Caterpillar, Inc.

Welcome to the third quarter 2022 Caterpillar earnings conference call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Ryan Fiedler. Thank you. Please go ahead.

Thank you, Emma. Good morning, everyone, and welcome to Caterpillar's third quarter of 2022 earnings call. I'm Ryan Fiedler, Vice President of Investor Relations. Joining me today are Jim Umpleby, Chairman and CEO, Andrew Bonfield, Chief Financial Officer, Kyle Epley, Senior Vice President of the Global Finance Services Division, and Rob Rangel, Senior IR Manager. During our call today, we'll be discussing the third quarter earnings release we issued earlier today. You can find our slides, the news release, and a webcast recap at investors.caterpillar.com under Events and Presentations. The content of this call is protected by U.S. international copyright law. Any rebroadcast, retransmission, reproduction, or distribution of all or part of this content without Caterpillar's prior written permission is prohibited. Moving to slide two. During our call today, we'll make forward-looking statements, which are subject to risks and uncertainties. We'll also make assumptions that could cause our actual results to be different from the information we're sharing with you on this call. Please refer to our recent SEC filings and the forward-looking statements reminder in the news release for details on factors that, individually or in aggregate, could cause our actual results to vary materially from our forecast. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. On today's call, we'll also refer to non-GAAP numbers. For reconciliation of any non-GAAP numbers to the appropriate U.S. GAAP numbers, please see the appendix of the earnings call slides. In addition, the appendix includes a calendar of expected earnings dates in 2023, starting with January 31st for our fourth quarter call. Today, we reported profit per share of $3.87 for the third quarter of 2022, compared with $2.60 of profit per share in the third quarter of 2021. We're including adjusted profit per share in addition to our U.S. GAAP results. Our adjusted profit per share was $3.95 for the third quarter of 2022, compared with adjusted profit per share of $2.66 for the third quarter of 2021. Adjusted profit per share for both quarters excluded restructuring costs. Now, let's turn to slide three and turn the call over to our chairman and CEO, Jim Humplebee.

