Caterpillar Inc. (CAT) Q2 2013 Earnings Conference Call July 24, 2013 11:00 AM ET
Mike DeWalt – Corporate Controller
Douglas R. Oberhelman – Chairman and Chief Executive Officer
Brad Halverson – Group President and Chief Financial Officer
Robert Wertheimer – Vertical Research Partners
Ann Duignan – JPMorgan
Ross P. Gilardi – Bank of America Merrill Lynch
Ashish R. Gupta – Credit Agricole Securities, Inc.
Andrew Kaplowitz – Barclays Capital, Inc.
Jamie L. Cook – Credit Suisse Securities LLC
David M. Raso – International Strategy & Investment Group LLC
Good morning, ladies and gentlemen, and welcome to the Caterpillar Earnings Call. At this time, all lines have been placed on a listen-only mode, and we will 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.
Thanks, Kate, and good morning, everyone, and welcome to our second quarter earnings call. I’m Mike DeWalt, Caterpillar’s Corporate Controller. On the call today I’m pleased to have with me our Chairman and CEO, Dough Oberhelman; and Group President and CFO, Brad Halverson.
This call is copyrighted by Caterpillar Inc., and any use, recording, or transmission of any portion of this call without our written consent is strictly prohibited. If you would like a copy of today’s call transcript, we’ll be posting it in the Investor Section of our Caterpillar.com website, and it’ll be in the section labeled Results Webcast.
Now, this morning, undoubtedly 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. Our discussion of some of the factors that either individually or in the aggregate, could make actual results differ materially from our projections, that can be found in our cautionary statements under Item 1-A, Risk Factors, of our Form 10-K filed with the SEC in February of this year, and also in the forward-looking statements language in today's release.
Now, in addition, a reconciliation of non-GAAP measures can be found in our financial release, and again that’s been posted on our website at Caterpillar.com.
Now, before we start the Q&A today, I’m going to be covering three main topics. The first will be a summary of our second quarter results and revised outlook. And then I’m going to take a few minutes and talk a little bit about our business segments and then I’m going to finish up with cash flow and the stock repurchase that we talked about this morning.
So I’ll start with second quarter, which I’m going to discuss in two ways. First, I’m going to cover at a high level our second quarter results versus the second quarter of 2012. And then I’m going to discuss the specific headwinds that we faced in second quarter and how we are thinking about them going forward, and our expectations for the second half of 2013. First, compared to the second quarter of 2012, our results this morning were quite a bit lower. But to put the year-over-year comparison in context, the second quarter a year ago was certainly a tough comparison. The headline from last year’s second quarter started with Caterpillar reports best quarter in history.
Sales this quarter were – sales and revenues were $14.6 billion and that’s a 16% decline from the second quarter of 2012. And this morning, we reported profit at a $1.45 per share and that was down $1.09 from the second quarter of last year. Now the sales and revenues declined versus last year and dollars was about $2.8 billion and about half of that was the result of dealer inventory changes and the other half from lower end-user demand. Now in last year’s second quarter, dealers bought more machines from Caterpillar than they delivered to customers. And their machine inventories rose again last year about $300 million.
In the second quarter of this year 2013 it was the reverse. Dealers bought less from us than they sold to the customers, and their inventory of new machines as a result declined about $1 billion. So in combination, the impacts and the changes of dealer machine inventories was negative by about $1.3 billion for the quarter-over-quarter. The remaining sales decline was the result of lower end-user demand for machines and to a lesser extent, power systems. The decline in profit was largely a result of that drop in sales.
And on page 6 of this morning's financial release, we have a waterfall chart that would step you through the quarter-to-quarter changes in operating profit. It shows a decline in total from last year to this year of about $1.59 billion and lower volume, which includes product mix more than accounted for the total decline in operating profit.
So the overwhelming story on a quarter-to-quarter profit decline was volume. And I think the waterfall chart covers the other pluses and minuses reasonably well. So I'm going to change gears a little here and talk about the headwinds in the second quarter and how we are thinking about them relative to the second half of the year and we'll start-off with dealer inventory.
