Caterpillar CEO Discusses Q4 2013 Results - Earnings Call Transcript

| About: Caterpillar Inc. (CAT)

Caterpillar (NYSE:CAT)

Q4 2013 Earnings Conference Call

January 27, 2014, 11:00 a.m. ET


Mike DeWalt – VP, Strategic Services Division

Douglas Oberhelman – Chairman and CEO

Bradley Halverson – Group President and CFO


Andrew Kaplowitz - Barclays

Ross Gilardi - Bank of America

Jamie Cook - Credit Suisse

David Raso - ISI Group

Nicole DeBlase - Morgan Stanley

Alex Potter - Piper Jaffray

Robert Wertheimer - Vertical Research Partners


Good morning, ladies and gentlemen, and welcome to the Caterpillar full year and Q4 2013 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.

Mike DeWalt

Thank you very much, and good morning everyone, and welcome to our year-end earnings call. This is Mike DeWalt, Caterpillar’s vice president of strategic services. On the call today, I’m pleased to have our chairman and CEO, Doug Oberhelman; and group president and CFO, Brad Halverson.

This call is copyrighted by Caterpillar Inc. Any use, recording, or transmission of any portion of the call without the expressed written consent of Caterpillar is strictly prohibited. If you would like a copy of today’s call transcript, we’ll be posting it in the Investor section of our website, in the section labeled Results Webcast.

This morning we’ll be discussing forward-looking information that involves risks, uncertainties and assumptions that could cause our actual results to differ materially from the forward-looking information. The discussion of some of the factors that individually, or in the aggregate, could make actual results differ materially from our projections can be found in our cautionary statements under Item 1-A, Risk Factors, of our Form 10-K filed with the SEC in February of 2013, and also in the forward-looking statements language continued in today’s release. Now, in addition to that, there’s a reconciliation of non-GAAP measures, and that can be found in today’s financial release, which has also been posted on our website at

Okay, let’s get started. And this morning I’ll be covering four main topics before we get to the Q&A. They’re fourth quarter financial results, a recap of 2013, the 2014 sales and profit outlook, and I’ll start this morning with the fourth topic, and that’s the $1.7 billion of stock repurchase that we’re expecting in the first quarter, and the new $10 billion stock repurchase authorization that we announced this morning.

Now, to set the stage for stock repurchase, it’s good to know that we had a great year for cash flow in 2013, and finished the year with a strong balance sheet. We set a new record for machinery and power systems operating cash flow at about $9 billion. And that was about $1 billion more than the previous record, from 2011.

We ended 2013 with a machinery and power systems debt to capital ratio of 29.7%. That’s almost 8 full percentage points below where we ended 2012 and our lowest debt to cap in more than 25 years. You have to go back to 1987 to find a lower one.

2013 was also a year where we repurchased $2 billion in Caterpillar stock and last year we raised the quarterly dividend by 15%. 2013’s cash flow and the strength of our balance sheet underpin this morning’s announcement that we expect to complete our existing stock repurchase authorization and our board’s approval for a new $10 billion program.

So, record cash flow, strong balance sheet, $2 billion of share repurchase in ’13, plus a number of $1.7 billion expected this quarter, and a new $10 billion authorization. We think that’s all great news for shareholders and a reflection of strong operational performance in 2013 and our confidence over the long term.

Let’s move on to fourth quarter results. And certainly, while 2013 was a tough year, we’re pleased to be ending it on a more positive note, with sales and revenues nearly $700 million above our outlook and profit $0.25 a share above the outlook.

For the quarter, sales and revenues were $14.4 billion, and that’s about $1.7 billion, or about 10%, below the fourth quarter of 2012, which was $16.1 billion. Profit per share was $1.54, and that’s up $0.50 a share from the fourth quarter last year.

While profit is up, we did have two large items that occurred in the fourth quarter of 2012 that had a sizable impact on profit. We had the $580 million goodwill impairment that was negative to profit, about $0.87 per share last year, but we had a $300 million favorable tax settlement in 2012, and that helped profit by $0.45 a share. So if you exclude those two large items, our quarter over quarter profit per share improvement was about $0.08.

Now, for sales, more than all the quarter over quarter sales decline was in resource industries, which is principally mining. Resource industry sales were down 48% from the fourth quarter of 2012. That substantial decline was the result of both lower demand from mining customers and from changes in dealer inventory.

While resource industry sales in the fourth quarter were well below the fourth quarter of 2012, they were about the same as the previous quarter, and that was the third quarter of 2013. Sales in each of the past two quarters have been roughly $3 billion for resource industries.

And I’ll talk about the 2014 outlook in a few minutes, but it’s worth noting at this point that the $3 billion a quarter that we’ve seen for the past couple of quarters for resource industries is about what we’re expecting to average in the outlook for 2014. Probably a little below $3 billion a quarter in the first half, and a little better in the second half.

On a much more positive note, fourth quarter sales in construction industries were up 20% from the fourth quarter of 2012. Power system sales were up 5%, and financial products revenues were up 3%. That’s great news, and that demonstrates balance in our business. While we serve a number of cyclical industries, they don’t all move the same way at the same time, and it’s great that construction and power systems were up.

