Caterpillar Inc (CAT) — Q1 2017 Earnings Call Transcript

Thank you very much, Kate. Good morning and welcome, everyone, to our First Quarter Earnings Call. I'm Amy Campbell, Caterpillar's Director of Investor Relations. And on the call today, I'm pleased to have our CEO, Jim Umpleby; our Group President and CFO, Brad Halverson; and our Vice President of Finance Services, Joe Creed. Remember this call is copyrighted by Caterpillar, Inc., and any use, recording, or transmission of any portion of the call without the express written 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 our caterpillar.com website. It will be in the section labeled Results Webcast. This morning we will be discussing forward-looking information that involves risks, uncertainties, and assumptions that could cause our actual results to differ materially from the forward-looking information. A discussion of some of the factors that either individually or in the aggregate could make actual results differ materially from our projection can be found in our cautionary statements under Item 1A, risk factors, of our Form 10-K, filed with the SEC in February of 2017. And it's also in our forward-looking statements language that was included in today's financial release. In addition, there is a reconciliation of non-GAAP measures that can be found in this morning's release, and it is also posted at caterpillar.com/earnings. We're going to start the call this morning with a few words from Jim, and then Brad will walk us through first quarter results and our revised outlook. And then we will turn it back to Kate to begin the Q&A portion of the call. Jim?

Thank you, Amy. Before I talk about our quarterly results, I'll spend a few minutes discussing my perspective since becoming Caterpillar's CEO on January 1. It's a privilege to lead this iconic company and this strong leadership team, and I'm confident we are well-positioned for the future. As you know, generally weak economic conditions and commodity price volatility have made the last few years challenging and have significantly impacted the industries we serve. We've responded to these challenges with a thoughtful approach to restructuring and strategies to improve our market competitiveness. Our product quality has improved. We're continuing to invest in R&D and expanding our digital offerings to help our customers be more efficient and productive. We've made progress implementing lean manufacturing and have strengthened our dealer network, which provides us with an unrivaled competitive advantage. We are focused on controlling costs and maintaining the cost flexibility necessary to invest in products and services to drive future growth and shareholder value. The goal of our entire leadership team is to return Caterpillar to profitable growth. Given the industries we serve, we will always be subject to cycles. But our goal – through focusing on profitable growth, a disciplined resource allocation methodology, and a more flexible and competitive cost structure – is to sustain profitability through the cycle. Before I turn it over to Brad to talk about the quarter in detail, I'd like to congratulate our team on a great start to the year. Quarterly sales and revenues were up for the first time since 2015. The difficult but necessary decisions we've made since the downturn have resulted in outstanding operational performance. Profit per share, excluding restructuring, is twice what it was a year ago. There are encouraging signs and promising quotation activity in many of the markets we serve. And retail sales to users have turned positive for both Machines and Energy & Transportation for the first time in several years. However, there is still a great deal of geopolitical and market uncertainty, along with economic volatility around the world that continues to present risks. Now I'll turn it over to Brad to walk through the results and the outlook in detail.

