I could not have asked for better drama as a backdrop for a review of my self-made battle between Google (GOOG) and Caterpillar (CAT). On Thursday night, Google reported earnings. On Friday morning, CAT reported earnings. At the close Friday, GOOG recorded an 7.9% gain while CAT sank a gut-wrenching 14.5%. This decline was apparently the largest one-day drop in CAT since the big market crash of 1987 (is that supposed to be ominous?!?). A year ago to the day (Oct 23, 2005), I wrote about the "diverging economies" represented by proxy by these two companies. The two had just reported earnings and GOOG soared 12.1% to all-time highs at that time, and CAT sank 9.5%. GOOG continued to soar and CAT did not stay down long. Now, CAT has erased all of its gains for 2006, and GOOG looks ready to finally fulfill the lofty promises from April when the market last got giddy about GOOG's earnings results. Back then, I happily encouraged folks to join the "Google parade," and the market was kind enough to immediately fade all of those post-earnings gains and then some. Now, $450 and $500 targets are giving way to $550 and $600 targets all over again. Maybe this time is for real. But take careful note that the analysts are pounding the table in overwhelmingly and enthusiastically bullish fashion. Let's see how many buyers remain out there...
On the other side of the economic divide, folks bullish about this economic cycle have been left scratching their heads wondering whether CAT has company-specific problems or whether the death knell for cyclical companies has finally arrived. GOOG and CAT look like they are diverging once again. GOOG seems to promise continued growth. CAT warns of a "pause" in 2007.
CAT is of particular interest to me here because it sits in the middle of numerous cross-currents with important implications for the economic outlook. I suspect the bulls will soon get over any foreboding caused by CAT's results, but I will take a close look under the hood anyway. From a technical standpoint, CAT's fall was very damaging to the resurgence of the Dow. CAT was a -75 point drag. In late Septmeber, I warned that CAT looked like it was in danger of losing its leadership status as being one of only 10 stocks to have increased in value since the Dow's last all-time high 6 1/2 years ago. At the time, I figured the sharp correction in commodities was finally weighing down CAT's stock. This was a follow-up to an even earlier warning on September 12 that CAT's sharp 4-day sell-off at that time looked ominous in the midst of a general market rally. It turns out that CAT has problems well beyond the potential reduction in demand for its equipment from mining companies. In fact, they are still running factories at capacity and cannot meet existing demand. Regardless, they are anticipating a slowdown in demand in 2007. This is the same company that has planned price increases in January. At the time of that announcement, I noted that it further supported the view that inflation risks remained strong and real in the economy. A cyclical company is not supposed to have pricing power this "late" in the economic cycle. Well, it turns out that CAT sure does not think we are late in the cycle. Instead, they are forecasting a slowdown in 2007 which will next give way to a resumption of robust economic activity. The following quotes are from the transcript of the conference call on Friday morning. The notes sprinkled throughout represent my own commentary and interpretation. All emphases are mine.
"This morning, we also released what we think is a very positive preliminary view of 2007, particularly when you consider the economic uncertainty we face as we look forward to next year. There were several key messages that we were trying to bring out in the release, and I will highlight them here. Overall, and this is an important point, we do not see 2006 or 2007 as the peak in this growth cycle for most of the industries that we serve. The underlying fundamentals remain positive. Some industries, like mining, energy, and infrastructure development, are particularly strong and are likely to continue for some time."
This is a bullish outlook for commodities. It supports my belief that dips in commodity-related stocks need to be bought.
"We see continued economic strength in most areas of the world outside the U.S. However, we do see a weakening economic picture for the U.S. in 2007, largely a result of the Fed's interest rate hikes over the past two years. We expect that housing in the U.S. will continue to weaken in 2007."
Pay close attention you bottom-fishers in the housing stocks! Now, not only are the homebuilders warning you that housing has not yet bottomed, but their suppliers are also saying the same thing! I know - you will blissfully ignore the accumulation of warnings, but I thought I would try anyway.
