Event: CAT reports its Q4 earnings on Monday before the open. The options market is implying about a 3.5% one day move, which is just about in line with 4 qtr average of about 3.25%, and slightly above the 8 quarter average of about 2.75%.
Sentiment: Wall Street analysts have been relatively mixed on CAT, with 9 buys, 17 holds and 1 sell, with an average 12 month price target of $93.36. The stock has been a dismal performer over the last year, down 6% in that period. It has started 2014 off on a negative note once again, down 2.5% year to date. Short interest is at 3.5% of the float, which is at the midpoint of the past few years. Jim Chanos, a famed short seller, has said that he is short CAT on expectations of further weakness in China.
Options Open Interest: Puts outnumber calls in total open interest by a ratio of 1.4 to 1. In contrast, the one month average volume has favored calls, at a ratio of around 2.2 to 1. The Feb22nd 80 puts and the Feb22nd 90 calls both have around 17k of open interest. Someone is long 20k of the May 70/60 put spread, which are the two lines with the most open interest on the board.
Price Action / Technicals: CAT had the look of a potential breakout to start 2014 after bursting above the $90 resistance level:
However, that breakout has turned into a failed breakout, and from failed moves often come fast moves. If CAT does report a weak number again on Monday morning, the stock could actually approach the lower end of that 9 month range, in the low $80’s.
That $80 level is crucial from a long-term perspective. It served as support throughout 2012 and 2013, after serving as resistance from 2006 to 2008. The stock has repeated bulls and bears alike with its range-bound price action over the last 18 months:
Fundamentals/Valuation: The main reason we have not liked CAT for the better part of the past 2 years is that the stock has been a victim of declining spending in the global mining industry since the end of 2011. The impact of that decline was not felt in full until the end of 2012, but the stock has been climbing uphill ever since.
Considering that earnings declined from $8.64 per share in 2012 to $5.46 per share expected in 2013, the stock has actually held up quite well (down only about 25% from its all-time high). The reasoning is that global growth is going to pick back up to start 2014, but so far, signs out of China and emerging markets are threatening that thesis.
With such a terrible year in 2013, you would think investors would have lowered expectations quite a bit for CAT. But CAT is still a 15x P/E stock with consensus estimates for 5-15% earnings growth over the next 2 years. Not exactly dirt cheap, and quite expensive if CAT ends up having a flat to down earnings year if the macro environment gets worse.
Volatility: Implied volatility in CAT is near 2 year lows, similar to many other large cap stocks:
However, CAT has not been in the steady uptrend of the broader market. Its low volatility has taken place in a range rather than a slow grind higher. In that sense, if CAT did break the lower end of its range, then implied volatility today will look quite cheap in retrospect. For now though, the stock remains in its 80-90 range.
Our View: Looking at the fundamentals and the technicals in CAT, we see a stock that is pricing in a recovery that is looking more and more fragile by the day, with a failed breakout to start the year to boot. We’re clearly bearish on the stock over the next 6 months, though the earnings report is a bit more difficult to call. The entry here is not great given the stock’s selloff into the number. Ideally, we’d like to see a bounce on earnings that we can fade by buying a put spread, given the low level of implied volatility. Doing nothing for now.