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Executives

Mauk Breukels - Vice President, Investor Relations and Corporate Affairs

Scott Thomson - President and Chief Executive Officer

Dave Smith - Executive Vice President and Chief Financial Officer

Donna-Marie Bergerman - Director, External Reporting

Analysts

Yuri Lynk - Canaccord Genuity

Cherilyn Radbourne - TD Securities

Sara O’Brien - RBC Capital Markets

Peter Prattas - Cantor Fitzgerald

Bert Powell - BMO Capital Markets

Benoit Poirier - Desjardins Capital Markets

Ben Cherniavsky - Raymond James

Kam Mangat - Salman Partners

Christine Healy - Scotia Bank

Finning International Inc. (OTCPK:FINGF) Q4 2013 Earnings Conference Call February 19, 2014 5:30 PM ET

Operator

Good afternoon, and welcome to the Finning International Fourth Quarter 2013 Results Conference Call for Wednesday, February 19, 2014. Your host for today will be Mauk Breukels. Please go ahead, sir.

Mauk Breukels - Vice President, Investor Relations and Corporate Affairs

Thank you, operator and thanks to everyone for joining us. On the call with me today are Scott Thomson, President and CEO; Dave Smith, Executive Vice President and CFO; and Donna-Marie Bergerman, Director, External Reporting.

As usual, there is a set of slides which accompany today’s remarks and they are available on our website, finning.com. The slides and an audio file of this conference call will be archived at finning.com as well. Today, Scott will start with his remarks and then Dave will provide a summary of the financial results for the fourth quarter. Following the remarks by Scott and Dave, we will open up the line to questions.

Before I turn the call over to Scott, I want to remind everyone that some of the statements provided during this call and the information in the slides that accompany the call and in the press release is forward-looking. This forward-looking information is subject to risks and uncertainties as discussed in the company’s Annual Information Form under Key Business Risks. Please treat this information with caution, as Finning’s actual results could differ materially from current expectations. Our forward-looking disclaimer statement is on Slide 2 and is part of our quarterly releases and filings. Finning does not accept any obligation to update this information. Scott, over to you?

Scott Thomson - President and Chief Executive Officer

Thank you, Mauk and good afternoon everyone. I will start my remarks today with comments on the quarter and full year results and then turn to an update on market conditions. We had a solid quarter. The highlights included strong revenue with product support growth of 9% and improving profitability trend and a significant reduction in invested capital. Consistent with our focus on improving working capital management, we reduced invested capital by approximately $200 million from the end of quarter three.

The fourth quarter is typically a strong free cash flow quarter. Nevertheless, I was pleased to see the focus on inventory management and I am convinced that our supply chain initiatives will continue to improve our capital efficiency over a multi-year time horizon. The significant inventory reduction in Q4 was mainly the result of reduced equipment inventory. Improvements to the parts inventory will be more gradual. We generated $365 million in free cash flow in the quarter enabling us to reduce our net debt to invested capital ratio to the midpoint of our target range. The strong free cash flow we generated in 2013 means that we have now paid for our acquisition of the former Bucyrus business.

Turning to the annual highlights. The back half of 2013 met our expectations. In August, we forecasted modest revenue growth and improved free cash flow performance, relative to 2012, 2013 revenue increased by 3%. Product support grew by 12% with the acquired shovels and drill business contributing to this growth. We had some hiccups on the Bucyrus integration in 2013, but South America’s drills and shovels performance in Q4 was a significant improvement over the first three quarters of the year.

Importantly, we improved from a profit pull-through perspective as consolidated EBIT grew by 7%, which exceeded the revenue growth rate. In Canada, we continue to make progress. If we normalize for the land sale in Q4 of 2012, Canada’s EBIT margin increased from 6.8% in 2012 to 7.8% in 2013. We recognized there is much more opportunity for improvement, but the operational excellence agenda we outlined will allow us to continue to improve from a profitability perspective.

As we look forward to 2014, we are cautiously optimistic. I was in Chile at the beginning of January and have the opportunity to speak with five of our largest mining customers. It was encouraging to note that our major customers are planning on significant copper investments over the next few years. New mining equipment sales will decrease significantly in 2014, but the copper fundamentals are strong, which is encouraging for our business longer term and we will see a growing product support business in 2014. Importantly, we have also increased our market share in Chile in the general construction line, which is an important offset to the slowdown in mining. Given the new equipment mining slowdown, we continued to work to address our cost structure. Two weeks ago, we reduced our work force by an additional 200 people which positions us well as we go into 2014.

While we are speaking about South America, let me briefly comment on Argentina. We are well aware of the potential for currency devaluation and we minimized our net asset exposure in Argentina in the back half of 2013. I was pleased with how our team managed the situation and minimized our exposure. We are continuing to manage the business with a high degree of caution.

Turning to the UK and Ireland, I will be traveling to the UK shortly and I am pleased to say we see economic conditions strengthening there. Order intake has been steady for our equipment solutions and power systems divisions. Our backlog is up approximately 40% over this time last year. We are making good progress in growing our market share in construction products and are encouraged by the signs of stability we see from the coal mining sector.

