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spk04: Thank you for holding. We sincerely appreciate your patience.
spk06: Good morning, ladies and gentlemen, and welcome to the Caterpillar 3Q 2019 Analyst Conference. At this time, all participants have been placed on a listen-only mode, and we will open the floor for your questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Jennifer Driscoll. Ma'am, the floor is yours. Thanks, Catherine.
spk04: Good morning, everyone, and welcome to Caterpillar's third quarter earnings call at our new earlier time of 7.30 a.m. Central. Joining us today are Jim Umpleby, Chairman of the Board and CEO, Andrew Bonfield, CFO, Kyle Epley, Vice President of our Global Finance Services Division, and Rob Rangel, Investor Relations Manager. Our call today expands on our earnings release, which we issued earlier this morning. You'll find slides to accompany today's presentation, along with a release, in the Investors section of Caterpillar.com under Events and Presentations. The forward-looking statements we make today are subject to risks and uncertainties. We'll also make assumptions that could cause our actual results to be different than the information we discussed today. Please refer to our recent SEC filings and the forward-looking statements reminder in today's news release for details on factors that individually or combined could cause our actual results to vary materially from our forecasts. Let me remind you that Caterpillar has copyrighted this call, and we prohibit use of any portion of it without our prior written approval. We're not reporting adjusted profit per share today, but remember we will at the end of the fourth quarter. This will exclude any mark-to-market gain or loss for the remeasurement of pension and other post-employment benefit plans, as well as any other material discrete items. As a reminder, our U.S. GAAP-based guidance for profit per share is continues to include the benefit of the 31-cent discrete tax item we recognized in the first quarter. In a moment, you'll hear from Andrew with a summary of this quarter's financial results. But first, let me turn the call over to Jim for our third quarter highlights, which appear on slide three. Thank you.
spk10: Thank you, Jennifer. Good morning, and welcome to Caterpillar's third quarter earnings call. First, I'll cover our third quarter results at a high level and give you my perspective on the key factors influencing our performance. I'll then provide some context for our decision to lower our 2019 guidance, and we'll discuss our expectations for the external environment. The primary factor impacting our third quarter results was lower volume, driven by reductions in dealer inventory and lower than expected demand from end users. Sales and revenues declined 6% during the quarter, mostly due to construction industries and resource industries. During the third quarter of 2018, dealers increased inventory by $800 million in anticipation of increasing end-user demand. This compares to a decline of $400 million in dealer inventory during the third quarter of 2019, a quarter-to-quarter change of $1.2 billion. Although the retail sales data we released this morning reflected an increase of 6% for both machines and energy and transportation, we believe dealers reduced inventory due to uncertainty in the global economy resulting from trade tensions and other factors. We've also made progress reducing our lead times, which allows dealers to maintain less inventory. Shorter lead times allows Caterpillar and our dealers to more quickly adapt to changing market conditions. We are taking steps to reduce production to match dealer demand. Our third quarter operating profit decreased 5%, driven primarily by lower volume. We maintained our operating profit margin percent despite lower volume and some continued pressure on manufacturing costs. We anticipate meeting the full year operating margin targets communicated during our investor day last May. Turning to the full year on slide four, we lowered our guidance for 2019 this morning. We now expect profit per share for the full year to be between $10.90 and $11.40 versus our prior guidance of the low end of the range of $12.06 to $13.06. Both ranges include the benefit of the $0.31 discrete tax item in the first quarter. Our revised outlook is primarily the result of caution being displayed by our dealers and customers due to uncertainty in the global economic environment. You'll recall that during our second quarter earnings call, we expected dealers to reduce inventories by about $900 million during the last six months of the year. We now anticipate that dealers will reduce their inventories by about $1.3 billion versus second quarter levels. This includes a decrease of approximately $900 million during the fourth quarter. As a result, our production and shipment to dealers for the balance of the year will be lower than we previously anticipated. As I mentioned earlier, the retail sales figures we released this morning showed growth of 6% for machines and energy and transportation. However, based on input from dealers and customers, we now expect fourth quarter end-user demand to be about flat compared to the fourth quarter of 2018. Based on our revised expectations for dealer inventory and end-user demand, we now expect sales and revenues to be modestly lower for the full year versus our prior expectation of modest sales and revenue growth in 2019. The global economic situation is very fluid due to a variety of factors. The decline in dealer inventory, along with our improved lead times, will position us to react quickly to positive or negative developments in the global economy during 2020. As I mentioned, we're taking actions to reduce production levels to reflect dealer order patterns and will be ready to increase production if order levels improve. We're also taking action in other areas to improve the competitiveness and flexibility of our cost structure, which Andrew will expand upon shortly. During our investor day in May, we shared our intention to drive long-term shareholder value by returning substantially all of our machinery, energy, and transportation-free cash flow to shareholders through a competitive dividend and a more consistent share repurchase plan. Our balance sheet remains strong. During the third quarter, we paid a quarterly dividend of $1.03 per share, representing a 20% increase over the previous quarter. As previously communicated, we expect to increase our dividend by the high single-digit percent during each of the next four years, continuing as a dividend aristocrat. Our most recent dividend increase reflects the company's confidence in our ability to achieve improved free cash flows through the cycle, as we discussed in May. We also repurchased $1.2 billion of common stock in the third quarter. We continue to expect share repurchases during the second half of the year will be similar to the first half. which will reduce our total quarterly average diluted shares outstanding by about 9% since the first quarter of 2018. Now let me comment further on our expectations for the external environment. In construction industries, we continue to anticipate North America end-user demand to be higher than 2018 because of strength in state and local infrastructure and non-residential construction activity. At the same time, we expect dealers to reduce their inventories in North America from current levels. Turning to Asia Pacific, we expect stimulus to help the industry in China, although the industry has weakened outside of China and Japan. We expect dealers in China to build inventory due to an earlier Chinese New Year in 2020. This will partially offset the decline in North America. We anticipate that the AME construction activity will be lower than 2018 as we are seeing weakening demand in Europe, while Africa and the Middle East are likely to remain challenged. We anticipate Latin America will continue to grow, but from a low level. For resource industries, most commodity prices remain at investable levels, with