Earnings Call: Q2 2013

Jul 24, 2013

Summary

Q2 revenue fell 16% YoY as dealer destocking and weaker end-user demand pressured results. FY2013 guidance was lowered, while H2 cost actions, inventory normalization and strong cash flow shaped the outlook.

Good morning, ladies and gentlemen, and welcome to the Caterpillar earnings call. At this time, all lines have been placed on a listen-only mode, and we will open the floor for your questions and comments following the presentation. It is now my pleasure to turn the floor over to your host, Mr. Mike DeWalt. Sir, the floor is yours. Thanks, Kate, and good morning, everyone, and welcome to our second quarter earnings call. I'm Mike DeWalt, Caterpillar's corporate controller. On the call today, I'm pleased to have with me our chairman and CEO, Doug Oberhelman, and Group President and CFO, Brad Halverson. This call is copyrighted by Caterpillar Inc., and any use, recording, or transmission of any portion of the call without our written consent is strictly prohibited. If you'd like a copy of today's call transcript, we'll be posting it in the investor section of our caterpillar.com website, and it'll be in the section labeled Results Webcast. This morning, undoubtedly, we'll 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. A discussion of some of the factors that, either individually or in the aggregate, could make actual results differ materially from our projections, that can be found in our cautionary statements under Item 1A, Risk Factors, of our Form 10-K filed with the SEC in February of this year, and also in the forward-looking statements language in today's release. In addition, a reconciliation of non-GAAP measures can be found in our financial release. Again, that's been posted on our website at caterpillar.com. Before we start the Q&A today, I'm going to be covering three main topics. The first will be a summary of our second quarter results and revised outlook. Then I'm going to take a few minutes and talk a little bit about our business segments, and then I'm going to finish up with cash flow and the stock repurchase that we talked about this morning. Let's start with second quarter, which I'm going to discuss in two ways. First, I'm going to cover, at a high level, our second quarter results versus the second quarter of 2012. Then I'm going to discuss the specific headwinds we faced in the second quarter and how we're thinking about them going forward in our expectations for the second half of 2013. First, compared to the second quarter of 2012, our results this morning were quite a bit lower. But to put the year-over-year comparison in context, the second quarter a year ago was certainly a tough comparison. The headline from last year's second quarter started with, "Caterpillar reports best quarter in history." Sales this quarter, sales and revenues, were $14.6 billion, and that's a 16% decline from the second quarter of 2012. This morning, we reported profit of $1.45 per share, and that was down $1.09 from the second quarter of last year. The sales and revenues decline versus last year in dollars was about $2.8 billion, and about half of that was the result of dealer inventory changes and the other half from lower end user demand. In last year's second quarter, dealers bought more machines from Caterpillar than they delivered to customers, and their machine inventories rose again last year about $300 million. In the second quarter of this year, 2013, it was the reverse. Dealers bought less from us than they sold to their customers, and their inventory of new machines, as a result, declined about $1 billion. So in combination, the impacts and the changes of dealer machine inventories was negative by about $1.3 billion quarter-over-quarter. The remaining sales decline was a result of lower end-user demand for machines and, to a lesser extent, Power Systems. The decline in profit was largely a result of that drop in sales. On page 6 of this morning's financial release, we have a waterfall chart that would step you through the quarter-to-quarter changes in operating profit. It shows a decline in total from last year to this year of about $1.059 billion. Lower volume, which includes product mix, more than accounted for the total decline in operating profit. So the overwhelming story on the quarter-to-quarter profit decline was volume. I think the waterfall chart covers the other pluses and minuses reasonably well. So I'm going to change gears a little here and talk about the headwinds in the second quarter and how we're thinking about them relative to the second half of the year. We'll start off with dealer inventory. As I mentioned before, dealers took out about $1 billion of inventories in the second quarter, and that was a sales headwind for us as our sales were about $1 billion below end-user demand. In terms of what that means for the second half of the year, well, we expect that to continue. We think dealers are going to take inventory down another $1.5 billion to $2 billion or so between now and year-end. The continued dealer inventory decline, in fact, is the main reason that we lowered our sales and profit outlook for 2013 this morning. We're expecting sales and revenues in a range of $56 billion to $58 billion and profit of about $6.50 a share at the middle of that sales and revenues range. That's a drop of about $2 billion on the top line and $0.50 a share at the bottom line. So dealer inventory reductions were a headwind in the quarter and the main reason we lowered the outlook. Our inventory was also a headwind in the quarter. In addition to what the dealers took out, we cut inventory by $1.2 billion in the quarter. That was negative to profit from a cost absorption standpoint. Just to help you get a handle on the profit impact, we use a rule of thumb of 13%-15% of the inventory change. The year-end expectation for our inventory is that it'll end the year about where it ended the second quarter. That means we do not expect the profit headwind that we had in the second quarter from inventory absorption to continue in the second half of the year. In addition, we also had a substantial currency headwind in the second quarter. In this context, I am not really talking about year-over-year. I am not comparing the second quarter a year ago. I am talking about actual translation and hedging losses of about $134 million that happened in the quarter and were reported in the other income and expense line of our P&L, which is a couple of