Earnings Call: Q1 2014

Apr 24, 2014

Summary

Q1 sales were flat, but adjusted EPS rose to $1.61 as construction growth and cost controls offset mining weakness. FY EPS guidance increased, while the mining outlook weakened and global risks remained.

Good morning, ladies and gentlemen, and welcome to the Caterpillar first quarter 2014 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. Thanks, Kate, and good morning, everyone, and welcome to our first quarter earnings call. I am Mike DeWalt, Caterpillar's Vice President of Strategic Services. On the call today, I am pleased to have our Chairman and CEO, Doug Oberhelman, and our Group President and CFO, Brad Halverson. This call is copyrighted by Caterpillar Inc. Any use, recording, or transmission of any portion of the call without our express written consent is strictly prohibited. If you would like a copy of today's call transcript, we will be posting it in the investor section of our caterpillar.com website, and it will be in the section labeled Results Webcast. This morning we will be discussing forward-looking information that involves risks, uncertainties, and assumptions that could cause our actual results to differ materially from the forward-looking information. A discussion of some of those 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, which is Risk Factors of our Form 10-K that we filed with the SEC in February of 2014. It is also in the forward-looking statements language in today's release. In addition, a reconciliation of non-GAAP measures can also be found in today's release, which has also been posted on our website at caterpillar.com. Now, before I get into the details, I should also mention that we made organizational changes that went into effect at the start of 2014. Responsibility for paving, forestry, industrial and waste, and tunnel boring products moved from Resource Industries, and you will find it in the financial release today in our All Other Operating Segments line. In addition, responsibility for some work tools was moved from Resource Industries to Construction Industries, and the responsibility for administration of three wholly owned dealers in Japan moved from Construction Industries, and it is also in the All Other Operating Segment in today's release. We also reclassified restructuring costs for 2013. We moved it from segment profit to corporate items, and we did that to be consistent with how we are presenting 2014. The most significant impact of these changes on our reportable segments was for Resource Industries. To put that in context, for the full year of 2013, that reorganization moved about $1.5 billion of sales from Resource Industries, but it had very little impact on profit for Resource Industries. In fact, only about $10 million for the full year. Now, after these changes, the vast majority of Resource Industries sales are related to mining and quarry and aggregates. We put a Q&A in this morning's release on the reorg. It's Q&A number 7 on page 17, and it includes a quarterly breakdown of the impact for Resource Industries. We also changed the name of our Power Systems segment to Energy and Transportation. We did that to better reflect what the segment actually does, and we made the changes before our analyst meeting at ConExpo last March. If you missed it, Power Systems is now Energy and Transportation. Okay, let's get into first quarter results. At $13.2 billion, sales and revenues were flat with the first quarter of 2013 and were pretty close to what we expected. Profit was $1.61 a share, excluding restructuring costs, and $1.44 including restructuring costs. The restructuring costs were $149 million, or about $0.17 a share. Most of the $149 million was related to the previously announced restructuring of our Gosselies Belgium manufacturing facility. To better compare results to the first quarter of 2013, the remainder of my discussion on the quarter will be excluding restructuring charges. The profit of $1.61, excluding restructuring, was $0.29 a share higher than the first quarter of 2013. While in the aggregate, sales were unchanged from last year, if you look at our three large segments, they were very different stories, and I'll cover each one. The most positive was Construction Industries. It was up 20% from the first quarter of last year. In fact, this quarter, it was our largest segment by sales, which were over $5 billion and up more than $800 million from first quarter last year. They were up about 36% in North America, 20% in Europe, Africa, Middle East, up about 10% in Asia Pacific, and were almost flat in Latin America. To understand what happened in Construction Industries sales, you do need to consider dealer inventory. It was a big part of why sales were relatively weak last year. Normally, during the first quarter of each year, dealers buy more from us than they deliver to customers, and they build inventory for the second quarter, we call it the selling season. That means that for dealer deliveries to end users, the second quarter is usually the highest quarter of the year. That inventory build didn't happen for construction last year. That's because dealers ended 2012 with sufficient inventory of construction equipment, and their inventories during the first quarter remained pretty flat a year ago. This year, that wasn't the case, and dealers reverted to the more usual seasonal pattern and built inventory in the first quarter for sale in the second quarter selling season. In addition to the dealer inventory impact, end user demand also increased versus the first quarter of last year. You may have seen that in our release of dealer statistics yesterday, where dealer deliveries for the first three months of 2014 were up 9% for Construction Industries. Bottom line for Construction Industries, demand is better for construction, and we believe dealer inventories are in pretty good shape relative to seasonal needs. Okay, that's construction. For Energy and Transportation, sales were up about 8% in the quarter. Remember, Energy and Transportation is made up of several sales that serve several industries: oil and gas, power generation, transportation, and industrial. Oil and gas, power gen, and industrial were all up a bit more than the 8% average that Energy and Transportation was up as a whole. Transportation-related sales were about flat versus the first quarter of last year. Energy and Transportation has been a stable performer over the past year, and that certainly continued in the first quarter. Let's move on to Resource Industries, which again, is principally mining. That's a different story. Sales were