Now, excluding the goodwill impairment that happened in the fourth quarter of 2012, operating profit declined about $166 million. That’s $166 million on a sales and revenues decline of about $1.7 billion, and there were certainly a number of puts and takes, but overall, we’re pleased with our operational performance and the decremental operating profit pull through of about 10% in the fourth quarter.

Manufacturing costs were favorable, $480 million versus the fourth quarter of 2012, and SG&A and R&D were favorable, combined about $200 million. Cost performance was the main driver of the good decrementals, and that was in a quarter where we didn’t get any help from price realization, which was about neutral, and our sales mix was unfavorable, because more than all of the sales decline was in resource industries and because of mining.

Bottom line for the quarter, resource industries was down, but power systems, construction, and financial products were all better than the fourth quarter of 2012.

Okay, so that’s the quarter. Let’s move on to a recap of the full year, which was a tough one, particularly for our resource industry segment. Back in January of 2013, when we started the year and provided our first outlook, the midpoint of our 2013 range expected sales and revenues to be down from 2012.

In fact, sales in 2013 were down and the decline in mining sales in our resource industry segment was much more significant than we’d expected. As a result, we ended 2013 with sales about $10 billion, or 16%, below 2012, and of that $10 billion, about $8 billion was in resource industries and about $1 billion each was in construction and power systems.

Now, as a result of that $10 billion sales decline, profit was down as well, from $8.48 a share in 2012 to $5.75 in 2013. While profit was down, our operational performance for the year was good. Our decremental operating profit pull through was less than 30% and that was despite a major headwind from product mix.

With most of the year’s sales decline coming from relatively high-margin mining products, the sales mix headwind on profit was about $750 million in 2013 versus 2012. We also had a sizable headwind from negative cost absorption, and that was related to our large inventory reduction in 2013.

We had good performance, despite those headwinds, because we took action on costs. Excluding the cost absorption impact from inventory, our manufacturing, R&D, and SG&A costs were collectively down $1.2 billion in 2013. That $1.2 billion improvement was the result of favorable material costs, lower incentive pay, short term actions that we took, like temporary plant shutdowns and rolling layoffs. And as the year progressed, we started on more structural actions.

The restructuring actions that we took in 2013 resulted in nearly 2,000 fewer management and support employees, 4,500 fewer production employees, and the closing, downsizing, or consolidation of a number of manufacturing facilities.

While those restructuring actions spanned the company, they were more concentrated in resource industries. We incurred $200 million of restructuring costs in 2013, of which about $130 million was in the fourth quarter, and we’re expecting another $400 million to $500 million in 2014.

I’ll talk a bit more about that when I cover the 2014 outlook, but before I do that, I didn’t want to end this recap of 2013 without giving a little rest of the story. While 2013 was a year overshadowed by the big drop in mining, there were a lot of good things that happened at Caterpillar.

First, while mining was negative, we’re a diverse company. We serve a wide range of industries across the globe. And while sales declined in construction and power systems, that decline was small compared with resource industries. Power systems profit was within $50 million of its 2012 record, and our financial product segment delivered record profit in 2013.

The fourth quarter of 2013 top line for construction, power systems, and financial products, and their bottom lines, were better than the fourth quarter of 2012. I mentioned it earlier, and I think it’s worth mentioning again, it was a great year for cash flow. We set a new record for machinery and power systems, operating cash flow at $9 billion. We repurchased $2 billion of Caterpillar stock in 2013, and we raised the dividend by 15%.

We ended with a strong balance sheet, with over $6 billion in cash, and the lowest debt to capital ratio in 25 years. It was also a year of inventory correction, for both us and for our dealers. We reduced our inventory almost $3 billion and dealers reduced their inventories by more than $3 billion.

They were significant sales and production headwinds in 2013, but we think the significant impact on our sales is largely over. That doesn’t mean that every quarter we’ll be exactly flat, but overall for the company, we continue to believe that inventory changes will be a big story in 2014, like it was in 2013.

In 2013, we also improved our market position for CAT machines again, and made particularly strong gains with excavators in China. And speaking of China, our total sales and revenues there in 2013 were about $3.5 billion, and that was up more than 20% from 2012.

From an operational perspective, we also continue to make improvements in safety and quality, and while we understand that quality improvement is continuous, our dealers and customers give us feedback that let us know they’re seeing results.

So, with that recap, let’s move on to the outlook. Overall, sales and revenues in 2014 are expected to be roughly similar with 2013, at about $56 billion. And that would be in a range of about plus or minus 5%.

There are encouraging signs in the world economy, and we’re seeing some in our own business, and that gives us optimism for sales in our construction and power systems segments, and we think they’ll each be up about 5% in 2014.

However, we continue to be cautious about the mining industry. Despite prospects for the improved economic climate and continued strong production at mines, we are expecting a sales decline in our resource industry segments of about 10% in 2014.

