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A closer look at the CAT - Q2 09 results demands further scrutingy. Let's walk through it with a magnifying glass and an open mind. Below are the main conclusions to be drawn from what was reported: (this is to be read after the CAT report: Caterpillar Inc. Preliminary Analysis Caterpillar Inc. Preliminary Analysis 2009-06-17 10:34:20 666.50 Kb, CAT Forensic Analysis Retail CAT Forensic Analysis Retail 2009-06-25 15:43:20 374.87 Kb, CAT Forensic Analysis Professional CAT Forensic Analysis Professional 2009-06-25 15:44:27 836.39 Kb and for non-subscribers - CAT’s 2Q09 results analysis) . Note and disclaimer: This material was put together from contributions from several readers as well as my own analysts. Please note that this is not investment advice (nor is anything that you get from my site), and everything presented is for illustrative purposes only, with no warranty (explicit or implied) as to accuracy or completeness.

  • Big EPS beat, mostly due to one-timers. We saw a big EPS beat this Q (60 cents actual vs 22 cents expected), but it was entirely due to factors that are not reflective of ongoing profitability or indicative of the health of core operations - currency fluctuations, low cost inventory liquidation, low tax rate. In essence, the accountants seemed to have packed every one timer they could find into this quarter to come up with an estimate beat. Does this fool the Street? Apparently since the stock is rising. Can it be replicated? Hell no!
  • Normalized Q2 09 EPS much lower. Adjusting margins and costs to where they should reasonably be given sharply lower sales offset by very respectable amounts of cost cutting, and we would have seen 18 cents normalized EPS. The logic behind the adjustment is to account for all of the factors included in this quarter that are just highly unlikely to happen again. In other words, what do we expect for next quarter???
  • Since the surprise was one-time in nature, another way of thinking about the one-time nature of this "beat" is to consider that the "beat" was 38 cents, which is 85% of the 45 cent increase in their 2009 guidance. It is the increase in guidance that the media has used to justify the optimism driving the share price rally. Wait a minute! If 85% of the guidance raise was baked into this quarter and this quarter can't be repeated, what does that portend going forward?
  • Conservative valuation calculations: Conservatively driving "normal" sales off the Q1/Q2 average, using the Q2 09 normalized net margin and a conservative 20 multiple implies a fair stock price well below our current $40+, and well below the conservative valuation band given in BoomBustBlog research reports - CAT Forensic Analysis Retail CAT Forensic Analysis Retail 2009-06-25 15:43:20 374.87 Kb, CAT Forensic Analysis Professional CAT Forensic Analysis Professional 2009-06-25 15:44:27 836.39 Kb 
  • Long term view - consensus is wrong (as it usually alwasy is, for some odd reason). If the consensus is correct, this will have been an irrationally short and shallow downturn for CAT from a revenue and profitability standpoint, historically speaking).
  • Leverage remains elevated. Machinery debt declined from $7.3B in Q1 09 to $6.9B in Q2 09. Off of "Debt / Capitalization" using Shareholders Equity, we saw improvement. Off of Debt / Revenues, we saw sharp deterioration.
  • Mgmt calling for very weak Q3, implying they are pinning all hopes on Q4 stabilization. The Q3 appears so weak that they are doing large scale rolling shut downs. Profits no doubt will be tossed out of the window. Their hope, and what it appears they are pinning their guidance on, is Q4 improvement. Basically, they are looking to eat those "green shoots"!

Let's move forward to expand on each and every one of the points above in detail.

Triangulating from a number of different vantage points it simply does not make sense that this was it.

The market is rallying hard on (1) a Q2 09 earnings beat and (2) improvement in 2009 EPS ex-restructuring guidance from $2-2.5 in Q4 08 to $1.25 in Q1 09 to $1.15-2.25 ($1.7 midpoint) in Q2 09, shrugging off lowered revenue guidance from an already weak level. Macro indications globally do not look promising, even when sourced independently. Take the anecdotal evidence from other companies with global exposure to the business cycle, ex. UPS - UPS Forecasts Profit Less Than Estimates; Sales Fall... 

What this analysis will show is that (1) their "beat" this Q was a lot more tenuous than they(apparently successfully) made it seem; (2) they themselves acknowledge Q3 2009 will be very weak ; (3) all hopes rest on stabilization in sales by Q4 '09 which are pretty much completely out of their visibility range ; (4) the current valuation, even off their optimistic normalized 2009 guidance, is 24x and that seems high.

