Get Ready For Positive Caterpillar News, Say Analysts

At the start of March short sellers in Caterpillar Inc (NYSE:CAT) stock such as Jim Chanos of Kynilos Associates, a group noted by their particularly thick skin, were found licking their wounds. Chanos shorted the stock in 2012 in part on the thesis that China, a big market for Caterpillar’s heavy equipment purchases, would fall into troubled times. That negative catalyst didn’t happen. The stock moved higher to $110 in 2014 and then bottomed at $59.87 nearly one year ago, but even then Chanos didn’t take profits. Since then the stock steadily climbed in a reasonably consistent price uptrend channel and significantly outperforming the broader stock market. Chanos told CNBC he was still short this past October, and he was alone, as short interest was climbing with the stock price, hitting a historical high of $3.9 billion in late November, calculations from financial analytics firm S3 Partners.

At the end of 2016, the $2.5 billion in total short bets against the stock were feeling pain after the stock had gained 35% on the year. Additionally, the analytics form notes:

CAT short interest averaged $3,245 million over the last 14 months and generated a 32% net of financing mark to market loss.

And

Short sellers may be loath to jump back into the name as their perseverance in holding onto their short positions from 2016 to 2017 resulted in losses totaling just over $1 billion.

But then came Tuesday, March 7 and the FBI, in an unusual move against a major multi-national corporation, accused Peoria, Illinois-based Caterpillar of Federal tax and accounting fraud, the New York Times first reported.

When the investigation was announced, the stock price trend quickly changed. In an instant, the fate of the short sellers had reversed, making $43 million in less than a week, S3 noted. While that might seem a tidy sum, it is relative to losing nearly $1 billion over the course of the previous year. Short interest averaged $3,245 million over the last 14 months and generated a 32% net of financing mark to market loss.

And the short sellers should be prepared for more losses. Plans are already in the works to rain on their parade. But S3, in a report titled “Tax Fraud Allegations Not Enough to Bring Back Caterpillar Short Sellers,” tends to agree.

Investigation of major multi-national by FBI is “rare”

The Federal probe, characterized by the New York Times as “rare,” is scrutinizing Caterpillar’s tax and accounting standards with a focus on one of the firm’s Swiss subsidiaries. It still remains clear if authorities plan on charging the component of the elite Dow Jones Industrial Average.

The report, which has not been made public but was reviewed by the New York Times, focuses on strategies used to avoid paying billions in taxes. Multi-national corporations have come under increased scrutiny over various schemes to reduce their US tax liability, with many declaring off-shore corporate headquarters in offices containing no more than a skeleton crew.

Jefferies analysts Stephen Volkmann, Chirag Patel and Alan Tadian explain the technical nuance:

Based on CAT’s 10-K filings for the tax years 2007 to 2012 (and including the impact of a loss carryback to 2005), the IRS has determined that certain parts transactions that were conducted through Caterpillar SARL (CSARL) came under question in respect to the “substance-over-form” or “assignment-of-income” judicial doctrines. More directly, the IRS has asserted that parts profits that should have been booked in the US were booked in a Swiss subsidiary. In respect to this time period the IRS has proposed an increase in back taxes and penalties totaling approximately $2bn, which CAT continues to contest. CAT notes in their filings that it has continued to use the same accounting treatment for periods since 2012, which may suggest that today’s information gathering is focused on tax years subsequent to 2012 — although neither the company nor any government entity has provided this detail. We would note that CAT has disclosed this issue for the last two years, so it should not be new to investors.

Get ready for an onslaught of bullish news, as charges against Caterpillar could take years to sort out

Shorts might do well to prepare for a bullish onslaught of news. Evercore ISI Industrials and Machinery research team of David Raso, Oliver Liao and Jeff Morrison, fresh off discussions at an industry trade show, note that positive news is likely to be on the horizon. Caterpillar could raise guidance amid a generally positive market environment:

Accelerating revenues is what will drive CAT stock, short-term price-cost not allowing even more of a blowout in EPS is “seeing the trees, missing the forest”; saw same thing in starting last cycle when early 2000s rising steel prices early in cycle squeezed margins a bit when volumes first started ramping but stock continued to work as investors correctly surmised price-cost would improve as volumes ramped further, delivery lead times started to stretch and the pendulum of power increasingly swung from the customer to the dealer and eventually back to CAT. That pendulum of power has now just begun to swing away from the customer and toward the dealer/CAT.

From Jefferies standpoint, the IRS probe is likely to take years to resolve “and should not change investors’ views of CAT’s earnings power over the next couple years.” Jefferies thinks the worldwide economic recovery and Trump stimulus already priced into the stock might have led to high valuations, which is in part why they have a hold on the stock.

S3, for their part, note a positive macro economic environment that could benefit long holders of the stock such as Joel Greenblatt’s Gotham Capital:

The potential increase of worldwide agricultural, construction, energy and mining demand has buoyed the stock prices of industry leaders Caterpillar, John Deere (DE US), Komatsu (6301 JP), Agco Corp (AGCO US) and CNH Industrial (CNHI US).

We have not seen a spike in CAT’s short selling today in response to the U.S.’s tax fraud allegations, but if the Trump stimulus plan is delayed significantly and commodity prices slump we may see short sellers come back and try to recoup some of their 2016-2107 losses.

On a technical level, the Federal probe news has taken the stock to the bottom range of its one-year uptrend channel, an assumed mechanical point of support. Shorts might do well to watch this level – and market reaction to anticipated positive news. There is a long history of making incorrect exposure bets on this stock.

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Source: valuewalk