The good news is, mine production has generally been up and improved in 2013, and we think it will likely be up again in 2014. The bad news is that orders for new equipment remain pretty low. But we don’t think that can go on indefinitely, and we remain positive on our long term view of mining.

Based on the size and age of existing equipment fleets, we believe that miners are buying new equipment at a rate that’s well below the average replacement level they’ll need going forward. As an example, we think that our sales of large mining trucks in 2014 will be around half the long term replacement level. That should be a positive for sales in the future.

In 2013, we took substantial actions to reduce cost, and we’re expecting to take more in 2014. That means that we’re expecting additional restructuring actions and charges in 2014 of $400 to $500 million, and that’s in addition to the $200 million of restructuring costs that we had in 2013.

The most significant item in 2014 is the restructuring of our Gosselies, Belgium facility. We announced that program on December 23 of 2013, and it’s designed to improve the competitiveness of our European manufacturing footprint by refocusing our current Gosselies operations on final machine assembly, test, and paint, with limited component and fabrication operations.

The actions there will include reshaping the supply base for more efficient sourcing, improving factory efficiencies, and workforce reductions. Our proposals are subject to Belgian ministerial approval, and we think a decision by the Belgian minister of employment will occur in the first quarter of 2014. And, subject to that approval, we expect to recognize about $300 million of employee related separation charges throughout 2014.

The remaining restructuring costs of $100 million to $200 million that are anticipated in our outlook are related to a wide range of actions across the company, and a part of our ongoing efforts to optimize our cost structure and improve the efficiency of our operations.

While we’re expecting numerous actions, we don’t expect that individually the charges would be significant. We expect that the restructuring actions taken in ’13 and that we’re anticipating for ’14 will be about $200 million favorable to our ongoing costs in 2014 and $400 million to $500 million per year favorable to ongoing cost after 2015.

Now, the most significant reason the 2014 impact is lower than the impact after 2015 is the timeframe involved in implementing the program in Gosselies, Belgium. It’s extensive, and it will take several years to complete. In addition, the other actions that we’re expecting to take in 2014 will occur over the course of the year, and as a result, we’re expecting partial year benefits in 2014.

In total, we estimate the after-tax impact of the restructuring charges in 2014 to be between $0.50 and $0.60 a share. Our profit outlook for 2014 is $5.85 a share, at $56 billion of sales and revenues, excluding the $0.55 midpoint of the restructuring charges and about $5.40 per share, all in, including the restructuring.

Now, there are a number of reasonably important moving pieces that are factored into our 2014 outlook, and we’ve provided a listing of those key items in the profit outlook section of this morning’s financial release. And if you haven’t already, I would encourage you to read through that.

So, in summary, on the outlook, $56 billion of sales and revenues in 2014. That’s relatively flat with ’13, in a range of plus or minus 5%, and $5.85 a share without restructuring, $5.30 all in.

One last point on the outlook, and that’s around the first quarter. For the full year, our sales and revenues outlook expects roughly flat sales. And sales flat with the first quarter of 2013 is probably a reasonable ballpark for you to think about for Q1 2014.

However, as you think about first quarter profit, you may be looking back to the first quarter of 2013 as a reference point. And if you do, there’s one fairly significant item you need to consider, and that’s that last year, we had an $87 million favorable tax item in the first quarter, and that was related to the research and development tax credit that was retroactively extended in 2013 for 2012. And that certainly won’t be in the first quarter of 2014.

So, that’s the outlook, and we’re ready to move on to the Q&A portion of the call.

Question-and-Answer Session


[Operator instructions.] Our first question today is coming from Andrew Kaplowitz.

Andrew Kaplowitz - Barclays

Your backlog declined to $18 billion in Q4. It was $19.1 billion in Q3, and it’s down $2.2 billion in the year. Yet you’re guiding to 5% increase in power systems, and you did mention in the release that some of the backlog decline was in power systems. So can you talk about the conviction of your forecast here, especially you do have some decent emerging market exposure in this business. Where is the growth coming from in power systems, and why?

Mike DeWalt

It’s probably worth noting that for construction, we still had a headwind in the fourth quarter on dealer inventory. Certainly not as much as it was in the fourth quarter or year ago, but the improvement in the fourth quarter, if we would have had flat dealer inventory, would have been a little bit more.

On power systems, we’re not looking for a big increase next year. We’re in the ballpark of about 5%. And I would tell you that it’s not any one sector. If you look at what’s in power systems, you’ve got industrial, you’ve got oil and gas, [unintelligible], and turbines. You’ve got electric power, you’ve got marine, you’ve got rail.

And we don’t really have any one of those sectors that up a lot. In fact, probably one of the smallest, which is marine, in the transportation piece, it’s probably a little bit stronger than the rest, but I wouldn’t really call that out too much. They’re all kind of in the same ballpark.

You asked about conviction and backlog, when we do our outlook, we try to give you our best guess at what we see in our backlog, what we’re hearing from customers, what we think is going to happen in the economy. And we try to put that together and do our best shot. So I would say it’s an outlook, so it’s not a sure thing, but I’d say we’re as confident as we usually are in an outlook.

