Earnings Call: Q2 2016

Jul 26, 2016

Summary

Q2 revenue fell ~$2B and reported EPS declined to $0.93, while $670M of quarterly cost reductions and over $1.1B in H1 savings cushioned the downturn. FY guidance was cut amid weak global demand; adjusted EPS guidance was ~$3.55, excluding restructuring.

Good morning, ladies and gentlemen, and welcome to the Caterpillar 2Q 2016 results conference call. 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, Mike DeWalt. Sir, the floor is yours. Thank you very much, and good morning, everyone, and welcome to our second quarter earnings call. I am Mike DeWalt, Caterpillar's Vice President of Finance Services. As usual, on the call with me this morning, we have our Chairman and CEO, Doug Oberhelman, and our Group President and CFO, Brad Halverson. Today, I will start by walking you through a short slide deck, similar to what we have done over the past couple of quarters, and then we will move on to the Q&A after that. If you do not have the slide deck in front of you right now, it is available on our website, caterpillar.com, in the investor section, and it is where the webcast link was. This call is copyrighted by Caterpillar Incorporated 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 in the investor section of our caterpillar.com website, and it will be in the section labeled Results Webcast. If you go to page 2 of this morning's slide deck, you will see our forward-looking statements. This morning we will be discussing forward-looking information that involves risks, uncertainties, and assumptions that could cause our actual results to differ materially from the forward-looking information. In addition to page 2 of the slide deck, a discussion is either individually or in the aggregate could make actual results differ material. It can also be found in cautionary statements under Item 1A of our Form 10-K filed with the SEC and the forward-looking statements language in today's financial release. In addition, a reconciliation of non-GAAP measures used in both the financial release and this presentation can also be found in the financial release on our website and is also the back page of today's slide deck. With that, let us get started on the slide deck, and I would ask you to flip over to page 4. It is the comparison of second quarter 2016 with the second quarter of 2015. It has the key lines for the second quarter versus last year. Sales and revenues down about $2 billion. About half of that was Energy & Transportation, and the other half was split close to evenly between Resource Industries and Construction Industries, and I will talk a little bit more about sales in a minute. Profit, the primary drivers of the decline in profit from $1.31 to $0.93 a share this quarter. Excluding restructuring, $1.09, down from $1.40, so a $0.31 decline. By far, the biggest negative in the quarter was the decline in sales volume, and that included negative sales mix as more of the decline was in higher margin products like oil and gas. Price realization was also a pretty substantial negative in the quarter, and that was off $233 million. On the favorable side, below operating profit, other income and expense was a positive $156 million. That was mostly all due to the absence of below operating profit exchange losses from a year ago. An important point I think to note about this second quarter was exchange had actually little impact on the quarter itself. The most substantial positive in the quarter from a profit standpoint was cost reduction. Period and variable costs were favorable, $670 million versus a year ago. That just brings up the point here that we've been really focused on execution. That includes the cost reduction, but is not exclusively cost reduction. We've improved our market position as well around the world and in particular in China as well. Let's switch on to the next page 5. It's a discussion of the sales and revenues. Again, the biggest sales decline in the quarter was in Energy & Transportation, just shy of $1 billion. We've been talking about this for the last year or so. The decline really started about mid-year last year. So this second quarter is the last, I think, of the big declines that we're going to see, particularly related to oil. First to first, second to second. By the time we got to the third quarter, and certainly by the time we got to the fourth quarter of last year, it was pretty much all baked in. In fact, I think by the time we get to the fourth quarter of this year, the comps will be a lot more like the prior year. So this should be the last quarter of declines, at least in this size. Resource Industries, down about $600 million, and most of that decline was lower end user demand and a little bit from pricing. Mining has just continued to be a very challenged industry. Customers are pushing out replacement purchases. They're delaying as much repair as they can, and we see that in our sales. Relative to kind of the trend, it's about flat with where we were in the first quarter, so no continuing deterioration from where we were last quarter, but down from a year ago. Finally, Construction Industries is down just under $400 million. A little more than half of the decline was price realization, and it is a pretty tough pricing environment out there today in construction, and we see it everywhere. We see it in the U.S., we see it outside the U.S. A word about this, because I know it may seem to you like it's accelerating, but it's kind of not. It started going up about mid-year last year, the sales variance, the discounting. So we had negatives in the second half of last year. The first half of this year is comparing with a better period a year ago, so it looks like it's quite a bit of an increase, but it's not much of an increase, actually, from where we've been over the last two or three quarters. I think as we go on and talk about this in the outlook, we kind of see it starting to flatten out. Sales were down in North America, Latin America. Europe, Africa, Middle East was pretty flat