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Shares of Dow-30 component Caterpillar (CATFree Caterpillar Stock Report) are trading notably lower after the world's largest maker of heavy equipment failed to meet expectations in the third quarter. Sales, at $13.42 billion, fell short of our $14.70 billion estimate and the year-earlier tally of $16.44 billion, with conditions within the Resource Industries unit proving to be especially weak. Results at that segment, which makes mining machines, remain turbulent, with orders from nearly all corners of the globe at low levels.Caterpillar's poor September-period performance was not a surprise. Although prices for certain commodities, including coal, iron ore, gold, and copper, have recovered some ground, demand is still well below levels seen in 2011-2012, and mining activity has been depressed. This continues to be an area of concern for Caterpillar, since the mining sector accounts for roughly one-third of sales and nearly 50% of operating income (EBITDA). Coal and iron ore are the biggest sources of mining equipment sales for Caterpillar. Capital spending by mining companies remains constrained, with the industry leaders BHP Billiton, Vale SA, Rio Tinto Plc, and Glencore Xstrata Plc likely to curtail their cumulative expenditures by 10%.


Top-line pressures have led this Illinois-based entity to focus on efficiency-maximizing measures, including temporary plant shutdowns, workforce reductions (including 13,000 layoffs), and lower capital spending, in addition to other austerity steps. Nevertheless, the bottom-line effect of lower volumes has been difficult to overcome; earnings came in at $1.45 per share in the September interim, well below our call of $1.67.

Taking these factors into consideration, Caterpillar has revised its guidance for 2013 sales and share profits, from $56 billion-$58 billion and $6.50, respectively, to $55 billion and $5.50. In all, management is looking for sales at the Resource segment to be down nearly 40% for the year. However, the heavy equipment maker may be entering the latter stages of a mining down cycle. In fact, investors should take solace in the fact that certain industry leaders, including BHP Billiton and Freeport-McMoran, reported strong third-quarter results. Still, those companies appear to be waiting for a sustained recovery in the metals realm before committing more capital to equipment purchases. Too, the coal industry, which usually accounts for 35%-45% of all equipment shipments, is set to recover from a two-decade low, as more efficient plants supplant older ones. According to the National Mining Association, usage of this fossil fuel will increase 7.0%-8.0% in 2013, and ought to forge ahead through the end of this decade.

At the same time, excess equipment inventory in China continues to restrict Caterpillar's ability to raise production, but demand for machines has begun to recover from depressed levels. China is the world's largest construction machinery market, accounting for more than 30% of global units and almost 25% of sales. To further exemplify that nation's importance in global affairs, it is responsible for 45% of world commodity demand. China's economic expansion is forecast to slow moderately within the next two years, to approximately 7.2%, compared with earlier targets of 7.6% and the 9%-10% growth experienced between 2008 and 2011.

The International Monetary Fund is projecting worldwide GDP growth of 3.5% in 2013, with the expectation of a 4.1% expansion in the following year. Total economic activity is a primary determinant of demand for machinery, which ought to take a turn for the better once elevated inventory levels subside.

Caterpillar is looking for a healthier global economy in 2014, but there are significant risks. Leading the way is the ultimate course of action by U.S. fiscal and monetary programs, continued recovery of euro-zone economies, and China's successful transition to a more consumer-driven economy. Too, low order rates have led this producer to expect a flattish top line next year.

China's stimulus programs, including construction of low-cost housing, as well as completion of agriculture and water resource projects, should prove to be a powerful catalyst. In addition, Brazil is determined to improve its infrastructure, as it prepares to host the upcoming World Cup and Summer Olympic Games. Lastly, India, along with a number of emerging markets, should resume incentives to upgrade inefficient manufacturing and agriculture bases. The confluence of these factors suggests healthier demand for heavy equipment over the coming 3 to 5 years and a worthwhile total return for these modest-yielding shares.

About The Company:Caterpillar Incorporated is the world’s largest producer of earthmoving equipment. Major global markets include road building, mining, logging, agriculture, petroleum, and general construction. Products include tractors, scrapers, graders, compactors, loaders, off-highway truck engines, and pipelayers. Also makes diesel & turbine engines and lift trucks. Foreign sales made up about 68% of the company’s total in 2012.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.