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«Caterpillar, Inc. (CAT) – Short (67% upside): The Ultimate Value Trap (Would you rather be lucky or smart?) Mkt Cap: $56.35B EV: $92B Price Target: ...»

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Caterpillar, Inc. (CAT) – Short (67% upside): The Ultimate Value Trap (Would you rather be lucky or smart?)

Mkt Cap: $56.35B

EV: $92B

Price Target: $28/shr

Recommendation:

Caterpillar (CAT) is an under-loved name that has lagged the S&P by 23% YTD, has a 2.5% dividend yield and to many appears to be at a cyclical trough. CAT has

grown earnings from a low of $1.43 per share in 2009 to an impressive $8.48 last year, and looks to benefit from a positive North American construction cycle alongside bottoming mining capex while being an $85 stock with a management 2015 EPS forecast of $15/shr… CAT is a short. We stress that this is not a play on the upcoming quarter; in fact we expect management to manufacture a strong print.

CAT will generate neither growth nor cashflow without ever-greater leverage pumping more product into both Caterpillar & dealer inventory, and continuing to adjust their own residual values at CAT Financial lower. Despite accounting EPS soaring the past few years, we urge investors to ask themselves where the cashflow generation really is and what they are overlooking in CAT’s financing arrangements. Upon closer examination of the financials, poor management incentives, $9B of failed acquisitions in the past two years alone, as well as negative earnings risk that is still not fully understood by current holders of the stock we highlight why CAT is a compelling short. Highlighted below are key catalysts which we believe will send CAT to its fair value of $28/shr by 2014.

CAT:

 Generates no free cashflow, unless via borrowing  Uses questionable revenue recognition to its own foreign subsidiaries using borrowed money for sales that do not end up at a dealer or end user  Will NOT be able to materially raise its dividend moving forward  Uses imprudent and aggressive economic forecasting as an excuse to stuff the channel and level load production to attempt to meet guidance  Is in the middle-innings of a multi-year capitulation of mining capex  Has completed $9B in failed (including one fraudulent), value-destroying acquisitions since 2010 to try and meet long-term earnings forecasts – and still can’t meet those forecasts.

 Very rarely mentions their own large financial subsidiary, which we believe will magnify its earnings downturn and impair cashflow moving forward  Has compensation targets mis-aligned and far beneath management’s guidance and stated goals

Questions For Management:

 Why does management’s own incentive plan include a profit threshold of $2.50 while their own ‘severe economic downturn’ EPS forecast for CAT is $3.50?

Link - 2012 Proxy.

 Why are CAT foreign subsidiaries allowed to purchase goods from CAT parent using borrowed money and then allow CAT to recognize a sale that never actually went to an end user? Link - SEC Correspondence.

 Why isn’t management held accountable for CAT Financial, a $36B balance sheet entity whose results determine if CAT’s original margins were correct to begin with?

 If your company has such great earnings prospects through 2015, why hasn’t stock been aggressively repurchased recently? And why has management allowed 7.3% of unchecked share creep ($4B of curr. mkt value) since 2009?

 If CAT machines have such high residual values and solid transaction prices, why isn’t an effort made to shrink its balance sheet during cyclical booms?

 Why are such aggressive economic forecasts allowed at an organization of your resources? And why are these flimsy forecasts later blamed for causing earnings misses and channel stuffing?

 Why has your deferred revenue grown so much (and this doesn’t relate to BUCY), allowing for an earnings piggy bank funded by borrowed money from foreign subsidiaries?

 Are CAT’s foreign subsidiary’s own orders from CAT parent within CAT’s reported backlog?

 Why does CAT’s compensation committee use such easy targets? Why does the compensation committee turn a $90B balance sheet into only $33B of ‘accountable assets’?

Our earnings vs. consensus (decidedly below):

Where is the value? Our view on CAT’s true earnings power and lack of ROC – definitive divergence between free cashflow & accounting EPS:

Thesis:

Caterpillar has benefitted from the now-fading 2009 Chinese stimulus package and global QE pushing rates near zero – both points which management has abused to build inventory and finance easy dealer floorplan financing – stuffing the channel for the past 4 years. We can’t stress enough: there is no growth and there is no cashflow to be found here. Period.

We see many similarities between CAT’s current behavior and Lucent’s near-demise in the late-1990s – at both points each firm’s core market was undergoing the ragged edge of a parabolic rise in demand. In the end a string of failed acquisitions as well as borrowing to finance ever-greater inventory and customer purchases was Lucent’s undoing – sending a stock price that had risen to $84 a few years earlier down to $0.55 by Oct, 2002. We believe that just like Lucent, Caterpillar’s margins aren’t real – and all this requires is following the cashflow to recognize.





 Earnings d/g ignored by the market  Revenue recognition shenanigans finally scrutinized properly  Poor management incentives ignored by the market  Caterpillar Financial residual risk & leverage ignored by the market  The moral hazard of owning your own finco – borrow to fund inventory & A/R as well as set your own residual values  Excessive inventory build ignored by the market  Complex and questionable accounting that has been ignored by the street, particularly cross-company arrangements between Caterpillar and Caterpillar Financial  Mining capex cycle showing no signs of turning around – likely in a secular decline through 2015  Caterpillar Financial borrowing costs rising (even without rising rates in general) due to write-downs and a heavy rolling debt burden  Caterpillar cashflow impaired by a reduction in deferred revenues funded by CAT Financial’s overseas borrowing  Longs more closely examining management incentives; containing payout thresholds that are below even that of management’s recent economic crisis EPS scenario  Realization that CAT Financial has been financing level-loading production and easily obtainable guidance goals as CAT level-loads production and uses low interest rates to both finance itself and its dealer’s purchases of inventory and used equipment.