lines below operating profit on the P&L. As we put our outlook together, we do not forecast future currency movements. We do our outlook based on exchange rates as they are. As a result, our outlook does not expect currency translation and hedging losses in the second half of the year like the $134 million in the second quarter. The flip side of that is we did have a positive item in the quarter. We had the $135 million gain on our settlement related to the Siwei acquisition, and that is also something that we do not expect to repeat. As we are thinking about the second half of the year, kind of relative to the second quarter, the average sales for each of the two quarters on a quarterly basis in the second half is about the same as the second quarter. But we do not think we will have the negative cost absorption impact like the second quarter had. We do not think we will have the 134, at least in our outlook, of currency losses. The Siwei $135 million gain, we do not expect to continue. The other difference that you need to take into consideration is that we are taking additional actions to reduce costs in the second half of the year. We started taking action in the second quarter, and began implementing cost reduction measures. We are going to do more of that in the second half of the year. Okay, that is enough for now on the quarter and the outlook. I would like to change gears just a little bit and talk about segments. I am going to start by saying that our largest segment this year, by sales, has been Power Systems. Our most profitable segment this year has been Power Systems. The highest margin rate of any segment this year has been Power Systems. I know that most of you on the phone here today already know that. But there are many casual observers of Caterpillar that if you asked them that question, would have said mining, which is in our Resource Industries segment. The point of this discussion is that we serve a number of different cyclical industries, but thankfully, they do not all follow the same path at the same time. The diversity within and, in fact, between our segments helps mitigate year-to-year swings in sales, both down and up for the company. The Power Systems segment, again, our largest and most profitable segment over the past five years, has also been, relatively speaking, the most stable of our three large equipment segments. That is because it spans a number of different industries itself, electric power, oil and gas, rail, marine, and industrial engines. Actually, even within those industries, there is diversity. In oil and gas, for example, our sales of engines for drilling and fracking are weaker, but gas compression continues to do pretty well. Moving on, our Construction Industries segment sells an extensive range of construction equipment around the world that supports infrastructure development, commercial, and residential construction. The worldwide construction industry is showing signs of recent improvement but remains relatively depressed from a historical standpoint. Construction in the U.S., while starting to turn up, is still far below the 2006, 2007 peak. The construction equipment industry in Europe is, as you'd expect, well below the prior peak. Construction equipment sales in China in 2013, we expect to be about half what they were in 2011. The point is, there's a lot of room to grow just to get back to where we've been before. When economic and construction activities begin to improve in the world, particularly in the U.S. and hopefully eventually in Europe, it should be a positive for our business. Our Financial Products segment is also important to our business, and it's doing very well. It provides financing to end users that purchase our equipment, and it also provides financing for some Caterpillar dealers. Financial Products revenues and profit have proven to be much more stable through the business cycle than our product-related businesses, and they're currently performing well. Revenues this quarter were up 5% from the second quarter a year ago, and profit was up. The segment that's currently getting significant attention is Resource Industries, which is primarily mining. I'm going to give you a rundown of what's happening in mining. But before I do that, I'd like to point you to today's financial release. On page 16 in particular, question number 5 in the Q&A at the back of the release, we've tried to provide a pretty comprehensive discussion of the mining industry and how it impacts our sales. The high points of that discussion start with the production of mined commodities. The underlying health of the mining industry relies on commodity demand and production. Based on the data that we've seen, it looks like mining production in 2013 is going to be a little higher than it was in 2012. Recently, a couple of the big public mining companies have reported they're producing at record levels. Commodity production underpins the need for mining CapEx. Despite 2013 increases in commodity production, it's clear that mining companies are currently cutting their CapEx after significant increases in 2011 and 2012. While we don't specifically accumulate CapEx estimates ourselves for the industry, we do follow the market surveys. Based on those surveys, it appears total mining CapEx in 2013 is likely to be down 5%-10% from 2012. Some surveys are also indicating a further CapEx decline, near 20% for 2014. The mining industry CapEx includes spending on exploration and development, buildings and structures, things like processing plants and equipment. At Caterpillar, we're most impacted by spending on equipment. While we don't have consistent CapEx data at that level of detail for the industry worldwide, we have reviewed data at that level of detail from the Australian Bureau of Statistics. It tells us that over the past few years, the largest and fastest-growing category of CapEx in Australia was for buildings and structures. While this is the largest category, the most significant declines in 2012 have been for exploration and development and equipment. Based on our own experience with large capital projects, that makes sense to us. It's difficult to stop construction on large-scale facilities once they get substantially started. That means in the short term, we believe that more of the decline in mining CapEx is for equipment, things like Caterpillar machines. That leads us to end user demand for our products. That's how much Cat dealers are actually delivering