Thanks, Ryan. Good morning, everyone. Thank you for joining us. As we close out the third quarter, I want to thank our global team for delivering another good quarter, including strong top-line growth, higher operating profit margins, and robust MENT free cash flow, despite continuing supply chain challenges. Our third quarter results reflected healthy demand across most end markets for our products and services. We remain focused on executing our strategy and continue to invest for long-term profitable growth. In today's call, I'll begin with my perspectives on our performance in the quarter, and then I'll provide some insights on our end markets. Lastly, I'll provide an update on our sustainability journey. Turning to slide four, overall, it was a very strong quarter. Sales increased 21% in line with our expectations. Operating profit improved by 46%, although the margin improvement of 280 basis points was slightly less than we had anticipated. The sales growth was led by price realization and volume growth. Sales were higher in all regions with double-digit increases in each of our three primary segments. Services growth momentum continued in the third quarter as a result of our services initiatives and investments. Similar to previous quarters, our top line would have been even higher if not for ongoing supply chain constraints. We generated strong operating profit margin improvements in the quarter both on a year-over-year and sequential basis. The adjusted operating profit margin was 16.5%. Adjusted profit per share increased 48% to $3.95. We generated robust MENT free cash flow of $2.1 billion. Our backlog continued to grow. It increased by $1.6 billion in the quarter and is now $30 billion. Compared with the third quarter of 2021, sales to users increased 7%. For machines, including construction industries and resource industries, sales to users increased by 2%, while energy and transportation was up 22%. Timing of deliveries from dealers to customers resulted in sales to users that were slightly below our expectations. Sales to users in construction industries were about flat. North American sales to users were up slightly. Dealer inventories in North America remained at relatively low levels due to healthy demand and supply chain constraints. Latin America experienced higher sales to users, while IEMI declined slightly. Asia Pacific sales to users were down in the quarter. However, excluding China, sales to users in the Asia Pacific region increased. In resource industries, Sales to users increased 10% with increases in mining as well as heavy construction and quarry and aggregates. In energy and transportation, sales to users increased by 22%. Oil and gas sales to users benefited in the third quarter from continued improvement in reciprocating engines. Turbine and turbine-related services were about flat. Power generation and industrial sales to users remained strong due to favorable market conditions. Transportation increased from a relatively low base, primarily on strength in marine and international locomotives. Dealer inventory increased by about $700 million in the third quarter, compared to a decrease of about $300 million in the same quarter last year. Most of the increase relates to timing differences between when we ship products to dealers and when the dealers, in turn, are able to deliver completed orders to customers. Although the rise in dealer inventory was greater than our expectations, inventories remain near the low end of the typical range. As I mentioned, adjusted operating margins improved by 280 basis points to 16.5%. Strong price and volume offset increases in manufacturing costs and SG&A and R&D expenses. Manufacturing cost increases reflected continued higher material and freight costs and manufacturing inefficiencies caused by supply chain disruptions. resulting in our margins for the quarter being slightly lower than we had anticipated. Moving to slide five, we generated $2.1 billion of MENT-free cash flow in the quarter. We repurchased $1.4 billion of stock and returned about $600 million in dividends to shareholders. We remain proud of our dividend aristocrat status and continue to expect to return substantially all MENT-free cash flow to shareholders over time through dividends and share repurchases. Now, on slide six, I'll share some high-level assumptions on our expectations moving forward. While we continue to closely monitor global macroeconomic conditions, overall demand remains healthy across our segments. We expect top-line growth in the fourth quarter, both year-over-year and sequentially. This expected performance reflects healthy demand and favorable price realization. We anticipate sales increases across the three primary segments as order levels and backlog remains strong. As a reminder, dealers have been focused on supplying customer orders and will look to replenish aging rental fleets over time when the supply chain situation improves. We expect adjusted operating profit margins to be significantly higher in the fourth quarter versus the prior year and slightly higher than in the third quarter. However, we now anticipate that our full year margins will be at the low end or slightly below the low end of the investor day target range. The headwind is primarily due to ongoing manufacturing efficiencies related to supply chain constraints, ongoing inflationary pressures within manufacturing costs, and our conscious decision to continue to invest for profitable growth. That said, we expect to achieve our investor day MENT free cash flow target range of $4 to $8 billion. Now I'll turn to our outlook for key end markets. Residential construction generally accounts for about 25% of sales in construction industries, while non-residential is the remainder. In North America, residential construction is moderating due to tightening financial conditions, but remains at relatively high levels. We expect non-residential construction in North America to strengthen, supported by the impact of government-related infrastructure investments. In Asia Pacific, excluding China, we expect moderate growth due to higher infrastructure spending and commodity prices. As we mentioned last quarter, weakness continues in China in the excavator industry above 10 tons. It is expected to remain below the 2019 levels due to low construction activity. In Yemi, business activity is expected to be flat to slightly down versus last year based on uncertain economic conditions in Europe. However, strong backlogs in announced infrastructure plans limit the decline. Construction activity in Latin America is expected to grow due to supportive commodity prices. In resource industries, our mining customers continue to exhibit capital discipline. However, commodity prices remain supportive of continued investment, despite trending lower recently. We expect production and utilization levels will remain elevated and our autonomous solutions continue to gain momentum. I'll highlight an example in a moment. We expect the continuation of high equipment utilization and a low level of parked trucks, which both support future demand for our equipment and services. We continue to believe the energy transition will support increased commodity demand, expand our total addressable market, and provide opportunities for profitable growth. In heavy construction and quarry and aggregates, we anticipate continued growth in the fourth quarter. In energy and transportation, we expect continued sales momentum in the fourth quarter due to strong order rates in most applications. In oil and gas, although customers remain disciplined, we are encouraged by continued strength in reciprocating engine orders, especially for large engine repowers as asset utilization increases. New equipment orders for solar turbines have strengthened significantly, particularly in oil and gas. indicating sales growth in late 2022 and into 2023. Solar services revenue is expected to remain steady. We expect a strong fourth quarter, which is typically our highest sales quarter of the year for solar. Power generation orders remain healthy due to positive industry dynamics and continued data center strength. Industrial remains healthy with continued momentum in construction, agriculture, and electric power. In rail, North American locomotive sales are expected to remain muted. We also anticipate growth in high-speed marine as customers continue to upgrade aging fleets. Moving to slide seven. As we continue to advance our sustainability journey through the third quarter of 2022, Caterpillar, cat dealers, and our customers announced a number of projects that will help contribute to a lower carbon future. I'll highlight two today. In late August, we announced a significant step in this journey when BHP Group Limited, Caterpillar, and Finning International announced an agreement to replace BHP's entire haul truck fleet at the Escondida mine in Chile, the world's largest copper-producing mine. We will replace one of the industry's largest mixed fleets that is currently comprised of over 160 haul trucks with new Caterpillar 798AC electric drive haul trucks. Deliveries begin in 2023 and will extend over 10 years. The new electric drive trucks will feature technology that delivers significant improvements in material moving capacity, efficiency, reliability, and safety. The agreements allow BHP to accelerate the implementation of its autonomy plans by transitioning the fleet to include technology that enables autonomous operation. In addition, the agreement set forth a path for BHP to meet its decarbonization goals through the progressive implementation of zero-emission trucks. Second, we're currently displaying four battery electric machine prototypes at Bauma in Munich, Germany, including mini and medium excavators, a GC medium wheel loader, and a compact wheel loader. Each machine is powered by Caterpillar battery prototypes and includes onboard AC chargers. We also plan to offer an off-board DC fast charging option. Leveraging our deep system integration experience, the batteries are scalable to industry and customer performance needs and maximize sustainability throughout their lifecycle, including recycling and reuse at the end of life. The Caterpillar-designed batteries in these machines will also be available to power other industrial applications, highlighting our ability to leverage technology across the enterprise. With that, I'll turn the call over to Andrew.

