I just love it when companies where I have made an investment announce negative news on a Friday before a holiday weekend. In the case of Caterpillar Inc. (CAT), the news announced Friday, that the company is taking a $580.0 mm write-off of the 2012 investment in ERA Mining Machinery LTD. (ERA) offers a black-eye to management but should not warrant an exit from the bullish thesis.
I don't like the approach by management in explaining the news. Irrespective of whether or not ERA is a public company or not, there is only one group responsible for acquiring a company that was "cooking the books": CAT management. Management firing the mining group leader (and likely others) appears reasonable, but the overall perspective by the company is misguided in that management appears to be shifting accountability to regulators, accountants and ERA and not the company's acquisition approach. The company's due diligence process was clearly flawed in this case, as the ambition to grow in China (which has been a focus of the CEO specifically since 2010) overshadowed what should have been a deeper look into an acquisition. One bad investment in China hasn't shaken my view of management overall, but I am a bit disappointed. Acquisitive companies need a strong process, especially in China and the Emerging Markets, where accounting standards and the legal framework is not equivalent to the protections offered in the United States (this is stating the obvious, but I didn't blow up $580.0 mm so stating the obvious sometimes is ok). Management just needs to do better, and I would have felt a little better had the talk been about acquisition practices and less about how they got cheated.
Financially, the news is not overly substantive, as CAT can more than withstand a non-cash Goodwill charge of $580.0 mm, as the equity account ($17.9 billion as of 9/30/12) can take the hit within the context of what will be an otherwise profitable Q4 (assume a few pennies off the equity account, but nothing to lose sleep over for the TD/TC ratio and the stability of the business). Again, as highlighted, the news is disappointing, but not overly serious financially.
The CAT bull thesis is pretty simple: management has outlined $12-$18 share of earnings in 2015, based upon assumptions around the Global Economy and forward prospects for the business. Using the low end of forward guidance ($12/share) against the current 11.00x multiple, the stock is worth $132/share, or 37.5% more. Even if it takes three years to get to that $132/share, the annualized return of 11.20% before dividends (12.9% including the current $0.52/share dividend) highlights an attractive opportunity within the context of the trough multiple (there is upside), using the low end of guidance (there is upside), the $10.50/share consensus estimate for 2015 (there is upside) all against the current valuation.
This announcement should not shake the view against the bull thesis. Should the downside from this announcement prove more substantive than a 1.0%-3.0% move (against the 8.9% YTD change, to which one could ascribe this news as a reason to take short-term profits) I would consider adding more for the long term. For now, CAT represents an attractive long-term opportunity despite management taking a short-term black eye that will really only be cured by realization of the outlined strategic and financial goals over the next several years. It is OK to be annoyed at this news, as management dropped the ball. But long-term investors should hold through this.