Caterpillar Inc (CAT) — Q3 2016 Earnings Call Transcript

Thank you very much, Paul, and good morning, everyone on the call. I'm Mike DeWalt, Caterpillar's Vice President of Financial Services. On the call with me this morning, we have: Doug Oberhelman, our Chairman and CEO; we have Jim Umpleby, who will be taking over the reins from Doug as CEO come January; and Brad Halverson, our Group President and CFO.

Yeah, good morning, everybody. It's Doug Oberhelman here. I just want to make a few opening comments and we'll get back to Mike and normal conference call stuff. I want to talk a little bit about the succession planning process the board used, just make a few comments on that. We've talked about this before in analyst conferences and so on, but we have a very robust succession planning process that goes all the way down to almost the first levels of management. We review and spend a lot of time on that every year. Every year, at least once, usually in October, we go through that with the board for the top 300, top 350 people and talk about succession, the future, some names. During the year, we try to introduce the board to a lot of those names and individuals, as we have been doing. I certainly have been active in that. I was very adamant that I wanted, when my time was up, and I'll be 64 in February, a good, sound process that the board was happy with, our executive office team was happy with, and that all the executive officers would go right on through performance and not miss a beat. I think we've achieved that. I've picked the timing. I've been very much supportive of Jim. I'm very much supportive of the full executive office. As we announced a week ago yesterday, I will be CEO until the end of December, and I will be Executive Chairman until the end of March. We've made a change in governance with a split Chair and CEO role. Most of you know we've had a shareholder proposal on that for several years in a row, and we have a couple of large shareholders that are fundamentally for that, pushing that at transition times. Obviously, this was a time the board considered that because we're in transition. Dave Calhoun will be the Executive Chairman come April 1. I've had a wonderful relationship and extensive, frequent dialogues with the current Director, Ed Rust. We talk frequently before, during, and after every board meeting, and have for years since I've been in the job. David's role will not be anything different than Jim. Jim will run the company, and David will coordinate the board as Executive Chair. Just a change in governance, both work very well. I've had great luck with the presiding director situation, and I'm sure Jim and Dave will have great luck with the split Chair/CEO role as well. Again, no drama, just a different way of doing things, and I think we'll carry on and not even miss a beat. I'm excited to move into the next phase and I'm very excited for Jim and the executive team that we have here. I feel the company is positioned well. We've been through a rough period over the last four years, as all of you know and endured, but I think we're set up for the future. So, Mike, if you'd take over.

Actually, Jim.

Sure. Thanks, Doug, and hello again to everyone on the line. It's an honor and privilege to be selected as the next CEO of Caterpillar. I've worked with Doug for many years. I have great respect for him and am proud to be part of his team that has kept Caterpillar strong throughout some of the most difficult market conditions we faced. Like other incoming CEOs, I'll pull together a team of leaders that will refresh our enterprise strategy in the coming months. Again, it's an honor to have been chosen to lead this great company. Thank you. Mike, back to you.