the exception of thermal coal, which remains weak. Quoting activity and end-user demand for mining equipment remains positive, and large mining trucks have further room for growth. We continue to believe we are in the early stages of a multi-year recovery in mining. However, miners are cautious due to economic uncertainty. Meanwhile, we expect softer demand for non-residential construction and quarry and aggregate equipment as dealers further reduce their inventory. Turning to energy and transportation, we expect that oil and gas will continue to be volatile based on oil price fluctuations and reduced capital spending for well servicing. Takeaway capacity constraints in the Permian Basin have improved, but overall industry demand remains relatively depressed. For gas compression, reciprocating gas engine sales for gas gathering have slowed, but solar turbines gas compression business in North America remains strong. Power generation continues to be an area of expected growth. We continue to anticipate that solar turbines and progress rail will both have a strong fourth quarter. Please turn to slide five. We continue to execute our strategy for profitable growth, which has three pillars, services, operational excellence, and expanded offerings. At our investor day in May, we announced our goal to double machinery, energy, and transportation services sales between 2016 and 2026. This target is challenging yet achievable. By growing our services, we will help our customers improve asset utilization and availability while reducing their owning and operating costs. We're continuing to invest to drive services growth, including expanding our digital capabilities. We continue to connect assets and invest in our digital architecture to provide actionable insights to our customers. For example, our CAT Inspect app helps customers identify the maintenance needs of a machine and plan accordingly. We're seeing close to 100,000 inspections on the app per month. In the area of operational excellence, we use lean principles at our large engine facility in Lafayette, Indiana, to improve safety, enhance engine quality, and achieve greater manufacturing efficiencies. Lean improvements drove a 40% reduction in assembly time for our large 3,600 engines, allowing us to produce more engines from the same facility while improving safety and quality. Our drive for operational excellence is a never-ending journey. Lean is helping us respond more quickly to changes in industry demand. And the final pillar of our strategy is expanded offerings, enabling us to grow our business by addressing the diverse needs of our customers around the world. We introduced a new dynamic gas blending, or DGB, engine for our well-servicing customers. The new Tier 4 engine, which is unique in our industry, allows customers to replace up to 85% of diesel fuel with natural gas. Our DGB product helps our oil and gas customers to be more successful by improving operating economics by offering fuel flexibility. We're continuing our focus on autonomy, semi-autonomy, and remote operation as we expand our offerings. We believe Caterpillar leads our industry in all three areas. Some of our early customers have cited productivity benefits of up to 30% using CAT autonomous mining solutions. In addition, our customers are seeing real improvements in safety, in some cases up to a 90% reduction in safety incidents. One of our competitive advantages is that we can retrofit our competitors' equipment, making our autonomous solutions an option for mixed fleets. We're encouraged by the recent wins we've had in autonomy this year. With that, I'll turn the call over to Andrew for a closer look at our financials.
spk00: Thank you, Jim, and good morning, everyone. I'll begin on slide six with third quarter results, focusing in particular on what drove the top line. Then I'll turn to our revised outlook before finishing on capital deployment. Sales and revenues for the third quarter declined by 6% to $12.8 billion. Operating profit decreased by 5% to $2 billion. Profit per share declined by 8% to $2.66. Overall, our results were lower than we'd expected. This quarter was largely a volume story. As you see on slide 7, sales volume declined by $751 million. Construction industries and resource industries drove this decline. The unfavorable currency movements were caused by the euro and the Australian dollar. It's important to understand the moving parts behind the volume figures. As Jim mentioned, the primary driver was changes dealers made in their inventories. If the impact of this year-on-year change were to be excluded from our top-line results, the underlying sales performance would be in line with the growth we reported in retail machine sales statistics this morning. We expect to see dealer inventory decline further in the fourth quarter, and I'll talk about that later when I discuss changes to our 2019 outlook. Now let me discuss the individual segments. Firstly, on slide A, we saw strong margin performance from energy and transportation, which is not surprising as the second half tends to be stronger for that business. Despite a 2% sales decline, segment profit increased by $48 million, or 5%, mainly due to low incentive compensation expense. The segment margin finished at 18.7% of total sales, an expansion of 120 basis points. In resource industry, shown on slide 9, the impact of lower volumes and higher warranty expenses, which were partially offset by favorable price realization, drove the margin down by 220 basis points. Total sales decreased by 12%, and segment profit decreased by 25% to 13.5% of sales. The top-line performance was driven by changes in dealer buying patterns. Dealers increased their inventories in the third quarter of 2018, whilst they decreased them this quarter. Margins in resource industries are the most sensitive to fluctuations in volume. In the first and second quarters, margins were strong, driven by the leverage associated with volume growth. We'd expect the fourth quarter to show a similar pattern to the third quarter, but overall we expect full-year margins for the segment to be higher than they were in 2018. Now turning to slide 10. For construction industry, sales declined by 7% due to reduced volumes. As sales in the Asia-Pacific region slowed versus a strong third quarter last year, as dealers decreased inventories, particularly in China, versus an increase in the prior year. For North America, we saw a solid third quarter in sales tied to road and non-residential building construction. In the September rolling three-month sales to users data published this morning, we showed an increase of 4% in worldwide dealer sales and construction equipment. We continue to develop and launch new products around the world, helping our customers win in their unique environments and enabling us to extend this growth over the long term. The segment margin fell by 80 basis points to 17.8%. While price continued to offset manufacturing costs, negative volume and mix were greater than the impact of lower short-term compensation expense. Let's move to slide 11 for a discussion of our profit performance. Altogether, third quarter operating profit decreased by 5%. The volume decline I spoke about earlier was the main driver of the change year over year. Our overall margin structure remains healthy, Although in absolute dollar terms, both have moderated in the third quarter, price realization continues to offset increases in manufacturing costs. Obviously, price realization was lower as we lapped the mid-year price increase in 2018. But equally, we have seen the rate of growth in material and freight costs moderate as we have gone past the start of the significant changes in 2018. Our profit margin was 15.8% of sales and revenues in the third quarter, flat versus the prior year. Let me talk you through some of the headwinds and tailwinds outside of the volume that impacted operating profit. Starting with tailwinds, period costs have declined, helped in part by lower short-term incentive compensation expense. As for headwinds, as