Caterpillar's CEO Discusses Q4 2012 Results - Earnings Call Transcript

Seeking Alpha

Caterpillar Inc. (CAT)

Q4 2012 Earnings Conference Call

January 28, 2013, 11:00 AM ET

Executives

Douglas R. Oberhelman - Chairman & CEO

Bradley M. Halverson - Group President and CFO

Mike DeWalt - Corporate Controller and Director, Investor Relations

Analysts

David Raso - ISI Group

Jerry Revich - Goldman Sachs

Jamie Cook - Credit Suisse

Seth Weber - RBC Capital Markets

Theoni Pilarinos - Raymond James

Robert Wertheimer - Vertical Research Partners

Ann Duignan - JPMorgan Chase & Co.

Andrew Kaplowitz - Barclays Capital, Inc.

Eli Lustgarten - Longbow Securities

Ted Grace - Susquehanna Financial Group

Presentation

Operator

Good morning ladies and gentlemen, and welcome to the Caterpillar Full-year and Fourth Quarter 2012 Earnings Results. At this time, all lines have been placed on a listen-only mode and we’ll open the floor for your questions and comments following the presentation.

It is now my pleasure to turn the floor over to your host, Mr. Mike DeWalt. Sir, the floor is yours.

Mike DeWalt

Thank you very much and good morning and welcome everyone to our year-end earnings call. I’m Mike DeWalt, Caterpillar’s Corporate Controller and Director of Investor Relations. On the call today, I’m pleased to have our Chairman and CEO, Doug Oberhelman; and our Group President and CFO, Brad Halverson.

This call is copyrighted by Caterpillar Inc. and any use, recording or transmission of any portion without the expressed written consent of Caterpillar is strictly prohibited. If you would like a copy of today’s call transcript, we will be posting it in the Investors section of our caterpillar.com website, and it will be in the section labeled Results Webcast.

This morning we’ll be discussing forward-looking information that involves risks, uncertainties and assumptions that could cause our actual results to differ materially from the forward-looking information. A discussion of some of the factors that either individually or in the aggregate could make actual results differ materially from our projections can be found in our cautionary statements under Item 1-A, Risk Factors, of our Form 10-K filed with the SEC back on February 21 of 2012, and also in the forward-looking statements language contained in today’s release. In addition, a reconciliation of non-GAAP measures can be found in our financial release and that’s been posted on our website at caterpillar.com.

Okay. This morning before we get into the Q&A, I’m going to cover four topics. The first will be a short summary of the full-year of 2012; then I’ll take a few minutes to discuss how we ended the year compared with what we expected in our outlook for 2012 that we issued back in October. Our third topic will be a comparison of the fourth quarter of 2012 with the fourth quarter of 2011, and then I’ll finish-up with my final topic which is a discussion about our 2013 outlook. Then I’ll turn the floor over to Doug Oberhelman, and Doug will take a few minutes to talk about our Siwei acquisition.

All right, lets get started with 2012, and we were very pleased there was report this morning that it was another record year for both sales and revenues and profit. Sales and revenues were $65.9 billion and that was an increase of 10% from 2011. Profit was $8.48 a share and that was up 15%. Now the $8.48 per share for the year did include the goodwill impairment charge of $580 million or $0.87 a share and we announced that back on January 18. At $65.9 billion sales and revenues were lower than we expected when we were at this point about a year ago in January 2011 with our first outlook.

After a great first half the economies around the world began to slow around mid-year, and as a result dealer sales to end users began to flatten out. We found ourselves with inventory that was too high and dealers also found themselves with too much inventory. As a result dealers slowed orders, and in the third quarter we began the process of scaling back production. Now while production declined somewhat in the third quarter, we took it down much more in the fourth quarter, and because of that we were able to reduce inventory in the fourth quarter by $2 billion, far surpassing our goal of reducing inventory by about $1 billion.

Now in addition to the $2 billion that we took out in the fourth quarter, dealers also reduced inventory by about $600 million in the quarter. So, in combination with our inventory and dealer machine inventory a total of $2.6 billion came out in the fourth quarter. That’s a lot of inventory coming out in one quarter, and it was certainly a negative for sales, efficiency and the impact of cost absorption.

Now turning back to the full year from an operational standpoint, 2012 was a good year. We've been providing a table near the back of our financial release each quarter this year highlighting our incremental operating profit pull through. Now when we show that, we try to make it apples-to-apples and to do that we've been adjusting for the impact of acquisitions and divestitures. And on that basis, our full year incremental operating income was 43% of incremental sales and revenues.

Now that 43% was helped by currency impacts over the course of 2012 and excluding those items, it was 33% still much better than our goal of about 25%. Now in addition to operating income, we continue to improve quality, safety measures and our sales improved faster than the overall machine industry in general.

Finally in response to the weaker economic climate we found during the second half of the year, we've slowed down capital spending. Our CapEx for 2012 was about 3.4 billion and that's over $0.5 billion under our original expectations for 2012. Okay, that's a quick review of 2012. Let's move on to the second topic and that's how we did versus the outlook we've provided last October.

Last October, we were expecting 2012 sales and revenues to come in at about 66 billion and with actual sales and revenues of 65.9 billion; we were right about on what we thought. Our outlook for profit at that time was a range of $9 to $9.25 with a midpoint of $9.13. We ended the year at $9.48, so we missed the outlook.

There were two large items that we didn't anticipate in the outlook; one negative and one positive. The negative item was the 580 million or $0.87 a share goodwill impairment related to Siwei. The positive item was the settlement of U.S. tax returns and that was a 300 million or $0.45 per share positive.

Excluding those two large items, again neither of which was anticipated in our outlook, profit was $0.10 per share lower than the bottom of our range and about $0.23 per share below the middle of the range. About two-thirds of the difference from the $9.13 midpoint was the cost impact from the more substantial production and inventory cuts in the fourth quarter. Most of the remaining difference was from currency translation losses reported in the other income and expense lines below operating profit and that was related to the euro primarily.