Thank you, Jim, and good morning, everyone. I'll start by walking you through our third quarter results, including the performance of our segments. Then I'll discuss the balance sheet and MENT free cash flow before concluding, as usual, with our expectations for the fourth quarter and fourth year. Beginning on slide eight, sales and revenues for the third quarter increased by 21% or $2.6 billion to $15 billion. The increase was due to strong price realization and volume partially offset by currency impacts. Operating profit increased by 46% or $761 million to $2.4 billion as price realization and volume growth were partially offset by higher manufacturing and SG&A and R&D costs. Our adjusted operating profit margin of 16.5% increased by 280 basis points versus the prior year's quarter as the impact of price realization and volume growth outpaced continued manufacturing cost increases. Adjusted profit per share increased by 48% to $3.95 in the third quarter compared to $2.66 last year. Adjusted profit per share for both quarters excluded restructuring costs, which were $0.08 per share this quarter compared to $0.06 in the prior year. In total, taxes benefited profit per share by about six cents per share for the quarter. During the third quarter of 2022, we reached a settlement with the U.S. Internal Revenue Service that resolves all issues for tax years 2007 through 2016. We are pleased to have settled the audit without any penalties and within our reserves. The settlement includes, amongst other issues, the resolution of disputed tax treatment of profits earned by Caterpillar SARL from certain parts transactions. The final tax assessed by the IRS for all issues under the settlement was $490 million for the 10-year period. $467 million of this was paid in the third quarter of 2022, and the associated estimated interest of $250 million is expected to be paid by the end of the year. The settlement was within reserves, and the company recorded a discrete tax benefit of $41 million to reflect changes in estimates of prior year taxes and related interest, net of tax. Now on slide nine. The top line increased by 21% on strong price realization and volume, while currency was a headwind within the strong US dollar. Overall, sales were about as we expected. Regarding volume, the largest benefit versus the prior year was a $1 billion favorable quarter-over-quarter change in dealer inventory. Sales to users increased by 7%. While there is continued uncertainty regarding the macroeconomic backdrop, demand indicators remain supported as sales to users increased by 7%, backlog grew by $1.6 billion to $30 billion, and dealer inventory remains at the low end of the typical range. As we've seen in recent quarters, the dealer inventory increase was primarily due to issues resulting from the timing of deliveries from dealers to customers and delays in the commissioning machines as a result of labor shortages at dealers. The main impact was that sales to users was slightly lower than expected with a corresponding offset increase in dealer inventories. As both Jim and I have indicated, we believe that the majority of this is timing and is not an indicator of changing market dynamics. Dealer inventories remain at the low end of the typical range. Moving to slide 10. As I mentioned, third quarter operating profit increased by 46% on favorable price realization and volume. Price realization was in line with our expectations and was supported by healthy demand. Manufacturing costs continue to increase versus the prior year, primarily due to material and freight cost increases as well as manufacturing inefficiencies due to supply chain constraints. Overall, the impact of favorable price realization exceeded manufacturing costs for the quarter. Finally, SG&A and R&D costs increased primarily due to investments aligned with our strategy for profitable growth, which included services growth and technology such as digital, electrification, and autonomy. Our third quarter adjusted operating profit margin of 16.5% was a 280 basis point increase versus the prior year. The impact of price actions accelerated, so price realization was strong. Although we began to let the significant increases in material and freight costs seen in the second half of last year, we are still seeing cost increases from suppliers for materials in particular. Finally, related to our recent price cost performance, Keep in mind that we are still catching up from the increases in manufacturing costs which have occurred over the last few years. In particular, material and freight costs have increased by about 20% since 2020. A gross margin of 28.5% for the third quarter is now only just getting back in line with the levels seen in the third quarter of 2019, despite sales and revenues being higher. Moving to slide 11. As we expected, segment sales and margins improved in the third quarter. Starting with construction industries, sales increased by 19% to $6.3 billion, driven by favorable price realization and sales volume partially offset by currency. Volume increased primarily due to changes in dealer inventories, which increased in the quarter compared to a reduction last year. Sales in North America rose by 29% due mostly to strong pricing, and a favorable change in dealer inventory. Dealers in North America decreased their inventories in the third quarter of last year, whilst we saw some build this year. North American dealer inventories still are very low, which impacts their ability to supply the region. Sales in Latin America increased by 51% on strong price realization, higher sales of equipment to end users, and a favorable impact due to changes in dealer inventories, In both the AME and Asia Pacific, sales were relatively flat as strong price realization was offset by currency. Third quarter profit for construction industries increased by 40% to $1.2 billion versus the prior year. Price realization and higher sales volume drove the increase as price more than offset manufacturing costs. Unfavorable manufacturing costs largely reflected higher material and freight costs in addition to manufacturing inefficiencies. The segment's operating margin of 19.3% was an increase of 280 basis points versus last year. Turning to slide 12, resource industry sales grew by 30% in the third quarter to $3.1 billion. The improvement was primarily due to favorable price realization and higher sales volume. Volume increased due to the impact of changes in dealer inventories, higher sales of aftermarket parts, and higher sales of equipment to end users. Third quarter profit for resource industries increased by 81% to $506 million as price realization more than offset manufacturing costs, which largely reflected high material, freight, and manufacturing inefficiencies. The segment's operating margin