I mentioned a moment ago, we incurred higher warranty expense from products and resource industries versus a very low level in 2018. We continue to address some targeted product quality issues as we're focused on ensuring our customers enjoy the performance and quality they expect from our products. We also experience some negative operating leverage associated with slowing production due to the lower volumes, and we are still experiencing some inefficiencies associated with supplier constraints and product launches. Turning to the outlook on slide 12, Let me comment briefly on the full year outlook a bit before turning to our fourth quarter expectations. As Jim mentioned, we have lowered our annual guidance. Our new outlook is based on changes in our assumptions around end-user demand and revised expectations for dealer inventory, reflecting caution on the part of both dealers and our end-user customers. Related to our lower dealer inventory expectations, This will mean that we will have less of an overhang from dealer inventory as we move into 2020. However, the other implication of this change is that we need to manage production and reduce our shipments to dealers for the balance of the year. Jim also mentioned that end-user demand is expected to dampen. We believe this reflects end customers delaying purchases of capital equipment in light of the uncertainty they're seeing in the business environment. Our assumption of modestly lowered sales and revenues for the full year 2019 flows from these changes to our expectations. Both of these factors are also flowing into the order backlog, which was $14.6 billion at the end of the third quarter, about $400 million lower than the second quarter. Order backlog decreased mostly in construction industries and resource industries. We believe this decline reflects a combination of our improved availability dealer expectations for lower demand from their markets in the fourth quarter, and dealers' desire to reduce inventory levels. However, it is difficult to disaggregate this decline into each of these components. Therefore, we'll continue to closely monitor end-user demand, commercial shipments, dealer inventory, orders and backlog, and adjust our production levels accordingly. As many of you know, our dealers are independent entities and control their own inventories. Our goal remains to strike a balance between satisfying dealer demand and avoiding excess inventory in the system. We're also taking actions in other areas of our cost structure, particularly around things like general administrative cost actions. While we've begun projects in a couple of these areas, we don't expect to recognize the benefits in the short term. We're committed to maintaining a competitive and flexible cost structure, and we are controlling discretionary spend. As we said in Investor Day, we are committed to improving margins by between 3 to 6 percentage points compared to historical performance. Now let me share a few of our assumptions on the fourth quarter performance. Based on those changes in dealer behavior I mentioned, we now expect about a $900 million reduction in dealer inventories in the fourth quarter versus a $200 million inventory build in Q4 last year. We also now assume flash end-user demand in the fourth quarter year-on-year. Previously, we had assumed end-user demand would increase at a similar rate to what we have seen throughout the year, or about 4%. As we no longer expect to see dealer inventories inventory reduced by higher sales to end-users, this means that almost all of the inventory reduction has to come from lower shipments from Caterpillar to our dealers. Given that, we now anticipate about a mid-single-digit decline in sales in the fourth quarter. So the assumptions for lower dealer inventory levels and lower end-user demand feed into lower guidance. So we'll need to cut production further in the fourth quarter. we do expect to see some negative operating leverage as a result of lower production. However, we expect this to be partially offset by favorability in material costs as we black the 2018 increases in freight and material costs. In addition, we expect slightly higher warranty costs given the increase in warranty expense year-to-date against a very low comparative in 2018. Obviously, it's very disappointing to reduce our guidance for the year. Our July guidance took into account the fact we expected deal inventory to reduce in the balance of the year. However, the greater-than-expected reduction in dealer orders in the third quarter and a shift down in anticipated end-user demand understandably dampens our expectations. That brings me to our capital structure on slide 13. We're committed to returning substantially all of our machinery, energy, and transportation free cash flow to shareholders through a competitive dividend along with more consistent share repurchases. We believe that's the best way to create long-term shareholder value. Excluding the discretionary contribution to the U.S. pension plans, which I'll discuss in a moment, our free cash flow remains strong. That means we've been able to fund a competitive and growing dividend through and indeed we paid about $600 million of dividends this quarter. Our recent 20% dividend increase reflects the company's confidence in our ability to maintain strong cash flows across the cycles. And to remind you, we've said we intend to increase the dividend by at least high single-digit percentage in each of the four years. We repurchased $1.2 billion of our common stock in the third quarter. At quarterly share repurchases, Repurchase plans consider our projected cash flows and takes into account the intrinsic value of our shares. We will continue to be flexible, and in periods of time where cash flow is more variable as a result of dynamics in the external environment, we'll be able to use the balance sheet to maintain flexibility in returning substantially all of our free cash flow to shareholders over time. We're continuing to project share repurchases for the second half to be similar to the first half. and we continue to expect to reduce our total quarterly average diluted shares outstanding by about 9% from the first quarter of 2018. Meanwhile, we continue to invest in services, operational improvements, and expanded offerings, and we ended the quarter with $7.9 billion of cash on hand. You may have seen our announcement last month that we had issued $1.5 billion of 10-year and 30-year notes in the third quarter, enabling a $1.5 billion voluntary contribution to the U.S. pension plans. This action increases the plan's funded status, allowing Catapult to further execute our strategy of reducing volatility in our pension liability. A secondary benefit of the contribution is that we now don't expect to make any further contributions to the U.S. pension plans for a substantial period of time, therefore freeing up cash for discretionary deployment. This contribution has no impact on my credit rating metrics. Finally, it was funded at attractive interest rates and was actually part of our cost-saving initiatives as it lowers our long-term pension insurance-related costs. So finally, let's turn to slide 14 and recap today's key points. Third quarters, sales and revenue declined by 6% and profit per share by 8% due to volume declines driven by changes in dealer buying patterns. We reduced our 2019 profit per share outlook range to a range of $10.90 to $11.40, based on expectations that dealers would further reduce their inventory levels and that end market demand would flatten in the fourth quarter. We're proactively managing production to address expected changes in demand. We're working on the competitiveness of our cost structure and the relentless execution of the operating Our overall financial position remains strong, and we remain very much committed to our strategy of profitable growth and deployment of capital back to shareholders through a growing dividend and consistent share repurchases. With that, I'll hand it over to the operator for the start of the Q&A session.
