Earnings Call: Q3 2018

Oct 23, 2018

Summary

Q3 sales rose 18% to $13.5B and adjusted EPS increased 47% to $2.86, with all three primary segments growing. FY guidance was maintained, while management expected 2019 revenue and profits to improve.

Good morning, ladies and gentlemen, and welcome to the Caterpillar 3Q 2018 Analyst Conference. At this time, all participants have been placed on a listen-only mode, and we will open the floor for your questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Amy Campbell. Ma'am, the floor is yours. Thank you, Kate. Good morning and welcome, everyone, to our third quarter earnings call. On the call today, I am pleased to have our CEO, Jim Umpleby, our CFO, Andrew Bonfield, and our Vice President of Financial Services, Joe Creed. Remember, this call is copyrighted by Caterpillar, and any use, recording, or transmission of any portion of the call without the expressed written consent of Caterpillar is strictly prohibited. If you would like a copy of today's call transcript, we will be posting it to the investors section of our caterpillar.com website. This morning, we will be discussing forward-looking information that involves risks, uncertainties, and assumptions that could cause our actual results to be different than the information discussed. Details on the factors that either individually or in the aggregate could make actual results differ materially from our projections can be found in our filings with the SEC and our forward-looking statements included in today's financial release. In addition, a reconciliation of non-GAAP measures can be found in the appendix of this morning's presentation and in our release, which is posted at caterpillar.com/earnings. With that, I will turn it over to Jim. Thank you, Amy, and good morning. First, I would like to introduce Andrew Bonfield, our new Chief Financial Officer. Andrew joined Caterpillar on September 1st. Andrew has more than three decades of global financial experience. Most recently, he was Group CFO and board member of National Grid PLC, a British multinational electricity and gas utility company. Prior to National Grid, Andrew was Chief Financial Officer at Cadbury PLC and also served as Executive Vice President and Chief Financial Officer at Bristol-Myers Squibb. We are delighted to have Andrew on board. He is a welcome addition to our company and our executive office. Andrew will walk you through our financial results, and after I provide a brief overview of our third quarter performance as well as our outlook. We had an outstanding quarter, thanks to both higher sales and excellent operational performance. Many of our end markets continue to be strong. Sales and revenue were $13.5 billion, an 18% increase over the third quarter of last year. We also earned profit per share of $2.88, which is the highest third-quarter profit per share in Caterpillar's 93-year history. This is the third consecutive quarter our company has delivered record profit per share. Adjusted profit per share was $2.86, up 47% from the third quarter of 2017. Third-quarter operating profit was about $2.1 billion, 41% more than the third quarter of 2017. Adjusted operating margin for the quarter was 16.6%. That's 260 basis points higher than the third quarter of 2017 and consistent with the first half of this year, despite input cost headwinds. These profit levels and margins are due to the excellent work of our global team and demonstrate that our strategy for long-term profitable growth and our discipline on structural costs are delivering measurable performance improvements. We finished the quarter with $8 billion of enterprise cash. That's after paying more than $500 million in dividends, repurchasing $750 million of Caterpillar common stock, and making a $1 billion discretionary pension contribution. In the first nine months of 2018, we've returned $3.4 billion to shareholders. Our solid operational performance gives us the flexibility to invest in growth and to continue returning capital to shareholders. We intend to continue doing both in a sustained and disciplined way. Using the operating and execution model as our guide, we will continue to invest in areas that represent significant opportunities for profitable organic growth, especially in services and new and enhanced offerings, which are key components of our strategy. We also continue to look at non-organic growth opportunities, but we'll do so in a disciplined way. Let me walk you through some examples of how we're investing for future growth. We continue to deploy more digital service offerings in autonomy and automation technology for mining. We're collaborating with a gold mining customer in Nevada, supported by our local Cat dealer, to automate underground loaders and enable machine operators to work safely and efficiently from a control room on the surface. We're improving existing technology and accelerating deployment of new features. We're also working with a mining customer in Western Australia, where we've secured a deal for the first commercial installation of a retrofit kit to enable autonomous operation of competitor mining trucks using Cat MineStar Command for Hauling. With this Cat system, customers can operate different brands and sizes of trucks, both manned and autonomous, in the same space and scale up fleet size to meet the mine's needs. Our autonomous solutions are demonstrating significant productivity improvements for our customers. We also continue to roll out expanded product offerings to meet the diverse needs of our customers. Last month, we expanded the articulated dump truck lineup by reintroducing the 40-ton size class with a new Cat 740 GC model that incorporates proven features and performance, including new controls and systems for transmission protection, stability assist, and advanced traction control, and a fuel-saving eco mode. Just last week, we unveiled several new Cat mini hydraulic excavator models in the one to two-ton and seven to 10-ton size classes. These mini hex are part of our next-generation excavator rollout that began in 2017. We believe these new models provide the best performance, versatility, safety, operator convenience, and affordability in these size classes. With these machines, we're also reaching out to a broader customer base, to local and regional contractors who may be in the market for their first yellow iron Cat machine. These examples of digital technology services and expanded offerings are part of our mission to help our customers, both current