In Western Canada, oil sands producers remained focused on reducing operating costs, but activity levels are stable. We are actively biding on mining deals with some coal and metal customers and have heavy construction and heavy construction remains very active for us and is a key contributor to our solid order intake. Order intake in Canada was up 5% over Q3 2013. I was at some of our branches in Northern BC a few weeks ago and I am very excited about the opportunities I see in the region. I visited Kitimat with one of our large customers who was busy in the region and I left with an even stronger conviction that Western Canada LNG will be a significant long-term opportunity for Finning and Caterpillar.

I have recognized mining companies are spending less CapEx dollars, but we are fortunate given our exposure to commodities that have constructive supply demand dynamics and because our product support business continues to perform well. That gives me confidence that we will perform up to shareholder expectations in 2014.

Despite my confidence with regards to 2014, it is important to set expectations for Q1. As all of you know Q1 is a seasonally slow quarter and that will be no different in 2014. Furthermore, the rapid depreciation of the Canadian dollar vis-à-vis the U.S. dollar will put downward pressure on Q1 results. Over time a lower Canadian dollar should be beneficial to 2014 financial results, but when the dollar weakens as quickly as it did it takes time to adjust our parts pricing in Canada and that results in some immediate downward pressure that will flow through the financial results in Q1.

Our focus remains on managing the factors that are within our control. These are costs, working capital and capital investment. As we communicated at our December investor meeting, we strongly believe that there is a meaningful correlation between increasing return on invested capital and improved shareholder returns. Company wide, our efforts are focused on improving our return on capital performance by increasing EBIT and managing our invested capital in a disciplined fashion.

Our four operating priorities namely service excellence, supply chain optimization, asset utilization and market leadership will result in improved return on capital over time. With regard to EBIT improvement, I am particularly encouraged by the progress we are making on the market leadership front. We continue to grow market share in core products in each of our regions and in Canada our general construction market share saw a two point increase in 2013 relative to 2012. Furthermore our customer loyalty scores for December were the highest for the year in Canada and were up materially year-over-year in both Canada and South America.

We are also moving forward with the rollout of service profitability improvement initiatives with the sense of urgency, two weeks ago, when Carlos and I were with our employees in Prince George, when they kicked off the service excellence program. As I mentioned in December we are in the very early innings in the service excellence agenda, but I am pleased we are rolling out the improvement initiatives into our first five branches early in the year.

Moving to the capital investment side, 2013 capital spending was significantly lower than 2012 and this lower level of spending will stay with us in 2014. Given our historic investments in Chile and Canada, we have the capacity to absorb higher activity levels and we won’t need to spend significantly more capital even if activity levels ramp up beyond our expectations. Our focus right now is on adjusting the allocation of work across our facilities. The supply chain optimization work in Canada is progressing well and will continue to reduce our working capital, particularly inventory and strengthen our service levels. Since 2012, our 24-hour and 72-hour parts fill rates have improved dramatically. We just received the January service level numbers and our 24-hour fill rate is at 86%, which compares to 76% for 2013. We are now operating that target and this is being sustained.

So in summary, I believe we had a solid fourth quarter and I was particularly pleased to see the reduction in invested capital and the free cash flow during the quarter. Although we will see weakness in mining equipment sales in South America in 2014, this will be offset by growth in product support and continued activity in Western Canada. And lastly, a little caution on the first quarter of 2014 given the rapid currency movement in Canada and the volatile Argentina situation.

With that, I will pass it over to Dave to discuss our financial performance in more detail.

Dave Smith - Executive Vice President and Chief Financial Officer

Thanks, Scott and good afternoon everyone. I will begin my remarks today with the fourth quarter highlights and then I will discuss our quarterly results in more detail. I will also talk about our invested capital performance and the changes we made to our MD&A to report on progress going forward. And then I will conclude my remarks by commenting on free cash flow and the balance sheet.

Overall, the fourth quarter was very solid. We delivered strong revenue and EBIT, the highest in any quarter in 2013. Excluding one-time items our EBIT performance improved by 9% year-over-year, particularly in Canada. We reduced our invested capital significantly from the end of the third quarter. And importantly, we generated very strong free cash flow, which allowed us to bring our net debt to invested capital down to near the midpoint of our target range. It’s worth mentioning that there were some significant foreign exchange movements in the fourth quarter and those have continued into Q1. The Canadian dollar weakened by about 6% relative to Q4 of last year or the prior year, which resulted in a positive impact on revenues of approximately $60 million. If this trend continues as was the case in January, we can expect a tailwind to the translation of our revenues in 2014.

On the EBIT side, the positive impact of foreign exchange fluctuations was less significant approximately $3 million positive in the quarter. In general, the weaker Canadian dollar has a positive impact on the translation of our results from South America and the UK and Ireland. However, in Q4, this positive impact down to EBIT was partly offset in our Canadian operations. This is mostly due to the time lag between the purchase of parts and equipment and their ultimate sale, which can put pressure on margins in the short-term when the Canadian dollar dropped so rapidly.