Well, good morning, and thanks, Jim. If you have the slide deck in front of you, I'd ask if you could please turn to page 4, slide 4, and we'll start with our first quarter results. 2017 has started off very well and exceeded our expectations for the quarter. Sales and revenues increased about $400 million or about 4% on the first quarter of 2016 to $9.8 billion in the first quarter of this year. This is the first time in 10 quarters that sales and revenues were higher than the prior year, although sales are coming off a very low base. Resource Industries had the largest increase, followed by Energy & Transportation and Construction Industries. In the quarter we announced our decision to close the Gosselies, Belgium, and Aurora, Illinois, facilities. Total restructuring costs were $752 million in the quarter, $591 million more than the first quarter of 2016. As a result, profit per share was down $0.14 from $0.46 to $0.32 in the first quarter of 2017. On a 4% increase in sales and revenues, profit per share excluding restructuring doubled from a year ago from $0.64 in the first quarter 2016 to $1.28 this quarter. The increase was driven by higher sales, favorable mix, improved price, and lower costs. As you know we've been working hard on lowering our cost structure, right-sizing our footprint, and allocating resources directly to the highest profit opportunities. All these actions were key in delivering a very strong quarter. Let's turn to slide 5, and we'll look at first quarter operating profit. First quarter operating profit was $417 million, as compared with $494 million in 2016. As I already mentioned, restructuring costs were up $591 million. Excluding restructuring costs, operating profit was up $514 million. Positive changes to operating profit came from several areas. The largest increase to profit was the result of higher sales volume and favorable mix. About half of the sales volume profit change came from a favorable mix of products sold in the quarter. And that favorable mix impact was about equally spread across all three of our primary segments. While the market remains very competitive from a pricing perspective, price realization was favorable $88 million, with more than all of the positive variance coming from Construction Industries, partially offset by negative price in Resource Industries. Variable manufacturing costs were favorable by $96 million, with about half of that positive variance coming from continued improvement in material costs. We continue to reap the benefits of collaboration efforts between our dedicated procurement team, suppliers, and engineers, but we do not expect material costs to be – but we do expect material costs to be under pressure as the year proceeds due to an expectation of higher commodity prices, especially steel, in the back half of the year. Lower period costs were better by $140 million. Lower period costs are a result of our restructuring and cost reduction initiatives that we have implemented over the last several years and delayed timing of R&D spend, partially offset by higher incentive compensation expense of about $100 million. We also had strong ME&T operating cash flow, which was $1.5 billion in the quarter compared to $200 million in the first quarter of 2016. And we ended the quarter with $9.5 billion in cash. Now let's look at each of the segments, starting on slide 6. Construction Industries' sales and revenues were up slightly to $4.1 billion. Positive price realization of $123 million drove more than all of the sales increase. While the construction industry market remains very competitive, especially in North America, favorable price realization was due to a particularly weak pricing environment in the first quarter of 2016 and previously announced price increases impacting the first quarter of 2017. However, the sales story is more than just price. Very strong demand in Asia-Pacific was largely offset by lower sales volume in North America. The strong demand in China resulted in a reduction in Asia-Pacific dealer inventory, as demand outpaced our sales to dealers. Strength in China has mainly been driven by a strong execution of public-private partnership projects, particularly related to infrastructure and strong housing investment. Credit growth has remained supportive and better than we previously expected. High replacement demand and a tight used machine inventory market have also helped. While March and April are traditionally the highest months for industry opportunity in China's peak selling season, if policy remains supportive we expect strong market conditions in China to continue at least through mid-year. North America dealer inventory increased, but by less than a year ago. And end user demand was lower. Both contributed to the sales decline in North America. However, order activity in North America has been very strong, which has contributed to the increase in the backlog. The Middle East and Brazil remain weak. Construction Industries' operating profit was favorable by about $200 million on about flat sales as a result of favorable price realization and lower cost. Construction Industries' multi-year focus on OPACC, as we call it, our operating profit after capital charge delivered the strongest quarter for operating margin percent in a long time. And this on sales that are about 20% below the highs reached in the second quarter of 2011. If we move to slide 7, we'll look at Resource Industries. We are very happy to report that we have good news in our Resource Industries segment. Sales were $1.7 billion or up 15% versus 2016, and operating profit was $158 million. After four years of declining sales, the part fleet has come down and is now under 20%. Hours of utilization on trucks is up. And for the fourth quarter in a row, parts sales have increased to support rebuild and maintenance needs. Sales increases for aftermarket parts were broad-based, and they were the primary driver of the change in sales. As you saw in the retail stats that were published yesterday, sales to users remain negative. However, after 16 quarters of underproducing retail demand, dealer inventory remained about flat in the quarter, with a positive change in inventory more than offsetting negative retail sales and driving Resource Industries OEM sales up. We are seeing sporadic order activity for mining equipment and expect to ship significantly more mining trucks than we did in 2016. Resource Industries delivered positive operating profit for the first time since the second quarter of 2015, which is the result of significant actions that have been taken to lower their breakeven point. The improvement in operating profit resulted from higher sales volume and lower costs, partially offset by higher incentive compensation expense. Let's move to slide 8 and look at E&T. Energy & Transportation sales were up slightly in the quarter, from $3.3 billion to $3.4 billion. Higher sales into oil and gas applications, primarily in North America, were partially offset by lower Power