After Q2 surprise, questions for Caterpillar

The logo on a piece of Caterpillar heavy equipment is pictured at a storage yard in Denver in this July 22, 2008 file photo.

CHICAGO (Reuters) - When Caterpillar Inc (CAT.N), the world's largest maker of earth-moving equipment, reported stronger-than-expected earnings this week, and raised its full-year forecast, the news cheered investors searching for signs that stability is returning to the global economy.

Shares of Caterpillar, a closely watched international bellwether that derives more than 70 percent of its revenue outside the United States, surged more than 7 percent after the results were released. Its gains helped fuel a broader market rally.

Strong margins in Caterpillar's engine unit, which makes everything from turbines used by oil and gas companies to the diesel engines used in its own machines, contributed to the earnings beat. So, too, did the company's aggressive cost-cuts, which have -- among other things -- resulted in the elimination of 17,000 jobs since the start of the year.

But the results were lifted by a number of factors that had little to do with Caterpillar, including a lower-than-expected tax rate and favorable foreign currency fluctuations.

More important: There was no sign of a recovery in key end markets, including the especially hard-hit residential and commercial construction industry. Caterpillar also warned the current quarter would be "very tough" and that it might wind up reporting a loss for the period -- only its second quarterly loss since 1992.

And the backlogs for oil and gas engines, power generation and mining equipment, which have kept some assembly lines busy and cushioned the Peoria, Illinois-based company from the worst effects of the current downturn, are expected to be gone next year. Absent a broad and sustained economic pickup that extends to housing, that could spell trouble.

So are Caterpillar's latest results a reason to buy the shares -- or run away?

'SIGNS OF STABILIZATION'

Merrill Lynch analyst Andrew Obin, who raised Caterpillar to "buy" even before this week's earnings, reiterated that recommendation after the results came out.

He believes 2009 marks the trough for machinery demand and that 2010 will be a year of recovery, even in the absence of a robust economic rebound.

The reason: The current radical destocking by Caterpillar dealers -- they are expected to reduce machine inventories by $3 billion this year -- will force them to restock next year just to have product on their lots. That, Obin says, will create top line growth for Caterpillar "even in a weak retail sales environment."

Analysts at Standard & Poor's seem to agree. They raised Caterpillar to "buy" from "hold" on Tuesday, citing, among other things, the "likely benefits of government stimulus packages and better credit markets."

'LESS THAN MEETS THE EYE'

Sterne Agee analyst Larry DeMaria, who rates Caterpillar a "sell," disagrees.

He believes a recovery in machinery demand next year is "highly unlikely" because mining equipment demand will not rebound as quickly as commodity prices and because the downturn in commercial building will grow worse in 2010.

Rolling three-month sales figures from Caterpillar's dealers also have analysts like Carol Levenson, who covers Caterpillar's debt at Gimme Credit, nervous.

Caterpillar said worldwide dealer sales of its machines were down 47 percent during the three months ended June 30, compared with a decline of 43 percent for the period ended May 31 and a decline of 39 percent for the period ended April 30.

Worldwide sales of engines were down 32 percent in the period ended June 30, compared with a decline of 21 percent for the period ended May 31 and a decline of 9 percent for period ended April 30.

"It's tough to detect much improvement in sales or profits apart from what can be attributed to cost-cutting," Levenson said. "Sales declines by region and segment are doing the opposite of stabilizing."

Option analysts at Susquehanna Financial Group, who advised clients to buy Caterpillar call spreads as an alternative to buying the stock ahead of the earnings, think the shares could be in for some volatility in the near term.

Noting what they characterize as a big potentially bearish three-way options trade on Wednesday and in light of the recent strength in CAT shares, they advise clients to consider a more protective position by using a so-called stock replacement strategy. That involves the selling of an investor's stock position and simultaneously buying an in-the-money call option.

(Additional reporting by Doris Frankel in Chicago, editing by Matthew Lewis)