In addition, the accelerated devaluation of the Argentine peso was the main driver in our higher effective tax rate compared to Q4 of 2012. Sequentially, from Q3, the results are trending in line with our expectation. As we head into 2014, our views on the outlook remain largely unchanged from what we communicated to you in December. We fully expect to increase earnings this year even in a relatively flat environment. However, I do want to remind you that Q1 is generally our softest quarter for revenues and earnings due to seasonality and we don’t expect that to be any different this year. And as Scott mentioned, recent currency movements will likely negatively impact Q1. We continue to expect strong free cash flow generation for the full year, but as you know, our Q1 is generally a use of cash quarter as we build inventory for the year. So we remain confident in our 2014 outlook and we expect to build momentum in our results as the year goes on.

I will now discuss our performance relative to Q4 of 2012 on Slide 5. On a consolidated basis, quarterly revenues were up 3% quarter-over-quarter driven by growth in product support and a positive impact of the weaker Canadian dollar. Quarterly new equipment sales were the highest in 2013, but 2% below Q4 of 2012. The decline was due to reduced volumes in South America. While we set a record for mining equipment sales in South America for the full year of 2013, mining and construction deliveries were lower in the fourth quarter compared to the record setting Q4 of the prior year. In Canada and UK and Ireland, quarterly new equipment sales were higher compared to Q4 2012 driven primarily by the construction in power system sectors. Product support revenues increased by 9% driven mostly by Canada, our mining customers in general continue to focus on cost containment which has translated into deferral of some repairs and maintenance and reduced demand for components and rebuild.

As a result, the rate of growth in mining product support has slowed somewhat compared to recent quarters both in the oil sands in Canada and copper mining in Chile. Gross profit rose by 6% as gross profit margin improved to 30.9% from 30% in the year – the quarter before. Gross profit margin was positively impacted by a higher proposition of product support in the revenue mix and favorable adjustments to certain mining service contracts in South America in the quarter.

Moving on to SG&A, SG&A expenses were 5% above Q4 2012. In Canada, higher SG&A cost reflect revenue growth in all lines of business and higher service related costs. Higher SG&A cost in South America, in U.K. and Ireland were solely results of a weaker Canadian dollar compared to Q4 of 2012. As we discussed at our Investor Meeting in December enhancing performance management around SG&A remains one of the key focus areas in all our operations and as linked directly to three of our operational priorities, service excellence, supply chain optimization, and asset utilization.

And as Scott mentioned, action plans are underway in Canada to improve profitability in our service business and we are making good progress on our supply chain initiative. In 2014, we expect to see improvements in our cost structure to drive better profit pull through. Turning to our EBIT performance, EBITDA of $145 million was comparable to Q4 of the prior year. However, there were one-time items in each quarter and excluding them, EBIT performance did improve year-over-year.

More specifically in the quarter, we decided to postpone any decision on implementation of an ERP system in the U.K. for two to three years due to the needs and size of our U.K. operation. This led to an accounting review and decision to write-off $5.5 million of previously capitalized costs mainly due to the further time delays and uncertainties around realizing future benefit. Additionally in the fourth quarter of 2012, we recorded a $9.7 million gain on the sale of property in Canada. And adjusting for these two items, EBIT would be up 9% quarter over prior year quarter.

Our consolidated EBIT margin was 8.1%. This was a solid result of below 8.5% a year ago with the variance driven mostly by these one-time items I just mentioned. Basic EPS was $0.54 down from $0.60 in Q4 the prior year due to a swing of approximately $0.08 per share from these one-time items about $0.06 from the land gain and $0.02 from the ERP write-off. In addition, we experienced an increase in our effective tax rate compared to the fourth quarter of 2012, which is attributable to foreign exchange impacts resulting from devaluation of the Argentine peso and also an unusually low tax expense in Q4 of 2012 due to the benefit of previously unrecognized tax losses.

Next, I’d like to talk about our invested capital performance which is shown on slide 6. As we presented to you in our Investor Day two months ago, we identified a number of KPIs to measure progress towards improving our return on invested capital. With that in mind, I’d like to point out that we made some change to our MD&A to report on these performance measures on a quarterly and annual basis. We have provided you with a four-year history of annual numbers as well as the past eight quarters.

Going forward, we will use Q3 of 2013 as our baseline for measuring progress. Improving our capital efficiency is a key driver to increasing return on invested capital. In the fourth quarter, our invested capital declined by $204 million from the end of the third quarter primarily driven by the reduction of equipment inventory along with other improvements and working capital items. Inventory levels were roughly $150 million below the end of September as strong equipment deliveries in Q4 relative to Q3 and continued improvements in inventory management. Consolidated return on invested capital of 15.7% was relatively unchanged compared to Q3 as we average invested capital over the last four quarters. Going forward reduced invested capital will translate into improved return on invested capital number.