down 37% from the first quarter of 2013, and most of the decline was end user demand, which again, you can see in the retail statistics that we released yesterday, where deliveries of new equipment were down 46% in the first quarter versus the same period a year ago. The decline we're seeing in the mining industry began in mid-2012, and it's continued. The business declined throughout last year. Because of that, the first quarter of 2013 was last year's highest sales for Resource Industries, and it came down from there. That's making it a particularly tough sales comparison for us Q1 to Q1. For Resource Industries, order rates for new equipment have remained weak in the first quarter and substantially below the peaks of 2012. That's the bad news. The good news is that we were close to an equilibrium with order rates and sales in the first quarter, and as a result, the order backlog for Resource Industries was fairly close to being flat with year-end 2013. In summary on sales, Construction Industries up, Energy and Transportation up, and Resource Industries down quite a bit. Sales overall, as a result, flat. But while sales were flat, profit was up. In general, it was a pretty good story across each of our three large segments, and I think because of that, it makes sense to talk about profit this quarter by segment. I'll start with Construction Industries, which had a great quarter with operating profit up $460 million on a sales increase of $845 million. I think there are three things to cover with Construction Industries. One, you have to go back to last year. Think about the first quarter of last year. Our sales and production were relatively low. Partly that's because we and our dealers started 2013 with probably too much inventory. In the first quarter of last year, most of the factories that we have that make construction equipment were at least partially idled. This year, we were producing more, and with our factories producing more, we were doing it more efficiently. Related to that, inventory reductions from last year resulted in negative inventory absorption impacts on profit. This year, that was much, much less. Second thing about Construction Industries' profit, we've continued to focus on managing costs, and we were able to hold our period costs. Those are costs that are relatively fixed. We've held them flat with last year despite a pretty significant increase in production volume. The third thing about construction profit is currency. Currency impacts versus a year ago were positive for us and mostly related to the yen. Remember, we are a net yen exporter. We're a Japanese manufacturer. All in all, profit for Construction Industries in the first quarter was the best since the second quarter of 2012. Okay, let's move on to Energy and Transportation, which had another good quarter, with operating profit rising $236 million on a sales increase of $371 million. That resulted in operating profit as a percent of sales being up from the first quarter of last year. The increase in our profit dollars was primarily due to higher sales volume, lower manufacturing costs, and price realization for Energy and Transportation was slightly favorable. When you think about Energy and Transportation and profit over the course of 2013, it's probably worth noting that the first quarter last year was the weakest profit quarter of 2013, and Energy and Transportation margins improved over the last three quarters of the year. The operating margin rate in the first quarter of 2014, this quarter, was reasonably in line with the last three quarters of 2013. Thankfully, it's a diverse business. It's been a consistent performer over the past year, and that includes this quarter. Let's turn to our Resource Industries. Operating profit for Resource Industries, again, that's predominantly mining, was down substantially versus the first quarter. Operating profit declined $310 million on a sales decline of $1.2 billion. That's the bad news. The good news is the decremental margin rate, that's the change in margin divided by the change in sales, was a mere 25%. That's a demonstration in our view of good cost management in a business with very variable margin rates that are much higher than 25%. Resource Industries has made substantial progress on reducing costs as demand has declined. Operating margin as a percent of sales is now mid-single digits, but for a capital-intensive business where demand has been hit this hard, we think that's pretty good performance. It's a business where sales of its most significant product, mining trucks, are expected to be down this year about 80% from the peak year of 2012. To be even profitable in an environment like this demonstrates the success they've had in managing costs. Okay, that's operating profit. Let's turn to the outlook for 2014. In our year-end financial release, from January, we provided an outlook for 2014 sales and profit. We said we expected sales and revenues to be similar to 2013 at about $56 billion, and we put that in the range of plus or minus 5%. We said then that there were encouraging signs in the world economy, and that we were expecting sales improvements in Construction Industries and Energy and Transportation. That's still the case. Our outlook in January expected Construction and Energy and Transportation to be up about 5%, and that's still the case for Energy and Transportation. However, we increased our view of construction from up 5% to up 10%. However, in our original outlook, we expected sales to be down in our Resource Industries segment by about 10%. In this outlook, we've reduced that forecast and now expect it to be down about 20% from 2013. Despite the prospects for a better year in the world economy and continued strong production at mines, mining orders for new equipment haven't really improved and remain at pretty low levels. Order rates are a fraction of where they were in 2011 and during the first half of 2012 and are substantially below where we believe the long-term sustainable level is. Our outlook from January expected mining orders for 2014 to remain low but be modestly better than the second half of 2013. So far this year, that hasn't happened, and based on where we are today, even if we started to see some improvement in orders, it likely wouldn't be soon enough to have much impact on 2014. That's why we lowered the Resource Industries outlook today. That's the bad news. The good news is new mining equipment sales in our outlook are low enough that we believe the downside risk for 2014, in our outlook related to Resource Industries, is reasonably limited. That doesn't