It appears that Caterpillar (CAT) management is utilizing the stale global business climate for excavation machinery and dismal near-term earnings prospects to discharge problems and set up for brighter days. While swing traders may wish to play various strategies or just exit, long investors may wish to sit tight.
Last week, famed hedge fund manager Jim Chanos made headlines when he proclaimed he was going short on Caterpillar stock, and the company is doomed. Kudos for Mr. Chanos in the short term, but cyclical stocks have a way of bouncing back quickly. When you think you've got them all figured out, they turn around and punch you in the nose.
In this article, we will look at some 2013 second quarter "behind the headline numbers" earnings report analysis, and offer long investors a possible thesis for continuing to own the stock.
Second Quarter Earnings Release
Despite Wall Street relentlessly lowering expectations prior to the earnings release, Caterpillar missed the headline numbers big-time. Estimates called for $1.70 EPS on $14.9 billion revenues. Actuals came in at $1.45 per diluted share on $14.6 billion in sales.
Revised 2013 full-year EPS forecasts now call for $6.50 EPS on a midpoint of $57 billion in revenues. This figure has declined to nearly the low-ebb earnings projection management claimed it could secure in a full-on global recession.
Fold up the tent and sell everything? Maybe not.
Behind the Headline Numbers
The earnings report wasn't good; can't put lipstick on a pig. However, there were several items in the release that lend credence to this article's title. Sometimes senior management, instead of fighting the macro tide, decides to use the downturn to clean out operational and fiscal problems; taking an earnings hit, but clearing the decks for better sailing.
Let's examine the following:
- Cash Flow
- Stock Buyback
- Dividend Increase
First half earnings have been pretty awful and 2Q missed the Street peg by a mile. However, first half operating and free cash flows are actually pretty good. Here's the details:
Notice that first-half Operating Cash Flow is two-and-a-half times Earnings Per Share. Indeed, even Free-Cash-Flow per share is significantly higher than diluted EPS. This is an unusually large gap.
Remember, Cash is King.
One of the major reasons for improved cash flows (and lower earnings) are huge reductions in Inventory. Here's a table showing how Caterpillar management has ground down inventory over the past several quarters. Balance sheet inventory now rests at the +/- $14 billion target management set back in April.
In the 2Q earnings release, CEO Doug Oberhelman indicated such actions will contribute to the process of "kitchen sinking" the business now, with the expectations of better times in the future. Here's an excerpt from his prepared remarks:
"....an additional $1 billion of dealer machine inventory reductions and a decline of $1.2 billion in our own inventory. While these were significantly negative to profit in the second quarter, our outlook doesn't reflect....reductions in our inventory during the second half of 2013. As a result, we expect profit to improve in the second half of the year," said Caterpillar Chairman and Chief Executive Officer Doug Oberhelman.
"The $1 billion reduction in dealer machine inventory was more than we previously expected and was negative and profit in the quarter. While dealer machine inventory is low by historic standards, dealers are utilizing inventory from our product distribution centers and are positioned to reduce inventory even further. As a result, we expect dealer machine inventory to decline about $1.5 to $2 billion in the second half of 2013 and end the year about $3.5 billion lower than year-end 2012. That means that we are underselling enduser demand this year, and it sets us up for better sales in 2014," Oberhelman added.
Please pay particular attention to the bold type sections (mine). Notably, the inventory drawdowns are not just on the Caterpillar balance sheet: they are ongoing at the dealer level, too.
In the second quarter, CAT directors and management acted aggressively upon a previously authorized share repurchase plan, buying back $1 billion in stock. Furthermore, management announced their intent to duplicate the effort in the upcoming quarter. The magnitude of the second quarter buyback moved the needle. Here's the numbers:
For the prior three quarters, the share count drifted up. However, the billion dollar 2013 2Q buyback reduced the shares outstanding by nine million or 1.3 percent. Another such third quarter effort has the potential to knock back the figure by at least this much again, particularly if the share price stays down.
A fifteen percent bump in the June dividend declaration marked a five-year, 8 percent annualized increase in the cash payout. This puts the current yield at 2.88 percent. While this won't put CAT into the class of a high-yielder, the distribution isn't chump change anymore.
