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Caterpillar, Inc. (NYSE:CAT)

Q2 2009 Earnings Call

July 21, 2009 11:00 am ET

Executives

Mike DeWalt – Director, IR

Jim Owens – Chairman & CEO

Ed Rapp – Group President

Dave Burritt – CFO

Analysts

Daniel Dowd – Sanford Bernstein Research

Henry Kirn – UBS Securities

Jamie Cook – Credit Suisse

Alexander Blanton – Ingalls & Snyder

Eli Lustgarten – Longbow Securities

Ann Duignan – JP Morgan

Andrew Obin – BAS/ML

David Raso – ISI

Terry Darling – Goldman Sachs

Mark Koznarek – Cleveland Research

Robert Wertheimer – Morgan Stanley

Operator

Welcome to the Caterpillar second quarter 2009 earnings results call. (Operator instructions) It is now my pleasure to turn the floor over to your host Mr. Mike DeWalt. Sir, the floor is yours.

Mike DeWalt

Thank you very much. Good morning everyone and welcome to Caterpillar's second quarter earnings conference call. I'm Mike DeWalt, the Director of Investor Relations. I am very pleased to have our Chairman and CEO, Jim Owens; Group President, Ed Rapp and our CFO, Dave Burritt, with me on the call today.

This call is copyrighted by Caterpillar Inc. and any use, recording or transmission of any portion of this call without the expressed written consent of Caterpillar is strictly prohibited. If you'd like a copy of today's call transcript, you can go to the SEC filings area of the Investor section of our cat.com Web site or to the SEC's Web site where it will be filed as an 8K. In addition, certain information relating to projections of our results that we'll be discussing today is forward-looking and involves risks, uncertainties and assumptions that could cause actual results to materially differ from the forward-looking information.

A discussion of some of the risk factors that individually or in the aggregate we believe could make actual results differ materially from our projections can be found in our cautionary statements under Item 1A, Business Risk Factors, of our Form 10K which we filed with the SEC on February 20, 2009 and also in the Safe Harbor language contained in today's release.

Okay. Earlier this morning, we reported results for the second quarter of 2009 and we updated our outlook for the year. To start I will summarize the quarter and the 2009 outlook and then we will take your questions.

First, the quarter. Sales and revenues were just about $8 billion. That is a $5.6 billion drop from the second quarter last year. That is a decline of 41% from what was our all-time record, best quarter for sales and revenues. Second quarter profit per share was $0.60 and that is down $1.14 from the second quarter last year and that does include $85 million or $0.12 per share of redundancy costs. Excluding the redundancy costs, profit per share was $0.72 in the quarter and that compares with the consensus profit estimate of $0.22.

Let me provide some color on the decline in sales and revenues. Machinery volume was down $4.5 billion excluding the impact of CAT Japan. Broadly, you can look at the drop in machinery volumes in two major chunks. One, weak end user demand. Two, the change in dealer inventories. End user demand was down quarter-to-quarter across the board geographically and by major industry. However, we did begin to see some improvement later in the quarter in countries like China, Brazil and parts of the Middle East.

Dealer inventory changes had a very sizeable impact in the change on quarter-over-quarter sales. Dealers lowered machine inventories almost $1.2 billion during the second quarter. That means that our sales of new machines were about $1.2 billion below dealer sales to end users. To put the year-over-year impact on sales in perspective you also need to understand what happened last year. During the second quarter of last year, dealers increased inventory about $200 million. That means that dealer inventory changes had a negative impact on our quarter-to-quarter sales of about $1.4 billion.

Turning to engines, very weak demand also had a very significant impact on engine volume which was down $1.4 billion from the second quarter last year. Financial products revenues were off $106 million and currency had a negative impact on sales of $225 million as a result of the stronger dollar compared with the second quarter last year.

On the positive side, price realization was favorable $259 million and the consolidation of CAT Japan added $290 million. While that covers the total change in sales, before I move on to profit, I would just like to cover a couple of more key points about the top line.

You will see in this morning’s release that in total machinery sales were down 49% in the quarter and that engine sales were off 32%. What is important to remember about both of these principal lines of business is that they do include all of our integrated services businesses other than financial products. They include areas like service parts, our remanufacturing business, progress rail, CAT Logistics, OEM solutions and turbine related services.

These integrated service businesses are a key element of our overall strategy and a very important component of our strategy for the trough of the business cycle. While the total sales and revenues of our integrated service businesses did decline from the second quarter of last year, the rate of decline has been much less than the decline in new CAT machines and engines.

In fact, when you look at our total $8 billion in sales and revenues for the quarter our integrated service businesses including CAT financial products were about 46% of the total. One final point about sales and its impact on dealer inventory, there is no doubt the significant reduction in dealer inventory had a substantial negative impact on our sales. As painful as that was, the good news is that we are well down the path to getting it behind us. That is not to say that it is over. In fact, we expect more in the second half. So far this year, dealers have taken out almost $1.5 billion and that could grow to nearly $3 billion before 2009 is over with the lion’s share of what is remaining this year likely to be in the third quarter.

