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Edited Transcript of FTT.TO earnings conference call or presentation 21-Feb-19 4:00pm GMT

Q4 2018 Finning International Inc Earnings Call

CALGARY Mar 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Finning International Inc earnings conference call or presentation Thursday, February 21, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* L. Scott Thomson

Finning International Inc. - CEO, President & Non-Independent Director

* Mauk Breukels

Finning International Inc. - VP of IR & Corporate Affairs

* Steven M. Nielsen

Finning International Inc. - Executive VP & CFO

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Conference Call Participants

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* Ben Cherniavsky

Raymond James Ltd., Research Division - MD of Industrial Research

* Cherilyn Radbourne

TD Securities Equity Research - Analyst

* Derek Spronck

RBC Capital Markets, LLC, Research Division - Analyst

* Devin Dodge

BMO Capital Markets Equity Research - Analyst

* Jacob Jonathan Bout

CIBC Capital Markets, Research Division - MD of Institutional Equity Research

* Maxim Sytchev

National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst

* Michael Doumet

Scotiabank Global Banking and Markets, Research Division - Analyst

* Michael J. Feniger

BofA Merrill Lynch, Research Division - VP

* Yuri Lynk

Canaccord Genuity Limited, Research Division - Director and Senior Engineering & Construction Equity Analyst

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Presentation

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Operator [1]

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Thank you for standing by. This is the conference operator. Welcome to the Finning International Fourth Quarter 2018 Conference Call and Webcast. (Operator Instructions)

I would now like to turn the conference over to Mauk Breukels, Vice President, Investor Relations and Corporate Affairs. Please go ahead.

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Mauk Breukels, Finning International Inc. - VP of IR & Corporate Affairs [2]

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(technical difficulty)

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [3]

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(technical difficulty)

And as a result, we experienced delays in delivering parts and components to mining customers. We estimate this created a USD 50 million shortfall in mining product support revenues in the quarter and a corresponding increase in parts inventory. I want to assure you that this experience is completely different from our ERP implementation in Canada 7 years ago. In South America, our interfaces with Caterpillar are working. And we are receiving and shipping the right parts to our facilities and customers. Our velocity issue is localized the parts flowing through our component rebuild center, which services our Chilean mining customers. We understand the root causes and are addressing them. As the speed of processing customer parts orders improves, we should see a return to normal revenue run rates in the second quarter.

In Argentina, we exited the year with breakeven profitability after significant cost reductions in the quarter. We estimate that the combined impact of the product support revenue shortfall in Chile, and the severance and one-off costs in Argentina was approximately $0.12 on our Q4 EPS.

On the positive side, our Canadian and U.K. operations had a very successful year. Canada finished the year with a record quarterly revenue of $1 billion driven by strong new equipment sales. In 2018, Canada's return on invested capital was up 300 basis points to 16.2%. EBIT margin of 7.9% increased by 60 basis points and invested capital turnover improved by 13% to 2.05x. U.K. and Ireland's return on invested capital increased to 14.2% up 140 basis points from 2017, as EBIT margin moved up 80 basis points to 4.4%. And we generated positive free cash flow for the sixth consecutive year in a row.

I will now comment on each of our regions. With respect to market conditions in Chile, mining activity has improved from low levels. In the near term, we are optimistic about some large-scale mining developments in the region, but are concerned about the long-term outlook for China, which may impact the demand for copper. Ultimately, we do expect that increased copper production will improve demand for mining equipment and product support. In addition, the Chilean government has announced public investments in infrastructure which is expected to benefit the construction sector and generate improved demand for construction equipment and product support in the medium term.

In Argentina, the economy has stabilized but market activity continues to be weak. In response, we have reduced our workforce there by about 25% and closed 4 branches. Going forward, we expect a higher return on invested capital in South America to compensate for its risk profile. With the ERP spend behind us, we are now focused on improving the velocity and deriving the benefits from the system. Our objective is to return to 8.5% to 9% EBIT margin in the second half of 2019. If we do not see an improvement in business conditions, we may need to take further actions.

In Canada, we achieved a couple of records this quarter. Our customer loyalty scores were the highest ever, and we exceeded $1 billion in quarterly revenue for the first time. We finished the year with very strong new equipment deliveries across all sectors, particularly mining. We've been keeping a close eye on market conditions in the oil sands and generally, in Alberta. Our Fort McKay shop is extremely busy. Oil sands activity has remained strong as producers and contractors are using machines for overburdened removal projects, and we are rebuilding a lot of equipment for them. The improvement in the Western Canadian Select oil price differential and reduction of production curtailments are a positive development for the oil sands business and have decreased the level of uncertainty in the sector for the short term.

The introduction of autonomous trucks is going well. We finished the year with 13 autonomous trucks operating in Western Canada. I'm also pleased that we just closed the deal with a large oil sands producer for 12 797 400-ton trucks. These trucks will be delivered throughout 2019.

The U.K. closed off the year with strong new equipment sales in the electric, power and industrial segments. We are pleased with the improved profitability of our U.K. operations following the successful business transformation initiatives undertaken over the past few years. In preparation of various Brexit scenarios, we have developed response plans to mitigate operational impacts. Despite the political uncertainty surrounding Brexit, we expect robust infrastructure spending to drive healthy activity levels.