Andrew Kaplowitz - Barclays

Just shifting gears, in [unintelligible] you said that you were not expecting a significant inventory changes at the company level. But it still looks like, if I’m doing the math right, that you lowered company inventories by about $700 million in the quarter. Was this mostly in resource industries, and that’s why your margins were so weak there? And how do you get conviction that these kinds of declines are behind you, when you kind of had similar issues all year, with company inventory destocks?

Mike DeWalt

I’d say one thing is our sales in the fourth quarter were higher than we thought, and the change in dealer inventory was about the same as we expected. And with production schedules relatively not changing a lot in the short term, some of that came from inventory. And I’ll tell you what gives us a little bit of conviction that it’s not going to go down as much as last year is essentially the amount of our inventory that is finished goods.

We’ve got the PDCs, for example. And a year ago, we had a lot of inventory in the PDCs. And it has come down substantially. I don’t have the numbers in front of me, but my recollection is that it’s down more than half. So I think that we expected that to happen this year. You know, there will be seasonal fluctuations, but by and large, I just don’t think there’s the likelihood that that finished inventory would come down as much as it did in 2013.


Our next question today is coming from Ross Gilardi.

Ross Gilardi - Bank of America

Just first on mining, can you talk a bit more about what happened to both OE and aftermarket orders from Q3 to Q4? And do you need a major pickup in orders in the second half of ’14 to deliver minus 10% for the year on the top line?

Mike DeWalt

I’m going to pull aftermarket out of this, because for us, aftermarket is kind of a daily thing. Our order board, if you will, is about 24 hours. So customers order, we fulfill and send. So sales are probably a better indicator of the future than what happened on the last day of the year.

So I think if you look at order rates for new equipment, they have remained very very low. That’s despite mine production. Our customers, they’ve actually had pretty decent years. Mine production has been up, and we think it will be up again overall, in 2014. Despite that, they’re not ordering much.

And we haven’t really seen much of a pickup. Certainly, order rates for resource industries were a little better in the fourth quarter than they were in the fourth quarter of the prior year, but that’s not saying much. And so I think to answer your question, we do need some improvement in order rates to be at minus 10, but I wouldn’t describe it as anything like robust or good or like 2012. But yeah, some improvement.

Douglas Oberhelman

Maybe it’s time for me to just add a comment on mining here in general. The interesting thing with our mining customers, and I have met, in the last 60 to 90 days, with several of my counterpart CEOs at the mining customers, and all of our mining team has been with all of our alliance customers, certainly, over the last 60 to 90 days, in some way or another.

The feedback is fairly consistent, and it’s not illogical at all. Their mining production continues. They are pulling ores out of the ground at faster and faster rates. They are just doing what we did, frankly, in ’13, and that’s pull our horns in, pull their horns in, with capex. We see that again in ’14.

But what they all have cautioned us on is that at some point in the future, because we’re extending cycles, duty cycles, because we’ve cut back on new acquisitions and even some parts in some cases, be ready for us at some point in the future. None of them can predict when that is, and I can’t either. but this is sort of typical with what we hear through these deep cycles. When it’s over, it tends to come back fairly quickly.

I’m not making that prediction here today. I hope it’s in 2014. I know it will happen in 2014 or 2015, but that’s kind of the quandary we’re in as well, trying to judge from our customers when they feel comfortable kicking back in with new purchases.

Now, capex is going down with miners in 2014, and you’ve all seen the numbers. We watch that too. A big part of capex in mining is not around mobile equipment. So when that turns, I’m convinced we’ll see not, as Mike said, a 2012 style ordering, and I hope we don’t, but we should see a fairly prominent turn, when it happens.

And as Mike said, we should see something in ’14 to make our forecast, but it’s out there, we just don’t know when. And I can’t provide any more clarity than that. That’s the feedback we get from our customers.

Ross Gilardi - Bank of America

And then just my follow up question on construction equipment, how did you get such a dramatic improvement from Q3 to Q4 in EBIT, on essentially a $300 million sequential increase in revenues? And then more importantly, do you think that $500 million of quarterly EBIT for construction is a sustainable run rate into ’14, particularly, as you mentioned, with some lingering price pressure in the business?

Mike DeWalt

For construction, I’ll say a couple of things. They had pretty good incrementals from third to fourth quarter. And there are a couple of things going on in there. Their pricing was a little bit better in the fourth quarter. They had more of this big order from Brazil in the third quarter that kind of dampened price realization a little bit. Again, sales were up. They actually did a great job on costs in the fourth quarter, and the impact on absorption of inventory decline for them was not a big deal in the fourth quarter. There was a little more of that in the third quarter.

But no doubt about it, they had a pretty good quarter. In terms of going forward, I’m going to try not to give any specific guidance on profit by segment, but they were around 10% in the fourth quarter, and that’s probably in the ballpark of, you know, we’re not looking for a big decline. They were hurt this year by inventory declines, and we don’t see that happening in 2014. So their margins in 2014 ought to be better.


