Finning International Inc.

Thank you for standing by. This is the conference operator. Welcome to the Finning International third quarter 2021 investor 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 Hodgson, Vice President, Investor Relations and Treasury. Please go ahead.

Thank you, operator. Good morning, everyone, and welcome to Finning's third quarter earnings call. Joining me today is Scott Thompson, President and CEO in Greg Powell's trust, EVP and CFO. Following our remarks today, we will open the line to questions. This call is being webcast on Binning.com. We have also provided a set of slides that we will reference during our prepared remarks. The 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 presentations 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. Those refer to slides 10 and 11 for important disclosures about forward-looking information as well as currency and 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 sitting to 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 speak about our improved earnings capacity and the exciting opportunities we see in our business as the transition to clean energy gains momentum. I will also talk about the steps we are taking to proactively manage supply chain constraints and inflationary pressures going forward. Greg will then provide an update on our financial performance in the third quarter and our strong execution towards the mid-cycle targets we communicated at our investor day. Please turn to slide two. We are very pleased with Q3 results. Our global team delivered a record third quarter EPS of 61 cents, which is the highest quarterly earnings in Finning's history on an adjusted basis. This performance is a direct result of our strong execution to deliver on our strategic plan and improve our earnings capacity. We have rebuilt our business to produce significantly better results across all metrics and expand our return on invested capital going forward. Our consolidated return on invested capital is approaching 15%. We continue to drive our construction product support growth strategy by leveraging our digital platform Cubic and offering a broader scope of customer value agreements and rebuild options to customers. We have seen growth in construction product support in all of our regions. While our total product support revenue was up 11% compared to Q3 2020, our construction product support revenue increased by 17% over the same period. In the UK, we are excited to provide HS2 customers with digital solutions on our Qubit construction platform. This platform gives customers access to data to enable smarter decision-making with a view to achieving productivity gains, cost savings, and better safety performance at construction sites. We are benefiting from our reduced cost base and continuous efforts to make our operations as efficient as possible. Our SG&A has a percentage of net revenue of 17.8% in the third quarter. All of our regions are demonstrating strong operating leverage as we are progressing towards our SG&A target. Our organization is becoming increasingly more digitized, relying on data from connected machines and market analytics. We are constantly driving improved inventory forecasting, more agile processes, and better pricing decisions. This allows us to proactively manage our inventory and generate solid gross profit margins in a highly competitive and constrained supply environment, such as the one we are facing today. We were able to increase our inventory by $150 million from December 2020. While we expect some delays in delivering equipment to customers, we are confident that our proactive measures have contributed to a healthy inventory position and will enable us to meet our revenue targets. When we compare our performance to the adjusted Q3 2019 results, which was pre-pandemic, our EBIT is up 13% and our EPS is up 24%. Our consolidated EBIT as a percentage of net revenue this quarter was 8.6%, the highest profitability in the last 15 years on an adjusted basis. Our teams should be proud of this achievement, especially since our revenues have not yet recovered to 2019 levels. It is their dedication and exceptional execution in serving our customers that have delivered such strong results for our shareholders in a very complex and dynamic environment. Our outlook remains positive. The market fundamentals are strong, our backlog continues to increase, and the supply chain headwinds could result in a more prolonged equipment cycle. We expect a tight supply environment to lengthen lead times for new equipment and parts in all regions. As a result, we are seeing increased demand for used equipment, rentals, and rebuilds. We continue to proactively manage these constraints by taking mitigation steps in collaboration with Caterpillar and our customers, such as optimizing preparation time on equipment, sourcing used equipment, and offering rebuild and rental options. While the broad-based strength in commodity prices has created a positive backdrop for our business, particularly in our resource markets, we are dealing with an industry-wide escalation of inflationary pressures from price and wage increases. We are monitoring