CAT in Neutral Lane

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We maintain our Neutral recommendation on Caterpillar Inc. (CAT) due to the recent loss of momentum in sales growth, margin headwinds, negative impact of the European debt crisis and a slowing Chinese economy. We currently have a Zacks #3 Rank (short-term Hold recommendation) on the stock.

Caterpillar has kick started 2012 by posting record earnings per share (EPS) of $2.37 in the first quarter. For fiscal 2012, Caterpillar’s sales guidance is in the range of $68 billion to $72 billion and has an EPS guidance of $9.50. This, if realized, would mark a record in Caterpillar’s history, even ahead of last year’s ground-breaking results.

However, on a monthly basis, there has been a clear downward trend in sales growth year to date. Even though Caterpillar continues to book sales growth, recent growth rates have been tempered by tougher year-on-year comparisons and weakening economic conditions, especially in Europe. Sales growth is now less than one-sixth of the peak level of 66% in 2011.

Caterpillar recorded machines sales growth of 11% for the three months ending May 31, 2012. Growth slackened from 27% in January, 21% in February, 18% in March and 12% in April this year. Compared to the lowest growth rate of 30% last year, the current growth rate of 11% is disappointing.

The Caterpillar-Bucyrus merger will position Caterpillar as the leading global mining original equipment manufacturer. The combined product portfolio will dwarf Joy Global Inc. (JOY), the only U.S.-based manufacturer of surface and underground mining equipment.

Caterpillar expects Bucyrus to be accretive to its operating profit by at least $450 million. Bucyrus has a wide product portfolio and will complement Caterpillar’s existing mining product line. The Bucyrus acquisition will also help Caterpillar gain a strong foothold in China and India, both of which are major mining markets.

Caterpillar’s order backlog has steadily increased throughout the quarter and is at a record high, which holds promise for the year ahead. Backlog stood at $30.7 billion, up from $29.8 billion at the end of fiscal 2011. Many products have long lead times, with some slated for 2014. This bodes well for Caterpillar's future performance.

The company is persistently adding production capacity for many of its mining products. We believe that the top line at the company 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.

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 as a result of 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 (CNH), Komatsu Ltd. (KMTUY) and Volvo AB (VOLVY).

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