What We're Looking For In Caterpillar Earnings

| About: Caterpillar Inc. (CAT)
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Summary

We expect Q1 EPS to come in in-line with guidance, but FY 2016 EPS to miss handily.

Watch for CAT's commentary in the 10-Q; it tends to be more gloomy than its more public earnings release.

We fail to see a world that results in a significant turnaround for CAT, and as such, the company's current valuation doesn't make sense to us.

Caterpillar (NYSE:CAT) reports earnings this Friday, and given the company's exposure to some of the more followed and interesting industries this year (namely oil and gas, resources, and China), it's worth pointing investors to a few things to watch for in Q1.

Our Thoughts on Guidance

CAT lowered its Q1 guidance in March (wisely from our point of view) to $9.3-$9.4 billion of revenue and $0.65-0.70 in EPS. We think this is certainly achievable. Q1 is historically the weakest quarter from a sales standpoint, and the sales figure, given the hardship in CAT's end market, seems a reasonable decline relative to Q4 2015.

We don't have particular trouble getting to CAT's guidance using reasonable metrics, which can be seen below.

Note that every $7-8 million of additional expenses or lost margin cuts $0.01 off of EPS.

Cat Finance

We expect Cat Finance revenue to be down mostly because of reduced lending activity. What we will be watching more closely is the rate of charged-off receivables, which have remained very stable to date at about 20 bps of CAT's loan portfolio.

This isn't a huge issue for CAT; even in the depths of the financial crisis, the company didn't write off more than about 1% of the portfolio. We believe, however, that over the next few months, the write-offs will tick up, as more of CAT's end customers are running into financial stress. In the early innings of the commodity collapse, many companies still had liquidity, but that is now running out, and so we expect to see default activity tick up across the sector.

The primary reason we watch Cat Finance is because it is a significantly higher margin business for CAT, and so continued erosion in it will negatively affect CAT's business. We believe that the reaction in CAT's finance business to adverse conditions in end markets is somewhat delayed, and so the deterioration in this business will pick up over 2016.

Outlook

Here's where the interesting tidbits will really be. Everyone knows CAT will shrink in 2016, but the question remains as to how permanent this new, smaller CAT will be.

There are a few negatives we see. First, the resource and oil and gas spaces haven't seen increases in activity. This quarter saw increases in commodity prices, but many of the companies we follow in the resource space are running into extremely tight liquidity conditions, and a one quarter increase in revenues by a relatively small amount doesn't really help.

Second, as CAT outlined in its most recent 10-K (on page 32), the reduced demand for equipment in the resource and oil and gas space will mean that the relatively strong construction in the US will not translate into stronger sales because the reduced demand in oil and gas frees up equipment for other uses.

We also expect to see continued headwinds in China, where we continue to believe the situation on the ground is significantly worse than what the statistics say. Indeed, CAT's sales in Asia in its construction segment are a useful barometer for actual construction activity in China, and should be monitored closely for that reason.

These two factors lead us to believe that CAT's rather aggressive guidance for its construction segment will not be met in 2016, a fact which many investors seem to not appreciate.

Another factor that will weigh on CAT's results is the huge builds in used equipment around the world. CAT and its dealer network have reduced inventory over the past year, but that fails to take into account the large increase in used products now available, which are likely to weigh on CAT's sales for a while going forward.

FY 2016 Guidance

We don't have a view on what CAT will do with its FY 2016 guidance, however, we see limited upside.

First, CAT has already told us it plans to continue restructuring into 2018, so that drag on earnings isn't going away. It recorded $908 million of expenses in 2015 to that end, and we expect that in 2016, that number will come to about $400 million. That $500 million in savings adds $0.84 per share.

To give some rough numbers, we expect revenue to come in lower than CAT's guidance, at about $37.5-$38 billion. At a 30% gross margin, and giving them $500 million of cost savings, on a constant share count basis, we come to an FY2016 EPS estimate of $3.30, which is below CAT's guidance of $3.50.

CAT may choose to lower its guidance for the year given headwinds really have not abated; however, we think it is more likely that it keeps its guidance in place until the second half of the year when it becomes apparent that it will not be able to achieve it. CAT's management has a long history of being slow to accept defeat when it comes to its outlook on the world. We find it particularly interesting to read its earnings releases and guidance, which generally seem upbeat and then compare it to the very somber tone that the 10-K and 10-Q's take.

Valuation

The question investors need to ask themselves about CAT is what is fair value really. For cyclical stocks, P/E expands at bottoms and contracts at tops, so simply looking at CAT's current P/E ratio isn't an effective way to value the company.

The big change we see with CAT is that this isn't a cyclical low it's dealing with. China is slowing down, a structural change which will apply permanently. Oil prices, we believe, are capped for the next few years at $65 or so due to a lack of commitment from OPEC to cut production, relatively unimpressive demand, and the capacity of shale producers to turn on the taps if oil prices rise too far too fast. Until we start to see shale producers' defaults increase, we expect that oil prices will remain roughly where they are.

What we're dealing with is a normalization from an unparalleled resource boom post 2008, and to that end, we see very little upside from an earnings perspective for CAT beyond what it can achieve from a cost perspective. In other words, we don't see it getting back to $7 or 8 in EPS even after taking into account buybacks.

Given the current environment is likely to persist well into the future (read 3-5 years), we see limited upside for CAT's business going forward. Even with the cost savings it has realized applied going forward, we fail to see a scenario in which CAT earns above $5 per share in the next 5 years.

Historically, CAT has traded between 8-25x earnings since 2010; however, the high end of that valuation was influenced by one of the greatest commodity booms in history, so it's not a particularly useful part of the sample.

The median valuation for CAT over the past 5 or so years has been ~15x earnings, a level we feel is reasonable. At $3.30 per share, this values CAT at $49.50 per share. At $5 per share, that values CAT at $75 per share.

Conclusions

Given shares of CAT are currently trading well above our valuation, we advise caution at the very least for investors going into earnings. We think this is a classic CAT case of management publicly hoping for an H2 2016 turnaround, but privately (buried in the SEC filings) acknowledging things on the ground are ugly, and likely to remain so.

Furthermore, even if it did appear, there is little upside in CAT's valuation from this point. Indeed, we believe that the market has priced in an improvement in H2 2016, and so incremental upside from that eventuality is limited.

Disclosure: I am/we are short CAT.

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.