these trends closely and are taking steps to address the potential impacts on our business. Many productivity initiatives are underway in our regions to further reduce fixed costs and make our operations more efficient. We are also taking proactive steps to mitigate technical labor shortages, including leveraging our improved network capacity and newly implemented continuous shifts, conducting targeted recruitment campaigns, and expanding our apprenticeship programs. For example, we have recently announced the investment in a new RRR facility located on the traditional territory of the Tecumseh Swabham Indigenous Band in Kamloops, British Columbia. Construction is now underway. The larger footprint of the new facility will allow for business expansion and the creation of approximately 100 new jobs. Importantly, the new building has been designed to be more energy efficient and will include improved heating and cooling, as well as efficient lighting, motion sensors, wash water recycling, light harvesting, and on-site renewable energy. This facility will reflect many of the operational efficiencies planned for our RRR network, including continuous shifts, specialist tooling, autonomous technology, and consolidation of all regional rebuild work. We look forward to sharing these benefits with our customers when we open the doors in late 2022. Before I turn it over to Greg, I will speak about the latest developments and exciting opportunities we see in the clean energy space, both in supporting our customers and reducing our own carbon footprint. Natural gas, hydrogen, and electrification are becoming an increasingly important aspect of our business as our customers are progressing towards their long-term goals of achieving net zero greenhouse gas emissions. I believe our business has great potential for growth as we support our customers in their transition to cleaner energy sources. Caterpillar has accelerated the development of power solutions utilizing natural gas blending and hydrogen. We recently hosted a technology demonstration day in Calgary to showcase Caterpillar's Tier 4 and hydrogen blending capability to customers in the oil and gas and electric power generation industries. We have cost-effective and reliable products today that will help our customers optimize their operations and support their emission reduction targets. A great example is a well-serviced fracturing trailer that utilizes a Tier 4 dynamic gas blending engine along with a transmission and hydraulic pump. CAT's dynamic gas blending engine is the only Tier 4 DGB engine on the market that allows for substitution of up to 85% of diesel fuel with natural gas. In addition, as was demonstrated on that day, these engines can substitute up to 20% of fuel with hydrogen. We are increasingly seeing our fracking customers switch to DGB technology. In fact, we have more than a dozen of these engines in our current backlog in Canada. We have a large footprint and capabilities in Western Canada to capture opportunities in natural gas, which is widely considered to be an effective and economic transition fuel to clean energy. Blending increasing proportions of hydrogen into natural gas is viewed as a near-term path to lowering emissions with existing technology. We believe that compressed natural gas Renewable natural gas and hydrogen have significant potential with our customers interested in exploring the use of low-carbon fuels. With this in mind, we made a strategic decision to expand our four fuel capabilities by acquiring a majority ownership interest in ComTech, an early-stage developer of alternative energy infrastructure and provider of proprietary mobile fueling solutions for CNG, RNG, and hydrogen. The electrification trend is also gaining momentum and accelerating demand for copper and lithium globally. Copper mining is contributing about 25% to our revenue today, mostly in Chile. We are cautiously optimistic about copper mining growth in Chile as we await the outcome of the general elections and clarity on the proposed mining royalties. We are also seeing meaningful growth in mining for copper and other metals in Western Canada. Caterpillar's advancements in electric equipment for underground mining in partnership with BHP to develop battery-powered large mining trucks are exciting news to us and our customers. Earlier this year, we announced our own target to reduce our absolute GHG emissions by 20% by 2027 from 2017 levels. Our initiatives focus primarily on minimizing the environmental footprint of our facilities and fleets, including the use of natural gas and hydrogen. In 2022, we will start using natural gas to power a portion of four fuel and thinning service vehicles. We have also recently secured sustainability-linked terms for our $1.3 billion credit facility, which aligns our cost of borrowing to our progress in reducing emissions and further demonstrates our commitment to the environment. Looking ahead, we expect strong market conditions to continue and the mid-cycle environment to transition to upcycle in 2022. We remain focused on growing and compounding our earnings and driving value for all of our stakeholders. I will now hand it over to Greg.