As a result of continuing weak demand and expected declines in dealer inventory, we have significant rolling factor shut downs planned for the third quarter. The third quarter is likely to be very tough in terms of sales and as a result on profit.

With that lets turn to the second quarter profit. To recap, we reported a $0.60 per share profit in the quarter. That included $85 million or $0.12 per share of employee redundancy costs. That was a drop of $1.14 versus the second quarter of 2008. Excluding redundancy profit was $0.72 per share. While profit was down substantially, given the drop in sales that happened as a result of the economic environment we are in we had a good quarter.

While the volume decline has been swift and deep, so has our response. Caterpillar employees, Cat dealers and our suppliers have mobilized to implement trough actions faster than any time I have witnessed in my almost 30 years with Caterpillar. That said, sales and revenues were down 41% in the quarter and the decline in volume was the major negative profit driver.

In addition to that we had the $85 million in redundancy costs, the impact of consolidating CAT Japan was negative and financial products profit was lower than the second quarter last year. There were, however, several positives that helped to mitigate the drop in profit. Combined, we reduced SG&A and R&D costs $291 million in the quarter with more of the impact being SG&A.

Price realization was positive $259 million and one point related to price realization, during the second half the comparison gets tougher because we will be lapping the mid-year price increase from 2008. That doesn’t mean we are expecting price levels to go down. It means that the comparisons year-over-year are getting tougher.

Our manufacturing costs in the quarter were favorable $85 million. That includes the LIFO inventory decrement benefits. Manufacturing costs excluding the LIFO impact were roughly flat. Factory labor and overhead costs were neutral and that is an outstanding result for our factories in the second quarter. They were able to lower their variable labor and overhead costs at essentially the rate of volume decline. Given the magnitude of the volume decline that is a remarkable achievement.

We are working hard on the continued deployment of the CAT production system and expect even better results ahead particularly when volume eventually picks up. Moving on, currency impacts were also positive in the quarter both on operating profit and below the operating profit line in other income and expense.

The income tax was also favorable primarily related to the geographic mix of profits and losses. One final point on profit, I know many of you are interested in the incremental and decremental operating margin rates and our decremental operating margin rate versus the second quarter last year for machinery and engines was 19% excluding the redundancy costs. Again, that is the change in the M&E operating profit divided by the change in sales.

In summary on profit, volume was a big negative. Price realization held up. We were able to lower our factor variable costs in line with volume and we made significant reductions in period costs particularly SG&A. In addition to profit we are highly focused on liquidity and generating solid cash flow. Our results are certainly moving in the right direction.

Some of the key points related to liquidity and cash flow included year-to-date machinery and engines operating cash flow improved $900 million from the end of the first quarter to the end of the second quarter. Our inventory, this is our inventory not dealer inventory, was down another $800 million in the quarter. It is $1.6 billion lower year-to-date and our target reduction for the year is $3 billion. Actually our inventory peaked at the end of the third quarter last year and then declined over $2 billion during the last three quarters.

Pension related funding for 2009 has largely been completed. Year-to-date we have contributed over $950 million out of what we expect will be about $1 billion for the full year. Access to debt markets has been good and we are very well positioned in terms of liquidity and don’t expect to need to issue additional term debt this year. Cash on the balance sheet at the end of the quarter was about $4 billion. That is up from year-end. That is up from the first quarter and historically the normal cash balance for us has been less than $1 billion so we currently have about $3 billion of excess cash.

The last thing I want to cover before moving on to the outlook is CAT Financial. Without a doubt this is a tough economic environment for CAT Financial and over the past two quarters many of you have had questions. Generally around three main topics; liquidity, the quality of CAT Financial’s asset portfolio and their profit. I will update you on all three subjects.

First, liquidity. As we started the year, CAT Financial had about $5 billion of long-term debt maturing in 2009. So far this year CAT Financial has issued $3 billion in 3, 5 and 10-year notes, nearly $700 million of retail notes, $650 million in medium term Euro notes and $500 million of Canadian dollar medium term notes. In addition, CAT Financial has been collecting more in receivables than they have been writing in new business. That is a result of the weak environment for new equipment sales.

In terms of CAT Financial’s asset portfolio, 30 day past dues increased very slightly from 5.44 at the end of the first quarter to 5.53% at the end of the second quarter. That is up from 3.35% at the end of the second quarter a year ago. We do expect continued pressure on past due through the remainder of 2009 and while it is tough to call a specific peak, past due does tend to follow economic conditions. Our expectation is that past dues will peak over the next six months at levels not far from our recent experience and then gradually improve as the economic recovery begins.

