Good morning, ladies and gentlemen, and welcome to the Caterpillar First 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 first quarter 2012 earnings call. I'm Mike DeWalt, the Director of Investor Relations, and I'm very pleased to have our Chairman and CEO, Doug Oberhelman, and Group President and CFO, Ed Rapp, with me on the call today. Today's call is copyrighted by Caterpillar Inc., and any use, recording, or transmission of any portion of the call without our express written consent is strictly prohibited. Section of our Cat's webcast. This morning, we'll be discussing forward-looking information that involves risks and certain forward-looking information. A discussion of some of those factors that either individually or in the aggregate, we believe could make actual results differ materially from our projections.
Well, that can be found in our cautionary statements under Item 1A, Risk Factors, of our Form 10-K filed with the SEC on February 21st, 2012, and in our forward-looking statements measures can be found in our financial release, and that'll be posted on our website at caterpillar.com as well. Okay, to report our first quarter 2012 financial results, kicking off the year with the highest profit of any quarter in history. Sales and revenues were $16 billion, an increase of 23% from the first quarter of 2011. Excluding acquisitions of Bucyrus and MWM, which we didn't own a year ago in the first quarter, excluding them, sales and revenues were up about 15%. Again, profit in the quarter was $2.37, the highest in history and up 29% from the first quarter a year ago.
In addition to the record-breaking profit, this morning, we announced an increase to our 2012 profit outlook. This morning, I'll start with a quick review of sales in our three large segments, Construction Industries, Resource Industries, and Power Systems. I'll start with Construction. That was up 13% compared with the first quarter of last year. The increase was organic. Construction Industries did not have acquisitions that impacted the quarter. While total construction sales were up 13%, the picture was mixed geographically. We had good growth in North America at 36%. The Europe, Africa, Middle East region was up 11%, and that's despite Europe's economic troubles. Asia Pacific was about flat, and Latin America was down 2%. I think you can sum up Construction Industries in just a few bullets. First, the North American increase is primarily being driven by strong replacement buying after several years of weak sales.
Europe is holding up, with customer replacement being a factor like in North America. Business was stronger in Africa, the Middle East, and CIS. Sales in the Asia Pacific region were about flat for Construction Industries. China was down significantly, but the decline was offset by increases in the other countries of the region. China has been a highly topical subject over the past few months, and in a few minutes, that is before we start the Q&A, I will summarize more about what is happening to Caterpillar in China. Moving on to Construction Industries in Latin America, the 2% decline was more than all in Brazil. That decline in Brazil was almost offset by gains in the other countries in Latin America. While Brazil has weakened over the past six months or so, we have started to see the beginning of improvement there. That is Construction Industries.
Let us move on to Resource Industries, which is largely mining. Mining has been a great business. Resource Industries sales were up 73% in the quarter. The increase was evenly split between the acquisition of Bucyrus and organic growth. The addition of Bucyrus added a little more than 36% to Resource Industries and organic growth in the rest of the business also added a little over 36%. In short, sales were up substantially in the quarter. Orders were up and lead times for large mining trucks remained extended, with most models being quoted into 2014. In addition, our Resource Industries order backlog increased during the quarter for both legacy Cat products and new Bucyrus machines. While mining remains robust overall, U.S. coal production is an area that has recently weakened. Over the past few months, we have also been asked about the impact of U.S. coal on our business.
The answer is, it has had some impact, but not much overall. To put it in perspective in terms of size, for dealer sales of our non-Bucyrus mining products, U.S. coal represents less than 10% of total mining in 2011. In terms of Cat machines overall, this is our total machines, including construction, it was about 2% of the total. As a percent of our total business, it was less than that. For Bucyrus product, the U.S. coal impact we are seeing is largely related to a portion of the underground business. That said, the overall impact on Bucyrus sales is not expected to be very significant, and we have not changed our 2012 outlook for sales and revenues for the two acquisitions of Bucyrus and MWM. So for U.S. coal, we have seen some weakening, but in the context of worldwide mining, it is not much.
In summary, global mining demand remains robust, and indications from our customers tell us that strong demand will continue. Again, our Resource Industries backlog continued to grow. Now on to Power Systems, and that is engines, turbines, and rail. Sales were up 12% in the quarter from a year ago. About 9% of that was organic growth, and about 3% was from the acquisition of MWM. Growth was primarily in two areas, our rail business and engines for petroleum applications. Rail is doing very well. We have a growing order backlog, and our rail group has done a great job of ramping up locomotive production. Power Systems sales for petroleum applications continue to increase. Although there has been some shift from dry gas to oil and wet gas, overall activity in our order book looks strong.
Sales of industrial and machine engines were about flat with the first quarter of last year but electric power is a little bit of a different story. While we don't expect much growth for the full year, we do not expect it to be negative. The first quarter, however, was, and that's mostly because we had a very tough comparable quarter with 2011's first quarter, particularly in North America, where sales more than doubled last year. Sales were up so much last year, and that was mostly higher horsepower products ahead of the introduction, to meet Tier four emissions requirements in the U.S. Recently, engine orders for electric power have been improving, and we do expect the full year to be up slightly from 2011. Okay, that was sales and revenues. Again, up 23% from the first quarter a year ago.
