We wrote an article a month ago expressing our negative view on Caterpillar (CAT). Since that time the stock has bounced within its trading range but today has declined 5+% on worse than expected earnings. In our view, our thesis is coming to fruition and see little upside in the shares from even today's lower levels. In fact, given the outlook for 2014, for both net income and cash flow, we see significant downside ahead and continue to think the share price will break well below its downside support of $80.
CAT reported earnings this morning and they were not good. Rather than rehash the numbers, we refer the reader to the press release and their conference call. Needless to say, with earnings estimates for the year being revised down $1, from $6.50 per share to $5.50 - a 15% change - the shares reacted. The fourth quarter is not likely to be improved much with the company stating earnings will be lower due to the onetime tax benefit in Q3. Given that earnings estimates are just beginning to be downward adjusted, there will continue to be pressure to maintain the share price.
There are a number of reasons that we are not sanguine on CAT's future. First, they stated that 2014 will likely be flat to 2013. We take that as meaning to the second half of 2013. They also stated that Q3 earnings were boosted by a onetime tax benefit and that Q4 should be 16% lower or about $1.20/share. Given the two, we feel that a $5 per share earnings for 2014 is a good guess. If macro-economic conditions sour, even that will look quite rosy. Analysts' earnings estimates are still at about $7 for 2014 so further downgrades are likely coming. Since the stock was trading at about 12.5 times '14 earnings before the announcement, the same multiple would imply a share price in the low $60s. Even if the market "looks through" 2013/14 to some degree, one finds an $80 share price (downside support) hard to justify.
Another reason we are negative on the stock is that we expect a significant writedown at year end. CAT performs its goodwill testing on October 1 to be incorporated into the year-end results. It is hard to imagine they will not have impairments with a significant amount of goodwill within their mining segment (~4bn) much due to recent acquisitions. We expect $2-3 per share of writedowns in Q4 bringing GAAP earnings significantly lower than forecast. While many investors give a company a pass on writedowns, in CAT's case it will shed light on their balance sheet. Out of the $18bn in stated equity, $11.5 bn is goodwill and intangible assets. Tangible equity is only $7.5bn and $4.5bn of that is for their finance division. Assuming that goodwill, intangible, and finance equity should trade at a multiple of 1x, this would imply $24 share price (fully diluted) for those segments. This means the market is assigning a $60 share price to the residual $3bn in equity or 13 times. That is absurd to us. A closer to market normal multiplier would imply a sub $50 share price.
Finally, we find CAT's touting of their robust cash flow for this year as being hollow. Looking through their financials, one sees that the positive cash flow this year was due to changes in working capital. In particular, $1.2bn was a result of lower net receivables and $1.9bn was a result of selling out of inventory. The company stated on their conference call that inventory effects were likely to be nil going forward and we are doubtful of a meaningful impact from lower net receivables. The company also failed to note that dividend payments were lower this year due to the accelerated payment of 4Q12's dividend, before the capital gains tax law change. Without the changes in working capital, CAT would have had $5.4bn in free cash flow against $4.1bn in capital expenditures and dividend payments, normalized, were $1.1bn. This leaves only $200mn for the first nine-months of 2013. So, in other words, the $2bn spent on buybacks so far this year came out of the onetime impact of working capital changes. Don't look for that to continue and we expect buybacks to come to a grinding halt soon. Without share buybacks, which we already question fundamentally, the support for CAT's share price will be challenged.
Looking forward, at $5 a share net income for 2014, free cash flow will be about $6.2bn. Capital expenditures are likely to be about $5bn, down about $400mn. We should note that the bulk of CAT's capital expenditures are due to equipment leases - equipment "purchased" by CAT finance and then leased to customers - and incremental finance receivables. This "accounting capex" can only be reduced by offering less financing to customers, presumably slowing down sales. The company also discussed on their conference call the limitations of reducing production lines or shutting down factories calling into question the ability to reduce "bricks-and-mortar capex" much. Dividend payments next year are scheduled to be a hefty $1.5bn so we see little room for CAT to increase dividend or buyback stock without issuing more debt. However, with tangible equity already quite low (11% of liabilities), we do not think CAT can maintain buybacks. In fact, if economic conditions sour, a dividend reduction will have to be considered. Given the lower payout ratio from free cash flow, we believe a dividend yield in the 4-5% range is more the market norm implying a $50-$60 pps is more appropriate.
We were not impressed with analyst questions on the CAT conference call. They all seemed like softballs intended to let management not have to discuss the real issues going forward. Even when pressed, however, management did not want to get too far into discussing the outlook for 2014. We understand why. CAT will have a very challenging year in 2014 as we see little improvement from the mining sector, where a bulk of their investments have occurred over the last few years. Even CAT's construction segment is exposed to the mining sector woes as mentioned on the call. Given all fundamental metrics point to a share price much lower than today's trading price, we recommend investors shy away from CAT. In the past, CAT has traded on earnings multiples without regard for the leverage on the balance sheet. But in a world of declining earnings and impairments, investor focus will change and we expect the stock to trade in a lower range - $60 remains our target for 2014. We are currently short CAT as hedge against other names where we see much better balance sheets and room for growth over the next 1-2 years.