mean that it couldn't go down further. It just means that the sales of new equipment for mining are so low in the outlook that even if there's no improvement in order rates at all, the downside in the scheme of things is limited. Overall, our outlook for sales and revenues remains $56 billion in a range of ±5%. There's certainly potential it could be higher than $56 billion if economic activity around the world accelerates or if mining orders increase meaningfully in the short term. But there's also plenty of downside risk that could cause it to be below $56 billion. A couple of examples include geopolitical. While we're hopeful that the situation in Russia and the Ukraine will be resolved, if it does get worse and has an impact on business confidence, world trade, and world growth, it could certainly be a negative for us. We're closely watching growth rates in China. We had a good first quarter in China. In fact, company sales were up 30%. But we're concerned that if economic growth in China slows enough, it could have an impact on our business. Those are two good reasons why we have a 5% plus/minus range around our $56 billion sales outlook. In terms of the profit outlook, on the strength of our great first quarter results, we raised our full-year operating profit by $0.25 a share. Excluding restructuring costs, our profit outlook moved from $5.85 to $6.10. With restructuring charges or costs, it moved from $5.30 to $5.55 a share. Our overall expectations for restructuring costs in 2014 remains at about $400 million to $500 million, with a midpoint impact on profit per share of about $0.17. To help you think about the rest of the year, there's one more thing I'd like to cover in the outlook, and that's how we think the rest of the year could shake out by quarter. Of the three remaining quarters of 2014, of course, that's Q2, Q3, Q4, we would expect of those three, the fourth quarter will be the highest for sales and profit. We think the third quarter will likely be the weakest. The second quarter will be slightly below the average of Q2, three and four in terms of sales and profit. I hope that helps you calibrate your expectations for 2014. One last point before we move to the Q&A. We had a good quarter for operating cash flow. We were up from $1.1 billion in the first quarter of last year to $1.9 billion in the first quarter of this year. Our balance sheet remains strong with a debt to capital ratio for Machinery, Energy and Transportation of near 30%. During the first quarter, we repurchased approximately $1.7 billion of stock. Over the last four quarters, we've repurchased about $3.7 billion. in January, the board authorized a new five-year program to repurchase an additional $10 billion in stock. While we've not announced additional repurchase for this year, as we move through 2014, we'll certainly continue to review our options for cash deployment. That's a rundown of the quarter and the outlook. With that, we're ready to move on to 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 touchtone phone now. Pressing 1 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 pull for questions. Our first question today is coming from Ted Grace. Please announce your affiliation and pose your question. It's Susquehanna. Hey, guys. Congratulations on the quarter. Thank you. I was hoping, Mike, maybe you could walk through, specific to Construction Industries, how production kind of progressed through 1Q and how you would encourage us to think about production in Construction Industries in the second quarter. I realize you gave that quarterly guidance, and that in itself is helpful on a consolidated basis. But could you maybe just help us understand how production and cost absorption worked through 1Q and how you would encourage us to think about 2Q? Yeah. We actually stretched it a little farther than we normally do on guidance for the rest of the year. I'm going to be a little hesitant on breaking it out even further. But what I can tell you is this, if you just think about how it's changed over the course of the past year. As we came into 2013, a year ago, we were cutting our inventory, our PDC finished inventory, and dealers would normally add inventory in the first quarter, and they didn't do that. So our production a year ago was pretty low for construction. And if you look at the first quarter of this year, dealers built inventory as is kind of the normal pattern. And as a result of that, and us not making as substantial reductions to PDC inventory, our production went up a lot. Our production was up more in the first quarter than sales. I think if you look forward for the rest of the year, you can kind of do the math on this a little bit, based on us saying sales up 10% for construction over the course of the year. Now, the rest of the year for Construction Industries sales will be probably not massively different than the first quarter. So probably not wide variations in production, because the sales numbers, the first quarter was not far off of a fourth of the year. Okay. That's helpful. The second thing I was hoping to ask is on the restructuring side, just an update on where things stand in Europe, specific to Belgium. And in the press release, it seemed like that you may have cited more potential restructuring benefits in the year. I was wondering if you could just elaborate on that. We certainly weren't trying to signal more restructuring benefits in the year. I think Gosselies restructuring is coming along about as we expected. We got approval in the first quarter from the local officials. I was expecting maybe a question on why the entire $300 million that we were expecting for the year wasn't in the first quarter, and that's because we'll be recognizing the expense related to that as we get specifics on the individuals that have accepted the offer. That'll probably come in through the course of the year. I would say if you look at all the restructuring activity that we have done over the course of the past year, one of the places you can see it is actually in employment. If you think about this, our sales in the first quarter of this year were about the same as the first quarter of last year. If you look at the employment schedule in our quarterly release today on flat sales, our employment levels are down I think 8,000 to 9,000 people. I think that's where you can see the impact of not just lower volume, but also some of the restructuring activities we've taken. Okay. That's really helpful. Best of luck this quarter, guys. Thank you. Thank you. Our next question today is coming from Steven Volkmann. Please announce