In terms of profit, it was also a great quarter. Again, $2.37 was our best quarter ever. Operating margin in the quarter was also good at 14.5%, one of the best quarters we've ever had. It would have been over 15%, excluding the impact of our Bucyrus and MWM acquisitions. Our incremental operating profit was 23% of incremental sales, excluding acquisitions. Very good results coming off a tough comparison with the first quarter of last year. That said, we did have $38 million of expense in the quarter related to the closing of our London, Ontario, locomotive assembly facility and $31 million of expense related to the sale of Bucyrus distribution businesses to Cat dealers. Now, before covering the 2012 outlook, I think now is a good time to talk a little more about China.
Both the economy and the machine industry in China have been common themes over the past quarter. I'll take a minute and run through what are likely your concerns. First, how is the decline in China's Construction Industries equipment industry impacting our sales? The answer is, China sales were down between $250 million and $300 million in the first quarter compared with the first quarter of 2011, mostly related to excavators. To put China's size in perspective, sales are a little over 10% of our total Asia-Pacific region and around 3% of total Cat. Second question is: How has machine pricing held up? The answer is, it's been relatively flat. Not much change versus a year ago. That said, there is too much finished goods inventory in China on the ground today, both ours and our competitors'.
Pricing in China has been largely rational, and we haven't changed our total company 2012 price realization outlook. Speaking of too much inventory on the ground in China, that's why this year we're going to divert some of the excavators that we make in China to other regions of the world where we're very tight on supply. We'll export probably around 20% of China's 2012 mid-size excavator production this year. The third question: What are our expectations for sales in China for the full year of 2012? The answer is, we have taken our forecast down, and we expect the full year will be modestly negative versus 2011, with a decline coming mostly in the first half of the year. That doesn't mean that we're banking on a major increase in the second half.
It's mostly because excavator sales were already declining in the second half of 2011. While we do expect the Construction Industries to improve moving forward, there's too much inventory in the channel, and it does need to be sold down in 2012. Fourth question: How has China's slowdown in overall economic activity impacted our global mining business? The answer is, global mining has remained very strong. Our worldwide order backlog for mining continued to increase in the first quarter. Remember, slower growth in China does not mean their economy is shrinking. In fact, it's growing faster than most of the world. Our forecast is for economic growth in China this year of over 8%, and that's driving continued growth in energy needs and consumption of most commodities.
As a result, most commodity prices remain high by historic standards, and mining companies are in generally good shape and continuing to invest. Question five: Has the recent weakness in China construction equipment changed your capacity expansion plans? The answer is no, but with a caveat. We continue to be a strong believer that China is a major long-term growth opportunity. It's a very large economy with significant development and growth still ahead. It's the world's largest market for construction equipment, and we intend to be the leader. So in that context, no, our build-out in China is continuing. The caveat is that our excavator expansion is staged, and we can adjust the timing of capacity additions if we need to. So in summary, is China down in 2012? Yes. Will it recover? In our opinion, absolutely. The long-term future for China looks very good.
Do we need to be prepared for the next round of growth? You bet we do. Okay, that's enough about China. A word on the full-year outlook for 2012, and then we'll move on to the Q&A. This morning, we held our sales outlook in a range of $68 billion-$72 billion for 2012 sales and revenues. While the headline numbers for sales and revenues were unchanged, below that top level, there have been a few changes. We've lowered our full-year estimates for China and Brazil, as we've previously discussed. While we do expect some improvement later in the year, the full year for both countries will likely be lower than we previously expected. Now, we are encouraged by actions that both governments have already taken. So far, China has made two cuts in bank reserve requirements, 50 basis points in December and another 50 in February.
We've also seen articles in the Chinese press that expect the government to begin increasing spending on infrastructure. Based on the long-term needs there, that makes good sense. In Brazil, the government has been more aggressive. After tightening from mid-2010 through August of 2011, the government has been easing since September. Since then, they've lowered interest rates by 350 basis points, eased lending restrictions, worked to recapitalize state-owned banks, and implemented tax incentives to spur growth. We have already begun to see the improvements in our business in Brazil. Now, while we've lowered 2012 expectations for China and Brazil, we've raised our forecast for sales in North America.
Demand in the first quarter was higher than expected, dealer rental fleet size is still well below the prior peak, fleets are still much older than historic averages, and rental utilization rates have risen to about where they were at the peak of the last cycle. In short, dealers will likely continue to refresh fleets and increase fleet sizes. The same thing is likely happening with end customers. We believe that much of the strength we're seeing in 2012 in North America is a result of customer replacement buying after several years of weak machine sales. In summary, lower sales than previously expected in China and Brazil, about offset by higher sales in North America. Outside of that, we haven't seen much change in the sales outlook.
In terms of profit, we raised the outlook at the middle of the sales range to $9.50 a share, and that's up from our previous outlook of $9.25. One last point before we move to the Q&A, and I think the point is an important one, and that's putting 2012 into perspective relative to the future. Here we are in 2012 with an outlook for sales and revenues of $68 billion-$72 billion and a profit outlook of $9.50 a share at the middle of that sales range. And it's a year where the U.S. economy is growing slowly. U.S. construction spending remains depressed. Europe is in or near recession, and China and Brazil have weakened. Looking beyond 2012, we continue to expect economic growth in the U.S. and improvement in construction fundamentals.
