Sales up, earnings up, outlook positive….but time to take some profits.

Mining and construction equipment maker Caterpillar is literally at the coal face of global economic activity. Its operational performance provides an excellent insight into the level of investment in mining and construction, which in turn serves as an indicator of the global economy’s underlying health. It is therefore encouraging to see Caterpillar’s second quarter result tick all the boxes.

The company delivered a hefty 30.5% sales growth, comfortably beat earnings expectations and upgraded its full year outlook. The result effectively covered each of the primary areas the market is concerned about. This is specifically sales growth and a positive outlook statement, but beating bottom line earnings estimates is never a bad thing either.

Caterpillar’s sales expanded from $7.975 billion last year to $10.409 billion for the 2010 second quarter. The sales boost was driven by strengthened end-user demand which saw dealers stop running down inventories that had softened sales in 2009. Dealer inventories have encouragingly remained flat for the first half of 2010, which is indicative of the dealers’ improved confidence in the level of future demand.

In terms of end-user demand, Caterpillar is seeing a recovery in world demand led by Asia, Latin America, the Middle East and Africa. Because this fastest tier of growth is coming from the developed world, it is generating strong demand for commodities such as iron ore, copper, coal and oil. This provides an additional boost for Caterpillar’s mining and energy associated products.

It is very much a two-speed recovery though, with sales to the developed world still quite depressed, albeit not to the same degree as was the case last year.

“…this was an excellent result from Caterpillar, which also provides a positive look through to the health of the global recovery.”

The company’s healthy sales growth was more than matched by earnings, which expanded by a whopping 91% to $707 million. The boost in sales volumes was an important element in earnings growth, but it wasn’t an unmitigated positive. More than half of the quarter’s sales were for machinery rather than engines. An engine is a higher margin product and so the sales mix was actually a negative for the company.

Nevertheless, the company more than made up for the negative sales mix through a considerably lower cost base. Manufacturing costs were down $316 million following efficiency improvements and lower material costs. The 2009 quarter also suffered from the cost of restructuring with about $85 million in redundancy costs. The restructuring has now borne fruit as evidenced by the efficiency gains.

In terms of the outlook, management has increased its full year sales guidance from $38-42 billion to $39-42 billion. Although this is a reasonably small upgrade to the lower band, it should be noted that the stronger US dollar is negative for Caterpillar. The raw demand upgrade is therefore stronger than the actual upgrade implies.

Management also upgraded earnings from $2.50-3.25 per share to $3.15-3.85 per share.

From a valuation perspective, Caterpillar trades on around 21 times consensus 2010 earnings, falling to 14.5 times 2011 earnings. The stock also provides a comparatively healthy dividend yield of 2.4%, which is expected to be maintained through the years ahead.

Turning to the charts, Caterpillar found firm support from the $55 level to surge higher, breaking above both the 50 (green line) and 200 (red line) period moving averages in the process. The progressive move higher has resulted in a continuation of the broader uptrend. Strong resistance does however lie at the May 11 and June 21 highs in between $68 and $69.

A convincing break above this region would entail an upside target towards the April 26 high of USD $72.83. The weekly chart depicts the strength of the uptrend in place since March 2009. The increase in price is supported by an increase in volume, which is bullish.

So all in all, this was an excellent result from Caterpillar, which also provides a positive look through to the health of the global recovery. We shouldn’t ignore the continued weakness in the developed world though. This will limit the pace of recovery and continue to provide a volatility catalyst from time to time. Given that we are in an inherently more volatile market, it is necessary to take a more active approach to our investments.

In this regard we are going to lock in part of our handsome gain on Caterpillar through a sell half recommendation at around $68.