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Executives

Mauk Breukels - Vice President, Investor Relations and Corporate Affairs

Scott Thomson - President and Chief Executive Officer

Anna Marks - Senior Vice President and Corporate Controller

Analysts

Christine Healy - Scotiabank

Peter Prattas - Cantor Fitzgerald

Cherilyn Radbourne - TD Securities

Jacob Bout - CIBC

Sara O’Brien - RBC Capital Markets

Yuri Lynk - Canaccord Genuity

Ross Gilardi - Merrill Lynch

Ben Cherniavsky - Raymond James & Associates

Bert Powell - BMO Capital Markets

Benoit Poirier - Desjardins Capital Markets

Finning International Inc. (OTCPK:FINGF) Q2 2014 Earnings Conference Call August 7, 2014 11:00 AM ET

Operator

Good morning and welcome to Finning International Q2 2014 Results Conference Call for Thursday, August 7, 2014. Your host for today will be Mauk Breukels. Mr. Breukels, please go ahead.

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, and Anna Marks, Senior Vice President and Corporate Controller. An audio file of this conference call will be archived at Finning.com. Today, Scott will start with his remarks and then Anna will provide the summary of the financial results for the quarter. Following the remarks by Scott and Anna, we will open up the line to questions. After the Q&A, Scott will make some concluding comments.

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 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

Good morning. Today, I will provide brief comments about the quarter and an update on the progress we are making with our priorities. Overall, we are pleased with our results. Highlights include improved profitability in Canada. South America maintaining its EBIT margin despite significantly reduced business volumes and good progress on our capital efficiency initiatives, which translated into an improved sales to invested capital ratio and strong free cash flow.

We’re also making progress against the five priorities we discussed in December. As you’ll remember, these are safety and talent management which are foundational, customer and market leadership, service excellence, supply chain and improved asset utilization. A key focus over the last 12 months has been the strength in our commitment to safety and talent management. To that end, we’ve taken a number of steps to build on the strong foundation in these areas. Steady reductions in our total recordable injury frequency rate or TRIF, and our lost time injury frequency rate or LTI demonstrate continuous improvement in our safety performance. Year-to-date, TRIF is at 0.77 relative to 0.91 at the end of June 2013. In the same six months period, LTI is down to 0.08 compared to 0.13 last year.

In the UK, we’d now gone over 400 days without an LTI. These results speak to our employees’ considerable dedication to maintaining a safe workplace and the reflective steps we are taking to strengthen the safety of our operations. Another key focus is optimizing the contribution of our people to achieve our business goals. To assist us in building an organization that attracts, retains and engages the best talent, we recently strengthened our human resources function with two key appointments. Gillian Platt joined us on July 7th as Chief Human Resources Officer and Chad Hiley will join Finning Canada as Senior Vice President of Human Resources in September.

At Finning International, other changes that have taken place over the past year include Dave Cummings joining Finning as Chief Information Officer which is the new role for the organization. Greg Palaschuk came from Goldman Sachs to join us as our new VP Treasurer in June. Tom Merinsky, who has held the position, will be retiring in the fall. And as you know, we’ve undertaken a search for a new CFO, and in the meantime, we are strongly supported by Anna Marks, Senior Vice President and Corporate Controller.

At Finning Canada, we recently announced the appointment of John Pollesel as Senior Vice President of Mining. John will join Finning on October 1st and will be accountable for leading the Canadian Operations Mining division. John is a proven senior leader with extensive executive experience in the mining industry in South America and Canada. His previous positions include VP and CFO for Antamina, a large mining company in Peru, and Chief Operating Office for Vale Canada. With this appointment, David Primrose, who currently leads mining, will take on the role of EVP, Core Industry Operations, primarily, to support us in capitalizing on opportunities in the construction and forestry sectors. David is known to many of you on the call. He’s been with Finning for over 25 years in key leadership positions. While, we have made some new additions to the Finning team, our ongoing focus on employee development and providing growth opportunities across all levels of the organization is the priority.

Recent examples include Branch Manager appointments in Grande Prairie, Alberta and Sparwood, B.C., a new head of power systems in South America and transferring a key manager from the UK to support our oil sands growth. All of these appointments speak to our efforts to promote from within and capitalize on the great talents we have across the organization.

Moving on to our operational priorities. First, I will speak about market leadership, and then I will turn to service, both of which are key EBIT improvement drivers. In all three regions, our market share for core equipment is up materially since the end of 2013. I am particularly pleased that we’ve been able to make these gains through better execution. In Canada, we have better sales coverage and are participating in and closing more deals. Our sales force is motivated by the restructured incentive schemes and improved quality of our inventory and our customers are excited by the quality and fuel efficiency of the Tier 4 equipment.

In Canada alone, core equipment market share is up approximately 5 points over last year, and importantly, we’ve grown market share while maintaining margins. Power Systems revenue growth in Canada has also been a key focus area to drive earnings. Year-to-date, power systems revenue grew by 36% over last year. This is the result of strong leadership in the Power Systems division and focusing efforts on better market segmentation. In addition, new products like Dual Gas Blending Kits are providing a great value proposition for our customers.