While the scale of production and inventory reduction was certainly negative to efficiency and profit, we're pleased with what we achieved in terms of inventory reduction. It's been a major focus throughout the company over the last couple of quarters and it was an exceptional result.

Okay, let me move on to my third topic this morning and that's the fourth quarter versus the fourth quarter a year ago. Sales and revenues of 16.1 billion or about 1.2 billion or 7% lower than the fourth quarter of 2011. While there were certainly pluses and minuses, the most significant factor in the sale change was the inventory. The others add about 800 million to inventories in the fourth quarter of '11, which was positive for sales back then and in the fourth quarter of '12, they reduced their machine inventories about 600 million and that was a negative.

In total then, the impact on sales of dealer inventory changes was about 1.4 billion and that was more than the total change in our top line. Our profit per share in the quarter was $1.04 and that's lower than the $2.32 per share that we reported in the fourth quarter of 2011 by about $1.28.

As with the full year numbers, the Siwei goodwill impairment was negative $0.87 a share and the tax settlement was positive $0.45. Other unfavorable factors in order of importance were manufacturing costs and they were unfavorable 417 million and that was primarily a result of the significant impacts of the decline in production in the fourth quarter and the $2 billion inventory reduction.

Sales volume was negative 371 million. Tax impacts and this is excluding the 300 million positive item were unfavorable $0.36 a share. We had a higher tax rate and absence of favorable items from a year-ago. Other income and expense, again which is below operating profit was negative $136 million. And that’s essentially the absence of currency gains a year-ago versus losses in the fourth quarter of ’12.

Now, one positive factor that partially offset those negative items was price utilization and that was a positive for the quarter. Now on our – in our release today on page 6 we have a waterfall chart that goes through the changes in operating income and that can provide a little more detail.

All right, that’s the fourth quarter, my final topic this morning here is the outlook for 2013. We will start with economics. And from that standpoint we do see conditions improving and expect world economic growth of at least 2.5% in 2013 and that would be a small improvement from our estimate of about 6.3% for 2012. I think the key phrase here when we talk about the world economy in 2013 is a bit better, but still weak.

In the United States we’re becoming increasingly optimistic. The feds interest rate policies and their plan that continue injecting liquidity are in our view positive for 2013 growth. We are expecting the U.S. economy to grow at least 2.5% in 2013. Now that’s now when any of us would consider a robust level of growth, but it’s certainly than what we saw – better than what we saw in the second half of 2012.

We expect the U.S. housing industry to help the economy in 2013 and we’ve all seen the positive news items related to housing over the past few months. In Europe we’re expecting another tough year for growth. The problems in Europe are well known and much of the region is entrenched in fiscal austerity. As a result, we expect growth in the eurozone to struggle to match 2012 and we expect that construction activity there will decline.

One more positive about the prospectus for the developing economies around the world, in many countries they’ve been easing policy and lowering rates for more than a year and average rates today are close to levels that were last reached during the financial crisis. So, we expect that contributes to better growth in ’13. Specifically in China, we’re expecting improvement in 2013. In response to the 2012 slowdown, the Chinese government did accelerate its credit growth in infrastructure spending and as a result the economic data that we’ve seen in the fourth quarter has begun to improve.

Our outlook assumes that Chinese government will maintain pro-growth policies throughout 2013, and we’re expecting the economic growth in China to be near 8.5%, a more favorable environment for construction and higher commodity demand. Okay, that’s a quick look at our economic view. Let’s turn to sales and revenues.

We’re expecting sales and revenues to be in a range of $60 billion to $68 billion reflecting both upside and downside potential from 2012. We’re increasingly optimistic that there may be potential for better growth ahead, but we remain cautious about how quickly that improvement in going to translate into higher sales for Cat. At the $64 billion middle of that outlook range, we’re expecting overall end-user demand to be relatively flat with 2012. We do expect pluses and minuses by segment and I’ll cover that in a minute, but overall demand relatively flat. At the mid-point of the outlook though we do have $2 billion decline in sales and revenues from 2012, and that’s primarily a result of dealer inventory changes.

Over the course of 2012, dealers added about $1 billion to their inventories and in ’13 our expectation is that dealers will reduce inventory by well over $1 billion, so the net of that is an unfavorable impact on sales of over $2 billion. By segment we expect sales in resource industries which is mostly mining to decline. As we said last October, mining customers have been lowering their CapEx expectations for 2013 and order levels have been very weak since the middle of 2012.

Another sales negative next year is going to be in our all other segment. In terms of sales is very small and we usually don’t have much to say about it, but over the first-half of the year we expect it to be about $400 million lower than in sales and revenues from the first half of 2012 and that's due to the absence of sales from our third-party logistics business which we sold in July of 2012.

We expect sales in our Power Systems segment to be relatively flat with 2012. And on the positive side, we expect that Construction Industry sales will be flat to up in 2013 with improving end-user demand.

In summary on sales, at the middle of our outlook range, dealer inventory changes are driving the most significant piece of the reduction in sales. For profit, we're expecting a range of $7 to $9 a share. Profit in 2012 with $8.48. So at the middle of the range, we have profit declining $0.48 a share.

Negative items include absence of the tax settlement that was 300 million in the fourth quarter, absence of about a roughly $275 million gain from the third quarter related to the sale of our third-party logistics business. The 2 billion decline in sales with higher depreciation.

Now if you look at costs and price realization together excluding depreciation, so price net of cost, we would expect that to be overall relatively neutral next year. We do have a big positive item and that's absence of the $0.87 per share impairment charge that we recorded in the fourth quarter.

