Caterpillar Inc (CAT) — Q4 2015 Earnings Call Transcript

Thank you, Paul, and good morning everyone and welcome to our year-end earnings call. I'm Mike DeWalt, Caterpillar's Vice President of Finance Services. On the call with me this morning, we have Doug Oberhelman, our Chairman and CEO; and Brad Halverson, our Group President and CFO. Now this morning we're going to do the call similar to what we did last October. We'll be going through a short slide deck before we get to the Q&A. If you don't have it yet, the slide deck is available on our website, at caterpillar.com and it's with the conference call webcast link. This call is copyrighted by Caterpillar Inc. and any use, recording or transmission of any portion of the call is strictly prohibited. If you'd like a copy of today's call transcript, we will be posting that 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 certainly involves risks and uncertainties and assumptions that could cause actual results to differ materially from the forward-looking information. A discussion of some of those factors individually or in the aggregate that could make actual results differ materially from our projections can be found in our cautionary statements under Item 1A, or which is Risk Factors in our 10-K filed last February and it's in the forward-looking statements language in today’s financial release and near the front of this morning's slide deck. In addition, a reconciliation of non-GAAP measures can also be found in our financial release and again that's been posted on our website at caterpillar.com. Okay. With that, let's get started. If I could ask you to pull out the slide deck and flip to page three, and that's the agenda of our slide deck. I'll start this morning with a quick review of the fourth quarter and the full year of '15 and the outlook for 2016. Then I'll hand off to Doug and he'll cover a few of the key points that we were trying to make in this morning's financial release. So with that, let's flip to what would be page four of the bottom of the slide deck. And this is a fourth quarter 2015 results versus fourth quarter 2004. You can see that sales and revenues are down $3.2 billion from $14.2 billion to $11 billion, that's a 23% drop. About $2.7 billion of that was lower volume, selling fewer things and most of that was due to lower end user demand, and about $400 million of it was related to reductions in dealer inventory. Price realization was negative in the quarter about $124 million and we did have a stronger dollar versus the fourth quarter of '14, which caused our sales outside the U.S. to translate into fewer dollars, contributing about $400 million. If you look at that by segment, the biggest decline was Energy & Transportation, which was off $1.8 billion. About $8.8 billion of that was CI construction and about half of that, a little more than half of that, was where the dealer inventory impact was most concentrated. About $0.5 billion was Resource Industries and again that's mostly mining. So the decline was across the board, but a bit more concentrated quarter-over-quarter in Energy & Transportation, and given what's happened to oil prices over the course of the past year, that's probably not a big surprise. The profit impact of those changes - or of that decline in sales volume was about $940 million negative. The next largest item quarter-over-quarter is restructuring costs and they were negative $585 million; they went from $97 million in the fourth quarter a year ago to $682 million this year. A lot of that increase is a result of the fairly significant actions that we announced last September and are in the middle of implementing right now. Costs though were favorable by about $461 million and that's pretty much all in excluding restructuring versus a year ago, so that's good news. Now taxes, it's probably a little hard to follow what's happening with taxes. It was a very low kind of all-in tax impact in both quarters. The rate this year is a little lower than last year and we had $85 million of favorable tax items in the fourth quarter of '14 and $77 million in the fourth quarter of '15. So a little hard to follow, but not a massive impact quarter-over-quarter. On the profit numbers, in the fourth quarter a year ago was $1.23. We actually had a loss of $0.15 in the fourth quarter of '15, largely because of the significant