Let me turn to service profitability. We are on target with the rollout of the new service process to our branches in Canada. To-date, with service model changes have been implemented at all of our Phase 1 locations, Mildred Lake, Fort McKay, Prince George, Peace River and Grande Prairie. We are now focused on sustaining these changes. We have started our Phase 2 locations including Calgary and COE in Red Deer, and in September we will decided which branches will be part of Phase 3. I was in both Prince George and Grande Prairie to see firsthand the rollout of the new service model and the progress we are making is significant. Since the end of 2013, we’ve been able to improve service labor recovery in Canada. We are also making service improvements in South America, but the profitability impact of these improvements has been offset by softness in equipment sales.

Turning to invested capital and the optimization of our supply chain. Most of the work we are doing in Canada, involves inventory management, network optimization and transportation efficiency. In Canada, we’re reviewing supply and demand planning branch by branch. In 2013, we completed five branches, in 2014, we plan on 17 more. As a result of the work done today, we are seeing some real success stories. Our part service levels are generally at or above our targets. Our 24-hour service level is running at above 86% which is on target and more than 6 points higher than 2013. The 72-hour service levels at over 95% and importantly our emergency orders are at around 27% an improvement of more than 6 points over last year and getting very close to our target. We continue to make good progress with our network optimization. For our southernmost branches, we have reduced touch points significantly by leveraging Cat’s Spokane facility. We’ve been able to reduce our transportation costs and that is promising when you consider the increase in parts volumes we’re experiencing. For example, the elimination of redundant truck trips will save us more than CAD1.5 million per year.

The single emergency and stock order truck in Spokane for Surrey, Vernon, Kamloops, Williams Lake and Prince George will improve truck utilization and also reduce SG&A. We are also making good inroads rationalizing the number of transportation providers. We are down 25% and have line of sight to bringing this down to 50%. With respect to improving asset utilization, we continue to move forward on this in Canada with some changes to how we allocate work and assets. Let me give you some examples. Shovels and drills moved from their location in Fort McMurray into the Mildred Lake branch, and the building which was vacated has been subleased. Power Systems moved from their Fort McMurray shop into the local branch and vacated their location. In Prince George, we will move the rental store to the main branch in Q4.

Edmonton used equipment, machining and welding moved into shovels and drills location in Edmonton. So, base on the west Edmonton branch can be repurposed for customer shop repairs. We have made great strides in centralizing our new equipment preparation at COE and we’ve eliminated approximately 20% of our pickups and service trucks and are reallocating trucks from low utilization branches to high utilization areas. The supply and asset utilization changes we are making are positively impacting service levels, reducing cost and invested capital. The progress updates on our invested capital metrics is as follows. Compared to Q2 2013, while our revenues are up approximately CAD150 million, our invested capital has been reduced by about CAD110 million and our inventories are down by approximately CAD140 million. Parts inventory is CAD73 million lower than in Q2 of last year despite product support revenues being up by CAD28 million.

Importantly, sales to invested capital improved to 2.12 times from 2.01 with Canada’s invested capital turnover increasing gradually over the last four quarters to 2.2 times from 1.9. We have seen a similar positive trend in the UK and Ireland where our sales to invested capital has improved from 3.1 times in Q2 of last year to 3.4 now. In South America although we reduced our invested capital by almost a US$190 million from last year, the significant decline in revenue over the past 12 months translated into a lower sales to invested capital ratio. While I’m pleased with our performance in the first half of the year and the progress we’re making on the key initiatives, we do see some headwinds in South America for the balance of the year. As you know, business conditions in our South American operations remain challenging, mostly as a result of ongoing uncertainty in the mining sector.

The South American team has done an outstanding job of responding to the challenging market conditions and has maintained its profitability level. Maintaining profitability has required some difficult decisions. Since the middle of last year we have made significant reductions to our work force. In addition, we have recently experienced a 23-day work stoppage during our collective agreement negotiations with the drills and shovels union representing roughly 15% of our workforce in South America. We were able to maintain business operations and customer commitments during the disruption utilizing our contingency plans. We now have an agreement in place that is equitable and brings this union’s agreement in line with the other collective agreements in South America. While we’ve obviously preferred to reach this agreement without a labor disruption, it was imperative that we reached terms that maintain our cost structure and we were able to do so. Looking ahead, there are tax related developments on the horizon in South America namely the tax reform in Chile which is expected to be in active during the second half of 2014. Anna will provide more detail on this in a moment. In addition, Argentina continues to be problematic in many ways including the devaluation of the Argentine peso which has increased our effective tax rate.

On a positive note, I want to highlight that the end of July, we acquired SITECH in the UK and Ireland, and we now operate SITECH in all of our regions. As you know, technology is increasingly important to our customers. SITECH delivers advanced technology solutions for site monitoring and productivity to heavy construction customers working in earthmoving applications such as construction of roads, railways and site preparation for large commercial industrial and residential projects.

I will end it there for now and make some concluding remarks after the Q&A. Anna, over to you.

Anna Marks - Senior Vice President and Corporate Controller

Thanks Scott and good morning everyone. I’ll now walk you through our financial results in more detail and all my comparisons will be with the second quarter of last year. Revenue was up 9% with higher revenues in Canada and the UK more than compensating for the decline in South America. A 20% increase in new equipment sales was the main revenue driver this quarter. In Canada, we saw higher mining deliveries and strong demand from construction and power systems which drove their new equipment sales up to 55%. In the UK and Ireland, we benefited from improved activity in the construction sectors. Not surprisingly, in South America, demand for new machines from both mining and construction was significantly below last year’s level. With strong deliveries in Q2, our backlog declined to CAD1.1 billion at the end of June from CAD1.3 billion at the end of March.