spk06: Thank you, ladies and gentlemen. The floor is now open for questions. If you have any questions or comments, please press star 1 on your phone at this time. We ask that while posing your question, you please pick up your handset, if listening on speakerphone, to provide optimum sound quality. Your first question is coming from Jamie Cook from Credit Suisse. Your line is live.
spk03: Hi. Good morning. I guess a couple questions. First, on the resource side, I think the sales and margins surprised people a little while the overall quarter was fairly good. You know, you talked about warranty. You talked about production cuts. Is there any way you can sort of quantify what the impact of that was in the quarter you know, on the margin front? And is there anything that you're seeing sort of from the order intake side to suggest that, you know, there's more downside risk on the sales side for 2020 and what that implies for margins? And then my second question, bigger picture, sort of on 2020, I guess the assumption is you go into 2020 with producing in line with retail demand. is there any way you can help us with other puts and takes? It sounds like there's a cost-cutting program that could be additive, you know, sort of incentive comp, share count lower. I'm just trying to think about the puts and takes that we should consider positive or negative. We can make our own assumption on volumes. Thank you.
spk10: Well, good morning, Jamie. Just a couple of comments. I think it's important to remember for resource industries that it's a mix of mining products and heavy construction and quarrying aggregates. So we've seen weaker sales than expected on the heavy construction and aggregate side of the business. Mining sales on a year-to-date basis continue to be positive, and rebuilds and part sales remain strong across the board. In the third quarter, we did see dealers reduce inventory related to heavy construction and some isolated pockets in mining for coal-related inventory. But, again, I just want to emphasize that, again, the RI does include both that aspect heavy construction, and mining. So it's not just a mining story.
spk00: Yeah, and moving on to the margins, Jamie, good morning as well. It really is all around volume and mix. So the biggest driver both on a year-on-year and quarter-on-quarter basis all relates to that. All the other items are puts and takes virtually as you move through. If you remember versus last year, we have lower short-term incentive compensation, but that is offset partly by a higher warranty. But versus quarter-on-quarter, all the other items are really a wash. It's all down to volume. And then moving into 2020, I mean, obviously at this stage, as we've said, the situation in the global economic outlook is very uncertain, so we are not going to be providing sort of sales guidance or top line or outlook guidance at this stage. We're still in the middle of our budgeting process, and things are very fluid. However, on some of the things, yes, we are continuing to look at our cost structure. As I mentioned, we are looking at things like G&A and back office costs, procurement costs, and so forth. All of those are initiatives that are ongoing and will continue to go. They are part of maintaining a flexible and competitive cost structure. And then as far as share count, as you said, by the end of this year, we'll have reduced the share count by about 9%. That will have an impact of about, you know, obviously that's split between 2018 and 2019, so there will be a bit of a tailwind from that. Next year, there will be a little bit negative on short-term incentive compensation. We expect this year to be about $150 million lower than our base plan. That obviously will be reset for next year.
spk03: Okay, but I mean, and the goal for 2020 is to produce in line with retail demand, so... Sort of in a flat market, it's not unreasonable to ensue. You could probably grow earnings.
spk00: Obviously, it depends on what your assumptions are on top line, yes. So if your assumption is that we have a flat retail market, that obviously would flow through, yes.
spk03: Okay. Thank you. I'll get back in queue.
spk06: Your next question is coming from Rob Wertheimer from Mellis Research. Your line is live.
spk08: Yeah, good morning, and thanks for the commentary on dealer inventory and otherwise. It seems like, you know, you made a positive step, and dealer inventories are going down, you know, up last quarter, going down now. You know, and yet that was only maybe a quarter of the total cut to revenues. So I'm trying to square the circle here. The dealer sales at retail seemed pretty good that we were released this morning up mid-single digits. you're reducing dealer inventory and those sales are up. And so I guess dealers must have really gotten more conservative on orders. But could you just talk about dealer inventory cut being a quarter of that overall revenue cut? And then did you see any cancellations in solar or any direct sales or larger projects?
