Old Wall perma-bulls are justifiably paranoid. That's because a preponderance of U.S. economic data is already in #Recession. To name a few: Industrial Production, Exports, Durable Goods, Capex, Producer Prices.
“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.
Takeaway: Despite the Fed's rosy economic narrative, the preponderance of economic data is rolling over.
We're not psychologists here at Hedgeye. But one thing seems increasingly clear to us following yesterday's FOMC statement. It appears the Fed is grieving the loss of economic momentum, but denying the reality of unfolding economic data.
The likelihood is rising that we enter a full-blown recession in Q2 or Q3 of this year. That's been our Macro call and we're sticking with it.
Back to Kübler-Ross...
First, the Fed will be forced to reconcile that everything they have predicted in the past year is wrong. It's a tough pill to swallow. As Hedgeye CEO Keith McCullough writes in today's Early Look:
"... the Reputational Bubble that is popping is that of an un-elected and un-accountable bureaucracy called The Federal Reserve. Until Bernanke’s legacy of linear forecasters embrace the non-linearity of it all, one of the most obvious risks remains their forecast."
It will take some time for the Fed to accept economic reality. But they'll eventually have to. We've got the charts below to help nudge them along the road to Acceptance.
Following the industrial production print a few weeks ago, McCullough wrote: "Industrial Production down -1.8% y/y accelerating to downside and 1st negative prints since 2009."
The latest exports reading was the worst since November 2009...
"Durable Goods Slowing like this = one of the many predictors of recession risk rising (grey bar coming)," McCullough wrote earlier today.
"Please ignore all red dots and grey (recession) bars," McCullough wrote today.
Analysis from a recent Investing Ideas newsletter:
"More on the depressed state of the producer. Deflationary PPI continued its march downhill with December reported numbers:
Do you still agree with the Fed's economic forecast?
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Takeaway: The cycle is late. We know it. Michael Crichton knows it. You should know it too.
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“Historically, the claim of consensus has been the first refuge of scoundrels; it is a way to avoid debate by claiming that the matter is already settled.”
While consensus still regards the labor market as strong and improving, the simple fact is that the labor data is getting less good from a rate of change standpoint. This matters, as second derivates are the natural precursor/harbinger to first derivate changes. Initially, things get less good, then they get bad.
Initial jobless claims have hit their frictional lower bound and we're coming up on the anniversary of that lower bound meaning that the best they can do going forward is not get any worse. Imagine if that were a company at full earnings power/potential and the best it could is not see earnings decline going forward.
Not to digress, but what would that be worth? Obviously, not much of a growth premium and yet the market is still trading at its 9th highest decile on CAPE since 1926. The analog here for Financials is peak earnings from a credit standpoint for balance sheet-intensive Financial companies. We've finally begun to see credit costs stop falling, and in some cases they have begun to rise. Even with some late-cycle loan growth, this spells peak earnings. Stairs up, elevator down.
Meanwhile, rolling SA claims are in their 23rd month below 330k. The last three cycles saw claims remain below 330k for 24, 45 and 31 months (33 months on average) before the economy entered recession. That puts us 10 months from the average, 1 month from the min and 22 months from the max.
Any way you slice it, the hour is late and there's a faint glow of asteroid on the horizon.
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Takeaway: Existing home sales are stalling with tougher comps on the horizon.We continue to expect volumes to be flat to down Y/Y for the bulk of 2016
Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.
Today’s Focus: December Pending Home Sales
Sales in the existing home market continue to underwhelm. Signed Contract activity rose +0.1% MoM and accelerated +170bps to +4.2% YoY as a softer comp supported the rate-of-change improvement. There are probably four notable takeaways:
In short, better sequentially but not “Better”. The positive 2nd derivative trends observed over much of 2015 will continue to reverse as we head through 2016.
About Pending Home Sales:
The Pending Home Sales Index is a monthly data release from the National Association of Realtors (NAR) and is considered a leading indicator for housing activity in the US. It is a leading indicator for Existing Home Sales, not New Home Sales. A pending home sale reflects the signing of a contract, but not the closing of the transaction, which occurs 1-2 months later. The NAR uses data from the MLS and large brokers to calculate the Pending Home Sales index. An index value of 100 corresponds to the average level of activity during 2001.
The NAR Pending Home Sales index is released between the 25th and the 31st of each month and covers data from the prior month.
Joshua Steiner, CFA
Christian B. Drake