year-over-year. Europe up, Africa, Middle East down, and sales in Asia were actually up year-over-year, despite price pressure. That's a quick run-through of sales. I know, related to Energy & Transportation, there's a lot of concern around the turbine business, because it's been pretty strong for quite some time. Just a couple of facts about that. We reported on the backlog last quarter, said it was up slightly from year-end. Second quarter of this year is about spot on where we were at the end of the quarter, so we're not seeing any deterioration there. It's a little early to talk about 2017, but all indications are the year's progressing pretty well. Oil is lower. Work backlog sales around natural gas and natural gas pipelines are still pretty strong. That's sales. Let's flip over to page six and talk a little bit about the operating profit change and cost in particular. This is the waterfall chart that we have actually in the release. No big new information on here outside of the release. It just highlights how well we've done on cost reduction. In total, between variable and period, or you might call relatively fixed costs, we're down about $670 million, and that's gone a long way to offset the impact of lower volume and product mix. You can see on here, price realization, the negative 233. Actually, we've had more variable cost reduction. If you think material costs and efficiency and that type of thing, we've about offset the impact on price realization with that. Year-to-date, if we turn to the next page, just talk a little bit about what we've done on costs. On the first quarter, between period costs and variable costs, we were down just under half a billion. This quarter, again, was 670. So through the first half of the year, we've taken over $1.1 billion of costs out. If you look up at the top of this page in the yellow bubble up there, what we're saying is we're on track. Our expectations are that we'll end this year with well over $2 billion of cost reduction. That's coming really in three sort of general buckets. The most significant is restructuring, and that is everything from combining office functions and reducing people to taking out manufacturing floor space and related costs. Material costs have also been favorable, and we've had a good track record on material costs over the past few years. I mean, we're down over $1 billion over the last few years, and it really comes from mostly design and sourcing-related cost reduction, and then important, but to a lesser degree, commodity-related cost reduction. Then everything else. It's everything from a bit lower short-term incentive pay based on lower results, and then cost reductions throughout the company, every place we can find it, from everything from travel and entertainment expense to consulting spend. Wherever we can take money out, we're working really hard to do that. Bottom line, we're investing in the things we need to for the future, things like digital and really important product programs. Everything else, we're really trying to put a lid on and cut where we can. The results have actually been pretty good. Let's flip over to the next page. That would be page 8. Talk a little bit about the outlook for the year. When we were sitting here a quarter ago, we were expecting sales in a range of $40 billion-$42 billion. $41 billion as a midpoint. We've taken that down from midpoint to midpoint, about three quarters of a billion. The gist of that is just everything that we're seeing in the economy today around the world. Additional risk, everything from the results of the Brexit vote and the short-term uncertainty that that causes, the trouble we've seen in Turkey, all the negative rhetoric around the U.S. elections. Oil prices have come off a little over the last couple of months. It's not any one thing, I would say, and we said this in the outlook. We have sluggish economic growth throughout the world in general, but not enough to drive growth in our end markets. The news we've seen over the last few months is definitely not giving us more confidence. The outlook for profit is $2.75 a share, and that's all-in. Excluding restructuring costs, which are going to be about $700 million now this year. Net of that, we're at about $3.55 a share. Both on the top line and the bottom line, our estimate is actually pretty close to the last consensus analyst estimates that we've seen. We're pretty close to, we think, where the market is. One point about this outlook, and this is in Q&A 11 in our release on page 15. It has been negatively affected about $0.08 a share by taxes. If we hadn't made the change in how we're looking at taxes on our profit excluding restructuring costs, the outlook would've been $0.08 higher. Which isn't too bad of performance considering a $750 million decline in the top line. I think it just goes back to the main theme of execution, cost reduction, doing everything we possibly can to keep the company strong and give us the ability to invest in the future. One last point I'll make about sales, and this might well be on your minds as well, and that's kind of the status of dealer inventory. We're pretty flat right now on dealer inventory with year-end last year. But we think it's going to come down quite a bit over the next two quarters, and that's not entirely unusual. Last year, we had a reduction as well. Full year reduction in dealer inventory this year is probably going to be, not quite, but close to double what we did last year. It's not so much, and you've asked this question before, do we have a glut of inventory? I certainly would not describe it as that. I think one of the things that's happening out there is a little bit of our own doing, and it's around lean. If you look at our delivery performance and the stability of our delivery performance to dealers, it's actually improved quite a bit over the last five years. We're to the point now where dealers, we think, have a lot of confidence in our ability to deliver what they need and when they need it. We think that's causing them