of 16.4% was an increase of 460 basis points versus last year. Now on slide 13, energy and transportation sales with sales up across all applications. Oil and gas sales increased by 22% due to higher sales of reciprocating engine aftermarket parts and engines used in well servicing applications and gas compression. Power generation sales increased by 31% as sales increased for both turbines and reciprocating engines as data center activity remained strong. Industrial sales rose by 22% for strength across all regions. Finally, transportation sales increased by 9% on reciprocating engine aftermarket parts and relative strength in marine applications. International locomotive deliveries also benefited sales. Third quarter profit for energy and transportation increased by 32% to $935 million. The improvement was primarily due to federal price realization and higher sales volume, partially offset by higher manufacturing and SG&A and R&D costs. As anticipated, price realization narrowly offset manufacturing costs. Manufacturing costs increases largely reflected high material and freight costs coupled with manufacturing inefficiencies. Also, SG&A and R&D expenses increased due to investments aligned with our strategic initiatives. including electrification and services growth, in addition to high short-term incentive compensation expense. The segment's operating margin of 15.1% was an increase of 120 basis points versus last year. Moving on to slide 14. Financial products revenue increased by 7% to $819 million, benefiting from high average financing rates in North America and Latin America. Segment profit increased The profit increase was mainly due to a favorable impact from a lower provision for credit losses at Cap Financial. Moving to our credit portfolio, our leading indicators remain strong. Past dues, a good proxy for the financial health of our customers, were 2.00% compared with 2.41% at the end of the third quarter of 2021. We also saw a 19 basis, 19 basis the second quarter of this year. Retail new business volume did decline compared to the record levels in the prior year. However, at this point, CAAT Financial is not seeing the slowing business activity but is instead impacted by strengthening competition from banks. This is typical in a rising interest rate environment as banks benefit from a lower cost of funds, especially due to customer deposits. Finally, used equipment demand remains strong as elevator prices have stabilized and inventories remain low. Now on slide 15, MENT free cash flow in the quarter increased by about $1.2 billion versus the prior year to $2.1 billion. The increase is primarily due to higher profit and favorable networking capital. We did continue to build production inventory to support shipments and mitigate component delivery delays, an increase of about $1 billion versus the second quarter. Cumulatively, MENT free cash flow year-to-date is $2.8 billion, despite the increase in inventories and the payment of incentive compensation in the first quarter of 2022. Looking ahead, we continue to expect to achieve our invested MENT free cash flow target of between $4 and $8 billion for the full year. As Jim mentioned, we paid around $600 million in dividends in addition to repurchasing about $1.4 billion worth of common stock, supporting our objective to be in the market on a more consistent basis. Enterprise cash was $6.3 billion, about a $300 million increase compared to the second quarter of 2022. The increase was primarily driven by higher free cash flow. liquidity remains strong as we continue to hold some of our cash balances in slightly longer dated liquid marketable securities in order to improve the liquidity to improve the yield on that cash now on slide 16 i will share some thoughts on the fourth quarter and the full year as a reminder the third quarter was generally in line with our expectations on the top line and while margins were better than the prior they were marginally lower than we had anticipated Pricing gained momentum against a backdrop of stronger demand, while manufacturing costs increased on continuous inflationary cost headwinds for our suppliers and manufacturing inefficiencies due to the ongoing disruption to the supply chain. We also continue to invest for future profitable growth. Looking ahead, we anticipate the fourth quarter will reflect our highest quarterly sales for the year, which is in line with typical seasonality. Compared to the prior year, higher sales to users and price realisation should support the top-line growth. At year-end, we expect deal inventories to remain at similar levels as they ended in the third quarter. We also expect sales increases across the three primary segments, both year-over-year and sequentially. Infrastructure spending should continue to benefit our segments over time as non-residential building accelerates and large projects commence. On margins, we should see slightly higher adjusted operating margins in the fourth quarter compared to the third on higher volume and continued pricing momentum. We do anticipate that manufacturing cost increases, including manufacturing inefficiencies, will act as a partial offset. At the segment level, we expect to see similar margins to the strong third quarter of performance in construction industries. In resource industries and energy and transportation, margins should strengthen compared to the third quarter and prior year. Compared to last year, all three primary mid-segments should benefit from price realization and higher volume. We expect price realization to more than offset manufacturing costs across our three primary segments in the fourth quarter. Finally, to assist you with your modeling, we continue to expect our accrual for short-term incentive compensation expense of about $1.6 billion this year. CapEx is expected to be about $1.4 billion. We anticipate a global effective tax rate of around 23%, slightly lower than previously expected due to changes in the geographic mix of profits from a tax perspective. Finally, restructuring charges are expected to be up to $800 million for the full year. There's a possibility that the largest item, which is a non-cash charge of approximately $600 million relating to divestiture, may slip into 2023. So turning to slide 17, let me summarize. Sales grew by 21% led by strong price realization and volume gains across all the segments. The adjusted operating profit margin increased by about 280 basis points to 16.5%. ME&T free cash flow was strong at $2.1 billion, and we continue to return cash to shareholders on a consistent basis. The outlook remains positive, with sales to users up 7% and the backlog up $1.6 billion to $30 billion. We continue to execute our strategy for long-term profitable growth. And with that, we'll take your questions.

