Caterpillar's Troubling Bond Issue

There is a new issue corporate bond today from Caterpillar (CAT) and the pricing of that issue is troublesome - quite troublesome, and reflective of the dire straits of the credit market and the dysfunction which has engulfed the corporate market.

Caterpillar announced a 5 year and a 10 year this morning. The size has yet to be determined, but it is likely to be around $500 million for each tranche.

In early August Caterpillar brought a 5 year bond to market, the 4.90 of August 2013. That bond priced 175 basis points cheap to the benchmark 5 year Treasury note. With the turmoil in the credit markets the last several weeks, the issue has widened on spread and this morning it was quoted 225/ 210.

The talk on the new issue is T + 325 basis points. That is fully 100 basis points cheap to the outstanding issue and 150 basis points above where the same maturity was priced six weeks ago.

This is very disturbing because Caterpillar is an industrial company, unsullied by association with the credit crunch. If it takes that much concession to sell a solid stable industrial, what might the outcome be when a large financial seeks to tap the market?

Rest assured that the result will be gory.

Comments

[User 265729:]

But this is the market... Why does everyone think that credit should be free so this country can binge on the future of generations to come? When money is tight it should become expensive no mater who/what you are. When there is an environment of increased risk money should be more expensive. They way it has always been

Our economy has contracted by $trillions over the past 18 months, but the banks and our government don't want to admit it or deal with the consequences. This why we are in the mess we are in and will be until the market comes clean -- not by playing a "shell game" with dept form the private to public sector.

2008 Sep 23 04:46 PM

[Obama is Bu...:]

Mr Jansen -- Caterpillar is NOT an industrial company. Yes, I know the SIC code says that CAT makes bulldozers and front loaders and such.

But their biggest division is Caterpillar Financial.

They make far more money financing bulldozers than they do manufacturing bulldozers.

Caterpillar is a bank in drag

2008 Sep 23 05:52 PM

[whidbey:]

But the point is this: even the best of the lot is being priced up,but not out of the market , (or very pricey) for a "blue chip". More precisely, With $800 B to roll before this fall, things are looking rather gloomy for credit markets, or do they know something we do not?

2008 Sep 23 07:28 PM

[fatcat:]

This caught my attention today...this is another sign of credit freeze,indeed....if a great multinational like Cat can't borrow at reasonable rates,what chance does Joe Blow have??

2008 Sep 23 07:37 PM

[User 251880:]

Gramps,

CAT's 2007 Sales & Revenue Breakdown:
63% machinery
30% engines
7% financial products

CAT's 2007 Profit Breakdown
86% machinery and engines
14% financial products
Source: www.cat.com/cda/files/...

2008 Sep 23 07:41 PM

[Obama is Bu...:]

User 251880,

You can cook the books to make them say anything you want-- you haven't been paying much attention the past 10yrs if you haven't seen that.

Caterpillar makes its money from finance. GE is another "industrial" company that makes almost 40% of its money from finance (down from 55% a few years ago). GM, another supposed industrial, makes **ALL** its money from Dietech and GMAC.

Caterpillar provides vendor financing for a majority of its sales -- and they book the "revenue" (which came from themselves) as sales of machinery. The cash, was was booked as a "machinery and engine" sale upfront, trickles in over several years. From an accounting standpoint, you can book this revenue as machinery sales or as financing.

CAT sold a lot of their accounts receivable, at a discount, which causes the financial products number to be understated. Also, when a customer fails to pay, the cost is assigned only to financial products (which understates financial products) -- the alleged "sale" of machinery / engines is never unwound.

2008 Sep 24 12:22 AM

[bearfund:]

The market really has it backwards. Who would you rather have owe you money: a corporation with cash, inventory, and plant, that is consistently profitable and is unable to print money to pay its obligations, or a corrupt government printing money and going deeper into debt at an accelerating rate while its tax base erodes by the day? And PS, there is often no recovery in sovereign defaults. If CAT goes belly-up its assets will be sold off and you will receive the proceeds.

2008 Sep 24 12:26 AM

[don2m:]

If you have been following CAT recently you will note that they are further positioning themselves globally especially in China and Russia. The infrastructure has to be maintained regardless of the general economy everywhere meaning that the "squeaky wheel" will get the grease .
Their entire business model is very unique in the "one stop shopping" department. A world class corporation with a top quality product line.
Komatsu and Terex are also rans. IMO

2008 Sep 24 09:38 AM

[Albert Meyer:]

I like Gramps' spunk. Accountants have written the rules in such a way that they can make the numbers tell you anything they want. Grumps, take cash from operations, deduct capital expenditures and then deduct actual credit losses recognized in the bad debt allowance account (in substance a loss of cash/capital). That will give you CAT's true free cash flow. Compare that to net income. I haven't done the calc for CAT, but it's a pretty useful tool to demystify the accountants' smoke-and-mirror show. Vendor financing was a game Lucent played... and see what happened to Lucent. Lucent's former CEO, McGinn sits on the board of American Express, but his bio in the proxy statement makes no reference to his tenure at Lucent - go figure. Off the topic, but I just thought I'd throw it in the mix.