to end users, the mining companies. Year-to-date deliveries to end users and our expectations of what dealers will deliver for the full year are declines of about 20%. While dealer inventories are down, while dealer deliveries, I'm sorry, are down, for the type of equipment that we make, we believe we're doing a little better than the equipment industry overall. That brings us to Resource Industries sales. We started with CapEx. We've moved on to end user demand from our dealers, and now to our sales. To relate the decline in mining equipment demand, placed on our dealers to our sales, you need to consider several other factors besides mining CapEx. Our Resource Industries segment includes things that are not directly related to mining CapEx, like aftermarket parts sales, as well as equipment sales to the forestry, paving, and quarry and aggregate industries. Although Resource Industries sales of aftermarket parts are down a little in the second quarter of 2013 compared with a year ago, the decline is much less than the decline for equipment. In the context of the total decline in sales for Resource Industries, it's just not a significant factor. The collective sales of equipment for forestry, paving, and quarry and aggregates are also down, but again, the vast majority of the decline in Resource Industries sales for the quarter, the second quarter of 2013, is mining equipment. In addition to those factors, to understand our sales, you also need to consider dealer inventory changes. Dealer inventory increased in the second quarter last year, and it declined substantially in the second quarter of 2013. That means that last year, we were selling more products to dealers than they were delivering to the end user mining companies. In the second quarter of this year, we sold far less equipment than dealers were selling to mining customers. In fact, our sales of traditional Cat mining equipment, such as mining trucks, large track-type tractors, and wheel loaders, would have had to have been more than 50% higher in the second quarter to match what dealers were delivering to end users. In the second half of 2013, we expect that dealers will continue to substantially reduce their inventories. That means we expect to continue to undersell mining demand for the remainder of 2013. Given the substantial decline in sales in 2013, the uncertainty around when cyclical recovery will resume, we've taken substantial action to adjust our production levels and to reduce costs. We expect to take further action in the second half of the year. Our intention is to reduce costs and drive operational improvement, and do it in a way that doesn't significantly reduce our ability to ramp up when production improves. I know many of you would like to get a better understanding of what we think will happen after 2013. We're going to discuss that here for a couple of minutes, but we want to start by saying we are not providing a sales outlook for 2014, either for Resource Industries or for Cat in total. It's certainly too early to do that. The activities over the past five years in the mining equipment industry certainly reinforce that. It's experienced significant demand shifts, both up and down, and the mining industry overall has had difficulty in forecasting those shifts in advance, and frankly, that's impacted our forecasts. We understand that it's a part of being in this industry, and this year is a good example, as mining companies have been cautious and dealers have reduced their inventories. What we will discuss here this morning is what the industry surveys, not our forecast, but what the industry surveys about next year suggest, and what that could mean as the impact of dealer inventory reductions wind down. Earlier I mentioned that we've seen surveys that suggest another 20% decline in mining CapEx in 2014 from 2013. Again, that's not our estimate, and we're not providing an outlook. But if you take that CapEx survey at face value, it suggests another down year in 2014. To put mining CapEx in the context of our sales, though, you have to consider the impact of dealer inventories. Even if dealer deliveries of new mining equipment were to be down 20% next year from 2013, if we see an end to the dealer inventory reductions over the next few quarters, we believe our sales of new mining equipment to dealers would be positive. In other words, we believe the significance of the end of dealer inventory reductions would have a more significant positive impact on year-over-year sales than a 20% decline in end user demand. Just to clarify this, we're not suggesting an increase in inventories next year, just the absence of the big declines in 2013 that pulled our sales well below what dealers are delivering to mining customers. Now, in addition to that, if the world economy continues to improve, we would expect commodity production to also increase, and that, coupled with a relatively large number of new machines placed in service over the past several years, that should be a positive for mining aftermarket parts sales. Again, this is not a forecast for 2014 at this time. Too early to do that. The purpose of this discussion was just to illustrate for you the significance that dealer inventory changes are having on our mining business today and what the implications are for when the decline comes to an end. Now, looking further ahead, our long-term view of mining remains positive. Commodity demand is driven by economic growth, population increase, and rising standards of living. And we believe they'll all continue to improve over the long term. In addition, declining ore grades imply that in the future, more material will need to be moved per ton of commodity output, and that's another positive, at least from our perspective, for long-term equipment needs. Finally, much has been written and said about the impact of China on commodity demand in the mining industry. Our long-term view of China is also positive. We expect continued urbanization and improvement in the standard of living for the people of China. We believe that means more electricity production will be generated and increased production and consumption of goods in general. Now, increasing electricity production, in particular, is a positive for coal. Coal makes up a large portion of the electricity generated in China, and they continue to add coal-fired capacity. That said, we do not expect the significant economic growth rates that China experienced over the past 10 years will