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Shares of Caterpillar Inc. (NYSE: CAT) closed up 0.41 percent, to $86.00 a share in Monday's session. So far this year, the stock has lost 4 percent. Reuters

Caterpillar Inc. (NYSE: CAT), the world's largest maker of construction and mining equipment, is expected to report higher third-quarter profit as strong replacement demand in the U.S., improved cost control and modest net pricing help drive growth amid pockets of weakness. Synergies from acquisitions will also play a part.

Caterpillar Inc. (NYSE: CAT), which reports earnings on Monday, Oct. 22, 2012, before markets open, is likely to book a profit of $2.22 per share on revenue of $16.79 billion, based on the average estimate of analysts surveyed by Thomson Reuters. In the same period a year earlier, EPS was $1.71 on $15.72 billion in revenue.

Over the past three months, the consensus estimate has dropped from $2.41.

For the year, analysts are projecting net income of $9.43 per share, a rise of 20.7 percent from last year, on revenue of $67.76 billion.

The Peoria, Ill.-based company didn't give quarterly guidance but lowered its 2012 revenues outlook in September. Management indicated it would reduce its 2012 sales guidance by $2 billion as dealers thin inventories, implying a revised sales outlook for the year of $66 billion to $68 billion. Earnings are still expected to come in toward the upper end of Caterpillar’s $8 to $10 range.

Overcapacity and weakness in China have been the biggest headwinds this year. In addition, European sovereign debt woes and U.S. fiscal cliff concerns have also weighed on performance and added to the uncertainty and regional market weakness.

“Deterioration in the macro environment, particularly in developing regions (China), is resulting in a slowdown in spending by mining customers,” wrote JPMorgan analyst Ann Duignan in an Oct. 9 note to clients. That said, Duignan believes that Caterpillar is “well-positioned to benefit from the positive trends in U.S. construction activity.”

Caterpillar’s sales in its largest market, North America, have benefited from strong replacement demand as equipment users replace worn-out machinery and dealers replenish the equipment fleet for their rental businesses.

Caterpillar usually provides 2013 revenue guidance with its third-quarter earnings call. Based on commentary at September’s MINExpo industry conference in Las Vegas, Nev., William Blair & Co. analyst Lawrence De Maria looks for initial revenue guidance range to be flat or even slightly up compared with 2012 levels as the company expects to realize some pricing. However, given that the macroeconomic environment is in flux, Caterpillar should prudently guide conservatively.

The world's largest maker of bulldozers, excavators and other earth-moving machinery said that global activity in 2013 is expected to be similar to 2012, with improvement expected in 2014 and 2015.

'Attacking' Costs

Cost controls are playing a central role.

Caterpillar has demonstrated solid margins in spite of slower growth as efficiency continues to improve. The company is scaling back acquisitions and capital investments and focusing on inventory management.

“The company has been growing its cost structure at roughly half the rate of sales and plans to continue ‘attacking’ costs, allowing margins to further expand,” wrote Vance H. Edelson, analyst at Morgan Stanley in a Sept. 25 report.

“If you look back at incremental margins from the 2005 and 2008 range ... we were barely above zero. And over this past three years, it's been closer to 25 percent,” Michael DeWalt, director of investor relations at Caterpillar, said in September at the Bank of America Merrill Lynch Global Industrials & Materials Conference.

Increased synergies from the Bucyrus International acquisition have also contributed to Caterpillar’s bottom line. Caterpillar expects to beat the original synergy target of $400 million by 2015 on Bucyrus, a mining equipment company that was purchased in July 2011.

China Softness

The Chinese economy has slowed to its lowest growth rate since early 2009, with gross domestic product growth at 7.4 percent in the third quarter. It was the seventh-consecutive quarterly decline, slower than the 7.6 percent posted in the second quarter and well below the 10 percent average annual growth rate that China has posted over the past three decades.

Beijing’s measures to cool an overheated housing market have weighed on consumer and industrial demand.

Excavator sales are down roughly 40 percent in China so far this year, according to data from UK-based consultant Off-Highway Research.

Caterpillar performed relatively in line with the market after several months of outperformance, with excavator volumes down 32 percent from the year-ago period and 10 percent sequentially.

The manufacturer warned that it had overestimated Chinese demand for construction equipment, saying that its inventories in the country were so high that it would export 2,300 excavators from China to the Middle East and Africa. It is also reducing production in China.

“The current sales level in China is quite depressed,” DeWalt said. "We've already lowered production in China and expect to reduce it even more in the third quarter.”

However, the company doesn't want to cut too much, noting that it expects the world's second-largest economy to begin rebounding later this year and needs to have enough inventory and capacity on hand to benefit. Two years ago, when demand in China was soaring, Caterpillar found itself unable to keep up and lost market share.

Doug Oberhelman, who joined the Peoria, Ill.-based company right out of college in 1975 and has had the top job since 2010, said Caterpillar remains committed to China despite slowing growth there.

"By 2015, at the latest, we will be the market share leader in China for all of our construction equipment," Oberhelman told analysts in September. “This little slowdown allows the industry to consolidate, and we intend to be there when it recovers and win there."

China is important to Caterpillar primarily as a driver of commodities, not so much for the actual sales there. It's actually a fairly small part of the company’s business -- about 3 percent of Caterpillar’s overall sales.

Moreover, Bank of America's Ting Lu thinks third-quarter GDP has troughed. He also says that there is increasing amount of evidence for green shoots in the economy.

“It might take another couple of quarters for growth to significantly recover, but we believe the risk for a hard landing is getting increasingly smaller,” Lu said.

Replacement Needs

As demand from China deteriorates, the U.S. became the pillar of strength for Caterpillar.

North American sales of Caterpillar's distinctive yellow machines rose 24 percent in the three months to Aug. 31, following a 25 percent increase in July and a 24 percent increase in June.

Caterpillar has attributed its North American sales performance to the replacement of worn-out machinery whose life cycle was extended because of the 2008 economic recession.

“We remain highly positive on the outlook for North American construction equipment volumes and margins,” William Blair & Co. analyst Lawrence De Maria wrote in a July 25 note. “Volumes are still well below peak and even normalized levels.”

Additionally, De Maria notes that construction margins are exceptionally high by historical levels, but nearly every region (if not all) are well below potential, which would suggest that margins should increase with volume growth.

According to the company, construction equipment volumes in Europe, North America and Japan are a combined 40 percent below prior peak levels

Stock Performance

Caterpillar is committed to its dividend and will not cut the dividend, even in the event of a recession. A dividend provides a floor to the stock and should continue to attract yield-oriented investors.

Earlier this month, Caterpillar announced it will maintain the quarterly cash dividend of 52 cents per share of common stock, payable Nov. 20, to stockholders of record at the close of business on Monday.

“Stock repurchases could be on the horizon as M&A and capacity expansion receives lower emphasis,” De Maria wrote in a Sept. 26 note.

Caterpillar competes with machinery makers such as CNH Global NV (NYSE: CNH), Deere & Co. (NYSE: DE), Joy Global Inc. (NYSE: JOY), Cummins Inc. (NYSE: CMI) and Astec Industries, Inc. (Nasdaq: ASTE).

Shares of Caterpillar Inc. (NYSE: CAT) closed up 0.51 percent, to $86.62 per share in Thursday’s session. So far this year, the stock has lost 4.4 percent.