your affiliation, then pose your question. Hi, good morning. It's Jefferies. I had a question about the revision in your outlook. I guess I'm wondering maybe two parts on the construction business. What and where are you seeing the improvement that gives you the visibility on the 5% improvement on the top line that you talked about, Mike? On the Resource Industries side, I'm curious, you talked about the OE being pretty limited at this point. Can you just discuss a little bit about what you're seeing on the aftermarket side and whether that's still declining? It sounds like it is, but what's the outlook there? A couple of things. One, with Construction Industries, I think the one geographic area that I would say has had the most upside for us is actually North America. You can kind of see that, I think, in the retail statistics that we've provided. It's doing pretty good. I'd say North America is the reason for the upside. On Resource Industries, your comment is specifically aftermarket. In our release today, we did say that versus the first quarter of last year, within Resource Industries, parts sales were lower than a year ago, and that's true. They came down over the course of last year. If you look at parts sales within Resource Industries over the last few quarters, it's been stable. It's not down like it was from Q1. It fell during last year. It's held pretty stable over the last couple of quarters, and we're hopeful at some point in time here, it'll start to pick up. It seems like it should. Okay, and then just a quick follow-up. I guess pricing in both of those segments was a little bit weak, a little bit negative. Should we worry about that? What's the outlook there? We're not really expecting much sale or much price at all this year. When we came into the year, we said, I think less than half a percent, if memory serves me, which is, in the scheme of things for us, pretty small. I think that, if you look at the four quarters of last year, actually pricing levels were probably, in those businesses, a little better in the first quarter than they were for the rest of the year. So it was a little bit of a tougher comp for us. There's certainly pricing pressure out in the marketplace, and that's why we're not expecting much for the year. But overall, our view on pricing, by and large, hasn't changed much from when we came into the year. Thank you very much. Thank you. Our next question today is coming from Eli Lustgarten. Please announce your affiliation, then pose your question. Longbow Research. Congratulations, guys. Thanks, Eli. Can we talk a little bit? When you talked about Construction Industries, in your commentary of the year, you basically said that the rest of the year volume levels will not be radically altered from the first quarter. Can you talk about the profitability of the sector for the rest of the year? You had a very impressive first quarter for lots of reasons. I assume you're expecting double-digit operating margin in the sector, but not quite up to the first quarter level. Is that a fair representation of what to expect the rest of the year? Yeah, Eli, this is Brad Halverson. It's a good question. One, I would say that we're extremely happy with the profitability of the Construction Industries. We had an operating margin of around 5%, kind of in our core product line. If you look back a year, we finished the fourth quarter at 9.9%. We like this business to be double digits. We did have good mix. Some positive things happened in the first quarter. They gave us a record return for the construction business at 13.6. I would say an expectation for the rest of the year, slightly above a double-digit number would be a good estimate, and we think that's good profitability for where this business is at right now. Yeah, Eli, it's Doug Oberhelman here. I would just add a comment on the pull-through objectives we've had going back a number of years of 25% on the additional dollar of revenue. While we did much better than that in Construction Industries and Energy and Transportation this quarter, I would expect that over time, 25% is our objective. We'll have some quarters that are juicy like this one and maybe some that aren't so juicy, I guess. Overall, we're after that. As Mike said in his comments, even our Resource Industries business on the way down held with 25%. I'm pretty happy with that. I'd steer it that way as an answer to your question. If it comes up better than that, great, but there'll be quarters where we'll be talking about the other side of that. Yeah. Along the same lines, when you look at Energy and Transportation, with the first quarter volume up 8% and the year up 5%, we're talking maybe slower top-line growth. I assume that we're expecting better product mix for the rest of the year that will enhance the profitability to match last year's numbers. Is that sort of the expectation that we should look at in that sector? Yeah, Eli, that segment serves a bunch of different industries that have, let's say, sort of different profitability characteristics. In any quarter that you get into, you're subject to a little up and down on margin. Based on whether the increase is oil and gas or industrial engines. They have a different margin profile. If you look at what Energy and Transportation has done over the last four quarters, the margin rate has been within a relatively tight band, and I don't think our view for the rest of the year would have it being dramatically at one side or the other of that. It's been a consistent performer, and I think our view of the rest of the year is that it'll continue to be a consistent performer. Yeah. One final question. Can we talk a bit of what we should expect out of the Financial Products company this year, given the changes in the first quarter? Yeah, Eli, this is Brad Halverson. The Financial Products division, I think, is continuing to perform very well. Their profit was down compared to the first quarter of last year. But in the first quarter of 2013, we had a positive adjustment due to improved warranty, improved quality, and we have a Cat Insurance business in Cat Financial. So we had, I think it was roughly $40 million positive adjustment in the first quarter. So their results quarter-over-quarter are slightly up. Their portfolio is growing slightly. Their past dues at the end of the first quarter were, I think, their record in the last 10 years or so. Their portfolio is performing well. I think you can expect similar to Energy and Transportation, pretty good stable performance out of them the rest of the year. All right. Thank you very much. Thanks, Eli. 