We have committed to generating positive free cash flow through the cycle. In 2018, we generated $78 million in free cash flow, while our new equipment sales were up 26% for the year. Since 2013, our free cash flow amounted to nearly $1.9 billion. In 2018, we increased the quarterly dividend by over 5%, and our dividend has grown at a compound annual growth rate of approximately 6% over the last 5 years. We also returned capital to shareholders via share buybacks. During the year, we repurchased $110 million worth of shares, $100 million of which was in the fourth quarter. In addition, we made a strategic complementary acquisition with the purchase of 4Refuel, which closed on February 1. These capital allocation decisions were enabled by our focus on generating positive free cash through the cycle and maintaining the strong balance sheet. Going forward, you can expect us to continue to maintain our capital discipline.

While we see continued robust market activity in most of our regions, and we enter 2019 with a good backlog and steady order intake, we are concerned about the external environment. Ongoing international trade tensions, the uncertainty regarding the outcome and impact of Brexit and reduced capital spending in Western Canada are not helpful. We are monitoring market conditions closely and are using data and technology to identify further opportunities to lower our cost to serve. As a prudent measure, we have also been taking steps to reduce our equipment inventories and are dialing back our capital and rental expenditures by 20% from 2018 levels. Despite the uncertainty in the external environment, we do expect revenue growth in 2019, albeit at a low level.

Given the ramp up in parts flow in Chile in Q1, our Q1 earnings will be similar or slightly below Q4 earnings per share. However, for the entire year, we expect to see profitability improvements in all 3 regions. The combination of earnings growth and significant free cash flow generation in 2019 will result in meaningful improvements in return on invested capital across the enterprise.

I will now turn it over to Steve.

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Steven M. Nielsen, Finning International Inc. - Executive VP & CFO [4]

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Thank you, Scott. Good morning, everyone. We finished the year strong in Canada, in the U.K. and Ireland. However, as Scott discussed, with the implementation of the new ERP system, our Chilean business was impacted by reduced speed of processing parts orders primarily in support of mining customers. In Canada, we saw very strong new equipment sales, driving our revenues to a quarterly record. These sales included significant mining deliveries as well as increased demand from construction customers. Some of whom are utilizing their capital budgets and taking possession of equipment before year-end to benefit from accelerated depreciation for tax purposes.

Product support activity in mining was solid, with continued strong overhaul activity. In the construction sector, demand for product support in British Columbia was robust. However, we saw slower demand for products in Alberta's construction sector in the fourth quarter, mostly in response to the sharp decline in the price of oil.

Our rental strategy is progressing well. Revenues were up 11% from the fourth quarter of last year and work continues to optimize the cost structure of our rental business. As expected, the significant shift in revenue mix to new equipment sales resulted in lower margins in Canada in the fourth quarter. Fourth quarter EBITDA margin was 9.7% compared to adjusted EBITDA margin of 10.5% a year ago.

On an annual basis, Canada's new equipment sales were up 48%, while product support revenues increased by 10%. SG&A as a percentage of revenue declined by 270 basis points from last year driven by leverage of incremental revenues on fixed costs. Adjusted return on invested capital of 16.2% was up 300 basis points on improved profitability and capital efficiencies. The working capital sales ratio in Canada was down 300 basis points from 2017.

In the U.K. and Ireland, activity levels continued to be robust in the fourth quarter, particularly in the electric, power and industrial segments. Construction volumes were also higher than in the prior year. Revenues increased by 13% on functional currency and were up in all lines of business. Fourth quarter EBITDA margin was 5.7%, up 50 basis points from the prior year. For the full year, U.K. and Ireland's EBITDA margin improved by 80 basis points to 6.9%, driving a 140 basis point increase and return on invested capital to 14.2%.

Turning to South America. In Argentina, although the economy has stabilized, customer activity remained weak and volumes were down significantly. In the second half of 2018, construction industry activity in Argentina was down more than 75% from the second half of 2017. Reduced profitability in Argentina continued to negatively impact our results in South America in the fourth quarter. After having rightsized our business in Argentina, the operations were a breakeven for the latter part of the quarter, normalizing for about USD 2 million in severance as well as other provisions.

In Chile, we saw another quarter of improved new equipment sales increasing 60% over the fourth quarter of 2017. The decline in product support revenues in Chile was attributable to the delays in delivering parts and components to our mining customers with the implementation of the new ERP system. The parts velocity will be increasing throughout the first quarter, and we expect to return to normal revenue run rates in the second quarter. Once we restore the speed of processing parts orders, we will focus on leveraging the ERP to drive efficiencies, improve velocity and reduce the cost to serve. As Scott stated, our priority in 2019 is to improve profitability and return on invested capital in South America.

Our focus remains on generating positive free cash flow through the cycle, maintaining a strong balance sheet and disciplined capital allocation. We generated $418 million of free cash flow in the fourth quarter, driven by strong equipment deliveries and collections, particularly in Canada. This brought our annual free cash flow to $78 million. An expected low-growth environment in 2019 coupled with approximately 20% less capital and rental fleet expenditures, should allow us to generate stronger free cash flow compared to 2018.

With regard to the implementation of IRS-16, we will be adopting a modified retrospective transition option. This means that, as of January 1, 2019, our balance sheet will be an adjusted for IFRS 16. While we will not be restating our 2018 comparative figures, starting with the first quarter of 2019 results, we will call out any material impacts on the year-over-year variances relating to IFRS 16.

I will now turn it back to Mauk for questions and answers.

