Event: CAT reports earnings on Monday, Oct. 22nd, after the close. The stock is implying a 2.75%, almost in line with the 4 quarter averaged of 3.25% and 8 quarter average of 3%.
Sentiment: Wall Street analysts are still relatively bullish (despite the stock’s 25% decline from its highs this year), with 15 buys and 13 holds. Short interest stands at 3% of the float, at the highest level of the year.
Fundamentals: Just this morning, CAT CEO Douglas Oberhelman mentioned difficulty in China once again, saying “China is changing in front of our eyes.” Perhaps more worrying, he said that South America and Africa are “showing promise” ahead. When a CEO shifts his long-term bullish talk to an entirely new region, you can bet that Chinese growth hopes within the company have taken a serious hit.
CAT is trading down a bit more than 1% on this news. That’s not nearly the negative reaction that such news would get in the spring, when expectations for the stock were much higher. The crux of the CAT trading thesis hinges on the debate between value (at a 9 P/E) and growth (earnings grew 80% on average in 2010 and 2011, but 8% average growth is expected over the next 2 years).
If you told me that CAT earnings will actually grow 8-10% in the next 2 years, then the stock is a buy here. BUT, I see 2 major problems for earnings growth:
- CAT gets 65% of its revenues from outside the U.S. But it’s not just Asia. It gets 25% of its revenues from Europe and the Middle East. Its exceptional sales growth in the past 3 years has set a very high bar for futures sales, sales that relies on global growth that might be missing.
- Analyst estimates have margin improvement built-in to estimates, as consensus sales growth for the next 2 years is only 6%. Margins generally improve as sales increase, but get worse as sales decrease. If so, earnings could be under further strain.
Valuation: The P/E multiple is near 5 year (and all-time) lows. This is clearly the bullish argument. As long as earnings growth does not turn negative, the stock offers significant value here, especially with a 2.4% dividend. It is also has a more secure balance sheet relative to pre-financial crisis, with a better asset / liability mix. Here is the 5 year chart of P/E:
At a 9 P/E, I do think the valuation argument has credence. The main concern is whether that turns into a value trap if earnings growth turns negative.
Price Action: The 5 year chart shows the importance of the $80 level going forward:
The 80-85 area acted as resistance in 2007 and 2008, and has acted as support over the last year. Traders have clearly been trading against the support level as a low-risk long entry. I don’t expect that level to break without significantly bad news in the near term.
Volatility: The Here is where CAT gets interesting. Look at the chart of 90 day implied volatility over the last 2 years:
from LiveVol Pro
It’s basically at 2 year lows. The stock has been stuck between 80 and 95 for 5 months, and options traders are clearly expecting it to stay in that range over the next 5 months as well. There might be a trade here.
My View: I was going to pass on initiating any new CAT trades. Until I looked at the implied volatility. Fundamentally, I see a fair balance between the bullish value argument and the negative growth argument. But from a volatility perspective, February delta-neutral strangles look interesting to me. The stock has been stuck between 80 and 95, but it has moved 10% multiple times within that range. A 10% move in either direction over the next 4 months is enough to pay for the strangle, and February options will capture their earnings report next quarter as well. I will post by the close if I pull the trigger.