Although down, our backlog is still solid and is comparable to the backlog we had at the end of the second quarter last year. Order intake was at good levels in both Canada and the UK and the Ireland while FINSA’s order intake continues to be soft due to the slower market activity. Product support grew by 4%, mostly due to higher parts sales in Canada predominantly in mining. In functional currencies, product support revenue declined in South America and the UK and Ireland. In FINSA, this was primarily due to lower service revenues as mining customers continue to focus on achieving cost reductions. In the UK, our part sales were negatively impacted by continued weakness in coal mining.

Moving to gross profit, it was slightly higher than the prior year with gross profit margins lower by just over 2 percentage points to 29.6%. Similar to Q1, this was mostly driven by a shift in revenue mix to more new equipment sales in Canada and a higher proportion of lower margin mining equipment in Canadian revenue. In addition, all operations reported lower growth profit from rental as a result of reduced rental volumes due to softer demand mostly in short term rental. On a positive note, SG&A cost were slightly lower than prior year even though revenues were higher. FINSA’s SG&A was down as a result of lower volumes, lower operating cost due to weaker Argentinean and Chilean peso and the measures taken to reduce operating cost. Our work force in South America is down by about 5% from the end of 2013 and currently stands at just under 7000 people.

In Canada, SG&A was only marginally higher despite volume related increases and severance cost related to operational improvement initiatives this quarter. And SG&A, as a percentage of revenue was down in all operations. Moving on to our EBIT results, I’m pleased to say that we achieved operating leverage this quarter as EBIT increased by 12% to CAD137 million which is more than our revenue growth. The major contributor to the increase in EBIT was Canada with an additional EBIT of CAD16 million. A 26% increase in EBIT in Canada reflected strong revenues as well as continued execution of our operational initiatives. As Scott mentioned earlier, we are beginning to see improvements in most of our key performance indicators. As a result, EBIT margin in Canada was 8.3% up from 7.9% a year ago and up from 6% in Q1, 2014.

In South America, EBIT was down 11% in functional currency impacted by lower revenues. However, EBIT margin improved to 10% from 9.5% a year ago benefiting from operational discipline and targeted cost reductions. EBIT in the UK and Ireland was slightly lower in functional currency and EBIT margin was 5.1% compared to 5.7% a year ago mostly due to a lower proportion of product supports in the revenue mix. Turning to earnings per share, basic EPS was CAD0.50 up from CAD0.48 in Q2 of last year. I’d like to remind you that our Q2 2013 EPS included a CAD0.03 benefit from previously unrecognized tax losses which reduced our effective tax rate to unusually low levels in the second quarter of 2013. Our effective tax rate in the quarter was 24.1% compared to 15.8% the prior year.

With regard to taxes going forward, we expect that the proposed corporate tax reform bill in Chile will be passed during the second half of 2014. Significant changes were included in the bill including proposed increases to the corporate income tax rate. We are monitoring the status of these proposals and once these changes are substantially enacted, we will evaluate the impact on our financial results and on our effective tax rate going forward. It shouldn’t increase in the corporate income tax rate occurs there will be a one-time impact from the revaluation of our deferred tax liabilities. Based on our understanding, that corporate income tax rates may gradually increase in Chile from 20% to 27%, our current best estimate is that this revaluation may result in a one-time decrease in our net income by approximately CAD8 million to CAD10 million at the time the proposals are enacted. However, it’s not clear this time what the final form of the proposals will be and our estimates may change.

Lastly, a few words on free cash flow and balance sheet. We generated positive free cash flow of CAD123 million compared to CAD7 million in Q2 of last year resulting from improved cash generated from operations as well as strong working capital management across the organization. Our working capital to sales ratio was 25.5% down from 27% in Q2 of 2013. The main driver of higher free cash flow compared to the second quarter of last year was mainly due to lower working capital spend in South America. Our net debt to invested capital was at 41% at the end of June lower than March levels and comfortably within our target range. In summary, we had a solid quarter. There is more work to be done on our operational priorities that we are encouraged by the progress. On this note I’ll turn it back to Mauk for Q&A.

Mauk Breukels - Vice President, Investor Relations and Corporate Affairs

Operator, that concludes our remarks. Before we go the Q&A, we request everyone in 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, if you could please open up the line for questions.

Question-and-Answer Session

Operator

Thank you. We will now take the question from the telephone lines. (Operator Instructions) We have a question from Christine Healy from Scotiabank. Please go ahead.

Christine Healy - Scotiabank

Hi. Good morning. The first question is just on new equipment sales in Canada. Very strong here in the quarter, so just curious, how much of this do you guys view as being related to overall industry growth versus Finning-specific market share gains and better execution? Any help you can give on that would be helpful.

Scott Thomson

Christine, hi, it’s Scott. I think it’s a combination, I mean I think the oil sands mining areas of business has been relatively strong in the first half of the year, we’ve had some good orders and some good deliveries. But, I also think we’re making some significant improvements on the market share front, so I think it’s a combination of market share, better execution and a little bit of industry growth. And, as I think as we look forward, Canada, year-to-date revenue growth has been very strong relative to comparable period in 2013. The third and fourth quarters last year were also quite strong from a revenue perspective. So, I think we’re unlikely to see that type of revenue growth in the back half of the year relative to 2013, particularly given some of the headwind in the coal mining sector but in general as you said, very pleased with the first half of the year performance.

