"The market can stay irrational longer than you can stay solvent." - John Maynard Keynes
When evaluating individuals stocks, it is the former high flyers that provide the most attractive downside. That being said, shorting individual stocks is inherently riskier than an index. It is tough for one to simply say, "this stock price is too high," because markets are simply irrational. The market is irrational, but there are some stocks that cannot hide forever.
In a recent interview earlier this month, David Einhorn, president of Greenlight Capital said that he is bearish on Caterpillar Inc. (NYSE:CAT). Based on the company's recent troubles, I too am bearish on Caterpillar and believe that the stock has yet to hit rock bottom, and in turn, leaving investors plenty of room for profit. I believe Caterpillar faces challenges from a boom-and-bust cycle in mining, and will take a hard hit with the slowdown in China and drop in energy exploration revenues. Not to mention, Caterpillar has not been affected as of yet, but faces a significant sales headwind from idled equipment.
The Global Perspective
Global economic growth, construction activity, commodity prices, and government spending on infrastructure are all key drivers of demand for Caterpillar's products. Simultaneously, Caterpillar's dealer network typically employs more people and has more assets than Caterpillar itself, offering a significant competitive advantage. By the end of 2013, 75% of Caterpillar's independent dealers were located outside of the U.S. Also, in light of the size of its organization, Caterpillar will benefit going forward from certain economies of scale related to materials sourcing and other manufacturing efficiencies, thus offering it some leverage from its major sources of revenue if the "(expletive) hits the fan."
The Management Flaws
Caterpillar recorded a $580 million ($0.87 a share) charge in 2012's fourth quarter for the writedown of its ERA Mining Machinery unit. The writedown was related to Caterpillar's discovery of accounting misconduct at ERA for several years prior to Caterpillar's mid-2012 takeover of the unit for about $700 million. The acquired business focuses on making roof support products within the Chinese coal mining industry. While this has hurt the perception of Caterpillar's management team, the team has begun its expansion within Asia, nonetheless.
The Construction Industry's Future
Based on a study by KHL Group, a construction information firm, sales of construction equipment by the world's 50 largest manufacturers grew 2.6% in 2012, declined 1% in 2013 and fell 2.6% in 2014. These numbers completely contrast the numbers of 2011, a time when sales grew by a massive 25%. The major demand in nonresidential markets reflected in 2010 and 2011 was a once in a lifetime scenario, a scenario which rarely comes around. The company benefited from a massive number of construction projects in emerging markets. These years specifically allowed Caterpillar to profit and grow as a major player within the construction industry. Today, with the recent economic uncertainties globally and specifically in China, there is a moderate downward pace in construction equipment markets seen in 2012-14 and going forth into 2017.
I see pressure on EBITDA going into 2016 based on negative fixed cost leverage on the lower revenues, along with higher pension costs, offset by ongoing cost cuts and restructuring actions. There will be continued weakness in the higher-margin mining equipment business, which will most likely create a negative mix as well. Expect to see EBITDA margins of 11.7% in 2016, and 13.2% in 2017 versus 14.2% in 2015.
Yes, some analysts project Caterpillar to make a recovery in 2017 and into 2018, but I honestly believe the stock is likely to trade at half its current value as the variables play out. Caterpillar is way too expensive. This construction and mining equipment maker has enjoyed the benefits from a "once in a generation, if not once in a lifetime" growth in infrastructure investment thanks to the buildout of China, a trend that is simply coming to an end.
China is scrambling to prop up its credit-driven economy, which released very weak Q1 results. Effects of the slowdown in China will be felt worldwide, specifically by United States Steel Corporation (NYSE:X). Credit is the life-blood of China's economy, with $1 trillion U.S. dollars in new credit created. China's economy is slowing industrially. The country has roughly 50 percent of the world's consumption of steel and as it slows, Caterpillar will be hit hard. The company is exposed to mining, fracking and equipment purchases globally. All of these categories are in structural decline. There is excess supply throughout the three sectors Caterpillar is mainly exposed to and could lead to a drastic supply shock that has been seen by the company in the past.
Caterpillar has 30% of its revenue and half of its operating profits tied to global mining capital expenditures. They have been experiencing steady growth year over year, which is now waning. For example, during previous downturns, Caterpillar would experience negative margins. The recent elevation has made even the weaker times profitable for the company. This trend of continually expanding corporate margins is likely to have a viscous outcome moving forward. This on top of issues created by negative free cash flow after cap-ex, indirectly calling the company's ability to keep hiking its dividend steadily into question.
After facing a 15% decline in 2015, I project revenues to fall another 10%-15% in 2016, followed by only a 3%-5% drop in 2017. Economic uncertainties have limited demand since 2012, and conditions in the construction equipment and power systems businesses are near a bottom. Both of these segments, most likely to be aided in the coming year by slightly better global economies, as well as the likely end of inventory reductions at dealers and a pickup in demand. Nonetheless, analytical predictions see a continued sales downturn in the mining equipment business, which has been impacted by lower commodity prices in oil and gas, coal, iron ore and copper.
My short analysis reflects the valuation that Caterpillar is simply too high in price. The company is faced with a weakness in the mining equipment business going forth. Their business is highly dependent on global economic conditions, and its overall results are likely to weaken in 2016. The timetable towards recovery is uncertain. Caterpillar relies on many factors in order to witness success, such as the strengthening in commodity markets and global economies. These factors, on top of struggling revenue and operating margin performance make Caterpillar a company, which has a deep hole to get out of and I just do not see them doing this over the next 12 months. Expect Caterpillar to trade around $50 over a 12-month period.
Disclosure: I/we 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.