Will This Stock Bounce off the Bottom Wednesday?

Hedge fund manager James S. Chanos might already be shorting shares of construction and mining equipment leader Caterpillar , but you may want to wait until Wednesday before deciding to follow his lead. That's when the bellwether reports its second-quarter numbers.

While there's no question about the persistent weakness in the mining industry, Caterpillar might raise a yellow flag if any of its other businesses start losing steam. Investors might have a reason to worry, because news from Cat's peers hasn't been too great lately. Here are the four important answers that Caterpillar investors should look for in its upcoming earnings release.

Is Caterpillar still on solid ground? Image courtesy of www.marketsandcompanies.com

Is the pressure building up?
As the world's largest construction equipment maker, Caterpillar's fortunes ebb and flow with economic activity. Increased housing activity in the U.S. bodes well for the company, and could help offset some of the weakness in Caterpillar's resource industries, or mining division.

But what if the North American construction market starts losing momentum? It could hurt Caterpillar substantially, because the market accounted for a little over 35% of Cat's total revenue in 2012. We might already be seeing some signs of a slowdown. Just last month, construction equipment maker Terexdowngraded its full-year earnings guidance by 20% from its earlier projection on expectations of slower growth in North America. At the lower end, Terex expects a 4% rise in its EPS year over year.

Caterpillar's own recent sales statistics haven't been any good, either. For the three months ended in May, Caterpillar's machine retail sales from North America slipped 16%. It was down 18% for the quarter that ended in April. In its upcoming earnings call, investors should keep an eye on whether Caterpillar cuts its views on the local markets. With Europe still struggling and important markets, such as China, not growing much, a slowing North American market is probably the last thing that Caterpillar investors would want to hear.

Losing power?
Caterpillar's power systems business -- which primarily includes gas engines, turbines, and locomotives -- accounted for 35% of it's total revenue last year. The division was also the biggest contributor to Cat's revenue during its first quarter.

While demand for Caterpillar's engines and turbines has remained relatively strong, General Electric's latest quarterly numbers might give investors something to think about. GE's transportation division recorded a massive 45% fall in new equipment orders for locomotives and mining equipment in its second quarter. Its locomotive shipments slipped 30%, while orders for its heavy-duty gas turbines slipped 20% year over year. Alcoa projects a muted 3%-5% growth for the industrial gas turbine market for 2013.

Like GE, if Caterpillar also reports a drop in orders for the second quarter, then investors should take it as a warning signal. Caterpillar had reported a 12% fall in revenue from its power systems business during the first quarter. Another quarter of lower revenue will confirm the softness in the business, which is bad news for the company, especially when its mining equipment business is in a rut.

Are inventory levels easing?
Inventory buildup has been one of the biggest challenges for Caterpillar in recent quarters. Caterpillar sells the majority of its equipment through dealers, who purchased huge quantities from Caterpillar last year in anticipation of robust demand. Unfortunately, the dealers were left in the lurch when customers, especially mining companies, tightened their belts on spending.

The dealers have focused on reducing inventory since then, instead of buying new equipment, forcing Caterpillar to scale down production. Caterpillar took down $2 billion worth of inventory during the fourth quarter 2012, and another $0.5 billion of inventory in Q1 2013.

To what extent has Caterpillar's, and its dealers', inventory situation improved during the second quarter will be a critical question. Until its dealers reduce stockpiles and resume purchases, Caterpillar's top-line growth will be stuck.

How is Caterpillar cutting the flab?
With growth in sales and profits uncertain, Caterpillar has resorted to aggressive cost cutting in recent months. Last month, Caterpillar decided to indefinitely lay off 260 employees at its Wisconsin plant. Investors should note if the company has similar plans for the forthcoming quarters.

More importantly, some of Caterpillar's capital spending plans could take a back seat, especially after the recent dismal GDP numbers from China. Though the market accounted for only 3% of Caterpillar's sales last year, it is also where Caterpillar is eying major expansion into the future. Alcoa, which relies on China for a good part of its revenue, projects the commercial construction market in China to grow between 8% and 10% this year, which sounds pretty optimistic.

Investors should pay attention to what Caterpillar has to say about China. Until things turn around, Caterpillar might be forced to hold back some of its expansion plans.

Foolish takeaway
Caterpillar had already lowered its full-year revenue guidance in the previous quarter to $57 billion-$61 billion, from its earlier projection of $60 billion-$68 billion. While a further reduction is unlikely, worsening conditions in key markets could hurt Caterpillar's earnings prospects beyond this year. Investors should focus on whether Caterpillar sticks to its long-term growth plans. If it does, Chanos' shorting might just give you the right opportunity to dive into the stock.

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The article Will This Stock Bounce off the Bottom Wednesday? originally appeared on Fool.com.

Fool contributor Neha Chamaria has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company and Terex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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