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Caterpillar Squashed

Nat Worden

At record highs, the Dow Jones Industrial Average felt one of its pillars crumble on Friday as Caterpillar (CAT Quote) recorded a big earnings shortfall.

The industrial giant and Dow component, whose stock had been up 44% so far in 2007, posted a 21% drop in second-quarter profits and missed Wall Street's expectations. The company recorded sales strength from outside North America, but its bottom line was hit by higher costs and weakness in the U.S. residential construction market -- as well as the broader economy.

Shares recently were down $5.91, or 6.8%, to $81.07

While Caterpillar backed its earnings forecast for the full year, the company offered a sobering look at the U.S. economy. In particular, the company signaled that the dwindling possibility of an interest rate cut and a troubling housing-construction market may weigh on growth.

"U.S. residential construction looks even more distressed now than three months ago, the result of higher mortgage interest rates, falling new home prices, tighter lending standards and limited progress in reducing the stock of unsold new homes," Caterpillar said.

Also, it noted slowness in the commercial real estate sector, a sign that weakness from the housing market's slowdown is spreading.

"U.S. nonresidential contracting declined year to date even though some of the supporting factors remained positive -- office rents were up, business profits were good, lending to businesses increased and federal highway funding was up," said Caterpillar.

"Weakness in building contracting possibly resulted from lower returns on commercial investments and fewer new home developments," the company said. "Delays in passing the federal budget limited the release of highway funds early in the year. We expect very little growth in nonresidential construction this year, which could cause contractors to be cautious about buying new machines."

Despite the projection for economic weakness, Caterpillar also dropped its previous forecast that the Federal Reserve will lower interest rates in the second half of the year.

"Without interest rate relief, many key industries in the U.S. face continued unfavorable economic conditions," said the company.

Ingalls & Snyder analyst Alex Blanton believes the U.S. weakness shouldn't weigh too heavily on Caterpillar. He says the stock's selloff is a knee-jerk reaction in the market that fails to take into account the company's long-term prospects amid a blistering expansion in global infrastructure demand.

"Caterpillar is a pure-play on global infrastructure, and the problems in the U.S. housing market are not going to derail it over time," says Blanton. "The growth is coming from Brazil, Russia, India and China, and we're not nearing the top of this cycle. It is going to continue."

For the second quarter, Caterpillar reported earnings of $823 million, or $1.24 a share, compared to the $1.05 billion, or $1.52 a share, it recorded for the same quarter last year. Analysts, on average, expected earnings of $1.49 a share.

Caterpillar's top line beat expectations, with overall revenue up 7% to $11.36 billion, compared with Wall Street's expectation for $11.1 billion. All the gains, however, came from abroad.

Sales and revenue in North America fell 10% to $5.1 billion due to a 14% decline at the company's domestic machinery business and a 8% drop in engine sales.

"Disappointing earnings in the second quarter were attributable to the sharp negative swing in on-highway truck engine profitability, weakness in North American machine sales, continued selected supply chain disruptions and higher material costs," said Caterpillar CEO Jim Owens in a press release.

Also, Caterpillar's core operating costs rose by $435 million, mostly because of rising material costs and operating inefficiencies resulting from lower on-highway truck engine production, supply chain challenges, new product introduction and greater capacity.

"While costs were a challenge, we were pleased with the spectacular sales growth outside North America and the performance of our engine businesses other than on-highway truck," said Owens.

Despite its shortfall, the company backed its previous outlook for full-year earnings in a range from $5.30 to $5.80 a share. Caterpillar sees revenue of $44 billion -- the high end of the range it had forecast earlier.

Overall, Caterpillar is expecting "below trend [economic] growth" in North America, with gross domestic product increasing by 2.1% for the year. Besides the continued weakness in the housing market, it sees a "very weak industry for heavy-duty truck engines."

The company said it expects sales outside North America to be up 24% for the year -- representing a year-over-year rise of about $4.5 billion. That should more than offset a $2.4 billion, or 12%, sales decline in North America.

"This reflects solid 2007 economic and industry growth in most of the world outside North America," said the company.

The disappointing report sparked a broader selloff in the stock market that recently had the Dow down 116 points to 13,884. The trading came one day after the blue-chip index had crossed the 14,000-mark for the first time in history.

While Caterpillar's results play into lingering uncertainties about the state of the U.S. economy amid rising interest rates and a broad housing slowdown, they also spoke to the strength of the broader global economy.

Sales in Europe, the Middle East and Africa rose 35%, boosted by increased deliveries to end users, economic growth in Europe, construction activity in Africa and increased activity in drill rigs and mine development.

Caterpillar said sales in the Asia/Pacific region rose 23%, boosted by growth in mining spurred by higher prices for metals and coal and higher construction spending in China.

"Economic growth outside North America appears slightly more favorable than we expected in the last report," said Caterpillar. "That improvement occurs even though interest rates are higher than what we assumed in the previous outlook."