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Questions and Answers

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Mauk Breukels, Finning International Inc. - VP of IR & Corporate Affairs [1]

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Operator, that concludes our remarks. Before we go to the Q&A, we request everyone on the line that you ask no more than 2 questions when it is your turn. Please go to the end of the queue, if you have more questions. Operator, can you please open up the line?

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Operator [2]

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(Operator Instructions) The first question comes from Michael Doumet with Scotiabank.

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Michael Doumet, Scotiabank Global Banking and Markets, Research Division - Analyst [3]

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Just given the issues around the ERP and the tougher comps in Argentina, any way you can size up or give us your expectations for product support and margin expectations for the first half in that region in 2019?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [4]

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Yes. So -- and that's what we tried to do on the call is one of the reasons the earnings per share will be similar or slightly below Q4 because as we ramp up -- we are ramping up velocity on the parts, but you've got 3 months of the ERP impact as opposed to 6 weeks. So Q1 is going to be a tough quarter in South America. And I think by Q2, we expect to have that parts flow velocity behind us in Q2. And I think you'll get back to a normal profitability range pre-ERP in Q2, and then in Q3 and Q4, we're expecting to get to that 8.5% to 9% range. So I hopefully that helps.

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Michael Doumet, Scotiabank Global Banking and Markets, Research Division - Analyst [5]

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Yes. No, it is. And maybe just a longer-term question. I mean, you're targeting decent sized improvements in ROIC and SG&A in the next several years. Any way you can size up that potential lever absent of -- or with the expectation of lower operational leverage. Like where, in your view, are the largest opportunities to drive the most efficiencies?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [6]

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Yes. So -- look, Canada and South America, these are the 2 big opportunities for us. And I think, in Canada, the team's done a great job, getting after the cost structure. And you see that in the G&A percentage of sales, and you also see that in the ROIC going up 300 basis points to 16%. I still think there is more opportunity to be more lean and more agile. I think, it's a combination of the technology enablements, data driving better decision making, the service business becoming a little bit more efficient. And Kevin, now in charge of the U.K., I think is going to bring some of the things that he did in the U.K. to back Canadian business, and you see the results in the U.K. So I do feel pretty comfortable that there's a lot more room to improve on that ROIC side in the Canadian business. On the South American business, we do have an SG&A percentage of sales which is too high, right, and the sales part of that hasn't been cooperating like we thought it would with Argentina falling off and Chile being a little bit slower to ramp up. We do think South America will continue to see the revenue growth and outsized revenue growth, but there is some concerning signals on the horizon with China. And I'm glad to see that there seems to be some progress on the tariff discussion between the U.S. and China. But I do think China has got some issues around gross capital, infrastructure spend and trying to transition to a consumer environment and how that's going to impact the demand for copper long term is still to be determined. And I think, we're going to have to take that into consideration when we think about the cost structure for our Chilean business.

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Operator [7]

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The next question is with Jacob Bout with CIBC.

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [8]

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Yes. We couldn't hear you on the first part of the call, but I think, you said it was $0.12 impact on the fourth quarter for Argentina in the ERP. But what was the split between the 2?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [9]

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Yes. Sorry Jacob, did you -- where you did not hear me to? Because I heard it a little bit, and I just want to make sure everyone got the message out. So what part of the call did you start hearing me and not hearing me?

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [10]

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Yes, just before that.

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [11]

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Okay. So you didn't hear anything before that?

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [12]

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Yes, the first, I don't know -- 4 or 5 minutes, couldn't hear you.

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [13]

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Okay. Well, that's a problem. So let me tell you what the breakdown was and then I'm going to repeat some of my messaging in the first 4 minutes, okay? So the ERP is about $0.09 and Argentina was about $0.03, okay?

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [14]

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Yes.

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [15]

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I'm just going to repeat a couple of the things that I said in that first couple minutes because I think it's pretty important that everyone hears that message. So a recognition that Q4 in South America was weaker than we expected. In mid-November, the implementation of the new ERP system reduced our transactional velocity for parts. And as a result, we experienced delays in delivering parts and components to mining customers. We estimate this created a USD 50 million shortfall in mining product support revenues in the quarter and a corresponding increase in parts inventory. I went on to say I want to assure everyone that this experience is completely different from our ERP implementation in Canada 7 years ago. In South America, our interfaces with Caterpillar are working. And we are receiving and shipping the right parts to our facilities and customers. Our velocity issue has localized the parts flowing through our component rebuild center, which services our Chilean mining customers. We understand the root causes and are addressing them. As the speed of processing customer parts orders improves, we should see a return to normal revenue run rate from the second quarter. And then lastly, I said, in Argentina, we exited the year with breakeven profitability after significant cost reductions. And that was something that we told the market we were going to do at the last quarterly call. I thought it was important to call out. So that was what was before the $0.12 breakout. Hope that's helpful.

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [16]

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Yes. No, that's very helpful. Maybe my second question here just on the Canada outlook. So you talked about the oil sands being stable, power system demand increasing, construction steady. As a percentage of the overall Canadian revenues, what would that represent and what is the outlook for the (inaudible)?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [17]

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Sorry. Repeat that Jacob. The oil sands -- repeat the question, sorry.

