Good morning, ladies and gentlemen, and welcome to the Caterpillar second quarter 2012 earnings results conference 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.
Thank you very much, and good morning, everyone, and welcome to our second quarter earnings call. I'm Mike DeWalt, the Director of Investor Relations, and I'm pleased to have our Chairman and CEO, Doug Oberhelman, and Group President and CFO, Ed Rapp, with me on the call today. This call is copyrighted by Caterpillar Inc. and any use or recording or transmission of any portion of this call without the expressed written consent of Caterpillar 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 we'll be discussing forward-looking information that involves risks and uncertainties and assumptions that could cause our actual results to differ materially from the forward-looking information.
A discussion of some of those factors that, 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 back on February 21st of this year, and also in the forward-looking statements language in today's release. In addition, a reconciliation of Non-GAAP measures can also be found in this morning's financial release, and that'll, again, be posted on our website at caterpillar.com. Okay, to start off this morning, I'll do a few bullet points that summarize this morning's release. It was an all-time record sales quarter, in fact, the best in the 87-year history of Caterpillar, and up 22% from the second quarter last year. A little over 12% of that was organic growth and a little under 10% from our acquisitions.
Sales and revenues rose about 9% sequentially from the first to the second quarters. It was a great quarter for profit and also an all-time record at $2.54 a share, and operating profit was over 15% of sales and revenues. We had very good incremental operating profit pull-through at 44%, excluding the impact of our acquisitions. We did, however, make a downward revision of $2 billion to the top end of our sales and revenues outlook range. About $1 billion was a result of negative currency translation and about $1 billion because of weaker world economic growth than we'd previously expected. We did not change the bottom end of the range, so that means the sales and revenues at the midpoint are down about $1 billion. And we increased our full year 2012 profit outlook from $9.50- $9.60 at the middle of the sales and revenues range.
Okay, those were the high-level points. I will add a little more color. Then Doug and Ed and I will take your questions, and I will start with sales. Again, sales and revenues up 22%, excluding the Bucyrus and MWM acquisitions, which we did not own last year. Organic growth, again, a little more than 12%. The largest increase was in our Resource Industries segment, which is primarily mining. Sales were up 68% from a year ago, about 37% from the acquisition of Bucyrus, and about 31% organic growth. Sales were up in all geographic regions, both with and without Bucyrus. Our Power Systems segment was up 12%, and that was 8% organic growth and about 4% from our acquisition of MWM. The strongest growth was in North America, and the strongest industries were petroleum and rail.
Our Construction Industries segment was up 8%, and that increase was essentially all volume, with negative currency impacts about offsetting positive price realization. Construction sales were up in North America, about flat in the Europe, Africa, and Middle East, and that is where most of the negative currency impacts were. Latin America was down 3%, and Asia Pacific was off 11%. Of that 11% decline in Asia Pacific, more than all of that was China. Speaking of China, over the past quarter, it has been very topical. What is happening there? What are we doing about it? When do we think it will get better? With most of the sales in China related to construction, this is a good place to address it. What is happening there? The construction equipment industry remains very weak, and it really has not shown much in the way of signs of improvement yet.
In addition to the weak demand, there is still quite a bit of inventory available on the ground in China. While the industry is still pretty weak, it did turn down at about this time last year. We are at about the point where the comparables are starting to get easier. On a year-over-year basis, the numbers will likely start looking better than the first half of 2012, even though the industry is not seeing much improvement yet. The question is, what are we doing about it? The answer is, we are actually doing quite a bit. First, we are working with dealers to actually sell more product. Over the past couple of months, we put new programs in place to get that done. We expect to start seeing results of those programs in the third quarter and expect to get more of the available market.
Second, we and our dealers are actively addressing inventory. During the second quarter, Cat dealers in China reduced machine inventories, and that is a good thing. However, with weakened user demand and dealers cutting inventory, it has resulted in a very low level of shipments from us to dealers, and that makes it tougher to reduce inventory. We have already lowered production in China and expect to reduce it even more in the third quarter.
That, along with a higher level of exports from China to other parts of the world, should help lower inventory there. However, because sales volume levels in China have not begun to improve much, we expect it will take a couple of more quarters to get inventory levels in China where we would like them to be. While we are actively working to get inventory down in China, we are trying to keep a balanced view.
One of the few certainties in this business is that markets go down and then markets go back up. In China, we are encouraged by the recent actions the government has taken to improve economic growth. They have cut interest rates. They have lowered bank reserve requirements, and we expect they will increase infrastructure spending later this year. We do need to be a little bit careful. The Construction Industries in China has a history of turning quickly, and when it does, we do need to be prepared. We are actively working the plan to lower inventory there, but we do not want to go to the other extreme and take it down to a point below where we would have difficulty reacting when improvement does inevitably come. Bottom line, we think there is a good chance that signs of better economic growth in China will start later in 2012.