to both order less. As our delivery times have come down in Construction, our backlog comes down a little. Think of it this way, this is an oversimplified example, but if we had delivery times that were one day, we wouldn't have much backlog. Dealers would order, and we would ship it. I think one of the reason the Construction backlog is a little lower, and one of the reason that we're getting probably more aggressive dealer inventory declines is how well we're performing on lean relative to delivery performance. We knew that was likely to happen, and in the scheme of things, it's a good thing. Let's move on to the next, the outlook. Let's move on to the next page, and I think it's probably a good time to talk about first half versus second half. We're through half of the year, probably time to reflect a little bit on how the second half of the year is likely to shape up. End user demand should be a fair bit higher than the first half of the year. We have our sales, which we think are going to be $600 million-$700 million higher than the first half, and that does include some substantial dealer inventory reduction. We have profit per share excluding restructuring costs up $0.09. With restructuring, it's down a little, and that's because of the extra cost for restructuring in the back half. If you look at how the sales shape up, that $6.65 billion increase in sales. Construction Industries is likely to be down a little bit. End user demand, pretty flat, but because of dealer inventory reductions, their sales are likely to be a bit down. That's our forecast anyway. Resource Industries is just slightly up from the first half run rate, and not a lot, no big changes there in terms of trends. Energy & Transportation is responsible essentially for the increase in sales. That is mostly seasonal pattern on some of the big project kind of sales that we have, turbines, for example, and we expect a bit more sales out of rail in the back half of the year, particularly in the fourth quarter. In terms of profit, we have the $0.09 a share. Better profit in the second half of the year than the first half. The higher sales volume is the most significant reason for that. Pricing, let's talk about this. I touched on it a minute ago. On a year-over-year basis, the negative impact of pricing ought to start easing a little bit, and that's because we really saw it kick up mid-year last year. First half versus second half, though, forget about last year, we don't see much change in the pricing environment. Inventory cost absorption will be a modest negative in the back half of the year. We're looking at taking inventory down, our own inventory, not dealer inventory, down $500 million-$600 million in the back half of the year. It'll be a little hit to profit, but positive for cash flow. We also had some sale of security gains in the second quarter, for Financial Services division and for the insurance portion of that, and we're not expecting that to repeat in the second half. Cost overall, we think will be fairly neutral first half to second half. We do have additional period cost reduction that we're looking at in the second half of the year. But with kind of low seasonal cost in the first quarter and probably a little bit of efficiency negatives. Production is going to come down because of the decline in dealer inventory. We think those will come close to offsetting during the second half of the year. We don't actually have an outlook for the third quarter, but if you think about the second half of the year, in a lot of ways, I think it'll look similar to the first half of the year. If you think to the first half of the year, we had a low first quarter and a pretty good second quarter. I think as we look at the rest of the year, the third and fourth quarter will play out similarly. We'll have probably a weak third quarter and a much better fourth quarter. Again, a lot of that is the timing of some of this E&T sales around larger projects. We're thinking that third quarter will probably be $400 million or $500 million in sales better than the first quarter, and profit will be in the range of $0.05 to $0.10 a share better than the first quarter. Then the fourth quarter will look a lot like second quarter. Sales slightly higher, profit about the same as Q2. That's how we think the rest of the year will shape up. Let's move on to the last slide that I'm going to cover today. That's slide 10, and that's kind of key discussion points. Just a little quick recap of much of what I've talked about. On balance, there's not much change in demand from the industries that we're serving. Construction demand is relatively steady, but with continuing price pressure. We have no clear signs of recovery in mining or oil and gas or rail for that matter. Good operational performance continues. Overall, our market position has improved, and that's been a continuing story for most of the last five years. Our decremental margins are pretty good and better than our target range, and that's despite a pretty negative sales mix second quarter to second quarter. Cost reduction is substantial, at $1.1 billion year to date, and we're thinking over $2 billion for the full year. We're on track with our restructuring actions. They've contributed to cost reduction this year, and that'll contribute to more in 2017. Then finally, our balance sheet's strong, and that's very important to us because maintaining our credit rating and the dividend are very high priorities for us. In the second quarter, operating cash flow was $1.2 billion. Our debt-to-capital ratio for our Machinery, Energy & Transportation business was 39%, about 21% net of about $6.8 billion of cash that we had on hand at the end of the quarter. That is a wrap-up. We are now ready to move into the Q&A portion of the call. Thank you, ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press *1 on your touch-tone phone at this time. Pressing *2 will remove you from the queue, should your question be answered. Lastly, while posing your question, please pick up your