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [18]

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Yes. Just trying to understand. So you gave a bit of an outlook here for Canada just talking specifically about your end markets, oil sands, stable power systems, increasing construction steady. As a percentage of revenue, what would that represent? And what would be the [rest]?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [19]

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Yes. So where the -- we do think we're going to see positive revenue growth in Canada next year albeit at low levels. And I think the breakdown is about similar between parts and new equipment. And so then the question is, on the back half of 2018, what's -- why the weakness? Because if you look at 2018, I think Steve highlighted, our equipment was growing at 40% and our parts were growing at around 10%. So where's the weakness? We're not seeing a lot of weakness right now, in the oil sands to tell you the truth. I mean, the production curtailments had some impact, but it was minor. And our rebuild facility and OEM and Fort McKay are all real busy. Where we did see a little bit of weakness starting probably in December was in the general construction segment, around parts. And that started to weaken a little bit in December, continued a little bit in January, so we're watching it closely. But that would be the area that's a little bit of the concern for us in terms of overall weakness. And that's why we're moderating the product support growth from 10% growth in 2018 to lower levels.

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Jacob Jonathan Bout, CIBC Capital Markets, Research Division - MD of Institutional Equity Research [20]

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And that's more of a -- in Alberta versus BC?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [21]

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Yes. It's definitely Alberta. Sorry, I should have highlighted that. It's an Alberta issue.

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Operator [22]

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The next question is from Cherilyn Radbourne with TD Securities.

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Cherilyn Radbourne, TD Securities Equity Research - Analyst [23]

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Scott, I just wonder if you could kind of walk us through your expectation for low revenue growth in 2019? What are some of the major puts and takes there? And would you say that visibility is different if we're thinking about the first half versus the second half?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [24]

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Yes. That's helpful. I mean, when I say lower revenue growth, I mean it, almost -- it's interesting, it's kind of across all 3 regions. So the low revenue growth in Canada, as I described it to Jacob, so both on the parts and equipment side. In the U.K., similar, we actually saw some great product support growth, and we're expecting that to continue. But there is a little bit of uncertainty right now with Brexit in the first half of the year, and I think we'll get through that, I think we're going to get through Brexit in a rational fashion. But there is some people sitting on the sidelines right now holding back and that's impacted us. In South America, I would have been a little bit more positive about something other than low revenue growth. And I do expect in the back 3 quarters of the year, pretty significant revenue growth in South America. But the first quarter, given where we are still ramping up the velocity, it's going to be weaker than we would have liked. And so all in all, you will see positive revenue growth in South America, it's just going to be impacted by the first quarter. So hopefully -- and then the split between parts and equipment, as I looked at it, is about similar. So when I say low, it's kind of low in both, it's not overrated to one or the other.

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Cherilyn Radbourne, TD Securities Equity Research - Analyst [25]

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Okay. And could you sort of give us some color on the purchasing behavior of your mining customers in South America? And how they're responding to just the ongoing trade tensions and the need for clarity about the trajectory of the Chinese economy? Or like if we set ERP aside, were mining parts orders up in the Q4?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [26]

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Yes. So -- and I'm not trying to normalize for ERP because you cannot normalize. But if you added back that $50 million that sitting in inventory, Q4 product support would have been similar to Q3. And when you compare Q4 over Q4, it looks like a reduction, but when you actually strip out Argentina and the impact of Argentina, it's kind of flat in Chile. So no growth year-over-year in Chile, but not a decline either, which is positive. I mean, I think, I do think the trade discussions and the tensions are having an impact honestly. And if you look at copper price today, it's recovered a bit, but if you went back to January 1 or 2, it was an 18-month low. And I just think there is some uncertainty out there right now. I do think, ultimately, Chile is a great place to do business and you'd seen some kind of big projects on the horizon with Teck and Goldcorp, and Barrick announcing yesterday that they're going to invest in Chile. So I do think Chile is a great place to do business, but it is taking a little bit longer to ramp up than I thought. And I think China is a little bit more uncertain than we all thought 3 or 4 years ago. And you're seeing that in some of the data coming out of China with imports and exports down. And that is a little bit concerning, as you think, 5, 10 years out for demand for copper.

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Operator [27]

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Next question is from Yuri Lynk with Canaccord Genuity.

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Yuri Lynk, Canaccord Genuity Limited, Research Division - Director and Senior Engineering & Construction Equity Analyst [28]

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I'd like to just drill down a little bit more on South America. If you do adjust for the USD 50 million estimated hit, I think, you still would have been down 9 -- about 9% from last year. So I mean, copper production, I know it's not great, but it seems to be holding in fairly steady. Are we seeing some erosion in market share or customer satisfaction or anything like that, that would cause such a relatively large drop?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [29]

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Yes. So I don't think that's right. I mean, if you -- the numbers I have in front of me, if you adjust for the $50 million and take out Argentina, which has seen a 75% reduction in activity. So I'm just focused on Chile right now. But if you look at Chile mining, we're about flat year-over-year. And so guys are showing me the numbers right now, but yes, it's almost flat year-over-year. Actually, Chile mining product support up, sorry, 6% year-over-year, for the year. So in the fourth quarter, it was flat, relative to fourth quarter last year, but Chile mining product support 2018 versus 2017 was up 6%. So I don't think -- and that's like you said, kind of aligned with the increased copper production. So there is nothing going on in our Chilean business that's concerning. We are dealing with Argentina shrinking at 75% and, [in fact], we reduced costs there, and we've also got the self-inflicted wound of the ERP ramp up which is -- impacts the financials this quarter.

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Yuri Lynk, Canaccord Genuity Limited, Research Division - Director and Senior Engineering & Construction Equity Analyst [30]

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Okay. I didn't think Argentina was such a big part of the product support in the same quarter last year. But...

