Finning International Inc.

Thank you for standing by. This is the conference operator. Welcome to the Finning International fourth quarter 2020 conference call and webcast. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. Analysts who wish to join the question queue may press star then one on their telephone keypad. Should you need assistance during the conference call, you may signal an operator by pressing star and zero. I would now like to turn the conference over to Amanda Hobson, Senior Vice President, Investor Relations and Treasury. Please go ahead.

Thank you, Operator. Good morning, everyone, and welcome to Finning's fourth quarter earnings call. Joining us on today's call are Scott Thompson, President and CEO, and Greg Palaszczuk, EVP and CFO. Following our remarks today, we will open up the line to questions. This call is being webcast on finning.com. We've also provided a set of slides that we will reference during our prepared remarks. These slides are posted on the events and presentations page of the investor relations section of our website. You can also view the slides on our webcast page. An audio file of this call and the accompanying presentation will be archived on our website. Before I turn it over to Scott, I want to remind everyone that some of the statements provided during this call are forward-looking. Please refer to slides 12 and 13 for important disclosures about forward-looking information as well as non-GAAP financial measures. Please note that forward-looking information is subject to risks, uncertainties, and other factors as discussed in our annual information forum under key business risks and in our MD&A under risk factors and management and forward-looking information disclaimer. Please treat this information with caution as Finning's actual results could differ materially from current expectations. Scott, over to you.

Thank you, Amanda, and good morning, everyone. On today's call, I will share my views on 2020, speak about the execution of our strategic commitments, and outline our views and expectations for 2021. I will start on slide two. As I reflect on 2020, it was a strong year from an execution perspective, particularly in the context of a difficult external environment. Our early investments and long-term strategic approach helped us navigate and have positioned us for success in the upcoming recovery. Our focus on safety and digital capabilities in particular, as well as our capital allocation decisions are paying off and driving improved customer satisfaction and better financial results. Our total injury frequency rate decreased by 35% and our customer loyalty scores increased by 10% compared to 2019. Our focus on sustainability is increasingly evident to all stakeholders and I encourage you to read our fourth annual sustainability report which we will release at the end of March. We have significantly reduced our GHG emissions and are further reducing our environmental footprint with the implementation of our long-term network strategy in Canada and other initiatives, such as efficiency upgrades to our branches, vehicle fleets, and equipment. We will also make material commitments to reduce our GHG emissions further between now and 2027. Our employees should be proud of these accomplishments, which demonstrate continued adaptability and unwavering commitment to providing essential services to our customers. This year required extraordinary determination, effort, support, and flexibility from our employees. I am proud of how we operated in this environment and of the results we've achieved. Our investments in technology over the last five years allowed us to effectively navigate through the pandemic and set the stage for a strong recovery. Our robust IT infrastructure has enabled efficient remote work for all employees who can do their work from home. Machine connectivity has been essential in improving our inventory management and is providing us with a great foundation to grow product support market share. We are closely aligned with Caterpillar's aftermarket growth strategy, which is showing early signs of success. For example, in Canada, our parts market share in construction has grown materially since the end of 2019, driven by an increasing number of customer value agreements, or CVAs, and connected machines. The number of active CVAs in Canada's construction segment grew by 35% in 2020, with great momentum in the back half of the year and into 2021. The revenue we earn on our performance solutions per connected asset grew materially over the last year. Our digitally enabled value-added solutions and services allow our customers to improve their equipment, fleet, and operational performance, and this differentiates us from our competition. A great example is our integrated knowledge centers, which are staffed by experienced equipment experts with domain expertise. Together with the customers, we work to optimize equipment health and operational efficiency. Our mining customers continue to adopt autonomy as they expand their existing operations and plan for new mines. We have started delivering equipment to TEC's QB2 site in Chile to enable autonomous operations. In Western Canada, two autonomous operations, Curl in the oil sands and Highland Valley Copper in BC, continue to ramp up conversions. With only 7% of the ultra-class truck population in Western Canada presently autonomous, it's a great opportunity for both Caterpillar and Finning. Turning to slide three. Despite the many challenges of 2020, we stayed focused on what we can control and delivered on the commitments we set out at the beginning of the year. We have improved our execution in South America against a challenging market backdrop. We exited the year with 8.3% EBIT as a percentage of revenue, reflecting the benefit of a lower cost base from leveraging one common technology platform. I couldn't be more pleased with performance in South America during 2020 as EBITDA increased, profitability increased, return on capital increased, and the team delivered in excess of U.S. $200 million in free cash flow in an environment where revenue was down 15%. In Canada, we have made significant progress to reduce our cost base and improve employee and facility productivity. We are moving customer work to locations with lower operating costs. Our optimized RRR facility network directs the most technically advanced work, such as machine rebuilds, to what we call our distribution diamond, while freeing capacity in repair and response locations. This hub and spoke model is designed to improve customer turnaround and experience drive productivity gains, leverage resources and technology, and reduce our environmental footprint. Canada's 2020 SG&A was down 8% from 2019. And over the last seven years, we've reduced Canada's SG&A by about 20%, and the composition of our workforce has shifted significantly to a higher proportion of revenue-generating employees. We have more work to do to further address our cost to serve in Canada with a focus on leveraging back office efficiencies and driving further supply chain and procurement benefits. In the UK, we secured our first orders for the HS2 project. Our current backlog includes approximately 65 million pounds of initial equipment orders related to HS2, and we are confident there will be significantly more to come throughout 2021 and 2022. Backlog in the UK was up 19% and order intake doubled from Q3. And finally, we've lowered our finance costs and significantly strengthened our balance sheet. Our finance costs were down 40% in Q4 and more than 20% for the full year compared to 2019. Our outlook for 2021 is positive. Please turn to slide four. Our key markets continue to recover. Commodity prices are expected to remain at constructive levels, and many of our customers have announced an increase in capital expenditures. In mining, production levels are expected to grow, driving demand for parts and service on a large and aging equipment population. Government stimulus spending on infrastructure and investments in other large projects in all of our territories underpin our positive revenue outlook for construction. Led by strong recoveries in Chile and the UK, we expect revenue growth in 2021, however, remaining below 2019 levels as the recovery in Canada will be a bit more gradual. In 2021, we expect to benefit from several profitability drivers as we continue to advance our strategic priorities. These drivers include operating leverage in a recovering market, which will improve our profitability and return on invested capital. Product support growth in all regions as we are leveraging our digital capabilities to win customer business. Significant progress towards our mid-cycle target of 17% SG&A. The execution of our global cost initiatives is on track to deliver more than $100 million of annualized cost savings. And effective allocation of capital, redeploying the significant free cash flow we've generated in a balanced way among organic growth, return of capital to shareholders, and high rate of return complementary acquisitions. We have improved our earnings capacity going forward. Assuming an undisrupted market recovery and the successful execution of our profitability drivers, we expect 2021 earnings to exceed adjusted 2019 EPS of $1.65 per share. Our free cash flow generation in 2021 will depend on the pace of recovery. We expect to generate roughly 50% EBITDA to free cash flow conversion through the cycle, in line with the average conversion over the last eight years. We are in the process of increasing our inventory purchasing and will likely be modestly below 50% in 2021. However, we expect to deliver material free cash flow for the full year. Since we started this journey in Q3 of 2013, we have generated roughly $3 billion in free cash flow. With that, we've grown our dividend at an approximate 5% compound annual growth rate and repurchased $250 million of shares at an average price of about $23 per share. We have made two highly successful acquisitions in this timeframe, the Saskatchewan Dealer and For Refuel. Saskatchewan was paid back in full within five years of the acquisition, and For Refuel has generated $50 million in free cash flow in the two years since acquisition, and delivered strong performance in 2020 with EBITDA growth of 14% from 2019. I am extremely proud of what our team has accomplished. We now have all three regions in a strong cost and inventory position, and through 2020 it has been rewarding to see our previous investments paying off. I am convinced we have positioned the business for strong performance in the upcoming recovery phase. We have an engaged and action-oriented leadership team that has been executing well and is excited about our future. And on that note, I'll pass it over to Greg.