As a reminder... Management asks that you limit to one question per analyst. If clarification is desired, please rejoin the queue. Your first question comes from the line of Rob Wertheimer with Melius Research. Your line is now open.

Thanks, and good morning, everybody. Good morning, Rob. My question is going to be... My question is about price and competition and, I guess, future market share. Your price is extremely strong. Your margins have come back strong with it. From the outside, backlog looks very, very good, as do orders. And I'm just curious if you can see your competition following your price increases, if your general market share trends are up, down, if you could give any comments on what you think your balance will be. Thank you.

Thanks, Rob, for your question. We're always focused on remaining competitive in the markets that we serve around the world, and we certainly factor that into all pricing decisions. It's not a one-size-fits-all situation. We do pay attention to the different dynamics in the different markets we serve. We are comfortable with our competitive position. Again, it's always something that we focus on.

Your next question comes from the line of Stephen Volkman with Jefferies. Your line is now open.

Great. Thank you. Good morning, everybody. Good morning. My question is on the cost side. And, Andrew, I think you mentioned a couple of times that of your $1.1 billion increase in manufacturing costs, some portion of that was related to manufacturing you know, unfavorable productivity from all the supply chain issues. And I'm wondering if you can maybe ballpark kind of how much of that it would be. And is there any reason not to think that productivity just sort of gets better and normalizes once supply chains are normal?

Yeah, Steve, as I indicated, effectively manufacturing costs were slightly adverse to our expectations. That was why margins overall came in slightly lower than we had anticipated. Most of that is due and it is a relatively small miss as a result of manufacturing inefficiencies. We don't break down manufacturing costs for a number of reasons. They do vary and all the buckets do vary quarter on quarter, but you are absolutely correct. Once we get past the supply chain bottlenecks, we do believe these inefficiencies will normalize. For example, they may be including things like additional labor in the factories, which are there to help support out-of-process work as we keep continuing to make sure we get machines out as quickly as possible. That will normalize when supply chains are normal. So we will expect that to moderate over time as we go forward.

Thank you.

Your next question comes from the line of David Rasso with Evercore. Your line is now open.

Hi, David. Hi. I'll let you answer this sort of open-ended question however you choose. I mean, it looks like if you get normal seasonality, third quarter to fourth quarter on your revenues, sort of the way you're discussing the margins, you're pretty close to $4 a share for the quarter. And I know fourth quarter is usually a little higher than the average quarter. But given what you're seeing in the backlog, your end market commentary, prior discussion about, you know, price cost and so forth. You know, what are the things that we should think about to not look at that $4 number as a bit of a run rate going into 2023 for quarterly earnings power? Thank you.

Yeah, David, of course, as you can imagine here in this call, you know, we're not going to talk about 2023 and what our expectations are for profit. But again, you know, we are pleased at the way that the team performed. in the year and we talked about the fact that we still have supply chain struggles that we're dealing with, but we also have strong demand across most of our own markets.

And David, as we've consistently said this year, it is an unusual year from a shape of earnings perspective because normally, as you know, we start the year very strong from a margin perspective and margins move downwards as we go through the year. This year, that is actually inverting the other way. So obviously, that is part of that, which we'll have to come back to when we talk about 2023, how the shape of that year will look as a result of those changes in market dynamics. And I remind you that obviously the fourth quarter is our highest, normally our highest quarter from a revenues perspective. That's consistently been the way for Caterpillar.

Your next question comes from the line of Jamie Cook with Credit Suisse. Your line is now open. Hi, good morning.

Morning, Jamie. Sorry to, you know, touch on 2023 again, but I'm just trying to think through as well. You think about Folkman's question on inefficiencies going away and Rasa's question on the $4 per quarter runway. I guess the other thing is we think about 2023 as dealer inventories are still exceptionally low and the rental fleet is also aged. So as you look at 2023, assuming the macro holds, Would you expect to, you know, get dealer inventories back to more normalized levels and replenish the rental fleet, you know, which would also sort of be additive to 2023? Thank you.

Yeah, and so much depends, Jamie, of course, on what happens with the supply chain. And as you mentioned, what happens with demand as well, if in fact supply chain situation improves significantly. And, you know, we're not making a prediction at this point. We've started to see some pockets of improvement and other areas remain very challenged. But if, in fact, supply chain situation improves, one would expect dealers would try to get their inventories, including rental fleets, up to a more typical level. But, again, so much depends upon, you know, the two big variables there are supply chain and, of course, what happens in the end markets in terms of demand.

Okay.

Thank you. Okay. Your next question comes from the line of Michael Fenniger with Bank of America. Your line is now open.

Michael. Hey, good morning. You've highlighted for some time the growth in resources, even when customers are constraining with their mining CapEx budgets and being disciplined there. I'm curious, Jim, how you see that evolving with energy CapEx budgets when we dig into that oil and gas and energy side. You know, there's some signs that rig counts flattening, discussion of more disciplined topics. Just within your energy portfolio, what do you see the most strength in that backdrop, you know, as we go into 2023? Thank you.

Well, certainly, you know, as we mentioned, we do see our customers displaying capital discipline. However, we do see, as I mentioned in my prepared remarks, a lot of strength in oil and gas. I mean, reciprocating engines is an area of strength. Solar turbines, their order rates have improved quite substantially, which should help us in 2023. So one of these to keep in mind, of course, is that customers need to maintain oil and gas production. To maintain a certain level of production requires continued investment, just to maintain a flat level of production. And so, again, we are certainly encouraged by the signs that we see in terms of the order rates that are coming and based on the conversations we're having with customers. we feel good about our prospects there.