Thank you, Scott. I'm going to provide more details on the regional performance in the third quarter, our progress towards mid-cycle targets, and our capital deployment. Our consolidated third quarter results and key drivers are summarized on slide three. We broke several earnings records this quarter and achieved the best working capital performance in our recent history. while our revenues remain well below record levels. Net revenue is up 21% for Q3 2020, driven by higher new equipment sales in South America and the UK, and an increase in product support revenue in all operations. As market conditions continue to strengthen, we are proactively managing our inventory and technical resources to meet customer needs. Improved gross margins as a percentage of net revenue in most lines of business, combined with strong operating leverage, drove a 29% increase in EBITDA compared to adjusted EBITDA in Q3 of 2020. EPS was up 65% from adjusted EPS in Q3 2020, reflecting record EBIT and lower financing costs related to reduced debt levels. Slide 4 shows changes in our net revenue by line of business compared to Q3 of 2020. Higher new equipment sales in the quarter were led by strong demand in construction markets in all our regions. particularly HS2 units in the UK. In addition, we had large mining equipment deliveries in Chile. Growth in product support revenue was a result of significantly improved customer activity and our continued strategic focus to capture aftermarket share in construction. Our backlog was $1.6 billion at the end of September, up from $1.4 billion at the end of June 2021, driven by increases in the UK and Ireland and Canada. As discussed last quarter, we expect to deliver key building blocks of our backlog, QB2, Wave 1 HS2, and Codelco, at typical lead times. But we expect more recent additions to our backlog to have longer lead times, which we've quoted and planned for. An increase in gross profit from Q3 of last year was driven by higher net revenue, higher used equipment margins, and improved rental physical and financial utilization. SGA was up 7% on a 21% increase in net revenue from Q3 2020, coming in at 17.8%, 110 basis points lower than in Q3 of 2018, which had similar revenue levels. While we continue to make progress on our fixed cost reduction program, it's becoming increasingly difficult to be deflationary, particularly in the near term with incentive compensation, transportation, and procurement initiatives. We continue to drive our initiatives globally to further make improvements across people, facilities, and supply chain productivity and are working to offset these headwinds. Moving to our Canadian results and outlook, which are summarized on slide six. Product support revenue is up 12% from Q3 2020, growing across all sectors. Construction product support revenue is up 16%, driven by a significant number of rebuilds. Used equipment sales were up 35%, and rental revenue was up 27% from Q3 2020, with higher used equipment sales to mining customers and strong demand for both used and rental equipment in construction. We continue to see strong activity for rental equipment for the purchase option, or RPO, with both construction and mining customers. New equipment sales were down 3% from Q3 2020 due to lower mining deliveries. However, new equipment sales and construction were up 13%. Imported gross profit as a percentage of net revenue and higher rental utilization, combined with lower SG&A as a percentage of net revenue, resulted in significantly higher profitability. EBIT as a percent of net revenue was 10.4%, up 230 basis points from Q3 of 2020 on an adjusted EBIT basis. It was a very strong quarter for Canada that benefited from a high proportion of construction equipment in the revenue mix, RPO conversions, and a very healthy backdrop for rental, parts, and service supported by a very active and dry construction season. Our outlook for Canada is positive, supported by robust market conditions and construction and strong commodity prices. While supply chain constraints remain a headwind, market activity in Canada is returning to pre-pandemic levels. We are seeing strengthening demand for product support and rebuilds, driven by higher production in the oil sands and slowly increasing mining budgets, and active construction projects. Please turn to slide 7 for our results in South America. New equipment sales were up 126% from Q3 2020 in functional currency, driven by deliveries to Chilean mining customers and improved demand for construction equipment to support mining infrastructure and general construction projects. We expect to continue delivering large mining equipment over the next two quarters. Product support revenue is up 16% from Q3 2020 in functional currency, with strong demand across all sectors. We continue to see improved demand for mining product support, with a projected increase in copper production, mature equipment population, and declining work rates. Our ROIC in South America was 19%, our best performance since 2012, a testament to the strong execution cost reductions, and supply chain improvements over the last two years. We recognize that the current political and economic uncertainty will continue to impact customers' investment decisions, particularly as it relates to mining greenfields and new expansion projects. However, market fundamentals remain strong, global demand for copper is growing, and copper prices remain high. We believe that Chile will remain a globally competitive copper producer, and our outlook assumes a moderate increase in mining royalties. Turning to the UK and Ireland, I'm on slide eight. New equipment sales were up 45% from Q3 2020 in functional currency, driven by deliveries to HS2 customers and strong demand in construction markets. Product support revenue increased 8% from Q3 2020 in functional currency, driven by improved market activity, mainly in construction, and our strategic focus on growing product support. Growing revenue, improved execution, and discipline on cost and capital is driving strong road performance in the UK and Ireland to nearly 15% in Q3. The outlook for our business in the UK and Ireland remains strong. Our backlog is at record levels, including about 110 million pounds of orders related to HS2. On slide 9, you can see our mid-cycle targets for the periods Q3 2021 to Q2 2022 that we discussed at our investor day earlier this year. We are pleased with the strong execution of our strategic plan to drive product support, reduce costs, and reinvest to compound our earnings. Given our momentum and improved earnings capacity, we now expect to achieve our mid-cycle EPS in a row of targets ahead of schedule. In the fourth quarter, we expect strong new equipment deliveries in Chile mining and UK construction. While consistent with prior years, both rental and labor utilization are expected to be below Q3 levels. We remain positive of the market backdrop for 2022 and 2023, with a healthy outlook for customer activity likely moving to the upcycle. We expect positive free cash flow in the fourth quarter, building on the $152 million of free cash flow generated year-to-date. Our balance sheet is strong, with net debt to adjusted EBITDA ratio at 1.3 at September 30, 2021. Our board has approved our second quarterly dividend of $0.225 per share, consistent with the 10% dividend increase last quarter. which marked our 20th consecutive year of dividend increases. We are making strategic capital investments in our Canadian facilities network, continue to add rental assets, and invest in our digital platform. We expect our net capital expenditures and net rental fleet additions to be at the top end of the $170 to $210 million range in 2021. We deployed and committed roughly $85 million of capital in Q3 between share repurchases and the acquisition of a 54.5% controlling ownership in ComTech. We repurchased 1.8 million shares in Q3, an average cost of $32.96, and we invested and committed $25 million in ComTech, of which $20 million is to support future growth of mobile natural gas and hydrogen distribution service platforms. This acquisition builds on the success of our forward fuel business, which since acquisition has delivered excellent returns and customer outcomes. Forward Fuel has shown excellent growth and profitability since acquisition and is accretive to the Canadian dealership EBIT as a percentage of net revenue. We are expanding our Forward Fuel capabilities to a wider range of renewable and sustainable low-carbon fuels to make this business even stronger for the long term. We will continue to evaluate other complementary businesses that are highly aligned with our strategy drive improved outcomes for our customers, and deliver attractive rates of return. To summarize, Q3 was a very strong quarter. We are executing well and demonstrating improved earnings capacity. While we remain vigilant and are actively managing through supply chain and inflation challenges, we're confident that our growing backlog, healthy inventory levels, and lower cost base will continue to support our heroic expansion going forward. 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'll 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. Our first question is from Sherilyn Radborn with 2D Securities. Please go ahead.