Our next question today is coming from Jamie Cook.

Jamie Cook - Credit Suisse

One, Doug, just philosophically, how should we think about the message you’re trying to send here with the share repurchase? Your views changed quite dramatically since you first became CEO. So should we think about the $10 billion over five year, like $2 billion a year? Would it be more front-end loaded? Would you look to be more opportunistic than the $1.7 billion you already talked about?

And then my second question, Mike, as it relates to guidance, you gave some color on the first quarter. I guess outside of that, is there anything unusual we should think about as we think about the progression of earnings throughout the year? Anything not in line with your typical seasonality? Just given we have restructuring benefits that are going to hit, I’m not sure how that happened, in terms of your saying you’re expecting mining orders to pick up? I’m just trying to make sure we have the quarters correct.

Mike DeWalt

I’ll take the second part of that, on the guidance. Of the $200 million ongoing benefit that we kind of expected for this year, a lot of that is based on the things that we did in 2013. So those kind of things are in place, the big reductions in people that we had. So I think that $200 million, I probably wouldn’t divide it by four, because we are doing more in 2014. But you know, I would say, if you divided it by four and then favored the second half of the year a little bit more than the first half, that’s probably reasonable.

Probably the biggest issue on timing that we’re going to have during the year is when the actual restructuring charges for ’14 hit. I mentioned in the preamble that we need to have the Belgian government improve our program. And so until that happens, we won’t be booking the charges for Gosselies. So that needs to happen.

Outside of that, I don’t know of any real big items. I do think that the first quarter, for example, will have more negative sales mix, likely, than the second half, a little bit. The first quarter of last year, mining was still quite a bit higher than it is right now. So I kind of was talking about the first quarter sales being relatively flat, but that’s with mining being down a bit, and construction being up.

Douglas Oberhelman

Thanks for a thoughtful question on our buyback and cash. Let me give you a fairly broad answer to that, and I hope complete. I have changed my position since I became CEO. You’ll recall when that announcement was made, it was the end of 2009. Our debt to cap was way over 50% at that time. We struggled to be sure we kept our credit rating, and we vowed not to cut the dividend at that time, and both of those came true.

But as we look forward, we all agreed that we had to have a strong balance sheet. A cycle like we saw in ’09 and now another mining cycle like we saw in ’13 really puts pressure on our balance sheet and we decided we’ve got to have a rock solid balance sheet, which we do today. You’ll notice at the end of the year it dropped below 30% debt to cap. If you take our cash into consideration, of about $6 billion at the end of the year, it was down 16% to 17%. And in my definition, that’s a pretty solid balance sheet.

So we accomplished that. The second thing that we needed to do in the early days of me being CEO was to build up our capacity. We struggled with capacity, we did not have adequate capacity in the upturn of the 2000s. We gave up market share around the world. And our business model purely runs on field population, which allows our dealers to do what they do in a downturn, better than anybody else, but by servicing the field population that’s out there.

We accomplished that one. We’ve got capacity in place today, obviously far above $55 billion. We did $66 billion in 2012, so somewhere north of that, we have operating capacity today. We’re capacitized just right. Our capex has come down substantially as a result of that.

So I think where we’re positioned today going forward is significantly different than where we’ve been for a while, and as a result, seeing cash build up on the balance sheet is not healthy. That’s one of the reasons when we had strong cash last year the two quarters, we announced buyback, we spent $2 billion. As we announced today, we’ll spend $1.7 billion more this quarter, which will take full advantage of our 2007 buyback program. And we announced another $10 billion today, of course, over the next five years or so.

I’m not going to make any prediction on when we’re going to do that, but as long as we see fairly stable and consistent cash flow, which I expect we would, as long as we keep our debt-to-cap in the low 30s, that allows us to acquire, if we choose to do so, and that’s another question that’s kind of embedded in yours, we do not have anything at all big on the horizon. I’d say we’d be back in the mode we have been for many years, a number of acquisitions possible, all relatively small in size.

In fact, we hold a placeholder every year of about $1 billion for acquisitions. Sometimes we go that high, sometimes we don’t. But we will be looking for acquisition opportunities, I would say particularly around power systems. That’s a great business for us, it’s very stable, obviously. There’s some places to expand. We’ve got lots of opportunity around the world, so that might be a place, again, in a smaller way, not a huge way, that we might do it.

And so I’d say that, if we get lucky, that every year we buy a little bit back. But I’ll make no forecast on that. We have cash. We’ll probably use it. If we don’t, we’ll probably wait. And that’s kind of how I’d look at all of that. Great question, thank you.


Our next question today is coming from David Raso.

David Raso - ISI Group

Regarding resource industries, if you add back the restructuring in the fourth quarter, the margin was about 7%. Can you give us some help on how you’re thinking about the margins for RI if the revenue, as you said earlier, would stay around the same level that we saw in the fourth quarter?

