Caterpillar Spooks the Street

The industrial giant's sluggish U.S. results -- and downbeat outlook -- cast a pall over prospects for corporate profits and the economy

Though its global business is booming, Caterpillar (CAT) sounded the alarm Oct. 19 about the U.S. economy, warning an already lousy situation at home shows no end in sight.

The heavy equipment powerhouse's earnings report ended one of the worst weeks for corporate earnings in five years.

Disappointments from Citigroup (C) and Bank of America (BAC) grabbed headlines, but "it's been pretty brutal across the board," says Ashwani Kaul, an analyst who watches earnings expectations for Reuters Estimates.

At the beginning of the week, Reuters Estimates using both actual profit reports and analyst predictions for the S&P 500 index projected a 2.7% rise in earnings from a year ago. By Friday, the expected growth in third quarter earnings had fallen to 1.8%. Also dropping like a rock were analysts' estimates for earnings in the fourth quarter and the full years of 2007 and 2008.

Caterpillar did much better in the third quarter: Earnings of $1.40 per share were a third-quarter record, up 21% from a year ago. Revenues of $11.4 billion were an all-time record.

But sales in North America looked terrible, down 11% from a year ago. Fortunately for the company, the weakness was outweighed by a boom in the rest of the world. International sales spiked 31.3%.

"Many U.S. industries important to our sales are in recession," Caterpillar said in its report. Hardest-hit is housing, but nonmetals mining and quarrying, nonresidential construction, freight movements, on-highway trucking and machinery also showed weakness.

Compare that to the rest of the world, where, one exec told analysts on a conference call, "Almost everything is up."

This global growth story has driven Caterpillar's stock despite the weakness at home. The stock is up 19% so far this year. High energy and commodity costs, along with the growth of emerging economies, has increased demand for Caterpillar's products.

Huge amounts of capital are put into new infrastructure around the world. That's a long-term trend that shows no signs of slowing, says Russell Croft, portfolio manager of the Croft Value Fund (CLVFX), which owns Caterpillar shares. "The global infrastructure build-out can be a very long cycle," he says.

However, on Oct. 19, shares dropped more than 5.27%, ending the session at $73.57 per share. Lower earnings forecasts hurt the stock, along with worries about the higher costs. Material costs are rising, and Caterpillar is also finding it expensive to meet overseas demand, notes Al Meyers, a portfolio manager at AMBS Investment Counsel.

As a maker of a broad range of heavy equipment, Caterpillar is exposed to some of the weakest parts of the U.S. economy.

Even so, says Harry Clark of Clark Capital Management, a 21% increase in profits from a year ago is "darn good" for Caterpillar. (Clark also owns Caterpillar stock.)

Though the economy is going to slow down, Clark sees positive signs. Cuts in interest rates by the Federal Reserve should slow the spread of weakness from housing and the financial sector into the rest of the economy, he says.

Also, for years analysts have underestimated corporate earnings growth, a trend that should continue this quarter. He expects earnings to grow 7 to 8% this quarter.

Others aren't so sure, saying this quarter could be the first in a long while when analysts are overly optimistic.

Keith Hembre, chief economist at First American Funds, says the economy is slowing to the point where "it becomes a very difficult environment for profit growth. You're seeing that in third quarter results."

Yes, export markets have been strong for U.S. companies, Hembre says. But there are other reasons to worry: Housing is very weak and getting worse. Interest rate cuts take a long time to affect the economy. Record oil prices could hurt growth further.

"I don't think [analysts] really gauged how bad things are in some places," Reuters Estimates' Kaul says. "I think they got caught off guard."

Still, the third-quarter earnings season is only two weeks old. Kaul says Reuters Estimates' earnings projection may have hit bottom and may be ready for a rebound. Earnings from many financial stocks, hit hard by the summer's credit crisis, arrived first, but large parts of the economy's bright spots, technology and health care, still must report.

Yet the real concern for investors might not be the third quarter, already in the past, but expectations for the fourth quarter and next year. If the economy slows down or even slips into recession, many could decide quickly that companies can't meet the market's high expectations. And then investors may wish there was a big yellow "Cat" to help them dig their way out of trouble.

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