Your next question comes from the line of Tim Thine with Citigroup. Your line is now open.

Hi, Tim. Hi, Tim. Hi. Good morning. Thanks. Just maybe another one back on the manufacturing costs. And, again, I get it. There's a – ton of pieces within that. But maybe we just circle back on the point about material and freight. You know, especially on the freight side, we've seen, you know, more real time, some fairly significant declines there. Obviously, that doesn't impact you the next day. But what kind of, I don't know, lag relationship would there be or should we expect Again, just as we think about some fairly significant declines here in recent months, especially on the freight side and when that potentially begins to impact CAT. Thank you.

Yeah, Jim, thanks. I mean, actually, the biggest single factor that we are focused on rather than actually just pricing of freight at the moment is actually utilization of freight because one of the challenges has been actually the amount of freight we've had to use in order to get components around to actually build machines. That's been probably the bigger driver of some of the increase that we've seen. The second part is, yes, you are correct, freight spot rates are coming down. We tend to contract normally six to 12 months in advance. So we have not yet seen the benefit of those lower rates. And those low rates are some things we are favorable on. For example, roll on, roll off. We're actually favorable to the current market. Property container freight is coming down as well. So we're seeing some favorability on that in the spot markets. Obviously, we'll expect some of that to flow through as we move into 2023.

Your next question comes from the line of Jerry Revich with Goldman Sachs. Your line is now open.

Yes, hi. Good morning, everyone. Morning, Jerry.

Morning, Jerry. Jim, really interesting to hear you talk about full-year margins at the low end of your analyst day range, considering how good the results were versus consensus expectations this quarter. I'm wondering if you could talk about to get to the midpoint of the range? Is it as simple as the pricing actions that are already locked in, or are there other discrete steps that you're planning in any of the businesses to get you to the targeted levels? I guess based on the 23 list prices that you folks have in place, it feels like pricing should be accelerating further into the first quarter. So I'm wondering, does that get you to where you want to be? Thanks.

Well, thanks for your question. One of the things to keep in mind is that our margin targets are progressive, which means that we need to achieve higher operating margins as sales increase. And in a moderate inflationary environment, which we saw for many years, sales increases typically are led by higher volumes. And the benefit of the operating leverage associated with those higher volumes helps us achieve our progressive margins. In the environment where we are in today, where a relatively larger portion of the sales increase is due to price realization, there's less operating leverage, which makes the delivery of those progressive margins more challenging to achieve. So part of it is just a math issue in terms of where the sales increase comes from. Is it primarily volume or is it primarily price and the impact on operating leverage? Having said that, our focus is closing out the year as strongly as possible in the fourth quarter. But that's really the issue. It's the issue around just the math and the assumptions that we made around our margin targets.

when we set them. Thanks. You bet.

Your next question comes from the line of Stanley Elliott with Stiefel. Your line is now open.

Hey, good morning, everyone. Thank you all for the question. Quick question. You mentioned if supply chain gets a little bit better, you start to see the dealer inventory piece kind of square back up a little bit into next year. Even if we do get a supply chain improvement, will you still be below what would be normal historical levels at the dealer? Inventory, just curious how to think about that. Thanks.

It really depends on the specifics of what happens to demand, what happens to how much does the supply chain ease. There's really so many variables there that it's difficult to predict. Again, as we look at the dealer increase we just had, dealer inventory increase we just had, most of the increases relate to timing differences between when we ship products to dealers and when they actually complete orders to customers. Again, we look forward to next year. It depends on demand. It depends on how much the supply chain eases, and a number of other issues.

Yeah, and just to remind you that dealers are independent businesses, so they make their own decisions about dealer inventories and what's something we can control. So they will actually build it based on what their expectations of the outlook is as well. Great, guys. Thanks.

Your next question comes from the line of Chad Dillard with Bernstein. Your line is now open.

Hi, Chad. Morning, Chad.

Hi. Good morning, guys. So I have actually a bit of a longer-term question, just going back to your 160 truck win with BHP and the S company to mine. I'm just trying to understand just like how does electrification change your gross profit TAM across those vehicles, you know, versus internal combustion? And just trying to think through the puts and takes as those deliveries start to trickle through in the second half of next year.

Yeah. So, so, you know, the, the, the profitability around, uh, diesel engine versus batteries is a lot of puts and takes there. And again, we are still working our way through what our services model would be in all that. We are excited about the opportunities that exist. And one of the things that, that, you know, we believe positions as very well as the fact that we have an energy and transportation segment, which allows us to have additional opportunities with our mining customers to help them get the site ready. So, um, Just to resolve any confusion, the trucks that we start shipping next year for that mine will not be 100% battery trucks. So I think that was inherent in your question. So they're diesel electric trucks. Just to clarify that. I think you may have misunderstood my statement.

Thank you. You bet.

Thank you. Your next question comes from the line of Steven Fisher with UBS. Your line is now open.