handset if listening on speakerphone to provide optimum sound quality. Your first question is coming from Ross Gilardi. Ross, your line is live. Please announce your affiliation and pose your question. Yeah. Hi, Bank of America. Thank you. Mike, some of your competitors sound maybe a little bit more sanguine on stabilization in the mining markets, at least in the aftermarket. There just seems to be some scattered new project activity around the world. Can you elaborate a little bit more on what you are seeing? Is there any chance you are losing any share right now? Yeah. I would say there is some improvement in mining on the horizon around aftermarket. We are seeing a little more activity on dealer rebuilds, and we would hope that that would translate into higher sales for us. I think one of the things that might distinguish us a little bit from competitors is that we sell through dealers. A lot of these projects might hit them quicker than they hit us. We are still expecting a decline in dealer inventory this year, and particularly in the second half of the year. If we were just selling to end-user demand, sales would be a bit better than they are right now. Yeah, I do not want to sound totally negative. It does not look to us like it is continuing to go down, and there are a few small signs like that, particularly like the rebuild activity, that is a little positive. But we track share of what's being sold, and we're not seeing deterioration there. So, it'd be nice if it would improve a lot quicker, and hopefully somewhere down the road, it will. Thank you. Can you just comment on the impact of lower interest rates on your pension and provide any preliminary thoughts on cash outflows into the pension next year to the extent you can? Yeah. I'll try not to get too far in front of myself, but I think based on where we sit now, we don't see the requirement for substantial increases in contributions next year. The number, I think, is less than half a billion, if memory serves me. Thank you. Thank you. The next question is coming from Seth Weber. Seth, your line is live. Please state your affiliation and pose your question. Hey, good morning. It's RBC. Mike, you mentioned a couple of times in the release, there were comments about the U.S. construction equipment supply-demand imbalance. Can you comment on where you think we are in the process of that smoothing out? Does equipment continue to need to be moved out of the energy markets? Where are we from an absorption perspective? Thank you. Yeah. As we sit now, the thing that's actually been pretty good is sales that go directly to end users, rather than through a rental fleet. The weakness right now is mostly what we've seen is in and around our dealers loading rental fleets. I think that's where this sort of hangover of equipment that was being used for oil and gas, a lot of it resides right now. They're pretty stocked up on rental fleets. Used prices are down a bit, so that's not encouraging them to sell used equipment out of a rental fleet and replace it with new. So I think that's right now the reason that we're not seeing a more positive construction number in the U.S. You would hope, time heals all things, and you would hope here sometime over the next couple of quarters that we'd be through that. That's helpful. Thank you. If I could just ask a follow-up on the Chinese construction equipment market. The numbers there have been probably, I think you talked a little bit more positively there last quarter. Any updated thoughts on what you're seeing in that market? Yeah. Thankfully, it is not another down year there. It is sort of flattish there for the full year up for the industry. We are doing a little better than the industry. That is kind of continuing a trend that has been going on now for a couple of years. We have got great product, great dealer distribution there. I think customers are kind of coming around to the quality business model. Hopefully next year can build on this. We will have to wait and see. At least for this year, we are looking for from an industry standpoint, a flattish industry. Okay. Thanks very much, guys. Thank you. The next question is coming from Adam Uhlman. Adam, your line is live. Please state your affiliation and pose your question. Hi, good morning. It is Cleveland Research. I guess back to the second half outlook for the year, I am a little surprised that the profits are not going to be up more than the forecast sales increase. I guess, Mike, you touched on some of the factors that are behind that. Could you talk to what you are seeing in material costs, and how do you expect that to play out as we go into 2017 with steel prices moving higher? Yeah. That's a great question. I'm remiss for not having mentioned that when I talked about the second half. We've had good cost reduction during the first half of the year for material, and our view is we'll continue to have cost reduction in the second half of the year versus 2015. Commodity prices have come up a little, so we're probably going to have less than the first half of the year. In other words, full year, even second half versus the second half of last year, positive, but the positiveness has probably peaked, and it'll probably go down a little bit in the second half of the year. That is one of the reasons I think that second half profitability. That, plus the inventory declines, plus the absence of the 4 cents we got on the security sale in the second quarter, all kind of make it look like it doesn't hang together, first half, second half with sales. Okay, gotcha. Related to the mining business, I was wondering if you could just talk about high level, how you folks see the industry changing, if at all, related to the Komatsu and Joy Global merger. I'll take that one. It's Doug Oberhelman here. I don't think it was any surprise that Joy was acquired, with what's happened to them and the mining industry in general and all the mining customers, particularly coal customers, that are out there around the world. Obviously, we've known