continue indefinitely. But we do believe that China will continue to grow at a much faster pace than the rest of the world. It's also important to remember that over the past 10 years, the size of the Chinese economy has more than doubled. That means that economic growth rates of 7%-7.5% have a greater impact today than a 10% growth rate would have had 10 years ago. It's a big economy that, relative to the world in total, is growing faster. In summary on mining, we don't expect much change in the environment in the short term, and the remainder of 2013 will be tough for our mining business. As dealer inventory reductions come to an end, our mining equipment sales could rise from 2013 levels, even if mining CapEx declines. Our long term of mining remains positive. The world needs mined commodities. As the world grows, we believe commodity demand will continue to increase. One last quick topic, and then we'll go on to the Q&A, and that topic is cash flow and cash deployment. While it was certainly a tough quarter for sales and profit, our machinery and Power Systems operating cash flow was better than it's been in a long time. We generated $3 billion worth of operating cash flow in the quarter, and that's a substantial increase from $1.3 billion in last year's second quarter. We've put that to work for stockholders. In the second quarter, we repurchased $1 billion of Cat stock, and we announced a 15% increase in the quarterly dividend. In this morning's financial release, we announced that with the strength of our cash flow, balance sheet, and cash on hand, we expect to repurchase an additional $1 billion of Cat stock in the third quarter. Repurchasing stock in a downturn has been a key part of our cash deployment strategy, and we're executing on it. With that, we're ready to open up the floor for Q&A. Thank you. Ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press 1 followed by 4 on your touch-tone phone at this time. Pressing 1, 4 a second time will remove you from the queue should your question be answered. We do ask, if you are listening on a speakerphone, to please pick up your handset for optimum sound quality. So once again, if you have any questions or comments, please press 1, 4 on your touch-tone phone now. Our first question today is coming from Robert Wertheimer. Please announce your affiliation, then pose your question. It's Vertical Research Partners. Thank you. Good morning, everybody. Good morning, Rob. Let's see. Let me just start with Power Systems since you did highlight that division. You had one of the strongest margins you've ever had. Wanted to just check in on whether you're seeing, actually, just whether that was mix related. I know backup power gen has been awful, whether it's structural improvement in the margin of that division, and then whether you're seeing any change in electric power at all. Yeah. If you look actually, Rob, at the dealer statistics that we put out yesterday morning, you can see that's a little bit better than it was a year ago. I think a lot of that has to do with, it was kind of even turned down a year ago. I think a little bit on electric power in particular, the comps will probably just continue to get a little easier. I think for Power Systems overall, they had a pretty darn good quarter. Sales volume was down a little bit, but some of the pieces were up. I think more of their profit improvement had to do with, they had a little price realization and they've done a pretty good job on cutting costs. As opposed to Construction and Resource Industries, they didn't have near the decline in inventory that those other two segments did. The absorption impact was relative to the company in total, a lot smaller for them. Can I ask you a different question? I am not sure if this is one you are willing to or able to answer, but is it possible to look through the turmoil that has gone on in Resource Industries over the past six months and think about what your margin would be in a more stable environment at these volume levels? Well, you are right. I am not going to throw out a number. But I think, in my opinion, we had one positive item, the Siwei $135 million gain, that would be in their numbers that you would have to take out. That would actually make it a little bit lower. But we are in the middle of pretty heavy inventory decreases and that, in total, the amount that they are really underselling real demand and the absorption impact probably more than offset that. Since we are moving from, let us just say, higher volumes over the last year to lower volumes this year, cutting costs has been a process and that is going to continue into the second half. So if, for example, end user demand kind of hung in at this level, our sales would probably go up a little bit because we would stop cutting inventory. We wouldn't have the Siwei adjustment in there, but costs would likely be lower as we are partway through the cost-cutting activities that we have been doing. So I guess my thought is it would probably be a little higher than it is now, but I don't know that I would want to throw out a number. I guess that was my cue. Thank you, Mike. Thank you. Our next question today is coming from Ann Duignan. Please announce your affiliation, then pose your question. Hi, good morning. JPMorgan. Morning, Anne. Morning. I'll start out with the decremental margin question. Doug, you've been pretty vocal about driving for 25% pull-through. Can you talk about the decrementals this quarter, whether they were disappointing or not to you and are we going to get back to 25% by year-end? Hi, Anne, this is Brad Halverson and it's a good question. If you look at the second quarter, I think there's a couple of things, if you look to the write-ups to consider in terms of results. One is close to 70% of our drop in sales are mining, which is negative for mix. Even putting that to a side, if you just look at the pure cost absorbed kind of impact, you get to a decremental margin slightly under 30%, and we've talked about 25% to 30% kind of a decremental margin, in terms of our target. So for the quarter, you would get slightly under 30%. If you look full year at our outlook, even with all the headwinds, you'll get to a decremental pull-through of 24%. This is something that we spend a lot of time on internally. We have targets that we've committed to, and if you looked across our segments, Resource Industries, Construction Industries, Power Systems, Financial Products, each of them, as