Christine Healy - Scotiabank

Okay, thanks. That’s really helpful. And then just turning to South America, can you talk about the competitive conditions there? Are your competitors taking disciplined approach and cutting costs to match market conditions too, or are you seeing some pricing action taken by them? Is your market share holding pretty firm there?

Scott Thomson

Yes. Actually it’s a great story in South America despite lower activity and frankly very little new equipment sales in the mining sectors, the general construction business has seen some activity and our market share is up materially I mean similar to what we’re seeing in Canada and our margins are actually up slightly as well. So, great story in South America from a competitive situation.

Christine Healy - Scotiabank

Does that hold true on the mining side too that you’re not seeing any pricing action really being taken by your competitors?

Scott Thomson

On the mining side Christine is just not variable activity. We’ve not seen any new equipment purchases from our mining customers, point one. And then point two, you’re actually seeing the deferral maintenance too and that’s been why there is some weakness obviously on the top line in South America in the first two quarters of the year. So, the competitive dynamics, I’m not sure on the mining side, yet but on the construction side, it’s been a very good story for us.

Christine Healy - Scotiabank

Great. Thank you.

Operator

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

Peter Prattas - Cantor Fitzgerald

Good morning, everyone. I just wanted some further discussion on South America there. Understandably, you’re still cautious over the remainder of the year, but just given that the slowdown began in the second quarter of last year there, is there hope for some abatement of the declines in the back half of this year, particularly, at the EBIT line given your success in lowing costs?

Scott Thomson

Peter, it’s Scott. So, one, I think what the team has done there is pretty remarkable and it’s been on this since middle of last year when they started the head count reductions. And, in some pretty difficult decisions and I think the total head count has been reduced by almost 600 people from the peak. So, that’s point one. And point two, there’s strike on the drill and shovels side, I think it highlights the disciplines with which the team is approaching the situation. The real issue in Chile right now is copper prices were actually quite strong, the real issue I think is the uncertainty the political uncertainty associated with tax increases and new government and that is impacting our customers allowing us to invest. And until you see I think some stability on that front, some clarity on that front. It’s going to be hard to imagine a significant pick up. I know Anna gave the outlines of tax proposal 20% to 27%, but frankly it’s very high level right now and we don’t know the details of how that faced in and we think it’s going to be faced in over five year period but we don’t know the details and it’s still being discussed in the government. So, I think until you get some certainty from a country perspective, I think that will impact that how quickly the copper mining sector comes back in Chile.

Peter Prattas - Cantor Fitzgerald

That’s fair. Okay. And in addition to lowering your costs in South America, I’m just wondering is there any further -- are you any further along in assessing rationalization moves to take place in Canada or elsewhere, i.e. do you see more moves to be made and how soon might you be able to communicate that?

Scott Thomson

Yes. I mean in Canada it’s the continual – aligning the cost structure is a continual process and I think the SG&A performance in this quarter highlights that we are making some progress included in the results are I think couple of million dollars of severance in the Canadian results this quarter. And in some areas, we’re making some pretty significant changes in our IT organization, we’ve done a pretty significant rationalization which has been difficult for the team but I think viewed as necessary. And that type of disciplined approach is going to continue in Canada but I would not be expecting any broad based lay-offs because that’s not the way we’re going to run our business particularly in light of the strength on the revenue side.

Peter Prattas - Cantor Fitzgerald

Okay. Thanks very much.

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.

Scott Thomson

Hi, Cherilyn.

Cherilyn Radbourne - TD Securities

It sounds like you’re making some good progress in Canada, which is certainly encouraging. I wondered if you could be a little bit more specific about the improvements you’ve seen in our labor recovery rate. If memory serves, that was kind of high 60s at the end of last year and you were looking to get that up to about 75% or 80%?

Scott Thomson

Yes. And year-to-date, Cherilyn we’re up 2 points. And so, we’re pleased with the progress but as they continue to stay we’re in the early innings on this and – in five branches. So, progress to-date, it seems very focused on it and we’re seeing a 2 point improvement in our labor recovery over last year this time.

Cherilyn Radbourne - TD Securities

Okay. And I wanted to ask a question about order intake. By my rough math, it was solid as you indicated in your MD&A, but a little bit softer than it has been in recent quarters. Is that just a function of the fact that you didn’t have any chunky mining orders this quarter?

Scott Thomson

Primarily, I mean we had as you know a couple of big chunky mining orders last quarter and we didn’t have those ones this year. So, there’s nothing on the order intake side that is concerning but it is down given the mining orders in the first quarter.

Cherilyn Radbourne - TD Securities

Okay. That’s my two. Thank you.

Scott Thomson

Great. Thanks Cherilyn.

Operator

Thank you. The next question is from Jacob Bout from CIBC. Please go ahead.

Jacob Bout - CIBC

Good morning. So, just, maybe just hoping to flush out a little more color on the backlog, is it particularly just the softness that we’re seeing in South America offsetting the strength in Western Canada?

Scott Thomson

No. Remember last quarter, Jacob, we had a very big oil sands order in the magnitude of CAD200 million, CAD260 million. So, the backlog in South America, haven’t – actually those dynamics hasn’t changed, I mean it’s not very strong. Canada has order intake has continued and we feel pretty good about it but that’s downtick over last quarter is higher deliveries this year – this quarter than order intake and we don’t have the benefit of that CAD260 million order that we had in the first.

Jacob Bout - CIBC

Maybe just talk a bit about product support in Canada, up mid-single digits. Given the growth in your installed base, would you expect that to be a little bit higher, and maybe take a little bit about the mix between service and parts and what’s going on there?

