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Caterpillar (NYSE:CAT)

Q1 2011 Earnings Call

April 29, 2011 11:00 am ET

Executives

Edward Rapp - Chief Financial Officer and Group President of Corporate Services

Douglas Oberhelman - Chairman and Chief Executive Officer

Mike DeWalt - Director of Investor Relations

Analysts

Ann Duignan - JP Morgan Chase & Co

Jerry Revich - Goldman Sachs Group Inc.

Stephen Volkmann - Jefferies & Company, Inc.

Henry Kirn - UBS Investment Bank

Eli Lustgarten - Longbow Research LLC

Robert Wertheimer - Morgan Stanley

David Raso - ISI Group Inc.

Ted Grace - Susquehanna Financial Group, LLLP

Robert McCarthy - Robert W. Baird & Co. Incorporated

Jamie Cook - Crédit Suisse AG

Operator

Good morning, ladies and gentlemen, and welcome to the First Quarter 2011 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Mike DeWalt. Sir, the floor is yours.

Mike DeWalt

Thank you. And good morning, everyone, and welcome Caterpillar's First Quarter Earnings Call. I'm Mike DeWalt, the Director of Investor Relations. And I'm pleased to have our Chairman and CEO, Doug Oberhelman; and our Group President and CFO, Ed Rapp, with me on the call today.

This call is copyrighted by Caterpillar Inc., any use, recording or transmission of any portion of this call without the expressed written consent of Caterpillar is strictly prohibited. If you'd like a copy of today's call transcript, we'll be posting it in the Investors section of our caterpillar.com website. It'll be in the area labeled Results Webcast.

This morning, we'll be discussing forward-looking information that involves risks, uncertainties and assumptions that could cause our actual results to differ materially from the forward-looking information. A discussion of some of those factors that individually or in the aggregate we believe could make actual results differ materially from our projections can be found in our cautionary statements under Item 1A, Risk Factors, of our Form 10-K filed with the SEC on February 22, 2011, and also in the forward-looking statement language contained in today's release.

Okay, this morning, we were pleased to report financial results for the first quarter of 2011 that were significantly better than last year's first quarter. Sales and revenues were over $12.9 billion, and profit was $1.84 a share in the quarter. Sales and revenues were up 57%, and profit was up over 400%. It was the best quarter for profit in our history. You'll also see in this morning's release that we raised the full-year outlook for 2011 sales and revenues and profits. And to start this morning, I'll summarize the results, then Doug, Ed and I will take your questions.

Also, in this morning's release, you may have noticed that we have made changes in our reporting format, including revised segment disclosures. As a part of the strategy update that Doug rolled out last year, the company was reorganized around end-to-end businesses managed by our Group President. That's how we're managing the company, and that's now how we're reporting. This morning's release is structured around those new segments. We're reporting sales and revenues by segment, and geography, and operating profit by segment, and we're providing sales and operating profit commentary by segment.

The segments that make up our Machinery and Power Systems businesses include both the sales of new equipment and aftermarket support for the businesses they serve. While there is a more complete description of each of the segments in the glossary in today's release, and I encourage you to read them, in a nutshell, the segments are: Construction Industries, which are essentially the businesses of CAT that support customers in most types of construction all around the world, everything from compact machines for a landscaper to larger machines to build a highway. Then there's Resource Industries, where we serve customers in areas such as mining, quarrying, and forestry. Next is Power Systems, which encompasses reciprocating engines and turbines across industries serving oil and gas, electric power, marine and industrial engines; and our Rail-related businesses, including new locomotives from EMD, and Rail Services from Progress Rail. We're reporting Financial Products in this segment, and there's an All Other Segments. The largest sales contributor to the all other segment is External Logistics and Remanufacturing. Again, I'd encourage you to read through the glossary of this morning's release to better understand what's in each segment.