Summary of what we saw

This is what we saw in Q2 2009 very simply:

Click any graphic to enlarge
cat_q2_09.png

-Revenues worse than expected
-EPS better than expected by a significant amount.
-Raised guidance.

There is optimism swirling around CAT right now for 2 things - (1) Q2 09 EPS beat ; (2) 2009 guidance raise. Let's dig deeper.

As can be seen below, Q3 2009 revenues are projected to be horrible, at least as can be discerned from management's guidance. The bulk of the positive from management guidance has already been packed into what is now the historical Q2. The hope, then, is that (1) revenues in Q4 09 stabilize ; (2) 2010 revenues are stable ; (3) inventory de-stocking is over.

Looking more closely at guidance - 85% a one time gain?

Below is a little snapshot which sums up my thoughts on guidance:

Click any graphic to enlarge
cat_guidance.png

Factors demanding significant attention from all who have an economic interest in this company include:

  • Abnormal margin in Q2 vs Q1 and H2 '09. Something helped the Q2 2009 margin which CAT itself is saying is completely one-time in nature as implied by the Q2 09 normalized margin of 5.6%, compared to the Q1 09 and implied Q3-4 implied margins of 2.5% and 2.2% respectively.
  • Adjusting Q2 for seeming one-timers puts things much more in line with historical performance trends. If you adjust the Q2 09 normalized margin down to the average of Q1 09 and the implied Q3-Q4 level, EPS would have come in at 0.31, not 0.6, and much closer to the 0.22 consensus EPS and within a penny or two of my estimates. This implies at least ~$255M (3.2% excess margin * $7.95B sales) of non-recurring profit.
  • There is an unduly fat multiple going into 2010. As we can see, we are trading at 24x the 2009 expected EPS excluding restructuring costs, inclusive of the seeming one-timer in Q2. Is this justified? Where will revenues go in 2010? (More on this later)
  • The surprise "beat" this Q accounts for 85% of the revised guidance. This guidance boost does not call for any fundamental improvement in back half of the year - so what was it exactly that caused this one time boost that was not there in Q1 2009, and will not be there in H2 2009? The table below illustrates this conundrum clearly:

E(2009) Q2 09 (A)
Consensus 1.25 0.22
- Actual 1.7 0.6
= A - C 0.45 0.38


What accounted for the profit improvement? Taking a look at the financials

There are 4 elements which brought about the unexpected profit improvement, only 1 of which is truly durable - cost cutting. This 1 durable element also has limited utility, for you can only trim but so much fat off of the pig before you get to the bone. After 34,000 jobs have been eliminated worldwide, one is led to believe that cost cutting has reached the point of diminishing returns... As for the other elements used to manufacture this "beat':
  • Inventory liquidation "LIFO decrement". CAT uses "LIFO" to calculate its COGS. During periods like this when inventory declines, CAT sells (1) inventory purchased this period at higher cost ; (2) inventory purchased in prior periods at lower cost. (3) is reflective of the ongoing margin CAT can obtain in today's marketplace. (4) represents a one-time benefit that can only be obtained due to an inventory decline. (5) will not be an ongoing benefit.
  • Currency fluctuation. (1) CAT produces more abroad than it sells. When the USD appreciates y/y, foreign revenues decline, but foreign costs decline more, improving profits. (2) CAT reaped hedging gains.
  • Cost cutting. "Worldwide employment was 95,761 at the end of second quarter 2009... Since the end of 2008, full-time employment has declined by about 17,100. In addition, we have long utilized a flexible workforce made up of part-time/temporary, contract and agency workers to better respond to shifts in demand. These workers are not included in our full-time employment. Since late 2008, we have reduced this flexible workforce by more than 17,000."
  • Low tax rate. (see below - 10% is low)

So the next question is, how much improvement came from these various factors?

The following table parameterizes the various components of this improvement [click to expand]:
cat_financials.png

I am fully open to new data and despite indications to the contrary am by far no perma-bear, but purely on the data backing these 4 factors, it appears the 3 "non-durable" factors accounted for more than the entire earnings "beat".

  • Inventory liquidation: I fully grant that in Q3 09 we will be liquidating more inventory. However the fact remains that this does not represent the ongoing margin in this business. Only if input costs drop hard will this cease to be the case.
  • Currency fluctuation: The dollar has weakened and the comp gets a lot tougher in Q3 2009.
  • Tax rate: In the call they noted that this rate may be odd next Q. Whatever the case may be, 10% is not their normal tax rate. 31% is, and even that is low relative to many corporations.

