New Trade – $CAT Nip

by Dan July 12, 2013 3:03 pm • Commentary

Caterpillar has been our go-to name to play Chinese weakness.  All those empty cities are meaningful as a broader sign of overcapacity, corroborated more recently by the weakness in global commodity prices as well as emerging market equities.

The fundamentals haven’t changed since our last CAT trade a couple months ago.  CAT reports earnings on the morning of July 24th, and based on the price action and commentary from Chinese policymakers in the last couple months, business has likely gotten worse not better, especially internationally.  CAT only gets 35% of its revenues from North America, so it’s likely been especially impacted by international weakness (as well as dollar strength).  

Sure, some bad news is already priced in, as CAT trades at 13x expected 2013 earnings, but only 11x 2014 estimates.  However, from 2012 to 2013, its earnings are expected to decline 20%, so analysts are basing a good bit of their optimism (17 buys, 9 holds, 1 sell) on the idea that CAT’s business is at a trough, and will turn around in the coming year.

But even on the recent market rally to a record close in the S&P 500 index, Chinese stocks (as measured by the FXI) have not even been able to make it back up to their 50 day moving average:

[caption id="attachment_28045" align="aligncenter" width="589"]FXI 2 year daily chart, 50 day ma in pink,  from Bloomberg FXI 2 year daily chart, 50 day ma in pink, from Bloomberg[/caption]

China has been THE driver of CAT’s mining business globally (China has consumed 30-70% of most globally traded commodities in the last 5 years), and also a major contributor to revenue growth in the machinery and power systems segments.  So Chinese weakness means no turnaround for CAT in 2014, and more estimate cuts going forward.

Not surprisingly, CAT’s chart looks a lot like FXI.  As a diversified U.S. multinational, it has showed a bit more strength, but a major market laggard nonetheless.  CAT stock has rallied along with the broader market in the past 3 weeks, all the way back up to near its 200 day moving average:

[caption id="attachment_28047" align="aligncenter" width="589"]CAT 2 yr chart, 200 day ma in black, Courtesy of Bloomberg CAT 2 yr chart, 200 day ma in black, Courtesy of Bloomberg[/caption]

CAT broke its steep uptrend in mid-2011, at the same time that emerging market equities topped out.  Since then, CAT has made a series of lows around $80 (white line), but each subsequent bounce has been weaker and weaker.  With the market near all-time highs, this month’s bounce hasn’t even been able to reach the 200 day ma.

Add it all up, and July’s earnings report from CAT is likely going to paint more weakness.  If true, then our expectation is that either the stock sells off into the report as traders anticipate another dud (that has been the trend over the past few quarters), or the stock actually sells off on the actual report.  $80 is still stout support, but a move down to there from the stock’s current level makes sense.

TRADE: CAT ($87.25) Bought July / Aug 85 Put Spread for 1.25

-Sold 1 July 85 Put at .35

-Bought 1 Aug 85 Put for 1.60

Break-Even on July Expiration: 

The ideal spot for this stock at July expiration (next Friday) is 85, or ~2% lower, at which point the short July 85 put will be at zero and the Aug 85 put will still be bid. Before then the structure is slightly bearish (~15 deltas) with 85 still acting as the ideal spot, but even without much movement the structure will benefit from July weekly decaying quickly with August remaining bid into the July 24 earnings event.  The main risk is a move above 88.50 or below 83.50 before next Friday.

Risk Chart:

[caption id="attachment_28055" align="aligncenter" width="628"]Screen Shot 2013-07-12 at 12.41.52 PM from ThinkOrSwim[/caption]


Trade Rationale:  I want to finance the purchase of downside puts for the earnings event, and will look to once again next week close to expiration sell the July 26th weekly 85 puts against the Aug that I own, or if the stock is close to 85 I will look to sell a lower strike put in Aug and stay long a vertical call spread into earnings.