More important, rarely does a board raise the dividend so much in the face of an anticipated secular decline in the business. A generous improvement in the cash payout indicates director and management confidence in the enterprise and its future. Indeed, Caterpillar is boosting the dividend alongside buying back a meaningful amount of stock. I consider this bullish for long-term investors.
An Investment Thesis
I am not here to say that Caterpillar stock will turn around on a dime. Quite the opposite -- I suspect that CAT investors may need to wait at least another couple of quarters. However, the wait for this cyclical stock to turn may be worth it.
Here's how I read the tea leaves.
Caterpillar's fortunes are generally aligned with the global economy. It is a well-run company, possessing a good balance sheet. The business generates strong cash flow. Management has underlined this point by aggressively buying back stock and raising the dividend.
If CAT's fortunes ride on the global economy, then the past several quarters could not have been much worse, short an all-out worldwide recession.
North America hasn't shown robust growth for several years. Finally, some green shoots are beginning to sprout. The EU is bottoming after years of recession. I see a gradual recovery in Europe. China has been slowing, but Caterpillar management saw some recent improvement there. Chinese leaders have stated that economic growth less than seven percent is unacceptable. I believe China will turn up in 2014; along with Japan. Latin America, particularly Brazil, has been in the doldrums. I envision improved construction and mining activity as the region improves, riding a Chinese rebound tailwind; and the 2016 Olympics.
The thesis is not without its caveats.
First, my short-term, line-in-the-sand share price is $80. CAT stock has held this line no less than four times since breaking through the mark in 2010. Whenever the story line got rough, the shares dropped to this point, but no more. I plan to watch this benchmark carefully.
A note: Placing a 12.5x P/E multiple on $6.50 a share EPS yields an $80 stock.
Unless expectations become such that the major global economies find 2014 worse than this year, I believe CAT will stay north of that line. If it breaks $80 to the downside, support is far below. Here's a four-year weekly chart summarizing the action. Notice the $80 support line:
Courtesy of ameritrade.com
Second, my thesis is underpinned by the assumption that China's economy bounces back. Sans China, the mining businesses in Asia, Latin America and Australia will all falter, thereby hurting Caterpillar's sales of mining equipment worldwide. Indeed, I do not agree with Mr. Chanos' media assertion:
"...the commodities super-cycle built on the back of the Chinese construction boom is coming to an end."
I suggest that if the world's developing nations and their economies are to continue improving, the mega-cycle for energy and raw materials must increase, not decrease. Furthermore, my thesis does not anticipate a 2014 global recession.
What About a Target Price?
Let's begin by asking the question, "What rational price may be placed upon the shares given a reasonably positive global economic backdrop?"
While there are a number of methodologies, I found using the historic RoA (Return-on-Assets) metric helpful when trying to determine a normalized EPS forecast. Here's Caterpillar's RoA over the past seven years, and through the first half of 2013:
(click to enlarge)
Note the half-year RoA is shaping up similar to 2010. Recall that 2010 was not a banner year, coming out of a deep recession. Caterpillar's 2010 revenues, operating income and net income were all below that for 2008.
The data suggest that in a normalized global economy, the company may expect an approximate RoA in the low 6 percent range.
Assuming a 6.2 percent RoA on Caterpillar's total assets, and solving for net income suggests a NIAT of $5.46 billion. This is below what the company made just last year. Assuming that the company reduces YE 2013 diluted shares to 650 million via buybacks, then keeps the count stable, a "normalized" EPS of $8.46 is estimated.
In addition, this premises that Caterpillar's total assets do not increase. Such an occurrence has happened once in the past decade: during the 2009 Great Recession. So there's some conservatism built in.
Placing a 14x P/E multiple on $8.46 earnings, a target price of $118 is generated. That's 42 percent greater than yesterday's closing price.
How many times over the past ten years has Caterpillar stock NOT commanded at least a 14x multiple at some point during the year?
Please do your own careful due diligence before making any investment. Good luck with all your 2013 investments and beyond.