and future, be more successful with Caterpillar than with any of our competitors. Now for the outlook. Our profit per share outlook for the year is $10.65 to $11.65, and we have maintained the guidance given last quarter for adjusted profit per share in the range of $11 to $12. We expect normal seasonal patterns for sales growth in the fourth quarter and also expect to continue our strong operational performance. As we discussed with you last quarter, Caterpillar participates in diverse end markets. Many of our end markets are in the early stages of recovery, while others are experiencing robust demand. We feel good about the state of our business. We continue to monitor end market fundamentals and will provide 2019 guidance in January. Currently, we believe favorable commodity prices, strong economic growth, and the global need for infrastructure will continue to drive strong end user demand across many of our end markets. More specifically, we believe economic fundamentals, attractive oil prices, and the need for oil and gas infrastructure are a positive for Construction Industries in North America. For Asia Pacific, while sales for CI remain strong across the region, we continue to monitor China demand to determine the trajectory of future sales. For the remainder of 2018, we expect normal seasonal trends for China. In EAME and Latin America, we are seeing positive signs for CI in most countries, but there have been some recent areas of weakness, which we believe will be contained. For Resource Industries, robust economic growth and infrastructure investments are driving strong demand in heavy construction applications, which we expect to continue. While our global mining customer sales are improving, the recovery is still in the early stages and we expect higher demand for new equipment moving forward. Energy & Transportation is our most diverse segment and serves a wide variety of end markets. Current oil prices are a positive for E&T. Sales into North American compression and well service applications remain very strong. While there have been takeaway capacity issues in the Permian Basin, we are seeing increased activity across other basins and expect production in the Permian to grow after the capacity issues are addressed. Demand for new equipment for onshore and offshore drilling, as well as offshore oil and gas production, remained weak. We continue to see positive momentum in power generation. The North American rail market is also showing signs of recovery. Total car loads improved and stored locomotives are down from a year ago. We are seeing an increase in activity for new locomotives, as well as demand increases for rail services and locomotive rebuilds. In summary, we feel good about the fundamentals of many of our end markets, despite the presence of geopolitical risks and global trade tensions. We are focused on a strong finish to 2018, and we will share more about our 2019 outlook in January. With that, I will turn it over to Andrew. Thank you, Jim, and good morning, everyone. First, I just wanted to say how excited I am to join Caterpillar. In particular, it's great to be here today to share such an impressive set of results with you. Let's start by turning to slide 3, and I will discuss the third quarter of financial results in a bit more detail. Sales and revenues were $13.5 billion, up 18% from last year, with continued growth across all three of our primary segments. While many of our end markets continue to improve, North American economic strength and oil price stability drove higher levels of construction activity, as well as higher demand for well servicing and gas compression equipment. In addition, Resource Industries machine sales were up significantly. Third quarter profit per share of $2.88 and adjusted profit per share of $2.86 are up 63% and 47% from a year ago on higher sales, improved operational performance, and disciplined resource allocation. As Jim noted, this was a record third quarter profit per share performance, and these results demonstrate that our strategy is working. If you move to slide 4, I will walk through what drove the 41% increase in operating profit. As you can see in the chart, higher sales volume contributed $793 million more operating profit compared to last year. Price realization was $155 million, or about 1% higher than the third quarter of last year. Manufacturing costs increased by $205 million due to higher material and freight costs. In all, material costs were up about 2% on higher steel prices and the impacts of tariffs. Freight costs continue to be elevated due to a variety of factors, including higher rates, less efficient loads, and expedited freight costs as we ramp up production to meet increased demand. Even though the mid-year price increase had only a partial impact in the quarter, the drag of higher input costs and tariffs was just $50 million more than price realization. We are also continuing to look for operational efficiencies to reduce the impact further. We expect that this effort, plus the benefit of the mid-year price increase, will further moderate the impact of material and freight costs in the fourth quarter. SG&A and R&D costs were up $77 million in the quarter. That's an increase of 5% compared to an 18% increase in sales and revenues. Jim gave a few examples of how we are investing that money to drive long-term shareholder return, but this cost discipline is a key factor in improving our operating margins. Financial Products was favorable by $36 million as the core business continues to perform well with higher financing rates, a favorable impact from return or repossessed equipment, and higher average earning assets in North America and Asia Pacific. While past dues have increased this year, this is largely isolated to a few customers in Latin America experiencing economic challenges, and in the Cat Power Finance portfolio. Overall, we believe the portfolio remains healthy. The adjusted operating margin for the quarter was 16.6%, which is on the high end of our Investor Day range and 260 basis points higher than the third quarter of 2017. Now let's look at the performance of each segment, beginning with Construction Industries on slide 5. Sales were $5.7 billion in the third quarter, an increase of $0.8 billion or 16%. CI sales increased across all regions except Latin America. Sales in North America were up almost half a billion dollars, and North America drove about 60% of the total third quarter sales growth. Much of this was driven by oil and