restructuring costs. The all-in change was a decline of $1.38 a share. Excluding the restructuring costs in '14, the fourth quarter was $1.35, the fourth quarter of '15 was $0.74, and we were down $0.61. We continue to report our results both with and without restructuring costs because we think it's important to help you understand what's going on in the business. So that's the fourth quarter. Now let's look to page 5, which covers the full year. It was obviously a tough year for us in 2015. Sales were off $8.2 billion, the vast majority of that were due to lower sales volume, but the stronger dollar impacted the full year in the same way it did the quarter. In terms of segments; Energy & Transportation was the largest decline at $3.8 billion, which was related to oil, rail, and electric power. Construction Industries was down $2.8 billion and Resource Industries $1.4 billion. From a profit standpoint, all-in we were $5.88 in 2014, all-in including restructuring, we dropped to $3.50 in 2015, a decline of $2.38 a share, more than all of that due to the decline in volume. If you take out restructuring costs, we were $6.38 in '14 and $4.64 in '15, down $1.74. The story for '15 is a big sales headwind of $8.2 billion, but we worked really hard on lowering costs. We took significant restructuring actions and new restructuring actions began in the third quarter. Our costs were about $520 million favorable and that's net of about $350 million of unfavorable cost absorptions, so let me explain that a little bit. In 2014, sales were pretty flat with 2013, not a big change, which means inventory didn't change much. In 2015, inventory declined $2.5 billion, so that's $2.1 billion more than it did in 2015, and there's a significant cost impact of that sizable decline in inventory, approximately $350 million. Without that cost absorption would have been even more favorable. Share count was positive to profit year-over-year by about $0.16 a share, largely due to the impact of significant repurchases made in '14 and a partial year impact from the repurchases made in '15. Overall bottom line all-in on tax, there wasn't much of a change year-over-year. If you take out the restructuring costs, our decremental operating profit margins were about 20%, and we would consider that to be pretty good performance, better than our 25% to 30% target. Let's flip to the next page, page 6. Page 6 provides a discussion on how we did versus our outlook. Since so much transpired over the year, we're kind of taking a long look back at how we did versus what we told you we thought we would do a year ago right now in our year-end call for '14, and how we came out versus the outlook we had in place at the end of October, the last conference call we had for the third quarter financial release. In January a year ago, we were expecting sales and revenues this year to be $50 billion, profit per share to be $4.60, restructuring cost to be only $150 million, and profit per share excluding those restructuring costs to be around $4.75. What we actually had was sales and revenues that were $47 billion, which were $3 billion below where we thought they would be when we started the year. Profit per share was lower by $1.10, with a lot of that due to restructuring costs, which were much higher. Excluding restructuring costs, we ended up at $4.64, which is $0.11 a share shy of our outlook when we started the year. Compared to the last outlook provided in late October 2015, we said our outlook was going to be about $48 billion, clarified further as somewhere in the range of $47 billion and $48 billion. We were looking at profit per share of $3.70, which included $800 million of restructuring costs. Excluding restructuring, we predicted $4.60. What we actually did was a little worse on sales due to the ongoing challenging environment. Profit per share was lower, again largely because we had more restructuring costs than we expected at that time. Excluding restructuring, we ended up the year at $4.64, actually slightly ahead of our outlook. I have seen analyst reports this morning confirming that we did not have the tax extenders in our previous outlook, providing us with unanticipated benefits, though it was offset by a sizable legal charge during our fourth quarter. All in, despite lower sales, we did a little better than our outlook and we are pleased with that.

