Caterpillar, Inc. Q1 2010 Earnings Call Transcript

Apr.26.10 | About: Caterpillar Inc. (CAT)

Caterpillar, Inc. (NYSE:CAT)

Q1 2010 Earnings Call

April 26, 2010 11:00 am ET

Executives

Mike DeWalt – Director Investor Relations

Doug Oberhelman – Vice Chairman, Chairman Elect.

James Owens – Chairman, Chief Executive Officer

David Burritt – Chief Financial Officer

Analysts

Alexander Blanton – Ingalls & Snyder

Mark Koznarek – Cleveland Research Company

Seth Weber – RBC Capital Markets

Ann Duignan – J.P. Morgan

David Raso – ISI Group

Henry Kirn – UBS

Eli Lustgarten – Longbow Research

Joel Tiss – Buckingham Research

Jamie Cook – Credit Suisse

Ted Grace – Avondale Partners

Andrew Casey – Wells Fargo Securities

Barry Bannister – Stifel Nicolaus

Andrew Obin – BofA/Merrill Lynch

Operator

Welcome to the Caterpillar first quarter 2010 earnings results. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Mr. Mike DeWalt, Director of Investor Relations.

Mike DeWalt

Good morning, everyone and welcome to Caterpillar’s first quarter earnings conference call. I’m Mike DeWalt, the Director of Investor Relations and I’m pleased to have our Chairman and CEO Jim Owens, our Vice Chairman and Chairman Elect, Doug Oberhelman, 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 the call without the express 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 website, or to the SEC’s website where it will furnished as an 8-K today.

In addition, what we’ll be discussing today is forward-looking and involves risks, uncertainties and assumptions that could cause actual results to differ materially from the forward-looking information. A discussion of some of the 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, Risk Factors of our Form 10-K filed with the SEC on February 19, 2010, and also in our forward-looking statements language contained in today’s release.

Earlier this morning we reported results for the first quarter and we updated our outlook for the full year of 2010, and to start this morning, I’ll quickly summarize the quarter and updated outlook, then we’ll take your questions.

Let’s start with the quarter and what a difference a year makes. In the first quarter last year, we were seeing rapidly declining demand, order cancellations, turmoil in credit markets and declining economies across much of the world.

At Caterpillar, we were busy cutting production, costs, employment and working capital. Our major focus was on three goals; maintaining profitability, holding the dividend and maintaining our mid A credit rating, and we were successful at all three.

This year’s first quarter saw a very different picture. Capital markets are in much better shape than last year. Demand for our products is rising, and our we’re seeing it in most geographic regions, although it’s much more robust in the developing countries of Asia, Latin America, Africa, Middle East and the CIS.

We’re also seeing a significant pick up in mining globally. In fact, we’ve already filled our available 2010 production slots for some of our large truck models and are taking orders for 2011.

Demand for after-market service parts in our machinery and engine businesses is very strong and gained steam as we moved through the quarter, and this is usually a good indicator of how much work is getting done in the field, and the strength we’ve seen is encouraging. We’re working with our suppliers and within our own factories to ramp up production, and in some cases, to accelerate plant capacity additions.

In terms of employment, we are able to absorb a portion of the production improvement with the existing work force by winding down the rolling plan shut downs that we used last year to manage production declines. However, we’re also selectively adding to employment to support increasing demand.

We’re seeing employment increases in our factories in Asia and Latin America where the demand improvement is the strongest, and also in key U.S. facilities that are seeing export demand, and the employees in those factories certainly understand the importance of free trade.

I think the contrast between last year and this year can be summed up by saying, last year we were rapidly ramping down and faced a very negative economic climate. This year, we’re rapidly ramping up and are seeing much better prospects for the world economy.

Sales and revenues in the first quarter were $8.2 billion, and that was down about $1 billion from the first quarter of last year. Now, given my positive comments about the economic environment, you may be asking why are sales and revenues lower than the first quarter last year when demand is improving and we’re ramping up production.

Well, there are two main reasons; first, we ended 2008 with a strong order book for mining productions and large engines, and while we saw cancellations, and very few new orders, we did continue to produce and ship mining products, large engines and turbines at relatively good levels throughout the first quarter of 2009.

The second reason is that it does take some time to ramp up, and not just in our factories. Our suppliers are seeing in many cases, dramatically higher demand from us. We’ve increased production schedules throughout the quarter and March was our best month for sales and revenues since the end of 2008.

One other point about sales, and that is, throughout 2009 we talked a lot about the impact of dealer inventory changes and the very negative impact that had on our full year 2009 sales as dealers shed inventory. This year, we’re expecting relatively flat dealer inventory and for the most part, that’s what happened in the first quarter. Overall, dealers have new machine inventories about flat but took engine inventories down about $200 million.