All righty, let's get on to the quarter and the outlook. Today, we'll be walking through a short slide deck, similar to what we've done for the past few quarters, and then we'll move on to the Q&A. Now would be a great time, if you don't have that slide deck in front of you, you can pick it up on our Caterpillar.com website, where the conference call Webcast link was. Just as a reminder, this call is copyrighted by Caterpillar, Inc. Any use, recording, or transmission of any portion of the call without the consent of Caterpillar is strictly prohibited. If you'd like a copy of today's call transcript, we will be posting it in the Investors section of that same Caterpillar.com website and it'll be in a section labeled Results Webcast. Moving on to page two of this morning's slide deck, you'll see our forward-looking statements. I am quite certain that we're going to be discussing quite a bit of forward-looking information this morning. That always involves risks, uncertainties, and assumptions that could cause our actual results to differ materially from the forward-looking information. A discussion of some of those factors that can make results differ can be found in our cautionary statements under item 1A, which is risk factors from our Form 10-K filed with the SEC earlier this year, and in the forward-looking statements language in today's release. In addition, a reconciliation of non-GAAP measures that are used in both our financial release and this presentation can be found in both the financial release and the last page of this slide deck. One more thing, before we get started on the slide deck, I know that with Doug's announced retirement and with Jim replacing him, you probably have a lot of questions for Jim about his long-term strategy. However, since Jim found out he was going to be CEO just about ten days ago, now is likely not the best time for those kinds of questions. So, today, we're going to try and keep the call focused on our third quarter results, the outlook for the fourth quarter, and our preliminary view of sales for next year. With that, let's start on the slide deck, and if you could flip to page 4, you'll see the high-level summary of what happened in the third quarter to sales and revenues and profit. We were down $1.8 billion in the quarter, continuing on the same trajectory we've been on most of the year. Profit per share dropped from $0.94 in the third quarter last year to $0.48 this quarter. Quite a bit of that was due to restructuring costs. Certainly in the quarter, we had additional asset impairments related to our Resource Industries business, and restructuring costs were $226 million higher than a year ago. If you exclude restructuring costs, profit per share was down $0.20, which is pretty good performance considering the $1.8 billion drop in sales. That’ll be a recurring theme across the next few slides. If we go to the next page, it will walk us through the change in sales in a little more detail. The most significant decline was in Energy & Transportation. We were down a little over $800 million. Transportation this quarter was the first time all year when oil and gas was not the most significant reason for the decline; it was Transportation, followed by power generation, oil and gas, and industrial engines. Resource Industries was down $465 million, which is a little over 25%, and it's been down about that in every quarter this year, so not a significant change. It's actually split between mining products and large construction. We don't talk much about construction in Resource Industries, but we have large products like articulated trucks and some of the larger off-highway trucks. Some of the large bulldozers and large wheel loaders are used in construction, and there was a notable decline this quarter in Resource Industries from construction equipment. We're seeing that significantly in North America. For the Construction Industries, we were down $521 million. About two-thirds of that was volume, with North America being the most significant region, and about a third was due to price. The total decline then is $1.8 billion. Let's move on to page six, which talks about profit; this is our normal waterfall chart. The black bar on the left represents third quarter operating profit from a year ago, and then we isolate what caused the changes. You can see that the $1.8 billion decline in sales and revenues had a significant impact on profit from lower volume. Price realization has remained a sizable negative, about the same compared to last year; it was a $213 million negative this quarter. The next two bars represent positives: variable manufacturing costs, which include material cost, variable labor, and overhead in our factories, have been positive all year. Period costs show that we've done quite a bit of work to reduce structural costs within the company. If you observe the decline in operating profit, about half of that decline was due to restructuring costs. So excluding restructuring costs from the previous page, we were down slightly over $200 million in operating profit. If you examine the price realization bucket, had we not faced such a tough pricing environment this quarter, we would have had sufficient variable and period cost reduction to essentially offset the impact of the $1.8 billion lower sales. So let's backtrack for a second. Given that good cost performance, let's revisit the previous page one more time. For Energy & Transportation, sales were down $818 million, but their profit on that level of sales decline was only off $111 million, indicating strong cost performance. For the Construction Industries, there was a $521 million decline in sales and revenues, and $165 million of that was price realization, yet their profit was only down $28 million. Resource Industries, mining, and large construction were down $465 million in sales but only down $35 million in profit. This reflects that cost reduction has been robust so far this year. Looking at page seven, where we stand on cost reduction this year illustrates favorable progress, totaling about $1.8 billion over the first nine months. This is accounted for in three major categories. First are restructuring efforts that we've been pursuing for a few years. We announced a