Staying on the Sidelines

 | Aug 21, 2014 | 11:00 AM EDT
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Caterpillar (CAT) shares are trading just 4 points from the stock's 52-week high, but the company's sales are a total disaster. The stock is short-seller favorite, but it has outperformed the S&P 500 and is up almost 20% year to date. What the heck is going on?

Going into the second quarter, investors were excited. The stock was up 35% from the December lows and analysts were expecting a strong quarter. Then, on July 24, the excitement turned to horror as the company missed on revenue and management slashed forward guidance. Investor reaction was immediate. The stock fell almost 10% as investors dumped their shares.

For the second quarter, Caterpillar reported that revenue fell 3.22% to $14.150 billion. Management blamed the decline on weakness on the construction industry in China. Sales were less than expected in Africa and the Middle East as well. Mining sales were down 29%.

For the full year, the company predicted sales between $54 billion and $56 billion. Analysts quickly huddled around the mid point and began publishing revenue estimates of $55.1 billion. If the company hits the consensus estimate, sales for the year will be down about 1%.

On Wednesday, the company published its three-month equipment sales chart and the Caterpillar bulls were left in shock. It was hard to find a product line or region where machines were actually selling.

Worldwide, total machine retail sales were down 12% in May, 10% in June, and 9% in July when compared to the prior year. These declines compare to year-on-year declines of 8%, 12%, and 13% in February, March, and April. 

In its Asia/Pacific segment, total machine sales were down 30%, 30%, and 29% for the months of May, June, and July, respectively. Yikes!

With sales like that, it's difficult to be bullish on the stock. But there are bulls out there. The bulls argue the company has accelerated its $2.5 billion stock repurchase program. Management has historically had a strong commitment to returning cash to shareholders so, in their opinion, the stock is worth owning.

Caterpillar bulls point out that the company's business is seasonal. The third quarter is expected to be similar to the first quarter. In the second quarter, sales improved sequentially for parts and equipment. Mining sales actually improved sequentially. Bulls point out that the company is producing 80% fewer mining trucks from the peak production levels in 2012, which should help the bottom line. The bulls are clinging to the belief that North American sales will improve over the next year and concerns over slowing international sales will prove to be overblown.

The bears say North America can't save the company because North America only accounts for 15% of the company's sales. The bears believe the construction business in China is slowing dramatically and it's only a matter of time until the stock gets plowed under.

I'm afraid to short Caterpillar for two reasons. First, I think the sales chart management published yesterday is old news. Second, despite slowing sales in China, Caterpillar has a lot of ways to win.

So I am reluctant to short the stock based on the sales chart management published because those numbers were built into last month's guidance. Management thinks the third quarter will come in at $13.4 billion, which is similar to first quarter sales of $13.2 billion. So for me, that chart is old news. Could the stock sell off a few points as people adjust their estimates? Sure. But I think it's baked in and not worth the risk.

Second, I've been burned shorting international companies that have a lot of ways to win. Right now there are 15 analysts who rate the stock a Hold. If, for example, the North American oil and gas business does better than expected, it could set off a wave of analyst upgrades -- and no short wants to be around for that. Mining grew sequentially last quarter. Another quarter of growth in the mining business and your goose is cooked if you are short the stock.

If I were going to short Caterpillar, I'd prefer to have most of the analysts rating the stock a Buy or Strong Buy. I would rather have analysts downgrading a stock I am short, rather than having 15 analysts telling their salesforce they are upgrading the stock.

I'm staying on the sidelines on this one. The closest I'll get to Caterpillar right now is watching re-runs of "Gold Rush."

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