Slower Housing Puts a Dent in Caterpillar

Long a Wall Street darling and economic bellwether, the equipment maker sees a leaner 2007 and its shares plummet Friday

Think Caterpillar (CAT) and you likely conjure images of huge road construction and mining equipment. But these days, turn your thoughts to the U.S. housing market, a depressed industry that helped to hammer Cat’s latest quarterly earnings and prompted the Dow component to curb its outlook through 2008. In turn, investors crushed Cat shares, sending them down around 12% at midday.

The company's reduced forecast reignited worries that the overall U.S. economy may continue to show tepid growth for much of next year. Cat’s warning came in a report of generally lackluster third-quarter results that fell short of Wall Street’s estimates. Income of $769 million, or $1.14 a share, was 21% above the same period of last year, but short of the mean analyst estimate if $1.35, according to the research firm StarMine.

For this year, Caterpillar now expects its sales to come in around $41 billion, up 13% from 2005, and earnings per share of $5.05 to $5.30. That’s down from a previous forecast for sales to grow by 12% to 15% and EPS of $5.25 to $5.50.

"A lot of people were expecting the slowdown in housing to have had an effect (on Caterpillar's results), but the question was how big," said Martin Slaney, head of spread betting at GFT Global Markets in London. "It was clearly worse than people were pricing in."

Caterpillar shares retreated to $60.02 per share at midday on the New York Stock Exchange. Cat’s weakness sent the overall Dow Jones industrial average lower by 20 points to 11,991.40, retreating from its first-ever close above 12,000 on Oct. 19.

In a research note, Citigroup analyst David Raso noted that Cat managed to maintain earnings per share above $2 in the recent downturn, partly because the housing cycle remained “robust” throughout most of the recession. But he still considers Cat's earnings closely aligned with the pace of economic growth.

“If the economy slows down more abruptly than we currently expect due to inflation concerns prompting an overly aggressive Federal Reserve regarding interest rate hikes, our EPS expectations for Caterpillar could prove too optimistic,” Raso wrote. He expects EPS of $1.63 for the fourth quarter and $6.69 next year.

In the third-quarter, an expense of $80 million, mainly related to the recent settlement of its legal dispute with the truck maker Navistar International (NAV), dragged down Caterpillar’s results. The Peoria, Ill.-based company also suffered from higher operating costs and lower third-quarter sales volume.

"We're expecting slightly higher sales and revenues in 2007 despite the prospects of a slowing U.S. economy, a sharp drop in sales of on-highway truck engines and weaker housing construction," Chairman and CEO Jim Owens said in a press release Oct. 20. His preliminary outlook for 2007 sales and revenues is flat to up 5% from 2006, and profit per share is expected to be flat to up 10% from the midpoint of the 2006 outlook range.

On a brighter note, Owens says the company isn't expecting any cataclysms soon. He’s betting that the Federal Reserve will manage to revive the economy in the second half of the year, enabling the U.S. to escape with a modest mid-cycle slowdown similar to the one that occurred in the mid-1990s. Owens thinks that the housing decline will soon end, given a chance that rates could fall early next year.

"We attribute the majority of the shortfall to higher manufacturing costs than we anticipated in the machinery segment," wrote Standard & Poor's analyst Anthony Fiore, who maintained his hold rating on the stock. (S&P, like, is owned by The McGraw-Hill Companies.)

Owens is finding hope from abroad for 2007. "It's a testament to the strength and diversity of the industries we serve and the global nature of our products and services that we expect at least modest growth," he said in the press release Oct. 20.

The Illinois heavyweight's North American sales increased $372 million, or 12% during the third quarter. But Europe, Africa, and Middle Eastern sales increased $311 million, or 26%, while Latin American sales increased $99 million, or 18%.

Cat shares hit a 52-week high of $82.03 on May 10, having nearly doubled from a 52-week low of $48.25 in seven months. The company did a 2-1 stock split last summer as its share price neared $100.

Given Cat’s third-quarter performance – and the major question mark that looms over Fed interest rate actions in 2007 – investors will certainly keep a close eye on the U.S. housing market for a read on Cat’s prospects.

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