Credit loss, net of recoveries, was $55 million in the second quarter. That is $8 million higher than the first quarter and up $36 million from the second quarter a year ago. During the second quarter CAT Financial increased the allowance for credit loss an additional five basis points to 1.55% of net financed receivables and that is up from 1.50% at the end of the first quarter, 1.44% at year end and 1.41% at the end of the second quarter a year ago.

Turning to their profit. The financial products’ profit before tax was $140 million in the second quarter. That is down $51 million from the second quarter of 2008 but it is $61 million better sequentially from the first quarter of this year. Considering the economic environment financial products is performing well. Liquidity is more than adequate. Past dues and credit losses are at historic highs but are manageable and reasonably stable and profit, while lower than last year, is up from the first quarter and the full year outlook is improved. There are several comprehensive Q&A’s related to financial products that are included in our release. They begin on page 20 and do provide more detail.

I will touch on the full year outlook for 2009 and then we will move onto the Q&A. First the outlook for 2009 sales and revenue. With the first half of the year behind us, we have tightened the forecast range for sales and revenues to $32-36 billion. The impact of the economic environment is really tough to predict so the range is still fairly wide. Also related to the sales outlook, our expectation for dealer inventory reduction is somewhat higher now. I mentioned a few minutes ago we think it could approach $3 billion for the full year.

In terms of profit, we are raising expectations for the year. The outlook is now in a range of $0.40 to $1.50 per share including about $0.75 per share of employee redundancy costs. The range excluding redundancy costs is $1.15 per share to $2.25. The middle of that range is $1.70. Our previous outlook at a mid point at $1.25 per share. While we don’t provide a quarterly profit outlook, we do want to reinforce the point that we are expecting the third quarter to be the weakest of the year for sales and for profit excluding redundancy costs.

End user demand will likely remain depressed and we expect dealers will continue with substantial inventory reductions in the third quarter. As a result, we are planning widespread and significant rolling factory shut downs in the third quarter. While that will make the third quarter extremely challenging, we do expect the dealers will have the bulk of inventory reduction behind them as we exit the third quarter. There could be more in the fourth quarter but not on the order of magnitude of the second quarter or what we expect for the third quarter.

In summary, and I think you can gather from the tone of our financial release, we think the second quarter performance related to profit, liquidity and for CAT Financial was pretty good considering the economy.

With that we are ready to move on to the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Daniel Dowd – Sanford Bernstein Research.

Daniel Dowd – Sanford Bernstein Research

Let me ask about the inventory draw down because if you are going to largely exit the third quarter with most of the inventory draw down at the dealers complete, let’s imagine that in 2010 the end user demand was roughly flat which is debatable but if it was how much would your revenue likely increase? That is, how much would you have under produced by the end of the year the dealer inventory?

Mike DeWalt

There are a lot of moving pieces. Certainly we don’t have an outlook for 2010. We are looking for dealer inventory to go down this year up to $3 billion. That is probably a good starting point.

Daniel Dowd – Sanford Bernstein Research

In theory you could end up having end market demand continued down next year and if it was down in the $1.5-2 billion range you actually could be flat or slightly up in terms of total revenue?

Mike DeWalt

Yes. The only thing we talked about was this year’s dealer inventory. I’m going to beg off on the 2010 discussion. Sorry.

Daniel Dowd – Sanford Bernstein Research

One other thing I wanted to follow-up on was in terms of guidance, you are obviously pushing to a guidance range for the second half of $0.04 to $1.11 in EPS. Is it likely that you are going to end up having to go negative given all of the shut downs? Can you give us some context on how extensive are the shut downs? Are they comparable to the auto sector or are they more on the order of a few weeks here and a few weeks there?

Mike DeWalt

On third quarter profit, for the second half of the year we have quite a wide range in terms of what profit can be. For the second half of the year at the bottom end it is close to break even. At the top end it is a fairly substantial profit. There is already within the range a wide, depending upon what happens with sales. I think without a doubt we have closer visibility to the third quarter. We have big, rolling plant shut downs. We had a lot of shut downs in the second quarter and the third quarter is going to ratchet up from that. I don’t quite know how to compare it to the auto companies. I guess I don’t follow on that closely but we will have more shut downs in the third quarter than we had in the second quarter which in and of itself was fairly substantial.

Given the outlook range that we have for the second half of the year I wouldn’t say it is certainly not impossible that we would have a loss for the third quarter.

Jim Owens

Just to quantify that a little bit, we have got most of our large machine and reciprocating engine facilities in the U.S. and Europe will be down for a number of weeks. We think that is the most cost effective way to essentially take production down. Not only the assembly plants but the component, feeder plants will be shut down for probably two out of four weeks over the next two months. July and August if you will. Starting to ramp back up in September and then most of them, at least in our current planning, will be running a full fourth quarter at least on the first shift.