Scott Thomson

Let me take a look. Let me take a crack at it. Actually I was – I saw that in your notes this morning, and I actually – we’re actually pretty pleased with the growth, I mean I think it was up 6% year-over-year. So, that I felt good about it. And it’s both on the service side and the parts side. So, they’re both growing. Actually, it’s a little bit more weighted to the parts side. So, 6% growth year-over-year felt relatively positive about.

Jacob Bout - CIBC

Is there a target here going forward, or is --?

Scott Thomson

No. I mean we’re not targeting specific line items, I mean obviously that the target we’re targeting improve return on invested capital and part of that will come through parts support growth obviously, but there is no – we’re not seeing over the part support at the end of the year.

Jacob Bout - CIBC

Thank you very much.

Scott Thomson

Thank you.

Operator

Thank you. The next question is from Sara O’Brien from RBC. Please go ahead.

Sara O’Brien - RBC Capital Markets

Hi, good morning. Scott, can you comment again, just a follow on that parts and service question. Given that there is a slow down in the service side in South America and I guess the UK, can you put more of a focus on market share, going after market share and parts, and maintain your margin that way, or is it expected that you may face some more margin pressure just based on the diminishing product support overall?

Scott Thomson

Yes. It’s a good question Sara. I mean I think if you look at the dynamics in South America, what we’ve seen is a reduction in parts support primarily on the service side. So, we’re still capturing and you’d expect a significant market share on the parts side. And therefore, I don’t see erosion on South American parts support margins and that’s the South American answer. In the UK, I think it’s little bit different. I mean I think in the UK, you’d seen very strong activity on the equipment side, but the coal mining sector is pretty negative right now. And so, our parts business is suffering a little bit in the UK and then that ultimately is what’s impacting margins in the UK. Now, I think we’re all quite aware of some of the challenges the UK faces on the energy side, so there maybe some slight bright lights on the horizon from the core sector over the next year. But, in general, that’s the dynamics that’s going on in the UK. In Canada, the reduction in the margins from a growth profit perspective is actually met I mean it’s not a significant pressure on the parts margins or service, it’s actually service improvements so it’s not a significant impact.

Sara O’Brien - RBC Capital Markets

So, it’s mixed within parts, you’re saying?

Scott Thomson

No, in an overall gross profit margin.

Sara O’Brien - RBC Capital Markets

Okay.

Scott Thomson

Again the profit of gross profit margin being down 2 points and that’s mix.

Sara O’Brien - RBC Capital Markets

Okay. And second question, how are you positioning Finning to take advantage of potential LNG build out opportunity? I just wonder if there’s some kind of a focus group within the organization that’s trying to attack that with caterpillar or on your own and how far along you are.

Scott Thomson

It’s a good question. We do have – we’ve actually established a internal team led by Joel, who is the Head of Power Systems, but it’s more than a power systems opportunity. It’s also earthmoving and pipeline opportunities or the cross functional team that involves probably 10 or 15 people on it. And, the trick with it is it’s pretty binary right, I mean I feel very optimistic to see activity in at some point you’ll see LNG development, but right now, it’s a little too early to make capital investment decisions. And that’s the struggle we’re having is that one point you make decisions around increased resources or increased capital and it’s a binary decision and the good news is we’re seeing some real strength in our power systems operation. I think some of that is driven frankly by customers pursuing, you know, delineating their gas fields and that’s really helpful. It’s been a great driver behind increased engine sales, and we do have a team thinking about it, but it’s too early to start making the resource or capital decisions in my mind.

Sara O’Brien - RBC Capital Markets

Okay. Thank you.

Operator

Thank you. The next question is from Yuri Lynk from Canaccord Genuity. Please go ahead.

Yuri Lynk - Canaccord Genuity

Thank you. Good morning, guys. Gross margin in Canada, I understand the mix, obviously, hurt gross margins year-over-year, but last quarter we talked a lot about currency impacts, and I’m just wondering if you feel like you’ve adjusted your pricing accordingly to the C dollar and if it had any impact on the Canadian gross margin?

Anna Marks

Hi, Yuri, it’s Anna here. We’re very pleased with our margins, there really is no FX impact in our margins at this point in time so we don’t see any noise there with that respect. So, we’re quite comfortable and happy with our margins on the parts support and new equipment sales.

Yuri Lynk - Canaccord Genuity

Okay. Just to come back to the LNG outlook, Scott, I don’t know how closely you’re following the developments there, so I’m curious for your insights. Were you surprised at all with Apache looking to sell their stake in Kitimat? It looks like that project is indefinitely delayed here at this point. Is this what you’re referring to when it’s still real early days, or do you think that this is kind of a step back for some of the opportunities that Finning saw in, perhaps, ‘15 and ‘16.

Scott Thomson

No. I actually – the Apache wasn’t what I was referring to, I mean I think the big issues are First Nations and pipeline access. And, those are challenges that we’re as Canada we’re going to have to deal with and I think there’s a way to navigate it but Supreme Court decisions and what we’re seeing happen in Caribou region right now are obviously pretty important inputs into those discussions. So, that’s what I was referring to. From an Apache decision, I mean I think that was pretty specific to Apache. They had an activist on their Board, the activist are not on the Board, sorry activist talking to them and the shareholder pretty focused on capital discipline. Apache is not a major like a Chevron or a Shell or Petronas. And therefore, I think there was a lot of focus on long tail return projects and Apache didn’t feel like they could do that and that’s why they pulled out of Kitimat. They also pulled out of their Australian LNG project as well. So, I think Chevron has been pretty public that they plan to find a new partner and move forward and I think Petronas is continuing to delineate gas and move forward as well. So, I still feel like this is a huge opportunity, but I do think there are some major challenges as a country we have to overcome.