While the midpoint of our outlook reflects relatively flat dealer inventories in 2010, in some regions, inventories are becoming lean, and the higher we are this year in our outlook range, the more likely it is that collectively, dealers may add some to their inventory later in the year.

Okay, let’s turn the first quarter profit. Profit in the quarter was $0.36 a share and during the quarter, we recorded a $90 million after tax charge related to Medicare Subsidy tax changes in the recently signed U.S. Health Care legislation.

Excluding that charge, profit was $0.50 a share. That compares with the first quarter of 2009 when we had a loss of 40.19 a share including redundancy costs of $558 million. Excluding the impact of redundancy, we earned a profit of $0.39 a share in the first quarter of last year.

Now again, that’s $0.50 a share in the first quarter this year, excluding the Medicare charge and $0.39 a share in the first quarter last year excluding redundancy.

Just a few key points about the quarter. Profit was higher despite lower sales volume and a negative product mix. Manufacturing costs were favorable $566 million and included in that, labor and overhead costs, warranty and material costs, were all favorable.

SG&A and R&D costs were close to being neutral despite added costs for incentive compensation and pension expense. Our machinery line of business was profitable for the first time since the third quarter of 2008 and engine operating profit as a percent of sales improved sequentially from the fourth quarter of 2009.

Cash flow was a positive and our machinery and engines debt to capital ratio improved from year end 2009. All in all, it was a good quarter. Demand in order rates have picked up. We’re ramping up production. Efficiency is improving. Costs were down and the balance sheet continues to improve.

That was a quick look at the quarter. Now let’s turn to the outlook. This morning we raised guidance for sales and revenues and for profit. Our original outlook reflected sales and revenues up 10% to 25% from 2009 and in dollars that was a range of $35.6 billion to $40.5 billion, with a midpoint of about $38 billion. The revised outlook we provided this morning has a top line range of $38 billion to $42 billion with a midpoint at $40 billion.

In terms of profit, the original outlook expected $2.50 a share at the midpoint of the sales and revenues range. In our revised outlook this morning, reflects a range of $2.50 to $3.25 per share with a midpoint of $2.88.

A point of clarification, that outlook does include the negative impact of the first quarter tax charge related to the U.S. Health Care legislation. In other words, our profit expectation for the year would have been higher if the bill had not been enacted.

Now there are four main reasons for the improvement in our outlook this morning. First, while our original outlook for 2010 did expect growth in developing countries, it’s now looking even stronger. Engine sales, particularly for gas turbines are looking better than we expected.

Sales of aftermarket parts, which are integral to and included in our machinery and engine businesses are growing faster than expected, and finally, mining is increasing more than in our original outlook.

Now in terms of costs in the outlook, in general what we said in our original outlook, looks to be about on track, and some key elements include favorable material costs for the full year, favorable manufacturing labor and overhead costs driven by improving factory efficiency, SG&A costs should be up slightly excluding short term incentive pay, and as we sais in our original outlook we do expect higher R&D expense.

As a reminder, pension costs are up as well and included in manufacturing, SG&A and the R&D lines.

Also one other point, with profit improving, we do expect increased short term incentive pay, and that’s linked to improving financial results and is as a result, highly aligned with shareholder interests.

That’s the outlook. In summary, the first quarter was a very good start to the year. We’re seeing positive increases in demand. Our machine production is increasing and we raised the outlook for 2010.

Just one more comment before we move on to the Q&A section, and that is, we’re going to hold our annual Analyst Meeting this year in New York City on August 19 in the afternoon. So mark your calendars. We’ll provide you more details on that over the next couple of weeks.

With that, we’re ready to take your questions.

Douglas Oberhelman

Maybe before we do that I’d like to interject here a little bit. It’s Doug Oberhelman speaking. As you know, I’ll become CEO in about two months time, and I thought given that this is Jim Owens’ last quarterly call, I would mention a few key statistics of Jim’s time in office here; what’s happened during what will no doubt be one of the most interesting runs as CEO in our history where sales mushroomed and then sales tanked and I’ll get into that in just a little bit.

Jim has done, we all think here, a wonderful job for our company, and let me tell you some of that. Jim became our CEO on February 1, 2004. That seems like many lifetimes ago, Jim but it went fast and here we are in 2010 already. That’s six years and 24 quarters for the record. 2003 earnings per share before Jim came in as CEO were $1.56 a share, and I know as I look back on some of these statistics, I had forgotten a lot of this history.

Of course we peaked at $5.66 a share in 2008, which was a record of any time in our history. 2003 sales were $23 billion and I can remember so well a couple of studies we did at that time wondering how we were going to ever break above $20 billion where we had been stuck for six or seven years or so at that number, and sure enough in 2008 we ballooned up to $51 billion and exceeded Jim’s strategic goal of $50 billion by 2010.