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. I'm just trying to reconcile the comment about Construction Industries on the aftermarket sales being flattish in the quarter. If demand is really improving, wouldn't you expect to see an increase in aftermarket sales for the construction business? I think aftermarket for the construction business, for any business, is usually related to activity. It was pretty flat for the first quarter versus a year ago. Aftermarket is not quite as, I don't know, maybe relative to the total, as significant as it might be in industries like mining. As activity goes up, as construction spending goes up, as housing starts to go up, you would think that would as well. Might have something to do a little bit, Seth, with a particularly bad winter. That might have put a little damper on actually work being done. Other than that, I don't know of any big reasons why it should be off that pattern. Okay, Tom, thanks. I guess a similar question on the Resource Industries business. Are customers still idling equipment or bleeding off of parts inventory? Because we are starting to get the sense that some commodity production volumes are rising, like U.S. coal. Can you give us a sense for where you think your customers stand on their parts inventory levels and how soon you think we could see a pickup in that business? I don't know about the inventory levels, but again, if you look sequentially at what's gone on over the last three months, it's not continued to go down. It's remained pretty stable over the last three quarters, actually. I think as activity goes up, we would fully expect parts sales to go up. There's a pretty strong relationship. Customers can only put off maintenance or cannibalize idle equipment or idle the oldest equipment for so long before that begins to catch up with you and the dynamics of a business that's pretty tough on equipment starts to come through. So, I think at some point here, we would think that it would pick up. Okay. Do you get the sense that the idling is still occurring then? Yeah, I think there's definitely still some parked fleets. It's not the same everywhere in the world, but yeah. I won't quote a number, but yeah, there's definitely still parked fleets. Okay. Thank you very much. Thank you. Our next question today is coming from Jerry Revich. Please announce your affiliation and pose your question. Good morning. It is Goldman Sachs. Morning, Jerry. Mike, you had nearly a 10% SG&A and R&D reduction on flat sales this quarter. Can you talk about, is there something in the comparable period, or is that consistent with your expectations for the year? The restructuring actions and resources on the manufacturing side came over the course of last year, and I am just wondering how far along in harvesting those savings are we at the first quarter compared to the ultimate run rate? Jerry, this is Mike. I will start this. We had a very good first quarter. Costs were lower than a year ago. I think we also were very cautious coming into the year. We purposefully tried to slow down. Even what we have in the hopper for program spending over the course of the year, we tried as much as we could to be very cautious on spending, even what we had planned to do for the first quarter. I think that has helped. As some of those programs that we want to do because they are the right thing for the long term, but we have been cautious on in the first quarter, I think there will be some increase in spending over the remainder of the year for programs like that. That's why if you look at the profitability in our outlook for the next 3 quarters, that's one of the reasons why it's down a little bit relative to Q1. I'll go back to a comment that I made earlier. This is actually a total company question. We've taken a lot of costs out since the first quarter of last year. I think if you look at the employment numbers, and particularly because this quarter was a quarter that had almost dead flat sales, I think it really brings home the magnitude of the actions that we've taken to adjust the cost base to the current volume situation. I might add, this is Brad Halverson. We're really happy with the quality of our earnings. We're focused on the business model. We're growing share, little price, and we're really focused on lean deployments across the enterprise, both in our factories and in the office. We had increased short-term incentive pay expense in the first quarter, which we're happy about, going to our employees based on our performance, of roughly $140 million. So we had roughly $500 million of period cost reduction for us. With a mining business that's contributing just a little over $100 million, that used to contribute $1 billion, that will come back where our cost structure is. We're going to continue to focus on this, but we're happy with where we're at. Sure. Thank you. Can you talk about what you're seeing in Western Europe for Construction Industries and Energy and Transportation? I know you're concerned about Eastern Europe, but it sounds like cement volumes are finally starting to pick up and maybe operating hours are starting to improve. I'm wondering if you'd just touch on if you're seeing a pickup in demand off of low levels in Western Europe across your businesses. Well, I was just looking at the construction numbers this morning, and if you look at our first quarter, actually Construction Industries in Europe was positive. It wasn't negative. I think it's not as robust as what we're seeing in North America, but I think it's probably a little bit of a case where the economic situation there doesn't seem quite so dire. I think the environment for customers to do some machine replacements is probably a little bit better. We're seeing some positive in our construction numbers in Europe in general. Okay. Thank you. Thank you. Our next question today is coming from Steven Fisher. Please announce your affiliation and pose your question. Great, thanks. Good morning. It's UBS. Morning, Steve. Just trying to get a sense of the growth rate of the segments that you moved to the All Other category as it compares to the core mining business. If you didn't do the reclass, would mining still have been down 20% or for the year would have been more or less than that? Because I guess if the stuff you moved into All Other is not quite as bad, then the reduction in guidance might not be as severe. What we moved last year, for the full year anyway, it was $1.5 billion. It's the kind of product that would, in most cases, more closely follow Construction Industries, paving, for example. Forestry has a