At some point, real residential and commercial construction activity will need to improve from today's depressed levels. And someday, probably after the upcoming elections, we'll get a longer-term highway infrastructure bill passed. In short, we're doing pretty well in the U.S. now, and with better construction fundamentals ahead, we expect to do better. We don't think that Europe will be this depressed forever. While they certainly need to make structural reforms, they can't cut their way out of the troubles they're in. They have to grow. And when that happens, it should be good for us. Brazil has already begun to ease to drive growth. They have major infrastructure development ahead of them. And looking forward, that'll be good for our business. In China, have they had slower growth over the past few quarters? Yeah, they have. Will they see solid growth going forward? We think so.
We believe in the long-term growth prospects there. Do they have infrastructure needs? You bet they do. Will we be coming off of a relatively low base for sales in 2012 in our industry in China? Yes, we will. Will continued growth in the world economy support an increasing need for coal, oil, gas, metals, and minerals? We think so. In short, we're expecting a record-breaking year in 2012, at a time when it looks to us like the world is setting up for further growth in the industries that are important to Cat. That's why we're so focused on improving efficiency and increasing capacity throughout much of the world. With that, we're done and 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 four a second time will remove you from the queue should your question be answered. Lastly, 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 Andrew Obin. Your line is live.
Good morning, guys.
Hey, Andrew.
Hi. Just a question on your guidance. As we look at sort of core operating leverage, and what I mean by core operating leverage, just incremental margin on volume alone, it has been well over 30% since 1Q 2011. If I look at your guidance for the remainder of the year, it implies that this core operating leverage will deteriorate into the second half of the year. Plus, as I look at your pricing guidance, first quarter obviously was also very nice ahead of expectations. Pricing sort of should turn pretty neutral by the end of fourth quarter. Is that an explicit expectation about something taking place inside Caterpillar in the second half of the year, or it is just conservatism?
Well, your definition of sort of core operating leverage, that's a new metric to me. What we've been tracking and what we've been reporting on is incremental operating margins. That was 23% in the quarter, again, excluding the acquisitions, which is the way we've laid it out.
Sure.
That's consistent with what we expect for the rest of the year. Our full year is somewhere around 25%. I don't think there's anything significantly different between the first and the second quarters in that regard. What I would say, though, is if you look at the first quarter, and we saw this a year ago as well, we do have some seasonality in our costs, and first quarter discretionary costs are usually a bit on the light side. We saw margins in the first quarter last year that were higher than the rest of the year, and that will likely be the case this year as well. But no, there's, I'd say, no deterioration in operating performance. We had 23% incrementals in the first quarter, and that's in the ballpark of what we expect for the rest of the year.
On pricing being stronger in Q1.
Yeah. We had that phenomenon last year as well. We expected a little more than 1% for the year. That's where we ended up. The first quarter was a little stronger than that. We're looking for 1%-1.5% this year. There's always impacts of geographic mix and product mix and which customers took what product that can bounce each quarter around a little bit. But fundamentally, the plan that we had for the year that said 1%-1.5% is still where we're at.
Can I have a follow-up question?
Sure.
On China, you commented that you expect China to be relatively weak in the first half and improve in the second half. I guess sequentially, that is how I read it. Could you comment on what you are seeing in China in April? I apologize for getting so granular, but obviously March is a huge seasonal month. What are you seeing on a sequential basis? Are you seeing any improvements in second quarter? Thank you.
Well, a couple of things. One, the comments were really directed year-over-year. You are right, the first from probably February through May are usually the big months in China. The point that we were trying to make is, whatever the impact year-over-year is going to be this year, most of it is probably going to be in the first half in China. It was up very significantly from the prior year. So, a pretty tough comp. Actually, March of this year, I think, was our fourth highest excavator month on record in China. It was the highest month since, I think, April of last year.
So, year-over-year, it is down, partly because last year was such a good year and a really tough comparable. The market there started to decline in the second half of last year. By the time that we get to the second half, year-over-year comparables, it almost cannot be as significant as it was in the first quarter. Even with that, I do not want to overblow that. I made a point in the sort of preamble to the Q&A here to kind of quantify the impact. China, it is not a huge part of our business.
I think sometimes people think that its significance to our machine sales in Construction Industries is a lot higher than it actually is. It was just a bit over 10% of our Asia Pacific region in the first quarter. It is a few percent of our sales overall. So I think sometimes it is an important market, particularly for the future. We have got a lot of growth opportunity focused there over the next five years. But in the context of total Cat machine sales in the short term, it is just not as significant, I think, as I think many people believe.
Thanks very much.
Mike, I want to add a few comments on China. Having just returned from there a couple of weeks ago, I spent q uite a bit of time in our factories with a lot of government officials and with many customers. Several things are going on. This is mid-April, let us call it, when I was there. Number one, the government last year did all they could to slow down inflation, and they really achieved that. That led to the second half slowdown that we are talking about here and that we have all seen.
The five-year plan revised growth down, as we have all seen as well, by arguably a half a point to a point. But those two actions and goals, in my mind, are extremely healthy. We were seeing a market that was too hot, boiling in our industry and many others, real estate, housing prices, and all the other things. China acted to curtail that, and they did. I think they did a very good job in getting that done and then resetting five-year goals for GDP growth. What we are seeing now in talking to customers is the blowback of that, which is higher inventory for all of us in our industry.