spk00: Yeah. So, Rob, if you think about it, I think you're talking about over the full year rather than actually in the quarter, because obviously in the quarter we saw a quite significant year-on-year impact of deal inventory, because it was up 0.8 billion last year and down 0.4. So when we started the year, if you remember, our assumption was that actually we would have flat deal inventories and a modest growth in sales. And obviously now what we're saying is with a $500 million build of sales, we are seeing slightly lower sales for the full year. Yes, our view is that probably we've lost about 2% on retail versus where our base case guidance started the year. So effectively, that's been the big driver. That mostly relates to expectations out there, particularly obviously in the fourth quarter where it's dampened down to flat. We've been running at sort of 4% to 6% for the full year. Our full year expectation was probably the top end of that range, and we're not going to meet that.
spk08: Okay.
spk10: And you asked a question about large order for solar. I know that solar's business continues to remain strong.
spk08: Okay. Thanks, Jim.
spk06: Your next question is coming from David Rasso from Evercore ISI. Your line is live.
spk13: Good morning. Hi. I think people are just trying to figure out, regardless where the street is for 2020, you've now kind of put out a 240 midpoint adjusted EPS for the fourth quarter. And just trying to get a sense, you know, sort of annualize that, say 960. The margins for the fourth quarter seem to be implied around 13 to 13.5%. And I'm just trying to get a feel from you. And I know 2020, you know, a lot of planning still going on. But the approach you took to the fourth quarter to get a sense of that 960 run rate, or do we feel like we're trying to bottom that? bottom the earnings a bit here if the retail can just be flattish, even down a bit next year. How do you view your margins in the fourth quarter? That 13% to 13.5% implied, is that, I mean, how much of a hit, because obviously the $900 million inventory reduction is a bit of a drag that maybe you wouldn't see again in 2020, that big a drag in one quarter. Can you just take us through your thought process on how you view the fourth quarter and those margins?
spk00: Yeah, Dave, so thank you and good morning. The fourth quarter, as you know, is always our lowest quarter from a margin perspective. As we think through the year and our production cycles and the way, obviously, through accounting and the way we benefit from operating leverage by volume, effectively you tend to see Q1, Q2 stronger margins, Q3 slightly lower. And particularly in CI, you normally see a historic, at least a percentage and a half point drop in margin in Q4. So that is why normally Q4 margins are lower than for the balance of the year. As we look for this year, obviously the deal inventory would normally be a further reduction in margin because you're having an element of deleverage. However, there are some things running the other way, particularly things like lower step, short-term incentive compensation. We also have lacked a lot of the material and freight cost increases from last year. So that does help from an overall margin perspective. And then we are seeing, obviously, last year we did have some negative in cap financial in particular as well. And then, obviously, as you get to PPS, you also want to see the benefit of lower share count. So all of those factors are weighing in as we think about the fourth quarter quarter. I would not read through fourth quarter margins as being a likely margin structure as we move into 2020. We would expect normal seasonable patterns to happen in 2020. Obviously, then it just depends on what the volume is and how that volume throughput flows through into variable margins.
spk13: Well, that was sort of the spirit of the question. I mean, the fourth quarter is usually low. I assume it's taking a little bigger hit, as we said, with the inventory reduction. The math I'm running, even if sales are down 5% next year, even if the margins stay that low, you're still run rating 960, right? That's assuming share repo and everything else. So just trying to get a sense of we can all make our view of retail demand, but it just seems like if that's the fourth quarter with that margin and you just answer my question, you don't think the margins should go lower than that. It is sort of trying to at least baseline this run rate earnings power. I mean, a lot could change, but I appreciate the answer. I just want to get a sense of how you view that fourth quarter margin. So, okay. Thank you very much. I appreciate it.
spk06: Your next question is coming from Joel Tiss from BMO Capital Markets. Your line is live.
spk12: Hey, guys. How's it going? Hey, Joel. Good morning. I just wondered around pricing. Is sort of the bulk of the pricing or any color you can give us, is that coming from new products and features, or is that just coming more from raw material pass-throughs? and any sort of setup into 2020, you know, how you're looking at pricing potential for 2020.
spk00: Yeah, so obviously, as I've mentioned, we did see the rate of price moderate in Q3. That was as effective. We've lacked the price increase that happened in the mid-year as well. And obviously, we are now working through the end of the beginning of the year price increase. We have given our dealers an indication of price increases in 2020. We expect price to be much more moderate in 2020. Obviously, that will also then depend on the competitive environment as well as we move into 2020, and we'll provide a little bit more feel of that when we get to our guidance in January. Okay.
spk12: And no color around the, is it more from new features and new products, or is it just raw material related?
spk00: Yeah, I mean, we tend, the price that we recognize on the way we give you tends to be around real price increases rather than actually mix increases. So obviously mix will go, which new product would tend to go into the mix bucket when we look at mix and volume rather than price.
spk12: Okay, and then just quick for Jim, any pieces of the portfolio that you feel like over the next five years need to be beefed up or things as you're getting deeper into your operational excellence that maybe wouldn't fit? And you don't have to name the pieces, but just more of a structural question of changing the portfolio versus just returning cash.
spk10: Yeah, we continually evaluate our portfolio. We're always thinking about resource allocation. That's, of course, part of the O&E model. We've talked a lot about our intent to continue to invest in services to grow the aftermarket because that represents the best opportunity for future profitable growth for both us and our dealers. But in terms of changing the portfolio, we're always evaluating what potential changes we could make to drive more shareholder value.
spk12: Okay, thank you.
spk06: Your next question is coming from Courtney Yakovonis from Morgan Stanley. Your line is live.