Thank you, Scott. I'm going to provide more detail on our Q4 results, review our market outlook by region, and discuss our strong balance sheet and associated capital allocation priorities. Slide 5 summarizes our consolidated fourth quarter results and provides key takeaways for 2023. Net revenue is down 12% in the quarter compared to Q4 of last year. Increased revenue in the UK and Ireland was offset by slower market activity in Canada and South America. Compared to Q3 2020, net revenue sequentially increased by 7%, with growth in all regions. All our operations achieved improved profitability compared to Q4 2019, driven by a lower cost base and stable gross profit margins. reflecting the resiliency of our product support business and ongoing operational improvements. Combined with lower financing costs and effective tax rate, we delivered significant year-over-year EPS growth despite the lower top line. EPS of $0.45 represented a 45% increase year-over-year. This included $0.07 of Canadian emergency wage subsidy. Adjusted EPS was $0.38, 25% higher than Q4 of 2019. We have significantly strengthened our financial position throughout the year and achieved EBIT data free cash flow conversion well above 100%. In the fourth quarter, we generated $292 million of free cash flow, bringing our annual free cash flow to $870 million. I will now discuss the key revenue drivers of our Q4 consolidated results, which are shown on slide six. Lower revenue relative to Q4-19 was mostly attributable to $150 million decline in new equipment sales. This was driven by Canada, where customer capital budgets remain constrained. Product support revenue was down $45 million or 5% from Q4-19. However, it was up 4% sequentially. While we have seen a gradual ramp-up of customer demand for parts and service, the activity has not yet returned to pre-pandemic levels in Canada and South America. We are encouraged by continued improvement in requests for proposal and quoting activity. Equipment backlog was up about 20% from September, driven by higher order intake in the UK related to initial equipment orders for HS2, and in South America, driven by mining. Our Q4 consolidated order intake increased by 60% from Q3 and was the highest since Q3 of 2018. Moving to slide seven. Our adjusted EBITDA was in line with Q4 2019. Adjusted EBITDA percent increased 130 basis points year over year. We saw a 260 basis point increase in gross profit margin, which was attributable to operational improvements, such as improved inventory quality and revenue mix shift to product support. SG&A costs decreased by 3% from Q4 2019. Savings from global cost initiatives were partially offset by higher LTIP expense. driven in part by a 33% increase in our share price during the fourth quarter, as well as a lower cost recovery in Canada, which I'll touch on in a moment. For the full year 2020 SG&A was down 115 million or 8% compared to 2019. Our Canadian results and outlook are summarized on slide eight. In Canada, net revenue decreased by 20% from Q4 19, mostly due to a 47% decline in new equipment sales. Q4 2019 revenue benefited from large mining equipment packages that did not repeat in Q4 2020, which meant our workshops were less busy with equipment prep work compared to Q4 2019. Net revenue grew 6% from Q3 2020, driven by improved sequential activity in mining and power systems. Product support revenue was 6% below Q4 2019 due to reduced activity in all sectors. Compared to Q3 2020, product support revenue recovered 5%, driven by improved sequential demand in the oil sands and higher rebuild activity. Mined oil production reached record levels in November and equipment fleet operated at full capacity. We saw a strong pickup in activity at our OEM remanufacturing facility in Edmonton, building momentum through the quarter. Adjusted EBIT as a percent of net revenue was 7.7%, up 30 basis points compared to Q4 2019. Improved profitability on lower revenue was driven by a higher proportion of product support in the revenue mix, a reduced cost base, and operational improvements. SG&A decreased by 7% from Q4 2019, reflecting cost savings from improved processes and efficiencies. These savings were partially offset by higher service and overhead costs. as no equipment prep activity was down significantly from Q4, and we continued to use the CEWS program to retain technicians. We recognized $13 million of this wage subsidy in Q4 2020, which is included in other income and excluded from our adjusted earnings. Including the wage subsidy, our reported EBIT as a percentage of net revenue is 9.3% in the fourth quarter. Support from the Q's program has allowed us to preserve over 500 jobs and strengthen our financial position. It will enable us to make strategic investments early in this recovery cycle. This includes the purchase and capacity expansion of our Regina facility in Saskatchewan, selected capacity expansions in Alberta, and the construction of new ultra-efficient facilities in Kamloops and Campbell River, British Columbia, which will be done in partnership with local Indigenous communities. Shifting to the Canadian outlook, while current COVID restrictions are causing some short-term headwinds, we are seeing many positive signs in approved marked activity in Western Canada for the full year, including an increase in oil sands production and capital expenditures, strong price of copper and other metals, and significant infrastructure programs planned in each province. With recovering oil prices and increasing budgets, we expect both new equipment and product support activity in the oil sands to continue to improve. with higher fleet utilization driving increased demand for maintenance and rebuilds. In addition, we're also seeing increased quotation activity for fleet renewal from both producers and contractors. The outlook for copper and precious metals has also improved. We're actively quoting on multiple RFPs for mining equipment and product support. For example, projects in the Golden Triangle area of BC, where there are several greenfield opportunities for us. We're also seeing an increase in order intake for construction equipment. We are encouraged by significant infrastructure investments being made by provincial governments who have announced multi-billion dollar infrastructure stimulus packages to support economic recovery. We expect to benefit from public investments in irrigation modernization and expansion projects in Alberta, Saskatchewan, orphaned well abandonment program and light oil projects in Alberta, as well as highway works in British Columbia. Moving to South America, and I'm on slide nine. In functional currency, net revenue decreased by 3% from Q419, mostly due to continued impacts with COVID-19 restrictions on mining operations. While high copper prices are generating significant momentum for mining investments and driving a large uptick in quoting activity, day-to-day operations are still being impacted by COVID-19 restrictions. Chilean copper production was down 9% in December, with these ongoing restrictions being a key factor. Compared to Q3 2020, net revenue increased 