Thanks very much, and good morning. It looks like rebuild could be an important source of supply for equipment and components for cycle, and Finning has clearly been preparing for that. So I wonder if you could just give us a sense of rebuild capacity in Canada and South America, and what opportunities exist to flex that higher if needed?

Yeah, thanks, Carolyn. You know, it's something we've been working on for quite some time with our global network strategy. And so we're happy with the position that we're in currently, where we've really looked to leverage our hub locations in Edmonton, Kamloops, Calgary, and Regina from a Canadian business perspective. And so while at the beginning of the pandemic we did pull some of our higher-cost labor out of other regions, we have been successful in adding back that resource within that distribution diamond. and replace about two-thirds of that technical headcount there. We're actually seeing higher levels of productivity overall versus the prior headcount. So I feel good about the way we've been able to attract people in the right places. And, frankly, part of the design of that network is where the depth of talent we can see at the appropriate cost. So I feel good about that. On the construction side, there's a lot of rebuilds ongoing, continue to have capacity. On the mining side, lots of quotations around rebuilds and discussions about rebuild versus new. And we're starting to see some of the CapEx budgets come out of the miners and certainly a lot of progress for them on cash flow and balance sheet. So we do think in 2022 that will be a theme and we've certainly got plans in place to be able to meet that demand if and when it comes. And then from a South America perspective, we've actually We've actually been able to hire over 350 technicians year-to-date. Finning has an excellent brand down there, a great team that we've been able to promote internally that attracts more junior resources from the market. And so a lot of rebuild activity in construction, for sure, and increasingly in mining. And we feel good about – while it's a challenge, we feel good about staffing up to meet those demands.

Great. That's helpful, Keller. And then in terms of how thinning is positioned with Caterpillar as a supplier in the context of supply chain disruption, it seems to me that Caterpillar probably has somewhat more control over its supply chain versus other OEMs because, for example, a cat machine contains a cat engine and not a third-party engine. So I'd just like to get your take on that line of thinking. Okay.

Yeah, sure. And so, Scott, so I think you're probably right in terms of I think CAD has spent a lot of time over the last four or five years, you know, fostering that supply chain and making sure the relationships were strong. And then there's, as you mentioned, a lot of components and parts that CAD manufactures themselves. So I think that's helpful. You know, I would say, and, you know, CAD mentioned this on their call, I think these supply chain pressures, no one's immune from them. And, you know, we are seeing CAT, you know, have to work to kind of mitigate some of these pressures. I think the benefit for us is, you know, we were on it early. And so we started working quite early when we started to see machine utilization hours go up. And so you actually see in the results our inventory built this year, which I think is a little bit different than some of our competitors'. And that puts us in a good position, I think, to meet the, you know, the demand requirements. You know, that being said, you know, as we mentioned, lead times are extending and, you know, there will be some impact to us as well.

That's my cue. Thank you.

