Tighter credit is an obvious negative for new equipment sales.


CAT: A Short Christmas Come January 26th? - jkq5




Upshot & Valuation


CAT has high quality products and employees, but has become a bit ‘low quality’ from an investor perspective, we think.  There is an S.E.C. review of the company's accounting, some fantastically unfortunate acquisitions, numerous guidance gaffs, and clear strategy issues.  We suspect CAT shares will put in a bottom when management is either changed, or does a 180-turn on strategy.  If CAT earns, say, $5.00 in 2015, ex-items, and has some of the credit, accounting, management, and strategy issues that we anticipate, a 12x-15x multiple might prove generous.  To us, it doesn’t seem unreasonable that the shares could trade in the $60-$75 range (although we do not like a P/E framework), and possibly even lower if it gets messy. 


Still, the 2015 guidance we should see when CAT reports on January 26 will likely miss consensus, and we would expect the shares to underperform into that report.  It also seems like a short-run cover the news event, but that decision can wait.



Moscow, We Have a Problem

When your country’s central bank raises its interest rate a monster 650bps to 17% (as the Russian Central Bank did early this morning local time) and the currency still doesn’t go up, Houston, we have a problem.


By all accounts, we saw some of the most epic swings (ever) across Russian markets today. The whipsaw moves beg the important question:  during these desperate times in Putin’s Russia, will we witness desperate measures taken? 


In today’s Hedgeye Poll of the Day we asked: “Will Vladimir Putin take major military action in 2015?” The response was 65% “YES” versus 35% “NO”.  Clearly, taking a “major” action to inflect the price of oil could be seen as desperate to some, or as a necessity to others.


Moscow, We Have a Problem  - w. putin poll


We run though the current risk set-up impacting Russia below and offer accompanying charts illustrating current risks. While it remains unclear exactly how conditions will play out from here, the risk has markedly increased to the upside (over even just the last 24 hours).


Four factors worth considering upfront:


1) OPEC may have an agenda to tighten the screws on Russia and other countries with high break-even prices;

2) Currency crashes can be expedient and self-perpetuating;

3) Russia’s economic isolation and nationalism may extend the prospect of economic recovery;

4) The heavy ties of Russia’s largest companies to the State could expedite and heighten the sovereign risk profile.


A key news item to this entire story was released yesterday: the Russian government disclosed that state-owned Rosneft needed to raise capital, with help from the Central Bank, to cover $6.9Bn in a USD-denominated bridge term-loan due early next week. Rosneft issued $10.9Bn in new bonds at Friday’s exchange rate with large, State-owned banks buying the issue. The banks then deposit the bonds with the central bank, and Rosneft is financed with the printed Rubles.  Rosneft, due to the current sanctions, is unable to roll the term loan with western banks, and so squarely looks like it desperately needed the money from the CB to foot the bill next week.  Of note is that Rosneft CEO Igor Sechin is a close ally with President Vladimir Putin. The next unsecured USD-denominated debt from Rosneft is a $7.1Bn payment due February 2015.   


While we look from the outside, on the streets the purchasing power of the Ruble is evaporating, quickly. Despite Putin’s popular approval rating still in the 80s, we’d be overweight the “YES” camp that in fact a crashing Ruble will propel him to take some form of desperate action. 


Moscow, We Have a Problem  - w. Russia cartoon 12.15.2014


We suggest you consider these risks to protect your portfolio during this downslide.

  • Crash Mode 1: The USD/RUB is down -27% W/W and -56% YTD
  • Crash Mode 2: The Russian Stock Market (RTSI) is down -28% W/W and -57% YTD
  • Russia’s 5YR Sovereign CDS rose to 551bps (+67bps D/D) (above 300bps = Lehman breakout line).
  • The Russian Central bank has spent ~ $80 - $100 Billion on FX interventions to strengthen the RUB – but yet to no avail. The FX reserve is now at a 5YR low. Their total FX and gold reserve base is at $416.2Bn as of 12/05 (-18.50% YTD) and we’ll get an updated number from the CB on Thursday.  They have already pumped dollars into the Russian banking system and bought Rubles (a move that would have been slightly reversed if there is any truth to the Rosneft debt bailout)
  • The Russian Central Bank has raised the main interest rate 6 times this year; today’s 650bp increase to 17% follows last week’s 100bp hike. Here too there’s been no inflection in the currency or stock market.
  • Brent Crude is down -46% YTD at $59.60. A close proxy for Russia’s Urals main export blend, according to Finance Minister Anton Siluanov the price needs to be at $90/barrel for the 2015 budget to balance (a level 51% above today’s price).
  • Russia derives about 50% of its budget revenue from oil and natural gas taxes and 25% of its GDP is linked to the energy industry.
  • The Russian Central Bank said today that 2015 GDP may shrink to 4.5% to 4.7%, the most since 2009, if oil averages $60 a barrel under a “stress scenario”. (We expect the 2015 GDP drag could be closer to -6% to -8%).
  • The Russian Central Bank said net capital outflow may reach $134 billion this year, more than double last year’s total.
  • Inflation is at a 3YR high at 9.1% while real wages are at a paltry 0.3%.
  • Lower purchasing power via a depreciating currency + some higher local prices given import sanctions = the perfect cocktail for massive declines in consumer spending (beyond buying goods to lock in the “value” of the Ruble – evidence we’ve received anecdotally).
  • Russian banking crisis risk is rising by the day: as a proxy, Sberbank, Russia's largest bank with 46% deposit share, has seen its CDS rise steadily since mid-year, up 50bps D/D to 576bps.
  • Further, the CEO of Sberbank said back on November 14th that if the Russian economy were to decline by more than 1.2% in 2015 Sberbank would need the State to bail it out.

