Why Caterpillar's Case For Its Stock Yesterday Appeared Unpersuasive

Jul.25.13 | About: Caterpillar Inc. (CAT)

As we know, Caterpillar (NYSE:CAT) is an icon. Transformed from a manufacturer of "things that go rust in the night" in the 1980s, it has seen a powerful two-decade growth surge. Amongst its virtues is one of the most informative earnings-related presentations extant (then click on "Cat Inc. Q2 2013" link).

Nonetheless, even investor-friendly presentations, a dividend increase and further share repurchases do not change the perceived value of a corporation to investors. This article discusses why CAT is not attractive to me yet. In order to keep this digestible, a reasonable knowledge of the company and its results announced yesterday is assumed. Briefly, CAT reported yesterday a serious decline in revenues and earnings, despite undertaking cost-control measures during the quarter. Both CAT's own in-house distribution network and its dealers had to shrink inventory, largely due to the weakness in global mining demand for CAT's high-margined products. CAT is trading around $82 this morning and has guided to a midpoint for earnings this year of $6.50.

If $6.50 is a cyclical bottom, then CAT is cheap. It "should" carry more than a 13X P/E at a cyclical trough. I think that was CAT's management's main point in attempting to defend the share price here. It's a good argument, and it may be good enough to keep many existing shareholders in the stock, but as a non-CAT shareholder, I'll use that as a lead into point #1:

1. If CAT's mining business is in the process of bottoming and the rest of its business also stops shrinking year on year, why wouldn't investors want to purchase depressed mining shares such as Vale (NYSE:VALE), Cliffs Natural Resources (NYSE:CLF), Rio Tinto (NYSE:RIO), or Southern Copper (NYSE:SCCO)? I would expect there's more upside price action with those names than with CAT if we're near a bottom in the mining/commodity cycle.

2. It's not just CAT that's down in its sector and related sectors. Deere (NYSE:DE) has also been weak lately, but has a lower P/E. CAT and DE have performed identically over the past 5 years.

3. CAT performed horribly during the last mega-cycle in which the U.S. transitioned from a low-rate to a high-rate environment (which may have begun). The shares actually dropped a little in price from their bull market high in the mid-1960s into their bottom in 1991-92.

Chart forCaterpillar Inc.

There's something about declining interest cycles that brings out the boom cycle, at least so I suspect.

4. CAT has a financial division. Late payments ("past dues", see page 11 of the earnings presentation) have increased the last two quarters, though they are lower than in June 2012. CAT sets aside over 1% of its receivables as reserves against losses. In contrast, DE has virtually no credit issues. Thus one may wonder if there is a correlation between CAT's unfortunate over-optimism about mining sector demand and, perhaps, over-optimism about the creditworthiness of some of its customers. I cast no aspersions, but it's not an issue I want to take on by purchasing CAT shares here.

5. The Jim Chanos concern about a serious accounting issue with CAT's acquisition of Bucyrus must weigh; if he's short CAT, then if one is not already long CAT, why argue with him? (Plus Chanos makes macro arguments against CAT's sector.) This is especially so given the embarrassment to CAT of having made a poor acquisition in China in which CAT did not uncover accounting fraud prior to acquiring ERA/Siwei.

During the Q&A, management did not deny that there was a possibility that CAT might end up taking an impairment charge on Bucyrus. (Reminder: CAT acquired Bucyrus at a price many times higher than its bear market bottom.)

6. CAT has been lagging the general market for some time. It has been stoutly supported around $80 for some time, which was a general area of resistance pre-Great Recession. Only in the liquidation period in the summer and early fall in 2011 did $80 give way.

Why not go with cheaper oil stocks that yield as much or more than CAT, have materially lower P/E's and often lower price:book ratios, and likely will participate in the macroeconomic upturn should CAT's hope that the mining cycle downturn will soon end its bear phase?

If CAT is incorrect about a turn in the cycle- say, China does not stimulate soon- why is this stock not vulnerable both fundamentally and on the charts to (say) $60?

7. The turn in business must have scared CAT this past quarter. From the Q&A:

So they've been, I'm not going to quantify for you, but they've been doing - rolling lay-offs, rolling temporary lay-offs for salaried management, employees. We've taken R&D down a little bit. And the things that we're going to do in the second half of the year, we certainly haven't announced to our own employees yet. And so the specifics on that are probably going to start coming out, I would guess over the course of the next month or so. So it's probably better to talk about the specific items after that, but definitely we're planning to take some more action here in the second half of the year.

Matters must have been tough and management is responding. Page 7 of the linked full management discussion details that already, CAT has lowered its global workforce by 13,484 (net of a divestiture) compared with June 2012. That's more than an 8% drop, with more to come.

One the one hand, this shows a proactive management, which we expect out of CAT- and from an investor's standpoint, it's a positive that they can do this and are doing it.

But from the standpoint of uncommitted new money that could go anywhere or sit as cash, there is an equal and opposite point. That is the cockroach theory. CAT now finds itself over-inventoried and over-supplied with employees. Thus it did not only not foresee the downturn in business, it was not even close. This point fits with the overall point that CAT reached over-aggressively for growth with the ERA/Siwei and Bucyrus acquisitions.

Now, with business down sharply, they are taking aggressive corrective action as well as pouring more money into investors' pockets with a higher dividend and repurchasing shares.

Given some clear evidence of misallocation of financial resources at CAT recently, why should investors now have a high degree of confidence that these "shareholder-friendly" actions are appropriate now?

Why isn't keeping more cash in reserve a good idea during a downturn that has not yet ended? Dividends can always be paid later if the money turns out to have been unneeded. Or, better, the cash could help CAT make a future acquisition at a depressed price, not a premium one.

If it's unclear that a company is a top-notch steward of its own capital, why should it deserve a new investor's capital?

Summary: CAT has problems. There's poor visibility as to when business will turn up. A billionaire short-seller has publicly announced that he is short this name. Maybe support around $80 will hold, but maybe it will not.

I am not a registered investment adviser and provide no investment advice. My take on CAT here is that everyone knows that it's a great company, so that's already in the stock. However, I find other names in its sector or related sectors more attractive both fundamentally and technically. [And then you have the competition for new money between the CATs of the world and the JPMorgan Chase (NYSE:JPM)-type financial sector. JPM remains around book value and under 10X earnings.]

This article expresses no view on whether an existing CAT shareholder should sell some or all of a position. As a non-shareholder and basically a long-only investor, my only decision is whether to step in here. Even if I were increasing my allocation to stocks instead of having decreased it into this latest rally, I just don't see CAT as attractive. The dust can settle here before I would want to press the "buy" button.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Not investment advice.