Shorts Dig Into Caterpillar: Tara Lachapelle

Short sellers are starting to gather around Caterpillar. They may be on to something.

Shares of the machinery company, considered a bellwether of the U.S. economy, are having more down days than up ones lately. The price fell again Thursday, at one point heading for the lowest closing level since 2010. This following last week’s announcement that it may cut up to 10,000 jobs through 2018. Caterpillar also warned that revenue this year may total just $48 billion, a 13 percent drop from last year and the lowest annual figure since 2010.

This is all the result of a five-year downturn in commodities that has crushed demand for Caterpillar’s mining equipment. And still the worst doesn’t seem to be over -- a situation some traders are looking to cash in on now.

Short sellers, as they did during the crisis, are piling in, convinced Caterpillar’s stock price is headed further downhill after declining 35 percent in the past 12 months. About 7 percent of the company’s shares outstanding are sold short, positions which represent $2.7 billion of market value, according to data compiled by Markit and Bloomberg.

It’s becoming evident that the company may be in worse shape than many sell-side analysts and long-time shareholders have been willing to admit. At least four analysts recommend buying shares, and most of the rest have a "hold" rating. Only four suggest selling. They have lowered their 12-month price estimates, though, to an average of $68.67, compared with $82.21 a month ago. The shares were trading for around $64 apiece midday Thursday.

Caterpillar shareholders tend to be a loyal bunch. When big drops approach and the shorter-term funds want off the ride, value funds just hang on tight. They accept the cyclicality of a business tied to the construction and mining markets.

The company also props up the stock by spending a lot of money on share repurchases and a dividend. Of the $10 billion the board authorized for spending on buybacks from 2014 to 2018, it had already used $3 billion as of June. The quarterly dividend has been raised six times since 2009, data compiled by Bloomberg show.

Caterpillar assured investors last month that three of its four best years of operating cash flow from the machinery, energy and transportation business lines have come since 2011. Cash flow has remained strong arguably because Caterpillar is making its operations as lean and efficient as possible, a process that has a breaking point. Only so much cost-cutting can make up for shrinking sales.

At some point, the revenue slowdown will have a negative affect on cash flow, which may put shareholder distributions in jeopardy.

Caterpillar’s dividend adds up to about $1.9 billion per year, based on its current shares outstanding. Free cash flow to equity -- meaning what’s available for shareholders after paying down debt -- was $4.5 billion in the 12 months ended June 30, according to data compiled by Bloomberg. Plenty to cover things, right? 

But that $4.5 billion is down 38 percent from the prior period and is the lowest for a 12-month stretch since 2011, according to data compiled by Bloomberg. 

Hypothetically, two more drops of that magnitude would put cash flow below what’s needed to cover its dividend. That will make the short sellers look prescient.

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