Komatsu for decades. We've known Joy, intimately as well, the last decade or so, since they emerged from bankruptcy and we entered mining in a bigger way. Neither one of these are new players. Certainly, it's a consolidation. That makes sense in the mining world. It's going to be smaller for at least a period of time, and again, we know them, they know us, and I think, going forward, we'll continue the competition just as we have in the past. I expect us to continue winning where we win. Great. Thanks, Doug. Thank you. The next question is coming from David Raso. David, your line is live. Please state your affiliation and pose your question. Evercore ISI. Just trying to think about the carryover cost savings of 2016 to 2017. Then second question about the orders continue to fall sequentially. I can appreciate some of the seasonality in rail for second half versus first half, but just thinking about the exit rate exiting 2016 to 2017, can you help us a bit where you see orders playing out from here? Have orders stabilized? Because obviously, they continue to fall sequentially. Yeah, I think, no doubt about that, and it's particularly in Construction Industries. Part of that, as you mentioned, is seasonal. I think part of that, again, is related to dealers taking inventory down during the second half of this year. Again, partly seasonal, I think partly delivery performance. We're doing a much better job of delivering on time stably to customers. So I think both of those things are contributing to lower orders. If you look at end user demand, I'm talking Construction Industries here, for the second half of the year, our sales to users, that's going to be pretty steady in the second half of the year. So it's not as though we're seeing a deterioration in demand from end users. It's more dealers have lowered orders to take out some more inventory. If you exit the year with an order run rate annualized below 2016, you are saying don't necessarily imply down revenues in 2017. You just feel your shipping capabilities are allowing a lower order rate, so to speak, or a quicker turn of backlog into revenues? Yeah, I think that is exactly what we are saying. Yeah, I think that's a fair assumption. The retail sales numbers are the one to watch and really drive this whole supply chain. As long as they are steady, the chain will work itself out. As Mike DeWalt said, second half will look different than the first, but that's the one that really drives us. Of course, that gets back to market share and a lot of other things as well, David Raso. Well, do you expect to see the retail sales get flat by the end of the year so we feel more comfortable about that assumption for 2017? Yeah, I don't know if they'll be flat, but they should be closer than they are right now, yeah. Then the carryover cost, the slide number seven, when you say on track for over $2 billion, I'm not sure if that's an annualized number, but assuming it's a $2 billion run rate exiting the year. Yeah Looking how the quarters play out, or really first quarter, second quarter, second half, are you implying a carryover cost savings of $1 billion? Yeah. So that's 2016 versus 2015 costs. A lot of that started coming out very early in 2016. Our first quarter was quite favorable. Our second quarter was even more favorable. So I think we will probably end the year with a, as you look forward, based on the timing of the cost reduction, a tailwind, but I don't think it would be $1 billion. Okay. That's helpful. I appreciate it. Thank you. Thank you. The next question is coming from Jamie Cook. Jamie, please state your affiliation and pose your question. Hi, good morning. Credit Suisse. Couple clarifications. One, Mike, in the press release, and I think in your commentary, you implied Solar was flat with the first quarter up from the beginning of the year, but you also talked about some customers pushing out orders into 2017. So I'm just wondering, is the backlog flat because of push-outs, or are you actually seeing order activity? My second question is for Doug. Doug, you've talked historically about managing to a sort of targeted $3.50 trough-ish EPS. As we sit here today, given the markets don't seem to be getting better, we're already at $3.55 this year. Is that off the table, or do you think there are incremental levers that you could pull to manage profitability as we think out over the next 12 months? I'll start with that on the Solar piece, and then I'll turn it over to Doug. On Solar, what we see customers pushing out a little bit is the timing of some maintenance, and that doesn't have usually as long a backlog as new product. So probably impacts this year's sales a little quicker than it does backlog, just by the nature of it. I think the reason that we made a comment on Solar backlog is because everybody's concerned about it, and we're just trying to reassure everyone that what they're selling, they're replacing with new orders. That's not falling off a cliff or off the table. The gas business just keeps on chunking along. So I'll turn it over to Doug. Yeah. Thanks. In terms of your trough earnings question, I think your question's a reasonable one to assume. As you say, without all the restructuring costs, we're at $3.55. As Mike said, if you take $0.08 back, we're a little bit above that even, but certainly around $4.00 where we are now. That's a reasonable assumption to go after, and that's where we're going to fight to try and find a bottom if that's what we're fighting in the future. This is Brad Halverson, and I might just add a quick point, Doug. The trough earnings number has been stated between $2.50 and $3.50. I'd say if you look at how, and I would say the sales decline modeled in those scenarios would not have been as severe as what we've experienced in the four-year trend. So going from above $60 down to $40, we've been absolutely trying to stay ahead of the process to be prepared if things did not get better. If we were not staying ahead, quite frankly, there was no way we could have done $2 billion of