Yuri Lynk - Canaccord Genuity

That’s fair. Thanks.

Scott Thomson

Thanks Yuri.

Operator

Thank you. The next question is from Ross Gilardi from Merrill Lynch. Please go ahead.

Ross Gilardi - Merrill Lynch

Hey, good morning. Thank you. Scott, just wondering if you can talk about your balance sheet a bit, it’s getting stronger and the free cash flow is improving, so what are you thinking on cash flow prioritization into next year, and is there any key capital structure target you’re working towards before you think about maybe shifting your prioritization?

Scott Thomson

Hey, Ross. Actually one of the most pleasing aspects of this quarter from my perspective was the free cash flow generation and if you look at all the things we’re doing around capital discipline around working capital management, around invested capital to see CAD100 billion of free cash flow relative to cash usage last year. And then think about third and fourth quarter that should continue to generate cash and I think that was a really positive aspect of this quarter. You’re right, with the CAD100 million of free cash in this quarter, we’re now 40% debt to cap, and by the end of the year, we’ll be at the low end of our target range. And I think as I said last quarter and I’ll continue to say as we get into ’15, and our target balance sheet levels we have to have a conversation around free cash flow deployment and what is that mean, I mean I think there is clearly three ways you can do a reinvestment in the business, acquisitions or return to capital to shareholders.

And on the reinvestment in the business, we’ve talked about not having to do a lot of capital reinvestment particularly in the mining business as given our asset utilization on acquisitions is not been we’re working on right now. And our in capital deployment, I think that depends on value of the share price and how you think about dividends or share repurchases. And so, I’m not ready to engage in that conversation yet but we will be able to do it in the first quarter of 2015 in all likelihood, if our plans proceed through the back half of the year.

Ross Gilardi - Merrill Lynch

Okay, great. And then can you talk about your expected margin trajectory into the second half of the year? Do you think South America is sustainable at 10%? Could it even improve, and, given what you are doing in Canada and some of the progress you’re making in this trend to the end market, could -- do you think you’ll tend to see positive progress in the back half of the year?

Scott Thomson

So, let me hit it in a different way, return on invested capital and that’s the main focus for me. And, as we’ve talked about return on invested capital in the numerator is EBIT margin, and the denominator is sales over the invested capital. And, I think as you look at Canada and the UK and Ireland, we will see improvements in return on invested capital in ’14 relative to ’13. And you’re starting to see that in particularly in Canada this fourth quarter in a row improvement in sales over invested capital, so that’s encouraging. When you look at South America from a return on invested capital perspective, it’s going to be hard to see improvements year-over-year frankly and that just because the sales have declined so much that despite about CAD180 million reduction in invested capital the sales to invested capital will go down in ’14 relative to ’13. I am comfortable that year-over-year, South America will be able to maintain its EBIT margins but the return on invested capital will likely come down.

Ross Gilardi - Merrill Lynch

Okay. Thanks very much.

Scott Thomson

Thanks Ross.

Operator

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

Ben Cherniavsky - Raymond James & Associates

Hi, guys.

Anna Marks

Hi.

Scott Thomson

Hey, Ben. Can you hear me?

Ben Cherniavsky - Raymond James & Associates

Yes, perfect. Maybe, first, just a point of clarification and forgive me, I haven’t had the chance to go through the MD&A in great detail, but the balance sheet shows an increase in inventories, but I thought -- I heard you say that inventories, at least, in parts were down. Can you break out what’s happening to inventories, because that’s a pretty key theme to the whole sector, right now?

Scott Thomson

Yes, for sure. So, let me just get the actual numbers in front of me. In South America, inventories are down significantly relative to both the year end and first quarter, so in the order of almost a CAD100 million so great progress on that side. In Canada, inventories are not down but you wouldn’t expect them to be down because sales are increasing so significantly. So, we see actually new equipment inventory down about CAD90 million since the end of the year and parts inventory around flat. And I’m actually – I’m encouraged by that because given the increase in sales, the sales to invested capital ratio is improving quite significantly. So, you’re right, inventory is not down on the parts side in Canada but returns improvement.

Ben Cherniavsky - Raymond James & Associates

But there’s two ways to think about the sales coming down with inventories being up. I mean if you are, and I’m not suggesting you are doing this, but it is happening in the industry and places. If you’re going out, inventory, then your sales turnover runs up, but not necessarily accretive to your margins. And your margins appear to be pretty stable, but we don’t have a direct sight line into, say, gross margins in Canada or anything like that. I mean how can you give us comfort that the inventories you have are the right kind of inventories that the sales and market share you’re getting is the right kind of sales and market share if you know what I mean? That’s because you know that’s still kind of a lingering question. What can you do to maybe give a little granularity around that?

Scott Thomson

Yes, sure. So, couple of things on that, one is margin flat in South America year-over-year or actually improved year-over-year. So, we’re not just getting rid of inventories for the sake of getting rid of inventories. And in fact, on the new equipment side, we’re having trouble getting rid of some of our inventories because there is just no sales available on mining sites, we got some – inventory that we’d like to give it but we’re not willing to do it at any price. In Canada, I think there was again margin improvement so I’m not and we’re not discounting new equipment sales and if there is margin improvement, I don’t feel like we’re discounting inventory in the parts side. That all being said, one of the issues we have in Canada is too much longer than inventory I mean I agree that’s an issue that we need to deal with and there is too much slow in the inventory in too many areas of not centralized so in too many branches and regional distribution centers.