Daniel Dowd – Sanford Bernstein Research

Is Solar slowing down a lot also or is that just reciprocating engines?

Jim Owens

Solar is not. They are sold out for the year.

Operator

The next question comes from Henry Kirn – UBS Securities.

Henry Kirn – UBS Securities

I am wondering if you could chat a little about the impact of further LIFO liquidation in the back half of the year outlook.

Mike DeWalt

It is obviously related to inventory reductions. We had $1.6 billion of inventory reduction in the first half. Our target certainly is $3 billion for the full year. Definitely we have more LIFO benefits built into the second half of the year. It is a bit of a varying scale. I can’t give you one number because again we have a range for the back half of the year. That incorporates different levels of volume and that has different inventory implications. We expect more in the second half.

Henry Kirn – UBS Securities

As you look at the other income line, is there any way to forecast that as we go into the back half of the year?

Mike DeWalt

That is a great question. We did in the quarter have pretty positive other income and expense for essentially hedging gains. We tend to not forecast that going forward so we would not be looking to forecast currency for the back half of the year. It is hard enough to forecast our own sales let alone forecast the exchange rates.

Jim Owens

Maybe I could just add one more thought to that inventory question. If we effectively reach our goal of $3 billion reduction in in-house Caterpillar inventories in the year and we are confident that will go out then you look for a comparable number in the second half at least to what we had in the first half. Most of which we took in the second quarter. Order of magnitude I think that should help you.

Operator

The next question comes from Jamie Cook – Credit Suisse.

Jamie Cook – Credit Suisse

I was just hoping you could give us a little more color on the engine performance in the quarter which was quite impressive given the lower volumes. I know you got some price but I guess my question is outside of that was there any material cost benefit we saw in the second quarter or does this reflect that we don’t have truck engines in there which were depressing profits? My follow-up question to that if you could just speak more broadly to how we should think about your backlog in engines at this point. I’m just trying to figure out how I should think about profitability in the second half of the year or does that sort of fall off a cliff?

Mike DeWalt

First on the second quarter engine margins there were a number of things that were positive for engine margins. You mentioned price right off that bat. We had very good price realization for engines. We had a very good engine mix in the quarter and that is related to several things. First to your point, we are not selling new truck engines any more. Truck engine business, certainly for new equipment, let’s just say was not a margin driver in the past so that had a pretty good positive impact in the quarter.

If you just look at mix more broadly we had a faster fall off throughout the first half of the year on the smaller engines than we did on the larger engines and Solar. Solar is a good margin business. As Jim said a bit ago this could be a record year for them and they are continuing to motor on. We had good price. We had very good mix. Actually we did not have much in the way of LIFO benefits related to engines. Of the total, the vast majority of it was machines so that didn’t do too much. We had continued good work on cost reduction actually across the board, not just engines, but certainly in engines. I think it was essentially good mix, good price and taking variable cost down with volume and good work on the period overhead costs.

I don’t think it was anything other than that that was an unusual item per se of any magnitude. In terms of the future, I think we kind of talked about the rolling plant shut downs in the third quarter. That will certainly impact big engines. Lafayette will have quite a bit of shut down during the third quarter. I think what we will probably see for the second half of the year, at least for reciprocating engines, I’m not speaking about Solar here, but for reciprocating engines we will probably see more of a decline relative to the first half in big engines. That will have a negative impact on engine margins I think in the second half versus first half. Overall engine margins are, I probably shouldn’t say it this way, but engine margins are great. They have been all year and they were last year as well.

Operator

The next question comes from Alexander Blanton – Ingalls & Snyder.

Alexander Blanton – Ingalls & Snyder

This quarter was marked by a very, very good incremental or decremental margin. If you conclude the LIFO benefit was a minus 22.7% or minus 24.2% without those benefits, either way it was substantially less than the 35% you would normally expect in terms of…and I am talking the decline here from the first quarter not year-over-year. I am talking gross margin line. So if we look at the sales decline, well actually no I am really talking year-over-year.

Mike DeWalt

The question is why did we improve first to second quarter?

Alexander Blanton – Ingalls & Snyder

Actually the numbers I was quoting were actually the year-over-year decremental margins with or without the LIFO. The question was why was it so much better than the 35% you would normally see and that you have seen in most years when sales have declined as long as I have been following the company?

Mike DeWalt

A couple of things. One, we did I’ll say a great job on taking variable costs out. To your point we had a variable margin rate, normally in the low 30’s. When you get into a downturn the question is can you take out variable costs with volume. We have demonstrated we can do that. We didn’t quite accomplish that in the first quarter. We announced a lot of cost reduction that wasn’t fully implemented in the first quarter. We had a lot more of it actually implemented in the second quarter.