Moscow, We Have a Problem  - a. 1

Moscow, We Have a Problem  - a. 4

Moscow, We Have a Problem  - a. 5

Moscow, We Have a Problem  - a. 6

Moscow, We Have a Problem  - a. 7

Moscow, We Have a Problem  - a 8

Moscow, We Have a Problem  - a.9


Matthew Hedrick



Ben Ryan


REPLAY PODCAST & SLIDES | #EmergingOutflows Round II: This Time Is Actually Different

Takeaway: In today's call, we expanded upon our negative outlook for EM asset prices with respect to the intermediate-to-long term.

Amid rapidly declining asset prices, we held a conference call today to expand upon our bearish outlook for emerging markets over the intermediate-to-long term. The presentation and its conclusions were organized as follows:


REPLAY PODCAST & SLIDES | #EmergingOutflows Round II: This Time Is Actually Different - Thesis Summary


CLICK HERE to access the replay podcast.


CLICK HERE to access the aforementioned presentation (~75 slides).


As always, we’re available to field any follow-up questions you may have and are more than happy to set up a call with you to discuss these risks live; just shoot us an email as needed.


Have a fantastic evening,




Darius Dale

Associate: Macro Team

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FLASHBACK: Industrials Fishfinder: Who Is Overinvesting Now?

Editor's note: This prescient research note excerpt was originally published by Hedgeye Industrials Sector Head Jay Van Sciver on March 12, 2014. 


High Returns (Eventually) May Beget Low Returns


Looking at the recent declines in iron ore and copper prices, we are reminded of how challenging capacity additions can be in capital intensive industries.  In the commodity section of our March 2013 Mining & Construction Equipment black book, we reviewed the supply outlook for copper and iron ore.  The coming supply increases in these metals, driven by a super-cycle/bubble in mining capital investment, seems likely to keep prices under pressure for years to come.  Copper may rally here and there, but the tidal wave of capacity appears to us somewhat inescapable.  That seems the case even in a relatively strong “Old China” growth scenario, where the country continues to suffocate itself.   


As for iron ore, it seems absurd to dig up rocks in the Amazon, ship them by rail to the east coast of South America, load them on a boat to ship them all the way to ports in China, where they are then taken to some of the dirtiest and least efficient steel mills in the world to be processed into construction materials to building buildings that few people actually use, but are built largely just to goose regional GDP statistics or protect wealthy owners against inflation.  If that interpretation is correct, the excess capacity in seaborne iron ore one day might be quite staggering.  Looking at Vale’s share price, this is increasingly old news, and we look below at what might be next.


FLASHBACK: Industrials Fishfinder: Who Is Overinvesting Now? - kjh1



FLASHBACK: Industrials Fishfinder: Who Is Overinvesting Now? - kjh2



FLASHBACK: Industrials Fishfinder: Who Is Overinvesting Now? - kjh3

Note: Forecast taken from March 2013 Mining & Construction Equipment slide deck


FLASHBACK: Industrials Fishfinder: Who Is Overinvesting Now? - kjh4



Of course, iron ore and copper are not alone.  In many capital intensive industries, elevated investment impacts capacity on a significant lag.  What other basic industries are investing at above “trend” rates?


Below, we present a table of the ratio of Capital Spending to Depreciation & Amortization (Capex/D&A) for the S&P 500 and S&P 400 Industrials, Utilities, Energy and Materials sectors’ sub-industries.  In the table, a ratio of 2 would suggest that the index constituents representing that sub-industry are spending twice the level of depreciation and amortization.  While we understand that this does not adjust for historic cost accounting in D&A, certain acquisition-related items and myriad other challenges, it does provide a ruler to measure relative investment over time.  Another potential flaw is that a lack of investment may indicate a lack of opportunity, such as industries facing secular decline.  In mature industries populated by larger capitalization competitors, differentiating these situations is reasonably straightforward.


FLASHBACK: Industrials Fishfinder: Who Is Overinvesting Now? - kjh5



What Does The Table Imply? 


To us, it suggests that caution is warranted when extrapolating the current performance of CAT’s Power Systems division (or Energy & Transportation segment, but we will call it Power Systems until at least the end of 1Q because retitling is not substantive).  Nearly all of CAT’s Power Systems key end-markets are investing well above depreciation and amortization.  We have previously discussed energy sector capital spending, but it is useful to see the exposure for gas compression, locomotives and power generation, as well.  In many ways, Oil & Gas capital spending could look like mining capital spending circa mid-2012.  CAT, CMI, DRC and several others may also, eventually, see normalization energy-related capital spending impact results.


The table above also suggests that several construction and building products industries are not over-investing, spending at or below D&A, despite a potential significant rebound in demand.  Building products is an industry we like from the long side, not simply from a cyclical perspective, but also because of structural improvements over the past decade.

Cartoon of the Day: Everything Good?

Cartoon of the Day: Everything Good? - Global economy cartoon 12.16.2014

"Nowhere to run to, baby ... Nowhere to hide." 

-Martha and the Vandellas

EXCLUSIVE: Keith McCullough’s 2015 Market Forecast

In this brief excerpt from today’s Morning Macro Call, Hedgeye CEO Keith McCullough finally offers his coveted 2015 market forecast in response to a viewer’s question. 


the macro show

what smart investors watch to win

Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.