relationship, say, with housing construction. So it would've been a year-over-year, at least year-over-year, first quarter to first quarter, it would've been a little bit positive. So it's a different profile than mining. Honestly, I haven't looked at that level of detail in the outlook, but it wouldn't surprise me what you say is, to some small degree, true. The difference, though, is that it's a smaller portion. It was a relatively small portion of Resource Industries, so I don't think the impact would've been that on the percent change, the 10% to 20%. I don't think it would've been massively significant to that. But it certainly wouldn't have been down 20%. It would've been likely up. Okay. Then to get to that -20% from -37% in Q1 in Resource Industries, are you assuming any year-over-year growth at all, or just kind of significant moderations in the declines? When you say year-over-year growth, explain a little bit more, Steve. No, just because you have to do better than the minus 37% in the balance sheet. Oh, yes. Sorry about that. to get to minus 20. Is that just a rate that is well below the 20, or could you actually see something that is up year-over-year? Yeah, I think as we go through the year, you'll see that gap narrow. I probably wouldn't want to be as so specific as to say at fourth quarter it's up or down. But if you just think about the trajectory of last year, it started out stronger. There were orders that were being produced and shipped, and sales were higher. It declined as you went through the year. I think the fourth quarter, if memory serves me right, for Resource Industries was about 20% below the first quarter. I think if we get any kind of a modest improvement going through this year, it'll narrow that gap. So I would think that year-over-year gap would come down probably in every quarter. Okay, great. Thank you. Thank you. Our next question today is coming from Andrew Casey. Please announce your affiliation, then pose your question. Good morning. Wells Fargo. Morning, Andy. I just wanted to go back to the profitability for the rest of 2014 and make sure I understand the puts and takes. Should I think about the slower margin improvement relative to what you posted in Q1 as driven really by three things, more difficult Energy and Transportation comps, fairly good-sized headwind from higher incentive comp, and then fading headcount benefit? Are those the three main things? No, I don't think so. I don't think Energy and Transportation is going to be materially different probably than the first quarter. What we're thinking about here, Andy, is the last nine months of the year versus the first quarter. I think the way to think about it is we usually have seasonally low costs in the first quarter. We would approve programs that our units can spend money on during the year, but it usually takes a little time for that to ramp up. So the first quarter is usually light on cost, fourth quarter is usually a little heavy. So we would see program-related costs going up. Incentive comp that you mentioned is up year-over-year, but we have that in the first quarter, too. So there's no difference really between the first quarter and the rest of the year for that. Okay. Depreciation usually kind of ramps up as we go through the year. As we put capital in place, it goes up. We have things like our annual merit plan is effective April 1, so we get a bit of a bump up in labor costs usually from Q2 on. I think another point, and Brad mentioned this earlier, and that's margins in Construction Industries. I think relative to the first quarter, Construction Industries mix is going to probably get a little bit worse. More of the rest of the year, we would have smaller product. We expect some rental loading to occur kind of over the course of the year, more than we had in the first quarter. First quarter was a little more excavation-focused, particularly in China. So probably a little bit of a declining mix in construction as we go through the year. For Resource Industries, there are programs that we cut last year, things that we really want to do for the long term. Engineering around getting our components in what was Bucyrus product, getting all the hundreds of thousands of part numbers into our systems for aftermarket. That all requires some spending. We delayed it last year, and as we go through the course of this year, those are programs that we want to spend money on. They are the right thing to do for the long term. The rest of our business is pretty stable, and we kind of need to get to it. I think those are the kinds of things that cause profit over the course of the last 3 months of the year to be maybe a bit below the first quarter. Okay. Thanks for that, Mike. If we go back, thanks for the clarity, but it makes me a little more cloudy in my thinking about how to get to the Q4 being the highest of the last 3 quarters. I am wondering if there is any- No. The fourth quarter for us usually is a big sales quarter. It is usually right up there with, sometimes the second quarter can be higher than it, but, in general, the fourth quarter is usually seasonally a pretty high quarter. The third quarter and the first quarter are usually the weakest. So of the last 3, the third quarter would be the weakest. We think, the second quarter is probably close to, but a little bit below the average of the 3. We do not really have anything unique, any big strange expenses. When I talk about these numbers, by the way, I am excluding restructuring costs, because the timing of that could have a different effect. Of course, that is why we pulled it out. No, we do not have anything that off the top of my head that I can think of that is going to be odd about any quarter. It might turn out to be that way, but certainly we are not planning it that way. Okay, thanks. I will follow up offline. Thank you. Our next question today is coming from Ann Duignan. Please announce your affiliation, then pose your question. Hi, J.P. Morgan. Actually, my first question is for Doug, if he is still in the room. Doug, it was interesting to me that you mentioned Ukraine, Russia, and also China as potentially headwinds, but you did not mention Latin America, and in particular, Brazil. Are you not concerned about the macro environment in Brazil, or is that something you have been planning for all year, and so incrementally it is not getting any worse than you might have anticipated? I would put Brazil macroeconomics as one or a macro situation as one of those we would be watching. I would not put it in the same category as the others that I talked about, China, Ukraine, and