The chart below highlights the basis behind the currency gain, and the current outlook for Q3 2009:
udx.png

Observations:
As things stand right now it appears currency will switch from a benefit to a cost in Q3. If we do see UDX take a hit it will help the competitiveness of their US manufacturing operations, but if it rises it will bite into profitability.


What would Q2 09 have looked like with "normal" performance? Valuation?

One additional question is how this quarter would have looked had they earned a "normal" gross margin, had a "normal" tax rate, and did not report that one-time hedging gain.
cat_norm_financials.png

I believe this is much more representative of the sort of performance CAT would be able to put up on an ongoing basis.

Look to  CAT Forensic Analysis Retail CAT Forensic Analysis Retail 2009-06-25 15:43:20 374.87 Kb and CAT Forensic Analysis Professional CAT Forensic Analysis Professional 2009-06-25 15:44:27 836.39 Kb for valuation. Keep in mind how conservtive my numbers usually are.


A Look at the Top-line and Profits - Long Term View

First, this is where we stand right now when comparing the current downturn to the prior 3 (sales are ttm):

 


[qtr's]
Start Duration Peak decline
Q4 1981 7 (50%)
Q4 1990 6 (16%)
Q1 1999 13 (6%)
Q4 2008 2 (22%)

 


Should sales come in at $34B for 2009, the duration and peak decline will be 4 and 34%, respectively. Will that be it, given how big our global construction bubble was? Think California, Nevada, Miami, NY (see "Who are ya gonna believe, the pundits or your lying eyes?" and Who are you going to believe, the pundits or your lying eyes, part 2 for visual impact and graphical evidence of the bubble), Spain and paricularly the Sun Coast, Ireleand, the UK, China, Dubai, etc., etc.
  
This is a long term view of sales since the 70's:
cat_lt_sales.png

And this is a view of profits if "this is it":
revs_profits.png

I am of the view that this is not "it".



Leverage

Below is the evolution of CAT's leverage:


Debt went down a bit while reported equity went up. As a result, the debt / cap ratios improved sequentially. However by any reasonable way of looking at it, leverage remains elevated.


Supplement - Notes from Earnings Call




Q2 09 Q1 09 Q4 08
Machinery and Engine Debt 6,851 7,348 7,820
+ Redeemable noncontrolling interest 481 513 524
/ Stockholder equity   7,375 6,336 6,190

         
= Adjusted Debt / Cap 51% 57% 59%

         

         
Machinery and Engine Debt 6,851 7,348 7,820
+ Financial Services Debt 26,445 27,543 27,711
+ Redeemable noncontrolling interest 481 513 524
/ Stockholder equity   7,375 6,336 6,190

         
= Adjusted Debt / Cap 85% 87% 88%

 

  • Next quarter will be very weak, as dealers whittle down inventory well further.
  • Dealers whittled off $1.2B in inventory in Q2 2009 vs $300M in Q1 2009. Mgmt expects $3B of inventory decline at the dealer level in 2009, most of the rest of which will be in Q3 2009.
  • Price realization helped $259M y/y. Price increase was implemented in Q2 2008 so we start lapping it next Q.
  • Q3 2009 we will see rolling plant shutdowns.
  • [Comment from Longbow analyst: Infrastructure spending is a mixed bag, as (1) the highway trust fund runs out of money in August 2009, (2) states have no money, (3) stimulus is hoped to pull things back to neutral ]
  • SG&A and R&D were down $291M in the Q, more of the impact in SG&A.
  • LIFE decremental benefits +$80M, materials flat.
  • Factory manufacturing costs flat - able to lower the variable cost at the rate of revenue decline.
  • Income tax was favorable due to geographic location of sales.
  • Don't expect to need to issue new term debt for the remainder of the year.
  • 30 day DQ increased slightly from 5.44% in Q1 09 to 5.53% in Q2 09.
  • Solar may not do as well in 2010 - depends on the price of oil.
  • CPS has been structurally improving the margins, making the business more variable cost in nature.
  • Most of the head count reduction is done - but plant shutdowns will lower labor tentatively.
  • $182M of improvement came from currency alone.
  • Materials saw no improvement sequentially in Q2 2009, but H2 might be better y/y because last year had the ramp in commodity prices in H1 2009.


Sources