2008 Sep 24 10:20 AM

[Obama is Bu...:]

There have been a lot of articles in trade publications, and a few academic articles written, about the problems of analyzing companies with "captive finance subsidiaries".

Consider an extreme example:
CAT goes and makes a bulldozer for $60K, and "sells" this to the finance subsidiary for $100K, booking a $40K "profit". The finance subsidiary goes and borrows the $100K at 6% (lets say we are looking at this before the credit crisis), and depreciates the bulldozer over 10 years, or $10K per year. The finance subsidiary tries to lease the bulldozer out for at least what it costs them to finance it. Lets look at the case where they are unable to lease it first:

So year one, the accounting books show:
machinery and engines: $40K profit
Finance $16K loss ($10k depreciation + $6K interest)

And CAT as a whole reports a $24K "profit" even though they didnt sell anything.

If the finance subsidiary manages to lease the bulldozer for $18K per year, they would make 2% ROA (which would actually be well above average for financing deals). In this case the accounting books say:
machinery and engines +$40K
Finance +$2K

This is roughly speaking what CAT's books are showing right now, which is why some people **think** CAT is a bulldozer company... most of the earnings **appear** to be coming from machinery, with only a small amount coming from finance.

But what happens if the home builder industry collapses and the finance division cannot lease the bulldozer for all 10yrs? What happens if the cost of financing goes up by more than the lease?

It quickly becomes obvious that the $40K "profits" on the machinery side is nothing more than an **advance** from the finance division. The actual profitability of producing the bulldozer is completely dependent on how well the financial division can finance their assets vs liabilities.

In other words, CAT is a bank

2008 Sep 24 11:47 AM

[User 251880:]

Gramps, it is fine to speculate. When you present hard facts about CAT to back up your speculation, I might begin to be persuaded.

GE's morphing to a largely financial services company is old news and well-supported by the figures in its annual report.

No homework by you or Albert, though, no joy.

2008 Sep 24 01:32 PM

[OldLimey:]

Reading the comments above - all of which are interesting - is it really any wonder that it's so tough to figure out what anything's worth in today's shell-game economy? And if we can generate so many grey hairs trying to figure out a 'straightforward industrial' like CAT, what hope is there for putting a meaningful value on a bank in today's climate - Paulson Plan or no Paulson Plan? And if bankers can't ascribe meaningful values to each others' assets and earnings, why should the Plan make that much difference to interbank lending?

I suggest that anybody who reckons the Plan is a silver bullet should look at a bank balance sheet, notionally sell the RMBSs to the US taxpayer for whatever, then ask himself/herself how much of what's left (including the off-BS stuff) can be properly valued. I've done this with a couple of large European financials, and it ain't pretty - but doubtless I'm missing something.

2008 Sep 24 02:53 PM

[Albert Meyer:]

Old Limey, you're not missing anything. Pretty good summary. old chap.

2008 Sep 24 05:54 PM

[Obama is Bu...:]

User 251880: there is nothing speculative about my description of CAT. I only gave a simplified illustration involving a single bulldozer to illustrate what is going on en mass within CAT's accounting. CAT is a bank.

It took the market quite a while to realize that GE was a bank -- and even after a lot of re-morphing, Imelt today acknowledged that GE is still mostly a bank (he said finance is back up to 53% of the total earnings).

People still think GM is a car company -- but a more thorough analysis of their books show that over 100% of GM's earnings in the last decade came from Dietech and GMAC. The auto manufacturing divisions lost money every single year.

Now before you get all upset: yes, I know GM reported positive SUV earnings on an **accounting** basis a few of those years... however, that was the result of very dubious pension fund assumptions that allowed GM to claim a pension related gain and to avoid making the normal contribution. If you back out the pension shananigans, GM's auto manufacture divisions lost money every single year.

As for CAT... the overwhelming majority of their "sales" are actually leases done through their captive finance subsidiary -- exactly the same as GMAC. CAT also provides financing for dealer inventories.

CAT is a bank

2008 Sep 25 03:03 PM

[objective:]

I agree CAT is a "bank".
But a "bank" without access to deposits for capital and the Fed discount rate for reserves...
CAT has to borrow the money they lend.
I Suggest this model may be broken. That is basically what BearStearns/Lehman/AIG... etc. did...
The supposed "smartest" people at GS and Morgan Stanley have given up and converted to the commercial bank model, so can CAT keep it going if the I-banks can't?... I think you have to take this into consideration when looking at a CAT/GE/GM etc...who depend on borrowing $ to lend to others....
If they get out or are forced out of finance, can they line up banks willing to lend to their equipment customers with underwriting standards that will still result in previous sales volumes?

2008 Sep 27 09:50 AM

[opiniom:]

i think the one big component that is missing here is that CAT sell the machine to an end user only when there is an end user to work it. i.e CATdoes not sell it to a financier unless there is a lessee. also it seems that the majority of the bad credit issues where based on poor lending to real estate owners. macninery is a totally different asset class and finance structures totally different.

Finally biggest growth area for this company is global mining..where the majority of large companies are cash buyers....

2008 Oct 03 11:01 AM