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [31]

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Yes, we can...

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Yuri Lynk, Canaccord Genuity Limited, Research Division - Director and Senior Engineering & Construction Equity Analyst [32]

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Make more sense. What -- so I mean, how long do you give the situation in Chile and before you start taking a hard look at your cost base? I mean, you were very quick to react in Canada. Just what are you looking for before you start taking some action down there on the cost side?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [33]

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Yes. So the first priority for me is to get the velocity of parts up and running. And I'm watching this, as you can imagine, day-by-day and it's improving day-by-day. And so the fact that the first quarter is going to be weak, is an indicative of the fact that we're not making progress. And I think as I said in my opening comments, I expect the parts flow to be at our normal run rates by the end of the first quarter, and I expect the second quarter to have financial performance that's similar to what -- since it was pre-ERP last year. And so to me that is pretty important because then we're back to 8.5% to 9% type profitability. That to me still is not sufficient to where we need to be in that market. And I think we highlighted in the Investor Day, we're expecting return on capitals in excess of Canada, so 20% plus. And in order to do that, we need a strong demand environment and we need an appropriate cost structure. And so we're going to be watching that as we go through the rest of the year, but that's how we're thinking about this.

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Yuri Lynk, Canaccord Genuity Limited, Research Division - Director and Senior Engineering & Construction Equity Analyst [34]

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Okay. And last quick one from me. Scott, I mean, how are your customers in Chile reacting to issues getting their parts? And will you have to make any concessions to kind of win them back later this year?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [35]

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Yes. So good question. I obviously, Marcello and the team are pretty focused on that, it's the #1 priority. And when people can't get parts, that's not a great situation, so we're on it. We're out in the front of people talking to people. I'd say, with our Integrated Knowledge Centre, we're using data to make sure we understand the life of components and making sure we understand how to prioritize those components that go to the customers. And so we're trying to mitigate the customer impact as much as we can in that way. And then second, Cat is also being very helpful in terms of getting us components straight from the factory to help us with the velocity issue. So we are mitigating that impact, but it's obviously it's top of mind for us.

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Yuri Lynk, Canaccord Genuity Limited, Research Division - Director and Senior Engineering & Construction Equity Analyst [36]

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Would you envision making any concessions on prices going forward that might kind of hurt your margin in the short term?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [37]

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I think we haven't seen a lot of lost sales as part of this, and so I'm not expecting concessions as we go through this, particularly -- you may have to also remember it's a pretty slow time in South America right now. I mean, this is the summer season, which is if there is any silver lining to this ramp up, it's the fact that it was in January and February, and so that wouldn't be my expectation.

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Operator [38]

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Next question is from Michael Feniger with Bank of America.

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Michael J. Feniger, BofA Merrill Lynch, Research Division - VP [39]

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Hey, guys can you hear me? Sorry?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [40]

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Mike, I can you hear you now.

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Michael J. Feniger, BofA Merrill Lynch, Research Division - VP [41]

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Just had a quick question on your inventories. I mean, obviously, you guys commented on the ERP issue, but outside the ERP issue, how do you feel about your inventory situation? And with our backlog flat kind of year-over-year, are you planning to kind of build inventories in the beginning of the year or you need to kind of order more from Caterpillar at this stage with where lead times are? Or are you kind of taking more wait-and-see approach?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [42]

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Yes. So when you're in an environment like this, where it's a little uncertain, you quickly go to control what you can control. And what you can control is costs and inventory. And so we have been pretty thoughtful on inventory ordering, probably starting back in October, November, December time line. And we're dialing back on that aspect of the business. I don't know, Steve, if you have anything else to add on that?

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Steven M. Nielsen, Finning International Inc. - Executive VP & CFO [43]

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Yes. I would add, we'll have, as Scott mentioned, the parts velocity in South America has caused an increase in inventories. And that increase in inventories, we will err on the side of having inventories to get through the recovery period. But we expect to sell-through that and relevel that out as we go past the second quarter. In the other markets with a strong but steady backlog, those inventory orders are placed well in advance, and we don't expect any level of inventory to support those. We have adequate inventories. And as we look forward at the -- with lower growth, as I mentioned, we would expect them to, as Scott mentioned, for inventories to come down in relation to the sales much lower growth than last year, which would allow us to, as normal, monetize more and carry less inventory.

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [44]

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Generate free cash flow. Having more cash flow.

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Steven M. Nielsen, Finning International Inc. - Executive VP & CFO [45]

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Correct.

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Michael J. Feniger, BofA Merrill Lynch, Research Division - VP [46]

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That makes sense. And I'm just curious on the pricing environment. I mean, OEMs have announced price increases to the dealers because of the higher raw material cost and cost inflation. Do you sense that the environment is kind of strong enough to absorb you passing those price increases along in this current backdrop?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [47]

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Yes. I mean, listen, the price increases haven't been significant, point one. Point two, we're used to annual or every couple of years price increases and managing them. And -- but that being said, Western Canada is a tough place right now, right? I mean, Western Canada is a tough place from a competitive perspective and a tough place for our customers. And so I don't think there's an expectation of gross margin improvement in that environment, but we're managing the price increases that our OEM are passing through to us.

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Michael J. Feniger, BofA Merrill Lynch, Research Division - VP [48]

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And lastly, just Scott on that. Just unused equipment, do you see anything change in used equipment value through the fourth quarter and January? Any step change there?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [49]

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No, nothing material. I mean, you can see, Ricci, has got a big auction right now at Orlando, so I'd watch that closely over the next couple days, but nothing material that I've seen over the last 3 or 4 months.