Turning to free cash flow and the balance sheet, we generated $365 million of free cash flow in Q4, driven by strong EBITDA and lower working capital spend largely through reduced inventory, equipment inventory and strong collections. Our net debt to invested capital declined to about 41% at the end of December from 48% at the end of September 2013 and 50% at the end of 2012. It is now within our 35% to 45% target range and at the lowest level since 2011 prior to the acquisition of Bucyrus. As we look forward into 2014, we expect another year of positive free cash flow with strong cash flow from operations, continued focus on improving working capital and discipline around our approach to capital investments. As I mentioned earlier we expect Q1 to be a use of cash quarter as we build inventory and we will see stronger performance on the cash side as we move throughout the year.

I will leave it there. And Mauk, I will turn it back over to you.

Mauk Breukels - Vice President, Investor Relations and Corporate Affairs

Operator, that concludes our remarks. Before we go to the Q&A we request everyone on the line that as a courtesy to your colleagues, you ask no more than two questions when it is your turn. Please go to the end of the queue if you have more questions. Operator, can you please open up the line for questions?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question is from Yuri Lynk from Canaccord Genuity. Please go ahead.

Yuri Lynk - Canaccord Genuity

Hi, good evening guys.

Scott Thomson

Hi Yuri.

Yuri Lynk - Canaccord Genuity

Scott, you are in the driver seat there for another quarter, what’s your level of satisfaction thus far with the rate of change that you are trying to implement at Finning, particularly around the supply chain initiatives and I guess more broadly SG&A?

Scott Thomson

Right, I guess a few comments, one is we have been working on these things for a while, right. So I have been here since July, but Juan Carlos and team have been working on this operational excellence agenda. And I think in some areas we are making really good progress, on the market share piece, core products, I mean a very big increase in market share during the year, I mean two points in the whole general construction line, but bigger improvements from that actually in excavators and various things like that. I am very pleased with that.

On the supply chain piece we are making again good progress. I think there is a good analysis we have done on transfer points, good analysis done on slow moving inventory, quick moving inventory. I think there has been particularly in the fourth quarter a pretty big improvement in terms of equipment inventory. Now, you are not going to see those types of improvements every quarter, but the fact that the organization is focused on it. It’s good news.

On the service side, I think we are in early days, I mean I think we have highlighted the fact that we have got issues on our service side from both customer loyalty perspective and a profitability perspective. And we need to get after those quite fast. And I know it’s on the top of the agenda for Juan Carlos. And as I mentioned in the opening remarks, we started to roll that out to the first five branches, so very encouraged. And frankly there is a lot of momentum, there is a lot of – people want to see improvements on the service side, so there is a lot – an appetite for change among our employee base. So that’s good news.

Things like these sorts of changes take a long time. I think the linking the compensation plan to the operational improvements to improving return on invested capital will help. I think having the clarity in our financial reports around invested capital, so that we are held accountable to that with our shareholders, but also talking about it internally will help. And I think you will see improvements over time, but it’s these are journeys not improvements that you make over a quarter or two.

Yuri Lynk - Canaccord Genuity

Okay, that’s fair. Thanks. I guess my second and final question is just maybe some more help on what revenue was going to look like in 2014? Obviously, it’s – 2013 is a tough comp. We are going to have the weakness in South America, but is the strength in Western Canada and the market share gains that you are looking for in the construction markets as well as on the product support side in parts. I mean is that enough to get revenue moving mid single-digits in 2014, just trying to figure how we should think about that at this juncture?

Scott Thomson

I mean, I will give you a comment on revenue forecast which I don’t want to get into, right. I mean, I think the objective for us is to improve profitability even in a flat revenue environment. So I want to stay away from revenue target. So that being said, the order intake is very strong in Canada in particular. And we said – I said in my opening comments, a 5% uptick Q4 to Q3 and that’s a much bigger uptick actually if you look at Q4 – over Q4 last year 2012 and in the forestry side, in the construction side and actually in the oil side too, there is a lot of activity in Western Canada. I think Chile and South America is a little bit of a different story in the mining side we have all talked about. So we know what’s going on there in terms of outlook for new equipment sales in mining.

On the construction side, it’s actually a different story. I mean, you saw a significant decrease throughout 2013 and that actually feels like its plateaued or getting slightly better. And I think there is a big market share revenue opportunity for us in South America in the non-mining piece. So combine that outlook with growing product support. And I mean, you can do your own expectations, but that’s why I’d say we are cautiously optimistic.

Yuri Lynk - Canaccord Genuity

Got it. Thanks Scott.

Operator

Thank you. The next question is from Cherilyn Radbourne from TD Securities. Please go ahead.

Cherilyn Radbourne - TD Securities

Thanks very much and good morning – good afternoon sorry. So in terms of the rollout of your standard service delivery model and the supply chain initiatives, I think you were at 5 branches at the time of your Investor Day and it sounds like that’s still where you are at. Can you just give us some color on where you expect to be at the end of the first half in 2014?