cost reduction this year to offset some of the price pressures and the drop in volume. We really like our mid-cycle numbers. Everybody wants to know when we're going to start recovering in that trend towards mid-cycle. But we still need to be prepared for what could happen in the short term on the downside. We've talked about kind of a 25%-30% decremental. I would say we're still committed to that. I would also say that we're being extremely directive in the things that we fund. Things like digital, which will be up significantly this year over last year. Things like funding the businesses that we believe have the highest opportunity to improve the value of the company and our operating profit after capital charge, which we call OPAC, in the medium term. We want to fund those industries which we think are attractive for us and where we play well, and things that are not as attractive are the places that we look first to cut. We're still in that process, and we're still preparing to stay ahead of the game. I would say that if required, we would be ready. Yeah, that is right, Brad. I would just come back to the incremental decremental pull-throughs on the way up and the way down that have served us pretty well going back to 2009 on the way up from $30 billion to $66 billion, and then on the way down from $66 billion to $40.25 billion this year. We have managed to stay inside of those targets all the way up and down, and I think that is probably one of the single biggest differences we have been able to accomplish from prior deep slowdowns in the 40% range top line, is we have got everybody targeting those, and that is where we go after with our cost reductions. As Brad said, our capital allocations in those businesses we really want to stay in and thrive in long term. Okay, thank you. I will get back in queue. Thank you. The next question is coming from Jerry Revich. Jerry, please state your affiliation and pose your question. Good morning, everyone. It is Goldman Sachs. Mike, you spoke about roughly $2 billion or so in implied dealer inventory reductions, which I think is mostly in the back half of this year. Can you just give us a flavor for the mix between Construction Industries and Resource Industries and any regional color that you can give us where you expect inventories to come down? As we enter 2017, do you think we are at normalized dealer inventory levels for the current demand environment? A couple of things. One, $2 billion is a little too high a number. It is probably more like year-over-year, $1.5 billion, and it is probably split two-thirds Construction Industries, one-third Resource Industries, and that sort of ballpark. In terms of adequate levels, I have tried to address this point. I think adequate levels is a little bit of a moving target around delivery performance. Again, if we were able to cut delivery performance in half from where it is at now, dealers would feel comfortable holding less inventory. Let us say things ticked up, orders ticked up, the markets heated up, and let us say we had trouble keeping up. That would concern dealers, and they would order even more. They would want to hold even more. But just the opposite is happening right now. We have excellent delivery performance. They can get pretty much what they need when their customers need it. That is causing them to hold or want to hold less. The better we do with lean, the more that will probably be the case. I am trying to stress the point. I do not think dealer inventories are excessive. There is a reasonable range, but I think they will come down over the second half of the year. Okay. You have spoken about the major restructuring changes as we think about the eventual recovery. Can you update us on how you are thinking about incremental margins and recovery, given the change in the manufacturing footprint? Well, it should be, and Doug Oberhelman has talked about this quite a bit. On the way up, we previously kind of had a 25% incremental target. But I think while we've not quantified it, certainly our expectation is that the first chunk of what goes up would certainly be at a higher rate than that. All right. Thank you. Thank you. And the next question is coming from Robert Wertheimer. Robert, please state your affiliation and pose your question. It's Barclays Bank. Thank you. Construction Industries margins are really quite impressive given negative pricing and given volumes that are trough-y in LatAm and maybe low cycle elsewhere. Can you see steep falls from here, or do you think that's bottoming? And I'm curious if you have any view or are willing to share any view, rather, on the structural margin upside if you actually get a healthy market, given what you're doing in low cycle. Yeah, that's a good question. I think our Construction Industries business is a great example of how our managing for maximum OPAC, operating profit less a capital charge, can work. They've been on this path to maximize OPAC for the last few years, which is fundamentally around figuring out where you make the most money and where you don't, fixing where you don't, and reinvesting in where you do to increase sales. That's oversimplification of it, but that's worked. They're also very cost-conscious. They've taken out costs, but relative to where we think a trough, a mid-cycle, a peak would be, they're not as bad off as, say, oil or rail or mining. But I think there's plenty of upside for them. North America is still well below the peak. Brazil is, wow, so far down you can hardly see it. I think there's plenty of scope for improvement, and based on the work that these guys have done to figure out where to invest to drive OPAC, I think there's still plenty of upside left for them. Do you see signs of stabilization in North American Construction Industries? As you said, we're well below the prior peak and some of the fleet told. Do you think there's material downside chances there, or are you seeing stable? Yeah. I don't see material downside at the moment, frankly. We've seen so many states step up