significant series of restructuring actions last September, and with these actions, we've reduced square footage, capacity, and personnel. Material costs have also had a favorable impact this year, not solely commodity-driven, but largely due to design and sourcing-related changes. There's also everything else, which includes short-term incentive pay; a little over $300 million of the $1.8 billion total is from lower incentive pay expectations this year. Even without that, we've achieved $1.5 billion in lower costs this year. Reflecting on the third quarter, we faced a tough sales environment, but we've made substantial progress on cost reduction across the board. Now, regarding our outlook, we have lowered the 2016 forecast. Initially, we anticipated $40 billion to $40.5 billion in sales and a profit of $2.75 per share, or $3.55 without restructuring costs. We've now lowered that expectation to around $39 billion and a profit of $2.35 a share, or $3.25 excluding restructuring costs. With this sales decline, the midpoint of our outlook represents a $1.25 billion drop across Construction Industries, Resource Industries, and Energy & Transportation. There's a notable decline in construction, particularly in North America, which has affected both our Construction Industries and Resource Industries segments for large equipment. We also reduced our expectations for Energy & Transportation, specifically in rail, where some forecasted business was pushed to later years. We observed a decline in oil and gas, mainly from service and overhaul work related to Solar, which we now estimate will be down closer to 15% for the year instead of the previous 10%. Power generation has also been weak, especially in oil-producing regions. Our restructuring costs are projected to be about $100 million higher for the year, primarily due to additional asset write-offs in Resource Industries during the third quarter. We don't generally provide quarterly guidance, but given the current outlook, it implies about $10 billion in sales and revenues, approximately $0.47 a share of profit, and $0.67 excluding restructuring. Moving to page nine, I'll clarify why profit is expected to be slightly lower in the fourth quarter despite higher sales. Looking at the third quarter versus the implied fourth quarter outlook, we expect an increase in sales and revenue of about $800 million, mostly in Energy & Transportation. We typically see some seasonality in our fourth-quarter sales, which is probably not a surprise. There will also be more locomotive shipments and some large turnkey power generation projects in the fourth quarter. Excluding restructuring costs, we anticipate profit to be about $0.18 lower. While we do have higher volume as a positive, we're also facing a negative sales mix. Historically, we tend to experience lower margins in the fourth quarter, which usually rebound in the first quarter, and we expect that will be the case again this year. Typically, we see a sizable inventory reduction in the fourth quarter, which we expect will result in negative cost absorption. In the third quarter, we had a favorable year-to-date adjustment for incentive compensation, which we don’t expect to repeat in the fourth quarter. There's also a tendency for costs to rise during the fourth quarter, and we have no reason to believe this year will be any different. Let's discuss our outlook for 2017, found on page ten. We generally provide a preliminary view for the following year in our third quarter release, and we're continuing that tradition this year. It is always challenging to predict at this stage of the year, given the year hasn't even begun, but currently, we're not expecting 2017 to be significantly different from 2016. That said, it doesn't mean it couldn't change. At this point, we want to offer you insight into our thinking by presenting both positives and concerns. Starting with the positives, commodity prices have improved from earlier this year. Oil has stabilized around $50, which is a positive signal. On the flip side, we don't believe commodity prices are sufficiently high to drive substantial sales increases next year; we'd like to see them rise more to create upside potential in the latter half of the year. In construction in China, we've generally had a positive year in terms of market position, performing better than most competitors. For example, today's release indicated a sales increase in construction in Asia of about 9%, which we believe could translate to growth next year if continued support for growth in China persists. Other developing countries, like Brazil, have had a challenging year, but we think sales in several countries may have bottomed out, presenting potential upside next year. In the mining sector, CapEx forecasts appear to be flattening, which is a promising indicator. Concerns persist, particularly regarding the North American construction scene, which has shown weaker-than-expected performance in the third and fourth quarters. If this trend continues beyond the election period, it could pose challenges for next year. We are cautiously monitoring economic growth in Europe, especially due to Brexit concerns, which may impact growth and business confidence. Additionally, the power generation sector remains weak in oil-producing regions with no immediate changes expected. Likewise, ongoing challenges for marine, particularly offshore service vessels, and a struggling rail sector, particularly in North America, are persistent concerns. Industrial engine sales to Ag customers have also been weak, as well as solar's performance, which remains stable, expecting 2017 to reflect flat performance compared to 2016. Our outlook for the segments next year reflects some negativity in Energy & Transportation, while Resource Industries could face less downside potential due to already bottomed out new equipment sales. Overall, we are set to wrap up with significant discussion points mentioned on page 11. There has been little change in the industries we serve since the last quarter, except for North American Construction, which has disappointed. Notably, our operational performance has been great, not just in cost reduction, and we believe our competitive position has improved compared to competitors.

