Relief Will Only Carry Caterpillar So Far

Jul.25.12 | About: Caterpillar Inc. (CAT)

Earnings from heavy machinery specialist Caterpillar (NYSE:CAT) certainly gave investors a little relief, but they shouldn't underestimate the risks to growth over the next 12-18 months. While this company certainly does have solid long-term prospects, the possibility of long-term gain isn't always enough to assuage the short-term pain that can go with wholesale institutional abandonment of a sector.

Sales Better Than Feared, But Margins Really Shine

Looking at the erosion in earnings estimates over the past few weeks, to say nothing of the guidance and industry comments from companies like Cummins (NYSE:CMI), Joy Global (NYSE:JOY), and Eaton (NYSE:ETN), it was pretty clear that investors were bracing for a pretty dour report from Caterpillar.

The company did relatively well though, with product revenue rising 23% from last year and 9% from the first quarter. Organic growth was a more modest (but still very solid) 15%, with roughly 11% growth driven by strong mining industry demand across the board and good construction growth in North America. The construction segment posted 5% sequential growth, with 13% and 11% growth in resource and power, respectively.

Margins were surprisingly good. Like Illinois Tool Works (NYSE:ITW), Caterpillar benefited from lower material costs (steel prices have recently dropped back to late 2010 levels), as gross margin improved two and a half points from last year (and were nearly flat with the first quarter). Operating income was even stronger, rising 66% and 14% over last year and last quarter.

Will End Market Exposures Weigh On The Near Term?

Relative to Joy Global, Caterpillar gets less of its mining sales from coal and more from copper and iron, but both companies are far less diversified in their commodity exposures than Sandvik (OTCPK:SDVKY) or Atlas Copco (OTCPK:ATLKY). With conditions in Appalachian coal so bad right now and limited capacity to refinance, miners like Arch Coal (ACI) and Alpha Natural (ANR) may not really be in great shape to make major new equipment commitments, though development trends in China and Australia are still constructive.

Similarly, Caterpillar's large power business is at risk to ongoing sluggishness in natural gas pressure pumping. Natural gas pressure pumping typically requires more horsepower than oil, and though the long-term outlook for energy production in the U.S. is pretty strong, weak gas prices are a short-term risk.

China, too, remains shaky. Nobody doubts that Caterpillar (or Cummins, for that matter) will prosper from the growing Chinese market for commercial trucks and heavy equipment, nor that the Chinese government is trying to drive stimulus towards engineering projects. Nevertheless, construction equipment demand has been very soft lately and companies like Sany and Volvo (OTCPK:VOLVY) have actually been gaining share on Caterpillar (largely on price, it would seem).

The Bottom Line

Caterpillar rightly gets a lot of credit for being a well-run, well-positioned, high-quality industrial name. But that doesn't make it a fail-safe name. Investors ought to keep in mind that current expectations still call for high single-digit free cash flow conversion rates, but the company hasn't delivered three straight years of that sort of performance for over a decade. Moreover, the sharp drop in sales from 2008 to 2009 (roughly one-third) is worth remembering if the most pessimistic global economic outlooks prove accurate.

If investors buy into the current analyst expectations on Caterpillar (including the sustained high single-digit free cash flow margin), fair value looks to be around $120. More modest mid-single digit expectations drop the fair value closer to $100. While the less demanding expectations for Cummins and Atlas Copco make them worthy considerations right now as well, Caterpillar could do well for investors so long as the bearish economic forecasts don't prove accurate (or optimistic).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.