6%. Product support revenue for the quarter was down 4% year over year, but up 8% compared to Q3 2020. Similar to Canada, we expect the maintenance catch-up trend to continue throughout 2021. New equipment sales were 10% below Q4 2019, with some mining deliveries deferred to Q1 2021. Order intake in South America increased by over 80% from Q3 2020 and was higher in all sectors. EBIT margin in the quarter was a very solid 8.3%, up 230 basis points from Q4 2019. Shifting to the South America outlook, we were optimistic about the recovery occurring in both mining and construction in Chile, while we remained cautious about Argentina. According to Cochelco, the Chilean Copper Commission, Copper production in Chile is expected to increase to 7.1 million tons by 2029, from 5.8 million tons in 2020. Chile's mining project portfolio represents $74 billion of total investment potential in 49 potential projects, mainly in copper, gold, iron, lithium, and industrial metals. We're actively quoting on multiple opportunities for new mining equipment, autonomy solutions, and product support contracts for both brownfield expansions and greenfield projects. Of note, the lithium triangle region represents an interesting growth opportunity for us. The lithium triangle is an area between Argentina, Chile, and Bolivia that holds approximately 55% of the global lithium reserves. Global lithium production is expected to grow at an average annual rate of about 12% in the next five years, driven by battery industry demand and the transition to electric vehicles. We're actively quoting equipment packages to support the industry build-out and are looking at additional value-added services we could provide to customers in the future. Looking at 2021, we expect mining product support revenue to continue to recover as customers are ramping up major maintenance and work in preparing their equipment fleet to meet increasing production targets throughout the year. Turning to construction, the Chilean government announced $34 billion public investment in infrastructure over the next two years to jumpstart the economy. As a result, we expect to see improved activity, stronger order intake in the construction and power systems markets in 2021. We continue to monitor currently muted social activities headed into the elections in November 2021. While the overall business environment in Argentina remains challenging, we expect stability in gold mining and oil and gas and some recovery in construction activity in 2021. We're actively managing key risks in Argentina, including peso devaluation. We're maintaining a minimal level of investment in our operations to manage risks and support our customers. Turning to the UK and Ireland on slide 10. In functional currency, net revenue is up 4% from Q419, driven by an 18% increase in new equipment sales attributable to power systems projects for data center and electric capacity markets. Product support revenue was up 3% year-over-year due to higher service and rebuild activity, and related parts consumption in construction and power system sectors. We are pleased with the results in the UK and Ireland. EBIT as a percentage of net revenue was up 180 basis points from Q4 2019 to 3.7%. We achieved a higher gross profit margin as the quality of our equipment inventory improved significantly compared to last year, and our equipment product mix shifted to power systems this quarter. Effective cost control remained in place as government furlough programs wind down and our revenues recover. The number of UK and Ireland employees on furlough was about 3% in Q4. The UK government's furlough program has been very successful in limiting business disruption and supporting a rapid recovery in the UK and Ireland. The Brexit resolution has removed uncertainty for our customers. And while economic activity in the UK and Ireland continues to be affected by COVID-19 mitigation measures, We provide services to industries that are deemed essential and current operations are not being impacted in a material way. The 2021 outlook for the construction equipment market in the UK is positive. Our order intake in the fourth quarter was more than doubled out of Q3, driven in part by initial equipment orders related to HS2. After some delays, we expect a strong ramp up in HS2 construction in 2021 and remain well positioned to capture further equipment and product support opportunities for this project. We also expect continued strength in the data center market where we continue to build a strong backlog and expect timing of these project deliveries to be phased towards the second half of 2021, similar to what we experienced in 2020. We'll now turn to slide 11 and discuss balance sheet and capital allocation priorities. Net capex and rental fleet expenditures were about $100 million in 2020. In 2021, we are expecting net capital expenditures and rental fleet additions to be in the 170 to 210 million range, with the range dependent on the pace of market recovery. Approximately one-third of the increase relates to strategic investments in our Canadian facility network noted earlier, which will enable a corresponding net reduction in leased assets in 2022. One-third of the increase relates to rental capex, which will be dependent on market conditions. with the remainder focused on supporting digital offerings where we have seen significant adoption and high IRR for refuel capacity expansion. Improved management of working capital and the strength of our business model resulted in 125% EBITDA to free cash flow conversion in 2020, which allowed us to reduce our net debt by $615 million and lower our financing costs by 20%. As of December 31st, our net debt to adjusted EBITDA ratio was 1.4, down from 2.0 at the end of 2019. Our significant free cash flow and strengthened balance sheet support our capital allocation priorities, which start with investment in inventory and organic growth to capture the market recovery. Then, subject to Board approval, dividend growth, followed by opportunistic share repurchases and acquisition opportunities. Taking a step back and reflecting on 2020, while the year was difficult in many ways, the organization pulled together and executed exceptionally well. with the passion of our people and the strength of our business model leading the way. Customer loyalty, employee safety, and employee engagement all improved from last year. Despite a challenging top line in 2020, we improved gross profit margins and materially reduced annual SG&A, while protecting our technical talent for the recovery. While we minimized our capital expenditures, our mission-critical investments in performance solutions and autonomy projects helped us win and execute HS2 and QB2, respectively. And the countercyclical cash flow nature of our business model allowed us to generate $870 million of free cash flow in 2020 at a time when liquidity was critical. Finishing with a strong backlog build and positive outlook was a great way to end the year, and we're all looking forward to continued momentum in 2021. Operator, I'll now turn the call back to you for questions.