While that is our view, our 2012 sales and revenues outlook does not rely on any material improvement in China sales this year. Okay, that is enough on China, Construction Industries, and sales. Let us shift to profit. It is a great story to talk about. It was a great quarter. In fact, again, at $2.54 a share, our best quarter ever, with operating margin just over 15% of sales and revenues. That was also one of our best performances ever. Cost control was very good. Material costs were about flat. Freight costs were not an issue. Variable labor productivity more than offset labor cost inflation and period cost control was very good, with period costs increasing at well less than half the rate of the sales increase. All in all, a very well-executed quarter. However, on the negative side, there was the tax rate.
We increased our estimated annual tax rate from 30% for the full year to 30.5%, mostly related to the geographic mix of where our profits are earned from a tax perspective. That means that after-tax profit in the second quarter was about $24 million lower than it would have been had we not made a change to the estimated tax rate. Okay, that is a quick review of the second quarter results. Let us move on for a moment to the outlook. As a starting point, remember, our previous outlook was a sales and revenues range of $68 billion-$72 billion and profit of about $9.50 at the midpoint of that range. This morning, we did tighten up the sales and revenues range by lowering the top end from $72 billion- $70 billion.
We first introduced that $68 billion-$72 billion range at the end of January with our year-end 2011 financial release, and we held it steady last quarter in April when we released our first quarter. This morning's $2 billion decline at the top end of the range was a result of two things, negative currency translation and weaker global economic expectations than we had previously thought. The currency impact is a result of a stronger U.S. dollar, its translation. Our sales that are denominated in non-U.S. currencies are translating into fewer U.S. dollars, and certainly the most significant negative impact is in the EUR. We did not change the bottom end of the range, and as a result, the midpoint is down $1 billion.
At the midpoint of that new range, that $68 billion-$70 billion sales and revenues range, we expect profit to be about $9.60 a share. That is up a dime from $9.50 a share at the midpoint of the $68 billion-$72 billion sales range that we previously had. A few points about the outlook. Profit is higher despite the increase in the estimated annual tax rate. Operational execution has been very strong, and we expect that that will result in better profit despite the tax increase. Currency, while impacting sales, has had little impact on the profit movement from $9.50- $9.60. Our global manufacturing footprint and broad cost base provides an offset to the impacts from sales. On that point, I frequently read media commentary about Caterpillar when exchange rates move, and it is frequently off-base.
Because of that, I think it is worth making this point one more time. We worked hard over the past 30 years to get a better balance on currency exposure. Because of that, we are in a much better currency position than we were historically. Rates can move and do move sales, but when they do, the cost impact is usually in the opposite direction and mitigates the overall profit impact. In summary, we had a great second quarter. We are a little more cautious at the top end of our sales and revenues outlook, and we raised the profit guidance to about $9.60 at the middle of the sales and revenues range. Another point before we move on to the Q&A, and that is the level of uncertainty in the world economy.
It is hard to pick up a newspaper today and not read about troubles in Europe with Greece, Spain, and Italy. There is angst with growth rates in GDP in China. There is concern about political polarization in the U.S., and what will happen at the end of the year with the fiscal and tax cliff. But those are the facts of life that we are all dealing with today, and there is no doubt that they have been a negative for business and consumer confidence. We see it, and we understand that some of these issues, like Europe's debt problems, could take a while to fix. That said, we expect that over the next couple of quarters, that some of those clouds will clear a bit, and we can start forming a little bit better picture of 2013.
While none of us know at this point what those outcomes will be, we do know that U.S. elections will be over in the fall, and we think chances are good there will be a resolution to the fiscal cliff. The leadership change in China will also happen later this year, and after another quarter or two, we will get a better sense of the effectiveness of the easing measures the Chinese have already taken and any additional measures they may take to improve growth. We know that in Brazil, they started easing late in 2011, and we are seeing some improvement in our business there today, and we expect that improvement to continue to unfold as we go through the rest of this year. We also do think that Brazil's preparations for the World Cup and the next Olympics will be positive for them moving forward.
Bottom line, we believe that some of the uncertainty that's facing the world economy today will at least be a little less cloudy by the time we get to the end of 2012. As a result of numerous monetary easing actions that have been taken around the world, we're cautiously optimistic that the world economy in 2013 will be better than in 2012. One last comment and then we'll start the Q&A, and that's a seasonality reminder. We have numerous vacation shutdowns around the world built into our third quarter. That's normal. That happens every year. As a result, the third quarter is usually a weaker seasonally sales quarter. The fourth quarter is usually a seasonally high quarter for sales. For those of you that are trying to model our quarterly results, please take that into consideration.
The third quarter is usually the weaker quarter of the second half. So that's a review of our results, and with that, we are ready to take your questions.
Thank you. Ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press the numbers one followed by four on your touchtone phone now. Pressing one for 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. Please hold for just a moment while we poll for questions. Our first question today is coming from Jerry Revich. Please announce your affiliation, then pose your question.
Good morning. It's Goldman Sachs. Mike, can you touch on how you're thinking about pricing heading into the back half of the year compared to the price realization we saw this quarter, and also comment on where you expect to see company and dealer inventories at year-end?