And one of the things we’re doing here is trying to decrease the slow moving centralized inventory and increase the fast moving. And that will take some time now this is not a quarterly kind of update so to say, this is going to take some time but we’re not in the – we’re not right now and then hopefully the margin performance shows that we’re not blowing out inventory at any price.

Ben Cherniavsky - Raymond James & Associates

Right. But I mean how do you manage that issue with Cat I mean they obviously, want you to buy more for varied reasons, of course, but there’s a balance there with, pushing back on supplier pressure to take product versus your own managing your inventories effectively. How are you working that -- those two competing forces out?

Scott Thomson

So, let’s talk about the new equipment side because that’s I think probably more relevant from a quarterly ordering perspective. Yes, I think Cat and us are both pretty aligned and pretty happy with our market share performance which has resulted in more inventory orders. And, that market share improvement of 5 points that I talked about year-over-year and revenue growth that you see, has been well received by Cat. So, I feel like there isn’t been I mean no misalignment between those two forces. One of the key areas here though is forecasting and you need to be very good at forecasting equipment. Now Cat has reducing its lead time so you’re not ordering equipment year in advance, you’re ordering at six months in advance but you need to make sure you have that forecast right and frankly I think we forecasted it a little bit and we have a little bit more equipment and inventory than we’d like. That being said, that’s small point when you think about the revenue growth and improvements we’ve made on the inventory side that we have today.

Ben Cherniavsky - Raymond James & Associates

Okay, thanks. If I can count that just one question. I just have something else I want to ask you about, the Bradtree configurations that you walked through, which was very helpful by the way to get that kind of granularity what you’re doing in the operations, did I hear you right? Are some of the branches being subleased and I mean effectively closing, rationalizing branch space, and how far are you in that process and how much of what you’ve already done has shown up in this quarter versus what we’ll see in future quarters and versus next years, etcetera?

Scott Thomson

Yes. The things that I talked about have all been done except with the exception of the Prince George movement of the rental store to the main branch and that’s going to happen in Q4. And there are one or two other branch decisions that we’re going to make that we’re talking about internally right now which they have actually been communicated to the branch network so there is not surprise to anyone and that will be helpful but it’s not an overhaul of the branch network family, I don’t want to leave that impression at all, I mean we’re trying to coordinate activities, we’re trying to take excess capacity and rationalize it. And in some instances, Prince George, rental store branch being one and Kelowna, rental store rationalization was another and then there is another branch that we are contemplating combining with a local nearby branch which is – has been discussed internally. So, I’m not saying anything that our employees don’t already know, which will likely happen probably in the fourth quarter and the first quarter. So, progress incremental progress no big closing down branches and I don’t think that’s appropriate frankly given the kind of the revenue growth that we’re experiencing.

Ben Cherniavsky - Raymond James & Associates

Did you say that Mildred Lake was subleased, though? That you’ve moved the activity out of that into the main branch?

Scott Thomson

No, we had the – we had a shovels and drills branch in Fort McMurray which we did.

Ben Cherniavsky - Raymond James & Associates

From Bucyrus.

Scott Thomson

Yes, which we did vacate and subleased, you’re right.

Ben Cherniavsky - Raymond James & Associates

I see. Okay, great. Thanks very much.

Scott Thomson

Thanks Ben.

Operator

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

Bert Powell - BMO Capital Markets

Yes, thanks. Scott, the service margins in Canada up in the quarter offsetting some negative mix and rental. I’m wondering if you could give us a sense of where you are at a run rate basis on the service profitability improvements focus against the sort of the CAD40 million to CAD60 million of EBIT that you think you can get from that, you know, over the next three years I think is where you kind of timelined it?

Scott Thomson

Bert, at the right time we’ll come back and give you an update but two quarters in, I think it’s too early to give an update. That being said, we are making good progress. I think the labor recovery 2 point increase which I referenced to Cherilyn, highlights that. And there’s lots of other progress too being made around warranty management around quoting goodwill management et cetera. But, to actually put a dollar figure to it, I think it’s too early to do. At the right time, I will come back and make sure that we’re updated on that CAD40 million to CAD60 million but two quarters in, I think I’m hesitant to do that.

Bert Powell - BMO Capital Markets

Okay, fair enough. I just wanted to get a sense if there was anything that was, to share in terms of progress against -- that’s fine. And not that I want to use the ERP word on a Finning call, but can you give us a sense in terms of, that IT infrastructure? Are you extracting the value out of that, that was originally contemplated? Just give us a sense of what’s going on that front would be helpful?

Scott Thomson

Sure. Absolutely. So, I guess two different points, and one I think Canada and then we’ll talk more globally. In Canada, I have to spend a lot of time with customers and a lot of time with our employees asking that the question you’re asking. And, what I’m hearing from customers is there is no concern around parts availability, customers are getting their parts. And, I think our service levels demonstrate that. So, that is I think good news. On the employee side, I think there is still some work to be done on change management and training because it’s in any system implementation that was a big change management exercise and we clearly didn’t do that well. But, Dave Cummings who’s now been with us for year and the Canadian organization I think a good plan for the training side and the change management side. So, I feel pretty good about that.