Unfortunately, in 2009 we cut that back by almost 40% and now as you can see from our outlook for 2010, we’re back up to $40 billion. This really gets interesting. During this period of time when Jim was our CEO and Chairman, our stock has risen almost 80% even with the ups and downs of 2009, a tremendously successful run as CEO and Chairman.

When Jim took over our quarterly dividend was $0.185 and today it’s $0.42. That’s 125% increase, and I will tell you that Jim was the main cheerleader, main arm twister of our Board and main driver of maintaining that dividend last year when everybody else was looking to cut around our industry and so many other companies.

He was forthright in his determination that we were going to make it through it. We were going to be profitable in ’09, which we were, maintained our dividend and our cash flow, which we did, and it paid off very well for shareholders.

Employment’s up about 25,000 during this period. It certainly was up more than up, but in the end, we’re still up over where he started, and I think what he’ll really be remembered for and all of you as shareholders and the sell side, probably don’t know a lot of this, but the internal things we changed on Vision 2020, which was his strategy plan that we are working on revising now again, it brought us to growth in China and emerging markets.

It brought us a cap reduction system. It brought us improvements in quality we’re seeing. It brought us efficiencies in our factories, set us up for the next few years, which will really see these things pay off, and we’re all pretty excited about that.

He set us up for the tier-four stage three B in Europe, emissions regulations, brought us the acquisition of Progress Rail which has turned out to be a real winner and one we’re extremely happy of, and I know Jim is very proud of his attendance and membership in the Economic Advisory Council under President Obama.

Another final cap on this, market cap when Jim took over was about $27 billion. Today’s I notice it’s right at $45 billion, and just a great run with this giant rollercoaster in the middle, but he got us through all that.

So Jim, with that, and this will be the first of many – not the first – but the first of many farewells between now and November 1. But congratulations to you and these statistics you can hold up to anybody anywhere in history anytime.

James Owens

Thank you, Doug. I’m speechless. It is true. Those are all facts. So Mike, we’ll go back to you and our Q&A session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Alexander Blanton – Ingalls & Snyder.

Alexander Blanton – Ingalls & Snyder

Last year you reduced dealer inventory by $3.9 billion so that if sales were $36.3 billion this year for you, they would be flat at the dealer level. Now the low end of your sales guidance is really only a couple billion less than $2 billion above that $36.3 billion, so that’s really only about a 5% increase at the low end if the dealer inventories are flat this year. Dealers would be up 5% at the low end of your sales range. That doesn’t seem like a lot considering what’s going on in Asia as you mentioned, so can you elaborate as to why it’s got such a low sales increase at the dealer level at the low end of the range.

Mike DeWalt

This is Mike. I’ll start that off. Just as a reminder, we did raise sales guidance today. The midpoint went up about $2 billion. The midpoint of our guidance is $40 billion. I think we provide a range around that because there are uncertainties in terms of what’s going forward.

Not everything in the year is positive. I mean there are some parts of the business that – engines for example – we see as being flat this year, not a big increase, at least at the midpoint. I think if you were to look at new machine production and look at the percentages around that, that would look better than the total overall.

I think you would find dealer sales are up more than what total sales are, again partly because engines are flat, and the services related businesses that were in the high 40’s in terms of percent of our total sales and revenues are much more stable than the machine and engine business.

So bottom line to that is I think just looking at new machine sales percentage wise, that’s where more of the increase is.

Douglas Oberhelman

Maybe just one touch of color to that too, as you know the recovery in machine sales, particularly in the United States, Europe and Japan, these are all OECD countries, is pretty anemic at this point, so we have very robust growth occurring across the Asia Pacific theater, Latin America and selected parts of Europe, Africa and Middle East, but very anemic growth in the OECD world which is a substantial percentage of the total industry globally.

Operator

You're next question comes from Mark Koznarek – Cleveland Research Company.

Mark Koznarek – Cleveland Research Company

I’d like to ask a question around the turbine business because you know 90 days ago we thought that would be down pretty significantly. I guess at the meeting that you hosted out there last year, there was, people got the sense it was going to be down double digit and you know, the guidance now seems to be flat. First of all, I’m wondering if those are reasonable suppositions in terms of the change, and then if you can talk about where the demand improvement is coming from.

Mike DeWalt

The second part of is being relatively flat, that’s a pretty good supposition. The piece before that about it being down significantly, we never used those words. We said it would be off of the peaks of ’08 and ’09. We never really did give a percentage range, but I would have never called it significant. In the improvement that we’ve seen is primarily for Solar than in Latin America, both oil and gas and electric power.