spk05: Hi, thanks. Just wanted to go back to the dealer inventory D-SPAC expected in the fourth quarter. It seemed like most of it was coming from resources and then also from APAC construction this quarter. Can you just comment on how much of that will be coming additionally from those regions versus you know, North America construction and whether you're also expecting a decent amount there. And then just back on resources where you called out, you know, Jim, the softer demand in non-resi construction and quarry and aggregate versus thermal coal prices. Can you just help us understand how big of a factor each of those was? And, you know, just again, as we're thinking about the fourth quarter and into 2021, how big of a drag this can still be or whether you're expecting the replacement cycle to offset that.
spk00: Okay, so let me start on the dealer inventory, Courtney, and hello again. The first, you know, fourth quarter expectations are that most of the dealer inventory reduction will come in North America, which will impact North American sales and revenues in Q4. We actually do expect an inventory build again, particularly in China, in Q4, and that's partly in recognition of the fact that there's an early Chinese New Year, and obviously that means the selling season starts earlier in China next year. So that will be a factor as we move into Q4. With regards to your question on RI, I think our view is overall positive. You know, mining probably will be, you know, remain positive for the year. If you look at mining CapEx and expectations of mining CapEx, that remains positive. So our expectation is that will effectively reflect through. If you look at things like Park Fleet, it's at the lowest level since we've ever been recording it, which is since 2013. So there is latent demand there, and as we said, we do think, obviously, miners are being cautious on their capital investments, but there is the demand and replacement cycle that is needed at some stage, particularly on large mining trucks. Just to remind you, that is only a portion of our RI business. I know it's often what people tend to use as the sort of marker, but relatively small. I think, obviously, as far as non-rasy construction is concerned, our expectation probably is, you know, relatively, you know, that will be a drag, particularly in Q4, as effectively, particularly that is the area where there's still more inventory to come out.
spk10: Maybe just to add a couple of comments, Courtney, on mining. So, again, we believe we're in the early stages of a multi-year recovery in mining. Just given the economic turmoil going on, our mining customers are being cautious. And so they are hesitant to pull the trigger on new equipment, although, again, we're seeing increased sales. So we're seeing improvement in that business. One of the things to also keep in mind is that, you know, when miners sometimes delay, that creates opportunities for us for rebuilds and parts. So that's not all negative either. So, again, it's an opportunity either way.
spk05: Would you characterize aftermarket as still being stronger than you would have expected otherwise?
spk10: I say that it continues to be strong. That's the way I would. characterize it. It continues to be strong, about as we expected.
spk06: Thanks. Your next question is coming from Ross Gilardi from Bank of America, Merrill Lynch. Your line is live.
spk14: Yeah, good morning, guys. I just want to ask, you know, on the dividend, in committing to a high single-digit increase over the next four years, I mean, if you apply a 7% to 9% increase, your dividend is 540 to 580 in four years. I would assume you plan on covering the dividend with earnings internally, even at the trough of the cycle. You know, and if that's the case, it would seem like you're implying at least $6 of trough earnings. So, I just wanted, I was hoping you could just comment on the thought process. And in your mind, is there some type of minimum earnings payout ratio that you were assuming at the trough of the cycle in making that commitment to raise the dividend at that level, given obviously you have no visibility on what's going to happen in the next three or four years.
spk00: Hi, Ross, and good morning. If you remember when we had an investor day, we actually talked about it in terms of cash coverage rather than actually in earnings coverage. And actually in cash coverage, even when our expectations of the low cycle were is that we would expect to actually pay out no more than 50% to 60% of free cash flow in dividends, even in the low end of the cash flow cycle. Obviously, cash is slightly different. If you plot cash against earnings per share, there are obviously differences in the way, because obviously if you are in a downward cycle from a revenues perspective obviously sometimes that actually is positive from a cash flow perspective because you are reducing working capital through that period of time so there are puts and takes as to why you can't correlate it exactly to EPS but it does reflect our confidence that obviously we do have to expect both cash flows and operating margins to be positive and to reflect our investor day targets through all parts of the cycle as we move forward
spk14: So in saying that, Andrew, just to do the math for everybody, I mean, it sounds like in your view you think you're going to do at least $10 of free cash flow at the bottom of the cycle.
spk00: Yeah, obviously we said $4 billion to $6 billion. I think it was $4 billion to $6 billion was our range that we talked about in Investor Day of cash flow. So obviously, yes, you can work that back through the math.
spk14: Okay, thanks. And then just on, you know, China excavator market share, I mean, there's a lot of focus on this six to nine months ago. If you look at the data, your share seems to have stabilized in recent months. Is that correct? And how has that been the case? You know, have you had to match the competition with lower pricing or is it more new product and innovation driven?
spk10: So this is Jim. So market share in any area of the world continues to be – is always fluid and dynamic. We've talked previously about the fact that we are introducing new products in China, our GC product line. Our dealers continue to build up their capability with better coverage. So it's a whole variety of issues. And, again, it's a very dynamic situation, but we're confident – in our ability to compete in China long-term, and we've demonstrated the ability to do that. But there will be fluctuations on a short-term basis, up or down. That's just part of the deal.
spk14: Okay, thank you.
spk06: Your next question is coming from Noah Kay from Oppenheimer. Your line is live.
spk09: Thanks. Good morning. Jim, you mentioned progress, the score with respect to shortening product lead times. Can you provide some more color around that? I guess particularly what's been accomplished internally versus a function of easing pressure from some of these inventory reductions? What have you actually accomplished in terms of making the supply chain reduction more nimble?
