“It is difficult to get a man to understand something, when his salary depends on his not understanding it.” – Upton Sinclair
Takeaway: In the short-run, spin and accounting maneuvers can keep results elevated. In the long-run, it could impair CAT’s reporting credibility.
CAT management lit their proverbial pants on fire with today’s report. We had expected them to blur the lines, but elements of the 2016 guide risk the company’s broader credibility. When managements enter the surreal world of accounting changes and restructuring charges, both shorts and longs want to be careful not to get burned. Long-term, investors usually punish gimmicks, and getting reporting credibility back is a serious challenge… Just ask GE (Is CAT the New GE?).
Beyond noting that order activity remains below sales, we’ll leave it to others to summarize the quarter. We highlight key items and charts below. Ping us for our CAT Black Books (most recent focuses on Cat Financial and midstream) and our updated EQM (data sets, model) for more background.
$3.50 Is A Magic Number: Changing CAT’s pension & OPEB accounting helps keep 2016 EPS above $3.50. Who cares? CAT management…just insert “bonus” instead of “salary” in the quote above.
“The 2014 ESTIP design provided that a bonus pool would only be funded if the Company achieved a minimum profit per share-diluted (PPS) performance “trigger” of $3.50." – 2015 CAT Proxy Materials*
In a negative “Say on Pay” solicitation, CtW wrote:
“We are troubled, not only by the return to an EPS focus – and the jettisoning of ROA -- but also by the decision to base a majority of the award on EPS. The change gives outsized influence to EPS which investors increasingly view as a problematic compensation performance measure given its susceptibility to large-scale buybacks and earnings management.” – CtW Investment Strategy Group**
Pension & OPEB Accounting Change: On the call, Mr. DeWalt “explained” the “elected” change in accounting principal. Comments like “… I think the market has done a decent job of, ah, you know, understanding what’s going on and that it is, uh, what it is for what it is” are really clarifying. So is “…it’s taking out losses from prior years that were masking operating results in the current year. That’s our view, anyway.”
See? It is entirely straightforward.
There is, you know, fixed income in the plan, too.
Congress-Level Creativity: Joking aside, why not have changed the principal last year if it was so good, or wait until next year in case markets soften? Our unkind take is that the higher profitability was needed to secure 2016 comp. The way we read it, they are retrospectively lowering prior years for the boost to 2016…but they will provide more on that later.
“The benefit primarily represents prior period actuarial losses that would have been amortized to earnings under the previous accounting policy. This change will be applied retrospectively to prior years. We are currently determining the impact on prior years and will provide that information later in 2016. Our current estimate of the impact on 2015 earnings is a benefit of about $575 million or about $0.65 per share.” – CAT 4Q15 Earnings Release
“Realistic” Forecast For Bucyrus Impairment: If past is prologue, Bucyrus is in for a very, very long period of weak results. That seems pretty “realistic” to us. The SEC is already looking into this, of course, and impairment testing is perhaps subjective…like pension accounting. At this point, it is hard to take the lack of impairment seriously.
CAT Financial: Write-offs jumped nearly 50% year-over-year on a smaller asset base. Yet the allowance for credit losses ticked down, despite obvious stress in CAT’s customer base. Management emphasized the decline in past dues, which is partly a product of the write-offs. We will need the 10-Ks to understand more, but the trends we track, like used equipment quantities and prices, do not look favorable.
Cost Reduction Composition: For a year with so many restructuring charges, we would have hoped for more manufacturing oriented cost reductions. Of course, we also would have hoped for an itemization of the restructuring costs when backing $585 million out of the quarter. We got neither.
Other Items: The tax rate was low, pricing was weak, and a reduced incentive comp (down $265 mil YoY) helped support headline EPS.
Upshot: In the short-run, spin and accounting maneuvers can keep results elevated. In the long-run, it could impair CAT’s reporting credibility. Today’s report doesn’t change the reasons to remain bearish on CAT.