"I think as most of you are aware, sales of on-highway truck engines are expected to drop sharply next year, with the decline being particularly deep in the first half of the year. As a result of models coming off of our managed distribution list, weaker conditions in the United States, and our efforts to increase velocity, our preliminary outlook for 2007 reflects a significant drop in dealer inventories. That means that we expect our sales to dealers to be lower than end-market demand. Improving velocity is a key focus of our strategy, and we are working hard to improve our processes and performance in that area. Overall then, we are expecting sales and revenues to be flat to up 5% next year, despite a weakening economy in the U.S.,despite slowing housing in the U.S., despite the drop in on-highway truck engines, and despite what we think will be a significant decline in dealer inventory."
In other words, CAT believes its business is still quite strong despite the other headwinds working against it for 2007. If you remain bullish on the economy, you need to keep an eye on CAT for some buying points. I know I will be. At a forward P/E of 10, we should expect some kind of support for the stock coming up soon.
"With the economic uncertainty we see for the U.S. next year, we think this is a very positive message. Further, we do not expect 2007 to be the end of this business cycle. We see 2007 in a light similar to the 1995-1996 time frame, when growth flattened after a run-up in U.S. interest rates, then resumed after the Fed began lowering rates."
If Mike DeWalt (IR Director) is correct, this assessment represents yet more bad news for the bears. However, I remain highly skeptical that the Fed will lower rates anytime soon. There remain too many inflationary threats. CAT's own views of the economy demonstrate the threats of inflation. Now, if they are relying on lower rates to buttress these optimistic longer-term outlooks, we should temper our eagerness to buy on the dips in CAT - or at least keep the stock on a short leash. Mike DeWalt goes on to confirm during the Q&A that "...One final thing I will just say about the outlook for next year. It is highly dependent upon what the Fed does and when they react. We certainly hope that they will act quickly and there will be upside to this. But based on what we see, we are 0 to up 5% on sales." Uh oh!
Note well that an astute analyst (Ann Duigan from Bear Stearns) pointed out that Caterpillar's earnings last peaked in the late 90s. She naturally probed CAT to find out whether they also now anticipate a peak in earnings soon. Doug Oberhelman, Group President, clarified as follows: "...we're predicting no peak here whatsoever. We're just making the comparison back to '95, '96. If you look at sales and revenue in '95 and '96, it was virtually flat. We were up somewhat in '96 over '97, I guess, by about $0.5 billion; and then picked up nicely in '97 and '98. Actually, our peak year of profitability was '97, for the record. But we are not commenting at about that today. We're just getting ourselves structured for whatever comes our way in '07 and beyond." Let's just say that this is something to keep a close eye on. It makes no sense to me to pattern-match on history and only learn the good lesson you want to believe.
One other interesting tidbit related to coal. Last week, Peabody Energy (BTU) forecast 2007 earnings in-line with expectations. Arch Coal (ACI) released earnings the next day and warned of slower demand in its outlook. BTU's stock sank along with ACI's. The jury is out on which outlook will prevail, but CAT remains bullish as expressed by DeWalt:
"Yes, I think coal mining is weaker than metals mining. But we still really like the fundamentals in coal mining. Spot prices have dropped, but contract prices, if you look at the complete picture, are actually up pretty well. We do know that there are permitting issues with eastern coal. But if you look at power plants on the drawing board, it is a predominance of coal. Energy demand, electricity keeps going up. You know, prices and production will fluctuate quarter-to-quarter, but the underlying fundamentals for coal are still pretty darn good."
Both BTU and ACI are down significantly from their highs of 2006. Again, if this thesis of a helathy economy holds any water, we should be looking for buying points on BTU and perhaps even ACI.
CAT's warning took down a number of other cyclical stocks, especially machinery stocks. Here is a short list of stocks that took a tumble on Friday presumably in sympathy: DE, BUCY, JOYG, CMI, PH, IR, and small-cap FLOW. Somewhere in there more bullish, buy-on-the-dip theses hide. Happy hunting and be careful out there!