Thank you. We will now begin the question and answer session. Analysts who wish to join the question queue may press star then one on their telephone keypad. You will hear a tone acknowledging your request. If you're using a speakerphone, please pick up your handset before pressing any keys. To withdraw your question, please press star then two. We will pause for a moment as callers join the queue. The first question is from Sherrilyn Radborn from TD Securities. Please go ahead.

Thanks very much and good morning. I wanted to start with a question on product support, which showed continued sequential improvement in Q4, but was still below pre-pandemic levels. Can you just elaborate a little bit more on how much pent up demand you think there is if the virus restrictions fall away? And do you think 2021 product support revenue can get back to 2019 levels?

Yeah, thanks for the question, Carolyn. Yeah, certainly the recovery continues to have good momentum, but it was a little slower than, frankly, we were expecting three months ago. I think we'd highlighted marginally lower revenue in Q4 versus last year, and ultimately was a bit shy of that. In Canada, we have seen continued trucks going back to work. Ultimately, customers continue to manage the budgets and perform. So we do expect more catch-up in Q1 and Q2. And we started to see our OEM workshop ramp up and is back to three full shifts. And then in South America, you know, we're pretty optimistic about managing the curve in Chile throughout the summer. Ultimately, the second wave has come as it has in other regions. And so we continue to manage it day to day. And you'll have seen the copper production come off a bit in December as miners manage that, as well as summer holidays. So it's That pent-up demand is still there, and we expect to see that throughout 2021 occur. It was just a little slower than we thought in Q4.

Okay.

And then in terms of 2019 levels, I think we'll have to see. We're confident that each region will focus on growth year over year, and we'll have to ultimately see how the year plays out.

Okay, fair enough. And then having proved the Canadian physical footprint quite a bit in recent years, Could you just give us a bit more detail on what's driving the investments that are planned for 2021?

Yeah, sure. Ultimately, you know, the RRR model that we've been talking about for a little while here that's been proven out really well in the UK is the hub and spoke model. And building up the hubs really strong is an important feature of that. And then having the spokes be very standard templates that are very efficient are important. And so we really want to own and control what we're calling distribution diamond or backbone. And so we want to own and control and expand Regina. Kamloops is a really important logistical hub to make the system work. And so we think that we need a really highly efficient facility there. And so that makes a lot of sense and will enable a lot of efficiency in some of the spoke locations. And then Kamloops River, as an example, will be a template of the Singular of the future. And, you know, it's a smaller footprint but very efficient for turnaround activity. And so that's what's driving the CapEx, and we think it's a solid investment for the operating model.

Great. That's my two. Thank you.

The next question is from Jacob Bout from CIBC. Please go ahead. Good morning.

Good morning. Um, question here on, on backlog, uh, up sequentially quarter and quarter year on year. And he talked a bit about, um, HS2, um, you know, what, what are some of the, the other big drivers there? I'm, I'm assuming that, uh, you know, QB2 is, is in there as well, but, uh, just interested in, in, you know, what you're seeing right now.

Yeah. And you'll see in our comments, I mean, there's lots of requests for proposal activity going on across the board. In the UK, it's focused on data centers and HS2, and so those are pretty clear themes. In South America, it's pretty broad-based, but mining is certainly leading the charge across the product spectrum. So within the quarter, ads would be in shovels, ancillary equipment, and trucks as well. So it's pretty broad-based, and there's a solid 80% increase in South America, and it's pretty broad-based.

Interesting, your comments on lithium. Is any of that in backlog and how big of an opportunity ultimately could that be?

Yeah, certainly emerging opportunity. While there's a huge amount of lithium, it isn't open pit mined like it is in Australia or the US. It is solution mining. So we've got equipment already working through contractors in Chile and Argentina. And we're quoting as we speak, you know, these are five, $10 million packages, not, you know, larger mining. But it's an emerging trend. It's growing. You know, we'll continue to scope that out and likely talk more about it at Investor Day in June. But, you know, it's a real trend. And we're also going to look at other ways that we can participate, you know, beyond, you know, kind of dozers and graders and excavators.

