Caterpillar Is Going Down, But It's Not Alone

Ash is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A few days back, at the CNBC/Institutional Investor Delivering Alpha conference, legendary short seller Jim Chanos said that shorting Caterpillar (NYSE: CAT) was his best investment idea of 2013. His short thesis was based on the fact that the company is facing “commodities super-cycle headwinds.”

Caterpillar's recent results proved that Jim Chanos was right. The company lowered its global growth outlook. Sales declined across all equipment segments with mining being the worst performer. In addition to slowing end markets, the company is also seeing significant inventory reduction at dealer level.

Although the company is expecting the second half of this year to be better than the first, there is little evidence on ground level that suggest that things will improve in the near to medium term. The company’s backlog declined to $19.1 billion from $20.4 billion sequentially, and the visibility going into the back half remains poor.

I believe the trend of lowering guidance has just begun, and the company might continue to reset Street expectations lower in the coming quarters. Although the company is trading at just 12.83 times the mid point of its current year EPS guidance, one needs to understand that the company is near the cyclical peak and its EPS is likely to decline going forward.

Caterpillar posted and EPS of $8.90 in 2012 and is expected to post an EPS of $6.84 in 2013 according to sell side estimates. Its revenue is expected to decline 10.90% in 2013. If we look at consensus estimates, the sell side is expecting revenue and earnings growth in the next year, but there is a little evidence that suggests that they might be right. I believe mining capex is unlikely to accelerate thanks to the Chinese slowdown and price headwinds commodities are facing.

In the last year and a half, Caterpillar’s sock price has corrected ~25%. I believe this downward trend is likely to continue going forward, and, hence, I recommend a sell on the stock.

But this story doesn’t end with Caterpillar. Other equipment manufacturers are facing similar headwinds. The most notable among them is Joy Global (NYSE: JOY). Joy caters solely to the needs of the mining industry, which is the weakest end market, even for Caterpillar. Joy Global’s stock declined ~50% in the last two years.

Although the company’s management is taking right steps in terms of using cash flows to repurchase shares and make accretive acquisitions, the macro headwinds keeps me on the sidelines. There has been an excess capacity in the mining industry thanks to a decade long bull run in commodities. It will take at least a few more years and the shut down of more mines before supply/demand condition reach an equilibrium level again.

There are not many new projects or capacity additions happening in the mining industry that can help drive Joy Global’s order book at the current levels. Although there are some bright spots like the US coal end market, where the company expects to see some strength, they are not enough to offset weaker end markets like Chinese coal and global steel.

The stock doesn’t look expensive at 8.25x, but if we factor in next several years of declining EPS, it is appears the best decision is to avoid it.

Another equipment company that is likely to face significant headwinds going forward is Terex (NYSE: TEX). Terex is a “mini Caterpillar” present in similar end markets as Caterpillar and offering competitive products. One of the main problems with Terex is that if Caterpillar starts getting aggressive on pricing (i.e. discounting) due to a prolonged slowdown, Terex will also have to do the same to protect its market share.

In addition since Terex is present in similar end markets as Caterpillar, it is also likely to witness slowing end markets and subsequent dealer inventory reduction. In fact this really is the case. In June, Terex’s management slashed its guidance given greater than expected weakness across its construction, material handling and port solution, and crane business.

The company has seen a sequential decline in backlog in the last few quarters, a trend which is likely to continue going forward. Although the company’s management has emphasized their focus on margin improvement and cash generation in 2013, there is little visibility on how they will achieve it. The company is trading at more than 14 times current year earnings and is the most overpriced one among its peers. Hence, I recommend avoiding it.

To sum up, Caterpillar is an industry bell weather, and if it is seeing some significant slowdown, many of its smaller peers are likely to see similar trends. Joy Global is the most exposed to mining which is the weakest end market for the equipment manufacturer, while Terex is one of the most overpriced stocks on a PE basis. I recommend avoiding all three stocks.

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Ash Sharma has no position in any stocks mentioned. The Motley Fool owns shares of Terex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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