Revisiting Two Economically Sensitive Picks

 | Jul 26, 2013 | 9:30 AM EDT
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In aggregate, industrials and economically sensitive stocks have had a surprisingly good second quarter. Revenues have shown modest growth, while margins continue to come in above expectations, thanks to continued cost-reduction actions. In addition, the qualitative discussion on the follow-up management conference calls featured better-than-expected outlooks with pickups in order rates.

In most cases, valuations are still pretty reasonable, and we continue to like the industrial recommendations we have made in the past 12 months.

Today, we update our recommendations on two of these stocks, TE Connectivity (TEL) and Caterpillar (CAT), on the basis of their recent earnings. While the quarter was somewhat diametrically different for the two companies, in each case we continue to like the stock, and would be looking to buy more here.

TE Connectivity reported better-than-expected earnings of $0.88 a share, compared with expectation of $0.83, on better revenue and margins. Revenue was $44 million higher on upside performance in the transportation, networks and industrial units. Operating margins were also ahead of expectations and ended the quarter at 14.8%, compared with an expected 14.4%. More importantly, order rates re-accelerated to +4%, while the book-to-bill ratio stayed over 1.

Management reiterated its long-term margin goals of 15% and committed to further enhancing shareholder value through dividends and share repurchases. Management also raised its lower-end guidance level from $3.10 to $3.18, setting the new guidance range to $3.18 to $3.22. At 15.9x September 2013's earnings of $3.19 per share and 13x 2014's earnings of $3.90, combined with a favorable 2.0% dividend yield, TE Connectivity still offers investors an attractive opportunity with considerable running room upward, particularly as the economy continues to improve.

Caterpillar is an industrial outlier that had a disappointing quarter and outlook. The stock has been a laggard for the past 12 months, including the year to date, because of a disappointing first quarter and analysts' caution about the company's outlook. Although expectations were pretty low, the company still managed to surprise to the downside.

Although we usually avoid buying into earnings disappointments, we believe Caterpillar is the exception that proves the rule.

The company reported a big revenue and earnings shortfall this week because of weakness in its large mining business. Demand for mining equipment continues to fall on weakening emerging-market infrastructure build-outs. More importantly, dealers continue to draw down inventory: Companywide inventories have declining $1.5 billion during the quarter. No one knows when the mining business will turn around, but Caterpillar's management isn't looking for a recovery until 2014.

As a result of the disappointing mining operations, Caterpillar reduced its revenue and earnings outlook for 2013. Revenue is projected to be $56 billion to $58 billion, compared with the previous target of $58 billion to $60 billion. Earnings were also revised downward to $6.50 per share, from $7. The balance of Caterpillar's businesses in power and construction held in steady during the quarter on rising demand for global energy projects and rebounding North American construction activity.

Importantly, management affirmed its long-term outlook. At 12.7x 2013 depressed EPS estimate of $6.50, CAT's shares are attractively valued and supported by a favorable 2.9% dividend yield. While it may take several quarters before Caterpillar begins to stabilize its earnings and rebuild investor confidence, we are encouraged that the issues facing the company are not related to internal problems, product concerns or managerial missteps, but rather a fierce macro headwind in a key business segment.

To our way of thinking, this macro weakness will eventually normalize, and a stock price at 12.7x depressed earnings should be a great point of entry for investors. We would use the $3.50 stock price weakness after the earnings release as a solid entry point to start or add to a position in Caterpillar.

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