My second question here, just on margins, how we should be thinking about 2021 versus 2021. Lots of moving parts. You're talking about oil sands, higher product support with higher fleet utilization, but then you've got the offset here of the lower margin new equipment sales in UK and Chile. If you put that all together, how should we be thinking about 2021?

Yeah, we do think we'll see more new equipment in the mix and more mining equipment, so that will put some margin pressure, but ultimately, As we continue with our other profitability drivers, we think we can net continue to yield up, but we'll be mixing new with product support, but we think we can continue to make progress.

I'll leave it there. Thank you. Thanks, Jacob.

The next question is from Yuri Link from Canaccord. Please go ahead.

Hey, good morning. You're giving a lot more detailed financial guideposts for the year ahead than you did at this time last year, which is much appreciated. But just curious if you could expand on what's giving you the confidence to put out, say, an EPS number where in the past I think you've been pretty hesitant to do that.

Yeah, thanks for the question, Yuri. Certainly we can see some trends in the market that we feel comfortable with. We've got really solid plans and feel like our execution's hitting another gear. And with the backlog starting to build, it just gives us more confidence. And ultimately, if you look at the back half of the year, we generated 75 cents of earnings. And so we think we can continue to build off that. And so we're starting the year with a lower better balance sheet and lower financing costs. So we think it's a pretty, pretty clear build up. And so, you know, we're putting it out there at this point.

Yeah, and I guess you're right, Scott, too. I mean, as you think about the seven-year journey here, I mean, definitely there's some uncertainty in the first quarter with the vaccine and activity, and we'll manage through that. But that's a little bit of uncertainty. But if you think, take a step back and look where we are in all three regions, you know, we've never been in a better place from a cost perspective. We've never been in a better place from an inventory perspective. And this is the first time we have a constructive backdrop from a commodity price perspective. And we're starting to see it come through and backlog in order intake. And so when you look at the back half of the year, all of the things we've been working on here for the last seven years are going to start to demonstrate. I mean, similar to 2020 with the technology investments, which really paid off. I think you're gonna see in the back half of 2021, getting through the vaccine, all of the cost and capital efforts we've made really pay off.

Okay, that's fair. Just as we think about the SG&A where you've made great progress on the 100 million in annualized savings, I believe at one point you suggested that about a third of that might come back depending on the pace of a revenue recovery. Given the wide range that you gave for where revenue might land this year, how do we think about some of that $100 million in SG&A coming back this year?

We'll continue to work away at the $100 million and continue to build on that and move towards our 17% target. We've added back about 100 techs in Canada and about 50 in South America. through the back half of the year. And so that would be kind of, you know, call it about half of the ad back. But the vast, vast majority are technicians. So, you know, we'll go into cost of sales and ideally drive service revenue growth. And so we're still feeling good about the 100 and continue to drive initiatives across procurement, working on the footprint, people productivity, leveraging our technology toolkit to keep driving that further.

Appreciate the color, guys. I'll turn it over.

The next question is from Michael Dumais from Scotiabank. Please go ahead.

Hey, good morning. Good morning. Just to follow up on the last question for the SG&A, the mid-cycle SG&A guidance implies that you need to actually maintain or even reduce your SG&A for your Q4 SG&A run rate through the cycle. So what's your confidence level? I mean, particularly as you're going to have to do that while adding costs back to support higher activity levels.

Yeah, I mean, it's certainly a target that we're setting up that's something that's going to take a coordinated effort. And so we continue to execute through our plans. Between Q3 and Q4, there was a lift. Some of that was LTIP. Some of it was a labor recovery point I hit. So I do think our run rate is lower than what we saw in Q4. And so we'll see that through the first half of the year. And absolutely, we're going to need to continue that level of run rate while growing the business, and that's the challenge. And so there are additional fixed costs that are going to need to come out to keep up pace with variable costs. But we're up for the task, and that's what we think is going to add value. And so that's the point. Okay, great.

And then I just wanted to dig a little bit into the Canadian margins here. So Q4 revenues were up sequentially and mixed, actually looked favorable versus Q3 as well. And I'm assuming, you know, there were higher service costs in Q3 as well due to Qs. So what explains the margin compression from Q3 in Canada? I mean, is it purely seasonality or was there something else in the quarter?

Yeah, a bit of that SG&A pressure that we highlighted, you know, labor recovery and cost allocations, you know, a little lower, which is always a seasonal thing in Q4. But typically what you'll have is some of the service work come off in November or December, and the workshops stay very busy prepping equipment as customers have budget to spend and we have model years to spend. And so, you know, that dynamic was a bit different this year given the low level of equipment prep, so that puts a little bit of pressure on SG&A.

I think the other thing to note, too, I mean, we're trying to be really transparent here with backing out queues. But in reality, you know, there's a population of the workforce here that isn't fully utilized. And so we should be taking credit for some of the queues, right, in that margin. And we've done that purposely to be transparent with all of you. And we've taken it because we want to protect that technical workforce. But, you know, you think about a second wave in Canada, essentially a lot of the markets shut down. kind of mid-December, right? And so you had a labor force that wasn't fully utilized.

Makes sense. If I could sneak one more in, I mean, there was quite a bit of capex spend in the prior cycle. So you've increased your spending levels in 2021, but I wanted to get your views on what you think the spending could look like through the next cycle and where the investments might be made.