Yeah. I'll start with pricing. We've actually done better on pricing through the first half of the year than we expected. It's really held up pretty well. Earlier in the year, we'd expected that we would get maybe 1%-1.5% price for the full year. We're at probably between 2.5% and 3% right now through the first half. We think it'll probably go down a little bit in the second half. That's what's baked into our guidance. We'll probably end up the year somewhere around 2%. You remember one of the points I mentioned was we're working with dealers, for example, to sell more product in China. There'll be certain merchandising programs, for example, related to that.
I think a lot better year than we thought it was going to be, even including the economic impacts that you see today, but probably a little less in the second half than the first half. In terms of dealer inventory, we did have a little bit of an increase in the second quarter. More than all of that was mining. When you look at dealer inventory for mining, you have to be a little careful. It's not a case where dealers are loading up 400-ton trucks on their lot and hoping for a customer. It's a case where we pass title to them, and then they have to get the product to their customer. They have to get it assembled and commissioned. So usually when our shipments go up like they did in the second quarter versus the first, the pipeline for mining inventory increases a bit.
And that's just a function of us shipping more through dealers to customers. In terms of our inventory, we did have a bit of an increase, about $800 million, in the second quarter, and there were four reasons for that. One, and I'll start from the smallest to the largest, in-transit inventory. That's basically where we've sold a product. I shouldn't say sold. We have a product that's been shipped, but it's an export. It's on the high seas, essentially, and it's destined for a customer, but we haven't passed title yet. When our shipments and exports go up, in-transit inventory usually goes up. We had a 9% increase in sales between the first and second quarters, and in-transit went up a bit. That's to be expected based on the sales increase.
About 20% of the increase in the second quarter was components, work in process, aftermarket parts, and that's very related to sales. And again, we had a 9% increase in sales from first to second quarter. 20% of the inventory increase was from the acquisition of Siwei and Bucyrus. Siwei is an acquisition, and Bucyrus inventory went up in the quarter. And again, that's not very surprising. We have businesses like Solar Turbines, like Bucyrus, where they have seasonally big fourth quarters. They build a bit of inventory all year long, have a big fourth quarter, and it usually goes down. And again, Siwei contributed about $100 million of the increase, not just an acquisition. About half of the increase was finished goods, and more than half of that was in our excavator division in China. And I tried to cover this a little bit in the release this morning.
It's a case where we're cutting production there. There are more declines that are going to come in the third quarter. But dealers are cutting inventory there as well. If you start with a slow market and dealers reducing inventory, there are not a lot of shipments going on from our factories to dealers then. It's pretty hard to take inventory down. Even with the reduction in production that we had in the third quarter, it wasn't quite enough yet to offset the impacts of a really slow market. We're going to take it down a little bit more in the third quarter. We're exporting a higher percentage of the business in China, outside of China. That should help there.
Hey, Jerry, this is Ed. The thing I'd add on Cat inventory, looking for the balance of the year. Between now and year-end, I'd be disappointed if we didn't take at least $1 billion out of inventory. But we're also trying to be very thoughtful in terms of how we manage the full supply chain. If you think about what the supply chain has done, and with $32 billion in 2009, midpoint of the outlook, $69 billion. If you look at the basic outlook that says there's some drivers out there that says 2013 could be a positive versus 2012. We want to be very thoughtful about how we take that inventory down. But between now and the end of the year, getting $1 billion out is something we ought to be able to do.
Okay. Appreciate the color. I'm wondering if you could talk about how much visibility you have in your gas compression business and whether that business can continue to outpace the slowdown we're seeing in U.S. pressure pumping and in electric power. Can you just touch on which regions are driving the weakness that we saw year to date and what you expect heading into the back half? Thanks.
Yeah, we don't break our petroleum business out in quite that much detail. But what I would tell you is the largest sort of application segment for our oil and gas business is gas compression. Contrary to popular belief, it's not drilling and fracking. It's gas compression. The more gas you have, the more wells you've drilled, the higher consumption of gas goes, the more need that you have for gas compression. That business is actually doing quite well and looking up. We do a lot of gas compression with Solar Turbines, and with Solar Turbines, we have very good long-term visibility. I'd say oil and gas, your point about fracking is right. Fracking is slowing down, but gas compression is doing very well. Our general view of the oil and gas industry is actually pretty good right now.
Jerry, we're going to have to move on to the next person in line. Thanks.
Thank you. Ladies and gentlemen, the next question today is coming from David Raso. Please announce your affiliation, then pose your question.
Hi, ISI. I'm just trying to look at the inventory guidance. Ed, you just mentioned $1 billion coming out, ideally by the end of the year. That would still imply the next couple quarters that inventory will be growing faster than sales year-over-year. Just coming off the last five quarters of inventory still growing faster than sales. I'm just trying to, A, just understand why we continue to grow inventory faster than sales, or B, is the answer, and everybody can have their own macro view. Are you just that confident 2013's enough year to continue to grow inventory at this rate?