Douglas Oberhelman

Let me just add a little bit to that. Mark you’re right. We were definitely more bearish last August about Solar’s 2010 than we are today. Several things have happened. Mike alluded to most of those. I would say the biggest surprise we had was, that’s new since we talked to you last was a couple of very big orders in Latin America that are coming through in2010 that we did not expect to surface. They did, and that really helped out the year for 2010.

And then secondly, the phenomena around shale gas in the U.S., which is growing everywhere. You can read about that constantly, but that’s driving lots of new investment drilling and that’s full compression of course into the mainline gas lines of the United States.

So those two things have been a, one in the case of Latin America, very positive outcome we did not know about at that time, and shale gas has held up a lot more briskly than we thought. So those two are the broader things that I would answer that with.

Mark Koznarek – Cleveland Research Company

Just to follow up on this turbine business, what roughly is the manufacturing cycle time? Are these two and three quarter kind of production schedules or could we potentially even see further upward revision if orders come in. Could they still impact revenues later this year.

Mike DeWalt

I would say on the short end, Solar would probably be, it depends a lot on the product, but in my last discussions with them, I think on the short end it’s about a six month lead time, and on the longer end, a year for some of the big, more complicated stuff.

Douglas Oberhelman

That’s for new packages for their customer services side of the business, which is very substantial for them. They can react in shorter time frames.

Operator

You're next question comes from Seth Weber – RBC Capital Markets.

Seth Weber – RBC Capital Markets

You mentioned a couple of times mix was a negative drag on margins. I’m wondering if it’s possible just to quantify that a little bit more. Give us some detail whether that was more on the machinery, on the engine side, and then as we look forward, is it possible to frame that to guidance is you see the revenue numbers coming in more towards the top end of the guidance. Would that be more of a headwind or less of a headwind?

Mike DeWalt

Generally speaking, the sales mix, I’ll give you just a couple of points around the first quarter, and then we can kind of talk about the year. If you think back to last year, we had really high engine margins in the first quarter, relatively weak machine margins. If you look at the sales change quarter over quarter, machines held up pretty well. Most of the decline was in engines.

So in the first quarter, a bigger decline in higher margin engine business than machines. And then if you get within machines, and within engines, you see even more of it. We were producing large engines, turbines, mining product out of a backlog to a higher degree let’s say in the first quarter of a year ago, so we had a pretty good engine mix. We had a pretty good machine mix, and engines were relatively stronger than machines.

All of that kind of turned around here in the first quarter. So those are the negatives. The positives, there were some positives. On balance, it was negative for the quarter. There were a few positives though. We talked a little bit ago about aftermarket. That has seen good improvement and that helped offset some of the other declines.

As you look out through the full year, partly because of the inventory declines, the dealer inventory declines last year, we’re going to have probably quite a rebound for much of the smaller product because it’s, it has more of an impact from the dealer inventory changes.

So our small BPC product production and sales on that is just going to up substantially this year, and a lot of that is from a dealer inventory impact. So I think as we progress through the year and the machines sales are up, we’ll continue to see this negative mix throughout the year. And we didn’t quantify it in the release separately, but it’s fairly significant.

Seth Weber – RBC Capital Markets

So just to clarify, so if you hit the top end of your revenue guidance, you think that will be a function of selling more of the lower margin product?

Mike DeWalt

I think in all things, there’s a range for all sorts of the product. In other words, there’s a range for mining. There’s a range for oil and gas. Jim made a point a bit ago about Solar service business for example, being able to react. So I think those plus and minus potential for each part of the business. So it depends which part of the business drove us toward the top end.

Operator

You're next question comes from Ann Duignan – J.P. Morgan.

Ann Duignan – J.P. Morgan

My question is around seasonality. Maybe you could help us understand given that you’re talking ramping up production from here on out versus we’d normally would model Q2 being stronger and then Q3 weaker. How should we think about seasonality, particularly machines as we go through 2010 because it’s not a normal year.

Mike DeWalt

Seasonality is much more difficult to play in when you’re in kind of an inflection point I think like we are now, where we’ve moved from things getting worse to flattening out to moving up. So I think the way I would think about it is, production will probably ramp as we go through the year.

Ann Duignan – J.P. Morgan

Since you raised the midpoint of your revenues, how comfortable are you still that input costs will not be a negative.

Mike DeWalt

You mean material costs?

Ann Duignan – J.P. Morgan

Yes.

Mike DeWalt

Material costs were actual favorable in the first quarter and a part of that $566 million of manufacturing costs that we reported. So we’re off to a pretty good start, but in all things you know, the outlook is a forecast and certainly things could change you know, based on where commodity prices are, our discussions with suppliers, the cost reduction actions that we’ve enacted, the purchasing forward that we’ve done. I think we’re reasonably comfortable that we’ll have favorable material costs this year.

Operator

You're next question comes from David Raso – ISI Group.

