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InvestorsObserver
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Bobby Raines
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July 28, 2014 - Look for CAT to Stay Flat

The Dow Jones Industrial Average is the most-famous measure of the market, even if it is somewhat less relevant than it used to be as a measure of how the market, or the economy is actually doing.

It turns out the Dow Jones Industrial Average is also less industrial than it has ever been. The index now contains retailers, banks, insurance companies, two phone companies, a shoe maker and a hamburger chain.

There are still a few companies that make things in the index though. One of the best known among them is probably Caterpillar (CAT), the company behind literally tons and tons of bright yellow construction equipment.

Caterpillar's sales of construction equipment tend to track along with the economy as people and companies spend money on new houses and buildings, and construction companies buy new equipment to keep up.  

Caterpillar's stock has lagged behind other stocks as the economy has recovered over the last couple of years. This is largely because of the company's acquisition of Bucyrus International, a company that makes mining equipment, in 2011. While the acquisition may have made sense from some perspectives, the mining industry has been slow to recover from the recession as commodities prices have remained relatively weak when compared to their pre-recession highs, and in the U.S. at least, natural gas has started to replace coal for a lot of applications, cutting into the need for new coal-mining equipment.

The stock started to rise late in 2013 after analysts at Bank of America-Merrill Lynch upgraded the stock to Buy touting the company's power systems business.

The rally continued after the company topped expectations for earnings in the first quarter and announced a $10 billion share repurchase program that runs through 2018, including $1.7 billion to be repurchased in the first quarter. Caterpillar also announced plans to cut between $400 million and $500 million in costs.

It turns out that spending $1.7 billion in a single quarter to buy any individual stock will probably make that stock go up. It also turns out that if you reduce the number of shares outstanding by however many shares you can get for $1.7 billion, and also cut another half billion or so in costs, earnings per share are likely to rise. That's how math works.

Sure enough, on July 23, the company said it earned $1.57 per share on $14.15 billion in revenue. The mean analyst estimate had been for $1.52 per share on $14.4 billion in sales.

So the company managed to increase earnings, while missing on the revenue line. Compared to the year-ago period, the company's EPS grew from $1.45, but revenue fell, from $14.62 billion.

Caterpillar expects both trends to continue as it raised its full-year EPS estimate to $5.75 per share, on sales of $54 billion to $56 billion. That compares to a prior forecast for earnings of 45.55 per share and sales of $53.2 billion to $58.8 billion.  

See that? Sales go down, but earnings per share still go up!

Oh right, Caterpillar also said it is going to buy about $2.5 billion of its own stock this quarter.

The company said lower revenues are due to weakening sales in China and some former Soviet republics, and added that mining equipment sales of mining equipment are still weak, particularly in Latin America.

The market seems to have caught on to Caterpillar's shenanigans and the stock fell for more than 3% after that earnings report.

Caterpillar isn't a stock I'd be interested in holding long-term right now. Shrinking revenues eventually hit the bottom line, even if it takes a while.

That said there are still ways to play the stock. With $2.5 billion on deck to be spent on shares in the next three months, it is hard to imagine it falling too far. You could take a bullish position with a September 95/100 bull-put credit spread. That position yields a credit of about 60 cents, which is a 13.6% return, or 85.82% on an annualized basis (for comparison purposes only).


Chart courtesy of stockcharts.com

If you also share my dim view of the stock's prospects for upward movement, you could pair that trade with a September 110/115 bear-call credit spread for an additional 60 cents. By itself, that position has a 13.6% return, but when these two positions are paired, the return jumps to 31.6% (198.7% on an annualized basis…).

This trade is called an Iron Condor. Since the bull-put spread requires the stock to be above 100 for a full profit, while the bear-call spread calls for it to be below $110, we're essentially betting that the stock will be in that range at September expiration. The return jumps because the stock can't be both below $100 AND above $110 at the same time. This means you can only possible lose in one direction or the other, so the amount you are actually risking is the same as doing just one of these trades, but you collect two credits. 

 

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