You couple taking the variable costs down with volume in a quarter where we got price increases, a decent mix and we took down our period cost structure. SG&A costs principally and factory overhead and you get a pretty good decremental margin rate.

Alexander Blanton – Ingalls & Snyder

Like I said it was a better performance than I have seen in some 36 years of following the company. Other income was up $99 million. You mentioned that hedging contributed to that. Could you elaborate on that? Was it all that?

Mike DeWalt

The vast majority of the total, over $90 million was currency related of which I think hedging was maybe 2/3 of that. We also had some translation gains in the quarter as well. Yes, hedging was probably 2/3 of that roughly.

Operator

The next question comes from Eli Lustgarten – Longbow Securities.

Eli Lustgarten – Longbow Securities

Can I get one clarification. You told us in the press release $0.14 from LIFO, roughly the same [after] the lower taxes. The press release says $89 million from foreign currency benefit. Does that include the hedging or is the hedging on top of it? Is there another $60 million or something on top of that?

Mike DeWalt

Currency was in two pieces. A piece of it was in operating profit. That we showed in our bucket chart, our table, and that was $89 million as a part of operating profit. That is just what was the impact on sales versus the impact on our operating costs. In addition to that, below the operating profit line we had an improvement quarter-over-quarter I think of $93 million in other income and expense as I recall and most of that was currency.

Eli Lustgarten – Longbow Securities

So the total benefit to earnings from currency was more like $170 million or whatever it works out to?

Mike DeWalt

It was a bigger number than the impact on operating profit.

Eli Lustgarten – Longbow Securities

Secondly, can you talk about the engine business? I think you mentioned that Solar was sold out for this year. Are orders picking up there? In the Q&A you talk about a weakness in 2010. Is Solar also facing weakness in 2010 as the rest of engines and will that impact the spectacular margins we are seeing at this point?

Mike DeWalt

We did put a Q&A in on Solar because we get just a ton of questions on Solar. They stick out a little bit this year as a fairly bright spot in a fairly depressing sales year. We get a lot of questions on well yes but what does that mean for next year. Again, we are trying not to get too far into 2010 because we have a wide range around 2009. But, I think what we are trying to say is it is probably not likely Solar is going to have another record year next year but that doesn’t mean they are going to have a bad year. It will probably be down. It is still on a historic basis based on orders they have been receiving and interest part of this point. Probably still have another good year.

Jim Owens

If you can tell us what the oil price will be on average for the fourth quarter that could help us with our Solar forecast for next year. There would be the dilemma. If oil prices were to move back say to the 70+ range and the credit markets continued to stabilize pretty good things will happen next year. That is the kind of uncertainty we deal with.

Eli Lustgarten – Longbow Securities

At this point are we really talking about a 20% decline in orders versus the current shipping level is that the magnitude we are seeing in Solar?

Jim Owens

We are not going to talk about 2010 outlook yet. Like I say, Solar is having a record year. I think the opportunity for another pretty good year next year but a lot depends on commodity prices, global business confidence, etc. We will wait until we get a little closer to see the whites of the eyes before we make that call.

Operator

The next question comes from Ann Duignan – JP Morgan.

Ann Duignan – JP Morgan

A point of clarification first. I know you said in your Q&A section you can’t reliably forecast your effective tax rate but what assumption have you made for the back half of the year in order to arrive at your EPS guidance?

Mike DeWalt

That is a great question and I’m actually glad you asked it because it highlights the difficulty in actually pegging it. At the bottom end of our outlook we are essentially break even in the back half of the year. If you think of a continuation of things like R&D tax credit, for example, we could actually end up with a negative tax rate if we hit the bottom end of our outlook. If we are closer to the top end of the outlook the tax rate would look more like what we have done historically over the last year or so.

It is actually quite a wide range and the closer you get to break even the more extreme it looks on a percentage basis. It really does span quite a wide range depending upon where we end up in that second half outlook.

Ann Duignan – JP Morgan

So something closer to Q2 perhaps or lower in Q3 depending on the impact of the rolling shut downs?

Mike DeWalt

In fact, I think because Q3 is certainly going to be the weakest quarter of the second half and certainly probably closer to break even as a result and possibly even negative, it could have a tax rate on a percentage basis even though the dollars might be very, very small in the scheme of things the rate could look unusual because it is so close to break even. I think the bottom line is, taxes in the second half in dollar terms regardless of what the tax rate is are probably not all that huge.

Ann Duignan – JP Morgan

On your integrated services profits, I do recall a few years ago you had said on a call that it may not have been all of your integrated services but profitability in those businesses was higher than the company average. I’m just curious if that is still so and what are the ramifications of that on the overall machinery margins if it calls into question the core machinery profitability or lack thereof. Could you give us some color just on the profitability contribution of integrated services versus your core machinery business?