Now my final point here on the outlook is really about the first quarter, and while we're not providing specific sales and profit outlook for the quarter, we are expecting that sales and revenues are likely to be significantly lower in the first quarter of 2012. Now to put it in perspective, let's think about the full year. At the middle of our outlook range, we expect sales and revenues to be down about 2 billion for the year and it looks like all or more of that 2 billion is likely to be in the first quarter. And that's the result of further reductions in production from the fourth quarter and we and our dealers continue to work down.

As a result, profit is also expected to be significantly lower than the first quarter of 2012, again a result of the lower sales and some negative cost impact from continuing to reduce production and take out inventory. Okay, that's my review.

With that, I'll turn the floor over to Doug.

Douglas R. Oberhelman

All right, thank you Mike and good morning everyone. It's Doug Oberhelman. I'd like to take a few minutes to talk about the $580 million impairment charge that we announced on January 18 related to our acquisition of Siwei and I'll start by going over some background.

Siwei's a company located in China and they make hydraulic roof supports that are used in underground coal mining. China is the world's largest coal producer and the vast majority of it is mined underground. The acquisition of Siwei is a starting point for Caterpillar entering into the Chinese underground coal business.

We've completed the acquisition in June 2012 and in about that time, as we do with Caterpillar, we moved experienced Cat people into our newly acquired company to start the process of bringing Siwei into the Caterpillar family. In the fall, we started a physical inventory and reconciled or I should say attempted to reconcile the physical inventory with the books.

Our newly appointed team with Siwei found a substantial discrepancy which led to our investigation. What we discovered was deliberate multiyear coordinated accounting misconduct at Siwei. It was executed by several senior managers at Siwei for the purpose of inflating sales, understating costs and over-reporting profit and it included fabricated documentation designed to cover their tracks.

In light of this new information, we had to take a goodwill impairment charge which was included in our fourth quarter results that we reported this morning. The conduct we discovered does not represent in any way, shape or form the way Caterpillar does business or how we expect our employees to work. As a result, we moved quickly and decisively to hold responsible the leaders that were directly accountable for the wrongdoing and we've changed the leadership at Siwei.

Because this happened at an acquisition we made in China, it's raised questions in the media about our strategy in China and I'd like to address that. China is the largest country in the world by population. It's developing rapidly and it's one of the fastest growing large economies in the world. It’s already the world’s largest market for construction equipment and has a large mining industry. It’s a very important market now and as we look to the future, we expect it to become even more significant.

While the industries we serve in China are significant, it doesn’t mean there are challenges. The construction industry in China had a tough year in 2012 as in other countries the construction and mining industries in China are subject to changes in the overall economy and over time move with the business cycle. You don’t have to look any further than U.S. housing to see that cyclicality happens in countries other than China.

Our strategy in China has served around bringing our products, services, support capability, manufacturing scale, supplier development, procurement, product development and distribution to China for the long-term. That will continue. The impairment at Siwei doesn’t change there. China is the world’s leading coal producer and the products we make at Siwei are important for that industry. We will develop and improve those products for use in China and for export and we intend to add more products to better serve the Chinese coal mining industry.

While we look at Siwei, we felt we could make improvements with Caterpillar’s experience and people and given our strategic imperatives, this deal make sense. In fact, we’ve already made good progress on significantly lowering Siwei’s most significant cost driver, steel. The ability to lower steel cost is just one example of leveraging Caterpillar scale and global network to improve Siwei’s operation.

Our announcement of the accounting misconduct in impairment is something that no CEO wants to make. Its disappointing, one we better not have had to deal with, but when faced with challenges like this, it’s how we respond that defines us. We talk a lot about accountability at Caterpillar and I sure have preached that here in the last three years as CEO. I recognize the decision to acquire Siwei happened on my watch and the buck stops at my desk. I’m accountable for that acquisition.

There has been a tremendous amount of time, energy, and resources dedicated to this investigation up to this point and we’re not done. We’re putting in more effort to finish our investigation as we do with processes and products at Caterpillar we’re constantly looking for improvement. We will imply what we learn from this as we go forward.

One final point, we were deliberately misled by the accounting misconduct at Siwei and we're considering all options to recover our losses and hold those responsible accountable for their wrongdoing. Related to that we have a long standing policy not to comment on pending or contemplated litigation and further comment is not appropriate at this time. That means we won't be going into more detail on this subject when we take your questions about 2012 results and the ’13 outlook. With that I’ll turn it back over to, Mike.

Mike DeWalt

Okay, thanks Doug. With that we’re ready to go into Q&A, please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question today is coming from David Raso. Please announce your affiliation and then pose your question.

David Raso - ISI Group

Hi, ISI. For 2013, the sales mid-point, if we strip-out cap financial we’re speaking about $61 billion. So, that said, a question on the Company inventory. Your Company inventory is a percent of trailing sales looking at the equipment company just came down from over 27% of trailing sale to now below 25%. So, when we think about 2013 and the target for Company inventory, are we comfortable with that 25% level? I’m just trying to get a feel for how much more Company inventory do you expect to take out in 2013?

Mike DeWalt

Yeah, good question David, and honestly we don’t -- we don’t track it as a percent of sales. What we’re targeting is inventory returns which is essentially related to cost of sales not so much sales although of course they’re tied together. I think to a large degree where -- in terms of dollars where we end up on inventory, at the end of 2013 will kind of depend to some degree on where we're at in terms of the outlook if we're at the bottom of the outlook or the top of the outlook. I suspect that the inventory number will look different. If you just start with where we are today in terms of inventory, there's more to come out in the first quarter. I certainly don't think it will be on the scale. We're not predicting it will be on the scale of what came out in the fourth quarter $2 billion, but certainly there is more coming out in the first quarter so it's going to come down from here.

David Raso - ISI Group

But at the midpoint, do we feel there's more inventory to come out?

