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Neutral on Caterpillar

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We are maintaining our Neutral recommendation on Caterpillar Inc. (CAT - Free Report) based on a muted fourth quarter outlook, reduced fiscal 2012 guidance, negative impact of the European debt crisis and a slowing Chinese economy. We currently have a Zacks #3 Rank (short-term Hold rating) on the stock.

Caterpillar reported record third quarter both in terms of earnings per share (EPS) and revenues. EPS in the quarter was $2.54, a 49% increase from $1.71 in the prior-year quarter, and way ahead of the Zacks Consensus Estimate of $2.21. Revenues upped 5% to $16.4 billion in the quarter, but fell short of the Zacks Consensus Estimate of $16.7 billion. 
Caterpillar has lowered its sales guidance to $66 billion from the prior guidance range of $68 billion to $70 billion due to weaker economic conditions across the globe. The company has also trimmed its EPS expectation to a range of $9.00 to $9.25 from the previous outlook of $9.60.
The outlook, even though lowered from the prior guidance, if achieved would mark the highest sales and profit in Caterpillar’s history, exceeding the record levels last year. For fiscal 2013, sales are expected to be down 5% to up 5% from 2012. 
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 construction sector has lately been weak and thereby affected Caterpillar’s earnings. However, the recent figures suggest a turnaround in the non-residential as well as residential construction sector.
According to the American Institute of Architects, after languishing in the negative territory for five consecutive months, the architecture billing index (ABI) climbed back into the positive territory with a score of 50.2 in August, which further improved to 51.6 in September, the highest in nearly two years. In September, both housing starts and building permits were record high in four years.
These figures are reflective of the fact that U.S. residential construction is finally stabilizing and is on the road to a much awaited recovery. This will provide a boost to Caterpillar’s earnings.
The company had been persistently adding production capacity for a number of mining products. Even though fluctuations in the emerging economies are expected to negatively impact near-term results, the expansion should provide long-term growth opportunities. Growing economies promote the expansion of roads, new buildings and reliable energy, which drives the demand for machinery
Caterpillar’s fourth quarter results is expected be lower than the third quarter as the company will cut down production to counteract inventory increases and backlog depletion. Furthermore, sales volume is expected to be lower, and the fourth quarter typically has seasonally higher costs.
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 - Free Report) and Volvo AB .

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