Caterpillar Is a Pure Energy Play in 2015

Following last Tuesday's earnings announcement, Caterpillar (NYSE: CAT) was crushed, falling $7 per share from $86 down to $79 overnight.  It's stayed in that $79 range for the rest of the week, based entirely on it's gloomy outlook for 2015. 

The exposure CAT has in the energy sectors is significant, and with no foreseeable end to low oil prices, it's no wonder that the stock of this well-run company has been pummeled.  The good news for traders and investors alike, however, is that we now have oil as a leading indicator for this company's eventual rebound.  Take a look at a chart of CAT (red line) compared with the Energy iShares ETF (blue line.)

CAT (red) vs IYE (blue)

The correlation between the two makes sense when you consider the company's outlook for 2015.  CAT is forecasting a 9% decline in revenue compared to 2014, primarily as a result of depressed oil and gas prices.  Consider what CAT sells relative to that industry:

• Engines for drilling;
• Engines, transmissions, and pressure pumps for well servicing; 
• Engines for compression sets for gas gathering;
• Engines and turbines for pipelines;
• Turbines for offshore production pipelines.

In 2014, $22 Billion in sales came from this industry alone.  With depressed oil prices, however, there is an anticipated significant reduction in CapEx expenditures on the part of oil exploration and production companies in 2015.  Lower CapEx in that industry translates directly into lower revenue for Caterpillar.

If the price remains low for the better part of 2015 - and at present, there's not much to suggest it won't - then the turbine business is expected to decline well into 2016.  Without a dramatic price move in oil in the short term, it's reasonable to expect CAT's stock price to remain depressed at least through their next earning period.  It's for that reason that I'm using oil prices as the leading indicator CAT's future growth.

In their January 27th conference call, CAT offered some insight into several other industries of note. 

• Agriculture is expected to be weak in 2015.  This will lead to lower sales of industrial engines, and you can translate that into lower sales of other farm equipment.  It may, however, be good news for the parts industries, since there will be a greater desire for maintenance as opposed to new purchases.
• The rail business is expected to be down, at least according to CAT.  Now, this runs contrary to what we're hearing from others that have exposure to that industry, so it remains to be seen if CAT is being overly pessimistic or if this is a reflection of their more global position as opposed to a pure domestic play.
• Construction is expected to be up in the US.  This coincides with the view from others in that industry, and given the pessimistic outlook portrayed by CAT as a whole, this adds a measure of weight to the strength of the construction industry domestically.
• Construction everywhere else is expected to be down.  That's a recurring theme, with Europe leading the charge into recession.  China's growth is slowing, and construction is forecast to decline there as well.
• Mining is very weak, with commodity prices - especially for copper, iron ore, and coal - trading well below normal.  Interestingly, CAT does not foresee this improving in 2015.  If they're right, the various mining industries will face serious headwinds throughout the coming year.

As is typical in earnings calls this week, the strength of the US dollar was raised as a major headwind to global profits.  Now, this makes sense from two aspects.  First, any company that relies heavily on US exports is going to face headwind since foreign currency now buys less in terms of US goods and services.  Second, sales overseas in foreign currency faces unfavorable US dollar terms, so those sales now result in less revenue expressed in the dollar.

The good news for the strong dollar, however, is in terms of overseas manufacturing.  Companies based in the US, like CAT, that have extensive overseas manufacturing facilities are expected to see much lower costs thanks to the favorable exchange rates.  In fact, CAT anticipates this artificial cost reduction as offsetting the impact to revenue in the overseas markets.  It's a factor to consider when looking at opportunities in other companies with a strong overseas manufacturing presence.

So there you have 2015 in a nutshell, at least as it pertains to companies with heavy exposure in the oil and gas industries.  As to CAT, watch the oil ETFs for signs of strength once the price of oil stabilizes and begins to recover.  I'm expecting the oil ETFs to be a leading indicator that will signal a great entry point for CAT, and one that may provide an excellent cross-earnings announcement play in the quarter in which we see oil rebound.

IMF Paints Dismal Picture for 2015

In what is sure to spook investors in companies with high global exposure, the International Monetary Fund (IMF) has lowered their global growth forecasts for 2015.  The big hit was in their forecast for China, lowering their forecasts to a 6.8% growth rate.  That's 0.8% lower than China experienced in 2014, and last year was already down from 2013.

That 6.8% growth rate is still almost double the anticipated growth rate world-wide, which the IMF is forecasting to decline to 3.5%.  While Chief Economist Olivier Blanchard acknowledged that the declining price in oil was providing a bit of an economic boost, he does not believe that it will be enough to stem the amount of global economic weakness that is forecast.

Interestingly, the IMF only cut their forecast for the Eurozone to by 0.2% to 1.2%.  From what we've seen to date, it's optimistic to assume that growth will be positive as Europe appears poised for recession.  They also cut Japan drastically, and with a consumer confidence level under 40 and falling, that appears more than justified.  In fact, the 0.6% growth level they are projecting may even be optimistic.

One major challenge related to validating the IMF's gloomy view of China is the lack of confidence in numbers produced by the Chinese government.  Instead, we'll need to rely on forward guidance from some of the larger US corporations with high exposure in that region.  Alcoa, for example, provided a stronger view of 2015 Chinese growth than is predicted by the IMF.  Caterpillar reports next Tuesday (01/27) and it will be most beneficial to compare their forecasts with Alcoa's.  Between CAT and AA, I trust their assessment of global economic conditions far more than I trust the judgement of either the Chinese government's reporting, or the somewhat pessimistic view of the IMF.

Despite my overall skepticism related to numbers coming out of China, there is one release this week that does warrant watch.  The HSBC Manufacturing Purchasing Managers Index for China is released at 01:45 GMT on Friday (8:45 PM EST on Thursday.)  The December number was 49.6, so there's a bit of interest in the direction it takes for January.  A reading above 50 signals economic expansion, whereas a number below 50 signals contraction.  It has been slowly - very slowly - trending down since 2009.

It's no exaggeration to say that China will make or break global economic health as we navigate a troubled period in Europe and Japan.  A strong US dollar is not helping there since the Chinese Yuan is pegged to the dollar.  The strong dollar is adding downward pressure on the health of their currency, which raises the prospect that they could decouple from the dollar for added relief.  That may provide a needed boost by improving their export market.

There's a lot to consider related to China and it's interaction with other markets.  For now, pay attention to the PMI number on Friday, but pay even closer attention to the guidance from companies with extreme exposure overseas.  You can count on them being far more forthcoming than the numbers coming out of any government release.