Douglas R. Oberhelman

Yes.

David Raso - ISI Group

Okay. And then related to that, the guidance by segment if I look at Construction Industries, you said flat to up slowly and you used 3% Power flat. I assume all other pull-out Cat logistics and this small number call it flat after you pull that Cat logistics out. It would seem to be implying Resource Industries is down, call it 10%, 11%, 12% on revenues for the year. Is that a fair characterization how you're looking at Resource Industries and how do we square that revenue guidance up with the orders for the equipment have been down more than that the last two quarters?

Douglas R. Oberhelman

Yeah, a couple of things. One, we gave general direction on the segments and I think the way you've described it in terms of general direction is absolutely correct. Resource Industries is going to have again other than absent the logistics really all the decline. How that squares up with orders, we're starting the year with actually a reasonable backlog for the big product but we do need to take – we need to take on more orders over the course of the next maybe two quarters to make the forecast. So it's not a case where orders can stay at the level that they have been during the second half of '12. So it will need to go up. But it looks to us like the bottom is actually the third and the fourth quarter of last year. We've already seen pretty substantial pickup in construction orders in the fourth quarter. Most of the decline in orders that we saw I think in 2012 and the second half of the year on construction was related to dealers wanting to take out inventory. Hope that helps. David, we probably need to move on to the next person on the line.

David Raso - ISI Group

All right, thank you.

Operator

Thank you. Our next question today is coming from Jerry Revich [Goldman Sachs]. Please announce your affiliation and pose your question.

Jerry Revich – Goldman Sachs

Hi, good morning. It's Goldman Sachs. My two questions are on the pricing outlook. Mike, first, how would you characterize the pricing environment on your Resource Industries bookings today compared to what you're shipping out of backlog? Do you expect positive price realization out of that business? And second, does the pricing outlook include any benefit for your Construction Equipment business from the next export position out of Japan given the recent movement that you had? Thank you.

Mike DeWalt

Okay, that's a real mouthful, Jerry. I think in general I would say we're cautious on the pricing next year. Our outlook reflects something around 1%. We did better than that in 2012. I think we were actually a bit surprised as we went through the year at how well pricing held up. We don't have a big difference looking forward to next year between the segments. We have small improvements baked into each of them, nothing big. I think given another year of relative weakness in the global economy, I mean my goodness, 2.5% is nothing to jump up and down about in the world economy, it's pretty weak. I think we're sounding a fairly cautious tone on pricing but by the same token we're not trying to be alarmist here. It's not as though you have big cuts anyway, it's just weak economic growth and caution on our part.

Jerry Revich – Goldman Sachs

Thank you.

Douglas R. Oberhelman

I would like to add to that, Mike, just a little bit on kind of our business model and strategy and we are really working on market share to build population around the world to make sure that that cedes our business model. And that plays also into the kind of pricing philosophy we had because we're trying to juggle that much better as we go after an increasing field population which then drives our aftermarket, drives our dealers, as you all know. So that plays into that equation as well.

Jerry Revich – Goldman Sachs

Thank you.

Mike DeWalt

Thanks, Jerry. Next question please.

Operator

Thank you. Our next question today is coming from Jamie Cook. Please announce your affiliation then pose your question.

Jamie Cook - Credit Suisse

Hi, good morning. Credit Suisse. Just wanted to dig a little deeper into, how you guys are thinking about the backlog and in particular mining backlog order of trends, I guess, Mike at what point do you expect to see a stabilization or improvement in orders within mining’s and which areas are you guys most optimistic or pessimistic on, because I guess when I think about your stock, the overhangs being mining, I’m sorry, its been inventory which you’re working through, mining is the next one because we’re just trying to get a feel can Cat, if you look at Cat 2013 is a transition year, can Cat grow their earnings in 2014 on just construction if mining continues to deteriorate and I will get back in queue after that.

Mike DeWalt

Okay. Well, in terms of 2014, of course we’d like to get through 2013 first.

Jamie Cook - Credit Suisse

I know, but you did lay out 2015 long-term target, so …

Mike DeWalt

On mining again, we had massive orders, I mean very large orders in mining throughout much of a ’11 and really through almost the entire first half of ’12. That’s when sentiment changed I think in the world economy it was evident, in China it was softer, you had an easing of commodity demand, although, overall mining activity actually did go up in ’12. So, orders on hand were quite significant and over the past six months customers have really eased off on ordering. It did started to pick up a little bit late in the fourth quarter, but it’s certainly not what we’d consider to be at a sustainable level, that means to go up from here. But right now we have good availability, so when the order rate start to move back up a bit, we will certainly be in a position where we can take care of the customers. For – again for the large product, we don’t have certainly 100% coverage for 2013, so we didn’t need to take in orders both for kind of filling up year in 2013 and for 2014. So, I think we would want to see some continued improvement in order rates, really between now and mid-year, let’s make that happen.

Jamie Cook - Credit Suisse

And Mike, can you just say, you said it picked up a little in the fourth – late in the fourth quarter. Can you just talk about which area specifically within mining that you saw that? Geographically by commodity, however you wish to?

Mike DeWalt

No, no, and partly because it's relatively small, I mean, I’m not trying to make a big deal about it. We went from – let’s say, very low to low. So, it's still below where we need it to be.

Jamie Cook - Credit Suisse

Okay.

Douglas R. Oberhelman

I would just add Mike that we did add a slightly firmer price forecast for iron ore, in copper you saw that in our outlook statement. If that happens, of course that will help the order rates as the miners respond to that. A lot of which is dependent on world growth as it goes through the year as well, and if that would be above our 2.5% rate on a global basis we probably would expect that go up, but if it's lower we’d probably not see it come back as fast. So, there’s really a high correlation there, but we did put out $135 ore price. So, we’ll see how that goes throughout the year.

Jamie Cook - Credit Suisse

Okay. Thanks.