spk10: Good morning. It's a combination of a variety of factors. We had discussed in previous calls that with the sharp increase in volume in 2007 and 2018, many of our suppliers struggled to allow us to have the lead times we would like to given that period of rapidly increasing demand. So there's been improvement in the supply base. As I mentioned in my initial remarks, we've also been very focused on becoming more efficient within our factories, reducing lead times, applying lean. So really it's a combination of all those factors.
spk09: And then on mining, maybe a question about how your customers are viewing autonomy relative to other CapEx priorities. You mentioned the retrofit offering. You've announced several greenfield projects. We did see a case recently, I believe, where one of your large mining customers was considering going autonomous but then decided to overhaul its existing fleet and focus on productivity. So I guess the question is, is that the trend or the exception? Is CapEx discipline generally holding back broader adoption of autonomous haulage or does this 30% productivity improvement from autonomy provide enough of a step change in fleet profitability that it would actually drive companies to replace or retrofit fleets earlier than typical?
spk10: We've seen a lot of interest in activity in autonomy. I think if you look at that 30% productivity increase, it really can be a game changer for many of our customers. Obviously, every customer is in a very different situation. They could be a coal customer, they could be a – in a variety of commodities. So customers make decisions based on their particular financial situation, but we're very, very pleased at the adoption rate that we're seeing in autonomy in the last year or so. You mentioned the Greenfield projects. Again, we do believe it's a game changer, and we're very bullish about the outlook for that product capability.
spk09: Okay, thank you. Thank you.
spk06: Your next question is coming from Anne Deignan for JPMorgan Securities. Your line is live.
spk07: Yes, good morning. Maybe you could address the comments you made earlier about Asia-Pacific sales. I think you said sales outside of China were weaker than expected, if you could expand on that. And then what specifically are you seeing in China in terms of market demand and the fundamentals, any green shoots in that region?
spk10: Good morning, Ann. Starting with your last question first. So in China, the industry, as you know for us, is mostly hydraulic excavators 10 times and above, and the industry continues to be strong. So given the fact that that's the majority of our market in China, we have not seen a decline there, so that's a positive. As I did mention earlier, outside of China and Japan, we have seen some weakness in construction over the last few months.
spk07: Where specifically?
spk10: Country-wise, I think it's pretty well dispersed over the Asia region outside of those two countries.
spk00: And just remember, most of our revenues in those markets are basically China and Japan, so that is the bulk. I mean, these other markets tend to be relatively small compared to China and Japan.
spk07: Okay, thank you. My follow-up is, you know, you've got 130 days of inventories on hand as of the end of Q3. Where would you expect inventories to end at year-end? And is your assumption at this point that end market demand is flat going into next year? I mean, what are the downside risks that we go into next year having to underproduce retail? Are you comfortable that you'll have right-sized your own inventories by year-end?
spk00: Yeah. So, Anne, as we look out, I mean, are you talking about cat inventories or dealer inventories?
spk07: Cat inventories, days on hand is 130 days versus 119 a year ago.
spk00: Yeah. So the rise in that, obviously, there is a lag between actually as we slow production down, ordering components, and so forth. before it actually flows all through into day sales. So obviously you're also reflecting based on day sales, which are also impacted by things like dealing with retreat as well. So that has an impact on this. You've taken that into account. But we are looking, obviously, inventory. We do normally expect a normal seasonal pattern, which is actually inventories to reduce in Q4. But obviously, as we talk at the moment, obviously we're looking at actually reducing material purchases to reflect the production declines that we've spoken about. But that should right-size itself. As we move into 2020, we would expect to be in a pretty normal position.
spk07: Okay, that's helpful, Keller. Thank you. I appreciate it.
spk00: Thank you.
spk06: Your next question is coming from Stanley Elliott from CIFL. Your line is live.
spk11: Hey, good morning, everyone. Thank you all for fitting me in. A quick question. Is there a way to quantify where you all will finish 2019 in terms of the service sales versus the 2016-2026 targets? And then also, you've done a nice job of developing a lot of this in-house. Is this something that the path will continue forward, or is this something that you'll need to look outside of the organization with M&A?
spk10: Good morning, Stanley. What we intend to do is when we announce our fourth quarter results, we will release our M-E-N-T service sale so you get a sense of how we're doing. And as we talked about at Investor Day, it won't be a straight line up, right? It can be impacted by a whole variety of factors in terms of rebuilds and what's going on. And we're making investments in digital and other things. To answer your question, you know, we utilize outside parties. We are certainly beefing up our internal capabilities as well. particularly in the area of digital, but we're open to M&A. So if you stop and think about resource allocation and think about how we intend to grow those areas that are most profitable, certainly we're open to that as well, and one of those things we continually evaluate. Perfect, guys. Thank you very much, and I look forward to seeing it firsthand at Conexpo. Appreciate it. I look forward to seeing you there. Thanks, Stanley.
spk06: Your next question is coming from Timothy Thain from Citi. Your line is live.
spk15: Thank you, and good morning. So the question is on orders, and relative to the guidance that you've provided in terms of what you think end-user demand and dealer inventories do in the fourth quarter, I'm curious how you think orders play into this. Presumably you'll have maybe a bit less year-end budget flush than prior years, but just curious to get your thoughts as to how that plays out and help us in terms of think about a range in terms of where year-end backlog may end. Thank you.
spk00: So as we look out, obviously, you know, if you look where we are on backlog at the moment, that's impacted by a number of factors. One of them, obviously, primary is dealers' expectations of inventory reductions. It depends on where we end. Obviously, the big unknown factor is what is our dealer's expectations of future growth going to be at the end of the year, because that will impact their order pattern in Q4. So it really is a function of that. As it stands at the moment, you know, you would obviously, the backlog decline in Q3 reflects a lot of the dealer desire to reduce their inventories, which will obviously the 0.9 billion. It depends whether they decide whether they would like to reduce inventories further in 2020. And at this point in time, we just don't know about that. That's too early for us to tell.