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

Good morning. Good morning, Jacob. I just wanted to ask a couple of questions about South America client behavior. And I know that new equipment deliveries were good in the third quarter. And you're talking about, you know, being good through the fourth quarter, but backlog levels are lower. I'm assuming a lot, much of that has to do with the drawdown because of the QB2 deliveries. Outside of QB2, you know, how much of a wait and see approach is there before the November elections? And maybe differentiate between what you're seeing on the mining and construction customer behavior in South America.

Sure. Thanks, Jacob. So certainly on the mining side, there are some pause and some of those public announcements from certain customers talking about, you know, waiting to make some decisions and clarity. That said, a lot of projects with Codelco are on the go, which is the government and won't have the same issues. A lot of stability agreements with customers like Tech who continue to move forward. But we continue to have significant order intake from miners, particularly on ancillary equipment. Not the larger packages like Codelco or Tech, but 5 to 10 million at a time, and so that continues to flow regularly. And so I think it is – and we see a lot, particularly in the mining contractor space, where they're being awarded contracts and fulfilling equipment quite regularly. So that's fairly normal. I think some of the larger greenfield or new brownfield projects will wait to get some clarity here in the new year. But on the construction side, really all scenarios point to more infrastructure, regardless of the direction of travel on constitution or mining royalties. So – We're seeing really strong activity across the construction base. We expect that really to continue in all scenarios. So as you can see from the results, it's strong. We've still got quite a large backlog we're delivering through, but we also have the order intake continue with some momentum.

And then just a couple comments on the overall political environment. So we have so many elections. I think our expectation is that they will move to a runoff in December. And then you've obviously got the constitutional process underway. And so I think this uncertainty, you know, political uncertainty will be with us for a while. Now, that all being said, I think the consensus is moving towards where we thought it was going to be, which is, yes, an increase in taxes and royalties, but probably on the modest side, which will allow miners to continue to invest and take advantage of a great economy that's well-developed and and strong institutions. So, you know, we do feel good long-term about Chile. And in the near term, like Greg said, you've got pretty significant infrastructure, pretty significant GDP growth, and high corporate prices. So that's why you're seeing the type of results you are in Chile.

Okay. That's helpful. And maybe just circle back here on the supply chain issues. I know last quarter you were talking about inventory health and age of inventory. I'm feeling pretty good about that. Is that still the case here? coming out of third quarter. And then, I guess, secondarily, you know, how should we think about, you know, I notice you maintained your net revenue range of 7.1 to 7.5. But given these supply chain issues, you know, should we be thinking something closer to the bottom end of that range?

Yes. Thanks, Jacob. So, on inventory, yes, it's certainly a supportive environment where we have inventory coming in. It's a very efficient backdrop where, as you can see from our turns, things are arriving and departing quite quickly. And where we have had some pockets of aged equipment, we've moved through it. You've all seen South America use equipment down year over year because we moved a lot of it this time last year. really tidy, healthy inventory position and moving through the system quickly, which is really helpful from a margin perspective and a turns perspective. In terms of our revenue range, we continue to work towards that. As you highlighted, planning for a growing market and ordering inventory and sourcing used and adding rebuilds to the equation. So we feel good about that range and like any range, you're trying to hit the middle for sure and then aim for the upside. So That's what we're trying to do, and the market's cooperating from a demand perspective, and we're working our way on the supply side.

All right. Great. Thank you, guys.

Thank you. Our next question is from Yuri Link with Canaccord Genuity. Please go ahead.

Good morning, everyone.

Morning, Gary.

Morning, guys. Greg, you introduced some more cautionary language surrounding inflationary pressures in the outlook section, which is understandable. Yet you do expect to achieve the mid-cycle a little earlier. So what are some of the offsets to these pressures, and generally what's kind of changed to bring your mid-cycle expectations forward a little bit?

Sure. Well, we set the mid-cycle framework at Investor Day, and we're really pleased with the way we've performed and executed so far. Q2 and Q3 results certainly were both very strong. So we're delivering the top line healthy from a margin perspective and continue to work away at SG&A. When you do all three at the same time, it drops nicely down to earnings, and the expanding growing helps the whole system work. So I feel good about how we've been executing. working towards our SG&A target here and, you know, supportive on the margin side. And so, you know, today it's been good on SG&A and probably a little more tailwind on the margin side. Some of that's mix, some of that's execution, some of that's, you know, supply and demand. But it's a mix of the three and I guess you can see all three regions contributing and executing well. And then we hit all three areas that I talked about earlier. It drops to the bottom line and we're pleased with That expanded earnings capacity.

That's helpful. How do you feel about the rental fleet as it stands? Is it adequately sized? And if you wanted to increase it, is there even any equipment available to do so? But any comments on that and what we should expect next year for additions?

