Boom/Recession Divergence - Does CAT's Recession Warning Make Sense?
By Dr. Duru written for One-Twenty
October 21, 2007
So here we are scratching at multi-year highs again, and, again, worrying about an imminent recession. If you are a glass half-empty person, all the dire comments from the earnings announcements of banks and industrial companies this week serve as reminders of fundamental economic weaknesses that are destined to take out the U.S. economy. You also see these warnings as further confirmation that the divergence between recession-like and boom-like sectors will resolve to the downside. If you are a glass half-full kind of person, you take comfort in seeing so much negativity instead of the drunk euphoria you would expect at these lofty price levels. You are looking forward to more Fed price cuts and suspect there is a lot more cash coming to the market from under-invested institutions and foreign investors looking for "bargains." I have to stick with the half-full folks, at least for a strong finish to close out the year once we get past the thicket of this earnings season.
Caterpillar (CAT) is the latest example of the attempt to get ahead of a feared recession. Since CAT's earnings blow-up on Friday, CAT's management has been quoted frequently as being the authoritative warning signal that a recession is surely around the corner. Yet, the company also insisted that it remains on track for 15-20% annual earnings growth through 2010. Something did not smell right, so I HAD to check things out for myself. I read through the entire transcript of Friday morning's conference call asking myself the question "does CAT's recession warning make sense?" My short answer is a definitive NO.
Let's just review the transcript from the beginning to the end and focus on the most important points.
For the third quarter, CAT reported it's second best ever quarterly performance on the strength of its global business presence and despite persistent weakness in North America.
From Mike Dewalt, Investor Relations: "Sales and revenues were $11.442 billion and profit per share was $1.40. This was the best quarter for sales and revenues ever, not just the best third quarter. In terms of profit per share, it was the best third quarter in our history and our second-best quarter of any quarter ever. A second point is that this was only the second time in ten years where sales and revenues in the third quarter exceeded sales and revenues in the second quarter, which is usually a seasonally-strong quarter. The growth was driven by continued and significant strength in sales outside North America, continued strength in a number of key global end markets, like mining, oil and gas, and engines for electric power generation, marine, and industrial applications. Sales and revenues increased 36% in the Europe, Africa, Middle East region, 30% in Asia-Pacific, and 20% in Latin America."
Dewalt tells us that things in North America look bad and are getting worse.
"...sales and revenues in North America were down 11%. From an end market standpoint, inside North America, it is a very weak picture for many of the industries that we serve. U.S. housing is down and we expect it to continue its decline. Non-residential construction is weak. Coal mining and quarrying are down in the U.S. And on-highway truck engines are down significantly from last year and we do not see much sign of a major turnaround for awhile."
We already knew that housing continues to be an economic sinkhole, and the stock market has effectively ignored any broader effect from housing. However, folks have assumed that non-residential construction would continue to make-up for this weakness, and certainly noone was thinking about on-highway truck engines as a major source of weakness. But where is the connection to a recession? Well, a slowdown in trucking suggests a slowdown in the demand for the goods that need shipping. If economic activity is slowing down, it would make sense that less energy in the form of coal is needed. And if all construction is slowing down, a wide swath of jobs may now be at risk. OK - time to worry if you like.
Although the U.S. will continue to slow, CAT is still projecting 2008 GDP growth at 1.5%. Hmmm...the definition of a recession is at least two consecutive quarters of NEGATIVE growth. CAT said nothing of the sort, so they fail this first easy check on their recession claims. So, CAT got everyone worried over slowed growth, which is not new news. But perhaps worse is that CAT tells us that these projections include the assumption that the Fed will deliver additional rate cuts with little impact on the economy and CAT's business. This news will worry anyone who expects the Fed to ride to the rescue, but I think it is more relevant to CAT-specific results for now.
Dewalt continues: "Our preliminary outlook for 2008 reflects another year of increasing sales and revenues by about 5 to 10% from 2007...We're expecting weak growth in the U.S., with GDP at about 1.5% for the full year, which is well below the economy's potential and historic average growth rates. While we do expect additional rate cuts by the Fed, we do not expect much benefit to the economy or the industries we serve in 2008. In the U.S., we expect housing starts to decline further to about 1.2 million units for the full year 2008 and that is a drop from our 1.4 million estimate for 2007. That would make 2008 one of the worst years in the last 50 and as you look at housing starts in relation to either population or the size of the country's housing stock, that picture is even worse. As a result of weakness in the overall economy, we expect the on-highway truck industry to remain depressed in 2008, but at levels that are little higher than 2007. And we expect continued pressure on many of the other industries we serve in the U.S."
Despite all these dire warnings, CAT still expects its business to perform at record levels next year, albeit at a slightly slower growth rate than originally expected. And best of all, the global growth engine will help keep them on track for their overall guidance through 2010:
Dewalt: "To summarize our view of the future, we expect 2007 and 2008 to be record-setting years with continued growth for Caterpillar despite the weak U.S. economy and some severely-depressed U.S. end markets in both years, like housing and on-highway trucks. We expect continued growth outside North America. We are confident in our ability to deliver on our 2010 goals for sales and profit growth. And that means sales and revenues over $50 billion and a compound annualprofit per share growth of 15 to 20% from our 2005 starting point."