Good morning. Good morning. So given the lingering manufacturing inefficiencies that you're still experiencing, I'm curious how your planning process for 2023 is comparing or is going to compare to your process for 2022, really thinking about the supply chain that you've had. Another year of lessons learned. I'm curious what you think you can do differently now for 2023 to further enhance your production capacity and flow?

Well, you know, we're working closely with our suppliers, and as I think all companies are doing, you know, thinking about our supply chain and certainly resilience is very important. And, of course, given the capital-intensive nature of our business and our suppliers, it isn't easy to make changes quickly. But we are working closely with our suppliers, trying to ensure that we have second sources in as many cases, in most instances, You know, we're doing things in our factories as well to really try to anticipate issues that are happening. There's no single magic button that we can push to make these issues go away. Again, it really comes down to our teams and our factories working to be creative, to find ways to mitigate disruptions, and again, working with our suppliers to try to get as much supply as we can get.

And then from a planning side, obviously one of the things we do is we do various scenarios and obviously, yes, we do look at what's happened, looking at that, try to then work through what the implications of that would be on production levels and how we would manage through that and then obviously trying to build in at the same time demand signals. So it's a very dynamic process. It's one that most large companies, as you would imagine, go through. The complexity for us is just scope and scale of Caterpillar in that, you know, obviously you've got running this through a hundred of plants and so forth. So it is a lot of work and people are working very hard as we speak, getting ready for their 23 planning cycle.

Thank you.

Your next question comes from the line of Kristen Owen with Oppenheimer. Your line is now open.

Morning, Kristen. Hi, good morning. Morning, Kristen.

Wanted to come back to your comments about the backlog offsetting maybe a weaker EME. You know, a lot of the focus in Europe has been around the energy crunch and impact on industrial activity. But I'm wondering if there's any sort of commentary you can provide as to whether or not you're seeing it contribute favorably to your business, maybe in the form of energy security investments or energy asset hardening. Any commentary that you can provide there would be helpful.

If we step back and think about it from a global macro perspective, certainly the increased investment in oil and gas benefits our business. And that's been driven by a whole variety of issues. The situation in Europe is only one of them. But as an example, if in fact the U.S. looks to export more LNG as an example, You know, Caterpillar participates across a wide portion of that natural gas value chain. Our engines are used for drilling. Our engines, our RECIP engines drive RECIP compressors for gas gathering. We're very involved at the well servicing site now with our acquisition from Weir Oil and Gas. You know, we play a larger portion there. Our solar gas turbine is driving our solar centrifugal natural gas compressors to compress gas down the pipelines. So as an example, there is a drive for more LNG, again, that that would benefit our business. So, again, there are a lot of factors there that are driving, of course, the dynamics in the oil and gas business. But our participation there, again, I believe, stands to benefit from just the increased investment that most believe will happen over the next few years.

And then just always as a reminder, any move to further renewables benefits us, and particularly in our mining business, again, as a result of the increased need for commodities in order to help with that transition. So ultimately that does have benefits. The other thing just to remind you is there are some infrastructure initiatives in Europe which are obviously helping to keep some level of demand going Obviously, the macro is obviously, as you know, and as we spoke, a little bit negative, but obviously those are offsetting benefits for us.

Yeah, a great example is the H2S project in the UK, right, where a lot of catapult equipment is being used. So infrastructure in Europe is important.

A lot of that, of course, is government support. Thank you. Emma, are you there?

Your next question comes from the line of Matt Alcott with Cowen. Your line is now open.

Good morning. Thank you. Hello. If I may take it back to North America, I know you guys have touched on the unfavorable trend in residential construction in recent quarters. But I'd love to hear your thoughts on how the current housing downturn feels relative to prior housing downturns from your perspective. In other words, the impact you've seen so far on your equipment business this year relative to a similar point of the housing cycle downturn. I know that's probably not super easy to gauge, but any thoughts would be helpful.

Yeah, it's difficult to make a comparison to prior downturns. to prior situations, but, you know, of course, we've been in a situation where the demand for our products that support residential housing has been very strong. So, you know, we've had very high order levels. We have talked about some softening there, but one of the things to keep in mind is, of course, that residential only represents about 25% of CI sales and the rest is non-residential. And non-residential remains more resilient due to a whole variety of of subjects, certainly they're more resilient to rate increases just due to capital planning cycles. Think about all the investments that are being made by governments around infrastructure, so that helps as well. But honestly, I don't have a good answer for your question in terms of how this compares to previous slowing in residential. Again, there's lots of predictions as to how that will play out over the next few years, but again, you know, demand for our products and CIs

at a macro level still remains quite robust. Great. Thank you very much.

Your next question comes from the line of Larry DeMaria with William Blair. Your line is now open.

Thanks. Good morning. Related to the prospects of an upcoming recession, are you seeing any concerns out there yet, aside from residential? Obviously, overall orders are pretty strong. And, you know, are you doing anything to prepare now for one, or is it more or less wait and see, considering the backlog is strong and there's low inventory?