As I mentioned before dealers took out about $1 billion of inventories in the second quarter. And that was a sales headwind for us as our sales were about $1 billion below end-user demand. In terms of what that means for the second half of the year, well we expect that to continue. We think dealers are going to take inventory down another $1.5 billion to $2 billion or so between now and year-end.
The continued dealer inventory decline, in fact is the main reason that we lowered our sales and profit outlook for 2013 this morning. We're expecting sales and revenues in a range of $56 billion to $58 billion, and profit of about $6.50 a share to middle of that sales and revenues range. That's a drop of about $2 billion on the top line and $0.50 a share at the bottom line. So, dealer inventory reductions where headwind in the quarter and the main reason we lowered the outlook.
Now our inventory was also a headwind in the quarter. In addition to what the dealers took out, we cut inventory by $1.2 billion in the quarter. That was negative to profit from a cost absorption standpoint. And just to help you get a handle on the profit impact, we use a rule of thumb of 13% to 15% of the inventory change.
The year-end expectation for our inventory is that it will end the year about where it ended the second quarter. That means we do not expect the profit headwind that we had in the second quarter from inventory absorption to continue in the second half of the year. In addition, we also had a substantial currency headwind in the second quarter. And in this context, I’m not really talking about year-over-year, I’m not talking, I’m not comparing the second quarter year-ago. I’m talking about actual translation and hedging losses with a lot of $134 million that happened in the quarter and were reported in the other income and expense line of our P&L, which is a couple of lines below operating profit on the P&L.
Now as we put our outlook together, we don’t forecast future currency movements. We do our outlook based on exchange rates as they are. As a result, our outlook does not expect currency translation and hedging losses in the second half of the year like the $134 million in the second quarter.
Now the flip side of that is we did have a positive item in the quarter. We had $135 million gain on our settlement related to the Siwei acquisition and that’s also something that we don’t expect to repeat. So as we’re thinking about the second half of the year, kind of relative to the second quarter, the average sales for each of the two quarters on a quarterly basis in the second half, it’s about the same as the second quarter, but we don’t think we’ll have the negative cost absorption impact like the second quarter had. We don’t think we’ll have the $134 million at least in our outlook of currency losses, and the Siwei $134 million gain, we don’t expect to continue.
The other difference that you need to take into consideration is that we’re taking additional actions to reduce costs in the second half of the year. Now, we started taking action in the second quarter, and began implementing cost reduction measures and we’re going to do more of that in the second half of the year.
Okay. that’s enough for now on the quarter and the outlook. I’d like to change gears just a little bit and talk about segments. I’m going to start by saying that our largest segment this year by sales has been Power Systems. Our most profitable segment this year has been Power Systems. The highest margin rate of any segment this year has been Power Systems.
Now I know that most of you are on the phone here today already know that, but there are many casual observers of Caterpillar that if you ask them that question, what is that mining, which is in our Resource Industries segment. The point of this discussion is that we serve a number of different cyclical industries, but thankfully, they don’t all follow the same path at the same time. The diversity within and in fact, between our segments have to mitigate year-to-year swings in sales, both down and up for the company.
The Power Systems segment again; our largest and most profitable segment over the past five years has also been relatively speaking the most stable of our two large equipment segments. and that’s because it spent a number of different industries itself electric power, oil and gas, rail, marine and industrial engines. And actually, even within those industries, there is diversity, in oil and gas for example. Our sales of engines for drilling and fracking are weaker and gas compression continues to do pretty well.
Moving on, our Construction Industries segment sells an extensive range of construction equipment around the world to support infrastructure development, commercial and residential construction. The worldwide construction industry is showing signs of recent improvement that remains relatively depressed from a historical standpoint. Construction in the United States well starting to turn up, it’s still far below the 2006-2007 peak, and the construction equipment and industry in Europe is as you’d expect well below the prior peak, and construction equipment sales in China in 2013, we expect to be about half of they were in 2011.
The point is, there is a lot of room to grow, just to get back to where we’ve been before. When economic and construction activities begin to improve in the world, particularly in the U.S. and hopefully, eventually in Europe, it should be a positive for our business. Our Financial Products segment is also important to our business and it’s doing very well. It provides financing to end-users that purchase our equipment and it also provides financing for some Caterpillar dealers. Financial Products revenues and profit have proven to be much more stable through the business cycle than our product related businesses, and they’re currently performing well. Revenues this quarter were up 5% from the second quarter a year ago, and profit was up.