Scott Thomson

Yes. Hey, Cherilyn, how are you. So on Investor Day, we were talking – there are two different initiatives, one is the supply chain and one is the service. So at Investor Day, we are in five branches on supply chain. On service, we were just starting. And so when I referenced 5 branches on service, it’s the different agenda. That being said on service, we will – the objective is to get through all of our branches through the course of this year. And clearly, we are picking high priority branches first. So, oil sands is one of the key areas for improvement. So hopefully that answered the confusion on the 5 branches. On supply chain, I feel like we are making a lot of progress, I do. I think the equipment inventory coming down Q3 to Q4. Again, we can’t count on that type of improvement every quarter, but that was very well received, not as much progress frankly on the parts side as we would have liked to have seen quarter-over-quarter. And I think that’s an area which will take a little bit longer time, but good progress will be made throughout the year. And what I would say is I visited a number of branches over the – since the Investor Day and direct shipment, I wouldn’t say, direct shipment, but reducing the transfer points between manufacturing facility and end customer. That type of initiative is being very well received. And frankly, when you look at our service levels and you see where they are relative to they were in 2012 and that’s not the only contributor to it, but it will allow us to sustain those types of levels.

Cherilyn Radbourne - TD Securities

And just in terms of the reduction in invested capital, which was driven principally by inventory reduction, I mean, it was a very, very strong quarter for new equipment deliveries by historical standards. So, how do you satisfy yourselves that this isn’t just a cyclical phenomenon and is in fact evidenced or progressed against your priorities?

Scott Thomson

No, I think it’s a good question and we are definitely not claiming victory, because this will take time. And in fact the fact that you didn’t see parts inventories come down as much, it tells you that we have got a lot of work to do on the parts inventory side. And I would say also the strong free cash flow and the reduction in invested capital was not only driven by equipment inventory, it was also driven by better collections. I mean, we had significantly higher collections. So, I think we are heading in the right direction, Cherilyn, but you are right, we should not be claiming victory after one quarter of good free cash flow performance.

Dave Smith

I just add Cherilyn to that. I agree with what Scott was saying, just in terms of the quality of the inventory, we did have a very high focus on trying to improve the ageing of inventory. And so we had some items that came out from last year that we were still trying to move so in Power Systems and mining. We are able to reduce the aging and move out a number of items that we have been trying to. So I think the mix or quality on equipment side improved as well.

Cherilyn Radbourne - TD Securities

Okay. And you were able to do that without much of a pension on margins?

Scott Thomson

Yes.

Cherilyn Radbourne - TD Securities

Okay. I think that’s more than two. So, that’s it from me.

Scott Thomson

Thanks, Cherilyn.

Operator

Thank you. Our next question is from Sara O’Brien from RBC Capital Markets. Please go ahead.

Sara O’Brien - RBC Capital Markets

Hi guys. Can you comment a little bit on the pricing environment on equipment now that the U.S. dollar effects are taking effect in Q1? And also maybe at a time where Tier 4 pricing is coming in to affect in Canada little bit more strongly, just wondering if the customer take-in of that price is going as expected or is there any margin pressure that we should expect for the first half of the year at least on that front?

Scott Thomson

Yes. Hey, Sara, it’s Scott. I think clearly prices are an important piece of the puzzle for our customers and we need to make sure we are competitive. In the first quarter, one of the issues we have is the currency devalued and we weren’t able to keep up and not because we weren’t focused on it, it just takes a month or two to transition our prices to the new currency levels. And that is why you will have a little bit of a negative impact in Q1. But longer term, our competitors price the same way as we do. So there is not a difference here from a competitive perspective, point one. Point two on the Tier 4 pricing, we are being very sensitive and when I say we, I say Caterpillar and Finning on price increases on new equipment into 2014 as it relates to Tier 4. And we are taking I think a very constructive approach of our customers. So I am hopeful that we will find win-win situations here for our customers and for – and hopefully that answers your question.

Sara O’Brien - RBC Capital Markets

Okay, great. And then maybe second question just on the Argentina exposure, I just wondered there was a devaluation in Q1 that was pretty significant, just wondering if you do have receivable exposure that may warrant a write-down in Q1 and maybe if you can explain a little bit on the tax rate effective or the tax effective rate and why that changed based on Argentina?

Dave Smith

Yes, sure, Sara. It’s Dave. In Argentina, there are, I would say three areas that foreign exchange will impact. The first one is probably the most significant one is around local cost. So our local cost will be lower in the devaluation situation. So that’s a positive impact. The second one is what you are referring to in terms of a net monetary peso position. So that’s the net of things like receivables that are in pesos and payables. And as Scott mentioned in his opening remarks, we have been actively trying to manage that net monetary peso position down and we reduced it pretty significantly and that had a very small impact on us in the fourth quarter. And thirdly, in regards to the tax, effective tax rate and what happens is that we end up paying a bit higher tax expense as a result of some balances like receivables which are geared to U.S. dollars. So part of our business transaction is U.S. dollars like to say sales to mining companies. And those amounts are payable in reference to U.S. dollars, so as the pace of the value that creates a gain. And if you look at it from an Argentina tax return perspective you pay tax on that gain.

Sara O’Brien – RBC Capital Markets

Okay.