Yeah, well, certainly, you know, we continue to closely monitor the global macroeconomic environment. You know, part of the strategy we laid out in 2017 was a competitive and flexible cost structure. So, you know, we've demonstrated the ability to take action when we need to take action. Having said that, as we sit here today, we continue to see healthy demand across most of our end markets. I mean, we have strong orders. Our dealer inventory remains towards the low end of the typical range. So, you know, again, we have demonstrated the ability to have a flexible cost structure and to react quickly when we need to. Think about 2020, the year when COVID hit and we had a pandemic-induced significant decline in our sales. We still met our margin targets that year. So, again, you know, we know what to do. But as we sit here today, even though we're watching things very closely, we continue to see healthy demand across most of our end markets.

Thank you.

Your next question comes from the line of John Joyner with BMO Capital Markets. Your line is now open.

Hey, good morning.

Thank you for taking my time. Good morning. I hate to pile on the manufacturing inefficiencies, but I guess how would you characterize the constraints today versus, say, you know, six months ago, a year ago, if a year ago or earlier this year was a 10, with 10 being the worst, what would it be today? I mean, I'm just trying to gauge how much things have improved or not. And maybe are there any areas that might not ever, quote, normalize?

Yeah, I wouldn't say that there aren't areas that won't normalize. So it's a mixed bag. So, you know, in certain areas, we still have real challenges. And again, the supply chain in certain areas have gotten a bit better. But in terms of manufacturing inefficiencies, if anything, they've gotten a bit worse as opposed to getting better in the last quarter.

In terms of value, they are higher now than they were in Q2 and Q1. And obviously, that is something we're monitoring and keeping a very close eye on. Most of the manufacturing inefficiencies, it's not just how the process works. It is actually labor-related. And part of that is obviously in an environment where we still see strong demand signals. You don't want to, you know, even though your labor may be slightly higher than you would need for the level of production you've got, you will actually keep those people working in the plants because there's plenty for them to do. So that is the main cause of inefficiency that we're seeing today.

Okay.

That's helpful. Thank you.

Thank you. Your next question comes from the line of Seth Weber with Wells Fargo. Your line is now open.

Good morning, everybody. Good morning. I just wanted to follow up on that last question. There's been a lot of questions and answers about the supply chain, but can you just maybe share what your partners are telling you about 2023? I understand you may want to handicap what they're telling you, but are they directionally

um you know telling you things are going to get better is it a first half is it second half you know are you getting any indications from the supply chain that things should be moving in the right direction for next year thank you yeah honestly it is it is a mixed bag um you know we caterpillar as you know has a very diverse product line and we have a very diverse group of suppliers thousands of suppliers around the world and there isn't one answer there so you know and You know, we continue to see semiconductor availability challenges are impacting things like engine control modules, which have an impact on many of our products. So that's still a challenge, even though certainly, you know, we follow what happens in the semiconductor industry and we've read about some of the improvements for the ones that we use. And again, those that go into ECMs, that's still a bit of a challenge. You know, my sense is that Many suppliers that are struggling now are quite reluctant to make any kind of predictions because many people have made predictions since we've gone into this situation that have proved to be wrong about improvement. So, again, what we're doing is working with them as closely as we can to help them get as much supply out as they can. And as we mentioned earlier, to try to mitigate the impact of those shortages in our factories. And that's really our focus.

Hi, Emma. Thank you. Hey, Emma. This is Ryan. We've got time for one more question.

Excellent. Today's final question comes from the line of Tammy Zakaria with JP Morgan. Your line is now open.

Hi, Tammy.

Hi. How are you? Thank you for taking my question. So based on the orders you're taking and the backlog you're clearing, any comments on what pricing may look like next year? Because it seems like you're going to get double-digit pricing this year. So should double-digit pricing sustain at least through the first half of next year as we run through the backlog?

Yeah, so again, as we think about any pricing actions for next year, obviously we're always focused on maintaining our competitive position in the markets, and we think about that in terms of any future pricing decisions.

As regards the run rate, obviously just to highlight, we're not talking about 2023 yet, but just think about the fourth quarter. We are actually mapping some price increases that we saw in the third quarter, fourth quarter of last year. So we will see slight moderation of price in the fourth quarter, still very strong. Obviously, that will help us as we move into 2023. But obviously, as Jim said, we're not yet into that situation where we have a plan that we can give you. And obviously, competitive positioning is obviously critical as part of that.

Paul, with that, I just want to thank you. You bet. Thank you. And thanks to all of you for your questions. Just I want to one more time thank our global team for performing very well in a challenging environment, increasing sales by 21%. As we mentioned, our backlog in sales to users increased, which are positive demand indicators as we look ahead. Just at operating profit margins improved by turn 80 basis points, we expect a strong fourth quarter with sales and margin improvement in addition to continued strong cash flow. And, of course, we remain focused on executing our strategy for long-term profitable growth. Again, thanks to all of you.

Great. Thank you, Jim, Andrew, and everyone who joined us today. A replay of our call will be available online later this morning. We'll also post a transcript on our Investor Relations website as soon as it's available. You'll also find a third-quarter results video with our CFO and an SEC filing with our sales to users data. Click on investors.caterpillar.com and then click on financials to view those materials. If you have any questions, please reach out to Rob or me. The Investor Relations general phone number is 309-675-4200. We hope you enjoy the rest of your day, and now I'll turn it back to Emma to conclude the call.

This concludes today's conference call. Thank you for attending. You may now disconnect.