Wells Fargo Securities. Good morning, everyone.

Morning, Andy.

On 2017, can you review some of the puts and takes we should consider when looking at the year, in addition to the revenue outlook you provided today?

Yeah.

And then, also, given the market outlook is pretty flat, are you considering any incremental cost removal actions?

Yeah, so regarding sales, I'm starting with that. On balance, we're not seeing a significant difference, but we've expressed caution about the first half of the year. The flattish for the year is dependent on a bit of improvement in the second half. Regarding cost actions, I suspect we will be planning a more conservative cost structure than what we think our sales could be for the year. Focusing on cost reduction will remain a priority. However, I won't delve into too many details yet as we're in the midst of our planning process for next year, but some big things you can expect: We will likely face a sizable headwind from incentive compensation. This year we found ourselves off of our outlook in most areas. Therefore, there's a potential headwind of $500 million to $600 million, depending on where the executive team and board set performance targets. On the positive side, we've done extremely well with cost reductions. We've taken out more cost as we've gone along this year, resulting in carryover effects for next year. Material costs have also been favorable. We've had good results from sourcing and design, which should work to our favor next year. We'll continue to work on other items in the plan, but by January, we'll provide a more comprehensive review of sales and profit drivers.

Okay. Thanks, Mike. And if I could follow up on the guidance for this year, the $3.25, I think in the past, a $3.55 included some benefit from change in pension OPEB policies. Is that still in the $3.25? And how should we view that in 2017?

Yeah, essentially, the change that we made had the impact of taking out prior-year amortization of gains and losses related to the assets and liabilities in the pension plan. This change better reflects the ongoing pension costs. It's not that there's a big benefit; I think it's just stated more accurately around what the actual expenses for the year are. This accounting change became effective at the beginning of this year and for prior years was stated as well. We will maintain this accounting treatment.

Okay. Thank you very much.

Thanks, Andy.

Hi. Good morning, Macquarie. My question's on excess capacity. It seems like rationalization, normal rationalization, isn't really happening, given the excessive liquidity provided by central banks. Does Caterpillar think deflationary pressures or pricing pressure will continue in this environment, or does it naturally abate? Or do you think M&A is the only channel for supply rationalization?

Sameer, I heard all the words you said. Is it a question about our pricing or what we tend to fix?

Caterpillar has indicated that excess capacity is a problem for price realization. My point is, if there's excess liquidity and many companies are not going out of business, does price realization continue to deteriorate?

Our pricing over the last couple of quarters has certainly been unfavorable compared to a year ago, but it has stabilized at this point. In fact, we had a Q&A in the release stating that we don’t see the pricing environment getting worse. Saying it's not getting worse doesn't imply that it's good; maintaining it at this level is a significant negative to our results. It was a $200 million drag this quarter. However, barring any major global economic event, I don't anticipate it getting worse; I expect pricing to remain stable at less than attractive levels.

Okay. Thank you.

Hi. Good morning, Credit Suisse. I appreciate the color on the fourth quarter revenues as well as the EPS. Can you provide a bit more clarity on whether you've changed your assumptions regarding dealer inventory at year-end and Cat's inventories relative to prior guidance? It seems like everyone wants to understand how as we approach 2017, what your confidence level is regarding production matching retail demand in light of current conditions.

Predicting dealer inventory precisely is always challenging, but I believe, based on where we've been year-to-date and trends likely in the fourth quarter, we might see dealer inventory decline by around $1.5 billion this year, with close to half of that reduction occurring in the fourth quarter. We are not currently producing to meet end-market demand; we are approximately $1.5 billion lower overall. As we move into next year, how we end this year depends significantly on how the second half of the year performs and what expectations for 2018 look like. If improvements occur mid-next year and there's optimism for a better 2018, dealer inventory may reflect that. In contrast, if the economic prospects appear weak, dealers may further reduce inventory. We'll have a clearer perspective on this in January, but for now, we expect some level of dealer inventory reduction next year, albeit less than this year.

So are you suggesting that in a flat environment, we'll still be under-producing retail demand next year?

I would say so.