we talked about before, have made a commitment as to what they'll make at certain volume levels, which ties to our external commitment. They're executing on that. So when we get through the end of the year, we'll be at 650, right around 24%, which is with the mining headwind, I think a good number. Fair point. Thanks for the clarification. It's normally in the press release, but it wasn't conspicuously there today. My follow-up would be on pricing. You also mentioned in the press release, some negative pricing. I think it was in Resource Industries in Australia. Can you talk about pricing overall and where you are seeing the most pressure? Obviously, probably in mining, but why would we be giving up pricing at this point in the cycle? Yeah. Anne, this is Mike. Just a couple of comments. I think when we talk price realization here, it is versus the second quarter a year ago. Again, I do not want to harp too much on this, but we had an absolutely fabulous quarter a year ago. Price realization the second quarter last year, kind of everything came up heads and we had just about $500 million reported for last year, which was pretty close to a third of the whole year. So I think to start the discussion off, it was, in total and in particular for price, a pretty tough comparison. We did have slightly negative price realization, well less than 1% for Resource Industries and for Construction Industries. For Construction Industries, it was mostly in Latin America, and we have a few big deals going on down there that had a little tighter pricing. I think for mining in general, it is a tough market out there right now. Volume is down quite a bit, and I think by and large, we are pretty close to holding our own again, with a slight reduction in the quarter compared with a really big quarter a year ago. I do not think there is any big fundamental shifts. You did not ask this question, but I am going to answer it anyway. As a part of this updated outlook, before we were kind of talking about 1% up this year. We are not far off that. I think we are looking at just a little under 1% for the full year for the total company this year. So it was a little tighter, I think, in the second quarter, but pricing did not overall go down. It was helped a little bit by better numbers out of Power Systems. Okay, wonderful. That is my two up, so I will turn it over. Thanks, guys. Okay. Thanks, Pam. Thank you. Our next question today is coming from Ross Gilardi. Please state your affiliation and pose your question. Hi, Bank of America. Thank you. Mike, in talking about mining, there's an awful lot of focus on dealer destocking and the business as the big source of pain, but this is a made-to-order business. So isn't the real fundamental issue that miners are just canceling orders, and as long as that remains the case, you're not going to see much of a pickup in production and margins until you see a pickup in orders? Yeah, Ross, that's actually a great point. One of the things I think that's been impacting orders, remember, we don't take orders directly from the mining companies. We take orders from the dealers. The dealers take orders from mining companies. So if you look at the destock and inventory, I think that's certainly having some impact on the dealer order rates to us. We definitely would like to see order rates pick up, but I think certainly until we get through the inventory reduction, that'll probably a drag, at least on orders placed on us. But to your point, I'll just kind of go back to it. I talked about the surveys that suggest mining CapEx down another 20%. For that to be the case, orders have to pick up. If dealers don't order anything, or I'm sorry, or if customers don't order from dealers and dealers from us don't order anything or don't order more, then 20% is just not, I don't think it's in the cards. That would look like an optimistic number. I think for mining CapEx next year to be down 20%, they have to order more. Dealers would have to order more from us than they are today. I'm not trying to make that overly complex, but to say that even a 20% decline in mining CapEx, considering that dealers ought to be out of inventory here pretty soon, would have to mean more orders placed on us. Maybe that's a better way to say it. Okay. Thanks, Mike. You mentioned in the discussion of Resources in the press release that acquisitions and divestitures negatively impacted operating profit by $33 million in Resources, I believe that is with the $135 million gain from Siwei in there. Is that $33 million a year-on-year swing in earnings, or should we assume that Bucyrus is loss-making at this point and No. I think what you need to do is go back in our second quarter release from a year ago. One of our Q&As in the back of that release had quite a bit of detail on Bucyrus, included in there, we had pre-tax gains on the sale of Bucyrus distribution. We had some big ones. Basically, the gains from last year on the sale of Bucyrus distribution to some of the big dealers more than offset the $135 million this year. I got you. Just related to that, though, have you had an impairment test for Bucyrus yet? If not, is there a next test coming up? Do you do that annually? Yeah, we do that annually. I want to be careful on how I answer this. If you do an impairment test, it looks forward to what you think you are going to generate in that business over a longer period of time. We certainly would not be using a cyclical low straight line going forward. In our mining business, I think there is reasonable headroom. I certainly do not want to predict what a test would be, but I think the chances of an impairment there are probably not. It is certainly not likely. Okay. Thanks very much. Thank you. Our next question today is coming from Ashish Gupta. Please announce your affiliation, then pose your question. Hi, good morning. It's CLSA. I believe in the past, Doug mentioned that China's not over-excavated, and I'm wondering with the pickup in sales we've seen recently, I'm wondering how to think about the machine population over time now that we're moving more to maintenance from infrastructure. I'm just wondering how you guys view the long-term machine population in China relative to some of the more developed economies. Yeah. This is a case where there's a short-term story, there's a long-term story. I think clearly if you look at long term, I know the market doesn't like to look out this far, but if you look out at a point where China is