Gen sales into EAME. Sales into industrial and transportation applications were about flat. The number of oil and gas rigs in service continues to increase and has more than doubled the lows that were reached last May. This has resulted in an increase in aftermarket parts demand to support the overhaul and rebuild of well servicing fleets. We are also seeing a significant increase in demand for our large reciprocating engines used for midstream gas compression applications. Demand for drilling and production application remains very low. Operating profit for Energy & Transportation was up $142 million, from $410 million to $552 million. This was largely attributable to higher sales volume, a favorable impact from cost absorption, and improved material costs. Period costs were about flat as the favorable impact of restructuring and cost reduction actions was about offset by a higher short term incentive compensation expense. I want to add a quick comment on financial products. Operating profit was up $15 million. The portfolio remains healthy and past dues were 2.64% versus 2.78% in the first quarter of 2016. Write-offs were down and used equipment prices are starting to recover. Okay. Well, let's move to slide 9, and we'll look at our full-year outlook. We announced this morning that we are raising the outlook for full-year sales and revenues. In January we provided an outlook for sales and revenues of $36 billion to $39 billion. As a result of better-than-expected first quarter, strong order rates, and an increase in our backlog, we are providing new guidance for sales and revenues in a range of $38 billion to $41 billion with a midpoint of $39.5 billion, which is up $2 billion from our previous outlook. At the midpoint of the sales and revenue range we have changed the profit-per-share outlook to $2.10, reflecting our decision to close the Gosselies and Aurora facilities. And we have raised the profit-per-share, excluding restructuring costs, outlook to $3.75. We turn to the next. While there are positive signs across many of our end markets, and we have seen a significant increase in order activity and the backlog, we believe given the political uncertainty around the globe and the potential for volatility in commodity prices, that it is prudent at this point in the cycle and at this point in the year to consider both the positive and negative as we look at our end markets and what could impact sales as the year progresses. There are several positive sentiments. World business confidence is at a two-year high, and world growth is accelerating. There are also positive indicators for North America construction demand. Many states have passed infrastructure bills. Pipeline projects that were previously stuck in permitting are now moving ahead and residential and nonresidential demand in certain parts of the U.S. remains robust. We believe business optimism, which may be contributing to elevated quoting and ordering activity in North America, is partially a reflection of the benefits of pro-business policy in regards to infrastructure and tax reform. However, we don't expect to see any meaningful impact from these changes until 2018. The backlog is up $2.7 billion on strong order activity in all segments. China construction equipment industry is robust, with industry sales up sharply versus last year. Gas compression demand for reciprocating engines is very strong. And miners' balance sheets are improving, and they are expecting increases to CapEx. However, there are other risks to the outlook that we believe are prudent to take into account. Outside of Asia-Pacific, retail stats for construction industries remain negative. Demand for overhauls and rebuilds in mining and oil and gas could diminish as those units go back to work. Brazil remains weak. The Middle East continues to struggle as a result of lower oil prices. Competitively, the pricing environment remains very challenging. The potential for oversupply of oil could drive volatility in the price of that commodity. And geopolitical uncertainty across the globe is elevated. If we go to slide 11, we'll look at it quickly by segment. We now expect Construction Industries sales for the year to be about flat to up 5%, driven largely by demand in China. We have yet to see retail stats in the rest of the world turn positive. While order rates are encouraging, they will need to be sustained by continued strength in business confidence. For Resource Industries, we now expect sales and revenues to be up 10% to 15% for the full year, driven by higher parts sales in the first half of the year to support rebuilds and maintenance work, and then transitioning in the second half to new equipment sales to support increased CapEx spending from the miners. We now expect Energy & Transportation sales revenues to be about flat for the year. Improvements in oil and gas to support overhauls in maintenance for well servicing fleets and higher demand for reciprocating engines used in gas compression applications are largely being offset by slight weakness across Power Gen, industrial and transportation. If we move to slide 12, we'll look at the outlook for profit. While there are several small puts and takes, the raise in the profit per share from $2.90 to $3.75, excluding restructuring, is primarily the result of an increase in sales volume of about $2 billion and a corresponding variable margin we would expect on higher sales, partially offset by an increase in short-term incentive compensation expense of about $200 million. The outlook reflects just slightly more than half of the year's sales and revenues in the first half, which would be similar to trends in recent years. We had a very strong quarter. And if you compare the first quarter to the average of the last three quarters, we expect some real headwinds, due to less favorable mix than we experienced in the first quarter, pressure on price and material costs, and the timing of period cost spend. That said, at a midpoint of $39.5 billion in sales and revenues, and a PPS excluding restructuring cost outlook of $3.75 for the full year, at this sales range we would expect – we expect to deliver an operating profit pull-through of just less than 50%, well ahead of our target range of 25% to 30%. So we'll wrap up on slide 13. First quarter was a great way to start the year, with higher sales and very strong operating performance across the board. We raised the outlook for sales and revenues to reflect a strong quarter and improved market conditions across many of our end markets. While uncertainty and the potential for volatility in commodity prices remain, we are ready to respond as demand increases. We remain very focused on cost management. And we are using our operating and execution models to be very deliberate about where to invest so that we deliver the highest shareholder value, investments that include lean, R&D, and digital. Before we turn it back to the operator for the Q&A portion, I believe Jim has a few additional comments.