Jim Owens

Our integrated services include everything from replacement parts to after market services from Solar to progress rails to logistic services, etc. Remanufacturing. So there is a lot of different business units in there with varying margins. I think on a weighted average basis there is a little richer margin contribution from those dollars. As Mike pointed out in his preamble a lot of that is buried in the machine and engine segments. It might be more appropriate to think of these as holistic businesses in terms of the market segments we serve with those customers. If we don’t sell the new machines obviously there is no after market service opportunity. I can’t quite divorce these two things in my mind. In a downturn the services business as part of our strategy does help us sustain earnings because they are somewhat less cyclical. They are down this year but keep in mind new machine and new engine sales in many cases the product lines are down between 60-80% for new capital goods purchases.

The services side of that is holding our level of sales and profit at a better level. We are dealing with one of the worst recessions since the depression and the trough strategies we have put in place including an emphasis on diversified services and our CPS initiatives and the nimbleness that we have emphasized with trough strategies I think are showing these strategies were the right thing for our company. I’m really proud of what our leadership team across all of our business units has been able to pull off in what is quite frankly a worse trough than any of us might have envisioned.

Operator

The next question comes from Andrew Obin – BAS/ML.

Andrew Obin – BAS/ML

Just a question on pricing. Just wondering what kind of pricing dealers had to do, what kind of discounting you had to do to reduce inventory as successfully as you have? What does it do to the pricing outlook for the second half and how do we think structurally about the pricing in the industry going into 2010?

Mike DeWalt

I’m going to turn the question around a little bit because when a dealer is trying to get inventory out in simple terms there are a couple of ways you can do it. You can discount and try and sell it or you can order less from the factory than your current selling rate. Generally that is what has happened. There has been no overall worldwide move to major discounting. What we have done, and you see that in our results, we have under produced market demand and we have worked out dealer inventory by essentially slashing production, not trying to discount what is out there. That doesn’t mean there hasn’t been selective discounting in regions but by and large we have not taken that approach.

Jim Owens

If I could just add briefly to that I was just with a group of dealers this weekend and I was pleased that they were quite complimentary of the fact we have allowed dealers to cancel orders where necessary and have worked constructively with them to help them manage that dealer inventory down so they can sustain profitability. Usually when you get into fire sale discounting is when you overload your dealerships with inventory that maybe they don’t want and can’t afford to carry and they have to have a liquidation sale. We have avoided those kinds of things with better management through this cycle.

Andrew Obin – BAS/ML

So I should not be thinking that new pricing is going to deteriorate significantly going into the second half of the year on the machinery side?

Mike DeWalt

I think if you look at the comps I think the percentage number is going to come down. That doesn’t mean we are engaging in big price cuts. It just means that we did a mid-year price increase last year that we are not doing this year.

Andrew Obin – BAS/ML

In terms of dealer inventories in terms of you talked about days inventory on a year-over-year basis but sequentially given that demand is still declining. Could you comment on day’s inventory at dealers versus Q1? I apologize if you said that already.

Mike DeWalt

No I didn’t. Unfortunately I don’t have those numbers in front of me. They did take a lot out first quarter to second quarter but then again sales to users at least the 3-month moving average declined more as well. Without seeing the numbers my sense is that the days they have, the months on hand probably declined some but probably not massively.

Operator

The next question comes from David Raso – ISI.

David Raso – ISI

A question about the revenue guidance. I’m just trying to think through the comment about the third quarter you said a lot of dealer inventory reduction. I guess it is implying third quarter revenues will be lighter than the second. To get to the mid point of the revenue guidance range it implies a solid double digit if you run the numbers it could be as much as 30% increase sequentially from the third quarter to fourth quarter. I guess the concept is dealers are done de-stocking into the third quarter. You can get that producing in line with retail and that would get you some of the way there but still seems a bit aggressive that sequential increase. Do you have an order book or color from the dealers on the retail activity from the fourth quarter that would reflect that kind of sequential strength?

Mike DeWalt

A couple of things. We have quite a range around sales for the rest of the year. Frankly we are predicting our outlook reflects some economic improvement in the fourth quarter and a higher level of activity as a result of that. To your point I think fourth quarter versus third quarter positives would be things like either no or certainly less of a dealer inventory reduction. To your point we would be certainly a lot closer to selling end user demand. Fourth quarter historically has been a pretty good quarter for Solar. They tend to ship more of their year in the fourth quarter.

They have historically had a weak third quarter. Normally seasonally the third quarter is one of the weaker quarters. I would say some general economic pick up. Dealer inventory and probably a good quarter from Solar would all be things that would help.

Jim Owens

Let me just go back to the previous question and maybe add a little bit of color on this one. Our dealer retail sales to users which were in kind of a freefall in November, December, January, February and March the rate of decrease has been falling of you look at our rolling three quarter numbers. In fact, June was somewhat better than May. As some of the stimulus initiatives around the world, it takes awhile for that money to actually get into the dirt, if you will, and contractors we have been visiting with lately more work is beginning to occur.

