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Dirt pays
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December 31, 2001: 1:13 p.m. ET
With construction stocks rallying, investors seek an earnings rebound.
By Staff Writer Andrew Stein
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NEW YORK (CNN/Money) - While slow and steady may not win many races, it's been the hallmark of a recent rally on the Big Board.
Shares of construction equipment companies like Caterpillar have been on the rise recently as investors are betting the firms will start to see orders pick up by the second half of 2002.
Caterpillar, a Dow component and the world's largest supplier of earth moving equipment, has seen its stock climb more than 25 percent from a post-Sept. 11 low of about $40, while shares of rival Ingersoll-Rand have bounced back nearly 50 percent from post-attack lows.
Goldman Sachs analyst Joanna Shatney recently upgraded Caterpillar to "market outperformer" from "market performer," saying "these stocks, as the deepest cyclicals of the industrial group, move early into a cyclical recovery, often before the bad news is over ... machinery stocks typically bottom in front of an earnings bottom."
Caterpillar and Ingersoll-Rand, which Shatney also rates as "market outperformer," are seen as early cyclicals as they produce the equipment needed to begin large construction projects, often the catalyst in an economic recovery.
But is there much upside left for these stocks and will they show improved earnings to justify the recent runup?
"Essentially they're going to have a move, it's just a question of when," said Mark Koznarek, an analyst with Midwest Research. "The stocks are kind of walking a tightrope."
Signs of improvement
Caterpillar and Ingersoll-Rand are highly sensitive to the economy and any major shift in corporate or investor sentiment could impact whether new construction projects go forward. While machinery analysts see the economy resuming growth in the second half of 2002, signs of a lingering recession could delay projects and drag down earnings estimates.
Delayed earnings could inflate the companies' valuations if the stocks continue to move higher. Caterpillar's current price-to-earnings ratio is a relatively lean 20.2 compared to 22.2 for the S&P 500, according to Thomson Financial. Ingersoll's current P/E is a slimmer 19.
For indications of when orders will pick up, Shatney focuses on manufacturing inventories, manufacturing purchase reports, and interest rates, all of which have been improving recently.
Manufacturing inventories fell 0.4 percent in October, the latest data available, following a decline of 0.9 percent in September, according to the Commerce Department. The National Purchasing Managers index came in at 44.5 in November, up from 39.8 in October and ahead of economists' estimates of 41.8.
In addition, the Federal Reserve Board has cut interest rates 11 times this year in an effort to prop up the sagging U.S. economy. The short-term borrowing rate now stands at 1.75 percent, the lowest in about 40 years.
"Rate cuts put more liquidity into the economy and that stimulates construction and it helps companies finance purchases" said Alexander Blanton, an analyst with Ingalls & Snyder. "But even when interest rates move higher, it doesn't hurt these companies. In an inflationary environment the higher costs can be passed along to the consumer."
Blanton added that Ingersoll and particularly Caterpillar are sensitive to commodity prices. "Caterpillar is the largest maker of mining equipment in the world and metal prices have been very weak this year," he said. "Commodity prices are also very difficult to predict."
Delayed recovery
Although the recent economic indicators are pointing to a recovery, there is no guarantee for earnings to rebound in the near term.
Indeed, Caterpillar is taking steps to insulate it from any further slowdown. The Peoria, Ill.-based company recently sold its tractor line to AGCO for an undisclosed amount. Caterpillar said it will take a $80 million pre-tax charge to cover the divestiture.
In addition, Caterpillar recently said it will cut 940 jobs, or 1 percent of its staff, and take a $55 million charge as a result.
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Even if their earnings don't follow the recent stock gains, analysts say the companies are well positioned to survive economic downturns with their market value intact.
"People have a high degree of confidence that earnings will come back because of their franchises - no one is going to threaten that," said Blanton. "These companies are going to gain market share in a recession as smaller competitors are bought or fold. In a bear market, these stocks will perform with the market. But on the way up, they outperform the market."
Remaining cautious
Both Caterpillar and Ingersoll-Rand are taking a cautious stance heading into the new year.
Before Sept. 11, Caterpillar expected an economic recovery in the second half of 2002, but in its third-quarter earnings release, the company said it delayed that estimate by "several months" following the attacks. It now expects the recovery to be "back on track by mid-year 2002, and [the recovery] is expected to gain momentum in the second half of the year."
Caterpillar sees fourth-quarter sales falling slightly compared to a year ago and it sees a 10-to-15 percent drop in profit for fiscal year 2001. The company anticipates revenue in 2002 will remain flat or increase slightly.
Analysts expect Caterpillar to earn 76 cents per share in the fourth quarter and $2.60 per share in for fiscal year 2001 when it reports fourth-quarter results Jan 23, 2002, according to First Call. The fourth-quarter projection is about a 29 percent increase from the 59 cents per share the company reported in the third quarter.
Woodcliff Lake, N.J.-based Ingersoll-Rand expects to earn $2.00-to-$2.25 per share in fiscal year 2001, at the upper end of analysts' estimates, but well below the $3.76 per share in earned in 2000. Ingersoll has not scheduled its fourth-quarter release.
Despite such conservative outlooks, "a retrenchment to low levels seen in Sept. is now unlikely," said Shatney. "Fundamentals are showing some modest signs of improvement, which could begin to alleviate downside in orders and earnings." 
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