Thanks, Brad. My first quarter as CEO has certainly been eventful. We had great first quarter results, announced the relocation of our headquarters to the Chicago area, the closure of our Gosselies, Belgium, facility and the relocation of manufacturing out of Aurora, Illinois. We've also ratified a new six-year contract with the UAW. Each of these are significant actions. Taken together, they will strengthen our company and create long-term value for our shareholders. Also, I want to provide an update related to the search warrant executed at three Peoria area facilities in March. At Caterpillar, we take very seriously our obligation to follow the law. And we are committed to maintaining our long tradition of pursuing the highest ethical standards in conducting our business. If we find something that violates our values and our code of conduct, we will take appropriate action. At this time we have nothing more to report. Caterpillar has retained former U.S. Attorney General William Barr currently of counsel to the firm of Kirkland & Ellis to take a fresh look, get all the facts, and help bring these matters to proper resolutions. We are continuing to cooperate with the government investigation. Amy?

Thanks, Jim. And now we will turn it back to Kate to open the phone lines for questions.

Hi. Good morning. First question just on the guide and what you're looking at for margin in the rest of the year. I think you talked to a number of headwinds, but if you could just talk maybe a little bit more specifically about some of the details, whether or not price you see continuing as a tailwind? Or if you have visibility into that reversing to some headwinds? What you see on the mix front? And anything else with material costs that are on the horizon? Just so we get some comfort with the implied step down in the margins.

Sure, Joe. And I think you have to look at it kind of two different ways. If you look at the new outlook that was provided this morning and compare it against the outlook from January, really broadly speaking the only two changes are those that Brad talked about, higher sales volume of about $2 billion, which will generate higher variable margin, offset by about $200 million more in short-term incentive compensation expense. In the original outlook we communicated that we expected material costs to be favorable about 1% for the full year. While we expect that number to come down some, we still do expect some positive, maybe closer to zero, but still some positive material costs for the full year. Our outlook for price has not changed really very much at all since the original outlook. And our period costs assumption, excluding that short-term incentive compensation expense, is also, broadly speaking, about the same. So versus the outlook that we provided back in January, it's really just higher volume minus the higher incentive compensation expense. If you look at what's changing from the first quarter to the rest of the year, there's a couple of things to keep in mind. We had very favorable mix in the first quarter. About half of the sales volume mix impact was from mix. And we don't expect to see that kind of favorable mix impact as we go forward. We do expect pressure on price and material costs in the back half of the year, especially around steel. But even though we expect them to be favorable versus last year, we don't expect them to be as favorable as we saw in the first quarter. And there was some period costs. Timing of spend, traditionally the first quarter is a low quarter for period cost spending, so some of our projects and initiatives that we have planned for the year did not pick up to their full spend rates in the first quarter. That would also increase as the year progresses. But I think if you take it all in, and we're committed to incremental profit pull-throughs, for the full year, and the outlook reflects almost 50% operating profit pull through, well ahead of our target range of 25% to 30%.