Mike DeWalt

I would say that fourth quarter usually has a little higher cost levels than the rest of the year. And with sales for resource industries kind of coming down to this $3 billion level, it has a little bit bigger impact on margin. So they had a little more of an inventory decline. That hurt in the fourth quarter. They had costs that were up a little bit in the fourth quarter. So that was a little negative from the third quarter. And as you mentioned, the restructuring charges that they had in the fourth quarter.

In terms of going forward, at this volume level, if you were to take the sort of average margin for the year, it’s probably not far off of what you’d think for next year. There will be puts and takes, though. They’ve done a lot of work on cost reduction. So that would be a positive. They would like to spend a little bit more to drive synergy benefits and spend a little more on R&D. So that will go the other way. But I think by and large their margins, from 2013, are not significantly out of line at this kind of sales level.

David Raso - ISI Group

It’s a little tricky though. If you think construction margins can be 10%, roughly, in ’14, that implies a incremental margin for CI of 65% next year. That seems aggressive. But then if you really think RI can do margins of 11 to 14, it implies power systems margins are down to 13 next year, after being 15. So the math’s not squaring up.

Mike DeWalt

I’m not trying to give you specific numbers. I didn’t say that construction would be 10. I just said I think it will be probably closer to that than the 5% to 6% that they had earlier in the year. I think also one of the things that you need to remember kind of year over year too is there are other things that are maybe not in the segments. We had pretty substantial negative below operating profit currency losses in 2013 that we’re not expecting for 2014. So I don’t think, from an operating profit standpoint, there will be major changes, but I’m not suggesting it will be exactly the same in each segment as it was in the fourth quarter.

David Raso - ISI Group

How about just qualitatively, then? Power systems, how do you think their margins, off of the 15.4 you reported for 2013?

Mike DeWalt

Again, I don’t think it will be substantially different. Again, I’m not trying to do a forecast by segment. But probably not substantially different. It was a great quarter. I don’t want to pick on the quarter, but if you were to take the year, I don’t think their profit is going to be dramatically different year over year.

David Raso - ISI Group

And lastly, for ConExpo, any framework we should be thinking about going into a meeting like this? Historically, you’ve spoken of long term targets before, in settings like this. Can you give us a little framework for this year?

Mike DeWalt

Yeah, I think generically, what we’ll talk about is our strategy update. We’ve been working on that for the last several months of 2013. So we’ll spend time updating you on the changes that we made to the strategy, and we’ll talk a little bit about each of the major segments. And it will be kind of a longer term view, what we expect for the future. But coming out of such a tough year in 2013, I remember this back in 2009, when we had a similar meeting, we kind of gave specific number targets, and it was tough to get anybody to think the business could be that big, or that good.

So I think what you’ll probably hear from us at ConExpo is more around strategy, business conditions, and the things that we expect to do going forward. It probably won’t be so much a here’s a forecast for a particular year.

Douglas Oberhelman

That’s right, and a couple of things. We’ll talk about how our business has changed since [unintelligible], and how we see it kind of, to use your word, qualitatively going forward. But one other thing I’d ask all of you to do while you’re out there, those of you who are attending. Go down on the floor and look at our product offering.

You’ll be seeing a couple of things that you haven’t seen from us before. Number one, fuel economy. Frankly, we have struggled in the past to get some of our competition on fuel economy. That period is over. Our tier four interim and final machines that you’ll see out there are, in almost every case, best in class, and best in class by quite a margin. So I’d really like you to spend time with our people on the floor.

Secondly, equipment technology. Condition monitoring, job site, controls, everything around the electronics. We’ll operate a live dealer control room there. It’s [unintelligible], but it would look like a control room like we have all over the world today, monitoring our machines and what we can offer customers. And those two are very different than what we’ve talked about in the past.

And then our meeting, I think you’ll enjoy kind of a little look back at how we’ve changed the company and where we’re going, as Mike said, between here and the next few years out.

David Raso - ISI Group

And Doug, if you can help us, at ConExpo, or even right now, the strategy comment reminded me of, it appears that the majority of your dealers in China have dropped the SEM brand. You still have the original SEM dealers selling. That’s probably why you’re still doing okay in China. But SEM obviously been lagging the industry data, I guess in part because the traditional CAT dealers, the majority have dropped it.

And thinking of SEM as maybe a lower cost solution, cost structure, around the world, do you care to maybe comment a little bit on that SEM decision by the CAT dealers, how it makes you rethink your kind of lower value price point strategy?

Douglas Oberhelman

Yeah, and I’ll make sure that Ed addresses that at ConExpo. But generally, we encourage that change, from here. The market is huge over there for excavators and the things that CAT brand does, and we’ve decided over the last year that that’s really where we want them to focus. We went kind of back to a strategy of SEM brand for SEM products, inside and outside, although we still have quite a few dealers outside of China representing SEM. That has worked well for us. We’ll concentrate on that as a brand.

It is a value brand, and of course we’ve been upgrading that technology a little bit within the value offering against SEM’s competitors. So we think we’re in a better position with that going forward, and again, that will be a relatively small play in the scheme of things, but it’s important inside China.