David Raso – ISI Group

Just thinking about the implied incremental margins for the rest of the year, year over year incremental are implied around 18% and even if I want to add back $400 million of higher R&D in the rest of the year, incentive comp say around $250 million, it’s only implying 26% incremental, and I appreciate the mix, but I know we’ve discussed the times, incremental are different that absolute. I know BCP is not a good margin business on an absolute level, but year over year we spoke of BCP could get to break even this summer. That’s a big incremental amount of business. So what I’m missing even with the R&D and the incentive comp, 26% incremental margin, but machine revenues are going to up 55% year over year the rest of the year as per guidance. Is there something I’m missing about the incremental margins?

Mike DeWalt

Just a couple of things, David, are a variable margin rate in the mid 30’s normally. So with that as a starting point, we do have negative mix like we talked about going forward. We do have a little bit higher R&D costs. When you have big increases in volume, that does drive a little bit of period cost in the factory.

Incentive compensation is higher. That’s related to higher profit. So I think those are all things that would take our variable margin rate and kind of mitigate it. Again, I think it’s R&D. I think it’s incentive comp. I think it’s product mix. And that’s what would take our mid 30’s variable margin rate down into the mid 20’s.

David Raso – ISI Group

Again, mid 20’s, I added back the R&D in a short term. I mean if you want to go all in, you’re saying the normal mid 30’s is going to be cut in half to 18, and I’m just trying to be clear. Is there something unique. I would have figured initially price versus cost. You’re still guiding in a way that price versus cost maybe is not quite as robust as three months ago, but it’s not a negative.

Mike DeWalt

It’s hard for me to guess what’s in your model, but I would suspect probably that maybe you’re not factoring in enough for sales mix, I don’t know.

David Raso – ISI Group

What implies for ’11. If dealer inventory is flat, and I know with the land strategies trying to keep the dealer inventory tight, I’m just curious what is management’s view of a comfortable level for the dealer inventory because whatever you want to assume at retail growth in ’11, the dealers did take out $3.3 billion of inventory in ’09. And it’s hard to handicap it, but what would the thought be on ’11, would it be logical that you’re going to get half of the $3.3 billion back? What are you comfortable with and obviously depends on how effective the land strategy is, but what is your comfort level?

Douglas Oberhelman

I would say at this stage, it’s going to be hard to judge ’11 for lots of reasons. But, we’re just over half way through implementation of our lean strategy right now, which we’ve got a long ways to go with that. Where it is working, the dealers love it. We love it and it’s really going to pay off.

But how that sorts out with the ramp up here the rest of 2010 and how fast we can get that fully implemented is going to part of the answer to 2011, as is the economic environment in 2011. But we’ve got a view that between rentals, between dealer inventory and between our finished goods inventory in lane one, that entire, the aggregate of that mix is what we’re aiming for to improve any prior cycle we’ve had.

So it’s a big, even if we wanted to comment about 2011, which we don’t we would not be in a position just yet to talk about the full impact of the lane strategy. But it’s coming and I think by the time we see in August, we’ll have a lot better I think, idea of where that’s going to end up. But we’re still in the growth stage and formative stage of that as we go, and many of you have heard that through your dealer surveys as well.

David Raso – ISI Group

But is it fair to say flat inventory in ’11 versus ’10.

Mike DeWalt

I’m going to interject. I think we’ll pass on talking about 2011, and we need to move on to the next question.

Operator

You're next question comes from Henry Kirn – UBS.

Henry Kirn – UBS

Congratulations to Jim and congratulations for a good quarter. Could you talk a little bit about how demand by end market applications will shift in 2010 versus the last few years?

Mike DeWalt

Definitely if we take machines, definitely we’re seeing increasing end user demand in mining. Actually, if you look worldwide, things actually look slightly positive for residential, although North America is certainly down.

Infrastructure spending around the world looks pretty good. I think generally speaking, if you look worldwide, again driven by the emerging market countries, I think most of all the end markets look from slightly to moderately positive. But mining, from a machine standpoint is definitely looking best.

I think for marine, things are looking up right now in oil and gas. We talked about Solar a little bit ago, and Doug touched on the shale gas. Electric power is looking a little bit better. Marine, still weak and the MAK business is probably likely to decline, so marine is probably a weaker one.

Actually, in the first quarter we had good sales from industrial. That piece of it I think turns a little quicker, so that’s looking a little more positive. But I think maybe with the exception of big marine, I think most of the end markets are looking a little bit better.

Operator

You're next question comes from Eli Lustgarten – Longbow Research.

Eli Lustgarten – Longbow Research

Can we talk a little bit more about the cost side of it. With material costs going up this year, how far out are you hedged this year? I assume you’re basically hedged for the entire year in most of your major steel and as part of it, with emissions coming next year, you have high material costs. You’re going to face at one point another in emissions. What’s the probability of seeing some sort of pre buy in both the engine and particularly in the machinery side as you get towards the end of the year because of the potential higher prices next year?

