Caterpillar – CAT Scratch

by Dan July 12, 2016 12:30 pm • Commentary• Trade Ideas

Shares of Caterpillar (CAT) have been a sort of an anomaly at times over the last five years as the commodity super-cycle, and the promise of everlasting emerging market growth came undone. A look back at the the massive rallies and subsequent declines since 2011, you can imagine the prospects for EM growth coupled with some well timed accelerated share repurchases, followed by the collapse in global growth expectations.

Back in mid May, a couple weeks after CAT issued disappointing 2016 guidance that was below their prior forecast, and following the stock’s rejection at long term technical resistance, I highlighted the potential for an earnings trough (MorningWord 5/16/16: CAT Nip):

In 2016, analysts expect CAT to earn $3.55 per share, down 24% from 2015 (which was down nearly 60% from their 2012 peak of $8.64 at the height of the commodity super-cycle, sales peaked that year at $65.88 billion that year, and are expected to be $40 billion this year). While that is a stunning decline, I’d add that 2009 sales decline from the 2008 prior peak was about 37% ($51.3 bil to $32.4b) and then doubled in the next 3 years. Point here is that CAT sales could be close to a trough in 2016. But given the data out of China overnight, and possible signs that U.S. early cycle stocks act in contrast with the cautiously optimistic data on our shores, stocks like CAT likely test their prior lows at some point again in 2016.

CAT did in fact bounce off of near term support at $70, and is now testing long term technical resistance:

CAT since Jan 2011 from Bloomberg
CAT since Jan 2011 from Bloomberg

Event:  The company is scheduled to report Q2 results on July 26th, and the options market is implying a one day post earnings move of about 4%, which is rich to its 4 qtr one day post earnings move of just below 3%, but basically in line with the 10 year average.

Sentiment:  Despite the stock’s recent bounce, and 16% ytd gains, I’d say sentiment remains weak at best with only 2 analysts rating the stock a Buy, with 18 Holds and 3 Sells and an average 12 month price target of $69.50 by 17 analysts polled by Bloomberg, that is 12% below where the stock is currently trading.  Short interest sits at 8% of the float.

My View:  It appears that investors and Wall Street analysts are all on one side of the ship, and as I said back in May, if guidance for the back half of the year suggests that earnings and sales declines have troughed, then a short squeeze above long term resistance could be in the cards, especially as investors look for beta as the SPX breaks out to new all time highs. Companies with high levels of exposure to emerging markets may offer that opportunity. But it’s also important to note the U.S. dollar’s strength of late. With the US Dollar Index (DXY) a few % above the levels of April when most large cap U.S. multi-nationals offered Q2 guidance, a company like CAT that gets 50% of their sales from outside the U.S. and expect much of their growth from overseas could see this offset potential gains from an uptick in demand.

Short dated options prices are cheap in CAT, with 30 day at the money implied volatility at 26%, while longer dated near the money options are lower.

So what’s the trade?

If I were inclined to play for a rebound in an industrial stock like CAT, I would want to define my risk at what could be a technical inflection point. For instance if I thought earnings could be the catalyst for a sustained rally, I might consider looking out to Sept expiration and buy the 80 calls for $2.50 vs stock at $79.20.  These calls break-even at $82.50 up about 4% and risk 3% of the stock price over the next 2 months, a period where we are going to get a far better sense of what the impact of Brexit was and will be on global growth. Those calls could be spread on any breakout above $80, possibly looking to sell the $90 strike call.

Personally I am not chasing the SPX at all time highs for fear of missing out, but that doesn’t mean there aren’t opportunities. And a stock like CAT could be at an interesting inflection point despite dollar headwinds.