with bond issues. We've seen many states step up with tax increases for infrastructure spending. Anecdotally, a lot of our customers are busy across the country. A 2% growth rate of the 1.5%-2% does not spur a lot of investment, but there's enough going on to tell me that we're not facing a cliff here, unless there's some outside event of some kind that occurs. I don't see it collapsing or, as you said, a big fall off. I would sure like to see the growth increase based on increased economic activity. Thanks, Doug and Mike. This is Brad. I'll just make one other comment. We're not going to give you kind of an incremental number this year to plot in. We've talked about it being fairly high. One thing I would say for reference is that the vast majority of costs we've taken out, we would not add back. As we've restructured, as we've changed things, if you think that there are costs that we're ready to add back that we've taken out, I would say outside of some very minor amounts, most of those costs we're not going to add back. As we add period costs in an upturn relative to our incrementals, it would be focused really around our OPAC improvement agendas, those places we want to invest more because we think there's a significant amount of value. That'll probably drive that incremental discussion when we get to that point. Thanks, Brad. Thank you. The next question is coming from Timothy Thein. Timothy, your line is live. Please state your affiliation and pose your question. Thank you, Citigroup. The first is on the energy part of E&T, and I guess specifically in well servicing, where I would think you would see a recovery first in a more stable oil price environment. The question just revolves around where the service companies that you and your dealers speak to, where they sit from a sentiment standpoint on CapEx. There's been some comments of some restocking of consumables, which is curious what you're seeing out there. Yeah. I think probably the best way to say that is where oil prices are today is probably not enough to drive a lot of incremental investment there. I think the thing you'll see first is the idle fleets being put back to work, particularly around drilling before we see some investment. So, oil prices this morning, I guess, were in the 42-plus range. We're probably still a ways away from that. Okay, got it. Maybe the second one on Cat Financial. I don't know if Brad's still around, but the question relates to the penetration rate in the quarter. I think new retail financing is now eclipsed 30%. It hasn't been there, I don't think, post the financial crisis. So I'm wondering, is that a shift in the underlying business mix that's driving that, or is that perhaps more of a kind of a strategy shift for Cat? Or maybe you could just speak to that. Thank you. Yeah. This is Mike. Cat Financial is always trying to increase their share. Just like every other part of our business, they are trying to increase their market share, if you will. The percentage of deals that they do versus their competitors. They have actually done a very good job over the last couple of years in increasing that, and I think that is what you are saying. The limit on that is you certainly do not want to do shaky deals. You do not want to sacrifice credit quality to do it, but you want to work very closely with the dealers, with the customers, and capture as much market share as you can. Yeah. This is Brad. I will add onto that. We are very proud of the people at Cat Financial and how they run that business very independently, in partnership with our product groups, but very independently. You will see our allowance being very well maintained at around 125, at 1.25%. Our past dues, similar trend at 2.93, fairly close to previous quarter and below historical average. We have grown our share there. But one thing I want to comment on, which we had a few questions come in on, there is pressure in the used equipment market. It is probably down 2% or 3% from the last quarter. It is probably down 5% to 10% if you look from a year ago. We carry a little over $600 million of used equipment, both from repossessions and residuals. Still pretty well behaved. We had a gain last year, and we had a very small loss this quarter. We do not see any big issues in that regard. But I would tell you that that is an area that does have some pressure, and that we are watching, but it is, at this point, very well maintained. Thanks a lot. Thank you. The next question is coming from Steven Fisher. Steven, your line is live. Please state your affiliation and pose your question. Thanks. Good morning. It is UBS. Just a question on the restructuring. How anticipatory would you say is the incremental $150 million in the quarter versus just kind of reflecting what current conditions warrant? In other words, you talked in your question eight in the back about too early to really say what impact Brexit would have. Would this incremental restructuring be intended to mitigate a potential slowdown from the U.K. Brexit and a potential slowing in U.S. non-res construction activity, or would you want to do more restructuring if those things play out? That is a good question. I would not relate it specifically to any one of those. I think you have to look at it in the aggregate. Brad made actually a really important point a couple of minutes ago, and that is that we do not have a crystal ball. We do not know what is going to happen in the marketplace. But we want to be positioned to deal with it if it does happen. I would say that over the course of the past quarter, we are a little more negative on the world economy. The Brexit, the Turkey, the elections, oil price, you name it, all of that contributes. We are less bullish on second half sales because of that. Whatever impact that would have in the future, we are trying to get ahead of that with additional cost reduction. I would say it is us trying to get ahead of the potential, not what we actually know, and not specifically related to any one of those items. Okay. That's