Okay. Good morning everyone. I do want to make a few key points as I look back on '15 and forward into '16. Mike said it was a very tough year, but when you think about everything that happened, the challenges and chaos sometime during the year with events around the world, a year ago today we were expecting $50 billion in sales, and we ended up at $47 billion. That $3 billion is quite a drop, but we really only reduced our profit per share outside of restructuring by $0.11. There's a lot involved in that, but basically I'm pretty pleased with cost management. The restructuring actions we took in the fourth quarter were more aggressive than we had planned and announced, leading us to take about $100 million more than we initially intended. But that positions us well for 2016. Our team did a great job and while it's tough to say, we're getting used to these cycles. Our 2009 volume at $32 billion doubled in three years, and now we're down about 30% from that; this experience will serve our team well in the years and decades ahead as everyone goes through these cycles. Operationally, 2015 was one of our better years. One proxy I use for plant management is their safety record. When I visit plants, if there's a safe environment and the numbers are good, chances are we're going to see high quality, engaged employees, and a profitable plant. Safety hit a record level of - well, recordable injury frequency in 2015 at 0.6 which is world-class for heavy manufacturing. We've improved our market position for five years in a row across the world and virtually across all markets for that matter, and in most all products. This indicates something about the quality of our product, our design, our Tier 4 implementation, as well as our strong dealer distribution organization. Mike mentioned it, but I would like to emphasize again our decremental operating profit of 20%. When you look at that without restructuring, I think it's actually around 17%. While that decremental occurred in the fourth quarter, that's what we aimed for. I'm very happy with that as it sets us up for ‘16. Our balance sheet is strong, as we noted in the release this morning, we saw a lot of free cash flow, about $5.2 billion in 2015, another great year. We expect a positive cash flow in '16, sufficient to cover our dividend and CapEx. We are closely examining CapEx and will likely get that number down below $15 billion while still working through it. Our focus on cash use has been clearly stated, with high priority on our balance sheet, credit rating, and protecting our dividend. With the cash we have on the balance sheet and today’s leverage levels, which is the best it’s ever been at this cycle stage, we feel pretty good about maintaining dividend protection. We had a conference call in November around Cat Financial. We view that business as strategic. We would not have the market position we have today without Cat Financial and the loyalty from our customers. They achieved a very high market share in what they financed in 2015. The quality of that asset portfolio is excellent; past due has improved a bit from 2014. We use that captive finance company primarily to finance Caterpillar products, ensuring our market performance around the world and operating a well-managed company. Looking into 2016, the market will be tough and I expect bumps throughout the year. Our outlook is revised down to $42 billion - another drop of about $5 billion, a little over 10% reduction from what it was previously. This is significantly impacted by a continued drop in oil prices around $30 a barrel and ongoing concerns about emerging markets, particularly China. As we examine next year and what’s expected, we see another down year for Energy & Transportation, projected down 10% to 15%, largely timing-related. Much of this decline was expected last year with anticipated oil price declines. Most of that reduction occurred in the second half of the year; Energy & Transportation only declined 6% versus the prior year in the first half. However, the second half saw a steep decline of 27%. We predict a similar trend continuing into 2016, with fluctuating declines for the energy business. Additionally, Resource Industries is projected to drop another 15% to 20%. The downside here is concerning, with our customers having challenged financial conditions leading to very few orders. However, equipment sales are relatively low, and it’s fair to state that the downside risk is somewhat limited.