So what gives? CAT one moment sends fear through the stock market about what would really amount to a "growth recession," and the very next moment they proudly declare that the business overall is going full throttle. Well, I think CAT is trying to manage expectations down for 2008 to set-up some nice out-performance relative to expectations next year. Note that CAT disappointed the street in its last earnings report in July and has now disappointed a second-time in a row. Management is now trying to get more conservative and probably even lay out the case for blaming any further disappointment on weak North American markets. But the glaring holes in CAT's story are that the U.S. can suffer a recession, the Fed acts and has no effect, the global economy grows as robustly as ever, AND CAT rolls into 2010 having achieved 15-20% annual earnings growth and $50 billion in revenue! Huh? Something tells me that after it is all said and done that CAT really thinks that the U.S. will do better in 2008; otherwise, I think they are being for too optimistic about the chain of events that keep their long-term guidance on track. Thus, to me, CAT fails this second check of its recession claims. I simply cannot believe their story through 2010 can withstand the shock of a U.S. recession in 2008 (and nevermind that their numbers do not pass the traditional definition of a recession).
Ann Duignan, an analyst from Bear, Stearns & Co., was the first analyst to ask questions. Understandably, she grilled CAT management on the their optimism regarding the long-term guidance. She smartly pointed out that CAT would have to accelerate their earnings performance from 2008 to 2010 in order to achieve their long-term guidance. CAT management seemed unfazed by it all. I suspect that their confidence stems from an abiding belief (faith?) that the U.S. economy will actually do fine in 2008. Just check out the exchange below. Note very carefully management's evasiveness on whether the 15-20% earnings growth is measured starting from now or still from 2005.
Dunigan asks: "Jim, maybe you could comment since you have talked before about an earnings range of 8 to $10 by 2010 and that will be implied with 15 to 20% earnings growth. But now, if we look at the top end of that, you would have to grow earning something like 30% in the next couple of years to achieve the high end of that. Is that's something you think that Caterpillar can do at this point or do you need to relook at your target for earnings in 2010?"
Jim Owens, Chairman and CEO, responds: "Ann, I would say we're very comfortable with that range and ability to grow our earnings per share by 15 to 20% between here and there. Keep in mind that in 2007 in the U.S., which has been our highest-margin market, we have experienced pretty severe recessionary conditions in housing and on-highway truck segment and managed a very significant inventory correction with U.S. dealers while that was going on..."
Not to be deterred, Dunigan asks again: "But you have to grow your earnings 30% in the next couple of years to achieve the target of 8 to $10 in earnings by 2010. Do you think that is achievable?"
All Mr. Owens can say this time is an unqualified: "Yes."
Doesn't Mr. Owen's response imply that CAt is already putting a domestic recession BEHIND it? Anyway, you tell me. Can a company average 30% growth in three years starting with a real recession in the U.S.? I will give an unqualified NO. So pick your poison: Either CAT is exaggerating the dire read on the domestic economy, or the company is very misguided on how well the rest of the world, and CAT's business, will hold up with a struggling U.S. For now, I am picking the side that says CAT is trying to manage short-term expectations downward while remaining firm on its now two-year oldlong-term guidance which has kept the market interested in the company's stock.
There is one more thing that probably spooked the market about CAT's results: the weak dollar did not help boost CAT's results! This strongly undercuts the enthusiasm the market has had in big-cap, internationally-oriented companies since the big bottom in August.
The weakening dollar is supposed to bring business money into the U.S. from overseas, but Caterpillar got nailed on currency weakness.
From Dewalt: "The impact of currency on profit before tax was negative about $60 million in the quarter. That affected profit per share by about $0.06 and is not something we had previously expected. It was primarily a result of a weakening dollar during the quarter."
And during Q&A, Eli Lustgarten, an analyst from Longbow Research, emphasizes that "Caterpillar has always been a weak dollar [play?] and to have a negative impact is sort of a big surprise, I think, to most of us."
Dewalt's response should cause analysts all across the country to re-evaluate all assumptions that the weak dollar is an automatic boon to U.S. global business activity. Some companies, like CAT, have insulated themselves as much as possible from the vagaries of currency swings:
"We have worked very hard over the last 20 years to have a reasonably-balanced position in terms of transactions in non-U.S. dollars. In the euro, for example, we are reasonably closely balanced in the euro. We actually have a few more sales than we do costs, which would be a benefit. Within the UK, for example, we have significant operations, more so than we have sales. So we have a lot more costs in the UK, for example, than we do have sales. In fact, if you look at the currency movement in the quarter, the dollar weakened more against the UK pound than it did the euro. So not only is that [where] our cost exposure is, that particularly currency even moved a little bit more."
Be careful out there!