Yes, certainly over, you know, in a mid-cycle approach, you can kind of look back over the last seven years and take an average. We do have four-way fuel, which would add a little bit to that full cycle. We think that's a reasonable benchmark. That's what we think about when we think about 50% EBITDA to free cash flow conversion. We'll continue to run the base business, continue to focus on digital initiatives where we're seeing good uptake and adoption. The rental fleet will continue to invest in the appropriate parts of the cycle. And, you know, we've got a bit of facility spend here, but we think that's a bit of spend to save, and that should moderate over the next couple of years. So, you know, we think that's kind of the solid mid-cycle approach. It's balanced, and you can kind of look at a five- to seven-year average, and that's probably what you should expect mid-cycle.

Perfect. Thanks for the call, guys. Thanks, Michael.

The next question is from Devin Dodge from BMO Capital Markets. Please go ahead.

Thanks. Let me start on the balance sheet. Leverage is on the low end of the historical range already. Arguably, this is on trophy, but you expect free cash to be free cash flow positive through the 6th of October, so leverage seems like it's going to be drifting even lower. So my question is, what do you think is the right amount of leverage for that business, and should we be expecting leverage you know, fitting to be a little more active on share buybacks or acquisitions in 2021.

Yeah, thanks, Devin. I mean, mid-cycle basis, I'd like to run the business at two times debt to EBITDA. I think that's the appropriate level, you know, with some flex, you know, throughout the cycle and depending on what opportunities are in front of us. But, yeah, I mean, we've been pretty clear with our capital allocation priorities, organic investment. I still think there's more capital beyond that. So we'll look at the dividend next quarter. We'll evaluate share buybacks as we go. And we'll continue to look at M&A. I highlighted lithium today as a spot where we'll be looking, and we think there's some interesting opportunities. There's a few other pockets like that that we'll continue to find ways that we can gain wallet share. But the priority now is to continue to just drive the business, focus on return of capital, but continue to evaluate. Okay, that makes sense.

Maybe just, you know, on refuel, just wondering, is that EBITDA growth that you realized in 2020, I think you said it was 14%, which is kind of impressive. Is that more weighted towards, you know, Western Canada, just given the overlap with the dealer network and the opportunity for revenue synergies?

Yeah, it's a balance, actually. So Western Canada, we've had some really good cross-sell upsell, and so there's been growth there. Eastern Canada has been solid as well, and we've had actually really solid growth in Texas. So I'd say it's a balanced approach, but, you know, higher growth rate in Western Canada, given that's where the sales synergies lie.

Okay. When you acquired 4Refuel, I think you were suggesting that Finning would consider, you know, selling some of the non-overlapping portion of the business. You know, we're clearly in an active M&A market. You know, do you think there's an opportunity to divest part of that business or are there synergies or scale benefits that we should be considering?

No, I think we're happy with the performance and encouraging that business to continue to grow and generate cash at the same time. So we're pretty pleased across the board.

Okay, thanks. I'll turn it over. Thanks, Evan.

The next question is from Sharice El-Sadahi from Bank of America. Please go ahead.

Good morning. My question relates to Chilean copper. In the mines there, are you seeing, or through the cycle, do you expect it to be driven more by greenfield expansion or a larger maintenance and replacement cycle? And on that 80% jump in orders, is that primarily driven by greenfield demand or replacement demand?

Great. Hey, it's Scott. I mean, I guess a couple things. One, as Greg said, I think it's across the board in terms of types of product. And I would say the same thing for, um, you know, Greenfield versus Brownfield. You think about the QB two investment, which was the first major mining investment, $5 billion investment from tech, um, which is, you know, now kicking off. And there's obviously the opportunity for QB three behind that. Uh, but I think if you take a step back and you, and you look at the copper price and the lack of investment over time into, you know, all mining, uh, areas, but copper in particular. And you look at what the forecasts are, you know, the forecast that we're seeing right now are 5.8 million tons to 7.1 million tons, you know, over, I think it's a, you know, seven or eight year period. And so the increase in production is going to be significant, and that's going to come from brownfield and greenfield. And I think the challenge, what you're seeing right now with copper prices, there hasn't been a lot of investments. There's not a lot of supply. And that's obviously with an increasing demand is causing those sorts of dynamics. So I suspect that will rectify itself with more investment going into copper, which will be obviously beneficial for us.

Makes sense. And then just as my second question, I understand that Keystone XL isn't expected to be a significant impact to your business, but could you expand on that and the broader implications for the industry?

Yeah, no, good question. I mean, I think this has been a 10-year journey, right? And, you know, through that 10-year journey, I think the Western Canadian market has adapted with different alternatives, and also there's been a little bit of a reset on growth in the oil sands. And so as you look forward, there's no doubt in my mind that oil demand is going to be with us for a long time, and the oil sands is competitively advantaged given the large sunk costs and the low variable costs of productions. And, you know, I believe Western Canadian crude is now actually more important to the U.S., given the reduction in capital going into shale developments in the U.S. So, you know, all projections I have seen out of Western Canada show production increasing over time. So, again, that's a good thing for us. You know, that being said, I think, you know, there is obviously an energy transition underway, which will take a significant amount of time. That will impact, you know, new capital, foreign capital going into the oil sands and big new development. So growth, you know, the five, you know, say 10% level is probably not in the cards, but growth in the three to five to 6% is in the cards. And so then the question is, do you have enough egress associated with that type of growth to keep the differentials tight? And then you go back to this 10 year journey. And when Keystone started, actually, there's, there's a lot of other egress options now, right? As you think about Trans Mountain coming on, you know, line three coming on, which adds significant capacity. And so, interestingly, Keystone goes away, but you have enough capacity once those two come online to get the oil out of Western Canada and into the U.S. So, you know, from an overall, you know, sentiment perspective, obviously has an impact. I mean, there's no doubt. But from an actual on-the-ground getting oil from Western Canada to the U.S., I think it's not that material.

Makes sense. Thank you. I'll pass it along.

The next question is from Brian Fast from Raymond James. Please go ahead.