That's really helpful. And then just one more on mining. And I think it looked like in the quarter actually, the benefit of some sell into dealers that was better than what you saw in kind of the pull through demand. But you also commented on expecting significantly higher volumes I think in mining truck shipments this year. I believe you've talked about large mining truck shipment volumes in the kind of 70, 80 units last year. Can you give any kind of frame for exactly what kind of volumes you're anticipating in 2017?

Yeah. So if you look at Resource Industries dealer inventory, it really broadly stayed about flat quarter over quarter. And so since we've been on kind of 16 sequential quarters of taking dealer inventory down, that was a positive to sales. But dealer inventory did remain – it was actually up just slightly in the quarter. As you mentioned, Joe, we probably sold about 70 to 80 trucks or so last year. It was probably closer to 70. We do expect shipments for large mining trucks to increase significantly. Most of those will be in the back half of the year. Several of those are going to large customers in less price-favorable regions, I guess you could say. But we have good demand. I think even if we double the number of truck sales – and I think that's certainly very doable this year – it would still be the second lowest year for large mining truck sales. So we're still at very low levels, even in 2017, with what will probably be some pretty significant increases in our total shipments versus last year.

Got it. Thanks very much.

Hi. Good morning, and congrats on a nice quarter. Jim, not a bad way to start off as CEO. I guess back to Resource, Amy or Brad, I'm just trying to understand what's implied in your guidance for research margins in 2017, given where we started the year at a 9.5% margin. I think that was better than what anyone would've hoped. Or did the margins get eaten away by selling to less profitable regions? I'm just trying to understand that. And then I guess – or was there anything unusual I guess in the first quarter that the 9.5% sort of isn't sustainable? And then I guess the second question I have is just sort of how you're handling the cyclical upturn. When I talk to your dealers, a lot of them are complaining about lead times and that lead times are extended. So I'm wondering if when I think about your sales forecast, is any of the upside constrained by your inability to ramp? Or could you just talk about how you're thinking about ramping production in your supply base? Thanks.

Sure, Jamie. If you look at Resource Industries margins, like I said we were very pleased with the margins that Resource Industries put up this quarter, $158 million in operating profit. If you kind of revert back to the fourth quarter call and Mike's discussion, we expected Resource Industries to lose a little money but be close to breakeven. And so it really had a great quarter. We don't expect this quarter to repeat, either in terms of operating margin dollars or operating margin percent. But moving forward for the rest of the year we would expect Resource Industries to either break even or do a little better through the rest of the quarters remaining this year.

But is there a particular reason for the step down? Like I understand you're saying it's not...

Sure. Yeah. So Resource Industries, as we talked about, that mix number was about equally spread across the three primary segments. We wouldn't expect that favorable mix to continue. There will also be, like in the other segments, some material cost pressure. And we do expect some sales for some mining equipment into some regions of the world that maybe aren't as price advantaged as other parts of the globe.

Okay. And then just sort of lead times or how much your sales forecast is being constrained by you guys not be able to ramp quickly enough?

Sure. I think there are probably two areas. Maybe I'll step back a little bit. If you look at Construction Industries, with a significant increase in orders for BCP product in the fourth quarter and first quarter, several of those products have been moved to managed distribution. And with the announcement that we were considering the closure of both Gosselies and Aurora, we also put all medium wheel loaders on managed distribution at the beginning of the year. In both cases that was to make sure that we got shipments to where they needed to go and to discourage some panic ordering or some unnecessary ordering to make sure we managed that. But we don't expect either of those actions to impact or drive a loss in sales situation. If you look at China, I would say that for Construction Industries, while we continue to grow market share there and we're very pleased with how the year is shaping up so far, I'd say if demand continues at these levels, we're continuing to keep an eye on China and make sure that we can continue to meet the higher demand in that region. But the other notable comment, and I've seen a lot of it being discussed out there, is for our large 3600 reciprocating engine. We have seen lead times for those extend out. And we're bringing the production back to our Lafayette, Indiana, facility. But we wouldn't expect that to result in any lost sales either.

