Since we first entered our CAT trade almost a month ago, the stock has been a one way train higher. Even with Chinese shares moving lower in the past week, CAT has mostly ignored that weakness. However, the stock has approached the psychologically important $100 level this week, which was the local high from Feb. 2013, as Dan mentioned in yesterday’s CotD post.
If CAT is going to retrace some of the gains over the past month, it is likely going to be around here. Unfortunately, our long Mar22nd 90 put position has lost most of its value, so a modest move lower here won’t increase the value of that put much.
With that in mind, CC discussed our CAT trade in today’s COO post, laying out a couple potential adjustments that we debated amongst ourselves:
This trade was profitable almost instantly and we even heard some of you say that you took it off for a nice gain. Since that initial success, the stock has been one way, up, until today. With the stock off its recent highs, these are worth about 30c and at a 10 delta will likely expire worthless. Rather than selling to close and locking in the loss we’ll leave them on, possibly adjust, and then hope for a market sell-off. The two adjustment options we are considering are to turn it into a fly by buying the 95/92 1×2 or rolling it into a higher strike put spread by doing the 95/90 1×2. The second would leave us with a 95/90 put spread for about 60c more than the initial naked put.
We want to use the remaining value of the Mar22nd 90 put, but move the overall structure into a higher probability position, all while not risking much more additional premium.
At the end of the day, we decided on the Mar22nd 95/90 1×2 put spread as our preferred adjustment. This adjustment adds an additional 0.55 of premium to our total cost, increasing our premium at risk. However, we think it gives us a much better chance to get out of the CAT trade with a much smaller loss (or if things go better than expected, no loss at all) than our current position.
Action: CAT ($96.90) Buy the Mar22nd 95/90 1×2 Put Spread for 0.55
-Bought 1 Mar22nd 95 Put for $0.95
-Sold 2 Mar22nd 90 Puts at $0.20
New Position – Long the Mar22nd 95/90 1×1 Put Spread for 2.25
For those of you who do not want to put much more additional premium at risk, the Mar22nd 95/92.5 1×2 put spread might be the better structure, which would turn the trade into a Mar22nd 95/92.50/90 put butterfly. That trade will be more based on decay rather than delta until we get closer to expiry.
Original Post Jan 27th, 2014: New Trade – $CATnip
Caterpillar reported better-than-expected earnings this morning, and the stock is trading up more than 6% in the pre-market, near its 2014 highs around $93. So is this a clean change of trend after a dismal 2012 and 2013 for CAT’s business?
Not so fast in our view. Management is continuing to aggressively cut costs in order to compensate for the stagnant sales environment. With such a backdrop, management has only been able to keep earnings guidance flat for 2014 with a large share repurchase program in addition to its restructuring efforts. The company guided to $5.85 for 2014 EPS, vs. the consensus around $5.78, but its real guidance is for $5.30 per share in earnings for 2014 if you include those restructuring costs.
Moreover, the underlying earnings power for CAT is still quite compromised if all of these financial accounting moves only result in flat earnings, and that’s assuming that international growth is stable this year. With more than 60% of revenues from the international market, and given what’s going on in emerging markets at the moment, that seems an optimistic assumption. Here is what we wrote in Friday’s preview, included below:
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.
With that bounce today, we like fading today’s strength, looking for weakness in the stock over the next couple months:
Trade: CAT ($91.80) Bought March 90 put for 1.70
Break-Even on Mar Expiration:
Profits: below 88.30
Losses: above 88.30 with total loss above 90
Trade Rationale:
We’re targeting the earnings gap and the 200 day moving average around $85. CAT’s bounce today is likely to fizzle if the international growth environment does not pick up. The weak perception of global growth looks unlikely to change over the next few months, and we like the technical entry with today’s pop. We’d look to spread this put on weakness, ideally when the stock is about $87.5.
$CAT Q4 Earnings Preview, January 24, 2014
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:
- CAT daily, 200 day ma in yellow, Courtesy of Bloomberg
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:
- CAT monthly chart, Courtesy of Bloomberg
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.