Caterpillar Upgraded to Outperform

Caterpillar Inc.’s (CAT) first-quarter EPS jumped to an all-time quarterly high of $1.84 from 36 cents in the year-ago quarter, driven by higher sales volume. Revenues surged 57% year over year to $12.95 billion on continued economic recovery and growth in machine demand. Stellar first quarter numbers and increased guidance, given higher sales volume and record order backlog, prompted us to upgrade our recommendation for Caterpillar from Neutral to Outperform. We currently have a Zacks #1 Rank (short-term Strong Buy recommendation) on the stock.

For 2011, Caterpillar expects revenues in the range of $52 billion to $54 billion and EPS of $6.25 to $6.75, the highest annual profit in the company’s history. However, the outlook does not include the acquisition of MWM Holding GmbH (MWM) or Bucyrus International Inc. (BUCY) as they have not yet closed. The acquisitions are expected to close by mid 2011. We expect a revision to guidance and our estimates once these deals close.

We expect Caterpillar to maintain its revenue growth trajectory aided by growth in emerging markets as well as construction and mining in developing countries. Increased domestic and international infrastructure spending, improved economic conditions and benefits from the yet-to-be closed acquisitions will support revenues over the next several years.

The merger with Bucyrus will position Caterpillar as the leading global mining original equipment manufacturer. The combined product portfolio will dwarf Joy Global Inc. (JOYG), the only U.S.-based manufacturer of surface and underground mining equipment. Caterpillar expects the deal to be accretive to its profit in the first full year, excluding 50 cents per share of one-time charges. The company expects synergistic benefits to noticeably add to operating profit in 2013 and exceed $400 million annually in 2015.

Caterpillar continued to beef up its financial status in the first quarter. The Machinery and Power Systems debt-to-capital ratio improved to 30.4% at quarter end compared with 34.8% at year-end 2010. Caterpillar generated Machinery and Power Systems operating cash flow of $1.6 billion compared with $1.1 billion in the first quarter of 2010. The increase in cash flow was primarily attributable to higher profit and lower receivables. Total Machinery and Power Systems cash at the end of the first quarter was $3.6 billion, higher than the prerequisite for normal operations. The company plans to lay out $3 billion in capital expenditures in 2011 with more than half to be expended in the United States, a move that would boost its long-term potential.

However, Caterpillar has entered into a bridge loan agreement of up to $8.6 billion from certain financial institutions to fund its Bucyrus acquisition. The loan will increase Caterpillar’s debt-to-capital ratio. Integration remains a key risk as Caterpillar has not carried out such a huge deal in the last five years.

Further, headwinds from an increase in period manufacturing costs, higher SG&A, and R&D expenses, primarily related to implementation of emissions requirements, higher tax expense primarily due to an unfavorable geographic mix of profits from a tax perspective, bridge financing costs of about $50 million related to the Bucyrus acquisition and some additional costs related to integration planning might affect Caterpillar’s margins.

Even though Caterpillar has upped its 2011 outlook, the increase would have been greater if not for the impact of the earthquake and tsunami in Japan. Even though facilities were not damaged, many of the company’s suppliers in Japan were impacted. Consequently, production has been affected at many of its facilities around the world, leading to a negative impact on sales, factory efficiency and costs, to be felt particularly in the second quarter. Therefore, the disaster is expected to have a negative impact of about $300 million on sales and about $100 million on operating profit in 2011.

Peoria, Illinois-based Caterpillar Inc. is the manufacturer of construction and mining equipment, diesel and natural gas engines, and industrial gas turbines. Effective from the first quarter of fiscal 2011, Caterpillar’s is now focused around the new segments, namely Machinery and Power Systems (which represents the aggregate total of Construction Industries, Resource Industries, Power Systems, and all Other segments and related corporate items and eliminations) and Financial Products. Caterpillar competes with the likes of CNH Global NV (CNH), Komatsu Ltd. (KMTUY) and Volvo AB (VOLVY).

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