After that period of freefall I think you may find retail sales to users at the dealerships and rental services beginning to firm up and pick up a little bit and that is part of our expectation as this year rolls out.

David Raso – ISI

Regarding the inventory reduction at the dealer level that you expect a lot of it to occur in the third quarter, can you give a little color on where do you see the inventory reduction most still to come geographically? I am assuming it is more machines than engines so you can enlighten me there if that is not the case.

Mike DeWalt

The only dealer inventory number we have talked about is machines. That is the number of dealer machine inventory we have been quoting. I think we will probably see it occur worldwide. Just think about it in these terms, we have rolling factory shut downs. We have factories around the world that are going to be on limited production the third quarter and so that is going to lower dealer inventory I think almost everywhere. Although in terms of need, probably Latin America and Asia have the least need to reduce inventory.

Jim Owens

Let me add one other thought. We have talked a lot about the CAT production system. That is a very holistic look at the value chain. It has been our thought and intent strategically for a long time to move away from heavy dealer inventory which extenuates our cycle every time and to move towards more just in time delivery and a lean strategy which we are actively putting in place right through this trough scenario. I think we are going to see better performance in the future because of the CAT production system, the lean strategy and less dealer inventory fluctuation.

We are kind of taking it down on a permanent basis and trying to thoughtfully manage it down with our dealer partners.

Operator

The next question comes from Terry Darling – Goldman Sachs.

Terry Darling – Goldman Sachs

I wonder if you could update us on your thinking with regards to an equity offering or a convert offering to accelerate the repair on the balance sheet and get yourself in a position to maybe play some offense as you see the whole cycle turning here?

Jim Owens

Quite frankly I’m not thinking about an equity offering. I think we have a line of sight to get our debt plus equity ratio back into the A, A1 P1 range in the year 2010. I feel pretty confident that if the economy just stabilizes, let alone improves, we will be able to achieve that. I think long-term if you think about our company our clear priorities for cash are to fund our growth and growth initiatives, investments in other words, take care of our employee welfare funding needs which we have done with equity, continue and maintain and hopefully grow our dividend over time and share buyback.

Eventually I expect to be back in a mode of being able to complete the share buyback the board has optimized. I am quite optimistic about the free cash flow this company is positioned to generate if you take a longer term view of the next 4-5 years. So I don’t see we have a need to issue equity.

Terry Darling – Goldman Sachs

Just to clarify you are including a convert in that context?

Jim Owens

I don’t understand that question.

Terry Darling – Goldman Sachs

A convertible security?

Jim Owens

We are not issuing any convertible debt.

Terry Darling – Goldman Sachs

You talked about cash flow in the second half of the year. You talked about inventories improved nicely. Payables were down a lot, $1.3 billion sequentially. Presumably you would think that working capital improvement gets stronger in the second half of the year. Maybe you could talk about what your free cash flow expectations are for the full year and the second half.

Mike DeWalt

If you look at the first half we had several negatives for cash flow that are probably not going to face us in the second half. We paid not all but a substantial amount of the employee redundancy costs or cash paid in the first half. In the first half we essentially paid last year’s incentive comp or bonus. That was built into the total payable number. That was a big negative in the first half that is certainly not going to be in the second half or the first half of next year because we are likely not going to have a pay out.

We have moved sort of the payable number down with volume. Inventory purchases are down with volume. We are kind of down to that level. I think the negative drain, if you will, as a result of payables coming down are principally due to those things. I just don’t think you are going to see that kind of a decline certainly in the second half of the year. We do expect more inventory reductions so that will be a positive. I think without giving a specific number if you were looking at our M&E operating cash flow I think you will find the second half of the year quite a bit better than the first half of the year.

Operator

The next question comes from Mark Koznarek – Cleveland Research.

Mark Koznarek – Cleveland Research

A question on the manufacturing costs. You know effectively neutral here in the second quarter after being up 330 I guess it was first quarter. Is that mostly a raw materials shift or is it really that you have hit a critical mass with CAT production system and if so should we expect continued sequential improvement on the manufacturing cost line if this is sort of the culmination of all that you have been doing with CPS over the last several quarters?

Mike DeWalt

It was not material costs. I think material costs Q1 to Q2 were given their size broadly similar. It was actual real live costs other than material coming down. In the first quarter we announced a lot of actions and we implemented a lot of actions in the first quarter. Again, there is a bit of lag. We have with shut downs, with employee reductions. I think what you saw in the second quarter was the implementation of a lot of what we talked about in the first quarter and more in the second quarter. It was not material costs. It was sort of factoring blocking and tackling.