In terms of profit per share, we are anticipating all-in profit per share of $3.50, which includes restructuring costs and pension changes we are making. We're making a change in accounting principle related to our defined benefit plans, which is favorable to our results by about $0.50 a share. This represents a shift from an accounting method that smoothes actuarial gains and losses from prior years into current year results to a method that's more mark-to-market, better reflecting our actual costs of the current year. Along with that, we have about $400 million of restructuring costs in our outlook, roughly another $0.50. So all in excluding restructuring costs, we are anticipating $4 a share for sales and profit in 2016. The negatives are lower sales going into 2016, dropping from $47 billion to a midpoint of $42 billion, resulting in a $5 billion profit drop, offset by considerable cost reductions resulting from restructuring actions that commenced in September. With that, I will turn the floor over to Doug Oberhelman.

Thank you, Mike. I want to touch on a few key points looking back on ‘15 and forward into ‘16. Mike indicated it was a tough year. Despite facing global challenges, we ended up at $47 billion in sales down from expectations of $50 billion, which was a notable reduction. However, we only reduced profit per share outside of restructuring by $0.11, highlighting our focus on cost management. Our restructuring actions in the fourth quarter were more aggressive than initially planned, further preparing us for 2016. The team demonstrated great resilience and adaptability during this cyclical downturn, reflecting our capability to manage through tough times. Additionally, 2015 saw improvements operationally, with record safety benchmarks and enhanced market positions in numerous areas worldwide. This demonstrates the quality of our products, effective design implementation, and robust dealer network. The balance sheet remains strong with considerable free cash flow of $5.2 billion in 2015, and we expect this trend to continue in 2016, allowing us to cover our dividends and CapEx. We are being rigorous with CapEx scrutiny and applying efforts to decrease it below $15 billion. Our main priority remains on maintaining a solid balance sheet and protecting dividends. Moving into 2016, we expect a tough environment, revising our sales outlook to $42 billion, a decline due to falling oil prices. Energy & Transportation is projected to drop 10% to 15%, with Resource Industries seeing similar reductions. So while we face challenges, we stay focused on adapting to market realities and preparing for the future.

Thanks, Doug. Paul, we’re ready to open the floor for our Q&A.

Hi, good morning everyone. It's Goldman Sachs. I'm wondering if you could talk about your expectations for solar, just flesh that out for us, if you could Mike this year? Comment on cadence over the course of a year within the past month we've seen pipeline MLPs cut CapEx and wondering if you could just calibrate us and what you're seeing in the order book?

Yeah, good question, Jerry, happy to do that. As is almost usual, solar had a great fourth quarter of 2015, which we expected. Backlog for solar, despite that big shipping quarter in the fourth quarter, was about the same at year-end as it was at the end of the third quarter, so no deterioration in their backlog. In fact, if you look at solar's total backlog, it's about the same as it was at the end of '14. The oil portion declined quite a bit; however, the natural gas portion is holding up quite nicely. We signaled that we would have some reductions in solar; in the third quarter, we did the preliminary outlook and stated they would likely decline but less than 10%, and nothing has really changed there.

Then separately, Doug, the last point that you made, the Caterpillar Internet of Things, can you talk about your expectations in five years? Are we looking at a significant revenue and profit pool for your business? What kind of business model should we be thinking about for you folks to monetize all of the valuable fleet that you have in the field and the opportunity to monetize that data? How should we think about the business model?

It's not going to be a software charge-off system at all. We're going to measure it and the benefit to us will be in aftermarket parts and service, maintaining a connection with our customers through the products we already sell and service. This is where we're headed, not a software-for-free basis; it's a simple adjunct to what we're already doing in many varieties today targeting directly our customers.

Thanks, Jerry.

Its Barclays and good morning everybody. I guess, a dual question on price and cost. You've had a little bit of lower pricing; although I think under your leadership, Doug, you guys have been very, very competitive, gained a lot of share, and not maybe margins with price, so I get that. But you still had a little bit of a contraction price. Is there anything significant going on with either currency or is it inventory flush or what's causing that? Are you able to continue to get cost back from your suppliers? Are you sort of ahead of the curve or does that continue to flow through into '17, the material moves we've already seen?

Hey, Rob, this is Mike. I'll start this out. I'm going to begin with material costs. We've done actually very well over the past three to four years in material costs. I think we have taken out over $1 billion during that timeframe, and last year, 2015, was a significant chunk of that. The combination of lower commodity prices helped some. But all the work we've done on lean, resourcing, engineered value change, and our supplier partnerships contributed to a substantial amount of that cost reduction as well. So if you relate that to our price realization, that was a net benefit for us in 2015. We continued to see good material cost reduction, and our pricing overall was neutral during the year. It was favorable in the first half, but unfavorable in the second half. Looking ahead to 2016, we expect that to shift downward a bit. Given current commodity prices, we're not anticipating as much benefit since we don't foresee another major drop. The efforts on material costs will continue, but on price realization, there's a bigger challenge in the current environment. I also believe that the geographic areas where we're selling products matter quite a bit. In the fourth quarter, we experienced a significant decline in Latin America, which affected our average prices in the quarter.