Mike DeWalt

That is one complicated question. I’ll start out with the first part of material costs. We don’t actually do a lot of hedging per se. There’s a little bit but not lot. What we have done a little bit more of this year is do some pre-buys. I guess you might call that a form of hedging, but we’ve gone out to some of our suppliers and done a little bit of pre-buying both to kind of lock in some supply and price.

I think those mostly just go out through a couple of quarters, so it’s not massively extensive. I think the biggest positives for us on material costs this year, I think commodity costs will be up, but we’ve done a lot of work to drive cost reduction, design and sourcing related cost reduction, and our view is that’s likely going to offset the commodity related increases this year and keep us slightly favorable.

Douglas Oberhelman

Let me talk about Tier Four a little bit, and you’ll be seeing our strategy on Tier Four roll out here in the next few weeks, a month or two in terms of what we intend to do with our models that we offer and our pricing strategy.

As you know, the off-road business really has never seen a pre-buy business phenomena like the on road business has. Depending on what the strength of the economy, when all of us in the industry announce 2011 strategies, I would expect some pressure from customers on some prebuy, but again, it’s going to be spotty and dependent.

You’ve got to remember, Tier Four 3B only applies to really Western Europe, Japan and America, and then it’s a phase in. the rest of the world has nothing to do with Tier Four at the moment which would be two-thirds of the business if not a little more.

But I would expect in some models, in some zones geographically, we would see some heightened order activity midyear, third quarter after they see how we’re all going to come at this for 2011. As it rolls on out through 12 and 13, as more and more the horsepower ratings and ranges come in, and depending on what happens with the January 11 early model adapters, you could see some of that.

I think we would expect something around that, but it’s really difficult to predict at the moment with so much uncertainty in exactly the places where Tier Four and 3B is going to occur, Western Europe and the U.S.

And it might not be that material, because just sheer capacity in the fourth quarter given how fast things are ramping up.

Operator

You're next question comes from Joel Tiss – Buckingham Research.

Joel Tiss – Buckingham Research

Of the $4 billion of underproduction in 2009, about how much came back in the first quarter?

Mike DeWalt

In the first quarter, machine inventory was about flat, so in the first quarter a year ago, I think machine inventory declined about $300 million. So we said this year would be flat and for machines, that’s what happened actually in the first quarter. Dealers actually took $200 million out for engines.

Joel Tiss – Buckingham Research

That’s on the production side.

Mike DeWalt

Right. Production is essentially for the most part sales.

Operator

You're next question comes from Jamie Cook – Credit Suisse.

Jamie Cook – Credit Suisse

Can you comment internally, I guess the concern is, if this recovery happens how you think Caterpillar is doing so far. I’m hearing surprising statistics in the channel already about lead time issues on the machinery side, so if you could comment where you are, where lead times are today from a machinery relative to where we were three or six months ago and you ability to – what you’re assuming in your forecast in terms of potential market share gains.

Mike DeWalt

I think basically, with the lane strategy, you almost have to look at this in pieces. It’s not as simple as just what are lead times because it really depends on what channel they come out of. With lane one for example, our target is about a ten day lead time, and except for a couple of products that are coming out of Japan, and we actually underestimated demand, except for those couple of products, generally speaking that’s about where we’re at.

So delivery time for the roughly 24% of machine sales that came out of lane in March, lead times are very, very short. Now, for product that dealers place on the factory and don’t get out of lane one, we’ve moved in terms of quota delivery time from 11 to 12 weeks to around 15 weeks. So it has moved out, and I think that really a function of again, being an inflection point where we are in process of moving production up to a higher level.

I would point out though, as a part of that, we are giving preferential treatment to dealer orders that have a customer attached. So if there’s a customer involved, those orders generally get shipped three or four weeks earlier than an inventory order, if the dealer is ordering to add t his inventory. So I think in the scheme of things, delivery times are going out, but really aren’t too bad.

James Owens

Just a brief comment. Capital goods are notoriously difficult to forecast. Three to six months ago, most of you, all of our dealers, many of our customers were very pessimistic about the global economy and I don’t think they saw the V-shaped recovery, particularly in a lot of commodity sectors and emerging markets that was unfolding even at that time.

So we’ve had a very sharp bounce back in enthusiasm here, and quite frankly, our economics’ group was well ahead of most marketing groups as well as even customers in forecasting the upturn and the strength of commodity markets.

So as early as October last year, we’ve been out working with suppliers, not only our direct suppliers, but our second tier suppliers helping them understand this inventory cycle and how it was going to impact their sales. I think we’re more ahead of it if you will certainly than we were coming into the ’04 cycle, and our ability to ramp up now, is really a function of how fast we can bring the supply chain along.