helpful, Mike. Then in terms of mining profitability, the $163 million loss was a step down in the quarter compared to Q1. How are you thinking about where that goes from here? How contained can your restructuring actions keep those losses going forward? Yeah. Hopefully, this is the worst quarter we'll see. I think embedded within our outlook, we see it getting a little bit better. Second quarter, price-wise, deteriorated a little bit from the first quarter. When you get to numbers, we're talking a change quarter to quarter of a couple hundred million. Not for pricing, but in total for them. Costs were a little higher because of some inventory adjustments, just kind of normal surplus and excess inventory. Then we had a little negative inventory absorption for RI. They took out inventory in the second quarter. That hurt a little bit. They are certainly a part of the extra cost reduction that we're going after in the second half of the year. When I talked a little bit about first half, second half, we think their sales are going to be up a little bit in the second half of the year. I think the combination of extra cost reduction and a few more sales, hopefully will make the second quarter the worst of the year. Great. Thank you. Thank you. The next question is coming from Steven Volkmann. Please state your affiliation and pose your question. Hey, good morning. It's Jefferies. Hey, Doug, I'm going to take you up on this since you mentioned infrastructure trends getting a little bit better. How big of an opportunity is that for Cat? How much of revenue might that be, or how should we think about sizing that going forward? It's hard to tell, actually. The Highway Bill, the Federal FAST Act that was passed last year, in itself, did not increase overall funding an awful lot in this country. It held it at inflation plus a little bit, but it did give it five years. I think as most states have recovered from their fiscal problems the last few years, they're starting to recognize the needs for infrastructure, and we're seeing that. If there's any impact, and I've said this all year long, from that FAST Act of last year, it's going to be a '17 event. We might feel it. I don't think it would move the needle a great deal, but we would certainly feel it, and it's hard to quantify until states start lining up for their matching funds. There's quite a big effort underway to get that done as well. We will just have to see it play out. It is certainly going to be a positive, but I would doubt we would see it move the needle in a big way in 2017, but we would feel it. Great. That is helpful. Mike, maybe just a couple of quick modeling questions. How do we think about taxes going forward with the various changes you have had? What is a normal level of short-term incentive compensation if we are thinking into the out years? Two good questions, Steve. First on taxes. All in, we are looking at a 25% tax rate this year, but that is a little lower because of all the restructuring, which has tended to be in a little higher tax jurisdictions. The restructuring is attracting somewhere around, I think, low 30s, 34%, I think. Excluding restructuring, it will vary a little bit by quarter depending upon how much restructuring there is, but probably around 27%, excluding restructuring. What is normal on incentive pay, I am going to qualify it a little bit here. It depends on how few employees we have because it scales, if you look at it in terms of dollars. Based on the number of employees we have right now, if we were to pay everyone at a 1.0 payout, which we would consider to be normal in a normal year, you are looking at something in the order of magnitude of, let us say, rough number $850 million. Super. That's perfect. Thanks. Okay. Thank you. The next question is coming from Joe O'Dea. Joe, your line is live. Please state your affiliation and pose your question. Good morning. It's Vertical Research. First question, just on the rail side. It sounded like from a geographic standpoint that the softness that you would have seen year-over-year was more international. Could you just give a little bit of commentary on what the North America trends are like for you, incremental softness with North America rail flat year-over-year, just how stable you think that is as we start to think about more kind of downside risk, upside risk, and how stable those North America trends are? Joe, I feel a little bad here. I tried to prep a little on rail, but I didn't do it by region, so I can't talk too much about North America specific. Sorry, I'm just not further up to speed. What I would say is, we're looking for a bit better rail sales in the back half of this year. Remember, we've just introduced our new locomotive at mid-year, and while sales aren't huge for that right now, given the state of the overall industry, we certainly are going to sell some. That's part of the increase in the back half of the year. Okay. On Resource Industries, it seemed like in the first quarter, one of the challenges was aftermarket came in a little lighter than we would have expected to start off the year, with the expectation that moving deeper into 2016, that would improve. From a margin standpoint, it did not look like there was a mixed benefit in the second quarter. Could you just talk about sequential trends, what you are hearing from dealers, the scheduled rebuilds? It sounds like that is a little bit better. Did you see some improvement in aftermarket from first quarter to second quarter? Well, we are hearing that dealers are booking a bit more. In fact, I verified that with our mining group last night. Dealers are seeing an uptick of bookings around rebuild. It has not really hit our parts business quite yet, but hopefully it will. Your synopsis of no big upturn in parts sales around mining is actually correct, at least so far. Great. Thanks. All right. Well, I think we are at the top of the hour here, actually a minute or so over. We will conclude the call. Thank you very much. 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.