CAT shares have outperformed since we removed CAT as a short from our Best Ideas List in late January 2015. However, we are interested in adding short CAT back to the list, and have focused on potential losses at Cat Financial as a downside catalyst. While we think CAT may beat and raise guidance again in the 2Q15 report, the second half of 2015 should bring much weaker results. We estimate that CAT’s 2H15 EPS will annualize to ≤$4.00 vs. 2016 consensus of $4.79. An increase in Mining past dues was a key takeaway from the 1Q15 release.
Losses at CAT’s captive finance subsidiary, a much lower EPS run rate, and uncertainty surrounding investigations/control issues may result in significant pressure on the shares later in 2015.
Cat Financial’s portfolio exposure to mining, coal, and upstream oil & gas producer defaults is hard to estimate given the current disclosures. While Cat Financial does not provide much detail on specific credit exposures, its marketing ‘pitch books’ do name some names. One important incremental piece of information is that Cat Financial does not appear to have any Export Import Bank (Exim) guarantees on these exposures. So Cat Financial would appear to be on its own should it retrieve collateral from Boseto, Kaunisvaara, and other troubled projects.
These deals may have made more sense in the 2007-2012 commodity price environment, but we wonder if Cat Financial was underwriting the equipment instead of the borrower. Remarketing repossessed mining equipment in the current equipment demand environment is unlikely to be easy, and repossessed equipment can compete with already depressed new equipment and parts sales. The recognition of these credit troubles seems likely to hit later in 2015. This should coincide with the step down in earnings as CAT's oil & gas backlog runs dry.
As for the 10-Q, there is quantification of the increase in past dues, an incremental subpoena, and a slight tailwind year-on-year from warranties:
Mining Past Dues: Management noted that past due receivables picked up in 1Q 2015, but the magnitude of the increase is noteworthy. Mining past dues were $39 million at year end 2014, but nearly tripled to $106 million during just the first quarter of 2015, and were up nearly 10x year-over-year. While the scale is still fairly small, we expect the ramp to continue during 2015. We also understand that some mining exposure is under the regional categories, as is Cat Financial’s upstream oil & gas exposure. The allowance for credit losses declined very slightly during the quarter.
Another Subpoena: Realistically, CAT can afford both the legal fees to keep these issues in court, and to pay whatever fines are needed to exit these investigations. It is a distraction for management, investors, and interested customers, however.
“The Company received an additional subpoena relating to this investigation requesting additional documents and information relating to, among other things, the purchase and resale of replacement parts by Caterpillar Inc. and non-U.S. Caterpillar subsidiaries. The Company is cooperating with this investigation. The Company is unable to predict the outcome or reasonably estimate any potential loss; however, we currently believe that this matter will not have a material adverse effect on the Company’s consolidated results of operations, financial position or liquidity.”
Warranty: Looking at CAT’s warranty accruals, it looks like a slight benefit year-on-year. This is partly a product of lower sales, and is offset by higher stock compensation in the 1Q15 results.
Upshot: While we think CAT may be able to post a favorable 2Q15, we expect significant pain later in 2015. By year-end, we see annualized EPS below 2016 estimates, mounting credit losses in the resources-exposed Cat Financial portfolio (mining, coal, oil & gas, etc), and renewed pressure on management/controls... perhaps (finally) precipitating a bottom in CAT's relative performance.