developed, say, to the level of Japan or South Korea or Europe maybe, the excavator population, the construction equipment population in terms of equipment relative to the economy currently is a lot lower than in those developed countries. So as the standard of living rises there, as the level of development builds out over time, the population of equipment in China will certainly need to grow. I guess the big question you have is, will that take three years, five years, 10 years, 20 years, 50 years? And I think that depends a lot on the scale of China's growth. From our perspective, I think it's going to grow. Our view is it's probably, I guess, the second biggest economy in the world today. It is growing at a faster pace than the rest of the world, and its importance is going to grow, and its level of development is going to grow. I think as a result of that, the construction equipment industry there is going to need to grow. It is true, and we see that in our parts sales in China. As the population has increased and the equipment gets used, it has driven parts sales up in China over the past few years. As that population continues to develop, that's a trend that'll probably continue. Yeah. Doug Oberhelman here. I'll just comment a bit on China as we see it, and particularly as I see it. I am not one in the camp of a China implosion, that China will implode and drag the world down into a massive black hole. I think what we will see in China is very healthy with a much slower rate of growth, and I would call it 5%-8%. They say 7%-7.5%. So be it. That means the maturing of that market for construction equipment and all kinds of things. As that economy has doubled in the last decade, we've seen our field population of machines grow and grow and grow, allow parts and service opportunity for our dealers, and our business model plays well with that, and that's exactly what we're trying to do. We've also been working hard on market share in China, and that is up, and we're quite happy with that. In fact, year-over-year sales are up, that is for all of our business in China, fairly substantially. We're going to see China go in fits and starts. Absolutely, and I've said this before to many, that I hope we don't see another double-digit boom. The aftereffects of that and the residue is painful for everyone. A 5%-7%, 8% growth rate is just fine. We've sized our business for that. We'll do very well with that, particularly trying to get to a leadership position in market share. That's really the way we see China overall. Mining certainly is an opportunity there, and we're working on that. Much of that is underground, as you know. We now have an underground offering to work with. Long term, China and mining are appealing to us. Short term, we go through cycles, and we're certainly in that downturn at the moment. Thanks for that, Doug. Just one quick follow-up. When you guys look at your global fleet of machines with GPS data, can you help provide us with some sort of indication of what you're seeing globally by region? Ashish, I'd like to give you the answer to that, but of all the myriad of data that I made sure I was up to speed on before I came in here today, I didn't look at that. I don't know the answer. We can't do it regionally anyway, but overall machine operation hours, service meter units on the field population that we have monitored today are relatively steady and have been, and I think that as we look back a few months. Overall, that's a worldwide number, including the U.S., China, and everywhere else in the world. It's hard to say that regionally. Great. Thanks very much. Thank you. Our next question today is coming from Andrew Kaplowitz. Please announce your affiliation, then pose your question. It's Barclays. Good morning, guys. Hey, Andrew. Can you hear me? Hey. If you look at your press release, one of the things that you said is you believe it's unlikely that dealers will continue to reduce machinery inventory in 2014. So maybe, Mike, if you can talk about your conviction level in that statement. This is the first down cycle that you've had with your PDCs, with your product distribution centers. So I guess what I'm wondering, is there any way to look at the overall inventory in the channel between the PDCs and the dealers to get a read on whether you think inventory is low enough that you can sort of make that statement? Because it's hard for us because the PDCs are a relatively new development. Yeah. That's actually a very good question, Andy. If you just look at dealer inventories, they're today, really on the lower side of the historic range. Actually, really on the lower side. If you include PDC inventories right now, the sum of the two is probably right, maybe more in the middle of a reasonable range. We're looking for continued dealer inventory reduction through the rest of this year. We're looking at somewhere between $1.5 billion and $2 billion coming out in the second half. So, further from here, mining inventory probably be at about half the level that it started the year and Construction down some. Now, your question about conviction level. As in all things, it depends upon what the economy does, what our sales forecast for next year ends up being, and we don't have that. But if you look at just where months of supply are, the severity of what's happening, particularly in Construction, the trajectory of the way the sales chart looks, I think there's a pretty reasonable conviction that dealer inventory is certainly not going to have the kind of declines that it had this year. Probably, I guess at this point, I think we would have a pretty reasonable conviction that it's not going to go down, certainly at least much, next year. But again, I'm going to qualify that because it depends a lot upon what happens to sales and to some degree, when it happens next year. Now, just a couple other comments. Dealers are using PDC quite a bit more this year. The usage rate, the percent of dealer machine sales that are coming out of PDC is actually quite a bit higher in the second quarter than it was last year. So it looks like dealers are using PDC inventory, and that's a good thing. Our delivery times for product to dealers, compared with a year ago, are much less, and I don't think that's probably a surprise. So, that's happened. So, I think there's a pretty reasonable conviction on dealer inventory that it's going to slow or stop. Mike, it's fair to say then that at the end of this year, when the