Operator

Thank you. Our next question today is coming from Seth Weber. Please announce your affiliation and then pose your question.

Seth Weber - RBC Capital Markets

Hey, good morning, it's RBC. A couple of clarifications just to start, the fourth quarter pickup in construction equipment orders that you sighted Mike, I mean, is that just typical a seasonality or can you talk about how that’s turning year-over-year?

Mike DeWalt

Yeah. No, I think in some ways I think that the year-over-year trend at least if we’re looking at order rates for construction have more to do with dealer inventory than actual demand levels. I think it's a case where – think about it, if you’re a dealer and you want to lower inventories, the way you do that is you lower order rates below what you’re selling and then we ship you less and then you lower your inventory. So, that’s what happens really beginning in the third quarter. Construction orders were very weak in the third quarter and that means our production levels in the fourth quarter went down and dealers cut out inventory. So, the order level is always -- order of magnitude, three, four months ahead of where our production levels are. So, what that means is, so I think that pick-up that we saw in the fourth quarter probably has more to do with dealers seeing the light at the end of the tunnel on inventory reduction.

Seth Weber - RBC Capital Markets

Okay, that's helpful. Thank you. And then on the inventory reduction that you saw this quarter, was the Siwei adjustment, did that contribute to the inventory reduction that you booked?

Mike DeWalt

No. I mean virtually not at all. I mean not at zero but it's so small that it'd be less than rounding.

Seth Weber - RBC Capital Markets

Okay. And then if I could ask another question just on the mining space, the slowdown that you're seeing or the cancellations, is that related -- is that still related to primarily growth projects or are you starting to see the mining companies scale back on sort of more maintenance type stuff?

Mike DeWalt

Yeah and I think if you were to judge it by order levels, they've cut back on capital spending across the board.

Seth Weber - RBC Capital Markets

So, including maintenance type stuff?

Mike DeWalt

Yeah, I mean order rates over the last six months in mining have been very low. I mean if you think about it, at about midyear, we have a very large backlog as a result of the year and a half of very high orders. And really for the last half of 2012, they essentially took a break from ordering and it was pretty much across the board. I wouldn't pick necessarily on one commodity versus the next or one type of project versus the next.

Seth Weber - RBC Capital Markets

Okay. Thank you very much.

Operator

Thank you. Our next question today is coming from Theoni Pilarinos [Raymond James]. Please note your affiliation and pose your question.

Theoni Pilarinos - Raymond James

Good morning. Raymond James. I'm just reading through your outlook section and I see a lot of bullish points that you have a higher housing starts, PMI, commodity prices going up, pro-growth policies. So I'm just wondering why you have such a wide guidance range and what's really baked into that $7 number?

Bradley M. Halverson

Yeah, this is Brad Halverson. I think if you look at our range, we've been down this path before. We do see some positive news as we've mentioned in our release. North America is getting stronger. At Cat Financial, we've finished the fourth quarter strong with retail financing up and frankly past dues at the lowest level they've been since 2007. But if you look at the last two years, we've been in this path with good momentum in the first half of the year, fiscal cliff issues, debt ceiling issues, election issues, China is slowing down and so in our industry we're prepared for both sides and that's why we have a wide range. And I think when we get through the first quarter, we're going to know a lot better but internally we're planned for both sides and we surely hope to see the high side of our outlook and another record year for sales and profit.

Theoni Pilarinos - Raymond James

Okay, great. And a follow-up question. You talked about your construction orders picking up at the end of the fourth quarter. Where do we see that in your dealer stats [indiscernible]?

Mike DeWalt

Theoni, you were cutting out. Could you restate that?

Theoni Pilarinos - Raymond James

Yeah, sorry. You mentioned that there was a pickup in orders in the back half of the -- at the very end of the fourth quarter. And I'm just wondering where do we see that in your dealer stats? From what I saw, they were declining.

Mike DeWalt

Dealer stats are what they're selling not what they're ordering.

Theoni Pilarinos - Raymond James

Sorry. You said there was a pickup in demand rather, and so the dealer stats indicate demand was declining in December. Am I correct there?

Mike DeWalt

If I said demand, what I meant to say was that for construction in particular, orders later in the fourth quarter picked up. Again, that's what they're ordering, that's not what they're selling.

Theoni Pilarinos - Raymond James

Okay, thank you.

Mike DeWalt

But I will make a comment on the retail dealer statistics that came out last Friday and it was a little weaker than it had been. I mean we were in the range over the last few months about 5% or 6% and in December, it was down to 1%. And I think there are two reasons for that or two – I'm sure there are definitely many more but the two that stand out are in the fourth quarter last year, we had just a very, very large pickup between November and December in North America, up more than 50% in one month. And I think a lot of that or some of that anyway had to do with the bonus appreciation that was expiring at the end of last year, so I think that helped out dealer sales a bit in the fourth quarter of last year. So I think between that and coal mining sales being down a bit, that in December, that really amounts I think for most of the decline.

Thanks, Theoni. Next question, please.

Operator

Thank you. Our next question today is coming from Robert Wertheimer. Please announce your affiliation then pose your question.

Robert Wertheimer - Vertical Research Partners

It’s Vertical Research Partners. Good morning.

Douglas R. Oberhelman

Hi, Rob.

Robert Wertheimer - Vertical Research Partners

My first question is on mining, it seems as though you have a little bit of mining inventory at dealers, which I don’t think is typical although an in-transit assembly and so are you able to quantify that or comment on it? And the related question to that is, it seems as though despite all the noise on mining CapEx and there is clearly cancellations and push outs in a more cautious atmosphere, it seems as though the top 10 or 15 miners are only spending down 10 or 15 – 5% or 10%, excuse me, in ’13 versus ’12, the order sound a lot worse than that. So, I guess, there is a question, did the Company’s over order and there is lot of inventory sloshing around either on mine sites or at dealers and at the normal level is actually based on CapEx as it stands now is higher than now or not? So, it’s how do you feel like orders at/or are versus mining global CapEx?