But everyone I talk to officials, to customers, to our plant people, everybody feel the mid to long-term forecast has not changed. So they are expecting this to recover fairly quickly. Nobody knows when it will be. Mike commented about our second half comps, which I agree with. But we will see an economy growing over there probably 7%-10% in the next few years versus what we had been seeing of 8%-15% over the last few years. I like those numbers. We are positioned for leadership there. That is what we have been trying to do, and that is where our capacity has taken us.
Finally, a lot of discussion there while I was there on a regime transition, not unlike here in this country. That, believe it or not, in China, brings some uncertainty and certainly not instability, but somewhat. That has, I think, influenced the overall market as well in a number of ways. As that sorts out the rest of the year, even though they know who the new regime will be, they are not in place, they will not be in place till later in the year. That cloud is out there. So several things, I think, conspired to make 2012 the year we are seeing, and I said this before, and you have all heard me. We were destined for a really bad ending a year ago. They slowed the economy down, they braked inflation, and I think we have a much more sustainable path well into the future.
However, in the meantime, that means a transition in our business, the way we look at the industry as well, and that is what we are working through right now. You saw some of those inventory levels that are a big result of that of our product in China. We have had complaints in China from our customers and our dealers for years that we did not have adequate availability and capacity. We have leadership goals there and market share. We now have capacity availability, and that is what we are going to be about and get after.
So that part is good news. Again, I am looking at China not quarter -to -quarter, year -to -year, but as a market that in, call it, 5 - 15 years from now, which is supremely underserved right now for infrastructure supply, will serve us very nicely. That is why we are continuing to invest, and you have seen some announcements along that way. So that is maybe a little bit more color and insight as to what I saw there just in the last couple of weeks.
Okay. Next question.
Thank you. Our next question today is coming from Jamie Cook. Please announce your affiliation, then pose your question.
Hi. Good morning, Credit Suisse. Two questions. One, sorry to harp on China again, but you talked about inventory levels being high. Can you talk about what your plans are to reduce inventory on a core basis, on a Cat basis, and also at the dealer inventory level? Then also, Mike or Doug, what you would need to see to take more drastic actions in terms of halting some of the capacity additions that you had spoke about. Then I guess more broadly, Mike, if we just look at the inventory levels in the quarter, again, were a little higher for Cat specifically than I would have anticipated. Can you just talk about where they trended relative to your expectations and how we should think about that throughout 2012?
Yeah, I will. This is a slight editorialization here. China is a very important market, but again, it was around 3% of our sales in the quarter. So we have a lot of discussion around a chunk of the company that's important but not huge.
Mike, you're saying 3% of total sales, not machinery sales, right?
Yeah, total.
Okay.
Yeah. We do have too much inventory in China. If you look at Cat inventory overall for the quarter, it was up. A part of it was China, where we have too much, and it is going to take probably the rest of the year to work it down. One of the actions that we are taking is to export machines from China to other developing world countries that are actually in quite tight supply, where we have essentially had dealers on allocation. That is one of the things that we will do. I think it is probably a safe assumption that we are not going to be taking production up in China on excavators for the second half of the year.
For what it is worth, we did actually reduce dealer inventory in the first quarter in China between year-end and the end of the first quarter, we did work down some of the dealer inventory. I think if you look at the rest of the Cat inventory increase in the quarter, the vast majority of it was finished goods, and both we and the dealers are kind of setting up for the summer selling season. I think most of that had to do with orders that are on the books for delivery in probably the second and third quarter.
I will address the capacity expansion question there. I take the long view on that. Having said that, we are introducing programs inside China to work with dealers to get some of that inventory in the hands of customers and get our market share up. We are in a pretty good position and able to kind of scale and scope our capacity expansion. The announcement we put out a couple of weeks ago about expansion over there really is out into 2014 and 2015. If the market does not come back by then, we just will not do it. But I am not going to be in a position in China of catching up on supply and capacity and availability like we have been the last 10 years.
But I guess—
We can't afford that for the long term. So we'll balance that today with, we've got some projects we have to finish because for efficiency and cost reduction, we're going to do it, and we're going to take a look at that market every month.
But I guess, Doug, it's still sort of unclear to me what you need to see to take more drastic actions. Is it the second half recovery doesn't improve? At what point does Doug get worried?
Well, I'd say, yeah. If the second half recovery doesn't happen, if the industry continues to shrink, if we don't see Chinese actions to spur the economy, in terms of some kind of central bank activity, those kinds of things that we're watching. And it's underway. And Mike mentioned the two stimulations the central bank did in China. I met with the head of the central bank when I was in China, and he gave a very central bank non-answer to this question about where the economy is going. But he gave a very good answer about where they want to go long term and where they will be with their five-year targets, which gave all of us a little bit of, I think, confidence that they've got a handle on that, and they have a pretty good track record of managing that economy so far.
Okay, thank you very much. I will get back in queue.
Thank you. Our next question today is coming from Andrew Kaplowitz. Please announce your affiliation, then pose your question.
Good morning, Barclays.
Hey, Andy.
Mike, maybe just following up on incremental margins in the quarter for a second. You, on the last call, had talked about difficult comparisons with 1Q, and you still put up very solid numbers, 23% versus last year. A lot of questions we get are around how much weather played a role versus productivity versus currency impact versus price cost. Maybe if you could flesh out a little bit, and was the first quarter better than your expectations overall in that regard?