maybe a couple of others in the Middle East at all. We have got a pretty stable business across Latin America. Brazil has got some projects that are coming in that will be doing some things around infrastructure this year, next year, and the year after that ought to help that. But the overall macro situation there is one to watch, frankly. Okay, that's helpful, the color. Can one of you talk about where Tier 4 pricing shows up in your numbers? Is that in the pricing bucket or is that not included because it's separate pricing? Just trying to get a sense of net pricing, or are you giving away the Tier 4 costs and is that impacting margins or are Tier 4 prices being passed through but not incorporated into pricing? If you could just give us some color on what's going on with Tier 4 pricing and whether you're actually giving pricing. Yeah. It's not included in our price realization bucket in our waterfall chart in the release. That's because the content is different. If you're going to add, for example, say, after-treatment, and you're going to raise the price for that, there are two ways that you could deal with that. You could say, "Hey, I have a price increase and I have a cost increase." We think that distorts what's really going on. The content of the machine is changing. It's a different machine. The way we deal with it is we net the content cost changes with the specific, in this case, Tier 4 related price changes. We would just show the net of the two in the price realization number. I think as a generic comment, I would say we're not giving away Tier 4. I think it's been a pretty successful introduction. The price increases that have gone in for Tier 4 generically were meant to cover the additional costs and a reasonable margin, and I think by and large that's happening. Okay. In the interest of time, I'll get back in queue to keep my other questions. Thanks. Okay. Thank you. Our next question today is coming from Ross Gilardi. Please announce your affiliation, then pose your question. Good morning. Thank you. Bank of America. I just had a couple of questions. From your backlog commentary, it sounds like Power Systems backlog is up fairly sharply due to locomotives. In the rest of your other parts of your press release, you mentioned that well service activity is picking up. You do not sound worried about oil and gas CapEx, natural gas prices have rebounded. Why are you not raising your Power Systems outlook today? Well, a lot of those things we had in our original outlook. I think we were probably, maybe in January, what we were seeing in terms of quoting activity, deals in place with customers, our expectations have not really changed all that much as a result of this. So, I think we were reasonably positive on that sector all along. Got you, Mike. Could you comment a little bit more about recent order activity in oil and gas and maybe give some color on what your exposure is to subsea drilling, which seems to be sort of the weaker spot for a lot of your peers? Yeah. I guess I would be careful how I say this. For our oil and gas business, particularly for recips, order activity has been pretty strong it looks like. It looks like the well servicing is starting to pick back up a little bit, and that's a good thing. In terms of deep sea drilling, I would say in the scheme of our overall oil and gas business, that's pretty minor. Okay. Thanks very much. Thank you. Our next question today is coming from Mig Dobre. Please announce your affiliation, then pose your question. Yeah, good morning. Robert W. Baird & Company. If we can, guys, going back to Brazil in Construction, Latin American revenue was slightly down this quarter. Can you maybe talk a little bit about dealer inventory levels in Latin America? Maybe also your view on fundamental demand through the year, excluding this large government order that you got from Brazil? Yeah. Dealer inventory, I think most places in the world, with a few minor product exceptions, is in pretty good shape. Dealers worked on adjusting dealer inventory to current demands really over the past year and a half. I can't see any reason it looks out of line. Now, you might be able to get to a country or a dealer and maybe draw a different conclusion, but I think by overall and by region, it's not sort of out of whack with selling season. Your comment on demand in Brazil, it's a little bit hard to answer because if last year, related to these large orders that we had that Doug mentioned a minute ago, because we had them last year. This year, the amount that we're going to sell related to those big orders I think is going to be a bit less than last year. So far this year, Brazil has actually been reasonably good for us. Most of the other countries in Latin America have been down a little bit, but Brazil has kind of held up for us. I think this big order, these large orders that we're getting from the government, certainly help that. We've had them in both years, last year and this year. Okay. Thanks for the color there. Maybe a quick modeling question on the corporate expense line. There's a lot of moving pieces there with incentive comp, LIFO, legal settlements last year. Can you give us some maybe color or guidance as to how you expect this line item to move through the year? Yeah, that's a tough one because I think the big variable for that will be the timing of the restructuring costs. That's probably the biggest variable. Then, as you go forward, if there happens to be changes, if the outlook from here goes up or goes down, that can have an impact on some of the corporate incentive comp. Based on the outlook where it's at now, we would think that to be pretty stable. Probably the biggest variation going forward there is likely to be restructuring costs. Okay, thank you. Thank you. Our next question today is coming from Andrew Kaplowitz. Please announce your affiliation, then pose your question. It's Barclays. Nice quarter, guys. Thanks, Andy. Mike, your cash flow generation in the quarter was strong, as you said. Some of it was obviously net income growth, but can you talk about the increased focus it seems that you have on keeping working capital down or any other changes you've made to generate more cash? Is this level of cash sustainable, this pace sustainable going forward? How should we think about buybacks in subsequent quarters? I know you'll tell me you'll be opportunistic, but it seems like you've shifted your focus that way at least a little bit. Yeah, Andy, this is Brad Halverson. I can start. I think on the cash flow side, it's another positive story for us that we're extremely happy