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We are maintaining our Neutral recommendation on Caterpillar Inc. (CAT - Analyst Report) based on margin headwinds, negative impact of the European debt crisis and a slowing Chinese economy despite a stellar second quarter. We currently have a Zacks #3 Rank (short-term Hold rating) on the stock.

Caterpillar reported record second quarter both in terms of earnings per share (EPS) and revenues. EPS in the quarter was $2.54, a 67% increase from $1.52 in the prior-year quarter, and way ahead of the Zacks Consensus Estimate of $2.26. Revenues surged 22% to $17.37 billion in the quarter, outpacing the Zacks Consensus Estimate of $16.97 billion. Volumes were up for both new equipment and aftermarket parts as well as across all geographic regions, except China and Europe.

Caterpillar lowered the upper end of its previous sales guidance range by $2 million. The company now expects sales to be in the range of $68 to $70 billion compared with the prior guidance of $68 to $72 billion. The company has now factored in weaker economic conditions prevailing across the globe and approximately $1 billion in negative currency impacts. The company has, however, upped the EPS expectation from $9.50 to $9.60 on better operating performance, partially offset by a higher tax rate.

The Caterpillar-Bucyrus merger has positioned Caterpillar as the leading global mining original equipment manufacturer. Caterpillar boasts the broadest product line in the mining industry with unmatched product support. The second quarter of 2012 was the best quarter ever for the company in terms of sales of mining products. The company has a substantial order backlog with lead times for several large mining truck models through 2014.

The company is persistently adding production capacity for a number of mining products. We believe that the company’s top line will continue to grow on the back of increasing demand for construction and mining equipment. Caterpillar plans to open new facilities and expand existing operations, particularly in the emerging markets, which will boost its long-term potential.

On the flipside, margins at Caterpillar may come under pressure from various quarters. These include rise in period manufacturing costs; higher SG&A expenses; R&D expenses, primarily related to implementation of emission requirements; higher depreciation expense arising from increased capital spending, higher taxes, incremental costs pertaining to Bucyrus inventory step-up and acquisition and integration expenses, including severance costs and other integration-related activities.

In addition to the European debt crisis, signs of a slowdown in China have triggered concerns. China has slashed its 2012 growth target to an eight-year low of 7.5%. A slowing Chinese economy will have a detrimental effect on infrastructure and construction spending with an immediate impact on Caterpillar’s sales in the near term.

Peoria, Illinois-based Caterpillar Inc. is the manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. The company is one of the few leading U.S. companies in an industry that competes globally from a principally domestic manufacturing base. Caterpillar operates two divisions – Machinery and Power Systems and Financial Products. Caterpillar competes with the likes of CNH Global NV , Komatsu Ltd. (KMTUY) and Volvo AB (VOLVY).

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