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Caterpillar Inc. (CAT) Warrants Some Caution

Just a couple years ago, Caterpillar Inc. (NYSE:CAT) was one of my favorite stocks. The Chinese economy was booming and there was so much demand for all kinds of materials (including but not limited to the precious metals like gold and silver), which fueled strong results for the company. Then things came to a halt as some materials lost value and the Chinese economy came to a slowdown. On Wednesday evening, Caterpillar Inc. (NYSE:CAT) announced its quarterly earnings and things don’t look that bright for the company at the moment.

Latest results

Caterpillar Inc. (NYSE:CAT)The company earned $1.45 per share, down from the $2.54 in the same quarter last year. The analysts were looking for $1.70, which Caterpillar Inc. (NYSE:CAT) failed to meet. Furthermore, the company’s revenue was down from $17.4 billion to $14.6 billion; whereas, the analysts were expecting it to generate $15.0 billion.

Half of the revenue decline stemmed from decreased inventory while the other half was a result of weak demand. This resulted in a sell-off in Caterpillar Inc. (NYSE:CAT)’s shares, bringing the share price down to $83. In the last 52 weeks, the company traded in a range of $79 and $99, which means that the stock’s current price is much closer to its 52-week low than its 52-week high.

Maybe it’s a little unfair to compare the second quarter of 2013 with the second quarter of 2012 (even though it makes perfect sense) because the second quarter of 2013 was the best quarter of Caterpillar Inc. (NYSE:CAT)’s history in terms of revenue and profits; therefore, it might have been an outlier. Keep in mind that in the second quarter of 2012, dealers ordered more products than they sold, which increased their inventory; whereas in 2013, they ordered less products than they were able to sell in order to reduce inventory.

The company’s CEO, Doug Oberhelman, didn’t sound like he was worried during the conference call. In fact, he listed some of the items that caused the weak results for the company and added that the results would have been a lot better without the one-offs.

For example, during the quarter, Caterpillar Inc. (NYSE:CAT) suffered from currency translation and hedging losses, dealer machine inventory reductions and a decline in the company’s own inventory. The company expects its inventory at the end of 2013 to be $3.5 billion lower than it was at the end of 2012.

Future guidance a bit lower

For the full year, Caterpillar expects to generate between $56 and $58 billion in revenue (narrower than the $57 to $61 billion range guided earlier) and $6.50 per share in earnings (down from $7.00 that was guided earlier). In the last quarter, the company lost $140 million in currency translations and hedging; however, its guidance for the rest of the year assumes no loss or profit from currency translations and hedging, which warrants some caution.

The company blames inventory reductions for its decreased sales and profit outlook. Because the mining industry suffered low demand, Caterpillar had to respond to it by shutting down factories temporarily and laying-off some individuals.

Buying back shares aggressively

In the second quarter, Caterpillar spent $1 billion on stock repurchases and it expects to spend another $1 billion in the third quarter. Since the company is having trouble increasing its raw earnings, it will try to increase earnings per share by reducing the number of shares outstanding. Luckily, Caterpillar has strong cash flow and a relatively healthy balance sheet and repurchasing those shares will not be a big issue for the company.

Caterpillar has about $6 billion in cash and $39 billion in debt; however, the company’s high debt level should not worry you because it mostly represents the loans offered to buyers by the dealerships. This is just like the finance arm of car companies that present loans to dealerships, car buyers and car leasers in order to attract them and the company’s manufacturing unit doesn’t really owe that money.

Deere is another good alternative

Back in the day, Caterpillar had a business unit that produced and sold farming equipment, just like Deere & Company (NYSE:DE). Deere is pretty lucky because when mining business is weak, it can usually offset the weakness by the strength of its farming business. I like both companies and in a growing global economy, both companies would prosper. Deere & Company (NYSE:DE)’s price-to-earnings ratio is 10; whereas, Caterpillar’s ratio is 11, which tells me that the basic valuation of the two companies isn’t that different.

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