Yeah. First, I'll do the easy one, weather. Our sales, our production levels, and our shipments, which turn out to be our sales, that's usually pretty well within reason. What's in the order book is kind of what we're going to produce and ship. I don't think there was any real impact from weather on us in the first quarter. Might have had some impact on what some dealers are selling in some territories. But again, we're global. Sometimes when we talk about weather, I think sometimes we believe the only place that business is done is in the U.S. I don't think that was a big deal. Currency was very neutral to the quarter. The impact on sales and profit was probably the smallest that I've seen in ages. It was negligible. So that was not an impact.
I think it was appropriate to be a little bit cautionary going into the first quarter on margins. We had a great quarter in the first quarter a year ago. When we put our plans together here, particularly for spending programs, it's around a year plan. There's always some differences in terms of how costs actually come in quarter -by -quarter. Considering the first quarter of last year was so good, I think a little caution was warranted. The fact of the matter is we executed very well. We kept a very good lid on costs and performed very well in the first quarter. But again, there are always shifts that you can have quarter -to -quarter in margins, and we're really focused on the year.
Okay, thanks. That's helpful. Maybe if I could step back and ask a bigger picture question. One of the questions we get most often on Cat is around mining CapEx going forward. I know you mentioned very strong markets, and maybe this dovetails with China a little bit, but investors are worried that you have a decent year in mining CapEx this year, and then it kind of falls off over the next couple of years as your customers get pressure to lower CapEx. What are your customers telling you? How confident are you that mining CapEx won't fall off over the next couple of years?
Hey, Andy, this is Ed, and through our alliance agreements, very tight connections with major mining companies around the world, the indications are right now that they're going to continue with their investment programs. I was in Brazil and Chile over the last 30 days, talking not only with the large mining customers, but the subcontractors that support them. I asked, "Are you seeing any signs of back off in terms of some of the projects that are in play?" The answer was no. We think they're going to continue to invest, based on the long-term fundamentals. The seven billion people in the world, the urbanization that's happening, the under-investment that occurred in mining over an extended period of time, we think this thing's got a lot of legs.
Okay. That's helpful. Thank you, guys.
Thank you. Our next question today is coming from Robert McCarthy. Please announce your affiliation, then pose your question.
Robert McCarthy from Robert W. Baird. Morning, guys.
Good morning.
Really, hats off to an impressive quarter. It is good to see the company starting to deliver on the potential that has been there for so long. My first question is a two-parter on the Construction Industries segment. You had about a 12% incremental in the first quarter, but of course, in comparison with the quarter last year that you all described at the time as sort of perfect planetary alignment. Our expectations, that number gets significantly stronger in each of the next three quarters, and that you should finish the year easily above 20%. Is that your expectations as well? Related to that, volume growth, low double digits in the quarter, can you sustain that level through the year, or should we expect to see more moderation there?
A couple of things, Rob. One, we have never really laid out incrementals by individual business. But, Rob—
Yeah.
Generally speaking, our targets for Power Systems and Resource Industries and Construction aren't all that dissimilar. One thing that did impact Construction Industries a little bit more than everybody else in the quarter, I made the comment overall that currency was not much of a factor for the company overall, but it was a bit of a factor for Construction Industries, and it would've been offset a little bit elsewhere. So that held them down, maybe roughly 1 point in the quarter. No, I would say incrementals in the construction business aren't dramatically different from expectations elsewhere.
I guess we'll say related to that, because it speaks to margins. From 30,000 ft, you had roughly 75% growth in SG&A expenses in the quarter. Really looks outsized relative to the revenue growth. Can you talk about the drivers of that, and if there's expectations that the absolute level of spending can moderate as we go forward, or is this a new table setter in terms of run rate?
Yeah, I think if you look at the change, probably a giant chunk of it was because of Bucyrus and MWM were in the numbers, and they weren't a year ago. So that's probably much of the change. Bucyrus. Pardon? I said Bucyrus. Oh, Brazil. Sorry. Bucyrus and MWM. Yeah. Brazil combined.
But we had most of that last quarter with Bucyrus, Mike, and the year-on-year increase is a whole different order of magnitude here.
Yeah, no. It was not in the numbers in the first quarter a year ago. It is in the numbers today. If you look at our SG&A relative to sales as a percent of sales, excluding the acquisitions, it would have gone down in the quarter versus a year ago.
Okay. I will follow up with you. Thanks, Mike.
Okay.
Thank you. Our next question today is coming from Ted Grace. Please announce your affiliation, then pose your question.
Hey, guys. Susquehanna. I was just hoping to ask a higher level question. Now that we can reflect back on two years of leadership by Doug and Ed and all the changes you have made since then, more mining, more rail, more engines, more aftermarket, benefits of CPS and lane strategy, I was just wondering if you could speak to how you think the company's full cycle returns have improved. Then also how you think about how you may have changed the cyclical profile of your earnings. Any kind of quantitative metrics you might be willing to share would be great.
Well, a couple things. If I look at where we are, given the progress around the Cat Production System and the sophistication of a very, I'm going to say, efficient supply chain, we've got a ways to go. We've come a long way, and there's no question these incremental margins and the pull-through of 23% or so, and a little better than that without Bucyrus and MWM and some other things, is extremely rewarding. I am very happy with that. At the same time, we are working hard, and we have anecdotes and stories every day of where we can do better with our supply chain efficiency, where we still have gaps between supply capacity and our throughput of our own factories. We have a long way to go, and a lot of that's ahead of us yet.