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Operator [50]

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The next question is from Derek Spronck with RBC Capital Markets.

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Derek Spronck, RBC Capital Markets, LLC, Research Division - Analyst [51]

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Just on the revenue growth side, outlook for 2019, does that include the Refuel (sic) [4Refuel] revenue pick up? And if so, what would your revenue expectations be on a organic basis?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [52]

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Yes. It didn't include 4Refuel acquisition. And say, as you know, we closed the acquisition in the February, so that would be an addition. But remember, as you think about 4Refuel, it's -- we reported on a net sales basis, and so the revenue associated with 4Refuel is only going to be about $100 million. It's a $30 million-ish EBITDA business on $100 million net sale business. So it's not material in the context of revenue.

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Derek Spronck, RBC Capital Markets, LLC, Research Division - Analyst [53]

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Okay. And you've installed close to $5 million of new equipment over the past 2 years. Should we start thinking about mix shift over the next 2 years towards parts and service as that installed base kind of matures?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [54]

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I mean, it's a good question. I mean, I think, we've got -- last year, new equipment grew 48% in Canada. And product support grew at 10%. And we're going to see a significant reduction in the new equipment sales, and so -- in 2019. So maybe a little bit in Canada. In South America, I think it might go the opposite way, frankly, as we're at a very low level in the cycle in South America. And although our new equipment sales are up, I think 60% or 70% in the quarter, it's off a very lower base. And so I would expect new equipment sales to continue to accelerate in our South American business. And so from a consolidated level -- I don't have the numbers in front of me, but on a consolidated level, I think assuming kind of flattish mix is -- over a years, like not quarter-by-quarter, but year-by-year is probably the right the thing to think about, Derek.

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Derek Spronck, RBC Capital Markets, LLC, Research Division - Analyst [55]

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Okay. And just one more, if I could quickly. Are you seeing any cancellations within the backlog?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [56]

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No, we haven't.

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Operator [57]

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Your next question is from Ben Cherniavsky with Raymond James.

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Ben Cherniavsky, Raymond James Ltd., Research Division - MD of Industrial Research [58]

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Scott, I'm wondering on the margins in Canada, if there was anything in the segment and performance that accounted for some of the compression? I mean, I recognize mix is always an issue, but you've also had a pretty substantial increase in revenue, which -- in Canada, which, as you know, we talked about in the past, drives a lot of operating leverage. So I was just surprised that the margins actually went down year-over-year. Can you speak to that a little bit?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [59]

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Yes. So it's primarily mix. And I guess, what I'd ask you to think about is, year-over-year not quarter-over-quarter. So as you think about year-over-year, we're up, I don't know, 90 basis points or close to 7.9%, 8%, which is a pretty significant increase year-over-year and 300 basis points improvement in ROIC year-over-year. So I must say, I'm pretty pleased with the pace of improvement in Canada. If you look quarter -- Q4 to Q4, it's primarily a mix. There's a few small things in there, I mean, severance, et cetera, that we didn't call out because it wasn't material, but the numbers are kind of as presented impacted by mix.

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Steven M. Nielsen, Finning International Inc. - Executive VP & CFO [60]

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But 17% revenue growth drives more gross profit dollars over -- in a -- a fixed cost base. I just -- I'm just trying to -- I mean, I recognize 90 days doesn't give you a good window, but it's -- I still would have thought that on that kind of revenue growth, you would drive your operating margin higher, not lower. So [profits] and margins and everything were fine, there's no issues there?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [61]

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Yes. No, they're fine. I mean, year-over-year, there's been a little bit of compression in product support margins, but we've offset that with significant reductions in SG&A. We've had some mining deliveries which are lower margins, which always impacts the issue. But again, 300 basis points improvement in ROIC and 90 basis points improvement in margin year-over-year, I'm pretty pleased with the results in Canada.

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Derek Spronck, RBC Capital Markets, LLC, Research Division - Analyst [62]

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And rental margins, same thing?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [63]

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Rental grew, I think -- you guys correct me, if I'm wrong. But I think for a company, we grew around 10%. And in Canada, we were a little bit shy of that. But the rental business is doing okay as well. I mean, I think one thing we're thoughtful about is, as we go into next year given our concerns on the environment, we're going to have to be thoughtful about the rental expenditure. And so I gave you, in my opening comments, a view that we dial back a little bit our rental and capital expenditures, but for the quarter rental was fine.

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Ben Cherniavsky, Raymond James Ltd., Research Division - MD of Industrial Research [64]

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Okay. I mean it's always a bit tricky for us to try and read into management's outlook and tone, but at the end of the day that's something we have to do. And my sense is your tone is more cautious now than at the end of the third quarter and even at the end of the year when you -- we had you in front of some investors. What -- first of all, is that a correct read? And second of all, what's changed in the last 6 to 8 weeks that would make you a little more cautious on the outlook?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [65]

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Yes. No, I think that's right. I think I am a little bit more cautious. And I don't -- I mean, I don't think you have to look further than the newspapers and the macro environment to come to that conclusion. I mean, the Fed has stopped raising rates. They stopped on the balance sheet reductions. So they've became more cautious. I think they're looking at China, and they're seeing a slowdown in that economy which is going to impact global growth. Imports down by 18%, exports down. A lot of discussion between the U.S. and China on trade tariffs. And the Brexit situation, which is complicated as well. Combined with, and I think this was post when I met with you and investors, but you've got capital budgets coming out in Western Canada that are 10%, 15% down. So those are all the things that make us cautious about the forward look. Now I think when you and I were together in November, December, I said that I was expecting revenue growth, and I still am expecting revenue growth. But I think it's -- in my mind, it's low revenue growth now as opposed to kind of mid-single digit revenue -- or mid -- yes, mid-ish type single-digit revenue growth back in December. So that's a little bit of the focus on being more cautious.

