Caterpillar's GAAP in the Machine
As the industrial earnings season winds down, one takeaway has been that even as companies start to dig themselves out of a sales slump, the quality of their earnings still matters.
General Electric Co. got punished for sub-par cash flow, despite posting significantly better-than-expected orders and core revenue growth. Fears that Emerson Electric Co.'s EPS outlook might not be as strong as it appears when you factor in its acquisition of Pentair Plc's valves and controls business drowned out an improved sales forecast. The list goes on.
Then there's Caterpillar Inc.
The $60 billion maker of construction and mining equipment last month reported adjusted first-quarter EPS of $1.28, more than double what analysts had predicted, and raised its 2017 sales outlook, gratifying investors who have been hoping and waiting for signs of a pick-up in demand for heavy machinery. GAAP EPS, on the other hand, fell well short of estimates. The main difference between the two numbers is a big spike in restructuring charges as Caterpillar shuts down even more manufacturing facilities. That knocked 20 cents off its GAAP forecast for 2017, even as Caterpillar boosted its adjusted EPS guidance. 1
Continuing their pattern of overeagerness, Caterpillar investors responded to the report by sending the stock up 7.9 percent -- the biggest post-earnings gain among industrial members of the S&P 500 this quarter.
There was definitely some good news, don't get me wrong. The 13 percent year-over-year increase in backlog stands out. But in an earnings season when investors have been perfectly comfortable ignoring positive developments at other companies in order to hammer home EPS gripes, why does Caterpillar get a pass on its adjustments?
Many companies use non-GAAP figures and sometimes they do provide a clearer picture of what's going on. But, as Robert W. Baird & Co. analyst Mircea Dobre puts it, restructuring is a cost of doing business for a heavily cyclical manufacturing company like Caterpillar, not "an outside event like a meteor.” Treating it as the latter doesn’t add much clarity, particularly because Caterpillar didn't exclude restructuring costs in past downturns, he says. Refocusing investors on a higher adjusted earnings base makes it harder to use historical comparisons to gauge the company’s ability to rebound and muddies the conversation around whether or not Caterpillar is expensive.
For example, Caterpillar is valued at about 19 times its estimated 2018 adjusted EPS -- but almost 22 times GAAP EPS.
Those restructuring efforts also deserve a close look. Take a look at this chart compiled by Bloomberg Intelligence analyst Joel Levington on Caterpillar’s restructuring charges relative to fellow machinery maker Deere & Co.:
The company says those efforts have set it up to eliminate billions in costs, but, as Levington points out, it hasn’t gotten much margin bang for its buck yet. The company's updated 2017 guidance implies $2.2 billion of adjusted net profit on $39.5 billion of sales at the midpoint of its range, suggesting a lower margin than it earned in 2005 when sales were actually lower. Even with the business improvement expected by analysts, particularly in more profitable after-market repairs and services, Caterpillar’s margins may resemble those of junk-rated companies at least through 2018. Perhaps that's why it’s shutting down even more manufacturing facilities to the tune of $750 million additional restructuring charges this year ($1.25 billion in total).
Caterpillar's EPS has also benefited from an accounting change in 2016 that allowed it to stop amortizing pension liabilities throughout the year. It instead realizes the loss or gain in the fourth quarter and then excludes that from its adjusted numbers. Its original EPS outlook didn’t include any goodwill impairment charges, which may be behind it at this point. 2 I'm not even going to get into the raid by federal agents earlier this year seeking evidence related to tax and export activities, but that obviously provides another question mark.
Why don't investors seem to care so much about this quality of earnings debate? One reason may be that because Caterpillar had suffered a far deeper sales slump than even peers like Deere, its stellar backlog and order numbers in the latest quarter matter a lot more to shareholders than the bottom line.
How strong that recovery will be in the long term is a matter of debate. 3 In the short term, there are some potential pressure points for sales and margins that could prove analysts overly optimistic in their call for Caterpillar’s adjusted EPS to surpass even its raised guidance (stalled commodity prices, less profitable business mix and rising material costs, to name a few). The absence of an improved outlook next quarter could be taken as a sign that growth hasn’t sustained its momentum, at which point the debate over quality of earnings becomes more important.
Just some accounting food for thought, industrial investors, as you close the book on this quarter.
Caterpillar says it doesn’t expect to see cost savings from the additional plant closures until 2019. But in theory, its prior EPS guidance issued in January would have incorporated a cost for keeping those facilities open, as their closure was just “contemplated” at that point.
Caterpillar took a charge of $595 million in the fourth quarter of 2016 in its resource industries division. That business is home to the company's $8.6 billion purchase of Bucyrus International in 2011 and the $790 million takeover of ERA Mining in 2012. Caterpillar announced a $580 million writedown related to the ERA acquisition in 2013, saying it had uncovered accounting misconduct. Goodwill -- the difference between what a company pays to buy a business and the estimated value of its assets -- has remained above $6 billion in the wake of those deals.
Even optimists have to admit it doesn't bode well for demand reaching prior-peak levels if Caterpillar is still shutting down facilities even as things appear to be getting a bit better.
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