gas-related projects, including pipelines and other non-residential construction growth. Asia Pacific sales were up 19% or $239 million, with the most significant increase continuing to be from China. in the quarter, our dealers in China were able to restock from very low to more normal levels of inventory. We continue to expect industry sales for 10 ton and above excavators to be up about 40% for the full year. Since there has been some speculation about our level of sales in China, I wanted to clarify that for Construction Industries, sales in China range from 10%-15% of total segment sales, and China accounts for 5%-10% of total company sales and revenues. Outside China, most of the countries in the Asia Pacific region had higher sales on broad economic strength. Overall, EAME sales were up 10% and Latin American sales were down slightly. While higher demand for infrastructure and building construction activities in both of these regions were broadly favorable, isolated economic uncertainties in Turkey, South Africa, and Argentina did have a negative impact on these markets in the quarter. Turning to profit. CI segment profit increased by 20% over last year to $1.1 billion. Operating margin was 18.6%, which is higher than the Investor Day range as Construction Industries continues to demonstrate the power of the operating and execution model to allocate resources to grow profitably and grow controlled costs. Let's move to slide six. The Resource Industries team also turned in another great quarter. RI sales were $2.6 billion, up 35% from the third quarter of 2017. Sales for new equipment increased across all regions, and demand for aftermarket parts remained strong to support overhauls and maintenance. In fact, this was the highest quarter for sales since the fourth quarter of 2013. Our mining customers are placing orders for new equipment as commodity prices remain above investment thresholds. However, our customers globally continue to focus on improving the productivity and efficiency of their existing machine assets, thereby delaying full fleet replacements. In addition to the recovery in mining, strong global economic growth and infrastructure investment also contributed to higher sales for heavy construction equipment. Segment profit of $414 million was up 81% versus the third quarter of last year. Segment operating margin improved to 15.7% at the top end of the Investor Day range of 12%-16%, and up 400 basis points from 2017. RI's improved performance and margin expansion is primarily due to higher sales, improved price realization of more than 4%, and the operating leverage gained through significant restructuring and the team's disciplined cost management. These gains were partially offset by higher manufacturing costs, including freight and material costs, and higher SG&A and R&D expenses to invest for profitable growth. Now let's turn to slide seven, where we will discuss Energy & Transportation. E&T sales in the third quarter were $5.6 billion, 15% higher than the same quarter last year, with sales increasing across all applications except industrial. Sales into oil and gas applications were up by $297 million or 28% as we continue to see strength in onshore activity in North America, especially for gas compression and well servicing applications. Power generation sales increased by $204 million, or 23%, driven primarily by sales of reciprocating engines to support data center and power plant applications, as well as higher aftermarket parts sales. Industrial application sales were down 2%, largely due to economic activity in Turkey. However, sales in North America and Asia Pacific increased slightly over the third quarter of last year. Transportation sales were up 12%. This sales growth continues to be driven by our recent European and Australian rail service acquisitions and higher North American rail traffic. Segment profit for Energy & Transportation was $973 million, up $230 million from the third quarter of last year. The segment margin improved by 210 basis points to 17.5%, which is also at the high end of the Investor Day range. E&T's profit improvement was mostly due to the higher sales volume, but this was partially offset by higher manufacturing costs and increased SG&A and R&D expenses. I want to spend a few moments discussing cash flow, which is shown on slide 8. Our ME&T operating cash flow was $848 million in the third quarter, and we finished the quarter with $8 billion of enterprise cash on hand. Operating cash flow in the quarter was $237 million higher than last year, reflecting the higher profits, but after taking into account a billion-dollar discretionary pension fund contribution. This pension contribution gave rise to a favorable tax deduction and also provides cash flow flexibility for the next few years. As Jim mentioned, we continued to return capital to shareholders with $511 million of dividends paid and the repurchase of $750 million of Caterpillar stock in the quarter. We remain committed to investing to profitably grow our business. Our current operational performance has provided the added benefit of strong operating cash flows to a solid balance sheet. We intend to use this flexibility to both invest for growth and continue returning capital to shareholders in a disciplined way. Resource allocation that brings long-term profitable growth will remain the highest priority. One of the many reasons I came to Caterpillar was my belief that the discipline created by the operating and execution model is the right way to evaluate opportunities and lead us to drive long-term profitable growth. In addition to profitable growth, our capital allocation strategy will remain focused on sustainable dividend growth and being in the market for share repurchases on a more consistent basis. We expect share repurchases in the fourth quarter to be at least $750 million, bringing the total buyback to at least $2.75 billion for the year. As we have said in the past, we will be more opportunistic and look to go beyond that, depending on market conditions and investment priorities. Let's move to slide 9. Our profit per share outlook for the year is $10.65 to $11.65, and we are maintaining our second quarter guidance of $11 to $12 for adjusted profit per share. We have not updated the adjusted profit per share outlook range because nothing material has changed since we updated the outlook in July. Since our assumptions have not changed and the third quarter came in about where we expected, we believe it makes sense to maintain that outlook for the full year. Order rates and the backlog remain healthy, with the backlog up almost $2 billion from the third quarter of 2017. Construction Industries remains on managed distribution, and production rates for large machines and large engines continue to increase with demand. We believe the increase in dealer inventory in the quarter reflects current end-user demand, and in some regions and in some products, was necessary to improve availability to the end customer. As measured by months of sales, dealer inventory ended the quarter at the low end of historical averages. In short, we feel good about the state of our business, and with that, I will turn it back to Amy to begin the Q&A portion of the call. Thank you, Andrew. Kate, it is now time to begin the Q&A portion of the call. Participants should limit their questions to one plus a follow-up. Ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press *1 on your phone at this time. We ask that while posing your question, you please pick up your handset if listening on speakerphone to provide optimum sound quality. Our first question today is coming from Joe O'Dea. Please announce your affiliation, then pose your question. Hi, good morning. It's Vertical Research. First question. Jim, your comments across end markets were pretty constructive and encouraging. I think we see kind of a disconnect in where we're seeing the stock reaction to what seems like kind of an outlook right now that would continue to support further growth moving forward. I guess one question just on backlog and seeing that nudge down a little bit sequentially. Any commentary across segments and whether or not some of this is lead time related, some of this is just general macro uncertainty, but seeing a slight softening there versus what sounds like otherwise pretty strong end market conditions. Well, good morning, Joe. It makes sense just to spend a few minutes expanding upon how we're doing in each of the markets. We talked about Construction Industries and that we continue to see very strong demand in Asia Pacific, particularly in China, but also in North America and EAME. In Energy & Transportation, very strong activity in onshore gas compression, well servicing. Industrial is also strong. We haven't experienced a slowdown. Much has been written about the Permian, but we have not experienced a slowdown in our business. It's still been quite strong. People have talked a lot about the fact that there are takeaway capacity issues. Of course, whenever pipelines are built, that's a good thing for our CI business as well. We feel bullish about that business. Heavy construction and Resource Industries continues to be strong. In rail, we've seen an increase in locomotive rebuilds and modernization. We've also seen higher service and parts sales. Rail traffic in North America has certainly increased, and we've seen a year-over-year reduction in the number of idle locomotives and rail cars. We expect new locomotive orders to continue to improve. We've seen some business from outside the U.S. as well. We have talked about the fact that Latin America's a bit slow to recover in Construction Industries, and offshore oil and gas production's been slow. We feel good about the state of our business. We feel that the business continues to be strong in most of our end markets, and we're not, frankly, concerned about dealer inventories or backlog, and I'll let Andrew comment on that. Yeah. We did see the backlog go down by about $400 million in the quarter, but remind you that for the year to date, it is still up nearly $2 billion since the third quarter of last year. At the same time, we were building inventory into dealers. We still are at the bottom end of normal ranges. Even though the dealer inventory's gone up over $2 billion since the beginning of the year, that's all indicative of dealers having confidence. The $800 million inventory build in the quarter was a lot less than the drop in order backlog. That does mean that overall, dealers are still sitting positive about end consumption. Thank you. Appreciate those details. Just a follow-up related to price cost and general outlook for price cost moving forward. Whether or not price cost should actually shift more favorably moving forward, looking at pricing announcements next year into dealers, material costs stabilizing, and whether we see any kind of improvement on some of the constraints with supply chain and materials, and whether all of that translates to a little bit more favorable price cost situation moving into the end of the year and then into next year. Yeah. On price, we are starting to see the impact of the mid-year price increase, and we expect price realization to more than offset material cost and freight expense for the full year. We recently communicated to our dealers a 1%-4% price increase that will be effective in January of 2019. We are working our way through supply constraints. Again, we feel good about the environment for pricing, just as I mentioned, moving forward. Got it. Thanks very much. Thank you, Joe. Thank you. Our next question today is coming from Ross Gilardi. Please announce your affiliation, then pose your question. Hey, good morning, guys. Bank of America. Jim, how do we think about the retail numbers that came out last night? You were up 21% in September, but your comp, I think, goes from being up 13% in September to up 34% by the end of the year in December. As you exit 2018, are we looking at low to mid-single digit retail sales growth? Is that what's implied at the mid-point of your guide? No, I'm not going to make a comment and give you a forecast for retail stats. I've talked about the end state of our markets and the fact that we feel good about those. Based on everything we see today, we expect our business to continue to improve in 2019. Okay. What's the feedback you're getting from the miners on some of the elevated uncertainty in China? Are there any RFPs out there that have been put on the back burner until things settle down with the trade situation? What are you seeing on large mining equipment demand from non-China emerging markets as well? Thanks. Again, as I mentioned earlier, Resource Industries business continues to improve. Truck levels are now at the lowest level they've been since 2012. There are still more trucks to bring back online, but it's contributing to strong aftermarket demand, and we're seeing strong parts demand to support increases in machine utilization. We certainly feel good about the trajectory