Are we getting the maximum benefit out of it? Absolutely not. I mean I think there is a continuous improvement program here that will allow us to capitalize on the investment, I think we are better than we were before we did it but there’s a lot more functionality that we can use that help us manage our supply chain and SG&A better. So, that’s more of a continuous so that’s not a big bang investment, that’s more of a just a continuous improvement program. So, that’s Canada. In South America and the UK, we’ve looked at the UK business and we’ve said it doesn’t make sense to given the size of that business to put that business through an ERP implementation at least right now. So, that’s we stopped that and that was why we had the – like CAD5 million right off in the fourth quarter last year.

In South America, we are going through a process where we’re looking at one do we need an ERP implementation upgrade if we do, at what point, what timing. And then third, is it a loss or is it something else SAP or Microsoft and that discussion is underway as we speak. I suspect there will be some upgrades required in South America from a systems perspective. But, if we do it, we will – it won’t happen this year for a while but if we do it, it will be done in a much different way than we did Canada much more slower, much more smaller scale and much different from a training perspective. So, we don’t take on the same sort of risk as we did in the Canadian business.

Bert Powell - BMO Capital Markets

Okay, that’s two. Thanks.

Scott Thomson

Thanks Bert.

Operator

Thank you. We have a question from Benoit Poirier, Desjardins Capital Markets. Please go ahead.

Benoit Poirier - Desjardins Capital Markets

Yes, good morning. Just to come back on the inventory obviously a good progress this quarter versus last quarter and a big driver on the free cash flow. I was just wondering whether it’s fair to assume still positive free cash flow generation but maybe less material given you expect a softer mood in terms of equipment delivery in the second half?

Scott Thomson

Hey, Benoit, it’s Scott. So couple of comments on that, one is in the second quarter, second quarter at South America’s free cash flow delivery was really impressive, I mean it was over CAD100 million. And that offset some weakness in Canada and so it’s not weakness but less free cash flow in Canada and the UK. And, I’m not expecting that type of free cash flow generation from South America every quarter. I mean I think there were some things that the team did that were from an inventory perspective that were very helpful. Then, I’m not sure you make those kind of step changes in the third and fourth quarter like we did in second quarter so don’t expect that. In Canada, we will generate free cash flow in the third and fourth quarter like we did last year, I’m not saying the amount, it’s like we did last year but similar to past that we did last year but one issue through in Canada is we did less about the absolute invested capital reduction, it’s more around the invested capital efficiency.

And therefore, I’m not asking the team to reduce invested capital for the full benefit of reducing the invested capital. I’m asking them to improve capital efficiency which is the sale to invested capital. So, when you see the type of sales growth which you do it obviously impacts the type of reductions you can see on inventory and both parts of the equipment which impacts free cash flow. So, depending on the revenue growth for back half of the year which I’ve said is not going to be as strong as the first half of the year, that could impact the free cash flow a little bit but we will see positive free cash flow in the back half of the year, I’m convinced about that.

Benoit Poirier - Desjardins Capital Markets

Okay. Very good color. And any color about the amount of slow moving inventory that could be reduced over time, Scott?

Scott Thomson

Not yet, it’s been while I mean I do think this is one of the biggest priority in Canada is getting that slow moving, fast moving inventory balance more appropriately but in terms of I mean this is a longer term process and I think we are making good progress but it’s going to take a little bit of time.

Benoit Poirier - Desjardins Capital Markets

Okay. And just on the rental front, could you help me to reconcile a little bit your comment about software demand in rental, and because when I look at the rental investment net of disposal I saw about CAD48 million in the quarter. And I think that the last guidance for the year was kind of a comparable amount to 2013. So was there any opportunity to do big investment in the rental, and should we expect a slowdown in the second half?

Scott Thomson

So, couple of comments on that. We do have a significant investment in rental as a company and in Canada and we are – and we think there is a good opportunity on the rental side. In the second quarter, it was soft relative to our expectations and I think there is a couple of things driving it, one, given the contractor utilization of fleets in the oil sands. I think there is a little bit of horse trading going on between contractors on their unutilized fleets which impacts our rental opportunity. I think the coal mining sector the reduction inactivity that’s been a big user of our rental business and that’s had an impact on us in the quarter. And then third, it’s a very competitive market and we were – I think we were a little bit more disciplined from a pricing perspective and we were willing to participate in some of those transactions and that all impacted the rental and I guess the fourth issue is remember second quarter last year was a pretty strong rental quarter because of the floods in Calgary. So, all four of those things led to a lower rental performance in the quarter relative to last year. I mean I think the prior guidance about rental spend being relatively comparable to rental spend last year it’s still relevant and the same on the capital side I mean I think those things that we said in December are still relevant for the rest of the year.

Benoit Poirier - Desjardins Capital Markets

Okay. Thanks for the time.

Scott Thomson

Thanks Benoit.

Operator

Thank you. There are no further questions registered at this time. I would like to turn back the meeting over to Mr. Thomson.

Scott Thomson - President and Chief Executive Officer

Great. Well, thank you very much for listening to the call today. On balance, I am pleased with the quarter and the progress we’re making on our priorities. There is a lot more work to do and we are relentlessly focused on achieving and sustaining the full benefits of the initiatives we’re implementing. Thank you very much and we look forward to speaking to you again after Q3.

Operator

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

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Source: Finning International's (FINGF) CEO Scott Thomson on Q2 2014 Results - Earnings Call Transcript
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