Our next question today is coming from Nicole DeBlase.

Nicole DeBlase - Morgan Stanley

I just wanted to ask a question on material costs. I think you guys noted in the 2014 outlook of the release that you expect material costs to be favorable in ’14. But you’re also looking for an improving economic environment, and usually that causes commodity prices to increase. So I’m just curious what you’re expecting for material costs, and why you expect a decline.

Mike DeWalt

We didn’t actually put it in the economic part of the release, but generally speaking, I would say, for mined commodities, like copper, for example, we’re expecting commodity prices for ’14 to be by and large around the 2013 average. So we’re not likely to get big increases or decreases in commodity prices, at least that’s our view.

And so for material costs, you kind of have to look a little bit at how things have trended for the year. We’ve gotten kind of better and better as we’ve gone through the year. We’re exiting the year, 2013, at a lower level than where we came into the year. So even if we don’t get any other cost reductions at all, we have a bit of a carryover benefit that comes from the prior year.

So that should be positive. And in addition to that, most of what we buy is not commodities, believe it or not. It’s components that have a lot of value added in it. And based on what we’ve negotiated with suppliers, the changes that we’ve made, we’re looking for overall material costs to be lower. And again, the bulk of what we buy is not commodities, it includes somebody else’s value added. And so a combination of reductions there and what we’re coming out of ’13 with already give us pretty good confidence on the material costs for ’14.

Bradley Halverson

And I may just add quickly, you know, coming out of the strategy with Doug, a big part of it was supplier collaboration, and the idea that we would get to know our suppliers as well as we know our dealers. And we spent a significant amount of time on that coming out of the strategy. So what we see in terms of our material cost reduction is really a benefit of coming out with stronger supplier collaboration. Their resources, their expertise, combined with ours, is producing a lot better decisions for us, and a big piece of that reduction.

Nicole DeBlase - Morgan Stanley

And then just on construction with respect to pricing, I saw in the release that you guys called out that there is some pricing degradation or challenges in the North American market too, which I think was isolated to Europe before. So if you could just provide us with an update on what you’re seeing in the competitive environment in North America, that would be helpful.

Mike DeWalt

I think overall, for construction, there’s not really been anywhere where we’ve had a lot of strength. I think it’s been a tough environment around the world, North America included. We have had some issues here and there where we came out with tier four products in North America before some of our competitors. Some of our competitors had credits that they were using to sell tier three products over a longer period of time. So as that expires, as I’d say everybody gets on a more equal footing with regard to tier four, I think that will probably help us a little bit in North America, because it’s been a little bit of a drag.


Our next question today is going to come from Alex Potter.

Alex Potter - Piper Jaffray

I had a question on China in general. There’s been this downtick in PMI, obviously bearishness around emerging markets that has surfaced here just over the last week or so. But your commentary on China seemed at least relatively upbeat. Asia Pacific construction business is up really nicely in Q4. Power gen seemed to be holding up okay sequentially. So basically I’m just trying to see if you’ve seen anything recently to substantiate these initial signs of weakness in China.

Mike DeWalt

The market reaction has really occurred over the past week or 10 days or so. I think in our business, it’s been pretty positive. We’ve seen not just our sales but kind of the overall construction equipment group sales in the industry ticking up year over year, over the past few months. And we saw that again in December. So I think what we’ve seen has been pretty good. We’ve done better than the market there as well. Our sales in China were up more than 20% this year. They were up in the quarter. So you know, it’s not been a big negative for us.

Now, the flipside of that is, we’re not looking for improvements in overall GDP for China. We’re more expecting 2014 to be another year like 2013, like 2012. You know, in that sort of 7.5%-ish range. So that’s what we’re seeing in China, anyway.

Douglas Oberhelman

Let me add a little bit on China. We are watching it very, very closely from a couple of aspects. Obviously liquidity in the banking system, and we keep a close eye on that, as well as their reform efforts. And we have been laser focused on being a leader in China, and that’s, again, around building field population.

So we have seen our market share go up, our field population go up, and our business go up as a result. That is not to say China is not without lots of caution, which we are very much aware of, and we watch that every day. But at the same time, we have to have our dealers, with a field population they can work on, when times are bad or good. So that’s really our focus, is that business model inside China.

Alex Potter - Piper Jaffray

Last question here. I was just wondering if you could comment a little bit on power systems, maybe just qualitatively. Which segments, looking into 2014, do you expect to perform better, perform worse, and some of the [unintelligible] or reasoning behind that.

Mike DeWalt

I think with the exception of industrial, which has had just a really really big up year this year, and is going to happen really tough comps as a result, I think we’re essentially looking year over year,’14 versus ’13, no really outliers. We have power systems overall up, we think, about 5%. And you know, for the big kind of subsectors, it’s not going to veer far off that. So with the exception of maybe marine, might be a little bit better, industrial might be a little bit worse, the rest of them, oil and gas overall, electric power overall, rail overall, kind of up a little.