Can you offer any quantify - not the $1.5 billion - but whether it will be considerably less than that and which markets it would focus on? Additionally, why not resolve this issue within this year instead of carrying it into 2017?

We don't control dealer inventory; dealers are independently managed, and their confidence levels dictate what they decide. They’ll anticipate future sales and might want to replenish in the first quarter for the selling season in Q2, hence the complexity of inventory management. In terms of ongoing product mix, it’s been a challenge across mining, construction, and some Energy & Transportation this year, with construction likely constituting about a bit more than the others.

Thanks, I'll get back in queue.

Yeah, good morning, Bank of America. Thank you. Mike, I've attempted this question for years; trying again this year. Caterpillar has approximately $3.6 billion in goodwill still residing in its mining segment. As you mentioned, new equipment sales are down 80% to 90% since purchasing Bucyrus. Your annual impairment testing is likely in the fourth quarter. I'm not asking if you'll write off the goodwill, as that's an auditor's decision; however, if you were to write it off, would it jeopardize either the dividend due to stipulations on shareholders' equity in your borrowing agreements, or negatively impact your credit rating?

Those are significant questions I'll answer generally. If we knew the outcome of the goodwill testing, we would already book it. The testing process is defined and ongoing. If we find there's an impairment, we will book it; if not, we won’t. The effect on the company would be entirely non-cash; it would impact equity but would not affect the dividend.

How can Caterpillar assert that the assumptions on value have not materially changed since the acquisition, particularly in light of the significant drop in equipment sales?

Well, Bucyrus does not exist as an entity anymore. The goodwill allocation does not fall within a single measurement. We assess goodwill based on the respective businesses it's allocated to. Since Bucyrus was merged with our operations, it’s been allocated across several segments, and we measure that accordingly. In last year's K, we provided details on goodwill. The segment nearest to triggering an impairment was around 15% off last year, accounting for about $1.2 billion of the goodwill. Hence, there’s no direct Bucyrus component left in the business. Whether there's an impairment or not, we will know after the fourth quarter.

Thank you, Mike.

Evercore ISI. Good morning. I was trying to think about the cadence and confidence in the 2017 outlook. Orders are down about 10% year-over-year, and we need them to grow about 5% sequentially just to start 2017 with orders still down about 10%. Can you provide clarity on current order trends?

Our backlog from the second to third quarter didn't change considerably. In construction, the backlog is fairly weak outside of China where it has remained consistent. We don’t have a long backlog for construction products, shipping in the 8 to 15 week range; therefore, orders are typically lower this time of year. Dealers are planning to cut inventory in the fourth quarter, which is likely causing reduced ordering. We anticipate a rebound in orders in the first quarter as dealers will want to build inventory for the second quarter. The Solar backlog is reasonable and should match historical flat performance next year. Overall, we are confident that the first half of next year may present some challenges; any improvements in the back half depend on the US economy and construction trends, specifically mining orders that are not currently much in sight. We're encouraged by positive sentiment from commodity prices that may lead to further discussions about CapEx, but so far, this hasn't translated into orders.

To be healthy, you need significant mining orders to drive a positive year-over-year. We're looking at next six to nine months, where orders seem rather flat or down 10% year-over-year going into 2017. Can you describe current order visibility?

We don’t typically disclose orders, so I'll have to review your numbers; however, you need to differentiate types of orders. Parts, for example, fill orders typically within two days, while rail orders can extend over two years. Therefore, understanding order trends requires context based on the product being discussed.

I noticed you didn't mention R&D expenditures as potential cost savings. It seems like it could be a beneficial area to evaluate given the 11-14% reductions you've had across previous quarters. What should we expect in terms of R&D in 2017?

Currently, we're in the planning stages, and we haven't finalized resource allocation decisions. I understand why you might think that, but I’ll hold off on making any definitive statements until we can complete that process.

Is it fair to anticipate that R&D expenditures should decrease next year?

I'm not going to commit to that right now as we haven't evaluated that inside our planning process yet. It could be possible; however, I'd prefer to finalize discussions before making a definite statement.

Thank you for your time.

