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On Jan 17, we upgraded our recommendation on Caterpillar Inc. (CAT - Analyst Report) from Underperform to Neutral. The upgrade takes into consideration the expected benefits from cost-cutting initiatives, increased share in the Chinese excavator market and share repurchases, tempered by a trimmed guidance, declining backlog, lingering effects of the European debt crisis and the uncertainty in the non-residential construction markets.

Why the Upgrade?

Caterpillar will benefit from its continuous focus on cost cutting. Given the challenging end markets, the company has resorted to temporary layoffs as well as shutting down or shifting operations. In the first three quarters of 2013, Caterpillar effectively lowered costs by about $700 million and reduced capital expenditures by approximately $400 million.

China excavator sales increased 21% year over year in Dec 2013 - the third straight month of more than 20% growth. In 2013, Caterpillar’s China excavator sales increased 25%, faring much better than the industry-wide decline of 3% while its market share increased to 12% in China. Caterpillar is expected to capitalize on the expanding Chinese excavator market going forward.

Through the end of the third quarter of 2013, Caterpillar completed the repurchase of $5.8 billion of stock, leaving $1.7 billion in the authorization. Caterpillar is generating strong free cash flow and has room to increase its buyback authorization, providing support to the stock. Caterpillar also hiked its quarterly dividend by 15% to 60 cents per share in the second quarter, marking the highest percentage increase since the financial crisis of 2008.

On the flipside, even though sales in the fourth quarter are expected to slightly exceed the previous quarter, earnings per share are likely to be lower due to higher costs resulting from seasonal spending patterns. The company also expects another substantial decline in dealer inventories in the fourth quarter. Caterpillar has trimmed its 2013 guidance for three quarters in a row and now projects sales of $55 billion, down from the previous range of $56 billion to $58 billion.

At the end of the third quarter of 2013, backlog was at $19.1 billion, down from $23.1 billion at the end of the third quarter of 2012, mainly due to a substantial reduction in mining-related products within Resource Industries. Caterpillar will need additional orders to meet its 2013 guidance.

The American Institute of Architects (AIA) Architecture Billings Index (ABI) further declined to 49.8 in Nov 2013, from 51.6 in October and 54.3 in September. Any reading below 50 signifies a decline in billings and this was the second reading below 50 in the last 16 months. Furthermore, weak public construction spending poses the most significant risk to a non-residential recovery, particularly in light of further government spending cuts. This makes the expected recovery in the non-residential market highly uncertain and raises questions about Caterpillar’s future results.

Other Stocks to Consider

Caterpillar currently holds a Zacks Rank #3 (Hold). Some better-ranked stocks in the sector include Kubota Corporation (KUBTY), Columbus McKinnon Corporation (CMCO - Snapshot Report) and Terex Corp. (TEX - Analyst Report). While Kubota and Columbus McKinnon hold a Zacks Rank #1 (Strong Buy), Terex carries a Zacks Rank #2 (Buy).

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