Beware: This Blue Chip May be About to Take a Dive
Last week, blue-chip Caterpillar (NYSE: CAT) reported dismal fourth-quarter and full-year results. 2015 was a tough year for the construction and industrial equipment giant, and the stock reflected this, falling 25%.
Following the earnings announcement, the company’s CEO warned that 2016 would be another “rough” year.
But the Q4 results were not as bad as many feared, and shares shot up nearly 5% after their release. Short covering was likely a factor, though, and the rally creates an excellent entry point for new short positions.
We think CAT is vulnerable to more selling. Here are four big reasons why:
1. Falling Revenues
The company’s sales have been declining since 2012, when they peaked at $65.9 billion. For 2015, Caterpillar reported revenue of $47 billion, which was down 14.8% from 2015. The severe slump in oil and gas prices, plus lower prices of mined commodities such as iron ore and copper for which the company makes equipment, have taken a big toll.
For example, in the most recent quarter, revenue from the machinery, equipment and transportation segment fell 24%, and a $921 million operating profit in the comparable quarter of 2014 turned into a $227 million loss. The resource division saw a 23% drop in revenue while construction sales were 18% lower.
Caterpillar operates globally, which in theory should help cushion a downturn, but all regions have been affected by weakness in commodities. In the fourth quarter, sales were down 36% in Latin America, 26% in North America, 20% in the Middle East and Africa and 16% in South Asia and the Pacific.
Furthermore, with the company deriving about half of its revenue from overseas, it is feeling the sting of a strong U.S. dollar, which has resulted in an unfavorable currency translation and aided sales for mining equipment manufacturers in other countries.
Looking forward, management forecast revenue in the range of $40 billion to $44 billion this year, which would represent another 6% to 15% drop. Many on the Street interpreted this as a positive, but CAT was projecting only a 5% decline just four months ago.
2. Earnings Continue to Weaken
While fourth-quarter earnings of $0.74 per share, excluding costs, beat expectations, they were down more than 45% year over year. And taking into account restructuring costs, thanks in part to layoffs, the company actually posted a loss.
Meanwhile, full-year earnings slid more than 27% to $4.64 per share. And management projects adjusted EPS will fall another 14% to $4 in 2016.
3. Dividend May be at Risk
One factor that could be supporting CAT’s share price is its dividend. Despite the company’s struggles, it boosted its quarterly payout 10% in mid-2015 to $0.77 per share. That equates to an annual payment of $3.08 and an attractive yield of almost 5%.
But considering the shaky fundamentals just outlined, analysts are questioning the sustainability of that payout. In 2013, CAT paid $2.32 per share in dividends while earning $5.75 per share, making its payout ratio 40%. In 2015, the payout ratio stood at 63%, and based on 2016 estimates, it could jump to a dicey 77% this year.
If commodity prices continue to weaken this year and the worst case forecasts of $20 oil materialize, sales and earnings could be weaker than expected, which could put the dividend in jeopardy.
4. Extremely Bearish Chart
As you can see on the chart below, CAT has been in a steep downtrend since late 2014.
Shares bottomed around $60 in the fall of 2011. Less than six months later, CAT had almost doubled, peaking above $100, which turned into a historical resistance level.
Then, after a steep drop, CAT spent a year and a half mostly trading in a fairly narrow range between the low $70s and mid-$80s.
Shares finally broke out of this trading range in early 2014, making a nominal new high in July and a secondary peak toward the end of that year. In early 2015, they broke the major uptrend, which had characterized price movement since 2011. CAT retreated to historical support near $75 and, after a weak rally attempt, continued to slide.
By late September, shares had almost completed a round trip back to where their uptrend began in late 2011. A rally into November saw a peak near $75 as historical support became resistance. The sell-off in late 2015 and early 2016 saw two more support levels give way, with the stock hitting a 52-week low of $56.36 on Jan. 20.
CAT should now have difficulty surpassing the $65 to $70 level, where it traded for much of the fourth quarter. The trendline drawn from the late 2014 high currently intersects near $69, and we will use that to define our stop-loss.
On Jan. 25, Goldman Sachs (NYSE: GS) downgraded CAT to a “sell” with a price target of $51, which looks like a very reasonable downside objective over the next quarter or two.
Recommended Trade Setup:
— Sell CAT short at the market price
— Set stop-loss at $69.51
— Set price target at $51.05 for a potential 18% gain by Q3 2016
Note: You could turn that 18% move in CAT into a 55% profit by risking just $1,500. Find out how here.