Description

Caterpillar manufactures large machinery used in construction and mining, resource industries, and energy and transportation. The equipment includes large earth moving machines unique to each of their end markets, as well as an array of engines and compressors suited for use in these industries. Products are sold into their worldwide dealer network which in turn sells the products to local end-users. The world may not come to an end due to the pandemic and Caterpillar will not go bankrupt, but I believe it likely the company’s end-markets will experience a more extended downturn than many other segments of the world economy.

Street earnings estimates are at $4.72 for 2020 and $6.75 for 2021. Both numbers, but especially the 2021 number, could be lower as project capex is cancelled and pushed out, the dealer network seeks to reduce inventories, and perhaps covid social distancing and supply chain disruptions cause some margin pain in the manufacturing process.  My 2021 number of $5.09 multiplied by a 16x p/e yields $81.50, or about 23% down from a current price of $106.  I’m trying to be conservative in terms of the pressure on revenue and margins that I forecast for the purpose of the thesis. However, I believe these numbers could be lower in both years as dealers seek to reduce inventories and protect their businesses.

CAT’s business is driven by large projects that need to literally move the earth in some way, shape or form. To help one conceptualize their business, their May, 2019 investor day presentation has photos of the various equipment they make for a range of end-markets. Almost all of it varies in size from very large to enormous.

While it is reasonable to believe that projects driven by this type and size of equipment begun prior to the pandemic may be completed, it seems that most companies and organizations are actively cancelling any and all growth capex on projects that have not yet been started. Rather than spend, companies are moving to limit risk, hoard cash and deleverage.

As companies exit 2020 and establish capex budgets for 2021 it seems unlikely to me they will greenlight much if any of their shelved plans yet. Arguably planning for new projects would be shifted forward to 2H 2021 for execution in 2022. This would be dependent on either a vaccine or herd immunity, but for purposes of this report I am assuming by end of 2021 we are likely to have herd immunity should the medical community fail to discover a cure or vaccine.

Companies that do proceed with projects in 2021 and 2022 – and some will – will need to have a combination of the cash flow, balance sheet and end-market demand to consume the capacity the project creates. However, in mid-2021, and even assuming a medical solution, companies across a wide array of industries will still be so sufficiently wounded – in terms of lower revenues, stressed balance sheets, as well as mental stress endured by the executives in charge – that a vaccine will not cause them to rush to create supply ahead of demand.

This means less holes dug to build a new commercial office building, major condominium, hotel, casino, new mine, new oil well, or new road into a new development, etc. To the extent that China was a significant driver of sales in the past decade, it may be that this recovery will have somewhat fewer new Chinese factories, fewer new high-speed rail lines to tertiary cities, not as many new skyscraping condos, and fewer ghost cities… at least for a while.

Governments at every level will also be cutting back on large projects as they seek to adjust spending to their new level of revenue. This is true not only in the United States and Europe, but the world over. Many a non-critical new, major expansion, or major road repair project will be pushed out. For instance, governments, especially those that can’t borrow (think state and local that cannot run deficits) will most certainly move forward with fewer major projects, be it roads or otherwise.

A multi-year decline and stagnation of revenues would not be out of character with the company’s recent past. The company experienced a multi-year drop in revenues starting from a 2012 peak (aided by the ill-timed Bucyrus acquisition), a decline that continued for four years before bottoming in 2016. The drop was from $63B in 2012 to $36B in 2016, a 42% drop. This was during an economic upswing! Busts in energy and mining played a role.

By 2018 revenues had recovered to only $52B and were down again slightly in 2019 to $51B. Thus, the rapid decline the company is experiencing now, greatly accelerated by pandemic, actually began in 2019. It offers at least a suggestion that end markets were peaking prior to recent world events.

Unlike the multi-year decline from 2012 to 2016, the slight decline that began in 2019 has, thanks to pandemic, snowballed into a collapse. This makes me believe that a bottom arrives in either 2020 or 2021. I’m modeling a slight increase in 2021 and then again in 2022. However, it is not impossible that 2021 is flat or slightly down, though I am not predicting that outcome in order to be conservative.

I am assuming revenue falls 33.5% yoy in 2020 ($35.8B) and rises 3.9% yoy in 2021 ($37.2B). However, right now I’d be lying if I had high confidence in my numbers. The world has hit pause, I need to see what remains when it is unlocked.

The company successfully cut costs and improved productivity over the past years such that management, prior to pandemic, had been projecting a 3% to 6% improvement in margins across the cycle. This leaves them with less room to cut in this downturn, but arguably better margin on the reduced level of business. I am giving them credit for ~4.7% better margins on their trough 2020 revenue that experienced on their trough 2016 revenue. That is three-quarters the entire 6% they claimed they they could achieve prior to 2020.

However, 2020 is not like other downturns. Thanks to shutdowns, supply disruptions, social distancing in restarted factories, margins this year are not likely to fully benefit from their past cost improvements and I would not be surprised if 2020 margins are more negatively impacted than I model. In fact, on the recent Q1, 2020 call management notes:

“And we talked a lot in our (2019) Investor Day presentations about the fact that we're driving to produce higher absolute margins and higher absolute cash flow at all points in the cycle compared to that historical performance between 2010 and 2016, and we still intend to do that. Just -- but, again, given the chaotic nature of this downturn, what's happening with suppliers, we're saying that it will be challenging for us to achieve those new targets that we established in May of 2019. But we do expect absolute margins and cash flow to be higher. “

Thus, there may be downside to my 2020, but for a company not facing bankruptcy risk it seems like 2021 should be the focus and I suspect by then the worst of the disruptions will be overcome.

My EBIT margin (my model, using GAAP) for 2020 is 9.29% and for 2021 is 10.98% this compares to 15% to 16% EBIT margin at peak over the past three years. But the better comparison is to 2016. In that year revenue was $37B and the EBIT margin was 4.56% (which adds back a goodwill impairment).

Perhaps the revenue drop I predict this year will be more spread over the next two years. If so, I believe even a slight revenue decline next year would weigh on the multiple, particularly in the first half of 2021.

Currently I am estimating earnings of $3.92 for 2020 and $5.09 for 2021. Appling a 16 multiple to the 2021 estimate yields an $81.50 stock, or a 24% decline from a recent price of $106.50.

At this moment in the recovery an investor, me included, can move revenue, margins, earnings and the multiple around to drive wide swings in a purported fair value at bottom for the downturn. Given the unprecedented economic uncertainly it is hard to have the highest confidence in any of these individual variables except for the shape and direction. I am arguing that for heavy earth moving machinery the shape of the recovery is a “U” with the upside beginning late 2021 and really happening in 2022.

The market has come out of Pandemic, Part 1 sporting a V-shape. If the path the market has thus far taken foretells the shape of the underlying economic recovery, then this is probably a poor short. If the market and the economy have some more backing and filling to do before a sustainable recovery takes place, then this is probably a good short in that it does not rely on draconian outcomes when compared with past CAT down cycles. The thesis requires revenue to decline in-line with the company’s past two cycles (one of which occurred in growing world economy) and margins that are well above anything achieved in past downturns. The key may be in how strong the revenue uptick is in 2021. I am predicting that though their end-markets trough in 2020, the recovery is weak in 2021.

CAT is also a large, liquid short. Even if one waited for better entry point in terms of price or more confidence in what will happen after world economies reopen, the stock can be entered and exited quickly when one desires more hedge from an industrial cyclical. This report provides a framework for possible outcomes for the underlying business.

Risks,

V-shaped economic recovery due to vaccine or herd immunity.

Catalyst

Caterpillar's large machinery experiences an extended U-shaped recovery that extends well into 2021.