Okay. Thank you. I'll get back in queue.

Hi. Good morning. Given your comments about the supply chain is not an issue at the moment, or loss of sales from any production ramp that you feel you can do, I'm just trying to reconcile really simply the sales guide. The rest of the year sales growth is implied at only 2%. But the backlog is up 13%, the implied orders are up twice as much as that. The revenues were already up 4% in the first quarter. So can you just help us square – do you see something that would suggest growth has to slow from what you've been seeing of late? Because even if I just annualize the first quarter, for example, in CI or even RI, you're already at or above the high end of your range for those segments. So if you could just help us better understand the sales guide?

David, if we go back and revisit some of the positive sentiments but also some of the negative, or risks that are out there in the outlook, we wanted to be thoughtful and mindful that there's still a lot of uncertainty in the world. And there's still the potential for volatility both in commodity prices and oil prices. And so even if you walk through a few of those, first of all we would expect – we're seeing a lot of demand for overhauls and rebuilds of both mining equipment and oil and gas well servicing fleets. We would expect that demand to taper off. Or I don't know if we would expect that, but it could taper off as the year goes on and all of those units get overhauled and repaired. We also – we do need to watch the volatility. It's possible that too much supply comes back online in North America, which would drive some additional volatility in oil prices when it comes to commodity prices. While the demand and supply seems to be in better balance, there still is some persistently high inventories for several commodities, which could put some pressure on commodity prices. If you look at North America order rates, as Brad mentioned and you mentioned, have been very strong. Certainly, there are some good fundamentals to support that that Brad talked through, pipeline. A lot of states have passed infrastructure bills. But we believe some of that has to do with business optimism. And we need to see that business optimism continue through at least the second quarter I think before we get more comfortable and confident about what the back half of the year will look like.

Just to be clear, I mean those are all very valid and potential concerns. But these aren't things you're necessarily seeing in your current order books or trends. Is that correct? I mean all those points are valid. But I mean I'm just making sure nothing there sounded like we are seeing in the second half the rebuilds. Because if anything, the lead times are getting longer out of Lafayette. Right? So I'm just trying to – some of the comments you made, I just want to make sure those aren't trends you're seeing in your orders. It's just – understandably it's April and things could change from a macro level. But from a micro level, are there any particular concerns? Because even the last nine months of last year, the dealers took out $1.9 billion of inventory. The year-over-year swing on inventory I assume the next nine months is a positive. Could you maybe help us with how you view dealer inventory the next nine months?

So if you look at dealer inventory, and we didn't include that in the Q&A. I think it's really going to shape up to what we expect 2018 to be. And it's really too early to make a forecast for 2018. Embedded in the outlook is a slight decrease in dealer inventory, certainly quite a bit less than what the $1.9 billion or $1.7 billion for the full year that we saw in 2016. I think back to your earlier question, we have seen I'd say the pace of order activity slow a little bit. But it is still doing better than a year ago as we said in April.

Okay. The reason I asked is the dealer inventory swing, if you even just get – you took out $1.9 billion the last nine months of last year. Say you take out only $650 million, that $1.25 billion of improved year-over-year dealer inventory, the rest of the year would give you almost 5% revenue growth. So it seems like your sales guide is not even a dealer inventory swing. So that's why I was just trying to make sure I understand what's in it. And it just sounds like...

Yeah. Yes. I think if you looked at any one of those assumptions in isolation, I think you could conclude that there's some upside. And I think that makes sense and we would agree with that. But as we sit here in April, there still is a lot of uncertainty, there still is the volatility. We're only three months through the full year. We need to see order rates continue at the levels we saw in the first quarter in order to get more comfortable about the rest of the year. But we are I think very pleased with our ability to raise the outlook by $2 billion here one quarter into the year.

Thank you. A question on resources mining. Would you be able to characterize the increase in parts sales? Was it more big rebuild and sort of scheduled maintenance than people coming in and doing big projects? Or was it more a flow in consumables, maybe a restocking to dealers and restocking to mines, et cetera? Just a little bit curious on the mix on that.