Having said that, if we end up with whatever the incremental pull-through, 23% or 25% every year for the next few years, I'd be very happy. We've seen that consistently throughout. That's in our plans for the rest of this year, right through to 2015. I do know we've got opportunities out there to really get after some improvements around supply chain and still around Cat Production Systems. That's ahead of us. But I've got to tell you, the quarter, as we saw it, given the really tough comp to a year ago, is rewarding. I think our people did one heck of a job to do the types of things we talked about in the second quarter. As I stand back and look at the, I'll pontificate a little bit here, sorry, but as I look at the whole world, who would have guessed a year ago that we would have a China slowdown of the magnitude we have, a Brazil slowdown, somewhat of a recovery in the U.S., but still anemic, and put up these kind of numbers with incremental pull-through? I think we're just starting to see the power of what can be done here.
Yeah. Hey, Ted, this is Ed. I'd add on your comment about the cyclical profile. I think the focus on the aftermarket and our business model, as you travel the world and meet with Cat or dealer employees, I think it's the one part of the strategy that has absolutely resonated around the world. I think that focus on aftermarket will serve us well as we go through cycles. The other thing that I think we've done different is if you look at Cat's investment profile historically, we've invested, I think, the vast majority in what I would consider mid to late cycle, be it CapEx or M&A, R&D type activity.
If you look at what we've done this time, we've really been thoughtful in trying to invest earlier in the cycle. Between 2010 and 2011, between CapEx, R&D, and M&A, almost $20 billion invested in the business. We think we're now in the early stages of that mid-cycle. When you make those investments early, you really have the opportunity to secure the return on that investment, bed down the acquisitions while you've got the wind at your back in terms of the industries that we serve. So that's another change I think we've made as a result of the update to this strategy.
That's helpful. Would we look for the biggest improvements to more likely come in Construction Industries, or do you think they'd be shared more equally?
I think generally we've got opportunity everywhere, but certainly construction, we would expect to see a higher, I'd say, rate of improvement.
Okay, then the last part I was hoping to ask is just an update on lane strategy, where we are both domestically in the U.S. and then outside the U.S., and I'll jump back in the queue.
Yeah. Ted, if you get into lane in terms of the inventory, that's part of the inventory build we saw in the early part of the year, and that's really us building PDCs. We've got about 9,500 units in Lane 1. We got 22 PDCs that are operational. Another six that are in process. We shipped about 5,600 units from PDCs in the first quarter. So as we get positioned at the end of first quarter heading into what is the selling season, we think the PDCs have us well-positioned.
Okay. Well, congratulations on the quarter and best of luck, guys.
Okay.
Thank you. Our next question today is coming from Vance Edelson. Please announce your affiliation, then pose your question.
Hi, Morgan Stanley. Thanks. A couple questions. If we shift the focus over to Europe for a minute, you mentioned Europe is holding up. Could you give us a feel for the progression during the quarter and into April, if possible, now that the month is almost over? Anything you can tell us about the pattern and the latest trends?
Yeah. This is Mike. I do not think there is anything to be gleaned from that. Europe overall, just think about it economically and all the troubles from last year. It has been pretty good. Not as good in terms of increases as North America, but it has been in generally positive territory all along. So I think it is a case where it is much like the U.S. If you look at, and I will use the U.S. as an example because I think people are frequently more familiar with the data, if you look at housing starts, relatively weak. If you look at commercial construction activity, relatively weak.
Do we have a highway bill? No. In the midst of all that, we are up in North America in the 30%, and a lot of that is replacement. So I think you have that same phenomena right now that is holding up Europe. To some degree, it is also a tale of different parts of Europe. Southern Europe, where, let us just say, proportionately more of the troubles are right now, it is actually down. Northern Europe, where the economies are doing better, it has basically more than offset that. So, I think overall, Europe is considering what they have going on over there is done very well.
Okay. That is helpful. Just shifting over to the mining side, you mentioned the U.S. coal weakness. Any other areas of strength or weakness by commodity that stand out? Similarly, if you could provide some more color geographically. Is it mainly LATAM and Asia PAC that are strong with the U.S. the weakest overall?
No, generally mining is up everywhere. There is not a region where mining is not up. I do not have the by commodity breakdown in front of me, and we are usually kind of vague on that anyway. But I would tell you that with minor exception around U.S. coal, which is not that big a percentage of the business overall, mining has just been very good. In my preamble to the Q&A here, I probably mentioned it five times, but our backlog went up in the quarter, including for mining, including for new Bucyrus machines. So mining just remains incredibly good. It is limited by supply. We are taking orders on the big product now out into 2014. So everybody seems to be searching for a negative in mining, but I will tell you from our perspective, there is not one.
Okay. That's great to hear. Just one more question, if I may. As you manage the inventories, I'm trying to get a feel for the longer-term goal of increasing the inventory turns. How quickly do you think you can get the inventories right-sized? Is there any change in your thinking about the long-term goals for inventory turns and driving the free cash flow higher that way?
