Editor's Note: This unlocked institutional research note was originally published August 08, 2015 by our Industrials Sector Head Jay Van Sciver. As you may have seen, Caterpillar (CAT) shares are down -7% today and have fallen -25% in the last three months. Van Sciver has been the bear on CAT since he launched coverage in 2012. Please email our sales team if you’d like access to Van Sciver’s research at firstname.lastname@example.org
- Looking For Short Re-Entry: We hope that CAT shares pop on this naively bullish article so that we can add them back as a Best Ideas short.
- Timing Has Wrong Decade: The resources-related capital investment cycle is closer to 30 years than 3 years, and we have visibility into declining capex beyond the article’s posited rebound timing.
- Losses Can Persist For Years, And Haven’t Started: It is not unusual for commodity-related capital equipment manufacturers to lose money for many years, CAT/JOY/BUCY included.
- Apparently Not A Joke: We have confirmed that it isn’t April Fool’s Day, raising the issue of what was meant by “But companies can control the degree to which margins deteriorate.”
- No Mention of Oil Exposure: CAT does more than mining equipment, which might form the basis of a credible bullish argument. And the article seems confused about CAT's Yen exposure.
- Next Step Lower: We see Used Equipment/Cat Financial as the next shoes to drop, as described in detail in our recent CAT Black Book.
CAT/JOY Customers Are Going Bankrupt, And The Author Apparently Hasn’t Heard Of Caterpillar Financial.
We have been negative on CAT since launching Hedgeye Industrials in mid-2012, citing a commodity capital investment bubble, overvaluation/ peak margins, and a bizarrely misguided management team. Ever since, a parade of bottom callers have been attempting to time the turn in resource-related capital spending. As we see it, the ‘major’ cycle in resource-related capital spending is not 3 years, as the article suggest, but more like 30 years. There was a peak somewhere around WW2, another in around 1979, and the latest in, say, 2011. On that basis, we would look for the next peak in, say, the 2030s. How long do they expect readers in the periodicals demographic to live?
In our June 2015 CAT Black Book we examined the next shoes to drop at CAT. From what we monitor, there is an alarming build in the inventory of used equipment in key categories. Cat Financial receivables are generally backed by used equipment values. With miners and energy companies – CAT & JOY’s customers – now going bankrupt and/or curtailing capacity (think coal, iron ore, fracking services), a meaningful snapback in the shares seems unlikely.
Instead, we expect a hard hit to Caterpillar Financial, and investors typically hate losses at captive finance subsidiaries. Have you seen the list of Cat Financials’ major mining accounts? Apparently, Barron's hasn’t. We include part of it below.
Some Specific Problems With Article
No Meaningful Upturn This Decade: If you don’t agree with us that the mining/commodity capital investment cycle will remain under pressure for years to come, consider, first, capital spending estimates for miners. On this basis, we have yet to hit bottom.
Or, simply consider Bucyrus’s long-term margin history. Last round, it was bad for twenty years. One has to ask if CAT management did the same high quality due diligence for the BUCY deal that they did for ERA. Not only did they overpay, but the business may generate losses for CAT (“decretion”?). CAT even divested the distributorships, which presumable earned steadier service revenue.
Resource Industries, CAT’s mining exposed segment, hasn’t reported losses yet, and we expect it to in 2H 2015.
More Than “Using Machines Longer”: Idling fleets and liquidating used equipment is a more serious issue. It is still getting worse, notably in North American coal, Australian mining, and Latin American mining, from what we monitor. When we presented our most recent CAT Black Book in June, there were 432 used off-road trucks (typically used in mining) listed for sale worldwide, a number that has increased to 461 in just the last month and a half (brutal extrapolation). In 2012, near the peak of the investment cycle, used mining equipment was extremely hard to come by – just listen to our May 2015 call with Michael Currie (former Finning mining executive).
Cat Financial, Oil Exposure Not Even Mentioned: Sure, CAT has low net debt if all of those Cat Financial receivables are netted out. Have you seen the borrowers? We hit on the magnitude of the Resource Industries exposure in our Black Book, which we think is more in line with revenue than what is disclosed in the “Mining” portion of the portfolio. “Mining” is “large mining customers worldwide”, and apparently was formerly categorized with “Asia Pacific”, as if that somehow made less sense than mixing regional and non-regional portfolio exposures. As we understand it, the disclosed “Mining” receivables are by no means all of what our readers would consider mining exposure. The list below excludes the riskier “Project Finance” counterparties.
[Chart removed. Please ping our sales team for access.]
Recent Coal Bankruptcies: If you read through the Arch Coal bankruptcy filing, you will find Joy Global and at least three CAT dealers (Carter, Wyoming and Walker) on the list of creditors. We understand that coal mines often lease some of their equipment, and presumably CAT or its dealers can repossess that equipment and remarket it. The second step (remarketing) should be quite challenging.
Commodity Comeback? Commodities may bounce around, but there is oversupply, we think, in key categories like iron ore. We have presented these charts before; ping us if you don’t see the problem.
Gold longs better hope that investors don’t lose faith, since they buy ~40% of annual supply, and the cost curve is fairly steep.
Management Control & Buybacks: “But companies can control the degree to which margins deteriorate.” Is this the author’s first day? The article isn’t positive on the capabilities of CAT management. Yes, let’s invest in a company run by a management team that overpays itself, makes disastrous acquisitions & allocates capital poorly, and can’t figure out where its business is going. Seems like a plan. The article also neglects the management compensation structure in discussing the motivation for share buybacks. Those buybacks were of overvalued shares, in our view. We think CAT management touts its decrimental performance because it is so hard to find anything else positive to highlight.
Sources Dubious: We won’t put Joel Tiss’s or Vishal Shah’s CAT recommendation history in here, but we do not think that the percentage of Buy ratings is particularly useful metric. With a long-cycle name like CAT, value buyers probably need to wait beyond disgust until the name is long ignored. And, while we show part of our July 2012 note below, and could show many others that look good retrospectively, we certainly acknowledge that we get stuff wrong, too.
We hope that CAT shares pop on this naively bullish Barron’s story so that we can add it back as a Best Ideas short.