David, two things. First of all, on inventory growing faster, if you really look at our guidance in terms of the midpoint of the outlook, we have sales in the second half actually slightly up versus first half. You've got a slight increase in sales and a lower inventory level. You don't have inventory growing at a faster pace than sales. Then your second point is part of it as well. If Mike kind of walked around the world and you look at what 2013 could look like versus 2012, I can't imagine with the degree of uncertainty we have in the U.S. today that we don't have greater clarity in 2013. I can't imagine with the steps that China has taken in terms of monetary policy, rate cuts, reserve requirement cuts, you don't see a better 2013 than 2012.
I can't imagine with all the moves that Brazil has taken, as well as the coming of the World Cup, the Olympics, you don't see a 2013 that's better than 2012. Part of our thinking is making sure we're very thoughtful across the supply chain. The other one to keep in mind, and I think second quarter really demonstrated it, there are also some benefits to the inventory position we have. Our point of use availability, our quality, our delivery performance, our pull-through, were all very, very strong. I do think there's been some benefits as how we've worked with our supply base to ramp up, and I think you're seeing it in some of those operating metrics.
I appreciate that math sequentially, but I was speaking about year-over-year. The math is you're still planning on inventory growing faster than sales year-over-year, and obviously it sets up a little more risk on how much retail you need in 2013 to continue to grow your production. I guess end of the day, obviously you'll give 2013 top line guidance. I assume, Mike, you guys will give it in October. But the way you're handling the CapEx for the rest of the year, essentially no cut, the way you're guiding the inventory, I guess base case, we have to be thinking you're thinking 2013's an up year. Otherwise, you'd be taking a bigger cut to your inventory and even maybe even the CapEx.
David, that's why we tried to give you some color as to why we saw 2013 being better. The other one to keep in mind on the CapEx is that in spite of the numbers that we reported today, which are an all-time record on both sales and profit, keep in mind that our traditionally strong markets, U.S., Europe, and go back in history, even Japan, are in the neighborhood of 40% off the prior peaks. At some point in time, those markets are going to turn. When they turn, we want to be ready. There's places where we're taking and slowing down some of that CapEx, China being one example. But we're going through it business by business, industry by industry, really looking at what the long-term prospects are going to be.
Last one?
Hey, David, I'm just going to add one more comment in there on the year-over-year. That is, you almost have to look at it by the type of inventory that we're talking about. We've increased parts inventory, for example, faster than sales. Part of the reason for that is we're putting additional Bucyrus inventory into the system. We're doing that to increase delivery performance there. That's a key part of driving higher parts sales and profit out of Bucyrus. Now, if you look at our actual production inventory, it's performed a lot closer to sales. If you look at PDC, that's where we're holding finished inventory on purpose. We call it Lane 1 inventory. That's up $1 billion or actually a little bit more than $1 billion year-over-year. That's very purposeful.
The problem was a year ago, we didn't have enough capacity in place to get it where we need it. Now we've added more than $1 billion to PDC inventory on purpose. That was all part of the plan. We've been able to do that really over the last six to nine months as production has come on stream. So it's not just a simple, how much did sales go up? How much is inventory going up? We also had acquisitions. Roughly half of the FIFO inventory increase is Bucyrus, MWM, and Siwei. Just acquisitions.
Okay. Thank you very much. I appreciate the color, Mike.
Okay.
Thank you. Our next question today is coming from Andrew Kaplowitz. Please state your affiliation, then pose your question.
Barclays, good morning, guys. Nice quarter.
Thank you.
If I could ask you about backlog, Mike, I know you've talked about in the past, you kind of rue the day when it would go down. I think we all expected it to go down sequentially here. How do you look at the backlog decline in terms of mining? With your comments in the release about mining customers extending investment over the next few years, how is it affecting your business now? If mining CapEx is down significantly, can you grow your business?
A couple of things. One, you say, how is it affecting our business now? Well, organic sales were up 31% in mining in the quarter. If you look at our year-over-year backlog, how are we doing on backlog versus a year ago? It's up 11%, not down. If you look at the change from the end of the first quarter, there are a couple of things that are definitely going on there. One, and this particularly affects Construction Industries, we took quite a few products off managed distribution. We've been in a situation for the last couple of years where we just couldn't supply enough, and we had dealers on managed distribution for quite a few products. We've been adding production capability over the last couple of years. That situation, delivery times have improved a lot. When that happens, it's almost like clockwork.
Dealers don't have to be quite so cautious because we can deliver quicker. That was definitely a factor for Construction Industries. On mining, customers did cut. We shipped more than we took in new orders, and the backlog did go down. You almost have to look at it in perspective. We were getting very large orders really over the past couple of years, and we're increasing every quarter. It's a function of we've been putting in more capacity to deal with that. We wanted for a long time to get the order book for mining to a more reasonable level, delivery times for customers to a better level. That's why we've been putting capacity in place to do that. That said, there's a lot of uncertainty in the marketplace today. Customers are just like my comments in the opening.