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Ben Cherniavsky, Raymond James Ltd., Research Division - MD of Industrial Research [66]

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And that's sort of more -- even though your first quarter guidance is flat to down, that's really an ERP FINSA thing, like you're confidence in the revenue growth would be more front-end loaded at this point based on backlog and everything else or -- because I would assume (inaudible).

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [67]

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Yes, exactly. Yes, no, The first quarter is all about South America. And if you think about Canada and the U.K., January, February, March is always, you start a little slow to the year, but I'm confident in the improvements in the order backlog and the sell-through in those 2 regions. And so the real reason why we're not seeing improvements is South America. And like I said, the velocity is improving day-over-day, I'm watching it. And by the end of the quarter, we'll be back up to our normal rates. But you have 3 months of the impact as opposed to 6 weeks of the impact, and that's why you're not going to see any improvements in South America in the first quarter.

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Operator [68]

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Next question is from Devin Dodge with BMO Capital Markets.

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Devin Dodge, BMO Capital Markets Equity Research - Analyst [69]

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So maybe picking up on an earlier question, but if you look at the seasonality of the Canadian business, it seems like Q4 has often been your most profitable quarter. We recognize that mix shift has impacted the margin performance in Q4. But can you comment on why there was a step down in profitability in Canada versus maybe Q2 or Q3 this year?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [70]

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Yes. I mean, I think you start by, actually, Q2 and Q3 are our strongest quarters. So I'd have to have the history in front of me, right now, but Q2 and Q3 are typically our strongest quarters. Q4 is a good quarter because there is that final push to get all the revenue out the door. But in this case, a lot of equipment, $1 billion in revenue, mix shift significantly to new equipment. And I think, actually, I know, on the third quarter, I gave you folks guidance that it was going to be a little bit slower or little bit compressed on the margin because I could see that backlog coming through. So nothing problematic at all in our Canadian business.

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Devin Dodge, BMO Capital Markets Equity Research - Analyst [71]

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Okay. Yes, I definitely get the margin, it's just, we look at the revenues and I feel like it was higher for each of the service -- or lines of business there. I guess, there is nothing really specific in Q4 that you wanted to call out.

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [72]

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No.

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Devin Dodge, BMO Capital Markets Equity Research - Analyst [73]

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Okay. If we think about -- again, sticking with the Canada business, if you think about like a low revenue growth environment in Canada, do you think you can get a margin lift in 2019 either from efficiency improvements -- I know the mix you talked about, higher equipment revenues and also higher parts. So just -- how should we think about margins in Canada?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [74]

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Yes. No, definitely -- yes, thanks. So definitely, so we're on this march. And I think, like I said, I think we're doing a good job in Canada to see ROIC improvements by 300 basis points year-over-year, but I'm not satisfied, and the team is not satisfied with where we are. And so the 8% margin is going to continue to improve and the ROIC is going to continue to improve. And that's going to be a combination of process efficiencies and being a little bit more lean and agile on the cost side. And on the working capital side, it's improving the velocity of how we get parts and equipment through the supply chain. And I feel good about some of the things we're doing on that front. So you should and will see -- should expect and will see improvement in profitability and ROIC in our Canadian business from 2019.

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Devin Dodge, BMO Capital Markets Equity Research - Analyst [75]

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Okay. And maybe just one last quick one. But drilling activity has been a fair bit weaker in Western Canada in recent months. Have you started to see any kind of any impact on your business, whether it's new equipment sales or parts and service or rebuilds? Just any color there would be helpful.

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [76]

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Yes. And -- so order intake is always slow at the start of the year and there's no real significant change year-over-year, we're watching it closely. I think the one area where we've seen a little bit of weakness, as I talked about on the call, is the parts and service business from the general construction line. And that started to weaken a little bit, Alberta. And that started to weaken a little bit in December and in January, and so that's one of the reasons we're being a little bit conservative on product support revenue growth for 2019. Rebuild activity remains very strong.

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Operator [77]

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The next question is from Maxim Sytchev with National Bank Financial.

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Maxim Sytchev, National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst [78]

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Scott, I think couple of weeks ago, you were discussing the outlook post sort of a 6 months'time frame saying that the visibility has worsened. And I'm just curious if anything is changing relative to that altered body language versus a couple of weeks ago, if that's possible?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [79]

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No. It's -- I mean, very similar to what I've been thinking over the last month or 2 and as we put the plans together. I mean, I just think there is a lot of uncertainty. And in fact, frankly, things have probably gotten a little bit better than the start of the year, right? I mean, if you look at where we were at the start of the year, copper prices were at an 18-month low, you had these big differentials, oil prices were weak, and now we're sitting here today and copper prices are -- have rebounded pretty significantly. You've got an oil price that's actually stabilized a bit. You got differentials that have started to come at the end of that, and you've got rumors about China and the U.S. getting it together on the tariff side. So frankly, relative to 4 or 5 weeks ago, I probably am a little bit more optimistic. That all being said, these things change day in and day out and in that kind of uncertain environment, the only thing you can do is control what you can. And what we can control is our costs and our inventory, and that's what we're going to do in an uncertain environment.