dealer inventory comes out as you expect, that the addition of PDC plus the dealer inventories would then be at the low end of your historical range versus dealer inventories in the past? Well, that will depend upon what our forecast for the first quarter sales is, because when we look at it in months of supply, it is kind of related to the forward-looking sales estimate for the quarter. Since we do not have that out there right now, it is a little bit tough for me to just say that. But I think our expectation is it would certainly be in the range, yeah. Okay. If I could ask a follow-up on Resource Industries margins. I know people are already hitting you on that. I guess the issue that we have is the decremental margin in that particular business looks exceedingly low, and you have talked about really accelerating cost takeout in Q2. Is it possible to quantify how much cost takeout you really started in Q2 in terms of expense? Maybe we can sort of parse through why the decrementals were so low. I know you are going to tell me that mix is negative also. Well, mix is certainly negative for the total company because more of the decline was mining. But we introduced this concept of profit curves inside the company to manage the business, and each of our three segments have a profit curve. In other words, if sales goes up, there is an expectation of a certain amount of profit. When sales go down, there is an expectation that only that much will come out. Basically, think of it as an incremental and decremental margin rate for each segment. The takeout rate for mining is a little higher than the 25% that we look at for the total company, and that is probably not a surprise. So we are trying to take actions on cost that will allow us to get as close as possible to that sort of curve decremental margin rate. I am not going to quantify it for you, but they have been doing rolling temporary layoffs for salaried management employees. We have taken R&D down a little bit. The things that we are going to do in the second half of the year, we certainly have not announced to our own employees yet, and so the specifics on that are probably going to start coming out, I would guess, over the course of the next month or so. So it is probably better to talk about the specific items after that. But definitely, we are planning to take some more action here in the second half of the year. Now, one thing that, and this is through the first half of the year, and this will ease in the second half of the year. It is particularly hurting decrementals, and that is this period cost absorption. We added a lot of inventory in the first half of last year and in the second half. I am not talking dealer inventory, I am talking our inventory. In this year's first half, we have taken inventory out. We took about half a billion out in the first quarter. We took $1.7 billion out this quarter. That has primarily impacted Construction Industries and Resource Industries. The more vertically integrated you are, the larger the impact is on your business. That has been a particular negative for Resource Industries in terms of incrementals. It was a positive last year, negative this year. It is not really an operational item, when you think about it is not operating efficiency. As the inventory declines start to slow down, that should be a little better in the second half. For that segment, the decremental to inventory reduction would actually be higher than 13%-15%, as you said, for the whole company? Yeah. We have not given out a number overall. If you think about it, the absorption thing is basically down to fixed costs that essentially get absorbed in and released from inventory when you build and sell inventory. If your entire business was just buying and selling material, you would not have a lot of value added to absorb. In the businesses where you are a lot more vertically integrated, you would have more, and I think Resource Industries is probably a little more vertically integrated than Construction Industries, for example. Thank you. Thank you. Our next question today is coming from Jamie Cook. Please announce your affiliation and pose your question. Hi, good morning. Credit Suisse. I guess just two quick follow-up questions. Under your new forecast, I think your old forecast implied that mining OE would be taken down about $7 billion. What are your assumptions under your new forecast? Because I am just trying to back into what mining OE will be as a percentage of total sales as we exit 2013. Because I actually think that would be most helpful as we all have different macro assumptions or assumptions on mining, but if we could get a sense of what mining OE would be, I think that would be much easier for us. As I calculate, it could be as low as 10% or as high as 15%, and I am just wondering how off I am. I guess my second question, Mike, last quarter, I think you said your core mining business would be down 50%, Bucyrus 15%, and then aftermarket flat. Just can you talk to what your new assumptions are? Thanks. Yeah. Again, if you look at the last outlook and this outlook, the main driver of the decline is dealer inventory. That is the biggest driver, and that is machines. It is a combination of Resource Industries and Construction. What we are looking at in the back half of the year is probably more slanted to Resource Industries. I think proportionately of the decline in the outlook, more of it would have been Resource Industries, certainly, than Construction. Actually, Power Systems is sort of flat to slightly up in the outlook. Okay. But you didn't answer the question on Oh, we don't disclose new equipment separately from aftermarket in our results, so I can't really give you a mining equipment number separate in Resource Industries. We just don't disclose it that way. I'm not trying to be cagey. What I am trying to tell you is if whatever your current estimate is, probably the majority of the decline in the outlook, and when I say majority, I mean more than half in this context, would be Resource Industries for equipment. They have more of the decline in dealer inventory in the second half. Then any change in your assumption? So Bucyrus trending what you thought aftermarket, can you just talk to those relative to your last forecast? Yeah, I think directionally, both of those numbers are kind of the same. But remember, when we were talking about the 50%, that's not end user demand. That's what we're selling to dealers. Yep. That has been