We're all trying to get a better picture in terms of what's going on economically. Central bankers have done quite a bit, but that takes a while to actually materialize in the economy. I think people are taking a little bit of a wait and see to see how 2013 is going to shape up. I think orders reflect that. That said, the mining order book is quite long. We have very good visibility into 2013. For a lot of the big trucks, we're still taking orders into 2014. It's not as though all of a sudden the backlog has dried up and we don't have any visibility.
That's helpful, Mike. If I could shift gears for a second. The first half of the year, you've done almost 15% margins. In the second half of the year, if you look at the implied guidance, you would do much lower margins. You talked about lower production in China. Incentive comp is going up. We see all the things that are in the release, but the question I have is this some conservatism in the guidance?
Well, what I would tell you is this, many of the comments that we've actually made here today were in the release. Price realization is probably not going to be quite as strong in the back half of the year. Seasonally, the fourth quarter is usually a higher cost quarter. Those things will certainly impact the second half of the year. You're right, the first half execution has been very good. I think our outlook is, we raised the outlook today from $9.50- $9.60 on a midpoint of the sales range that went down $1 billion, and we're looking at a higher tax rate. I think actually the profit story for the rest of the year is pretty positive.
Thanks. Appreciate it, guys.
Thank you. Our next question today is coming from Henry Kirn. Please announce your affiliation and then pose your question.
Hey, good morning, guys. It's UBS.
Hey, Henry.
In the release, you called out the dealer rental inventories as old. How much opportunity is there to refresh the fleets? If we went through a pause, do you think the dealers would take the opportunity to start to refresh?
Yeah, Henry, this is Ed. Yeah, I think we're already seeing some of that in terms of dealers refreshing those rental fleets. If you look at it in terms of the total fleet size, it's still below kind of historical levels, historical peaks, and on average, the age is older. I think it's not only a view of the rental fleet, but I think that's a pretty good proxy for where customer fleets are, especially in the developed parts of the world. In a period of uncertainty, they just delay the decision to make that upgrade to the fleet, that new purchase. Like I said, as we talk about moving forward, I think at the point in time they get greater clarity. One of them that helps is the fact that we did finally get a passage of a highway bill.
We are starting to see some of the bottoming out and improvement in housing. I think as those issues get a bit clearer, the opportunities for not only rental fleet replenishment, but also the upgrade of customer fleets is one of the opportunities that lies ahead.
That's helpful. Could you share your latest thoughts on Cat Financial and your appetite to take risk there, gain share or use it as a competitive weapon?
Well, Henry, Cat Financial has been a competitive weapon since we launched it back in the 1980s. The thing that we do with Cat Financial is we stay very close to home. So it is there to support and pursue the growth of the Caterpillar business. If you think about the 2008, 2009 financial crisis and how well it performed, I think it shows the benefits of staying very close to home in terms of the way you manage your captive finance company. I think with the uncertainty that you have today in the financial markets, having a captive finance company has become, I think, even a bigger strategic advantage. I think the other place where we are going to see it play out as a strategic advantage as we drive the full integration of Bucyrus is we will really be the only full line provider in that mining industry.
Plus, with a captive finance company, I think there is a real strategic advantage there. But we are not going to significantly alter our risk appetite. We think we manage that part of the company well. I think you will see us consistently manage it moving forward. But as you saw with the results, they had a good quarter. They are a great part of the company.
Thanks, Henry.
Thank you.
Thank you. Our next question today is coming from Robert Wertheimer. Please announce your affiliation, then pose your question.
It's Vertical Research Partners. Good morning. You mentioned rail was strong in the press release, and I wondered if you could break that down into a pre-buy maybe in North America versus I know rail has been booming in mining globally. Is that a business that's gotten up into a solid double-digit profit margin or is it still lagging?
Yeah. A lot of the rail increase that we've seen so far this year has actually been in North America. To your point, a few years from now, there'll be a move to new emission standards in rail. I think there's certainly some buying that's going on ahead of that. We're actually doing a bit better than the industry. When we acquired EMD, it had lost a lot of its business over the years to GE. Thankfully, we're taking some of that back now. So actually, we're doing pretty well. In terms of profitability, in general, that business is actually doing quite a bit better than when we bought it. We've got the new factory going in Indiana right now in Muncie. They have come up on production remarkably well.
We had a good quarter despite the fact that we essentially shifted assembly in the first or the second quarter from Ontario to Indiana. So they've done a great job.
Okay, great. If I could ask another Power Systems follow-up, just on electric, one of your competitors had cited some weakness. I know you have some tough comp issues that maybe are fading. Is it possible for electric power gen to be up for you guys this year? Do you have an order book that would support that, or is it looking a little softer?
Well, a couple of things. One, if you look at our overall Power Systems business versus that competitor that we're talking about, thank goodness for rail and thank goodness for oil and gas. It's good to have a quite varied business. So we have some end markets that are weaker. We have some that are stronger. We happen to have a very good balance. So in total, you saw our sales to end users accelerate, the three-month moving average from overall a +2 to a +7 in June. That was a good thing. Their comments about Power Systems in general, particularly the smaller diesel end of it, we're definitely seeing that in the marketplace. Certainly at the smaller end of electric power, it'll likely be a negative year.