of our mining business. Commodities such as copper and gold have been strong. RI's experienced growth across all regions. Again, we do feel good about RI. Market fundamentals seem to be improving and are quite solid. Thank you. Thank you. Our next question today is coming from Steven Fisher. Please announce your affiliation, then pose your question. Great. Thanks. Good morning. It's UBS. I know on China, you said you expect the normal seasonal pattern for the rest of 2018, but really curious how you're thinking about China in 2019. Does what they have announced so far in this regard sound meaningful enough to support ongoing growth in the Construction Industries business there for you? Just a few general comments about China. Certainly, it's an important market for us. It averages 5%-10% of total company sales and revenues. For CI, it's about 10%-15%. There's a lot of different scenarios, of course, forecasting what's going to happen in China. Based on everything that we see, we believe that the China market will continue to be healthy. Excavator demand is up significantly this year after it had been more than doubled last year. Again, we feel good about China for next year. Okay. In terms of the Resource Industries business, how should we think about the margin trajectory there going forward as the original equipment sales continue to pick up? You didn't really call out the margin mix on the margin result this quarter, which came in a little bit lower than our expectation. Has that mix shift even noticeably started yet? As it does, can that be offset by any more advantageous price versus cost? I'd urge caution both in, particularly in RI and in E&T, in looking at quarter-to-quarter margins. Both of those businesses tend to be very lumpy. We expect quarter-to-quarter variations in margins up and down. What we really suggest you look at is our year-to-year improvement, which is what we're really focused on doing. We talked about our targets for margin expectations at Investor Day, and we're towards the top end of those or above those. Again, we feel good about that as well. Have you seen that impact start yet on the mix shift between OE and aftermarket, or is that still mostly ahead of us? I would say that in terms of the new equipment, we expect that to improve moving forward. We are starting to see activity for new equipment, but we expect that to continue to improve. If you step back and think about where we've been from a historical perspective, we are still below averages. Not just comparing to the peak, but we have a long way to go to improve on OE for mining. The margin mix might change, but you're going to still see bigger dollars ahead, it sounds like. Yes. One of the things also to keep in mind is for next year, we're going to have a STIP tailwind that's going to have a positive impact in all of our segments as we reset STIP for next year. That's also out there as well. It's another tailwind to keep in mind. Terrific. Thank you. Thank you. Our next question today is coming from Jamie Cook. Please announce your affiliation, then pose your question. Hi, good morning. Andrew, welcome to the fun world of industrials. I guess two questions. One, Andrew, for you specifically, can you just talk about what your top priorities are as CFO of Caterpillar? While Cat has answered some questions on share repurchase, how you guys are thinking about being more opportunistic on share repurchase, given where your stock price is today and perhaps the market's view of what's going on in the macro versus yours and your ability to earn a higher trough EPS. My second question, Amy, or I'll try, you guys sound fairly constructive as we think about 2019 in terms of volume without specifically stating a number, but are there any material positives or negatives we should think about, whether it's stock comp, repo, restructuring benefits, dealer inventories as we think about 2019 versus 2018? Thank you. Yeah. Thanks, Jamie. Yes, it's great to be here. Yes, it is always exciting to see such a good set of results be put out in front of you guys today. Priorities, I think you shouldn't be surprised, obviously, the things about making sure that we execute the O&E Model particularly well as we move forward. Resource allocation, in particular, obviously needs to be something we keep a focus on to make sure we drive that profitable growth that we're trying to target and achieve. So working with Jim and the other members of the executive office to do that. Obviously, again, you mentioned about capital allocation. That is something which, again, obviously is, I know a lot of investors have a lot of focus on. Obviously, we have the $10 billion buyback approved by the board. That will obviously be a key focus as we move forward. Obviously, we need to think through how we manage the balance sheet through the cycle. That's something which I will work on and look to as we move forward. But obviously, as we said, and we indicated again, we will be opportunistic and go above the $750 million if, obviously, at times where we think the share price is below intrinsic value, which is what it is at the moment. I'll jump in, Jamie, and take on the question you had for Amy. On 2019, obviously, it's too early for us to provide a lot of specifics. As I mentioned earlier, we expect our business to continue to improve in 2019 versus 2018. There's a lot of puts and takes, but we expect price realization, along with the reset of STIP and continued cost discipline to offset cost headwinds. We have a healthy backlog, good order rates, and we're taking orders for some products well into 2019. We feel good about the state of our business, and frankly, we expect both the top and the bottom line to improve in 2019 versus 2018. Okay. Thank you. I appreciate the color. Thank you. Our next question today is coming from Ann Duignan. Please announce your affiliation, then pose your question. Yeah, good morning. JP Morgan. My question is around dealer inventories. I know you said we're at the low end of months of supplier or based on historical metrics, but historical metrics may not be the right way to look at dealer inventories for Caterpillar because in prior cycles, dealers double ordered and ordered just in case, and then we had the lean strategy, et cetera. Jim, how do you reassure investors that this cycle is different, that your dealers are not double ordering or ordering ahead of price increases, or ordering because just in case? Yeah. We've worked very hard over the last couple of years on