The Rally in Caterpillar Inc (CAT) Stock Is Over

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Following an epic 16% rally since the November election, shares of Caterpillar Inc. (NYSE:CAT) are finally stalling out. This follows an earnings report that beat on earnings per share but missed dramatically on the revenue side, along with lowered guidance. Last week’s raid by the Criminal Investigation Division of the Internal Revenue Service certainly put a further damper on the euphoria and may explain how the company continues to manufacture earnings in the face of deteriorating sales.

The Rally in Caterpillar Inc (CAT) Stock Is Over

I look for CAT stock to continue to struggle over the coming weeks.

A Swiss affiliate, CSARL, was the impetus for the raids. The foreign subsidiary was designed as a tax avoidance mechanism to escape paying U.S taxes and instead move those revenues as Switzerland-based sales, where Caterpillar had negotiated an effective tax rate of only 4%-6%.

Nice way to have lower revenues magically turn into higher earnings.

Caterpillar Earnings

Speaking of earnings, a closer look at the latest earnings report highlights that very notion. Earnings per share came in at 83 cents per share, handily beating analysts estimates of 66 cents per share. Yet somehow revenues missed wildly, falling to $9.57 billion versus expectations of $9.84 billion.

Guidance was also lowered, with EPS for 2017 now projected to be $2.90 per share versus analysts previous projections of $3.04 per share. This equates to an eye-popping 2017 forward price-to-earnings ratio of 33, with Caterpillar retail sales having fallen for 50 straight months and 2016 showed no sign of improvement. To say earnings quality is poor would be an understatement.


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Besides the many issues from a fundamental standpoint, CAT stock is also looking toppy from a technical perspective. The $99 price level certainly has provided impenetrable resistance area over the past month, with each attempt to break out being quickly rejected.

CAT stock also pierced the 50 day moving average at $95.12, adding to the bearish thesis.


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Normally, CAT stock is correlated to the price of oil, which makes sense since crude oil production is a main user of Caterpillar machinery and accounts for a healthy percentage of overall revenues. Since last June, however, that correlation has broken down dramatically, with CAT rising sharply and oil remaining flat. Previous instances when CAT stock prices diverged this far from oil prices proved to be very opportune times to take a short position in Caterpillar.

Caterpillar bulls point to the healthy dividend yield as a solid reason to own CAT stock. The yield is currently 3.3%, which is still decent although well off the recent 5% level. More alarming, however, is the payout ratio. The chart below shows the payout ratio for CAT stock now approaching an astounding 300%!


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With a total annual dividend of $3.08 per share, 2017 projected earnings of $2.90 per share fall far short of even covering the dividend payment. The sustainability of the current dividend should certainly be questioned, especially given the quality of earnings.

In my previous post on CAT I touched on some of the same concerns and recommended a put spread strategy, which ended up being profitable.

With implied volatility (IV) now elevated, option selling strategies are favored, so a bear call spread makes intuitive sense.

CAT Stock Trade Idea

Buy CAT April $105 calls and sell CAT April $100 calls for a 65-cent net credit.

Maximum gain is $65 per spread with a maximum loss of $435 per spread. Return on risk is 19%. The short $100 strike provides a 5.1% upside cushion and is also positioned above the $99 resistance area. I would use a meaningful move past $99 as a stop while hoping to let the spread expire worthless and keep the initial $80 credit if CAT remains well-behaved.

As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at tbiggam@deltaderivatives.com.

Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, four years as Lead Options Strategist at ThinkorSwim and three years as a Market Maker for First Options in Chicago. Tim makes weekly appearances on Bloomberg TV  “Options Insight”, Business First AM “Trader Talk”, TD Ameritade Network “Morning Trade Live” and CBOE-TV “Vol 411” to discuss everything from volatility and option related.


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