Yeah. I don't have that breakdown, Rob. Kind of more it would just be anecdotally what I've heard the business teams share. Certainly we believe that a lot of it has to do with overhaul and rebuild of mining equipment. We do believe that there may have been some restocking of dealer shelves in the first quarter. And certainly if you look at the hours of utilization of the mining equipment versus where it was at its depth, kind of middle of last year, mining equipment is being used quite a bit more extensively. And I think that you can conclude from that that it's driving consumables of filters and fluids and other things like that as well. So I think it's pretty broad-based across all three of those categories.

Thank you. And if I could ask a second. I mean Construction, CAT has spent a number of years sort of improving its competitive position relative to peers through limited pricing. And I think has successfully done that. I mean do you have any thoughts on what you think your sustainable margin is? Whether this quarter is starting to be more a reflection as you normalize your pricing versus competition what Construction can do? Or just thoughts on normal?

Sure. As you could expect, I'm not going to give you a guide kind of on normal operating margin for Construction Industries. As I said a little earlier, we do expect a small improvement, a slight improvement in operating margins for the full year for Construction Industries versus a year ago. And that's going to be on significantly higher incentive compensation expense. So I think it continues to reflect the great work that that team has done and their focus around OPACC or operating profit after capital charge. The pricing environment for Construction Industries, especially in North America, is very competitive right now. We are looking at that. I'd say it's across numerous competitors, not just with transaction pricing but also with financing deals. That's certainly a risk that we have in the back half of the year that we continue to keep our eye on and make sure that we're meeting our market position goals.

Thanks. Good morning, everybody.

Good morning.

Morning, Andy.

Question on the outlook. If I take the implied $3.75 midpoint, subtract the really good Q1 from that, it applies about a $0.30 earnings decline for the last three quarters of the year compared to last year. And then if I take the 50% pull-through expectation for this year, kind of implies flat Machines and E&T operating profit for the last three quarters. Could you help us understand the factors, if I'm doing the math right, below the operating profit line that are driving this $0.30 headwind?

Yeah. So there's a couple things. The tax rate is a little bit higher. I think it's about 28% now in the outlook versus 25% I believe for 2016. We do have a slightly higher assumption for shares. And then there are several things that happened in the other income and expense line, some hedging gains or losses that we don't put in the outlook as well as some income – or interest income, excuse me, and a couple other small things that are all occurring kind of below that operating profit line. That'll net you out to that reconciliation you're trying to do, Andy.

Hi. Good morning, everyone.

Good morning, Jerry.

Morning.

I'm wondering if you folks can talk about – now that you're closer to completing the manufacturing footprint restructuring program, can you update us on your next set of strategic priorities? Jim, I appreciate it's only a quarter in. But I'm wondering if you could just outline for us the next areas that you folks are focusing on? And how you're thinking about the business over the next cycle?

Yeah. And, Jerry, we have a group of senior executives that we pull together to really lay out our strategy moving forward. I mean call it a strategic planning committee. Something that Caterpillar CEOs typically do when they come into office. And so we're working our way through that. It's too early for us to talk about that. But certainly at the analyst meeting we're having later in the year, we'll lay those out.

Okay. I guess on the shorter term front, you folks have rolled out the general contractor grade product lines across your developed market, construction equipment product lines. And I'm wondering if there are any other strategic priorities that are near term that you folks can talk about outside of what's planned for later this year?

I think certainly – and there's certainly a lot of them. But one that comes quickly to mind, Jerry, would be our focus on digital, making sure that we have the best services and solution to meet our customers' needs and help them be successful and make more money using our products than our competitors'. So all of the advancements, a lot of them on display at ConExpo, is a huge area of focus for us right now. We believe we have the largest industrial connected fleet in the world of about 0.5 billion connected assets. And we continue to expect to grow that this year. And so I think that's one area of many, as well as continued focus on new product development. And then I'd say lastly, using the operating execution model to make sure we're very deliberate about where we put our resources to make sure they're being put around projects and investments that'll drive the highest shareholder value. And I think with that, well, that'll be the last question. So, Kate?