Yeah, from a rental perspective, as you can see, particularly in Canada, it was an important feature of the quarter. If you benchmark Q2 and Q3, the rental ramp really helped. And so we've actually taken steps through the year to make sure that we've maintained the rental fleet and resisted the urge to, you know, monetize. And so we've kept it kind of as planned for the year. Next year, we're looking at a modest increase. You know, we work with CAD each year for our annual planning. We are seeing strong market conditions, strong physical and financial utilization. And so it won't be a huge tough change next year, but, you know, modest growth.

Okay. I'll turn it over. Thanks, guys.

Thanks, Gary. Our next question is from Michael Dumont with Scotiabank. Please go ahead.

Okay. Good morning, guys. Yeah, the first question is on mining. Can you maybe just discuss your thoughts on the shape of this recovery? The track back to 2019 product support levels feels like it's taking longer than expected, especially if you consider the outperformance on the construction side. Do you think miners have the flexibility to continue to invest incrementally, or is there a point where the spending needs to ramp a little bit more significantly?

Yes, it's a good question, Michael. And, yeah, of course, as we highlighted, you know, construction, aftermarket share is a key focus. We're pleased we're making progress there. And mining is a big part of our business. And both in Alberta and in Santiago, you know, there's been a lot of, you know, restraint over the last several years. Of course, we've seen some good moderation in the last two or three quarters. And we've seen some catch-up maintenance. but also, you know, you've seen some lower copper production numbers in South America. We do expect that to moderate and then increase. And then in Canada, there's just been an unprecedented amount of discipline. We're working with customers to extend lights on things, but ultimately there's going to be some rebuild and new decisions that need to come here, you know, in 2022. And so we do think there'll be momentum just as we've got age fleets coming logging a lot of hours, and so we do see momentum there, and we do see continued growth. Certainly there hasn't been all the catch-up that we had been thinking maybe six months ago, but we do think that there's good momentum there.

Gotcha, thanks. And on inventories, is it, I mean, are you able to estimate maybe how short you are on inventories in the context of the current environment, And I guess maybe thinking about it from an inventory turns perspective, you know, has the enhanced visibility in your end markets, maybe fewer touch points through your supply chain, has that been the major driver on the lower inventories, or is it really just the supply and demand imbalance?

Yeah, like with everything, it's a mix. We've done a lot of work around standardizing our inventory, you know, what we stock, how we sell it. trying to be very efficient with training customers through the rental fleet to get on more standardized product. That does really allow us to move things through the system, you know, once and more efficiently and optimize obsolescence, to give you one example. So we've made good progress on the nuts and bolts for sure. But as I highlighted earlier, we've also, you know, there's strong demand. There are some delays. When things arrive, customers are looking for them quickly. We're getting things through the shop faster than ever. And so... There's definitely a market pull that helps that dynamic, so it's a mix of good execution, but also a supportive market.

Great.

Any – And then from a supply – Yeah, just from a supply perspective, too, is the first part of your question. Very similar to what Kat said, you know, we're pleased with the revenue growth. Of course, it could have been a bit higher if there was free supply, but But it's still a very solid market, and we'll continue to work away on the proactive tools we've got in our toolkit.

Great. Thanks, guys. Appreciate it. Thanks, Michael.

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

All right, thanks. Good morning, guys. I just want to start with a question on gross margins. Look, if you strip out the impact from mix, it appears that gross margins were, you know, up across I think most or nearly all lines of business. Just can you speak to how much was internally versus externally or market-driven? And if you think these gains are sustainable, and just when we look at that framework for getting to mid-cycle earnings, I think you have been targeting – You know, 17% SG&A costs. It looks like you're going to be at that mid-cycle earnings in 2021, but SG&A is going to be able to, you know, 150 basis points higher than that. So just kind of one thing about that sustainability of the gross margins where they are. Yeah, sure.

So, you know, as you highlighted, the way we look at that is there's a bit on mix, a bit on execution, and a bit on market conditions. So on the mix, you know, we've continued to benchmark this year as mid-cycle to 2018. And so Q3 of this year and Q3 of 2018 are roughly similar product support mix. But we are at our basis point higher on margin this quarter. And I'd say it's really around the framework that we laid out at Investor Day. You know, part of it's operational excellence, part of it's data analytics. And then in this market, you know, some of it is, you know, just strong demand and some supply constraints. And so I'd say probably a third, a third, a third there. Certainly we've made improvements. I just highlighted in Michael's question some of the standardization, but also commercial governance around terms of conditions and other things. Also data and analytics. Having the right inventory at the right time makes a big difference. And you were able to make some good data-driven decisions around inventory and pricing. So that's certainly helpful and certainly matured since the last cycle. And then market conditions, you know, you've got strong demand and tight supply, which is just supportive, and things move through the system quickly and efficiently, and that helps margins. So I think it's a mix of those things, and I do think that, you know, we're going to have a strong market here, we believe, for the next period of time into the up cycle, and so we think a lot of those dynamics, you know, stay for the foreseeable here.