spk15: Okay. All right. Thanks a lot.
spk06: Your next question is coming from Jerry Revich from Goldman Sachs. Your line is live.
spk01: Yes, hi. Good morning, everyone. Jim, I'm wondering if you could talk about what you folks are seeing in terms of the forward-looking parts demand indicators for your resource business. As we've seen, the useful life assumptions get pushed out by the miners. Presumably, you have pretty good visibility on major rebuilds coming up as 2020 continues. a major inflection, and then you spoke about the moving pieces in the market given the economic uncertainty. Can you just talk about when, based on the project award that you anticipate, when do you expect resources will go back to growing the backlog as we hopefully see an acceleration towards more replacement type levels of demand?
spk10: Good morning. So for resource industries, our rebuild activity and parts activity has been strong, and we expect that to continue to be strong. So we're not looking forward to a significant increase or decrease. It's been strong, and we think that will continue.
spk00: Yeah, and as far as actually when do we expect the, you know, back to this point about what is the timing of any bounce on sort of particularly around Park Fleet and replacement, I think it's really, really difficult for us to see when that will happen, Jerry, to put a particular timeline to it. I think, obviously, based on all the stats that we're looking at, we do expect it to happen. It's just a matter of time of that. And that really depends on miners' views of their outlook. And obviously, as we said, everything apart from coal is investable. So it's not the investment decision. It's probably their view of the outlook.
spk10: Well, just given the history of the last 10 years, I believe that miners will continue to be cautious here. So, again, I think it will be a multi-year increase, so it will gradually get better, as opposed to we probably won't see the volatility that we've seen in the past either up or down, which frankly would be a positive thing for us and the industry to have it be more of a steady increase over several years than, again, the volatility we've seen previously.
spk01: Okay. And, Andrew, on the free cash flow number at the trough that you spoke about at the analyst day, what level of working capital contribution are you folks embedding? I think in prior cycles it's generally been $1.5 to $2 billion of positive free cash flow as inventories have come down. Is that what you're contemplating relative to that trough number?
spk00: Yeah, so actually to correct the number, I said 4 to 6 is actually 4 to 8, so I actually underestimated the top end. But actually what we do, I mean, we use similar working capital assumptions as we've seen in previous cycles. So actually using working capital, which is the main benefit to cash flow, is the lack of restructuring costs, is lower capex, and also the fact that obviously the structural costs will be taken out so we improve margins. Those are the three biggest drivers of improved cash flow.
spk01: Thank you.
spk06: Your next question is coming from Meg Dobry from Robert W. Baird. Your line is live.
spk02: Greg, good morning. Thanks for squeezing me in. Just looking to clarify some earlier comments on the dealer inventory D-stock. So, you know, you're exiting the year with an additional $500 million of inventory at dealer level year over year. So if we're assuming that retail sales are flat in 2020, would that allow you to produce the retail demand, or is there additional destocking that would be needed?
spk00: So, I mean, just to remind you again, it's dealers who make those decisions about their inventory levels. It's not us. Availability and all those things can play a part. Ultimately, at the end of the day, given the lead time for production and the fact that dealers don't want to miss revenues, they'll make decisions based on that and what their expectations are of the future. When we look at it, we believe that the level of dealer inventory is within the range of probability that we would expect at the comfort level that we talk about, three to four months, and it stays in that range. Obviously, there can be movements within that range which aren't necessarily within our control. They are dealer decisions.
spk10: And, again, just given the external environment, the uncertainty in the dynamic environment we're in, we believe we're well-positioned. regardless of what happens, positive or negative, in 2020. We shortened our lead times. We have an appropriate level of – our dealers have set up an appropriate level of inventory, so we think we're prepared either way.
spk02: Okay, understood. And then my follow-up is really on the levers that you have to manage your costs, as we're seeing some volume fluctuation here. I mean, if I'm looking at incentive comp, it came down modestly from last quarter – As we look going forward, how do you think about any restructuring or any other actions that you might have to undertake if, indeed, volumes remain weak? Or do you feel like at this point you've got enough flexibility within your cost structure to be able to handle that without any meaningful moves?
spk10: So we continually evaluate our cost structure. There's a number of things that we're working on. some things that we're doing, looking at our back office costs, if you will. So we have some things, projects that we've started there. We're looking at material costs. That's certainly a big lever for us, and that's one of the things that we're working on, both direct and indirect costs. We continue to look at ways to become more efficient. So, again, we're continually doing that. We won't make a call as to whether or not we'll have major restructuring or not. Again, we'll see what the market brings to us, over the next few months. And either way, we're ready to respond. Thank you.
spk04: Okay. And that's our last question. Jim?
spk10: Well, thank you for your questions. We really appreciate your interest. We'll continue to execute our strategy with a focus on services, expanding offerings, and operational excellence to deliver long and profitable growth. And we'll look forward to chatting with you again next quarter. Thank you.
spk04: Thanks, Jim. Thanks, Andrew, and everyone who joined us on the call today. Before we close, let me point out slide 16, where we're providing our preliminary 2020 earnings dates. If you have any questions, please reach out to Rob or me. You can reach Rob at R-E-N-G-E-L underscore Rob at CAT.com, and I'm at Driscoll underscore Jennifer at CAT.com. Our general phone number for Industrial Relations is 309-675-4549. And now let me ask Catherine, our operator, to conclude the call.
spk06: Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.
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