Yeah, Vance, it's going to take, if you look at the issues we talked about in terms of China, pretty significant ramp up, relative to what's going on in mining and some other areas. I think you'll see us focus on improving that number through the balance of this year. As Doug commented earlier, there's still opportunities to improve the integration across the supply chain. Out to 2015, there's another half a turn there that we ought to be able to go get.
Okay. That's helpful. Thanks, guys.
Thank you. Our next question today is coming from David Raso. Please state your affiliation, then pose your question.
ISI. Two questions, one quickie to start. The short-term incentive comp, the $280 million benefit for the full year, you only got $10 million of the benefit in the first quarter. So the next three quarters, can you lay out for us how you see that incremental $270 million benefit playing out year-over-year?
Yeah. I do not have the numbers off the top of my head, but basically, we are one quarter into the year. So what we book in the first quarter, and that is in the Q&A in the release, that is what we would expect in each of the next three quarters. We would accrue it evenly unless we change our outlook. And then if you go to the year-end release, we broke last year's out by quarter.
Okay.
So if you take the first quarter of this year, assume that for Q2, three, and four, you can compare that to the numbers that we had in our fourth quarter release by quarter for last year.
Okay.
I just do not have them off the top of my head, David. Otherwise —
That is fine. As long as it is straight through this year, I can comp it year-over-year.
Yeah.
So bigger question on the inventory again. No one has asked questions just directly, how do you feel about where the inventory is? I know you mentioned China, but China is just not that big. It cannot be driving the whole inventory number. It has been many quarters in a row where inventory has simply grown a lot faster than sales. Maybe one number you could help us with, what is the inventory in the first quarter that is Bucyrus and MWM, so I can get more of an apples to apples. Sales are up core 15%.
Yeah.
Inventory was up what? 35%?
Yeah.
I am just trying to get a feel.
Yeah. You are right, there is a bit of an apples and oranges in there because you do have MWM and Bucyrus in the inventory number today, and they were not in the sales or inventory number a year ago. I do not have either number off the top of my head. I think the quarter that we released Bucyrus, I think that was a part of certainly our Q in the quarter that we acquired it. So, if you were to go back to the third quarter Q, I think in there we say how much it was. That is a good question. That is a part of the increase relative to sales. I just do not have the number off the top of my head.
Hey, David, this is Ed. But like I said, the Bucyrus is part of it, the MWM is part of it, that as both Doug and I have commented earlier, if you look at working capital in total, we are very pleased with the performance on accounts receivable. We are very pleased with where we are at on accounts payable. We know there is more work to do in the inventory turns side of it. And we are keenly focused on getting it done. Yeah, we have got to build up in China. Yeah, we have got to ramp up on the mining side and some other things that is driving it. But there is also opportunities for us to improve core performance in the area of inventory, and we are all over it.
Not saying you want to highlight this, but where are the areas that you feel the inventory is highest on your radar screen of, "Hey, we might need to be careful the next quarter to cutting that back." That is really the situation in China. We appreciate that. In the Q&A section, Mike, you highlighted two-thirds of the dealer inventory growth is North America.
Right.
The company inventory growth, and when the Q comes out, we will get how much is finished goods versus WIP and raw, so maybe a little better color. We are just trying to get a feel, where are the areas where you may be getting a little bit anxious? Because it is a little inconsistent to keep, even from some of the dealers, we cannot get enough excavators. There is definitely some products where it is still a capacity constraint issue.
Yeah.
But in the interim, we are seeing inventory growing a lot faster than sales for the company.
I think if you look at the first quarter, the vast majority of the increase was some form of finished goods. It was either goods in transit that have been shipped but not recorded as a sale yet or it is PDC inventory or finished goods inventory. And part of that is a function of expected sales. If you look at our outlook for the year, the middle of that range, just to use one number, is $70 billion. If you pull out what we actually did in the first quarter and then look at what is coming in the next few quarters, it is up a fair bit from the first quarter.
First quarter is always kind of seasonally low. So I think part of what you are seeing is an increase in a variety of forms of finished goods, PDCs, in transit, and inventory waiting to be commissioned, that it is really a function of future sales.
Can we just wrap it up with, is there any target for the end of the year? Just so as we go through the year, obviously 2Q, you would like to think inventory should come down seasonally, but is there anything that we can monitor where we know your bogey is inventory to trailing sales for the year at year -end is X, call it 25%? So we know if we are running above or below, we are just getting sensitivity to the production schedules, where is the risk if we are tracking it that, hey, they might need to take some inventory down internally.
Yeah. I think we definitely have turns baked in between here and the end of the year. So absolute inventory is probably not going to come down. But as sales go up from the $16 billion sales and revenues from the $16 billion level in the first quarter, I think effectively what you'll see is, I don't think total inventory is going to come down, but turns are going to go up. In other words, we'll take it down relative to sales.
Okay.
Yeah, a couple things I would add here on this. You are exactly right. Virtually every segment of inventory has its own story and logic. The most intense focus we have right now that actually has been building over the second half of last year and early this year is China. We acknowledge that. We've got excess inventory there in wheel loaders and excavators. We're working on that. I think we have a good story on that one as to why and where we're going to go with it. Bucyrus, former Bucyrus products. We are building inventory by plan to get after higher volumes there and develop an aftermarket business that we find with lots of opportunity. So that's a buildup that makes a lot of sense for us.