Douglas R. Oberhelman

Well, there is a lot wrapped up into that Rob. But I think there are a couple of differences between order rates and mining CapEx. First off, I mean, we come into the year still with for the large products in particular, reasonable order backlog. So, that is reflective of that plus whatever new orders we take in, what we’re actually going to sell. What’s happened and those dealers have low or – dealers and customers have order – mining orders over the last six months, a bit of that’s come out of the backlog. So I think there is a little bit of the difference because of that. Your point on dealer inventory is also actually a good one. We don’t usually have dealer inventory in that normal way you would think about it where we ship, a bunch of trucks to a dealer, they put them together and set them on the lot and wait for a customer to come by. It doesn’t normally happen that way. But we do have substantial dealer inventory and that’s essentially a pipeline.

Now with activity levels, with sales levels coming down, that we’d expect a part of the decline in dealer inventory actually quite a bit of it next year to be related to mining. So what that means is what the miners would have as CapEx is what they would be buying from dealers, not what we’re selling to dealers. So, I think their CapEx numbers probably are going to look a little bit better than our sales number, because some of them will be out of dealer inventory, if that makes any sense to you at all. There are a couple of spots where we actually do have inventory that’s a little bit beyond what you would think that was just a pipeline that’s in process waiting to get put together or assembled and commissioned on site. But by in large most of the mining inventory around the world is a pipeline that’s kind of on its way to dealers.

Robert Wertheimer - Vertical Research Partners

That is helpful; and then if I can ask my quick follow-up, on hours run on mining equipment, has it come off at all, and I know Central Appalachia is a little down, but if you look to your global, total number of trucks running and total number of hours the aftermarket mining was down again this quarter. Are they running fewer hours or not?

Douglas R. Oberhelman

Rob, I don’t know the answer to that, if I did I’d give an indication, but I don’t. I did know that parts volume around coal mining is down, but in terms of hours elsewhere I’m sorry, I don’t know the answer.

Robert Wertheimer - Vertical Research Partners

Great. Thanks.

Mike DeWalt

Okay. The next question.

Operator

Thank you. Our next question today is coming from Ann Duignan. Please announce your affiliation and then pose your question.

Ann Duignan - JPMorgan Chase & Co.

Hi, good morning, JPMorgan. And Doug, you and Jamie Dimon, can commensurate I think together. Yeah, my question is around China and the inventory overhang that we’ve been dealing with there on the construction equipment side. I would be remissive, I didn’t ask how that is going and where are we in that process and according to our context when we were over there in December that we’ve got about a years worth of excess inventory still there, so maybe if you could update us in that region?

Douglas R. Oberhelman

I am not quite sure what the context is Ann, but in China remember they normally have a pretty good selling season in the spring, it's sort of disproportionate with the rest of the year in terms of seasonality. We have really not taken much inventory, our dealers have taken a bit of inventory out of China over the last quarter, but we’ve not taken much inventory out. If you look at our $2 billion decline in the fourth quarter, actually very little of that had anything to do with China. Our view is that, that will be a first and second quarter phenomena as we go through the selling season. We're keeping production levels in China pretty low so that we can use the selling season to kind of soak up the inventory that's there. But certainly, there is not years' worth of sales.

Ann Duignan - JPMorgan Chase & Co.

Well, that was actually the President of LiuGong and also confirmed by comments on excavators in particular. And then can you talk about in general reducing your inventories, are you having to use financial services as a way of incentivizing sales in anyway, both either you or the dealers. We look around the world and it doesn't seem like the greatest environment we're trying to liquidate inventories. Can you talk a little bit about what you're having to do to get those inventories down?

Mike DeWalt

Yeah, and I feel like in a little TV commercial we're doing it the old fashion way. If you think of inventory as a bucket with water flowing in and water flowing out, we've severely restricted the water flowing in. So we have really lowered production. That's the main driver of inventory down. There is no fire sale of finished inventory going on, it's lowering our production.

Ann Duignan - JPMorgan Chase & Co.

So no extended terms or changes in leasing arrangements or anything on the financial services side?

Mike DeWalt

I mean nothing of any materiality, no. I mean if you just think about it in context, sales to users have been relatively flat. We've lowered -- dealer lower orders rates, we lowered production, our inventory is going down, dealers are receiving less materials, their inventory is going down. So it really has to do with what's going into the channel. What's leaving the channel I think has been fairly stable.

Ann Duignan - JPMorgan Chase & Co.

Okay, I'll leave it there and get back in queue. Thanks.

Mike DeWalt

Thanks, Ann. Next question, please.

Operator

Thank you. Our next question today is coming from Andrew Kaplowitz [Barclays Capital]. Please note your affiliation and pose your question.

Andrew Kaplowitz - Barclays Capital, Inc.

Good morning, guys. It's Barclays.

Mike DeWalt

Hi, Andy.

Andrew Kaplowitz - Barclays Capital, Inc.

Mike, can you talk about the Bucyrus business in particular, maybe talk about its execution. Sales were up in the quarter, but margins were still I think pretty low, maybe how it's trending versus your expectations?

Mike DeWalt

Yeah, I mean there's a lot of moving parts in Bucyrus. I'll make a few generalizations overall to kind of maybe frame it for the future. There is a lot that we're working on there, a lot of benefits that we're working hard to deliver. One of the things that we talk a lot about is putting Cat components in Bucyrus product, and we have what we've done that for some of the products, we've done that for some of the hydraulic shovels, have availability at Cat engines, that engineering work goes on. So, on one hand, there is a lot of extra engineering spend going on right now, Bucyrus to get that done. That's a big positive for the long term that we don't have completed yet and aren't really seeing much of the benefits. So that's sort of one point.