Thanks very much, and good morning. I'll take the flip side of Devin's earlier question on for refuel. It has performed well for you in your current regions. Is there a possibility we see an expansion of that offering into other regions like the U.K., where it seems density of the region would be, I guess, conducive to a product like that?

Thanks, Brian. You know, it's an interesting platform because it has, I mean, we had high expectations for it, but it exceeded our expectations. And when you look at 14% EBITDA growth through a pandemic and $50 million of free cash flow, I mean, the IRR and the base investment is really high. So that's good. But the interesting thing about it, it is a platform for distribution, right? And as you add more capacity, the IRR increases pretty significantly. And so you know, we're gonna be thoughtful about it, but adding organically through, you know, incremental capacity does have pretty high returns. And as Greg said, that's a little bit of the capital, you know, uptick relative to 2020. You know, as you think about where it may fit in other areas, the UK is a good fit, right? I mean, as you think about HS2 and all of those machines, and, you know, you noted our success on HS2 to date, you know, we're going to have a big population of machines there. And you think about customer share of wallet and the ability to provide additional services, you know, that's a really logical fit. And, you know, we're in the early stages of thinking that through. I think South America, a little bit more challenging and a little bit more challenging just because of some of the safety issues with distribution of fuel that, you know, I think we have to be pretty conscious of. And then I guess the last thing is in terms of, you know, the strategic rationale when we did this, it's also delivery of other services, not just fuel. So beyond fuel, so lubing, you know, oil changes, oil filters, all in the pursuit of increased share of wallet, increased intimacy with our customers, increased service revenue. And so, you know, so far so good. Two years in, $50 million of free cash flow, 14% growth in EBITDA, high IRR, I don't think we could be more pleased with the allocation decision, capital allocation decision.

Thanks, Scott. That sounds encouraging. And then maybe just on the parts side of business, have you been experiencing any disruption in sourcing parts? I'm just trying to get a sense of, I guess, supply channels have recovered at this point.

Yeah, it's a great question, and we're spending a lot of time on that. But it's not on the parts side so much. It's on the equipment side. On the parts side, I think what's been fortunate is just great alignment between the dealers and CAT on growing services revenue. And so you think about CAT's strategy of doubling services over a period of time, obviously making sure supply chain is operating well is critical. So even through the pandemic, we saw almost no interruptions. and our on-time in full delivery to our customers has gone up pretty significantly. And I think that's actually been a driver of our increased customer loyalty. So no concern on product support. I think where there is, you know, something we have to be really cautious about is lead times on new equipment. And this isn't, I mean, Kat's all over it. You can hear Jim respond to it in his call, and he feels good about it. But I guess the only thing we just have to watch carefully is, As the whole world reflates here, you see what we're seeing from an order backlog perspective. I suspect others are seeing that as well. And so I think it's going to put a pretty big demand on CAT's supply chain. And so getting real good alignment with CAT on what we need, when we need it, and how far in advance is key. And that's what we've been spending a lot of time on. in the last three months. And frankly, you're going to start to see the impact of that in the first quarter as we go back to more seasonally typical free cash flow patterns in the first quarter with inventory additions coming on, on the back of some of these order intake and backlog improvements that we've highlighted today. So, so far, so good, but something we're keeping a close eye on. Okay, good stuff. That's it for me. Thanks.

Thanks, Brian.

The next question is from Sabahat Khan from RBC Capital Markets. Please go ahead.

Thanks, Anne. Good morning. Just a question on kind of the seasonality that we should think about through 2021. You indicated that H2 seems to be the one that'll be a bit stronger, but I guess through H1, with Q1 being compared against a non-COVID corridor, should we expect H1 to also be getting sequentially better with Q1 being maybe less growth than Q2? Just any color there would be helpful.

Yeah, listen, I think we've got a lot of conviction around on the back half of the year. And when you look at the performance in 3Q and 4Q, you know, without queues in a pandemic dealing with the second wave and knowing that, you know, we'll be through it at some point here, you know, we get a lot of confidence on that EPS projection. I think where we're less confident is in the first quarter, frankly. And I'm not trying to say anything different than what we've said. I mean, we're still seeing improvement. We're still seeing a recovery. But it's such an uncertain environment that Q1 isn't going to see the ramp relative to the back half of the year. And that's just going to be dependent on vaccines and how we get through that. In terms of that vaccine issue, You know, you look at the UK, it's leading the way, right? I mean, I think 20% of the population in the UK has been vaccinated now. I mean, it's unbelievable. They're doing such a good job. So they're going to come out of this, you know, early. I think I'm really pleased with Chile. You know, I think Chile right now is in the second wave, and it's primarily impacting Antofagasta, so the mining region, and that's why you saw Chile copper production down 9% in December. But I also believe from a vaccine perspective, they're, you know, interestingly going to come through this quicker than Canada. You know, in talking to some people that are, you know, associated with the hospital boards down there, we think, you know, March, April, May is going to be a good time to get through that. So I feel pretty good about the outlook on Chile. I think the Western Canada and associated with our guidance here on gradual is, you know, the vaccine rollout has been a little bit slower than I think all of us on the phone were hoping. So, you know, that's the area that we just have to keep an eye on. That's the area that we've guided to, you know, a little slower recovery, you know, because of that issue. And, you know, to your point, the second half is going to be a little bit stronger than the first quarter.

Okay, thanks for that, Culler. And then just during the quarter, it looks like in Q4, the used equipment really performed well across both Canada and South America. Do you think that was maybe, you know, just given the caution in the backdrop, folks were relying on used equipment a bit more? And do you expect that maybe reverses towards, I guess, with new equipment maybe picking up next year that reverses a little bit? I just want to get a bit more color on the drivers there.