Our ability, we’re kind of capacitized for $55 billion or so top line sales and revenue, but we’ve got to bring our supply base up to get to that kind of level, and that’s going to take some time. And we’re working that issue very hard. Again, we had a road show in October, helping get them prepared for this eventuality. We weren’t certain it would happen, but we thought there was a high probability. So I think we’re out in front of this to a reasonable extent compared to where we were back in ’04.

Operator

You're next question comes from Ted Grace – Avondale Partners.

Ted Grace – Avondale Partners

I had a quick question on the integrated services in the press release. We could see that it was about 47% of 1Q revenue. Just wondering if you could give us the year ago comp and then if you could also speak to the key elements. I know that you mentioned that aftermarket parts was looking better on the outlook side, but just wondering if you might be able to give us some more color on machines versus engines, and then if you could give us any color on any of the other big parts and logistics in progress will be terrific.

Mike DeWalt

I’m going from memory here, but I think last year was around 40% in terms of integrated services. So this year is a little bit above that. So in other words, last year we did $9.2 billion and 40% would have been integrated service related.

Ted Grace – Avondale Partners

Any specific color on machines versus engines and logistics versus progress rail, like what happened with financial services?

Mike DeWalt

The only place we actually made any specific comments is around the aftermarket piece of that, and that is definitely improving. Again, the rest of the, in general, in the integrated services business, we don’t go up and down as dramatically as certainly new machine and new engine sales, so I’ll leave it at that. We’ve never really broken them out and shown them separately.

Douglas Oberhelman

I would just add a couple of things. The manufacturing business and our Progress Rail element have performed well in 2009 as we expected them to do, and they’re enjoying a bit of uptick as well not dissimilar to the rest. So it’s across the board, but the big driver is those aftermarket parts as we’ve said many times, and that’s important to us.

Operator

You're next question comes from Andrew Casey – Wells Fargo Securities.

Andrew Casey – Wells Fargo Securities

Clarification on the gas turbine comments, should we expect production to flip positive when compared to the prior year as you get to the end of 2010? And then is the $55 billion capacity size for the company at today’s pricing levels?

Mike DeWalt

The answer to the first question is if you look at Solar, just a couple of observations. One, we said full year could be close to last year, but last year they had a really big first quarter and second quarter and already in the first quarter their deliveries were below the first quarter of a year ago. So the last three quarters ought to be better.

They had a really big second quarter so I would suspect year over year they’ll probably see a bigger increase in the second half of the year.

Douglas Oberhelman

Having said that, we’re still cautionary beyond in terms of where we’re going to be in 2010. We were surprised by a couple of big orders we did not anticipate. We’ll see how it goes after that. So I’d say that’s a fair comment, but we go no further.

Mike DeWalt

On the capacity issue, that’s a rough number. Again, we actually did over $51 billion at ’08 prices in ’08 with only one quarter of Japan in the number. So basically the $55 billion is an observation based off where we were in 2008.

Andrew Casey – Wells Fargo Securities

I just wanted to clarify that in front of whatever the strategies before Tier Four.

Douglas Oberhelman

That does not include Tier Four prices. That would be where we’re at today. Tier Four pricing would definitely go up.

Operator

You're next question comes from Barry Bannister – Stifel Nicolaus.

Barry Bannister – Stifel Nicolaus

I was looking at an Engineering News Record article on February 22, and it said that Cat construction equipment prices will rise about 12% over the next four years as the company rolls out Tier Four. And then it goes on to say that about a third of the increase or 4% would start in 2010, said Cat officials at the Peoria headquarters. Pricing in the quarter was 2%. Are you planning on trying to do 4% this year or was the article out of context and does 12% over several years sound about right?

Mike DeWalt

The 12% was really starting in 2011 not 2012 when Tier Four starts, and it’s not necessarily an overall machine number. You know, it’s adjusting those places where you’re going to get Tier Four, I mean for the product that goes to emerging markets that’s not Tier Four, that certainly wouldn’t apply.

The point of the article was that kind of on average over kind of the Tier Four implementation, we’re seeing a cost increase and we felt the need to get about 4% for Tier Four and the thought was that we would try to do it uniformly over a few years rather than just one lump sum at introduction say in 2011. So it really wasn’t so much a 2010 comment.

Douglas Oberhelman

Let me come back to this a little bit in terms of Tier Four phase in and Tier Four is not a big bang by any stretch. In fact, there’s some fairly narrow horsepower band ratings that phase in beginning January 1, 2011. That’s the very first pricing activity we would take for Tier Four emissions and then over the next four years, culminating with the big high horsepower stuff and locomotives and barges, Tier Four is done.