Okay, that's good color. Thanks for that. Maybe just a quick one on free cash flow. You know, is free cash flow conversion of slightly below 50%? That's something you were highlighting earlier this year, subject to change, but just wondering if that's still achievable. And any early thoughts you can share with regards to the setup for free cash flow in 2022, assuming we get into this sustained upcycle?

Yeah, we've been pleased to have some more consistency of free cash flow here and really pleased to be here to date, you know, over $150 million. There's quite a number of things on boats and in progress, and we've certainly got a 50-50 days left here to deliver a lot of equipment. And so we'll continue to push. You know, we've highlighted strong free cash flow. I don't think we're going to put a decimal point on it because there's quite a few things in flux, but we just feel good. It'll be strongly positive, and we'll have to give you an update as as we finish up here.

Okay, thanks. Congrats on the good quarter. I'll turn it over. Great. Thanks, Evan.

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

Great. Thanks, and good morning. Just a bit of a follow-up on kind of the Western Canada demand that you're seeing. There's been some discussion out there about just the oil sands producers focusing a bit more on return of capital versus sort of investments. It looks like the results there were generally good, but I'm just curious what you're hearing in terms of, you know, whether it's demand for new equipment or rebuilds from your customers there.

Yeah, certainly customers have been busy. There's a lot of production, strong prices, and a lot of them just have their quarters. You can see great cash flow. They're certainly prioritizing reinstating dividends, and each seems to have their own kind of gross net debt targets they're working towards. And so they've made a lot of progress in repairing balance sheets and reinstating dividends. And, you know, I think once they move beyond those debt targets, which looks like they're moving to pretty quickly, we do think there will be some more capital to spend. And some of those discussions have started, but we expect them to more kind of – ramp up into 2022.

Okay, and then I guess when we look at the backlog that you have right now, you know, there's been some discussion for a while around the age of the equipment in Latin America and in Western Canada being quite old, you know, are you seeing some of that renewal of fleet in that backlog right now? Or is this more just related to current demand out there just want to understand how your customers are thinking about fleet renewals at this point?

Hey, Sam, but just to make sure I understand your question, I think if you're talking about our inventory, we feel really good about the age of that inventory. There's been a lot of progress in South America over the last few years to get that inventory in great shape, and we're in even a better position than going into SIP. So I just wanted to make sure. I think what you were talking about is our customers' fleets and the age of those. So let me address that, and if I got the question wrong, just correct me. I think it comes back to some of Greg's comments around just capital discipline from miners in general. So a lot of these fleets are quite old. We've been rebuilding and helping our customers maintain productivity and keep up and running. And so our fleet utilization is very high. I think as Greg highlighted, our our sense is that capital budgets will free up a little bit, you know, on the back of a little bit more political certainty in Chile and then on the back of high commodity prices in both Chile and in Western Canada. And so we do feel pretty optimistic around, you know, increasing activity around our big miners going forward, although, you know, moderate, not type of what we saw back in 2013, 2014, 15, or 2012, 13, 14, but but a moderate increase, which is what CAT has been positioning for the last year or two as well. So we're pretty consistent with CAT's view on that.

Thanks. That covers it. And then just I guess the last question, this might be a bit more philosophical, but you talked earlier about just the energy transition and how CAT sort of can fit into that. One of the things that we've been seeing headlines around is just the significant amount of capital this energy transition might require. As you talk to some of your customers in some of these resource industries, How do you see the cap machines and fitting into that broader transition? Is it just through more efficient machines, or how else can you maybe play a part or benefit from some of that CapEx over the next coming years?

