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Remain Cautious About Caterpillar

NEW YORK (TheStreet) -- About two weeks ago, after missing revenue and earnings estimates for four consecutive quarters, the world's largest mining and construction equipment company Caterpillar (CAT - Get Report) surprised Wall Street by delivering better than expected quarterly results. Caterpillar reported strong demand for construction equipment, helped by aggressive cost-cutting measures. Moreover, the business also gave an optimistic forecast for 2014. Amid all this positivity, Caterpillar shares have risen by 11% since the earnings release, including yesterday's rally, and are currently hovering around $96.

However, I believe investors should think twice before buying into this optimism. Caterpillar's core operating area, resource industries, will likely struggle through 2014. This will be an extremely challenging year for Caterpillar, as it is targeting flat revenues in the current year, as compared to last year. This means that its other segments will have to show consistent improvements to offset the declines coming from mining equipment.

Caterpillar gets 95% of its revenue from the sale of machinery and power systems via three segments: resource industries, construction industries and power systems.

In the previous quarter, Caterpillar posted a 10.4% year-over-year drop in total sales and revenues to $14.4 billion, which was entirely due to the 11.1% drop in sales of machinery and power systems. On other hand, earnings soared 44%, to $1 billion or $1.54 per share, from just $697 million or $1.04 per share in the corresponding quarter of 2012. The company easily managed to surpass the market's expectations of a profit of $1.28 per share from revenues of $13.6 billion.

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However, this massive jump in earnings is largely due to controversial write-down of a Chinese acquisition (Siwei) last year. Excluding the impact of that one-time item would bring down Caterpillar's earnings growth from 44% to just 5%.

Aggressive Cost Cutting

Some of this earnings growth can also be attributed to the firm's aggressive cost-cutting measures. Due to fewer sales, the cost of goods sales has naturally dropped. But the business has also been able to reduce its selling, general and administrative expenses by 11%, while the research and development expenditure has been cut by 24%. This was already anticipated, as Caterpillar has been scaling back operations in several regions, ranging from Minnesota to Belgium. The business also eliminated around 9,700 jobs, of which 40% were its U.S. workforce.

The ongoing cost cutting and restructuring efforts, which started in 2013, will continue through 2014. They will have a positive impact of nearly $200 million in 2014 and around $450 million each year after 2015.

This, I believe, will give a much needed support to Caterpillar's earnings, as it will offset some of the pressure coming from an unfavorable product mix.

Strength in Key Areas

However, the Chinese acquisition and cost-cutting measures aren't the only things that have driven Caterpillar's earnings. More importantly, the business has benefited from the accelerated recovery in the U.S. housing market. This led to an increase in demand for construction equipment and power systems, and had a positive impact on Caterpillar's earnings.

The business's revenues from the construction industries and power systems segments increased by 20% and 5% from last year to $4.8 billion and $5.5 billion, respectively.

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