Dave Smith

So that increases the tax rate, but that gain doesn’t exist in U.S. dollar statement. So it creates a higher effective rate.

Sara O’Brien – RBC Capital Markets

Okay, that’s helpful. And then we will see the same kind of thing in Q1, I assume for the tax rate and then we will see where it goes from there?

Dave Smith

Yes, I think it really depends on the relative devaluation period to period, but as long as the Argentina peso is devaluating at a rapid rate it will put pressure on the effective tax rate.

Sara O’Brien – RBC Capital Markets

Okay, fair enough. Thank you.

Operator

Thank you. Our next question is from Peter Prattas from Cantor Fitzgerald. Please go ahead.

Peter Prattas - Cantor Fitzgerald

Good evening. You made mention of some headcount reductions in South America recently and I was just wondering if there are any other similar initiatives planned and is that largely the reason you are expecting higher earnings on flat sales or do you see that more indicative of a change in mix?

Scott Thomson

Yes, so on the headcount reduction – I mean headcount reductions did occur in South America just a few weeks ago. I mean these are difficult decisions. And it was unfortunate that we had to take that action, but given the activity that we are seeing on the mining side it was necessary to adjust the cost structure. And that was above 200 individuals, so unfortunate but necessary. We had to do it.

Going forward – I mean it highlight how focused the South American team is on the cost structure. And they are going to continue to watch the market and make sure we will have the appropriate size and resources required for the market activity. In terms of headcount in general as – actually if you compare 2013 to 2012, I don’t have the exact number here, but my recollection is we are above Canada at least and we see about 250 heads lower 2013 relative to 2012 and for the firm we are about 450 heads lower in 2013 relative to 2012. So obviously, very difficult decisions but important that we keep on top of that given the changing market conditions.

Peter Prattas - Cantor Fitzgerald

Okay. And then just a question on free cash flow obviously you had a very strong quarter there and you finish the year at 41% debt to capital, I think well below your target, I am just wondering if your 2014 target I think you are aiming for the low end of the 35% to 45% range. If that target changes now at all or do you factor in anything like dividend increases into that number?

Dave Smith

Hi Peter. As I mentioned, we expect to see strong free cash flow in 2014. We will build through the year and I think we are very pleased with the cash flow performance, the inventory management that we are achieving within the business, but I think it’s too early to be claiming victory. So we want to stay focused on that. And I think we will continue to watch it as it goes through the year and stronger performance in the back half of the year is what we expect. If we perform to expectations, I would expect to see cash flow still taking us down to that lower end of that range, but we are looking at that as we go into the back end of the year and how ’15 looks and as well and if we start to see strong free cash flow opportunities in 2015, I think we need to be looking at what are options like we discussed with many of you at the Investor Day as to what we do with that excess cash, what investment opportunities or return on capital type options that we have. So that will be something for the back half of the year. As for the dividend that’s very important part of the discussion as well and we will look at that likely for May and you can stay tuned, but we are committed to paying a very competitive dividend and have a very strong track record of increasing it.

Peter Prattas - Cantor Fitzgerald

That’s great. Thanks Dave, thanks Scott.

Operator

Thank you. Our next question is from Bert Powell from BMO Capital Markets. Please go ahead.

Bert Powell - BMO Capital Markets

Thanks. You noted a favorable adjustment on certain mining contracts in the quarter. And I am just wondering if that is something that is a step function change that’s sustainable or is that more a one-time in nature?

Scott Thomson

Hey, Bert, it’s Scott. So in general, fourth quarter, we are quite strong and part of that was Bucyrus just a better fourth quarter. And we have been pretty public about some of the hiccups in the first three quarters and was better fourth quarter on Bucyrus front. And product support Bucyrus, we continue to expect to grow as we look forward to next year. That being said, we did benefit in the fourth quarter from some things that had been negatively impacted us in the second and third quarter and we got the benefit of it in the fourth quarter a little bit which helped results. As you think about 2014, I would be inclined to think about profitability in a similar way into what we have done over 2013 period.

Bert Powell - BMO Capital Markets

Okay. And then Scott, just in your opening comments you used the one you said perform up to shareholders’ expectations for the year. And if the dollar stays where it is, I think all things being equal that would be a positive for Finning’s earnings for the year despite maybe a slow start in the first quarter? So should we be thinking about those comments in terms of the way you have been talking about the business like it’s a change for the base business, notwithstanding the FX impact or are things going to be skated a little bit more onside for you because of the FX?

Scott Thomson

That’s a good question. I mean, I am pretty comfortable where when I look at analyst expectations for the company in 2014 and we can have debates over revenue and profitability and all those, but the end result, I am pretty comfortable with those types of expectations. I think we are going to see a benefit from FX over the year, but I am also cognizant of the fact that Q1 is going to be a little weaker given the rapid depreciation of the Canadian dollar and the month’s lag in terms of being able to adjust to that from a pricing perspective. So I don’t know if that answers your question or not, but…

Bert Powell - BMO Capital Markets

It does. I appreciate that, Scott. Thanks.

Operator

Thank you. Our next question is from Benoit Poirier from Desjardins Capital Markets. Please go ahead.