Thank you. It's Barclays. Congratulations to Doug and Jim. Doug, we've observed excellent work under your leadership on competitive positioning, production systems, and market share, which should benefit the business for years to come. Congratulations.

Thank you, Rob. I appreciate that.

I have a specific question regarding SG&A expenditures in the most recent quarter, which have been quite low, indicating excellent cost control. Even accounting for potential increases in incentive compensation, they should remain relatively low compared to numbers we’ve seen previously. What should we expect for sustainable SG&A levels from the quarter?

Yes, the incentive compensation played a role in the low SG&A this quarter, but outside of that, we haven't identified anything unusual or materially different. I anticipate that SG&A costs might be a bit higher in the fourth quarter due to timing, but there’s nothing significant beyond incentive compensation that I’m aware of.

Can you provide a sense of the total raw material benefit for 2016 so far?

As for 2016, I don't recall the precise total number, but it’s probably a couple of hundred million dollars or slightly more.

Thank you.

Good morning. It's Vertical Research. Regarding pricing in 2017, early expectations came from your late September announcements, which had a broad range of expectations; how are you thinking about pricing overall for 2017?

That's a great question, Joe. During our update on 2017, I was silent on price realization, which is critical for next year. On the positive side, we did boost list prices across many machines, between 0% and up to 4%, depending on the product. However, that does not cover aftermarket or our Energy & Transportation divisions. While we expect to see better pricing based on list price increases, I don't see that translating into a positive price realization as it varies by market conditions. At this point, I can't definitively categorize it as a headwind or tailwind.

Can you elaborate on dealer inventory, particularly historical norms for inventory levels? What impact does Lean manufacturing have, and how could efficiency affect future dealer inventory?

While there are usually reasonable bands for months of supply, predicting precise inventory levels is challenging since future sales prospects impact dealer decisions significantly. Typically, we recommend around three to three and a half months of supply, but that fluctuates based on many economic factors. Achieving optimal inventory levels helps us both as a manufacturer and for dealers who want to ensure they have adequate supplies without excessive overhead.

Thank you.

Thanks. It's Morgan Stanley. Can you provide clarity on North American construction weakness that you noted earlier? What drove that concern?

In North America’s construction sector, the heavy construction and rental businesses are sizable for us. Housing markets are performing well, but larger infrastructure projects and equipment refresh cycles are lacking, with rental channels further demotivated by excess used equipment in the marketplace. This has resulted in subdued sales into that channel, which impacts our overall performance. We’re hopeful that after the election, increased infrastructure spending will stimulate demand, but as of now, we remain concerned.

Regarding Resource Industries, you mentioned a breakeven outcome in 4Q. Should that still be how we think about it today?

I would refrain from providing guidance at this point; they have performed well in the third quarter, with a notable decline in sales but minimal variations in profit. However, looking at overall expectations for the fourth quarter, we do expect cost absorption headwinds and typical seasonal costs, which means I wouldn’t anticipate better conditions for profitability in Resource Industries for the fourth quarter.

Understood, thank you.

Thanks, Mili. We have time for one more question before wrapping up.

Hi, JPMorgan. Doug, I just wanted to express appreciation for your visibility and accessibility over the years as CEO, regardless of our stock weighting; we value that, and I hope Jim continues in that spirit.

Thank you, Ann. I appreciate that too.

Regarding steel prices and raw material costs, we see significant increases over the course of the year. Can you explain how that might impact your outlook into 2017? It's an advantage for mining but could be a headwind for gross margins.

I don't expect significant impact. Over the past few years, we experienced high material cost reductions, some stemming from commodities and some from sourcing and design. The commodity benefits have largely evaporated this year, and going forward, we expect pressure; however, should commodity prices rise, we would gladly welcome that. Even if material costs increase, the impact on sales could offset those challenges.

Thank you. A follow-up: is the variable cost reduction you highlighted reflective of actions that come back into the system aligned with revenue?

Yes, that's a key aspect; material costs contribute to that overall variable cost profile, and you should assess future declines relative to the anticipated revenue in evaluating that process.

Thank you very much, and good luck, Doug.

Thank you.

Thanks for joining today's call. We look forward to speaking with you again in January.