CAT: A Master of Managing Expectations

by Dan Burrows | January 28, 2013 1:39 pm

It’s sometimes said that if you’re the chief executive of a publicly traded company, the most important part of your job is managing Wall Street’s expectations.

If that’s true, then Caterpillar (NYSE:CAT[1]) CEO Doug Oberhelman gets an A+ for the market’s reaction to Caterpillar’s fourth-quarter earnings report on Monday.

CAT, the world’s biggest maker of heavy construction and mining equipment — things like bulldozers, excavators and power generators — suffered a 55% drop in quarterly net income, hurt by slower global economic growth and a huge charge for a blockbuster acquisition gone bad.

Furthermore, the Dow component forecast a “tough” year ahead, with the first half in particular suffering against comparisons to 2012.

And yet shares popped as much as 3.3% soon after the opening bell.

So, what gives?

CAT didn’t move heaven and earth to get out in front of the bad news, but it more than adequately telegraphed the accounting hit and slowdown in business to the market.

The unkindest cut came from CAT’s disclosure a couple of weeks ago that its splashy purchase of ERA Mining Machinery — a Chinese heavy equipment concern — was marred by accounting fraud.

On Jan. 18, CAT said an internal investigation[2] uncovered “deliberate, multi-year, coordinated accounting misconduct” concealed at the company, located in Zhengzhou, China. As a result, CAT would have to take a non-cash charge related to goodwill on the deal of 87 cents a share. That’s what caused net income to plummet by more than half.

At the same time, CAT gave the market a heads up about any revenue softness and too-high inventories back when it reported December dealer figures.

As Raymond James (NYSE:RJF[3]) analyst Ben Cherniavsky wrote in a report well ahead of CAT’s results:

“CAT has telegraphed weak year-end results (with some carry over into 1Q12) due to lower production rates as both the OEM and its dealers right-size elevated inventory levels. In addition to inventory headwinds, December dealer stats imply weaker end user demand, particularly on the Machinery front.”

Taken together — the accounting charge news and the weak dealer numbers — the Street had ample data and time to model a worst-case scenario.

And thus, without too much trouble, CAT was able to top analysts expectations rather easily. For the most recent quarter, earnings came to $1.91 a share — excluding the non-cash accounting charge — far better than the Street’s forecast for $1.70.

At $16.08 billion, sales squeaked past analysts’ forecast for $16.06 billion in revenue, too. And although CAT confirmed that the first half would look bad compared with 2012 results, its full-year forecast of $7 to $9 a share comfortably brackets the Street’s estimate.

The market already knew that a sluggish U.S. economy, slower growth in China and a recessionary Europe were acting as a drag on CAT. The goodwill write-off was also more than reflected in the share price. Hence the pop in the stock Monday.

CAT’s careful communications strategy appears also to be helping competitor Joy Global (NYSE:JOY[4]), which has sales and accounting concerns of its own.

Like CAT, Joy Global made a big acquisition in China’s mining industry, buying International Mining Machinery (IMM), a maker of underground mining equipment, for about $1.4 billion in mid-2011.

Since two board members and significant shareholders at scandal-plagued ERA were also co-founders and former board members of IMM, there are concerns that Joy Global could be facing a huge accounting fraud/write-off of its own.

Moreover, Joy Global’s main end market is coal, which hasn’t been so hot recently, because natural gas prices have been falling again.

As Raymond James analyst Theoni Pilarinos wrote in a Monday note in downgrading Joy Global to market perform from outperform:

“A large part of our bullish stance on Joy’s stock was predicated on a bottoming out of U.S. Coal markets as higher gas prices would lead to a reversal of coal-to-gas switching. However, as per a recent note out by our RJA Energy team, uncooperative weather has kept gas prices sufficiently low to reduce expectations for a meaningful reversal in coal to gas switching.”

CAT’s better-than-expected results and the analyst downgrade ended in a wash for Joy Global’s stock Monday, as it has traded essentially flat through the early going.

Furthermore, Joy Global is by no means assured of suffering the same kind of write-off CAT did with ERA. For one thing, as Pilarinos notes, IMM was owned for several years by a private equity firm and went through a more rigorous IPO listing process. So, there’s hope that auditors would have caught any accounting shenanigans before now.

Ultimately, the bottom-line big-picture takeaways from CAT’s Monday report aren’t really news, but they’re instructive nonetheless: Managing expectations is critical, and the global economy remains frustratingly soft.

As of this writing, Dan Burrows did not hold positions in any of the aforementioned securities.

  1. CAT:
  2. said an internal investigation:
  3. RJF:
  4. JOY:

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