At the big end and the turbine end, we had some really tough comparables in the first quarter that were with us throughout March. year-over-year, that part of the business has been, comparably, a little pressed because we had such big turbine sales in the first quarter a year ago. But on balance, I would say the bigger stuff is a little better than the small stuff, and the competitor that you referred to is probably, relatively speaking, stronger in the small stuff.
Yep, true. Thanks, Mike.
Thank you. Our next question today is coming from Seth Weber. Please announce your affiliation, then pose your question.
Hey, good morning. It's RBC Capital Markets.
Good morning, Seth.
Morning. Just back to the mining business. You gave some good color on the trends on the truck side. Can you comment on what you are seeing more on the underground side?
Underground hard rock or underground coal? Underground hard rock has amongst the longest backlog of all of our products.
Okay.
You mean underground coal, Bucyrus Underground Coal, you mean?
Yeah, the old DBT business.
Yeah. That is probably weaker than the rest. We talked a lot about that, I think, in the first quarter, where we were seeing some decline there. We have not broken out Bucyrus in a lot of detail separately in the outlook, but I think the overall sales for Bucyrus this year are going to be lower than we had originally thought, and really for two reasons. One is underground coal is a bit weaker. Thankfully, we do not have as much of our business tied up in U.S. underground coal as maybe our largest competitor does, but it is still going to be a bit of a negative. On the flip side of that, we have now sold four of the distribution businesses to Cat dealers. Those are in our numbers now and in our outlook.
That will probably take a little bit off the top line for Bucyrus as well, and that is baked into our outlook as well.
Okay, thanks. If I could follow up on Europe, on the Construction Industries business, can you just comment, did it accelerate to the downside through the quarter? Are you seeing trends get weaker there during the quarter?
Yeah, I think it's probably fair to say. If you just look at the Europe, Africa, Middle East rolling numbers, you've seen that monthly get weaker, and I think that's certainly been the case in Europe. Europe, Africa, Middle East has moved from up to being about flat, and it's moved that way throughout the quarter.
Do you think that that continues to deteriorate through the year, or does that kind of stabilize at a low level here?
Again, we don't provide our outlook in quite that level of detail. But to Ed's point earlier, we have a decent sales outlook for the back half of the year. We're not looking for a big deterioration. That said, there are pluses and minuses. We're seeing, for example, better business in Brazil. That's turning up a bit. You also would've seen that in the Latin American numbers. It moved from, I think, down 6% to down 3%. So you're seeing that move a little better. It was actually positive later in the quarter. In fact, our machine retail sales, I'll say this. In June, we report the three-month moving average, but from a monthly perspective, June was the best month we've had since January in terms of month-over-month increase. It was one of the best months on a volume basis we've ever had.
Okay. Thanks very much, guys.
Thank you. Our next question today is coming from Ann Duignan. Please announce your affiliation and then pose your question.
Hi. Good morning. JPMorgan.
Good morning, Ann.
Morning. Can we take a step back again and look at U.S. Construction? Doug, you noted on CNBC this morning that you are seeing a more broad-based recovery in housing starts across the country. There are pieces out there that the rental channel is secularly going to grow versus kind of contract or ownership. What are you guys seeing out there right now? Doug, when would you anticipate that your contract customers would start to purchase equipment again rather than rent, which they usually do at the beginning of a cycle, but as we get into the cycle, they usually prefer to own their own equipment. What are you guys seeing out there, and what do you think happens over the course of the next year or two?
Well, my comments earlier on broad-based housing recovery is relative. I mentioned that I was on the West Coast, in California specifically, and I met with several contractors, and all of them had, for the first time in five years, a subdivision underway. None of them were massive projects like we saw in the 2000s, but it was fairly widespread in that a subdivision here, a subdivision there in different areas of California. I was impressed with that, but from a very small base. I have heard that elsewhere around the country as well, and I think the housing statistics support that as we look at that. There is no question the rental market, the multifamily, is booming, I guess, in some parts, and we take advantage of that. I do not really see our contractor base significantly kicking up orders based on housing probably until at least next year.
If anything happens, it will be the transportation spending and some degree of clarity on that through the highway bill we just saw, I suppose, the next 2.5 years. I would say that if we see it, when we see it will really be spring, but it is too late in this construction season to get much underway. We will see it first in the rental market for sure. Depending on the prospects of the debt cliff and everything else in this country and how that settles out this winter, that will impact the spring greatly. So I see a couple of those things coming together that could be positive. If the country blows itself up as some of the politicians are threatening, I guess it would be negative.
Fair enough. On the operating side, you noted that material costs were flat in the quarter. Should we anticipate or why wouldn't we anticipate that material costs, shouldn't they be a tailwind going forward from here? Particularly, even if pricing weakens from here, but it is still a positive, shouldn't the net be a positive for Caterpillar going forward?