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Maxim Sytchev, National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst [80]

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Right. And then just not to push you, obviously, on the subject, but just -- obviously, you accelerated the pace of share buyback in late Q4, then the ERP issue, looks like it popped up around mid-quarter, so do you mind maybe just describing the time frames for especially on the share buyback being pretty aggressive on that front? Or at the time, you just didn't have the visibility what was happening in LATAM specifically?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [81]

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Yes. No, I think the ERP production velocity issue, you start to become aware of that near the end of the year because we went live 6 weeks in. We had a relatively successful Argentina deployment, albeit in a low environment and partly because Argentina doesn't have the CRC, so in a lot of these big component rebuilds. And so as we went through the fourth quarter, we felt pretty good about where we were on ERP. And now, as we've gotten into the first quarter -- and by the way, this is not about -- the system is working. We need to do some tweaks to increase the velocity, but this is about a few things. One is, user proficiency. So getting the users used to it and increased discipline in the system. And this is why we did it. We put increased discipline to get better controls on working capital and reduce costs. And as you put increased discipline in the system, it slows down the velocity a bit. And so ultimately this is going to turn out to be good for the business, but it has taken a little bit longer to ramp up than I thought, and that's a learning for me. But we will get through it. And it didn't really have any impact on how we're thinking about share repurchases, and frankly, it won't have an impact on how we're thinking about share repurchases going forward.

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Maxim Sytchev, National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst [82]

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Okay, fair enough. And just in terms of your confidence in being able to get from kind of now to having no negative drag by Q2. I mean, I understand that you're seeing some of the numbers kind of live, obviously, we don't have that privilege, but your level of confidence is like 80%, 90%. I mean, how do you think about it?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [83]

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Yes. No, I think -- the way I think about it is, we're going to get back to parts flow by the end of the quarter. I mean that's clear to me, by just watching it day-by-day. There is a little bit of lag on revenue from recognizing revenue to having the parts flow. And so as you think about the second quarter, I think we're going to have a reasonable revenue environment. Probably third quarter is going to be higher than second quarter because there is going to be some catch up, but second quarter is going to be a reasonable revenue environment. And the margin profile in Q2 is going to be similar to pre-ERP last year. And that's why, in my opening comments, I think by the -- to get to the 8.5% to 9% is going to be the second half of the year as you will have then the full run rate of revenues and you'll have some of the benefits from the ERP embedded with less technology spend, but the second quarter, I'm fully expecting to get back to pre-ERP profitability in South America.

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Maxim Sytchev, National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst [84]

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All right. And sorry, just to clarify, The 8.5% to 9%, that's in the back half not for the entirety of the year obviously?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [85]

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Yes. I think second quarter is going to be similar to pre-ERP and then in the back half of the year, third quarter, fourth quarter, you get the 8.5% to 9%.

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Maxim Sytchev, National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst [86]

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Okay. And then last question on ERP. So in terms of what has to be done on your side, is it just more training or is it releasing more modules in the system? Can you just maybe kind of walk through kind of the steps that are...

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [87]

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Yes. It's a combination -- and I'll give you an example. It's a combination of a few things. One is, training and user proficiency, and second is process efficiency, and third is, there's some system tweaks we have to do. But I'll give you an example. We used to get a pallet in from CAT, we would unpack that pallet with parts, put it on the shelves and then send it out to our customers. So now with the new system, you get a pallet in, you completely barcode it right away and it goes right to -- those parts are ascribed to a very specific service order. And so we used to have a lot of flexibility. The parts came in a pallet, and we'd send it to a customer. And you can imagine it was more costly and had less control of working capital. Now the parts come in, they have to go to a specific service order. So that one, when you get a working right, it is less costly and better control over working capital. So ultimately, we're seeing the right kind of behaviors. But it just takes a little bit of time for our folks and our processes to adjust to the tighter controls. And this happens in every system implementation. I guess, the learning here for me is, I was assuming we could do it in the first quarter with less of an impact on overall product support. And it's going to take a little bit of time until we see the benefits of those controls play through the system.

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Maxim Sytchev, National Bank Financial, Inc., Research Division - MD and AEC-Sector Analyst [88]

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Right. So then you make a good point around working capital, so should we expect further cash free up? And then -- because I think right now consensus is probably around $120 million, $150 million FCF for next year. And then, I guess, theoretically, we should be able to build from there, right, once the ERP system is fully implemented. Is that how we should be thinking about this?

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L. Scott Thomson, Finning International Inc. - CEO, President & Non-Independent Director [89]

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Yes. And so we got $80 million of free cash flow this year on a 26% top line new equipment growth, which I -- we were all pretty proud of. If you think about next year, and a top line that's low growth, you're going to see significantly more free cash flow for the reasons Steve talked about, in terms of not purchasing as much inventory as we had, but still selling through. And so for 2019, I think you can expect significantly more free cash than 2018.

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Operator [90]

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(Operator Instructions) This concludes the question-and-answer session. I would like to turn the conference back over to Mr. Breukels for any closing remarks.

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Mauk Breukels, Finning International Inc. - VP of IR & Corporate Affairs [91]

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Well, thank you very much operator, and thank you, everyone, for listening.

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Operator [92]

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This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.