Cat Plays Into Inflation Equation

Caterpillar's huge quarter came amid big price hikes. Will future price increases hurt the market?
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On Monday,

Caterpillar

(CAT) - Get Report

joined a string of industrial giants whose strong first-quarter results point to a booming U.S. economy. Does that bode well for the broader stock market?

The idea that a thriving economy wouldn't be a boon for stocks is counterintuitive, but a faster-growing economy means higher interest rates. And the "one and done" crowd on Wall Street has bet the market up to a six-year high on the premise that the

Fed

will stop raising rates next month, as evidenced by the nearly 200-point gain in the Dow last Tuesday after dovish signs from the FOMC.

Meanwhile, Caterpillar's results showed signs of pricing traction, as the Dow component and industrial bellwether successfully passed on higher materials costs to its customers.

With the red-hot commodities market pointing to even higher costs in the future, some analysts are speculating that overall inflationary pressure could be building as Caterpillar and other companies move costs down to customers. Those pressures could eventually make the "one and done" bet a loser.

Caterpillar earned $840 million, or $1.20 a share, in the first quarter, compared with $581 million, or 81 cents a share, a year ago. The earnings per share easily surpassed Thomson First Call's average analyst estimate of $1.05. Meanwhile, Caterpillar raised its earnings estimate for 2006 to $4.85 to $5.20 a share from the previous forecast of $4.65 to $5 a share.

Despite the upside, shares of Caterpillar ultimately closed lower, down 49 cents, or 0.6%, to $77.38.

Eli Lustgarten, an analyst with Longbow Research, said the increased earnings guidance brought the company's outlook in line with analysts' expectations, limiting the upside in the market's valuation.

"Underlying business conditions and demand for our products continue to be strong," the company said. "The fundamental strength of the industries we serve -- notably global mining, infrastructure construction, oil and gas, and energy -- continued to improve."

Caterpillar's first-quarter sales rose 13% from a year ago to $9.39 billion, while sales of machinery and engines rose 12% to $8.74 billion, which was slightly above analysts' estimate of $8.70 billion. But about half of Caterpillar's sales gain resulted from recent price increases aimed at passing along the company's rising materials costs on to customers.

"They've had a lot of rapidly escalating costs in the last year, and if you go back to the third quarter of 2005, the stock reacted to a margin squeeze from rising costs," says Lustgarten. "The message from these results is that Caterpillar may not be able to perfectly time when it can pass through costs, but they can pass through these higher costs."

Joel Naroff, chief economist with Naroff Economic Advisors, cautions against deriving too much meaning from a single company's results, but he said fears that the rising costs of oil and other commodities eventually will be passed on to consumers is one of the chief concerns among economists.

"This is the first time where we seem to have moved into a generalized worldwide economic expansion," says Naroff. "So, we have a situation where world demand is strong, and that creates the incentive to pass these prices along in a way that could eventually raise consumer prices. When you have the need to pass these costs along, and you have the ability to do it, you have a situation that is worrisome for the Fed."

Douglas Oberhelman, group president with Caterpillar, told analysts on a conference call Monday that the company has no plans for more price increases this year. He also said the company's strong operating margins would shrink in the quarters ahead, because the effects of price increases that boosted year-over-year comparisons in the first quarter would taper off.

But with crude oil futures now spiking to $75 a barrel, and other commodity prices still spiraling, it seems higher costs could necessitate more price increases in order to offset a hit to margins.

"We are tracking this on a daily basis," Oberhelman said. "Right now, we're feeling good about material cost increases." He said he doesn't expect oil and commodity prices to keep rising at recent rates.

"If things start to get out of hand again, we will look at whether we need to do anything," he said.

Morningstar analyst Scott Burns wrote in a research note that Caterpillar could see continued cost pressure.

"Any price spikes or shortages in these materials could put renewed pressure on Cat's margins, similar to what the company experienced in 2004," wrote Burns.

"If there are more significant cost increases, they will try to push through more price increases," says Alexander Blanton, analyst with Ingalls & Snyder LLC. "When commodity prices go up, it adds to demand for their products. This company always does best when commodity prices are rising. Yes, their own costs go up at the same time, but they're always able to pass that along."

So far, prices increases at the consumer level in the broader economy have been relatively tame, according to government statistics, but the accuracy of the government's measures are debated endlessly. Last week, the Labor Department said the March consumer price index rose 0.4%, matching economists' expectations. Excluding food and energy prices, prices were up 0.3%, coming in just ahead of forecasts. Meanwhile, gas prices at the pump have soared over $3 a gallon in many areas of the country.

"There's an inflationary bias in the economy," says Blanton. "There's no question about it. Capital goods companies, like Caterpillar, do well in that kind of an environment."

Will stocks?