Yeah, Ann, this is Mike. Even when commodity prices were moving up, the impact on our actual material cost was quite muted. If you go back to the first quarter, we were up about 1%. Last year, we weren't up much more than 1%. So the impacts on us are quite muted, and part of that is because for a lot of our purchase volume, we agree prices annually. The majority of our material purchase are not actually commodities. So, I think broadly speaking, your sentiment is correct. Obviously, the portion of our business that is commodity-related, the pricing is a little bit easier. But I wouldn't get carried away in terms of order of magnitude there.
Okay, and just a real quick follow-up on that one then. You are looking at taking $1 billion out of inventory by year-end. What would the target be for days on hand or inventory turns once we get through all the sales of the Bucyrus distribution businesses, et cetera? What should we be looking at a year from now in terms of the right kind of inventory levels for Caterpillar?
Ann, if I was going to look out and net out all the acquisitions and all that and look out into a 2013 type timeframe, something around the three turns would be a place I would fall.
Okay. Thank you.
That would be sort of, think of it as FIFO, not LIFO.
Okay. Thank you. I appreciate that.
Yeah, I want to just come in here a little bit on our inventory outlook, run rates, et cetera, going forward. I will tell you that we are playing the game here on a world that grows, maybe anemically, but grows between now and, let's call it, the next 12 months- 24 months. We are not playing for an implosion. We are not playing for a drop like we saw in 2008. The tea leaves that we see based on the monetary conditions that exist right now and the easy money flows should loosen up the economies a year from now. What we're seeing today are the effects and impact of pretty tight monetary policies a year ago. These things take time to wind through.
We have only, in our dreams, arrived at an availability position that we have today where we can concentrate on market share and pricing, which we are doing. I am very reluctant to take too bold of a move on inventory in China because we have seen this China show before, many times in the last 25 years. We've seen it in terms of an absolute stop in demand for excavators and wheel loaders probably three times since I've been watching China in my career, maybe four times. Within a year, we've seen a recovery, sometimes booming recovery, and some just a nice recovery. We are in a position today where if we miss that and have insufficient inventory with the amount of competition we have there, we'll be out of that game, and it'll be hard to get into a leadership position that we want.
We are watching China very carefully. There's no question we have too much inventory for today's run rate of sales. But again, I am not at all convinced that a year from now or less or a little more, we'll see China back on its feet as we have seen so many times in the past. Everybody can argue that this is different and China's changed, and maybe it has, but I suspect there will be some amount of recovery. We'll be in a position where we have availability, and we can build pins in our distribution model that will work for us long term. That's not a dissimilar place where we are with PDCs.
We arguably are a bit heavy everywhere today at the run rates, but we are in a position where we finally have availability that we have built capacity around that we didn't have in the last two recoveries around here. That's been part of our strategy to take market share with availability. Our quality levels are as good as we've ever seen them. Our efficiency levels are as good as we've ever seen them, and we now have availability in the marketplace. We're not playing for an implosion. We're playing for arguable growth, maybe anemic, but as I sit here today and we look at 2013, as Ed Rapp said, it's almost got to be better on an economic basis, GDP growth in the world, and that's what we're playing for.
While, yes, we are watching inventory, and yes, I'm very worried about inventory turnover, we're doing all we can with our supply chain, and it is improving. We don't want to call this the wrong way with too little inventory, and I would say get stuck with too much. It's all hands on all levers every day with inventory and run rates. We've got schedules in the third quarter that are very much reduced with maintenance shutdowns, with vacation shutdowns around the world, and we'll manage production to sales that way as well. But inventory levels are important if we believe the world is going to grow, which we do, maybe anemically. I guess that would be my statement around all of that, which is a little lengthy, and I apologize for that, but it is something we're managing.
We're being very cautious and guarded with, both on the upside and the downside when it comes to working capital and specifically inventory.
Fair point, Doug. Thanks for the color.
Thanks, Ann.
Thank you. Our next question today is coming from Jamie Cook. Please announce your affiliation, then pose your question.
Hi, good morning, Credit Suisse, and a nice quarter. Two questions. One, Doug, with regards to the economic outlook you just sort of laid out, and obviously you guys are a little more constructive on 2013 relative to what the market is saying, well, relative to what your stock is saying. I guess just beyond 2012, and given the environment you just laid out, how do you think about CapEx? Do we need to state this $4 billion number to meet your targets in an okay macro, but slightly weaker than what you were calling for? I guess, how do you think about share repo in that context, given where your stock is? My second question is, can you just talk about your comfort level with dealer inventory levels outside of China?
I guess my thought or concern would be, as I talk to dealers and just given the weaker macro, and just given your ability to deliver and given the fact that your lead times have come in, do you think the dealers can sit there with less inventory than they had been historically? One, because they're concerned the macro is weaker, and two, they're not as worried as they were historically that Cat can't deliver. They have actual confidence that Cat will deliver the equipment, so they don't need to sit with as much inventory as they've had historically.
