Caterpillar (CAT) is a large cap, widely covered stock so the first thing we asked ourselves is: Can we add anything to the discussion? On the one side, there is the Jim Chanos crowd who've been crowing about CAT from the short side (from a lower price mind you). And then there is a large majority of long-term investors who feel the stock is a true value, especially with the price decline from $115 in early 2012 to its current price of around $87. So where do we come down? Our inclination is to lean to the short side. Not because we necessarily feel there is a liquidity crisis brewing or some near-term catalyst but more we feel this is a high-leverage, high-beta name that provides a decent hedge against some of our other long positions. We think CAT would get hit hard in a general market swoon and, if mining companies continue slashing capital expenditures, which looks likely, CAT will be in for a tough slog for the next few years.
The first thing we noticed about CAT is that it looks highly levered. Its consolidated equity is $17.6bn or about $27 per share so it trades at over 3x book value. Even more disturbing to us is that tangible equity is only $6.6bn as they have near $11bn in goodwill and intangibles on their balance sheet. The goodwill is the price they paid, over book, for acquisitions in the past and intangibles are for things like customer relationships et. al., representing another premium to hard assets. In general, we don't like putting a premium on top of a premium and would value those assets at their stated book value. That said, we've seen a lot of goodwill write-downs in our day and not as many write-ups so maybe a lower than unity multiple is more in order.
A more detailed look at the balance sheet finds that CAT is actually two companies. The construction equipment manufacturer (CAT-MP&S) and CAT Financial (CAT-FIN). CAT-FIN is the side of the business that makes financing available to CAT dealers and other third parties along with leasing, insurance and other activities. CAT-FIN is not small. Their assets are $37bn with liabilities of $32.3bn and equity (owned by CAT-MP&S) of ~$4.5bn. To put that in perspective CAT-FIN's assets and liabilities are about 45% of CAT's overall balance sheet.
Given most non-diversified financial companies are priced at, if not under, book value, we see no reason to put a premium on this part of CAT's business. CAT-FIN is an integral part of CAT-MP&S sales and revenue generation. In 2012, the $5bn in increased revenue from CAT-MP&S was entirely reflected in an increase in CAT-FIN's portfolio of a similar amount; the money used to buy CAT-MP&S's equipment was borrowed from CAT-FIN. Whether the same sales numbers would have been maintained if CAT-FIN was not there to offer financing is unknown but we suspect it didn't hurt.
CAT-FIN has about $4.5bn in equity. As we mentioned, goodwill and intangibles are about $11bn for CAT-MP&S. That leaves $2.2bn of tangible equity remaining, which seems kind of slim to us. Given we believe that the former two should be valued by the market at book, it implies that CAT-MP&S's tangible equity is being valued at 19x book value by the market. That looks extreme to us. We looked back 10-years ago, to 2002, when there was more tangible equity, and a smaller CAT-FIN, and found CAT's stock price was reflecting more like a 10-11x multiple to CAT-MP&S tangible equity. Applying that multiple to today, would imply a stock price more like $60/share. Now we're not setting that as a target; it is just closer to where we think a proper valuation would be. As an aside, we noticed that CAT-FIN has become more levered of late (8.2 assets/equity), not seen this high since 2008, as well as CAT's overall balance sheet (12x tangible assets/tangible equity vs. 7-8x historically).
On their recent conference call, CAT's management stated a revised 2013 estimate of $6.5 earnings per share. To be honest, given their first half number of $2.8 per share, we find it difficult to get to that number without a decent increase in sales, and margin improvement, in the latter half of this year. Given management's own statement that CAT dealers will continue to drawdown inventory, taking supply from CAT's product distribution centers, we see a big jump in volume or pricing tough to swallow. Even with an improvement in margins, we see more likely we'll end the year at a $5.75-$6 EPS number.
Now, while that depressed number still sounds reasonable with a $2.40 dividend, investors need to consider it relative to the leverage in the company's balance sheet. It is easy creating high return on equity and growth via increased leverage, but at some point - usually during a downswing - the market punishes higher leverage as its risk is uncovered. Given CAT's leverage, we think a 10x multiple is not out of line, getting us back to $60 pps. It doesn't look like 2014 is going to be a robust sector in construction/mining, so it is unclear to us if results will improve much on a forward basis. Given analysts are still calling for $7.25 in earnings next year, we see downward revisions going forward.
CAT is buying back stock. It bought back $1bn in Q2 and plans were for another $1.5bn in Q3. For the life of us, we can't rationalize this given the premium to book value, an already levered-up balance sheet, and the high EPS multiple given a likely $6 target in 2014. Why not pay a special dividend? Or pay down debt? Or top off a very underfunded pension benefit plan?
A cat has 9-lives and CAT has made it through many cycles in the past, particularly in 2008-9. However, we question how much further CAT-FIN can lever up to CAT-MP&S's benefit and what the end-game would be with a commodity-led bust. One thing for sure is miners in all fields, whether gold, iron-ore, or plain fertilizer, are all cutting back spending dramatically and we suspect it will last well into next year. Whether CAT will maintain a premium stock price is anyone's guess, but we find it a good short hedge against other growth prospects.