I think as you look forward, I suspect the labor and overhead piece of it will probably have a tough third quarter because we are going to have more shut downs. The flip side of that is I would expect in the second half of the year remember we had a big run up in material costs in the second half of last year, if that doesn’t happen this year and material costs stay sort of in a band not far from where they have been we will have positives on material costs versus the second half of last year.

So I think by and large if you are just looking at the quarter-over-quarter comps I think largely because of material costs and continued cost reduction we will probably have a good second half of the year.

Mark Koznarek – Cleveland Research

What about headcount. Will that further drop from where we ended the quarter or are we at now a run rate for the company?

Mike DeWalt

We don’t provide a headcount forecast but I think by and large most, not necessarily all, but most of the reductions we have had planned have been implemented. The way we are trying to adjust production to volume for the most part in the second half is through these shut downs. It is not headcount. It is cost reduction for us where people won’t work for 2-3 weeks in a month but we are even still on our employment level.

Mark Koznarek – Cleveland Research

So other than this third quarter dislocation then we ought to see stable or better costs from here on out for the company?

Mike DeWalt

Yes. I think that is one of our key focus. One minor exception to that might be R&D. We have got tier four coming up. Q2 was a low quarter for R&D. It is not our intent to slash and burn on R&D. We definitely want to do a good job on tier four.

Operator

The next question comes from Robert Wertheimer – Morgan Stanley.

Robert Wertheimer – Morgan Stanley

I wanted to follow up on costs which was obviously very, very strong given how awful the revenue environment is. Can you give a little bit more color on how it was achieved? Can you talk about whether rolling lay offs can be done indefinitely? Can you do them into 2010 and is that sort of an ongoing variable cost mix? Was there anything temporary in the cost savings this quarter like advertising cuts or anything like that?

Mike DeWalt

No, I wouldn’t say there is anything temporary. I hope pay increases aren’t temporary. As an employee I would like to see one next year. In the context of something big and unusual no. That was not the case in the quarter. In terms of can rolling lay offs answer the question they can. That is a short-term or medium term kind of thing. I mean if we were going to be at this depressed level forever I think you have to look at capacity. Certainly it is not our view we are going to stay at this level forever. It is actually a very effective way in the short and medium term to get your costs in line with production and I guess we will continue doing it.

Ed Rapp

The thing I would add is it not only helps us get our costs of production down short term but it does leave us in a position that at some point when we get a snap back you are much better positioned if you would to respond. So it does both things for us. It manages costs near-term and leaves some flexibility as well.

Jim Owens

One other little bit of color. Keep in mind that the capital goods business for new machines and engines is very difficult to forecast for anybody. Even if you go back to the year 2004 when this recovery kind of got underway after a very prolonged global recession in our industry, our sales for most every machine product line in the world were up over 40% on the year in 2004. So the rolling lay off concept gives us as Ed pointed out a lot of flexibility in being able to take out costs and yet be in position to respond to opportunities as they present themselves. We are very confident long-term we have dropped well below trend rates of activity to sustain any kind of global GDP growth and we will see our sales recover. It is a question of timing.

Robert Wertheimer – Morgan Stanley

When you look at the cost picture again you have taken out a lot of temp workers. Can you talk about CPS and is there a chance when you roll back into production and volumes improve you don’t have to add any or 50% or whatever of those temp workers. Has there been as yet a structural improvement in factory flow and productivity?

Jim Owens

We were gaining and we have talked about this several times with the analyst community. We were gaining substantial traction with our CAT production system deployment during the year 2008 and towards the end of the year we certainly met I think a very aggressive target for how that deployment would be going. We had the completion of that deployment in 2009 and 2010 clearly in our strategic line of sight. We think we will be approaching the gold standard in industrial manufacturing operations by 2010.

We are very focused on delivering that strategy. We said it would deliver world class performance in safety, for example, and I think if you look at our numbers now you will find we are going to be counted in the five to ten best companies in the world in industrial safety in a manufacturing environment. We said it would result in a big improvement in product quality. That is clearly happening. We said it would yield a dramatic improvement in velocity. That was a lagger and disappointing to us last year. As Mike pointed out in the fourth quarter we began to see good traction with reducing our end process inventories and our flow, if you will, of material.

That is continuing this year and I am confident will continue to improve through 2010. We are getting a lot of traction there. You are going to see a lot of productivity gain there and therefore I think we will be able to run our factories with lower variable manufacturing costs going forward.

Mike DeWalt

We are at the end of our hour. I just want to say thanks everyone for listening in. We will be talking to you over the quarter. Remember our analyst meeting here in Peoria on August 3 and 4th. We look forward to seeing you then.

Operator

Thank you ladies and gentlemen. This does conclude our conference call. You may disconnect.

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Source: Caterpillar, Inc. Q2 2009 Earnings Call Transcript
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