Yeah, you got a lot there, Jamie Cook. Let me take the CapEx one right off the bat. We are on track to get close to $4 billion. I will tell you also that each of our groups, whether it's Construction Industries or Resource Industries or our aftermarket business, are looking at that very carefully. We've significantly, I'd say, delayed some of our plans and most of our plans in China for the time being as a result of that market to see how that sorts out. We have an aftermarket distribution business that is very antiquated, that needs upgraded. Most of the CapEx you can argue is capacity related, but I would also equally argue that it's cost reduction related. A lot of the Victoria, Texas excavator plant, the small dozer plant in Georgia that we're expanding, bringing production back here. Those are cost reduction activities as well.
Again, we're playing for growth, albeit slight growth, and significant cutback in CapEx would only hinder us in 2014 and 2015. We may have to do it. As sure as I'm sitting here today, if something happens on a macro scale between now and year-end, and we have to take actions, we will, and we've proven we'll do it. But right now, we're playing for some kind of growth in the next 12 months- 24 months. That's kind of around the CapEx. That's kind of around the inventory question. I think there's no question that dealers are gaining confidence in our ability to supply equipment, and our PDCs are at optimum levels. Hopefully, that model will work. They will carry less, we'll carry more. The chain takes cost out, and that's what we're seeing. But again, depending on if we see growth or not, we'll have to adjust that model.
I forgot what you had in the middle there, Jamie Cook.
Well-
Oh, share repurchase.
Yeah, share repurchase.
Oh, yeah. How could I forget that one?
Especially at $82.
Well, it's dirt cheap at $82. But having said that, we have a balance sheet today with debt- to- debt and CapEx at 40%. A net debt position when we consider our cash and securities at somewhere around 34%, 35%. And I want to be sure that as we go forward in this very uncertain world, although I have painted it somewhat rosy with anemic growth
That we have a bulletproof, rock-solid balance sheet that we never have to worry about our credit rating or dividend, which I don't think we do. Share repurchase is not on our radar screen today. It's the last of our priorities. I have said before, and I think I've said to all of you, that I hope in my career, which has a few years to go, I can buy one share back. But right now, we've got other priorities, and I think we're investing them wisely.
Okay, great. Thanks. I'll get back in queue.
Okay.
Thank you. Our next question today is coming from Robert McCarthy. Please state your affiliation, then pose your question.
Hi, it's Robert W. Baird. Morning, everybody.
Hey, Rob.
Jamie basically asked my question, but the other side of that coin is, with valuations depressed and recognizing that uncertainty has a lot to do with that, how tempted are you to try to take advantage of that and continue what so far has looked like a pretty successful external investment program? I am talking about acquisitions.
Well, Rob, this is Ed. We have laid out our cash deployment strategy, and I think you are going to see us consistently stay focused on it. We think the number one is the opportunities for growth. We have moved aggressively in terms of the acquisition space. We try to do it early in the cycle because it is easier to integrate as you work through the cycle. I think on the acquisition front today, our primary focus is what I would describe as slow down, chew, and digest. We feel good about where we are at with the integration of Bucyrus, but that is a lot of work. We feel good about where we are at in terms of EMD, and Mike talked about the operating performance there, but there is still more work to do as well with MWM and Siwei.
I think you are going to see us stay clearly focused on integrating what we have in the acquisition space.
Ed, if that is the case, you are not showing any appetite, really, to try to reduce the absolute level of debt on the balance sheet. Should we just then expect to see cash continue? You are generating significant free cash flow. Are you just going to watch that accumulate on the balance sheet over the next two to four quarters?
Maybe. We would like to get that debt and CapEx gross number, not the net number, down into the low 30s. I think that sets us up to have any flexibility we want in a downturn for acquisition or any growth opportunity that comes along. I would say that the concentration on the balance sheet while generating cash and making sure our pull-through numbers are at that 25% level is exactly where we would be in the next two years, particularly with the level of uncertainty out there.
My follow-up has to do with disclosure, if that is the right way to characterize it. We have now anniversaried the Bucyrus acquisition. Two sub-questions. One, does that mean next quarter you are going to stop providing visibility into its performance as differentiated from the rest of Resource Industries? Second, Doug, do you have some plans to maybe quantify the company's progress towards its existing synergy targets when we see you at MINExpo?
I will handle the first part. How is that?
Okay.
I will handle the second part, too.
That would be good.
The first part is we will probably continue to report Bucyrus just as we are throughout the rest of this year.
Right.
They are, for example, not in our monthly dealer statistics from a disclosure standpoint, and we would plan on doing that, for example, at the beginning of 2013, where you have good comparables. So we will continue to break it out, certainly for the rest of this year. In terms of MINExpo, we have an outline at this point of what we are thinking about in terms of material to share at MINExpo. Since it is MINExpo, there will probably be a little extra emphasis on mining and Bucyrus as a piece of that.
Yeah.
We will talk about that.
Yeah, we will put some definition around that. Just tell you that our synergy plan and the business case is ahead of schedule as of today, and we will get into some detail on that in September for sure.
We will look forward to that. Thanks, Doug.
You bet.
We have time for one more question.
We have no further.
Hello?
We have no further questions in the queue at this time.
All right. Well, thank you very much, everyone. We are happy to report a great quarter and an increase in the outlook. With that, we will sign off.
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.