 Residual values turning south as miners begin to cancel equipment purchase agreements, leaving dealers forced to put the equipment back to CAT or liquidate into the market.

Below we take you through our thoughts on the above compartmentalized into the following 1) Revenue recognition/recent aggressive accounting issues, 2) Lucent – remember your history!, 3) What is Cat Financial, 4) Management (lack of ) Credibility, 5) Poor management incentives, 6) $9B in value-destroying acquisitions, 7) our take on (much weaker) earnings and 8) Our highlights on mining capex only beginning to crater and 9) Valuation.

Revenue Recognition: The Smoking Gun We believe CAT is now resorting to borrowing to fill in gaps in revenue/earnings through both questionable revenue recognition, continued inventory build and aggressive financing terms to customers.

We believe that CAT is stuffing the channel and resorting to recognizing revenue between itself and wholly-owned foreign subsidiaries with no end user at the end of the transaction – this also serves as a way to fund CAT’s operations without repatriating any foreign cash. CAT’s questionable accounting is enabled by low interest rates driving higher leverage and their internal ability to set their own residual values. We believe these questionable practices will only be scrutinized more heavily going forward, especially given CAT’s growing deferred revenue account (grown from $1.2B in ’09 to $3B in 1Q’13 – BUCY was acq. w/$467MM of deferred revenues and is at best similar in size to acquisition) and their ability to not only fund inventory build via foreign subsidiary sales to the US parent, but also borrow to fund foreign subsidiaries’ purchases of CAT equipment not delivered to an end user or intermediary and recognized as revenue. Again, we wonder how much of CAT’s current reported backlog of $20.4B are foreign subsidiaries placing “orders” with the parent for delivery – manufacturing revenue/earnings with borrowed money.

SEC Correspondence, 5/2013:

An SEC staff question recently asked CAT about its arrangements with its own foreign subsidiaries – their answer (if you read between the lines) confirmed a lot of our suspicions about the moral hazard of CAT’s finco: CAT is using sales to its own foreign subsidiaries to pump up earnings/revenues, stuffing the channel while recognizing sales that do not end up in the hands of an end user or customer.

Or we can take you through those same staff comments below, from correspondence between CAT and the SEC, 5/30/2013:

–  –  –

3. We note in your response to prior comment 3 that your intercompany agreements provide for short term advance payments for certain purchases of U.S. manufactured products destined for sale outside of the United States. Please describe to us in greater detail the terms of the intercompany

agreements that allow for these advance payments, including the following:

• Tell us the usual period over which the advances are outstanding, including how the transactions get initiated and cash paid, and how long after are the U.S. manufactured products typically shipped

• Clarify for us whether these are transactions between your U.S. and non-U.S. subsidiaries, or transactions undertaken by non-U.S. subsidiaries on behalf of customers located outside the U.S. and whether the profits being taxed are intercompany profits or profits on the sale to the final customer.

• Tell us the frequency with which you have entered into these transactions in the past three years.

• In describing the arrangements, please provide us an example of a typical transaction.

CATERPILLAR RESPONSE:

A non-U.S. subsidiary that distributes our products to independent dealers outside the United States routinely enters into advance purchase agreements with manufacturers globally including Caterpillar Inc. (“Cat Inc.”), a U.S. company. Under the agreement, the non-U.S. subsidiary makes payments in advance for equipment manufactured by Cat Inc. which is destined for export and sale to non-U.S. independent dealers. This agreement recognizes Cat Inc. as a primary source of the non-U.S. subsidiary’s products, and that manufacture of many of these products in the United States requires long lead-times. The agreement provides the non-U.S. subsidiary a discount for goods purchased with advance payments in accordance with arm’s length principles.

Under the terms of the current one-year agreement, the advance is made on a monthly basis in an amount equal to the average daily purchases for the preceding six months multiplied by 85, less any outstanding balance from the prior month. The advance payment calculation is based on 85 days to reflect the average time from receipt of an order from an independent dealer to delivery.

The profit on the intercompany sale to the non-U.S. subsidiary is subject to U.S. taxation at the time of shipment. In addition, profit on the sale by the nonU.S. subsidiary to the independent dealer is taxed in the United States under Subpart F contributing to our “previously taxed income” referred to in response to Comment 2.

Advance purchase transactions from the non-U.S. subsidiary have occurred regularly throughout the past three years. An example of such a transaction

is set forth below:

–  –  –

Do You Remember Lucent? History Rhymes:

For those who don’t remember Lucent Technologies was a spinoff of AT&T in 1996 and soon became a growth investor darling rising to a market cap of $202B in 2000 from an initial IPO valuation of $26.2B – by 2002 it had fallen to $2.65B. At the time the internet infrastructure boom was supposed to last forever (similar to today’s mining capex boom), and as the bubble continued common sense was abandoned and investors backed in a narrative that justified a higher future stock price – no matter the current trading levels.

During Lucent’s mea culpa, in which revenues were amended and restated downwards for the 2001 fiscal year by $680MM, Lucent’s new (and former CEO) said “Don't try to run the business faster than it's able to run.". This was exactly what Lucent management had done during the prior four years – espousing an infinite trajectory of 14-17% revenue growth for the telecom equipment market, and a 17-22% growth rate for Lucent itself. But as Lucent and its competitors Cisco, Juniper and other telecom equipment makers created excess capacity in the face of waning demand then pricing & financing terms became more favorable to customers – this was where management took short-cuts and ‘temporary’ measures that nearly lead to Lucent’s demise.



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