with. We finished the end of 2013, I think, with a debt to CapEx at 29.7. We did complete the buyback of the $1.7 billion, and we had some incentive pay expense. Even with all that, we're going to finish debt to CapEx at 30.2 at the end of the first quarter, with $5 billion in cash. We have been steadily working on our working capital management. We've made great progress, I think, in all areas. The one that I think remains the biggest opportunity for us would remain in the inventory turn area, where we talked about a little bit in ConExpo. If you look out a few years, we see still continued improvement there. Our cash flow situation is very good. Our priorities remain the same, and the credit rating today is in good shape with our position. We're continuing to fund growth and push for organic growth. We don't see anything big. Pension plan, well-funded. We only have $200 million of required contributions for the rest of the year. We will make our normal dividend decision in June to the board and announce that at that time. Our history of dividends will remain kind of consistent with our approach there. You're right, stock repurchase will be opportunistic. I can tell you what we will do is when we get to that decision time, we look out a couple of years, and we'll model a couple of years of trough and look at what our balance sheet strength would be. But at this point in time, Andy, yes, I would say we continue to be positive about our ability to generate cash out in the rest of the year and in the next 3-4 years, and we're in great shape. That's helpful, Brad. Then if I could ask you guys to step back and maybe talk about U.S. and European non-residential construction. We've heard a lot of mixed sort of feedback this quarter. I think a lot of people were positive at ConExpo. Your results look good, but maybe just commentary on how you see that market unfolding here this year and beyond. Sorry, I missed that question, Andy. I was saying something to Doug here. No worries. Just on U.S. and European non-res or commercial construction, a lot of mixed feedback we get on that topic. People were pretty positive on it at ConExpo. Your numbers look good, but maybe just commentary on the overall market. Yeah, it seems like you get mixed messages almost every day on housing. One day it's prices are up, and it's a hot market. Then, the day after that, you get sales of existing homes down. But if you look at the fine print of that, it's because one of the comments is there's not enough supply. So I think our view of housing is that it'll continue, particularly for starts, kind of continue to get better. We think this year is going to be over 1 million. So I think we're pretty constructive on, at least for the U.S., housing. But again, you got to put that in perspective. It's still way below where it was six years ago, seven years ago. So getting better, but not great. Europe has been. I don't think I can give you a separate comment on res versus non-res there, but it has been steady positive for us over the course of the quarter. Whether that'll keep up, I think, depends a lot on kind of confidence there and kind of is this economic growth starting to get a little bit better? Does it continue? Because one thing you got to remember about our business, and that is most of what we sell at any given quarter is to replace something that's worn out. And what customers are, certainly at this point in those markets, it's not about increasing the capacity of the installed base. It's about replacing things that need to be replaced. And what you need is business confidence, reasonable results for construction activity, interest rates that are supportive. And we kind of have those things. I'd say we remain reasonably constructive on construction for the developed world. And you're right, the numbers for the first quarter kind of panned that out. Thanks, Mike. Okay. I think we have time. We're a little over, but we'll take one more question, and then we'll wrap up. Thank you. Our final question today is coming from David Raso. Please announce your affiliation, then pose your question. ISI, thanks for getting me in. Just trying to figure out the EPS progression the rest of the year. It seems like you're implying second quarter EPS is below 1Q, and really, it's only happened once in the last 20 years, and that's the quarter when you were trying to absorb Bucyrus initially. So I'm just trying to figure out, are you being conservative? Or maybe I need to figure out more about the sales mix health in the first quarter for Construction so I can more understand why the margins need to come down in Construction. Or do you feel the Resource Industries margins have bottomed yet? So I'm just not understanding why we're down sequentially in 2Q. Yeah, I think a couple of things. One, even in Resource Industries, it's our intention to increase spending on programs that we really need to do for the long term, and I kind of talked about those a little bit. So I think if you look at our level of spending on programs in the first quarter, it was extraordinary. It's usually seasonally light, and it was probably even more so in the first quarter this year. We had a rough year last year, and I tell you, we came into the year, with the management team, with a lot of caution. We were purposely trying to push as much of the program spending out that we had allowed in the plan and was in our outlook, beyond the first quarter. We wanted to get part of the year under our belt to see how it was actually going to turn out before we started up some of the programs. So we have been cautious with the management team early on the timing of expense for this year. So I think we benefited by that in the first quarter, and we'll see some cost increase for things, again, that we need to do, that will come later in the year. For Construction, I think there will be some margin decline. The first quarter was heavier on excavation and earthmoving. The rest of the year proportionately will be a bit more of the smaller BCP product. I think we expect some more rental loading as we go through the year, and that'll be a little bit negative to mix. So we think that'll be the case as well. It would be great if it was better than that. We would certainly like that, but I think our outlook for the year is kind of our reasonable and prudent view today of how it looks. All right. In interest of time, I appreciate it, but that is it for me. Thanks. Thanks, David. Okay. Thank you, everyone. With that, we are a couple minutes over. Thanks for sticking with us. 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.