We are in the middle of selling off to the dealers Bucyrus distribution, and again that's a good positive for the long run for us. That puts one of the world's premiere distribution and service organizations, the Cat dealer network squarely in the middle of driving aftermarket sales for that product. But we're still in the middle of doing that. In the short term, immediately after you do that, after you sell distribution to a dealer, they have essentially bought profit stream and they have margin, and our margin goes down. So while we're in this process of transferring the distribution to Cat dealers and they're ramping up and making improvements, and we're putting inventory in place, there is going to be a bit of a lag between the time that we lose margin because they bought it and the time where the good things that they can bring to it generate higher sales.

So I think we'll probably be in a period for a year or two where we would think of sort of normalized -- I would hate to use that word, but if you look at the rest of the mining business, you have much higher margins. Because of the extra engineering work, the process of selling, distribution to the dealers, we're probably looking at more high-single digits for a while until the benefits start kicking in as opposed to mid-teens prior to the acquisition.

Andrew Kaplowitz - Barclays Capital, Inc.

Mike, that's helpful. If I could step back and ask you maybe slightly more philosophical question. If I ask you about lean inventory strategy, like, this is sort of the first - I don’t know if you want to call it mini downturn or whatever it is, to test this strategy. How would you assess this strategy? How has it worked and is there anything that you could do to improve it as you go forward?

Mike DeWalt

Well, you know there's always things you can do to improve it. I think lean inventory right now despite everything that we took out in the fourth quarter lean inventory did not – it was a piece of the total, but it wasn’t the major piece of the total. I think we still and I talked about this a little bit ago, there is still too much inventory in China and again the post Chinese New Year selling season, we think we’ll take care of much of that. Outside of that, generally speaking, it’s our view that the lean inventory is by and large they’re about the right level based on what we think we’re going to sell.

We’ve got a good performance in terms of shipping out of Lane One and I think that is certainly going to be a contributor to dealers being able to take out some more inventory. So, it’s like all things, there are things you can do better, while the overall inventory level excluding the China piece is probably close to what we would like it to be. There are some product that we wish we had less other than some products we wish we had little bit more. But I think by and large it’s about the right amount and it’s doing what we want.

Bradley M. Halverson

Hi Mike, this is Brad Halverson, maybe I will make one quick comment here. As dealers start to reduce their inventory, it really kind of delayed the benefit that of all the actions that we really started on mid-year and we’re really happy with the inventory reduction that came out in the fourth quarter. As we move forward, integrated supply chain from order to customer delivery is something we remained focused on and we’d expect improvements throughout the years and we have operating targets at all of our units as we call it inventory turns to improve in 2013 and this will remain a focus for us. We see some opportunity in this space.

Andrew Kaplowitz - Barclays Capital, Inc.

Thanks, Brad.

Douglas R. Oberhelman

I will just add also, I think you probably all read our announcement regarding Gerard Vittecoq, our Group President who is retiring in May of 2013. We’ve asked him and a small team of very deep experts on everything from lean manufacturing to integrated supply chain to order to delivery to really study where we’re right now and deliver by May timeframe, a vision and strategy to really take us into world-class levels of integrated supply chain and ordering, and I expect great things from that that study, as you're always really wound up about it and off to a great start, and we’ll probably talk more about that at an analyst meeting later this year I suppose, but that will really chart us then for the finale that I would say of our CPS efforts between now and ’15, and I am really excited about it. I will be leading that, cheerleading that and driving that the next couple of years.

Andrew Kaplowitz - Barclays Capital, Inc.

Appreciate it.

Mike DeWalt

Thanks. Next question please.

Operator

Thank you. Our next question today is coming from Eli Lustgarten. Please announce your affiliation and then pose your question.

Eli Lustgarten - Longbow Securities

Longbow Securities. Good morning everyone.

Mike DeWalt

Good morning, Eli.

Douglas R. Oberhelman

Hi, Eli.

Eli Lustgarten - Longbow Securities

Can I just have one clarification, the $85 million R&D tax credit that are all going to be taken in the first quarter?

Mike DeWalt

Yes.

Douglas R. Oberhelman

Yes.

Eli Lustgarten - Longbow Securities

Okay. Can we go back to resources; you basically said $2 billion, more than $2 billion down in the first quarter. I mean the implication and when you look at the years, the second and third quarter will be relatively flat and you hope you get enough orders to get to match the fourth quarter which was quite strong, is that sort of a fair profile of what we can expect?

Douglas R. Oberhelman

Well, Eli I’ll respectively decline – I mean, we can try to give a little guidance on the first quarter. We tend not to do quarterly. I think the way and we’ve kind of set it up and I wouldn’t say it is specific to every quarter, but I think most of the – I don’t know call it pain, inventory reduction, negative impact on sales and production and is likely to be in the first quarter. Again from an overall demand standpoint, we’re looking at right now at the mid-point anyway for 2013 to be relatively similar to 2012. Again ups and downs by segment, as you mentioned mining, weaker construction, stronger power systems relatively flat, but I think what that leaves you, if you think about most of the decline being in the first quarter at the mid-point of our range it would tell you that we wouldn’t be expecting big changes for the rest of the year.

Eli Lustgarten - Longbow Securities

Yeah. And then a follow-up, we have final Tier 4 being effective January 2014. Can you give us some idea of how that's going to affect Cat as you go through it? Do you plan to roll out the product issue at the beginning of next year? That's another big deal that we have to deal with, not as big as interim, but still some to deal with?