Yeah, so I guess a couple thoughts on that. One, the energy transition is real, and we obviously are very supportive of that transition and working with our customers to help them address their emissions. And I think what you've seen for the last three to six months from Caterpillar and major customers is some pretty significant announcements. And, you know, I'd point you to the BHP announcement, the Rio announcement, you know, an announcement with one of the rail companies in Canada here last week. And so I think CAD is working hard with customers to come up with solutions that will help them address their needs, whether it be battery electric or hydrogen. And, you know, that will take a period of time, but that's the ultimate, you know, the North Star. I think in the near term, what we're seeing is using the great CAT technology that exists today to drive emissions lower. And I would point you to the technology demonstration that we had in Calgary about a month ago. Actually, I think there's some social media on that right now. I mean, it was a great event. Ninety of our customers showed up, and what we were profiling was the dynamic gas blending engine that CAT has. No one else has this engine. You know, it's essentially a tri-fuel engine where you can substitute diesel for natural gas and also have a 20% hydrogen blend. So you think about a customer that's sitting there with a lot of desire to reduce emissions, and it's an economical way given, you know, different commodity prices to drive great productivity improvements and emission reductions. And so it's those sorts of things that we're working hard with our customers to help them meet their needs. And I think Cat's extremely well positioned in this regard. One other comment, you know, we're seeing this in the underground space is Cat moving, you know, with pace on electrification. And so we've got a great underground battery loader, the R1700, which was profiled at Mine Expo. We've got one here. piloted right now in our territories, and we'll continue to push that forward. So those are just some examples of what CAT's doing, and we feel really pleased with the progress here over the last year.

Great. Thanks very much for that. Thanks, Alan.

Once again, any analysts who have a question may press star then 1 on their telephone keypad. Our next question is from Ross Killardy with Bank of America. Please go ahead.

Thanks. Good morning, guys. Good morning, Ross. Yeah, I just wanted to check. You gave some of the moving pieces for the fourth quarter. Are margins, these record margins, holding in the same general, you know, range in the fourth quarter? And then how do we think about – second half of 21 into first half of 22. Do you hold the second half run rate? Do we see, like, what used to be kind of the normal seasonal weakness in early 22? Or just given your comments about shifting more into, you know, mid to upper mid cycle in 22, I forget exactly how you phrased it. Do you actually see first half of 22 earnings up? versus the second half of 21.

Yeah, I guess, you know, we highlighted, you know, Ross, you know, after a number of quarters of sequential growth coming out of COVID, which is kind of unique, you know, certainly the trajectory that you had in 2020. And then, of course, we've been rebounding the strong growth since. And I think we've reached that point where we'll start to see some more of the typical seasonality where, you know, particularly in Q4, You know, the rental fleet isn't as fully utilized as Q3. Some of the labor recovery, I think in the latter half of the quarter, is a bit lower. So those are just a couple reminders around the seasonality of Q4. And then, you know, typically Q1 will ramp up. Q2 and Q3 are, you know, peak summer season in the northern hemisphere.

And that's the typical seasonality, and we think we're back towards that.

We've got strong new equipment deliveries in Q4 and in Q1 in Chile and in the U.K., and then the product support business will kind of be back to kind of normal seasonal trends. So I don't think we're going to contour next year right now, but those are some of the building blocks, and we feel like there's good momentum, but certainly not just continued sequential quarter over quarter like we've seen for the last four quarters.

Got it. And then I just wanted to ask if you could provide any additional color on just this real – acceleration you've seen in product support on the construction side. I mean, is it more large equipment, small equipment, or is it everywhere? And is it directly a function of the extended lead times? And, you know, with that EPC mix in construction, maybe moving back more towards new equipment as the lead time issues abate.

It's like a lot of the answers today. It's a mix. So we're really pleased that we were working with Kat even pre-COVID around the rebuild strategy. So we had a lot of customer propositions ready. We got a lot of CBA propositions ready. And we've been breaking down our business within the sector and looking at competitors for over a year and a half. So that was all ready to go before some of these supply chain constraints. So Even before that, we saw a lot of progress. It's across the board. Of course, larger equipment has a bigger impact on us, but it's across the product range. We're looking under every rock to find lost opportunities and capture them. We're making good progress. And then, of course, from there, with some of the constraints, customers are turning to rebuilds. And we're doing some rebuilds, frankly, ourselves to fill supply. And so it's a mix. But we're really pleased that we have that strategy ready for the market that we're in.

Yeah, and I rebut just a couple things. I don't think it's really a supply chain issue here. I mean, following up on Greg's point, this is pretty aligned with Cat's view on aftermarket and construction. You know, we've spent a lot of time over the last four or five years connecting machines, getting CBAs in place, and driving market share where we were underpenetrated in the construction aftermarket. And so I think you're seeing that all come together. which, you know, is good news, and our expectation is that continues into 2022 and 2023. Got it. Thank you, guys. Thanks, Russ.

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

Thank you, Operator, and this concludes our third quarter earnings call. Thank you all for joining and have a safe day.

This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.