Yeah, in South America, you know, we've had some excess equipment that we've done a really good job of shifting. And so they've had a pretty solid year for used and wouldn't expect it to necessarily, you know, grow off of that base. In Canada, you know, we've got a few initiatives driving increased volume there that we're pleased with how it's working. And yeah, we do expect new to be more primary in 2021, but ultimately we'll continue to drive used. We're seeing solid margins and whether our potential product gaps or equipment lead times stretching out, we'll try and fill that with some used propositions. So I think solid, but certainly for 2021, we're seeing more opportunities on the new side.

Okay, if I could just squeeze one on the lithium commentary that you had earlier. It looks like for now you indicated that the mining shovels are in the $5 million to $10 million range, smaller than typical mining. Do you think that as the market develops over time you could get something similar to what you see elsewhere in mining, or is it more related to having to develop some capacity or certain capabilities to be able to get that similar order size in that market?

Yeah, I mean it's not open pit mining, so it's going to be hard to compete with copper. But certainly it's a solid opportunity and an area where if we got into additional services, that could scale up. And so we're encouraged. We think it's a growth area. But, yeah, we don't expect it to compete with Copper on the current platform. But we'll continue to review the opportunities, and it's just such an interesting fit with our footprint.

I think the one thing, I mean, just to keep in mind, too, is, As you think about this energy transition, I mean, as I said, I'm very optimistic on the oil sands and thinking that it's going to be a competitively advantaged energy source for a long time. But, you know, inevitably you are in this energy transition over time. And you think about how Finney's positioned. You know, we've got natural gas in Western Canada that is as big as the Marcellus, right? I mean, that is a massive opportunity for us. And then you look at the South American footprint, and you see 30% of the world's copper in Chile and 55% of the world's lithium in that triangle of Argentina, Bolivia, and Chile. And so from an energy transition perspective, we couldn't be better positioned, recognizing that oil and fossil fuels are going to be with us for a long time as well. Great. Thanks very much.

The next question is from Maxim Sichev at National Bank Financial. Please go ahead.

Hi, good morning, gentlemen. Good morning, Max. Just wanted to focus a little bit on the e-commerce technology capabilities. So, Scott, when we talk about, you know, 40 parts transacted online, wondering if you don't mind maybe commenting what that means from a margin profile and maybe ease of service. Do you mind maybe sort of painting kind of like an operational perspective slash financial picture on that.

Yeah, sure. So as you think about the two, without three big initiatives, but two of them I'll focus on for this conversation that we embarked on five years ago. One, it was connecting all our machines and getting an e-commerce platform that was appropriate for our large customers and our small customers. And so as it relates to the e-commerce piece, We've gone from 10% of our non-service parts online to 40% online. And it's a massive advantage for us because you just have more options for the customer. And so that doesn't mean the branch network is going away. It's an omni-channel approach, and that's really important because some customers will want to use the branch network. Some people will want to use online distribution. It has really helped through a pandemic, right? I mean... The fact that we've been able to have these options for our customers, you know, I think I talked about supply chain availability, but I think that's also been a big driver of the customer loyalty improvement and the resiliency of the product support business. So that's great. And then if you get to the economic piece of it, it should be accretive, right? Because you're actually providing a better service to your customers, some more options, so there's not a financial discounting aspect to that. and you're doing it at a lower cost. And so you should be able to reduce the cost structure. Now, there's a period of time there where you're duplicating costs, obviously, but I think we're through a lot of that. And as we think about this RRR network going forward, this hub-and-spoke network off the distribution diamond, that's obviously a big part of how we design that network will be with e-commerce in line. So I think Max is kind of all good from a customer perspective, from a cost perspective, and then ultimately from an efficiency perspective. Just one quick comment on the connected machines, because I think that was the second part of the journey. We've gone from 10% of our machines connected to 70% of our machines connected over that same period of time. I think one of the reasons we've been able to manage through this pandemic so effectively on the inventory side is because of the connected machine data usage. That's really allowed us to have insight into machine utilization, which has allowed us to have to adapt from a ordering perspective. And it comes back to me saying that we've never had our inventory in such great shape. So that's a good connection. And then the second connection is around product support. And back to what we've continually said is when you connect a machine, when you put a customer value agreement around it, and when you create that intimate relationship with the customer, you drive higher parts market share. And it's hard to see in this year when you're dealing with a pandemic where product support is off. But when I see our product support aftermarket share, it's improving materially. And that bodes well for when you get back to a normalized revenue market. And then that all-connected aspect of this then plays into the e-commerce too. If you have that relationship, that digital footprint relationship with your customer, you can also have more dedicated marketing offerings. You can have more disciplined approach to maintenance. And so it's one part of the digital journey we're trying to bring our customers along with us that is good for them and it's good for us.

Yeah, no, I agree 100%. And maybe just, I don't know if you want to potentially quantify this, but I mean, how much revenue are you driving right now from that connectivity and condition monitoring revenue generation?

Yeah, so I mean, that's obviously very... Yeah, I'm not going to disclose it, is answer one, as Amanda looks at me. But I think the key here, though, is there is value here, right? And you look at this HS2 situation that we have, and this gets to the third pillar of our digital strategy that we rolled out five years ago, which was value-added services, performance solutions. And one of the real drivers of our outsized market share on HS2 is the technology solution we've wrapped around the equipment, which provides insights to the customers, which improves their productivity, which makes them more efficient. And there is a revenue stream associated with that, for sure. I think for us, though, we think about amplifying the traditional parts and services business, right? I mean, if you can... wrap technology around the equipment, and you can drive significantly incremental market share on the new equipment side and significant incremental market share on the parts side, that is a great outcome for Caterpillar. It's a great outcome for Finney. And at the same time, do it in a way that you obviously get value for, you know, the investments that you're making. And that's how we're thinking about it, Max.

Yeah. Okay. No, I wanted to try. But, yeah, thanks a lot for the call, obviously. Thank you.

This concludes the question and answer session. I would like to turn the conference back over to Ms. Hobson for any closing remarks.

Thank you for joining us today. This concludes our conference and have a safe day.

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