But nothing happens in ’10, and then it’s really a building wave in ’11, ’12, ’13, ’14 and ’15 as those new products come in. There’s lots of ways to use the regulations to the industry’s benefit in there as well. So we’ll be talking a lot more about that probably in August and you’ll see as we go what our strategy will be as the year rolls on.

Operator

You're next question comes from Alexander Blanton – Ingalls & Snyder.

Alexander Blanton – Ingalls & Snyder

Thanks for allowing a dialogue on our questions this time because it really didn’t work too well last time cutting us off right at the beginning of the answer. So I think that worked a lot better and you got everybody in it looks like.

Could you clarify what that 12% is on that last question from Barry. Is it 4% a year for three years?

Mike DeWalt

What we talked about was increases of up to 12% on Tier Four product and we were going to phase it in.

Douglas Oberhelman

Remember Tier Four is machines, engines, locomotives, every single product off road we make across our 300 product families and beyond. So I’d say it’s a very broad statement that applies to a lot of things. Specifics will be, we’ll be dealing with the specifics as we introduce these products going forward. It’s a very almost technical review of pricing as well as competitive environment at that time.

Alexander Blanton – Ingalls & Snyder

But it sounds like it’s because you’re phasing in various products each year, because if it’s just a cost catch up, picking up the cost of this and you only do 4% the first year, would there be a negative impact on your costs that year?

Mike DeWalt

We’ll talk about that more when it happens in 2011, but remember all the sales don’t phase in the first year either.

Operator

You're next question comes from Andrew Obin – BofA/Merrill Lynch.

Andrew Obin – BofA/Merrill Lynch

The question I have is the phasing in of the manufacturing costs throughout the year. Could you just give us some guidance as to, is this the number that you disclosed in your flow chart, how should we be thinking about it throughout the year and if it can actually become a drag by the end of the year.

Mike DeWalt

Again, manufacturing costs are material, labor, overheard, warranty, and we expect all of those to be favorable for the full year. They were actually pretty favorable in the first quarter. You know, I think for material costs, it’s probably a little bit easier in the first quarter because we were coming out of, the first quarter of ’09 was coming off of the higher cost level coming out of ’08.

So I would say probably for material costs, with commodity prices up, and I think the comps will get increasingly difficult, so I think material costs will get harder as we go through the year.

I think in terms of labor and overhead, we’ve got a lot of programs in place. I think we’re doing a pretty good job. Now the first quarter of last year, that’s when we started the ramp down, but I mean, I think it will probably be favorable as we go through the year. I think further implementation of Cat production system. We’ve got higher volumes, and all of that ought to be pretty good for manufacturing costs.

Andrew Obin – BofA/Merrill Lynch

So by Q4 we’d still be better than nothing. I know it’s hard to forecast the future, but in general, that’s the direction I should be thinking of.

Mike DeWalt

I think that’s correct. Again, though I think the comps get harder as you go through the year on material costs, so that’s one where I would guess the gap would be shrinking.

With that, we’ll let Jim wrap up.

James Owens

Thanks Mike, and my thanks to all of you. Let me just start by saying I’ve enjoyed the opportunity over the last six and a half years to work with the analyst community. You’ve been very understanding. We’ve had good working rapport I would say and I appreciate the work that you all do.

Secondly of course, the greatest honor for me has been playing quarterback for what I think is one of the finer companies on the global stage; great people the world over and in terms of accomplishments, the people side of the equation, what we’ve done on the safety and engagement side, I think bodes very well for the future of our company. It’s just indicative of the kind of very positive change that we’ve made on a continuous and steady basis.

We’re very much focused on managing through the cycle. I think we were challenged certainly to get the pull through we would have liked with explosive growth from ’03 through ’08. I think we demonstrated a lot of capability, maybe surprising some of you, on our ability to manage a very troublesome and horrific recession in ’09.

I think it was one of our finest hours. We showed a lot of nimbleness in taking cost out in a hurry and did achieve what we consider a hat trick of sustaining profitability, sustaining our credit rating and our dividend. And, I think we continued to invest in key capacity bottlenecks and in research and engineering that bode very well for our future.

We’re very much focused on delivering results for long term shareholders, and sometimes I know that doesn’t square with the image of CEO’s that are focused on just quarterly pennies, but we’re very much focused on the long term shareholder.

I think we have our company exceptionally well positioned for growth on a global scale. I can’t tell you, I was honored with Doug’s opening comments, but I think the transition that we planned has been well laid out. It’s going exceptionally well. I’m confident you’re going to hear a strategy roll out in August which shows you exactly how the team is going to take our company to another level going forward for the next five or ten years.

So again, it’s been an exciting time. I again appreciate all the work and rapport that we’ve had and good look on the forecast for the coming year.

Mike DeWalt

With that, we’re at the end of our hour. Thank you very much and we’ll be talking to you over the next quarter.

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