impacted, of course, by the dealer inventory. So that means that our sales of the traditional product is down. The Bucyrus product is down a little bit, but I think that sort of proportion that you used with Bucyrus sales holding up much better than the traditional Cat product is absolutely true. A lot of that is because the dealer inventory impact is much more pronounced for trucks and dozers and wheel loaders than it certainly is for Bucyrus products. Then the mining aftermarket? I mean- Yeah, it's holding up pretty steady. We had a really strong first half last year. Coal mining was still doing okay. Then it started to tail off a bit in the second half of last year. But our expectations for aftermarket this year haven't really changed. Okay. Thanks. I'll get back in queue. To any degree that you would be concerned about. Thank you. Our next question today is coming from David Raso. Please announce your affiliation, then pose your question. ISI. I am just trying to gain some comfort with the second half implied margins. If you pull out the Siwei $135 million gain in 2Q, the margins for the year so far are about 8% and 9%. The second half of the year is implying more like 11.5%-12% operating margins. When I think about how to bridge that gap, basically find about 300 bps of margin improvement, you are looking for sales growth of about 7% sequentially, first half to second half. I can get a decent amount of that margin improvement with a pretty healthy incremental margin on that sequential build increase. Can you help us a bit with the mix to better understand the incremental margins, the overhead absorption benefit? Where do you see the 7% sequential increase? Which businesses, maybe geography? Just help us a bit with trying to get a feel for how much could the incremental margins be, the overhead absorption benefit, what could it be on that sequential improvement? Yeah. When you say incremental margins, you're talking about kind of from the first half to the second? Yeah, I'm talking sequentially. Yeah. I think there are three big things that are driving that. One is just the absence of negative inventory absorption. If you start with the premise that the second half of our year, if you look at the implied guidance at the midpoint on sales and revenues, it has sales in the second half of the year averaging about what they did in the second quarter, but up a bit from the first half average. So volume will be some help, and we would certainly expect reasonable incremental margins on the volume. I'm not talking massive, but our kind of target range is around 25%. So incremental margin on volume second half versus first half a little better. I think the second thing is absorption. That was a pretty big deal in the first half, and in particular, in the second quarter. We had a $1.2 billion inventory decline, so that had a pretty sizable effect. I think the third thing is to get to a point where inventory is not going to go down further, our production needs to go up. That's certainly the case, particularly for Construction Industries. So that ought to be positive for just efficiency in general. Then we have cost reduction activity. We've said we're going to do it, particularly because we haven't announced it internally, any specifics, but we're going to take additional actions in the second half of the year to lower costs. So volume, some efficiency as production goes up, absence of the large negative cost absorption impacts, and some additional cost reduction. But where is it coming? You mentioned construction. If you had a handicap- Eric, what's that? -the 7% increase in revenues sequentially, first half, second half. Is the increase mostly in Construction Industries? Is it Power Systems? Or are you even suggesting Resource Industries sequentially better? I'm just trying to get a feel to better gauge the incremental profitability. Yeah. Normally, if you think about fourth quarter, our Power Systems business usually has a stronger second half than they do first half. I do not know anything this year that would cause that to be different. And where we are ramping up production is mostly in Construction Industries. Okay. And lastly, not to even suggest you are going to tell me 2014 sales guidance, but just going from what you have articulated in this press release, in this discussion. You feel inventory won't be lowered further next year as a base case, right? That is $3.5 billion of Cat sales growth next year if retail is flat. That is a caveat there. But when I think about your commentary and your thoughts around Construction Industries and Power Systems, can we walk away from this call saying base case Cat is thinking revenue growth at a bare minimum is up next year? I would love to answer that question directly, and I said it about five times in my script, we are not doing an outlook. I think the message that we are trying to get people to think about is just the scale of the impact that dealer inventory reduction has had in this year. The likelihood that there is a lot of water to go under the bridge. I am hesitating a little bit on making too much in the way of predictions about next year. But I think given the scale of what has happened this year, it is certainly not likely that that is going to happen again in terms of dealer inventory reduction. David, Doug here. I have kind of been waiting to make this point. This inventory swing up and down has been painful on us and our dealers. That is the fundamental reason we established our Enterprise System Group, structure, organization, and emphasis a few months ago. Working on lead times, lean manufacturing, and really getting after a condensed supply chain. That is my number one initiative between now and the end of 2015, and I think I said on the last call, we expect to see some of that in 2015. There is lots of fruit to be picked on this one, and if there is ever a reason or a good way to get after it is this inventory swing that we have seen up and down. I just want to make sure you all understand how important that is that we get that organized. We have come a long way, but we still have a ways to go with that. We will start to see that manifest itself out late next year, and certainly into 2015 a little bit. Okay. Thank you very much. All right. With that, I'm afraid we're at the end of our hour here today. Thank you very much for joining in, and we'll talk to you this time again next quarter. 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.