getting more lean internally and also I've looked at our supply chain. Obviously, our dealers are independent businesses, so they make their own decisions as to what they do. But we do feel, based on the strength of the markets, that we don't have an issue in terms of dealer inventory. I'll let Andrew jump in here as well. Yeah, Anne, just to give you a comment. I am actually really impressed by the amount of data that the company actually does have on dealer inventory. You may want to go back to look at my background at Bristol Myers and why I would be very focused on that, because that was at wholesalers in that particular point in time. I do think, A, first of all, the visibility is important. Actually, in absolute dollar terms, these look relatively low versus other parts in the cycle. It is something that is very well monitored. So I think as best as it can be, but as Jim said, because obviously the dealers are independent. It does give us confidence that there isn't any excess inventory build. In fact, actually, what's happened in the last 3 months is as we ramp up production, effectively we are now getting into a situation where dealers actually have enough inventory that they are able to sell through. So that's an important part of what we've been doing. Much of CI still ends on managed distribution, as you probably know, and much of the CI increase restocking in China, for example, is off of very low levels. Again, we feel comfortable with what we see. Good. That's helpful. Is there any color you could give us if we look at Europe and the Middle East? How much of that region is Middle East and any changes that you're seeing due to political unrest in the Middle East that's currently going on? Is that anything we should be concerned about going into 2019? At this stage, the bit where we did see some impact in the Middle East area is really around Turkey, and obviously they have had a fair amount of economic uncertainty. Elsewhere actually through the rest of Europe, and most of the rest of the Middle East, actually, things were pretty much okay. It has really been Turkey that has been the big driver of uncertainty around that region. Okay. I will pass it on in the interest of time. Thank you. Thank you. Thank you. Our next question today is coming from Andrew Casey. Please announce your affiliation, then pose your question. Thanks a lot. Wells Fargo Securities. If I could go back to Anne Duignan's last question there in EAME, did you see any moderation in any of the EU countries? Separately, can you explain why you think the weakness, and it sounds like it may just be Turkey, why do you think that will be contained? Well, firstly, Turkey has been obviously going through a fair amount of economic uncertainty. Obviously with U.S. sanctions as well being applied, that has had some impact on the broader economy in Turkey. I think we'll start hopefully seeing that moderate now as we move forward, and hopefully start seeing Turkey recover. Around the rest of Europe, if you look around the rest, U.K. sales were sort of flattish in the quarter as would be expected with uncertainties there. But generally actually the rest of EAME actually was pretty good and Europe was actually pretty strong as well. Okay. Thank you. I just wanted to confirm something. So we've had several quarters where Construction Industries remains on managed distribution. Can you comment on whether the constraints you may be still encountering are part of Cat's internal suppliers, or is it mainly external? Really what I'm trying to get to is if there's any change in past comments about CapEx remaining beneath depreciation. Andy, there is no change. Construction Industries has plenty of bricks and mortar capacity to meet demand. The issue has been with suppliers, and as I'm sure you know, it isn't just Cat and our competitors, but manufacturers in many different industries have struggled with just the general increase in economic activity and what that's driven in terms of demand. So no, it's not internal, and you shouldn't take anything away from a capital investment perspective based on that. Okay. Thank you very much. Thank you. Our next question today is coming from David Raso. Please announce your affiliation, then pose your question. Evercore ISI, good morning. I am just trying to figure out the confident comments that you seem to be having about 2019 that you have made. I am trying to understand why we still have a $1 EPS range in the fourth quarter. I am just trying to understand. You obviously seem fairly comfortable in your production schedules moving forward. If I heard you correctly, it seems like the fourth quarter sequential versus third quarter, you would expect some normal seasonal patterns in your sales. I guess maybe first, if you can confirm that. Because the $1 range in the fourth quarter, I appreciate the comment, nothing has changed since our prior view, so we just figured we maintain it. But it does at least raise the question, your confidence in 2019 to leave a $1 range for the fourth quarter is interesting. I guess first, can you confirm that you expect normal sequential sales patterns third to fourth? Yeah. Then David, let me be as clear as I can be. Obviously, yes, we do expect normal seasonal sales, sequential patterns in the fourth quarter. If you look at our margin structure for the year to date, it is 16.6%. In the third quarter, it was 16.6%. We expect margins to be broadly similar as well. That very much is in line with where we have been expecting. I think on the range, I think changing the range would have sent some sort of message about something had changed since July. We were very clear in our thought process that we actually just wanted to be very clear to you all and say nothing has changed. Our expectations of outlook have not changed. We just wanted to reflect that through the guidance. Yes, it is a wide range. Yes, but nothing really much has changed since where we were in July. Narrowing it may have created some noise, either at the bottom end or at the top end. We just thought it would be better to leave it as is and explain it on the call today. Yeah, no, I appreciate that. I am just trying to think of a launching pad into 2019, because if your sales are up their normal 6%-7% sequentially, third to fourth, and the margins are the same, that means the fourth quarter EPS is above the third quarter. Your guidance implies it is not. I am just trying to understand. That's the bottom end of the range. You sound comfortable, it's just the