Mike DeWalt

I think at the risk of patting ourselves on the back too much, Tier 4 for us whether it was interim or work that's going on for final, has just gone exceptionally well. In our releases over the last couple of years and the outlook that we talked about today, you've not really heard us talk about one bad thing that was a result either on margins, pricing, costs. We haven't said one bad thing about Tier 4. The changes that we made in our R&D process, what we learned from Tier 3 we've applied, and it has gone very well. So I wouldn't expect -- if the rest of it goes anything like it has so far, I wouldn't expect anything negative.

Douglas R. Oberhelman

Yeah. Mike's right, Eli, and I will just add here that we're about halfway to Tier 4 final, and certainly January of '13 brings up another batch of new machines in throughout the year as does January '14. And then in 2015, of course, we have heavy horsepower locomotive and inland marine and ocean going coming. So, so far our teams have just performed outstandingly with quality results on Tier 4 introductions and our customers are happy, our dealers are happy, but we're really just about halfway and the next 18 months are going to be heavy as you suggested.

Eli Lustgarten - Longbow Securities

All right. Thank you very much.

Mike DeWalt

Okay, I think we have time for certainly one more.

Operator

Thank you. Our final question today is coming from Ted Grace [Susquehanna Financial Group]. Please announce your affiliation and pose your question.

Ted Grace - Susquehanna Financial Group

Hi, thank you. It's Susquehanna.

Mike DeWalt

Hi, Ted.

Ted Grace - Susquehanna Financial Group

Hey, Mike. How you're doing?

Mike DeWalt

Good.

Ted Grace - Susquehanna Financial Group

I don't know if this is for Mike or Doug or possibly if Steve is on the line, but we've talked about kind of the need for mining orders to inflect some point this year to potentially reach the goals, but could you at least characterize how sentiment feels on 2014, some mining companies have already given a framework; Vale, Freeport, Newmont to name a few, but can you just maybe give us a sense for based on what you're hearing, how you're thinking about 2014 on the Resource Industries side?

Mike DeWalt

Yeah, this is Mike. I'll start it off and I'll let the other guys chime in as they would like to, but again, what's going to happen with mining is a function of world growth. What happens to commodity demand? As Doug mentioned earlier, we're I would say cautiously optimistic on China, which is good for commodities which stabilizes prices and ought to be good for mining. So, our long-term view of mining remains I think very good. The issue of declining ore grades and deeper mines is still there. So equipment sales over the long term in our view should outpace actually even mining production. So, I think the fundamentals economically around it look pretty good for the long term on our part. I'm not personally close to the miners. I don't talk to them. So I'm afraid I don't have any insight on that piece of it.

Douglas R. Oberhelman

Yeah. I don't have much to add, it's Doug here, but I fully, fully believe that our idea on long-term mining around the world and our strategy to get after it whether it's surplus or underground is exactly the right one for this company. I'm not sure anybody saw -- could see the current cycle with what happened in China and slowdown, but having said that, we deal with cycles in this company and we have for many, many years. You know 2009 dropped 39% one year. We're used to this unfortunately, but I've got to believe that the decade out mining, the moves we've made in mining and the strategy that comes from that, if we execute well, will really pay off. I also think that at some point we're going to see world GDP above 2.5% and I don't know if it's '13, I hope it is and I don't know if it's '14, I really hope it is, but we'll see world growth move up to 3% to 4% at some point. I've got to believe that in our near-term future, if that happens, it's going to be mineral-driven. It has to be around the world as we’ve seen every time. Housing starts we’re calling for over 1 million, the drive for copper on that [SKU], if you all know that number. So, I'm still as optimistic as I’ve ever been on mining long-term. The cycle we have to deal with and we always have and we’ll get through it. But I really like the play, I think, I come back to the number of people on the planet that want to move up their standard of living and we all and over time that’s played right to mining and arguably to some of our infrastructure disruption as well. But maybe in the long-term, I’m still really bullish on what I see for mining.

Ted Grace - Susquehanna Financial Group

And then as a follow-up maybe a Brad or Mike question, if you look at the mid-point of earnings guidance and you think about pulling more inventory out and the guidance you’ve given on CapEx, it looks like it could be a really big free cash year. So, I’m wondering if you could just maybe frame out your expectations on free cash and then just philosophically how you’re thinking about use of cash whether it’s continuing to kind of fortify the balance sheet and build cash, any change in use towards dividend increase or buybacks and things of that sort, that would be great.

Mike DeWalt

Well, that’s very longwinded question, Ted, and I’ll get started on that. I think if you look at – we report on operating cash flow, so let’s use that for a proxy, I think our expectation is that at the midpoint of our outlook range, we would see operating cash flow substantially better in ’13 than ’12, I mean, substantially. And the factors are declining inventory rather than increasing inventory, and I think there is a little bit of a timing impact there as well. I mean, we took $2 billion out of inventory in the fourth quarter and that was split between raw material work-in-process and finished goods, and so we had a quite sizable decline in payables related to that, and as that kind of stabilizes out, you won’t have that year-over-year negative on that. So, I think all in all, from a cash flow perspective, 2013 looks like a better year relative to ’12 than if you just look at the profit relative to ’12. And I think beyond that in terms of our overall structure of our balance sheet, nothing has really changed over the last 30 days or three months in terms of what we’re thinking about the future and how we structure the balance sheet.

Bradley M. Halverson

I would just say Mike, our balance sheet is strong right now. Our debt-to-cap is 37% under 30% on a net-to-cap basis. We’ve over $5 billion in cash and so we did manage our CapEx down this year below expectations as the volume moved and so, we think we’re in a great position. Capacity wise we’re in a great position moving forward and clearly our priorities for cash that we’ve talked about many times has not changed.

Mike DeWalt

Thanks, Ted.

Ted Grace - Susquehanna Financial Group

That’s great guys. Congratulations. Good luck this quarter.

Mike DeWalt

We are little past time, thank you for joining us and we will sign off.

Operator

Thank you ladies and gentlemen; this does conclude today’s conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Rates

View Comments (0)