Now the segment that’s currently getting significant attention is Resource Industries, which is primarily mining. Now I’m going to give you one down of what’s happening in mining. But before I do that, I’d like to point you to today’s financial release. And on page 16 in particular, question number five in the Q&A in the back of the release, we’ve tried to provide a pre-comprehensive discussion of the mining industry and how it impacts our sales. Now the high points of that discussion start with the production of mine commodities and the underlying health of that mining industry relies on commodity demand and production, and based on the data that we’ve seen, it looks like mining production in 2013 is going to be a little higher than it was in 2012.
And recently a couple of the big public mining companies have reported they’re producing at record levels. Now commodity production underpins the need for mining CapEx. And despite 2013 increases in commodity production, it’s clear that mining companies are currently cutting their CapEx after significant increases in 2011 and 2012. While we don’t specifically accumulate CapEx estimates ourselves for the industry, we do the follow the market surveys. Based on those surveys, it appears total mining CapEx in 2013 is likely to be down 5% to 10% from 2012. And those some surveys are also indicating further CapEx decline near 20% for 2014.
Now the mining industry CapEx includes spending on exploration and developing, buildings and structures and things like processing plants and equipment. At Caterpillar, we’re mostly impacted by spending on equipment, while we don’t have a consistent CapEx yield at that level of detail for the industry worldwide; we have reviewed data at the level of details from the Australian Bureau of Statistics, and it tells us that over the past few years, the largest and fastest growing category of CapEx in Australia was four buildings and structures, and while this is the largest category, the most significant declines in 2012 have been for exploration and development and equipment and based on our own experience with large capital projects that makes sense to us. It’s difficult to stop construction on large-scale facilities once they get substantially started. That means in the short-term, we believe that more of the decline in mining CapEx is for equipment, things like Caterpillar machines.
It now leads us to end-user demand for our products. That’s how much CAT dealers are actually delivering to end-users of mining companies. Year-to-date deliveries to end-users and our expectations of what dealers will deliver for the full year are declines of about 20%. While dealer inventories are down – while dealer deliveries, I’m sorry, are down, for the type of equipment that we make we believe we are doing a little better than the equipment industry overall. And that brings us to resource industry sales. So we started with CapEx, we’ve moved onto end-user demand from our dealers and now to our sales.
And to relate the decline in mining equipment demand placed on our dealers or sales need to consider several other factors besides mining CapEx. Our resource industry segment includes things that are not directly related to mining CapEx like aftermarket part sales as well as equipment sales to the forestry, paving and quarry, and aggregate industries. Although, resource industry sales of aftermarket parts are down a little in the second quarter of 2013 compared with the year ago, the decline is much less than the decline for equipment and in the context of the total decline in sales, the resource industries is just not a significant factor.
And the collective sales of equipment for forestry, paving and quarry and aggregates, are also down, but again, the vast majority of the decline in resource industry sales for the quarter, the second quarter of 2013 is mining equipment.
Now, in addition to those factors to understand our sales, we also need to consider dealer inventory changes. Dealer inventory increased in the second quarter last year and it declined substantially in the second quarter of 2013. That means that last year we were selling more products to dealers than they were delivering to the end-user and mining companies.
And in the second quarter of this year, we sold far less equipment than dealers were selling to mining customers. In fact, our sales of traditional CAT Mining equipment such as mining trucks, large track excavators and wheel loaders would have had to vend more than 50% higher in the second quarter to match what dealers were delivering to end-users.
In the second half of 2013, we expect that dealers will continue to substantially reduce their inventories. And that means we expect to continue to undersell mining demand for the remainder of 2013.
Given the substantial decline in sales in 2013, the uncertainty around when cyclical recovery will resume, we’ve taken substantial action to adjust our production levels and to reduce costs. We expect to take further action in the second half of the year. Now, our intention is to reduce costs and drive operational improvements and do it in a way that doesn’t significantly reduce our ability to ramp up when production improves.
