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Caterpillar Upgraded to Neutral

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On Jun 7, we upgraded our recommendation on Caterpillar Inc. (CAT - Free Report) from Underperform to Neutral. The upgradation for this leading manufacturer of construction and mining equipment is based on expected benefits from the resolution of its issues related to ERA buy, inventory adjustments nearing completion, resumption of stock repurchases offset by negatives - trimmed guidance, declining backlog and negative impact of the European debt crisis.

Why Upgraded?

Even though Caterpillar’s sales declined 9% in April, it improved from the 13% dip in February and 11% drop in March. With a 28% jump, Latin America was the only bright spot during the month. Demand for construction and infrastructure projects spurred equipment demand in Brazil as it prepares for the 2014 World Cup and 2016 Olympic Games.

Caterpillar has announced the resolution of its outstanding issues with Mining Machinery Limited regarding its acquisition of ERA, and its subsidiary Siwei. As per the agreement, Caterpillar’s obligation of $164.5 million for the acquisition has been slashed by $135 million. In exchange, Caterpillar has agreed to end any litigation targeting ERA’s former directors or auditors related to the alleged accounting misconduct discovered in January. The company also incurred a charge of approximately $580 million (87 cents per share) in the fourth quarter 2012 results.

The settlement will help management better concentrate on the company’s operations and will help Caterpillar realize the targeted benefits from this acquisition. The Siwei acquisition is expected to expand Caterpillar’s role as a leading equipment and solutions provider for the Chinese coal mining industry.

Caterpillar has been making progress on its inventory reduction efforts to better align supply with demand. The inventory adjustments have almost run their course. Even though the company anticipates some additional inventory reduction in 2013, it is expected to be less than the reductions in past two quarters. The company is thus planning to increase production in the second quarter of 2013 when compared with the first quarter of 2013.

Caterpillar announced the resumption of stock repurchases in the first quarter. The company last repurchased stock in 2008, after which $3.8 billion remained under the authorized program. The company expects to repurchase about $1 billion in the second quarter, providing support for the stock.

On the flipside, citing lower mining-related sales, Caterpillar has trimmed its sales outlook to a range of $57 to $61 billion from the previous $60 to $68 billion. Caterpillar now expects to earn $7.00 per share in 2013, down from the earlier projection of earnings between $7.00 and $9.00 per share.

At the end of the first quarter of 2013, the backlog was $20.4 billion, a significant decline year over year due to a reduction in mining-related products within Resource Industries. Caterpillar will need additional orders during the year to meet its guidance.

The lingering economic uncertainty in Europe and the slowdown in China’s economic growth will continue to be the headwinds for Caterpillar moving forward.

Other Stocks to Consider

Other stocks in the industrial products sector with a favorable Zacks Rank are Kubota Corporation with a Zacks Rank #1 (Strong Buy), and H&E Equipment Services Inc. (HEES - Free Report) and CNH Global NV that carry Zacks Rank #2 (Buy).

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