What do you do with a highly cyclical stock like Caterpillar (NYSE:CAT)? It's one thing to try to use common valuation techniques to help make an investment decision, but the truth is that its revenue and earnings numbers are largely guided by movements in its end markets. Moreover, with cyclical stocks it's often the case that they look their most expensive precisely when you should be buying them. In other words, just before their earnings are about to turn up with the cycle. With that said, what's an investor to make of Caterpillar in 2015?
Caterpillar prepares for a tough year
Readers already have an idea of how cyclical some of Caterpillar's construction end markets can be, and recent events have demonstrated that its other end markets are equally prone to the ups and downs of their business cycles.
Back in October, in its third-quarter earnings release, management gave its preliminary sales and revenues outlook for 2015. At the time, they forecast 2014 sales and revenues to be $55 billion, and for 2015 sales and revenues to be "flat to slightly up from 2014." Fast-forward to the fourth-quarter results, and 2015 sales and revenues are now expected to decline 9% to 50 billion. Similarly, management's guidance for 2015 EPS of $4.75 was significantly lower than analyst estimates of around $6.80. What went wrong?
Guidance lowered, across the board
Mike DeWalt, VP of Caterpillar's financial services division, outlined the biggest issue on the fourth-quarter earnings call: "Without a doubt, the impact of substantially lower oil and gas prices is the most significant reason we're expecting lower sales in 2015."
If falling mining commodity prices weren't bad enough for Caterpillar already, the decline in oil and gas prices is expected to hit its energy and transportation sales in 2015. It gets worse: DeWalt also outlined the indirect effects of lower energy prices on demand for its construction and electric power generation businesses.
The following table summarizes the guidance given by Caterpillar in its fourth-quarter earnings call.
|Energy and Transportation||Drilling and Well Servicing||"Hurt the earliest and most significantly ... particularly in the second half of the year."|
|Energy and Transportation||Turbines||"We don't expect much impact there in 2015." However, if energy prices stay "depressed" there could be a negative impact after 2015.|
|Energy and Transportation||Industrial Engines||Lower sales of industrial engines expected due to "weakness in agriculture."|
|Construction Industries||Construction||Construction activity around oil wells could decline.Oil-producing countries could slow construction spending.
"With lower expectations for China construction, we think our 2015 sales in China will be down."
|Resource Industries||Mining||"Continued efficiency improvements by our mining customers have caused us to lower our sales estimate."|
Ultimately, Caterpillar's management expects "roughly half" of the expected 9% decline in sales to come from the decline in oil prices. However, as readers can see, management sees weakness in China, as well as agriculture and mining.
Where next for Caterpillar?
Caterpillar's bears include people like hedge fund manager Jim Chanos, and it's hard not to associate his bearish viewpoint on the company with his well publicized negative views on China's capital and property markets. In fact, prospects for China and emerging markets are seen by many as being the key deciding factor in determining commodity price movements.
With this in mind, I can think of three stances that investors might take regarding investing in Caterpillar stock.
- Bull -- Downside is limited, and oil and mining commodity prices are about to bottom, especially with stronger U.S. growth in 2015.
- Bear -- China carries systemic risk, growth will continue to slow and take other emerging markets and commodity prices demand down with it.
- Soft Bull -- Low commodity prices will eventually spur faster growth, particularly in emerging markets; the commodity cycle will eventually turn as demand kicks in and it will take Caterpillar with it at some point.
Clearly, investors with bullish views on commodity prices will like the look of Caterpillar right now. After all, its management's commentary above appears to have baked almost every conceivable negative into its guidance -- meaning that it if commodity prices rise, then Caterpillar is likely to outperform expectations. As for China bears, they will simply avoid the stock altogether.
The soft bull case?
However, it's the soft bull case that grabs the eye. The question is, when are lower commodity prices likely to feed into higher growth? One useful source on the subject is Emerson Electric. Emerson is interesting to look at because it has a broad exposure to industrial spending, particularly with oil and gas processing.
On the company's recent earnings call, CEO David Farr outlined: "I think with lower energy prices, you're going to see some of the emerging markets accelerate growth late 2015 and going into 2016."
If Farr's viewpoint is accurate, it could be a while before Caterpillar starts to see the cycle in its favor. In other words, if you buy the idea that the cycle will turn eventually, then you might need to be patient.
Lee Samaha has no position in any stocks mentioned. For the record, the author's position is somewhere between the bear and soft bull positions. Closer to the bear, at least on China, but who knows when it will all unravel?
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