Just to add a little philosophy here. You alluded to what we've tried to achieve over the past few years, and that's raised our market share. We have performed well in this regard. This dynamic will adjust; this business relies on field population, and as long as that field population grows, it allows our dealers to thrive in tough times like these and outshine during favorable economic conditions. As Mike mentioned, we've anticipated more price adjustments due to factors like the dollar situation and excess competitor capacity. I believe we can continue enhancing our market position while also managing margins, maintaining the balance we've successfully executed over the past five to six years.

I just wonder if you can help us a little bit with some first half, second half color especially in E&T. You're going to have tough comparisons, obviously in the first half of the year. Can you give us any idea like revenue decline first half versus second half or anything to help us figure that out?

Yeah, Joel, as I mentioned earlier, if we look back at 2015, we had a lot more decline in the second half of the year than in the first half. The strong first half was driven by backlog, particularly in drilling and well servicing sectors, but that has diminished. It’s safe to predict that year-over-year for Energy & Transportation, expecting a decline of 10% to 15% in 2016. It will probably be a more significant decline in the first half and less in the second half. We typically do not provide quarterly breakdown guidance, but you are correct that comparisons will be tougher in the first half than in the second half.

Any signs of aftermarket business stabilizing? That's usually the early warning sign that we're deep enough into a downturn that things are starting to stabilize?

The percentage and even dollar basis changes in aftermarket demand have decreased, there's no doubt about that over the last couple of years. However, the decline is much less severe compared to new equipment. The last fourth quarter was down as well, but I would suggest there's no strong evidence indicating a spike in demand yet. Customers are still opting to operate and maintain existing machinery, and so long as they continue to do that the output remains steady, there will eventually be a need for replacement; that has not yet materialized.

Yeah, good morning, thanks guys. I believe you normally have your annual impairment test in the fourth quarter. It doesn't look like you've booked any impairments, even though you've had a competitor just write off 50% of its book value. Can you talk about that? You're speaking candidly about pressures in the mining business that you've been feeling for four years. Can you discuss the rationale behind not writing down a substantial portion of goodwill on this latest test?

Certainly. First, the current mining business is weak; there's no question about that. Second, what I can tell you is that we completed an impairment test in the fourth quarter with a realistic long-term view, and we had no impairments recorded. If an event triggers us to reevaluate before the next fourth quarter, we will investigate further. However, the calculations indicate no impairment now. Keep in mind this business is highly cyclical, so while sales in the sector are below replacement levels currently, they must return to that at some point. The impairment test considers long-term projections, not just next year's projections. We performed in line with our historical approach, and we did not experience an impairment, that's about all I can explain on that.

Doug, one bigger picture question. We've seen Zoomlion bidding for Terex publicly. While it might not be a huge direct competitor, does the prospect of a significant Chinese OEM acquiring a U.S. company set a precedent that concerns Caterpillar?

We saw the signing by Putzmeister a few years back, becoming a dominant player in concrete pumping. The crane business is broad, and I would anticipate even more Chinese investment in the United States and various industries, and we'll see how this unfolds if it indeed closes. If I were in their position, I would be looking to make these types of investments to enhance our capabilities. I expect to see some moves like that, although we haven’t been significantly challenged by it in the recent past.

I was wondering if you can help us a bit with the cadence of the earnings for '16? Just given the moving parts around the restructuring, can you give us some pace on that? Even regarding the accounting change, is it simply a linear day one, and just run it out per quarter, just for some sense of the cadence exiting '16?

Yeah, David, that’s an excellent question. So on the pension, that just plays into what the annual cost is, and that will essentially be spread evenly over the course of the year. In terms of restructuring, the short-term benefits we were anticipating for 2016 result from headcount reductions, and most of that is expected to be realized quickly. So the majority of those savings will likely be evenly distributed throughout the quarters. We’re giving you a full-year number, and while there’s still more action planned, that should average out fairly consistently.