I know many of you would like to get a better understanding of what we think will happen after 2013. Now, we're going to discuss that here for a couple of minutes, but we want to start by saying, we are not providing sales outlook for 2014 either for resource industries or for CAT in total. It’s certainly too early to do that. And the activities over the past five years in the mining equipment industry certainly reinforced that. It has experienced significant demand shifts, goes up and down in the mining industry overall has had difficulty in forecasting those shifts in advance and frankly, that’s impacted our forecasts.
We understand that as a part of being in this industry. And this year is a good example as mining companies have been cautious and dealers have reduced our inventories. What we will discuss here this morning is what the industry surveys, not our forecasts, but what the industry surveys about next year suggest and what that could mean and the impact of dealer inventory reductions wind down.
Now, earlier I mentioned that, we’ve seen surveys that suggesting another 20% decline in the mining CapEx in 2014 from 2013. Again, that’s not our estimate, and we’re not providing an outlook. But if you take that CapEx survey at face value, it suggests another down here in 2014. To put mining CapEx in the context of our sales though, you have to consider the impact of dealer inventories.
Even if dealer deliveries of new mining equipment were to be down 20% next year from 2013, if we see an end to the dealer inventory reductions over the next few quarters. We believe our sales of new mining equipment to dealers would be positive. In other words, we believe the significance of the end of dealer inventory reductions would have a more significant positive impact on year-over-year sales than our 20% decline in end-user demand.
Just to clarify this, we’re not suggesting an increase in inventories next year. Just the absence of the big declines in 2013 that pulled our sales well below what dealers are delivering to mining customers.
Now, in addition to that, if the world economy continues to improve, we would expect commodity productions to also increase and that coupled with the relatively large number of new machines placed in service over the past several years, that should be a positive for mining aftermarket part sales. Again, this is not a forecast for 2014, this time, too early to do that. The preference of this discussion was just to illustrate for you the significance that dealer inventory changes are having on our mining business today and what the implications are for when the decline comes to an end.
Now, looking further ahead, our long-term view of mining remains positive. Commodity demand is driven by economic growth, population increase and the rising standards of living, and we believe that will all continue to improve over the long-term. In addition, declining ore grades imply that in the future more material will need to be moved per ton of commodity output, and that’s another positive, at least, from our perspective for long-term equipment needs.
Finally, much has been written and said about the impact of China on commodity demand in the mining industry. Our long-term view of China is also positive. We expect continued urbanization and improvement in standard of living for the people of China. We believe that means more electricity production will be generated and increased production and consumptions in general.
Now, increasing electricity production in particular is a positive for coal. Coal makes up a large portion of the electricity generated in China and they continue to add coal fire capacity. Now that said, we do not expect the significant economic growth rates that China experienced over the past 10 years will continue indefinitely. But we do believe that China will continue to grow at a much faster pace than the rest of the world. And it’s also important to remember that over the past 10 years, the size of the Chinese economy has more than doubled, and that means that economic growth rates of 7% to 7.5% had a greater impact today than a 10% growth rate would have had 10 years ago. It’s a big economy that relative to the world in total is growing faster.
So in summary on mining, we don’t expect much change in the environment in the short-term and the remainder of 2013 will be tough for our mining business. As dealer inventory reductions come to an end, our mining equipment sales could rise from 2013 levels, even if mining CapEx declines. And our long-term of mining remains positive. the world needs mine commodities. As the world grows, we believe commodity demand will continue to increase.
One last quick topic, and then we’ll go on to the Q&A, and that topic is cash flow and cash deployment. While it was certainly a tough quarter for sales and profit, our Machinery and Power Systems operating cash flow was better than it’s been in a long time. We generated $3 billion worth of the operating cash flow in the quarter, and that’s a substantial increase from $1.3 billion in last year’s second quarter, and we’ve put that to work for stockholders.
In the second quarter, we have repurchased $1 billion of CAT stock and we announced a 15% increase in the quarterly dividend. And in this morning’s financial release, we announced that with the strength of our cash flow, balance sheet and cash on hand, we expect to repurchase an additional $1 billion of CAT stock in the third quarter. Repurchasing stock in the downturn has been a key part of our cash deployment strategy and we are executing on it.
So with that, we are ready to open up the floor for Q&A.
Earnings Call Part 2: