Name That Trade – $CAT Scratch Fever

by Dan September 4, 2014 11:51 am • Commentary

After what can only be described as a massive under-performance for Caterpillar (CAT)  in 2013 (up 1% vs the SPX up 30%), the stock is making up for lost ground in 2014, up about 20% (33% from the 52 week lows), vs the SPX  up about 9%.  After a 33% earnings decline from 2012 to 2013 on the heels of weaker demand in emerging markets, CAT is expected to grow earnings in 2014 by 9% year over year, with analysts expected the company to return to mid teens growth in 2015 and 2016. Unfortunately for CAT, this earnings recovery doesn’t have a whole heck of a lot to do with increased demand for their products as sales are expected to decline 1% this year, but likely have a ton to do with their fairly aggressive stock repurchases.  Earlier this year the company completed a $1.7 billion accelerated buyback and after the companies Q2 revenue miss, and subsequent decline announced another accelerated share repurchase (ASR) this time to the tune of $2.5 billion.  This is financial engineering at its best.  In the short term shareholders should be nothing less than happy as the stock is now back within a few % of the 52 week highs, but still well below the all time highs made in early 2012:

CAT 5yr chart from Bloomberg
CAT 5yr chart from Bloomberg

Just as most technicians had pointed at $80 (green line) for most of 2013 as significant support, most would suggest now that $117 (red line), the prior double top high should serve as important long term resistance with $100 serving as intermediate term resistance (yellow line).

From a vol standpoint, this aggressive share repurchase behavior has been vol dampening, in an already low vol environment.  The 3 year chart below of 30 day at the money implied vol (IV) shows CAT at multi year lows.  While I would normally say that long vol directional strategies in a low vol environment are a bit of a fools errand, this situation could be a tad different once the bank charged with buying back the shares is done doing so:

CAT 3yr chart of 30 day at the money IV from Bloomberg
CAT 3yr chart of 30 day at the money IV from Bloomberg

The next identifiable catalysts for CAT shares will be their Q3 earnings to be reported in late Oct (likely missing Oct expiration).  The set up into earnings could be interesting as the accelerated buyback will likely be done, and the company just raised full year guidance on lower than expected restructuring costs. Hardly a wildly bullish reason.

Heading into the print, if the ASR is done, and data points continue to point to sluggish demand in emerging markets, I would be inclined to target some of the technical levels detailed above to play for a disappointment and a move back towards support.

The first trade we are considering targets Q3 earnings catalyst:

Hypothetical Trade:  CAT ($109.25) Buy Nov 110 / 100 / 90 Put Fly for 2.50

-Buy 1 Nov 110 put for 4.35

-Sell 2 Nov 110 puts at 1.10 each or 2.20 total

-Buy 1 Nov 90 put for .35

Break-Even on Nov Expiration:

Profits:  between 107.50 and 92.50 make up to 7.50, max gain of 7.50 at 100

Losses: between 107.50 & 110 and between 90 and 92.50  lose up to 2.50, max loss of 2.50 above 110 and below 90

And Maybe:

The second hypothetical trade is more near term and simply plays for a pullback from this run with the idea that stock repurchases tail off in the next few weeks and the stock finds some sellers:

Hypothetical Trade:  CAT ($109.25) Buy Oct 110/105 Put spread for 2.00

– Buy 1 Oct 110 put for 3.05

– Sell 1 Oct 105 put at 1.05

Break-even on Oct Expiration

Profits: between 108 and 105 profits of up to 3.00

Losses: above 108 losses of up to 2.00 with max loss of 2.00 above 110


Rationale for both hypothetical trades:

Ideally we’d like to time a short entry in CAT at the moment that the stock repurchases wane and possibly have the catalyst of earnings in October. We’ll keep an eye on the name and see if those opportunities present themselves.

Stay Tuned.