numbers don't fully back it up, and you're just saying it's still within the range. It might be the high end of the range, but you decided just to keep it as a wide range. Yeah. If you do the math as you've done it, then you would see the quarter as being up. I think that our view is the range is wide, yes. We don't expect to be at the bottom end of the range. Based on what we're expecting, we expect the normal sales pattern and operating margins to be broadly in line with where they've been all year. Last one, the price increases announced to start 2019. The impact of those, can you just help us a little bit? They seem to be they're not price-protected shipments, so I'm trying to get a sense of the price cost as we start 2019. Can you help us a little bit with that on the timing of the cost versus the timing of the price as we start 2019 for a run rate? Yeah. Obviously, we did give quite a long lead time, partly so that we can actually put it into effect. We expect a significant proportion, a majority of that portion to stick obviously into 2019. When we are doing our initial guidance for next year, we will take into account that not all of that will be fully realized in the 2019 timeframe. We will give you a bit more of an update and a bit more color then. Also, don't forget, we will have the full year benefit of the mid-year price increase in 2019 as well. Then we have a double stack to start the year. Okay. Yeah. All right. Thank you very much. I appreciate it. Thank you. Our next question today is coming from Jerry Revich. Please state your affiliation and then pose your question. Hi, good morning, everyone. It's Goldman Sachs. Can you talk about the M&A pipeline and the relative attractiveness of M&A versus buyback to you folks at this point? You mentioned stocks below the intrinsic value, but how does that stack up versus your M&A options? As you folks look at the balance sheet today, the cleanest it's been in over 30 years, what do you think is the right level of leverage for this business longer term? Yeah, this is Jim, and I'll start it off and let Andrew jump in at the end if you would like. You mentioned M&A and buybacks. The other thing we can also do is invest in organic growth, which we are very much doing. All of our businesses continuously evaluate M&A opportunities. We're continuing to do that. We're not excluding anything. We're not saying that there's a definitive plan for a big M&A either. We are very focused on organic growth, particularly in areas of services and digital. We're increasing our capability there. I'll let Andrew take the buyback question. Yeah. Jerry, on the sort of what's the right level of leverage, I'm seven weeks in, so I think, if you would excuse me to start batting that out for a little bit longer, because actually it's one of the things I want to work through and work through how do we think about this through the cycle, which is what we do have to do. We do want to maintain the mid-A rating through the cycle. So we have to think through that and how that capital allocation works. Obviously, at the moment, we do have more cash than we inherently need, therefore we are, as you've seen, accelerating the buyback program. That is obviously the key at the moment. Okay. Thank you. You folks gave us good color on new dealer inventories of new equipment. Can you just talk about what you're seeing on the used equipment side? I guess we're seeing used inventories inching up in North America construction equipment. Are you seeing that as well? Can you just talk about your comfort level on the used side? Yeah, Jerry, I think if you look at used equipment, the inventories are quite tight, and we are seeing increases in used equipment prices continue. Any color by region, Amy? I do not have any specific color by region. It is certainly the case in North America where I have most of that data. Okay. Thank you. Thank you. Our next question today is coming from Steven Volkman. Please announce your affiliation and then pose your question. Hi. Good morning. It's Jefferies. Thanks for taking my question. Just a couple quick follow-ups. Just back to the Resource Industries, if we actually do sell more equipment next year than parts, can you still have up margin? Yeah. I'm not sure we said that we'd sell more new equipment than parts. I think what we said is that, talking about mining and Resource Industries, correct? Yes. Thank you. That's your question? Yes. Both are improving. Our parts sales are increasing, as are the opportunities for our new equipment as well. We're obviously leveraging period cost. We're seeing higher volume, and that's a good thing. I'm not going to make any comment on margins, new versus parts. Okay. Fair enough. Thank you. Just a couple quick ones on tariffs. I know you've been managing that quite well so far. What happens when and if, it looks like more of a when, those tariffs go to 25% on the Section 301, what type of impact would that have? Are you either doing or seeing from your customers any kind of pre-buy activity around that whole issue? We previously stated that in the last six months of the year, we'd have cost headwinds of $100 million-$200 million. We're going to be at the lower end of that range, we believe. We haven't seen a big pre-buy, but of course, we're in a situation where, as you know, we've had some constraints, and we've been on managed distribution. We don't expect a major impact because quite frankly, we were already hit with the earlier tariffs, so we don't think a later change will have an impact on us. It was already baked in for us. Are you buying any parts ahead of changes in pricing? Well, again, we're in a situation where, as we talked earlier, there's a supply constraint challenge, not only for Caterpillar and our competitors, but for many other manufacturers as well. I don't think anyone honestly has the luxury of making a lot of big pre-buys, so no. Understood. Thank you. Thank you. Our next question today is coming from Rob Wertheimer. Please announce your affiliation. Then pose your question. Yeah. Thanks. It's Melius Research. Thank you for the prior answer. If I could just get a little bit more specific on it, obviously tariffs are a remaining big uncertainty for the market and estimates. What you just said, is that meant to suggest that if there is 25% on the additional $200 billion of goods tariffs, that that would be at or smaller than the impact you've had this year? We just sort of can't see all the different things you and your suppliers buy. Obviously, you've