Our PDCs, we have been behind the eight ball on that since we announced that program five years ago. We've been working on that. We're finally to the point where within PDCs that we own, we're about where we think the minimal inventory level should be to really get after market share and service our customers. If you look at U.S. dealer inventory with our dealers here, in terms of months of sales, based on expected sales and outlook for the rest of the year, it's reasonable and in line with historical areas.
It's really a mixed bag. We'll probably be talking about it, I know we'll be talking about it in the future much more, but we're managing it as a mixed bag also in every single segment, because every single piece of it has a different logic to it. Overall, with the exception of China, we've got a pretty good program to get inventory where we want it based on our CPS and our inventory turnover targets over time.
Yeah. It's like, obviously, when the inventory goes up 13%-14% sequentially, the easy follow-through on that statement would be, "And thus we're raising our sales guidance." We're building inventory because we're confident in the sales growth. To maintain the sales growth this report, but the inventory grew 13%-14% is just, I think, the crux of the—
Well, no, I think inventory goes up based on what you think you're going to sell next couple of quarters relative to this quarter. If you look at our sales outlook, the next few quarters should be well up on the first quarter. It's not so much a function of changing a full year guidance, it's where are the next few quarters going to go relative to where you've been.
That would imply the inventory growth sequentially was kind of in line with what you were thinking then, essentially.
In China, it was more we expected a bigger selling season there. There are parts of it that were more than we thought, and that's one of them.
All right. I really appreciate it. Thank you.
Okay, I think we have time for one more.
Our last question today is coming from Ann Duignan. Please announce your affiliation, then pose your question.
Hi, it's JP Morgan. Switching total gears here, can you talk about what you're seeing out there in the natural gas sector in the U.S.? We've seen rig counts come down significantly, yet they're switching from dry drilling to liquid drilling. But what are the customers in that segment talking about? Are there discussions about deferring CapEx spending? In my view, I think that is the biggest risk to sales for Caterpillar in the near term because I'm sure it has great broad-based impact, not only on engine business, but also on rental of equipment. Can you just address what you're seeing out there in the near term, the very near term in the U.S.?
Yeah. Well, that's a very specific question, and let me put it in a context. Oil and gas overall, turbines, engines, the backlog has continued to go up. Solar, for example, which is a good chunk of our oil and gas business, is for all practical purposes, almost sold out for the year. They have significant order coverage for the year. They have got a good order flow. In terms of our oil and gas business overall, sometimes I think people believe that the bulk of it is drilling, and that is not the case. The largest segment of our oil and gas business is gas compression.
Actually, the ample supply and relatively low prices are very positive for consumption. If you are going to consume it, you have got to move it. So actually what we are seeing in our oil and gas business overall has been pretty positive. Customers have been pretty bullish. On the drilling side of it, on the fracking side of it has shifted from dry gas to oil and wet gas. Another kind of point, you are totally focused on the U.S., but this business is global. In fact, probably three quarters of Solar's business, for example, is outside the U.S. So I think sometimes there is a little bit too much of a focus on our global oil and gas business just for the U.S.
I want to add in here, Mike, a couple of things we are seeing, and we virtually have seen no I would say, order variation in our gas business whatsoever. In fact, we are seeing a couple other things. We just announced and signed a huge deal for some of the first fracking with our 3500s in China. China actually has more gas through fracturing available there than the U.S. does. There is no market for that yet at all. Part of the fact is there is no pipeline system in China. So you can just about see what is coming in China down the road, which will really create demand for our products. Coupled with our new 3500 plant in Tianjin, that is just coming online. The other thing that surprised all of us around here is the, what I have been calling demand creation for gas products.
We are getting calls from virtually every customer segment to burn natural gas in our reciprocating engines, which we have been doing for 50 years. It is a huge growth opportunity. We created kind of a strategic group around this to coordinate all of our efforts. The opportunity is enormous when the gas equivalent of BTU burn to diesel right now is 70% cheaper. The bad news is that spark spread is not going to last very long. The good news is we are in a supply chain all through it.
So I view cheap gas as net a huge opportunity for us around the world, as Mike said. While in the U.S. we will probably see cheap gas for some time, the rest of the world wants that too, and it is not that fungible of a product. There are some LNG you can move around, but if you have local source, you are there. We are seeing that virtually everywhere. So I view this as a long-term opportunity for us that has come out of nowhere. Fortunately, with our MWM acquisition a year ago, we bring a lot of expertise with that, coupled with actually a pretty good gas business that we had before.
Excellent. One quick follow-up, just building on the margin improvement stories. A lot of the trade magazines have been writing in recent weeks about your announcement that you will source Kubota engines for your smaller building Construction Industries products. I mean, that is a real change in strategy for Caterpillar. Could you just talk a little bit about the thinking behind that? Is it the opportunity for margin improvements? I think it is great, but I think it is a real change in strategy by Caterpillar.
Ann, this is Ed. On a good portion of that product line, historically, they sourced engines from Mitsubishi.
Okay.
That was based on the fact that there was a gap in the Perkins product line, primarily in the 3-L space. So really what you are seeing is Kubota kind of fill that gap. So no significant change in terms of strategy.
Okay. Thank you. I will leave it there.
Okay, everyone. Thank you very much. We are very pleased to report another record-breaking quarter. And 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.