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For my explanation on pair trading, please see here.

Farm and Construction Machinery Industry

The challenging economic environment has brought much of the production for machinery producers to a grinding halt. As credit markets tightened, new financing for construction projects also slowed, causing many of the firms to lower the near-term and 2009 outlooks. However, there are bright spots within the group as some infrastructure plays receive a majority of contracts from the government and will succeed more than the consumer driven industry members. As a whole, the companies that can sustain the slowdown in growth by maintaining liquidity and using cost reductions to make the impact to the bottom line negligible will be the outperformers in the group.

Long: Astec Industries (NASDAQ:ASTE), $26.14: Astec Industries is a small-cap company that trades at a discount, has sustainable cash flows, has 15.28% of the float short, and has the healthiest technical chart of the 11 industry members that made it through the filters. Its price/book ratio of 1.34 is in-line with the industry, as is its PEG of 0.63, but ROA and ROE are nearly double many of the group members. Also, it is the only industry member with zero long term debt and has one of the highest current ratios in the industry. 

Astec recently reported earnings that topped estimates and backed its 2008 outlook. As an equipment supplier to road-building and related utility construction spending, it is well positioned to capitalize on the expected increased government spending on infrastructure to boost the economy and add jobs. Astec hit a triple bottom at $20, and recently broke out of a descending triangle, while also exhibiting improving RSI and MACD indications. Astec Industries is down 39.1% this year, and we expect it to continue to outperform the farm and construction equipment group, that has lost on average 50%, for quite some time.

Short: Caterpillar Inc. (NYSE:CAT), $39.01: Caterpillar, on the other hand, is a struggling blue chip name that is debt ridden and seeing earnings and cash flows decline sequentially. Contracting margins due to rising costs and inefficient management initiatives are also leading this company lower, as it has lost 46.44% this year. Caterpillar has a very large exposure to international spending and the global economic crunch is at the earlier stages than it is in the United States, which could further impact Cat’s outlook.

Furthermore, due to the weakness in the overall markets, Caterpillar is likely to have an additional pension expense in 2009 of $148mln, much higher than its peers, which could have a $0.16 impact to EPS. Caterpillar shares bounced off the $31 level recently, but it could be a dead cat bounce, as volume was weak on the move and MACD and RSI are still extremely weak.

“Fight Card”

The Trade

ASTE: Long 1 March ’09 Vertical Call Spread $25/$35 for a $3.20 debit

CAT: Short 1 May ’09 Vertical Call Spread $30/$35 for a $3.25 credit

Disclosure: none

Source: Pair Trade: Farm and Construction Machinery