I appreciate that insight. Last question, Doug, the commodity prices outlook doesn't suggest much recovery. If we presume commodity prices are unchanged at the end of 2016, how should we think about 2017? Considering the $1 billion in dealer inventory reduction, will that be adequate?

Right now, our focus is firmly on managing through 2016 and hoping we can achieve our stated goals. Our efforts have resulted in a 30% reduction in sales alongside inventory reductions of a similar scale, which I believe reflects well in continuing efficiencies. Once we stabilize and potentially see a slight upward trend, I suspect our inventory turnover metrics will be very favorable and efficient. That's as far as I want to go with that for now, because I cannot predict oil or commodity performance and will stay focused on operational execution.

David, it’s Brad. I wanted to add a comment on prioritizing cash flow. We've done work to significantly reduce costs in the lead-up to September in anticipation of this environment. Outgoing cash flow is projected to be adequate for our CapEx and dividends regardless of sales drops. We're committed to our decremental pull-throughs. Should sales decline further, we’re prepared to execute on further restructuring strategies.

Hi, good morning. Credit Suisse. I have two questions; the first, Doug, you addressed a lot of your confidence level with the balance sheet and protecting the dividend. Can you elaborate on how you think about cash flow in 2016? If you observe the previous few years, working capital has been a major source. What is your concern in this area moving forward? This raises the question of whether the balance sheet may come under pressure.

Our cash flow in '16 will remain reasonably strong based on the projected outlook. We are keen to cover not just our CapEx, but also our dividends, and I believe we will have cash flow above that. Our balance sheet will likely stay solid, and we'll be able to maintain its state, if not strengthen further. However, I’m also cautious about '17, as we may need to use our balance sheet strength to protect dividends if necessary.

Jamie, I can address the second part regarding margins by segment. In 2015, we witnessed notable changes in profit by segment that should be highlighted. In construction, decrementals were 10%, signifying strong management throughout what has been a challenging period. Although Resource Industries faced decrementals around 36%, their investment in R&D is laying groundwork for future growth. Energy & Transportation's decrementals were around 24%, which is consistent with operational constraints. Overall, our 20% decremental target has been met, and while we won’t provide specific ROS guidance, we will stress the critical importance of maintaining manageable decrementals across the board.

Thank you, I’ll get back in the queue.

All right. I think we have time for one more.

Hi, good morning. Thanks for squeezing me in. My first question is just a little bit more big picture. Given the strength of the dollar and weak emerging market economic activity that we're seeing, particularly in Canada and Latin America, is there any risk that we start to see equipment, either used or unused, flowing back into the U.S., thus putting incremental pressure on new equipment sales in the U.S.?

Good morning, Ann. Our EPA regulations have mitigated some of that, as the requirements for low sulfur fuel on machines produced in the U.S. create barriers. There may be some flow from Canada, but Latin America has historical dynamics that we'll continue to watch. It would not be surprising to see some of this, but it is not overly alarming.

Okay, thank you for that insight. My second question is about the smoothing of the pension plan and moving to mark-to-market. I understand the initial reasoning behind smoothing was to reduce volatility, so are there concerns that transitioning will create more earnings volatility?

Ann, this is Mike. A few points here. Several years ago, we decided to sunset our defined benefit plans by 2019, and in doing so, we've been derisking the asset fund balance. We are shifting towards more fixed income rather than equity. This strategic movement towards mark-to-market won't entirely eliminate volatility but is intended to reduce it compared to the status quo. Moreover, similar movements in other companies have seen the market adjust, indicating a lower level of surprise regarding year-end adjustments. The transition is anticipated to render a clearer reflection of current year expenses without masking previous operating results, these outlines our reasoning.

I appreciate that clarification. One final inquiry: where do you see restructuring in 2016? Will you have it all done by year's end or carry some costs into 2017 and 2018?

We'll likely have some costs in '17. As a part of the plan announced last September, we expect to conclude restructuring efforts sometime in '18. Thanks, Ann. Thank you all for joining us. We'll talk to you again at the end of the first quarter.