On September 24th, CAT lowered its outlook on the same day a firm named Axiom put out a bizarre negative report.* The shares were crushed, hitting $64 and we suggested ‘covering some’. Since then, CAT shares have moved a bit higher with new narratives emerging to explain that move. To be clear, we are in the CAT bear camp but did not want to press after such a large decline. So what are the new positive stories on CAT? We have heard a few of late:
- Chinese Stimulus/Reflation
- Hey, Look At That Dividend
* The report is a rehash of this earlier sensationalized bearish thesis
Without a time machine and control of the commanding heights of the economy, it is hard to see how an activist could bring value creating change to CAT. We suspect that some C-suite management changes would generate a one-day pop in the share price, but structural change is unlikely to work. Most of the businesses that CAT has belong at CAT. They could sell Solar or Progress Rail, but it is not clear those units are undervalued in the current market appraisal of CAT shares. They are probably not large enough to move the needle, either. Attempting to unlock value by divesting non-core assets would likely create more problems than it would solve.
What would we do as an activist at CAT? Probably find another target. CAT has an entrenched culture, a dealer network with its own agenda, and a strong market position/product portfolio. It does not need an activist. One could argue for a broadening of the Construction Industries portfolio into adjacent markets (e.g. cranes), but this is also likely to be too little too late. Basically, an activist cannot make mines expand, drillers drill, or retroactively back out of the Bucyrus deal.
As a short, we certainly worry that a large Chinese stimulus proposal could fuel optimism for CAT, much as it did coming out of the financial crisis. Given the supply dynamic in key mining categories, like iron ore, we would view a strong rally on the expectation of stimulus driven demand as a potential set-up for a short entry.
Weakness in commodity demand is not limited to China, either, with US coal a key market that is also under pressure. On the bulk side of ‘old China’, it looks like a demand rebound would take quite a bit more stimulus than was delivered to fight the financial crisis.
Hey, Look At That Dividend
CAT’s dividend has not helped stem the decline in the shares so far, and we do not expect it to matter much. While we do not explicitly forecast a dividend cut, the combined repurchase plus dividend may become a bit of a struggle in 2016. CAT is on pace for a dividend of a bit over $3 per share and about $1.75 in repurchases. That $4.75 pace does not stack up well against a current 2016 consensus EPS estimate of $3.88. Of course, CAT’s cash generation and funding options may facilitate dividend and repurchase activity beyond EPS, but it is not a great set-up for dividend dependence. Also, we expect issues at CAT Financial, which could also end up consuming some cash if our views play out.
Upshot: The latest round of CAT bottom callers are likely to be met with the same success as earlier ones. We think CAT is mired in a multi-year downturn in resource-related capital spending. While the company has already guided lower, 2H 2015 is not likely to generate much optimism. In many key ways, 2016 looks worse. We would look to press our bearish view if the shares rebound on faux bullish narratives.