Benoit Poirier - Desjardins Capital Markets

Hi. Just to come back, good afternoon, just to come back on your dealer inventory, obviously the turn went up from 2.4 to 2.7 quarter-over-quarter and at the Investor Day you mentioned that you wanted to improve the inventory turn by 0.5 to 0.9 over the next three years. So is it fair to assume that this could be realized sooner than expected? And also if you could help me to reconcile the comments with Cat that said that they expect no significant change in their dealer inventories in 2014?

Scott Thomson

Right. Hey, Benoit, it’s Scott. So you are right, we forecasted an improvement on total inventory turns of 0.5 to 0.9 over a three-year period. And I think that’s the right – that continues to be the right projection. It’s a little bit difficult to look at quarter-over-quarter improvement and extrapolate that. I think Cherilyn’s comment earlier today is a relevant comment in terms of it was a high delivery quarter. And we are very pleased with the free cash flow performance. We are very pleased with the equipment inventory discipline, but that being said, I wouldn’t expect those types of improvements each quarter. And I do think we had a significant delivery quarter and I also think there was some lower hanging fruit initially that we were able to clean up around aged inventory like Dave talked about. So I am not changing the projection that we made in December.

Benoit Poirier - Desjardins Capital Markets

Okay, perfect. And my second question is related to your outlook you provide very good color about South America also the construction of oil sands, but what about the outlook for mining in Canada? How does it compare to FINSA? And any color with respect to four deals on the timing side?

Scott Thomson

So on the mining side, I mean, clearly the oil sands is being counted as much more constructive than what we are seeing on the mining side in FINSA. That being said in my opening comments, I spent a lot of time with customers in January in South America, I am actually going back there next week. And the supply demand dynamics of copper are positive. And there will be or there is a breather going on right now, but over a longer period of time, copper prices will remain strong and activity will be there and that will benefit us, but shorter term it’s a little weak on the new mining equipment sales. In Canada, we are actually seeing pretty good activity. I mean, I think the contractor work force is not being utilized as much as historically it’s been the case, but we are seeing new equipment sales. We are seeing product support continue to grow in Canada and frankly in some areas, non-mining for example forestry, we are seeing pretty significant improvements and we have also seen relative to LNG and I know this is a longer term opportunity, but we are seeing – starting to see sales of equipment to contractors who are focused on the LNG opportunity. So the Canadian business feels pretty good to me.

Benoit Poirier - Desjardins Capital Markets

Okay, thanks for the time.

Scott Thomson

Last question Benoit I didn’t answer was Fort Hills and I can’t answer to that. I think the Fort Hills consortium announced that they were going to sanction to the product – project and obviously we are very interested in that type of equipment we have big relationships with those companies, but I can’t comment on the process.

Benoit Poirier - Desjardins Capital Markets

Okay, thanks.

Operator

Thank you. Our next question is from Ben Cherniavsky from Raymond James. Please go ahead.

Ben Cherniavsky – Raymond James

Good afternoon, guys.

Scott Thomson

Hi, Ben.

Ben Cherniavsky – Raymond James

Most of my questions have been answered, you guys are providing some good commentary today. I was pleased to see the breakdown of return on capital by region, so thank you for doing that improves the transparency or it’s however, little bit surprised to see South America step down so much from a year-to-year basis. Not just that the inventory levels didn’t come down as much there and in your margin, I think your EBITDA actually was still up in the region maybe you can just elaborate a little bit on the down step in South America is return on invested capital because obviously we don’t want to see lot of the focus that you guys have framed for investors is around improving return on invested capital mainly in Canada that sort of a low hanging fruit so we wouldn’t want to see you get gains in Canada and then see you lose take steps back in South America.

Scott Thomson

Yes, I know it’s a good question, Ben and the main issue and I want to thank you for the comment on transparency, I mean, I think if you look at the MD&A were pulled in ourselves accountable that we talked about at December meeting and these were all the metrics we talked about so that provides some better transparency for you going forward. On the South America side is mostly related to Bucyrus. I mean we had the acquisition of Bucyrus which was the significant acquisition for this company, most of it was allocated to South America and Bucyrus performance has been at least in the early days actually at least in South America has been a little bit below expectation and will take some time to work through. And then secondly Bucyrus came with a significant amount of inventory as well and that inventory moved a little slower than the core yellow line and we do not to do a better job at moving that inventory and getting the processes in place to get the turns on that inventory up to the level on the yellow line. So there is nothing in my mind, there is nothing going on with the business, it’s related to the Bucyrus acquisition.

Ben Cherniavsky - Raymond James

And when you talk about sizable portion of the acquisition being allocated to South America, you are referring to intangibles?

Scott Thomson

No, just the purchase price, so when you did have the purchase that’s part of it.

Ben Cherniavsky – Raymond James

So lot of the intangibles would go into South America and then those are being amortized. Is that affecting your margins to some degree?

Dave Smith

Yes, and from – Hi Ben it’s Dave. We do allocate all of that process to each of the region so that everybody knows that is part of their invested capital. The intangibles by the accounting rules we cannot – it amortized those particular I will call distribution – network distribution.

