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Tickers in this Article: CAT, TEX, CNH, DE, JOYG, BUCY
Scores of investors look to Caterpillar (NYSE:CAT) as a bellwether, and the company deserves its place under the economic microscope. Not only does the firm have a sizable market position in six continents, but the end markets they serve are generally considered the tip of the sword of economic cycles. Construction, infrastructure projects, mining and materials extraction - they all need big machines to complete the task, and big machines are Cat's bread and butter.

The Peoria, Ill. maker of industrial engines and machinery reported a blowout second quarter, with revenue of $10.4 billion (versus estimates for $9.8 billion) that was up 31% year-over-year. EPS, meanwhile, rose 90% to come in at $707 million, or $1.09 per share; analysts were looking for just 85 cents.

The devil's advocates will say the comparative hurdles were quite easy considering the dire straits of Cat's 2009, but the growth in profitability is quite promising given that this could easily be step two in a 10-step global recovery. After all, residential and commercial construction is still in the doldrums, and infrastructure stimulus money here in the U.S. is just beginning to reach "shovel ready" status. So far, it has been mining - on the back of strengthening commodity prices - and emerging markets that have been driving the gains.

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Segment Results, Forecast
The company operates in two main segments - machinery and engines. Machinery was the obvious slugger in the second quarter, as sales rose 55% year-over-year, compared to just a 3% rise in engine sales. The positive from this draw is that machinery sales grew in all geographic regions, including a 43% jump in the previously languishing North American market. The downside is that gross margins on machinery are lower than on engines.

Caterpillar tightened its revenue forecast and hiked earnings estimates for the full year, as it now sees $39-42 billion in sales (bottom of range lifted from $38 billion) and EPS of $3.15-3.85, versus earlier calls for $2.50-3.25. Order backlog also grew to over $15 billion, up from $10 billion at the end of 2009.

Investors should take note of two things here: one, the EPS range is quite wide, given the unpredictability of product mix, materials costs and dealer inventory changes that could come about later in the year. But more importantly, a tiny 1-2% lift in the sales forecast has translated to a 21.5% higher midpoint for earnings guidance, a sign of just how much operating leverage there is to be had here.

Operating Margins more than doubled versus a year ago, from 4.4% to 9.4%. Helping to increase margins were manufacturing costs that were lower by some $316 million, modest price increases that were passed through during the quarter, and some starting savings from a long-term plan to optimize manufacturing to meet anticipated demand. Management has promised to release more details on this plan during an analyst conference in early August, and investors could see some upgrades come as a result of it as well as an updated status of global demand patterns.

Global Growth Still Intact
Seven years ago, Caterpillar sold two-thirds of its products in the developed world (U.S., Europe and Japan) and one third to emerging market nations. Today the ratios are flipped as Cat has established a global production and supply chain. While North America is still the largest single market, China has vaulted into second place. Cat already has production facilities in mainland China, but they are stepping efforts up further by targeting a 400% increase in excavator production in China by 2014. Globally in the second quarter, sales rose by 45% in Asia, 83% in Latin America, and 8% in the Middle East/Africa region, to go along with a 24% consolidated rise in North American Sales.

Cat Upping its Non-Cyclical Revenue Stream
Both investors and Cat's management realize that industrial machinery is a very cyclical business. After peaking at over $51 billion in sales in 2008, Caterpillar had a torturous 2009 in which revenue fell to $32 billion, and operating profit was cut by 88%. By the company's own admission, it was too focused on a continued Goldilocks scenario for global growth, so 2009 was rife with huge layoffs, production cuts and high inventories at its dealerships. (To learn more, see The Ups And Downs Of Investing In Cyclical Stocks.)

In an effort to "de-cyclify" its revenue stream, Caterpillar has been acquiring a major stake in the rail business, first with its purchase of Progress Rail Services in 2006, then with the $820 million acquisition of Electro-Motive Diesel in June. Analysts now say that CAT, along with GE (NYSE:GE), are the top two players in the rail service and production space.

Both Progress Rail and Electro-Motive are focused on rail car maintenance & repair as opposed to new production. Electro-Motive has an installed base of 33,000 cars, as well as a growing exposure to Asia.

Balance Sheet, Cash Flows, and Valuation - The Fundamentalist's Corner
Caterpillar's balance sheet improved mightily over a year ago, as debt/capital fell from 53% a year ago to 41.9% in the second quarter. Operating cash flow in the first six months of 2010 was $2.4 billion, four-times higher than in the same period last year.

And as to share valuation, while CAT shares may seem pricey at 20-times current year estimates, the forward P/E on 2011 estimates drops to 14, and those estimates could be in for some skyward bumps in the months ahead if Caterpillar keeps busting through estimates at this point in the economic cycle.

The Bottom Line
On the back of these strong earnings, investors should expect to see strong earnings come out of Deere & Co. (NYSE:DE) on August 18, 2010. Rival Dutch firm CNH Global NV (NYSE:CNH) also reported strong earnings last week, and while Terex Corp. (NYSE:TEX) is still reporting net losses, its stock got a solid bump last week following its earnings release, as did Bucyrus Intl (Nasdaq:BUCY). Investors might see the same result come from mining equipment maker Joy Global (Nasdaq:JOYG) on August 30. With bulls and bears deadlocked for the year, the results and guidance from such an important indicator as industrial equipment could be a divining rod for the direction of the broad market's next 10% move.

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