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Market Update

Caterpillar's Incremental Profitability Slips Sharply in 2Q

We expect higher incremental margins from here, driven by Cat's solid cost focus and continued volume increases, but it seems the recovery will prove lumpy.

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After reviewing  Caterpillar's (CAT) second-quarter results, reported Friday, we plan to adjust our near-term assumptions to reflect management's increased guidance (which now also includes the completed acquisition of mining equipment manufacturer Bucyrus), but our long-term forecast is unchanged. We're maintaining our fair value estimate.

In the quarter, Cat enjoyed continued strong demand, with revenue in its core machine and engine business climbing 39% from the prior-year period. However, increased costs and continued headwinds from the Japan disaster earlier this year led to declining gross margins, both sequentially and year over year. As a result, although operating margins climbed to 11% from about 10% in last year's second quarter, the metric fell from the first quarter's strong 14%; incremental margins fell to about 17% from 28% in the immediately prior period (including some negative currency movements in the quarter, but excluding the late 2010 purchase of EMD). Management believes the negative effects from Japan are largely behind the company now, but we caution that competitor  Terex (TEX) also saw supplier price increases and component shortages during its second quarter, reported Thursday. We expect higher incremental margins from here, driven by Cat's solid cost focus and continued volume increases, but it seems the recovery will prove lumpy.

Adam Fleck does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.