Ben Cherniavsky – Raymond James

Well…

Dave Smith

Also it gets well. It is treated in a similar fashion, but it’s technically not called goodwill. There are some other factors Scott talked the key one, there are changes in the liability side just in terms of the payment timing that also cause the invested capital said to be higher than the prior year, so that could be just the timing thing as well.

Scott Thomson

And the breakdown of that purchase prices in the financial statement, so if you are interested there is that…

Ben Cherniavsky – Raymond James

Okay, I will go through that. And then just sort of maybe as a related follow-up. With the change in the mining conditions down there since you bought Bucyrus, have you done impairment tests or is there any risk of a write-down to any of those intangible or for that maters any of your inventory in Argentina at risk with the currency change?

Scott Thomson

The latter one, no I mean probably the strongest currency in Argentina is yellow iron. So that has maintained its value very well (Technical Difficulty) results in Argentina from our team down there have actually been quite strong and prices have held and appreciated on inventory. So that’s not been a problem. We did go through from the first part of your question, a review of as you would on each quarter and very thoroughly on your end all are carrying values tested all of the amounts that would be goodwill or intangibles to long-term projections and we had no issues other than the write down on the previously capitalized ERP cost.

Ben Cherniavsky – Raymond James

Okay, thanks very much guys.

Operator

Thank you. The next question is from Kam Mangat from Salman Partners. Please go ahead.

Kam Mangat - Salman Partners

Good evening. Just circling back to the LNG opportunities you mentioned and how you have been visiting your customers in Kitimat, I just wanted to get some more color on the opportunities there, are you actively bidding on business within that region and is that something we will see really start to come through in the latter half of 2014 or is that something we will see in 2015?

Scott Thomson

Sure, I will take that. I mean I went up to Prince George and Paris to visit our branches and during that trip I spent some time in Kitimat just to get a sense of what was going on there. I mean money is being spent. Chevron is spending money and Shell is spending money. And I also know that drills are being contracted, drill rigs are being contracted by LNG players. So activity is happening. I think as I mentioned in December I think the large part of the activity will happen once the oil and gas companies go through final investment decision, which I don’t expect to happen until probably early 2015. But when you do go to Kitimat and you look at what Chevron is doing, there is significant cat gear on site. So that’s good news, that’s good news. And I suspect there will be additional opportunities for us throughout the remainder of the year, but the real ramp up I suspect will be a ‘15, ‘16, ‘17 type opportunity Kam.

Kam Mangat - Salman Partners

Okay, great. And one final question is during your Investor Day you mentioned that the rental market was something that you were still in the process of assessing. I just thought I would see if you had any updates on that portion of your business?

Scott Thomson

On the rental side, I mean rental clearly is extremely important area of the business and something we need to participate in and something we do participate in. I think our total rental spend this year is going to be very similar to last year and it’s a significant amount of money. The key for us if we need to make sure we are treating that rental business in a different way than the new equipment business. And we need to treat it as a business that isn’t just focused on market share, but focused on running a very good rental business that has the appropriate return on capital type characteristics. And that is my focus going forward. I mean you have to separate that out from a financial perspective. Yes, we have to have the different capabilities that we would have for rental business and you have to make sure you are aligned with Cat in terms of how you thinking about rental. And frankly Cat is doing a lot of work on that. I am actually off to Nashville tonight with the group presidents we are at a Cat dealer conference where we are talking about some of these issues. So stay tuned, but recognize it’s an important piece of the business and something we are going to participate in.

Kam Mangat - Salman Partners

Okay, great. That’s all I had.

Operator

Thank you. (Operator Instructions) Our next question is from Christine Healy from Scotia Bank. Please go ahead.

Christine Healy - Scotia Bank

Great, thank you. Just on your market share, you mentioned you are making some headway in construction and that you have dedicated more resources there, just hoping you can give us an update on your plans to grow share in Power Systems. Do you expect that could take a little bit longer to play out?

Scott Thomson

Hi, Christine. No, I don’t think that’s going to take – I mean, I think we are going to make progress this year. We have a Vice President of Power Systems in Canada, who is very focused on it. He has actually hired some individuals that will help them. We are actually seeing more activity in the oil and gas space giving gas prices recovered. And that’s maybe associated with the cold winter, but nevertheless you have had higher gas prices and therefore more opportunity in the oil and gas space and then you have the LNG opportunity obviously. So I do think Power Systems will grow. And we gave a target over a three-year period, but I wouldn’t say that’s back-end loaded. I mean, I think you are going to see growth throughout the three-year period.

Christine Healy - Scotia Bank

Okay, great. Thank you.

Operator

Thank you. We have no further questions at this time. I would like to return the meeting back to Mr. Breukels.

Mauk Breukels - Vice President, Investor Relations and Corporate Affairs

Well, thank you very much operator and thank you everyone on the line for joining us today. We look forward to speaking with you again after the next quarter. Bye for now.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time and we thank you for participating.

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