Douglas Oberhelman

Just a qualitative comment about power systems. Really sparkled in a tough year like 2013. And if you look back over the years, power systems has done that. Because there’s a fairly wide array of businesses in there. Take our rail business, between progress rail and EMD, EMD, in its third year of ownership, is just getting it done. We’ve seen a lot of cost reduction in locomotives, we’ve seen a lot of work around the aftermarket, kind of building up the Caterpillar DNA into locomotives. And we’re very, very happy with that acquisition and our current market position.

Electric power has been very anemic, as you all know, but within that is our acquisition of MWM in Germany, which brings us a natural gas and gas in any form offering. We’re building that out, expanding through CAT theaters. Long term, that’s going to be a very good piece of business for us. And, again, kind of countercyclical to everything else in the power systems business.

Our industrial business, which is really the reciprocating engines that we sell to everybody from ag to lift trucks, to other construction equipment makers, saw an increase in 2013 to make up for some of the shortfalls in the other segments. So within that power systems business, there’s a ray of diversity.

And then finally, the turbine business, which has just been fantastic for us, really the whole time we’ve owned it, going back to the mid-80s. But with the oil and gas boom, the fracking boom, around this country and elsewhere, that has been a real stellar performer the last few years, and I expect it to continue.

And then just an anecdote. I just returned from the Eagle Ford area, actually last week, and I had my ears to the ground on what they’re seeing down there. And actually our dealers there are a bit more optimistic than I expected. I’m not going to say wildly at all, but there’s still activity going on, and they feel like ’14 could be another solid year. So that’s anecdotal, but certainly a positive thing at this point in time.

But our power systems business is one that we’re very happy with, and again, within that, it’s kind of a complete and various array of businesses in itself.


Our next question today is from Robert Wertheimer.

Robert Wertheimer - Vertical Research Partners

I wonder if I could follow up on what Doug was just mentioning. There’s a little bit of consternation in the market with some of the big oil majors talking about maybe declining returns on some of the expensive capex, maybe cutting back, and maybe some of the other segments in oil and gas being strong. Are you able to delineate your exposure to the big international oil companies? And maybe you could just say is [Solar] set to have another record year?

Douglas Oberhelman

Yeah, I’d say, at this point in time, as Mike said also, our power systems in ’14 ought to look a lot like it did in ’13. We’re hopeful for a very modest increase, but that’s after a lot of gives and takes across that business.

As you all know, the fracking business has changed the gas pipeline and gas compression business immensely in this country. And there’s still a lot of buildout on getting that gas out of the ground, and that’s what I think we’re seeing primarily around solar. The big nationals around the world certainly are questioning where they’re going, and we see that. I’ve got to believe the opening in Mexico, when that starts, because I do think they will pull that off, is going to change the dynamics completely again.

And that could be some upside, although I don’t know how much of that we’d see in ’14. It ought to start. So really, I think you almost have to look at it country by country and see where that goes. But we’re not wildly optimistic about it, nor are we that pessimistic for ’14.

I have been surprised with gas here the last month or so, going above $5. I would not have predicted that at all, but it’s quite interesting. I don’t know what that will do, but I think it’s probably a fairly short term phenomenon, based on the cold weather.

Robert Wertheimer - Vertical Research Partners

And I don’t know if you’re willing to answer this or not, and you have given a decent amount of mining information, but there are concerns that there’s a couple more years of capex decline out there, and obviously your sales have already maybe front loaded some of that decline, having fallen so far. Are you willing to say how far your unit deliveries in mining have fallen from peak in ’12 to what your outlook is in ’14? It’s more than 50%, I’m sure. It’s probably more than 60%. Maybe it’s more than 70%. I don’t know. Maybe you can help out?

Mike DeWalt

I’ll help you maybe a little bit, Rob. We have a varied business, you know. It’s everything from drag lines to drills to big trucks to shovels. The largest selling product category for us is large mining trucks. And if you look at large mining trucks, and you look at what we’ve shipped this year, which would be relatively lined up with what our sales are, we’re down probably close to 60% in ’13 versus the peak. And if you look at what we kind of have baked into 2014, you’re looking at something like 75% below the 2013 peak for our shipments.

Bradley Halverson

When we look at our resource industry business, you know, we’ll give you a forecast which is our best estimate in terms of that particular time. But from an operational standpoint, we clearly understand there’s risk. We knew there was risk in ’13, if you were in the resource industry business. And in that business unit, they started taking action in the first quarter. The companies joined in, and we really focused on structural cost reduction. And with that, we were able to deliver the $1.2 billion of cost reduction.

And I’ll tell you that we’re bullish in mining in the longer term. Mike talked about our orders need to increase for the 10% down scenario. And we’ll walk into the first quarter in a cautious standpoint, and we’ll remains focused on cost reduction around here. But clearly, longer term, we see that as a great business for us. But we remain cautious, and we remain focused on the structural cost reduction in ’14.

Mike DeWalt

Okay, with that, we are just past the top of the hour, and we’ll sign off. Thank you very much for joining us today, and we look forward to seeing many of you at ConExpo in March.

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