got a lot more information on quantifying that than we do. Yeah. So the impact would be quite minor in the bigger scheme of things for Cat's results. Okay. Perfect. Are you doing any material sort of production mitigation where you produce more in Brazil or elsewhere to offset that? Or is it just straight minor on a gross basis, like the stuff that's tariffed isn't as large in the second round for you? Yeah. We're not making a lot of production shifts. Our teams obviously continuously monitor the situation, and as you know, with politics you get together, the situation can change dramatically day to day. So we have not made production shift decisions based on this. Great. Thank you. Yeah, just to expand upon that, we have a global footprint. We have the luxury of, unlike some other companies, we manufacture products in Asia, in the Americas, in the EAME. So that does help us mitigate this somewhat because we do have a global manufacturing base. Perfect. Thank you. You bet. Thank you. Our next question today is coming from Sameer Rathod. Please announce your affiliation, and then pose your question. Macquarie Research. Thank you for taking my question. Just one quick question on labor cost. It seems like there's growing political pressure for $15 per hour, and we've seen some response to that already. Can you quantify how much of an impact, if any, it would be a cost in terms of if Cat paid at least $15 an hour to its manufacturing staff? Thank you. Yeah. For the most part, it's not going to have an impact on us. We are above $15 in the vast majority of places, certainly in the U.S., so I don't see an impact on us. Thanks. You bet. Thank you. Our next question today is coming from Joel Tiss. Please announce your affiliation, and then pose your question. Hi, Bank of Montreal. Just two quick ones. You guys are running now near the top end of your Investor Day margins, and I just wondered if there's more kind of leaning toward raising those targets, or are we kind of passing the maximum point of the internal efficiencies and you're more comfortable just leaving them in place? As we talked about, we're focused on growing our business as well. While our teams are continuously focused on making our operations more efficient, we're also investing for growth. There's always a balance there between those margins and growth. But we're pleased that we are ahead of where we said we would be from a time perspective, and our team has a laser focus on those margins. But again, there's a balance between investing for growth. We just don't want to continue to wring out higher margins every year at the expense of growth. However, if we can both grow and have higher margins, then that's fine as well. Again, it's a balance. Okay. Just- Sorry, so one comment. Sorry. If certainly volumes go up, obviously that gives us an opportunity to have higher margins because we are leveraging that overhead across the higher volume. So that opportunity certainly exists. Andrew, there has always been kind of this historic inside of Cat, a push and pull between growing market share and having more pins in the map and profitability. I just wondered, based on your experience and history and all that, what would be your initial input into that debate? Yeah, I think, let me just say, history is littered of companies who have either gone for market share at the expense of margins, and/or then gone for margins at the expense of market share. Ultimately, at the end of the day, we want to do both. It is all about trying to do profitable growth. I think that is really one of the reasons why I joined. I love the term profitable growth, and the fact that it does mean that you actually have to do a focus, not just on growth and profits, but actually sustainable long-term profitable growth. So ultimately, at the end of the day, you want to do both, is the simple answer. Okay. I appreciate you guys squeezing me in. Thank you. Kate, we have time for one more question. Thank you. Our next question today is coming from Chad Dillard. Please announce your affiliation and then pose your question. Hi, good morning, everyone. From Deutsche Bank. I just want to go back to the $800 million increase in dealer inventory. Can you give a little bit more detail, by segment and by region, where the increase came from? Then where do you expect that to exit 2018? Yeah. I'm not going to break down the $800 million for you by region, but as we said, one of the biggest areas where it was in China. As a result of the selling season in the second quarter, there was a very strong pull-in, in China. Overall, across all the segments, we are comfortable that we still remain at the low end of the range. Then obviously, as with the production ramp-ups, we are starting to get to a situation where dealers have adequate inventory on hand. Again, I think rather than get into the sort of then start having to give you an update exactly where the inventory is, the inventory is across all the segments. It was built across all segments in the quarter. But generally, we are comfortable with where we've ended. That's helpful. Then, just switching over to price. You mentioned a 1%-4% increase in 2019. How does that break down across your various segments? Then also, the thing that jumped out at me, was a 4% price increase in Resource Industries, and I was just curious whether it was more of a mix issue or are you actually getting price on an apples-to-apples basis? If so, has the market tightened enough so that that's sustainable? Yeah. Again, the price realization in RI is a lot due to mix versus the prior year. With regards to the 1%-4%, we're not going to break it down by segment. But basically, it depends geographically, and it depends on business segment as to what the price increases were put through. Great. Thank you very much. Kate, that is going to have to be our last question. Jim, do you have a couple of wrap-up comments? Well, just thanks everyone for your time this morning. Just wanted to end by saying I am very proud of the Caterpillar global team for a record profit per share for the third consecutive quarter. We continue to deliver record quarterly profits even while many of our end markets are still in their early stages of recovery. We will continue relentless execution of our strategy, supporting our customer success, very focused on profitable growth and total shareholder return. Look forward to speaking with you all next quarter. Thank you. Thank you, Jim. Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.