Okay, let's get to the numbers. And again, sales and revenues were up 57%. Now in that number, Financial Products revenues were nearly flat, and Machinery and Power Systems sales were up 63% or $4.7 billion. Now in that 63% increase in sales, Construction Industries were up 71%; Resource Industries, up 84%; and Power Systems sales were up 51%. Another way to look at the $4.7 billion increase in sales, $4.1 billion of it was from higher sales volume. And most of the sales volume increase was driven by customer demand, with first quarter dealer-machine sales to end-users, up 61%. In addition, during the first quarter, dealers did increase dealer-machine inventory about $800 million from year-end 2010, and dealers commonly increased their inventories during the first quarter of the year to support higher end-user sales levels that usually occur during the spring and summer selling season. We do not expect to see this level of increase during the rest of the year. In the first quarter of 2010, by comparison, dealer-machine inventories were about flat with year-end 2009.

Now in addition to the higher volume, $295 million of today's sales increase was from improved price realizations. $264 million was from the acquisition of EMD that was not included in the first quarter of 2010, and currency impacts were positive to sales by $94 million. Sales improved in all 4 major geographic regions; North America, up 72%; Latin America, up 90%; Europe Africa/Middle East, up 67%; and Asia/Pacific, up 35%. Now the increase in North America may seem surprising with the continuing depressed level of construction activity in the United States. Housing starts are at historic lows. Commercial Construction is still very weak. But in the phase of weak construction activity, sales from our Construction Industry segment were 92% in North America. While the growth rate is dramatic, remember, it's coming off of a very low base in 2010. And sales of new construction equipment in North America remained well below the 2006 peak, in fact, new machine volume is still only about half of the 2006 peak levels. Now most of the machines sold in North America, we think, are likely replacing aging machines and customer fleets and in dealer rental fleets.

During the recession, customers cut machine purchases much more rapidly, and deeply than overall construction spending decline. As a result, their fleets both shrunk in size and age, and we're seeing that in customer fleets, and we're seeing it in dealer-rental fleets. We believe customers are beginning to buy enough machines now to slow or stop their fleets from continuing to degrade. But let's be clear, though. We do not think this is any kind of a bubble. It's not that customers are buying more than they need. And judging by what we're seeing in dealer rental fleets, we're not seeing increases in either fleet size or a reduction in fleet age. We believe they are essentially buying enough to keep their fleets from continuing to degrade.

Let me give you a few statistics about North American dealer-rental fleets that illustrate that point. Let's start here with BCP products in rental fleets, and that would be small and compact machines. Rental fleet sizes are still very close to the recession load, and the fleet is older than it's ever been. In fact, the rental fleet for BCP-sized product is even smaller than it was in the 2002 recession, and about 50% older than it was then. It's a similar story for earthmoving products in rental fleets. Despite higher sales to dealers for rental, the size of their fleets continued to decline during the quarter, and remains both smaller and older than even the 2002 recession. The dealer-rental fleets for excavation products also declined in unit volume in the first quarter, despite much higher sales to dealers. And fleets were at their lowest levels since we've been tracking it, and the average age of the fleet is the oldest on record.

Now an actual Construction activity like housing starts, commercial building and road construction begin to improve, it will likely place additional pressure on customers on dealer rental fleets to both improve fleet age and increase fleet sizes. In short, new machine sales in the United States, while better, are still depressed and far below the peaks of 2006. When Construction activity begins to improve, we expect sales will continue to improve.

Now in addition to Construction activity, Mining and Power Systems also improved in North America, but again, from low levels in the first quarter of 2010. Mining activity and higher commodity prices, including coal, have encouraged customers to invest in large mining equipment. And higher sales to oil and gas and electric power customers, along with the acquisition of EMD, drove the increase in Power Systems sales.

Outside of North America, sales continued to improve in the developing countries around the world. Machinery and Power Systems sales increased in the developing countries of Africa, the Middle East and the CIS. Sales were up 90% in Latin America and 35% in Asia Pacific. Economic growth in developing countries has been good, and is driving investment and infrastructure and increased demand for commodities. And that continues to be good for our business. A wise man in Caterpillar once said, "The road to progress begins with a road." And that's what we're seeing in emerging markets. In Europe, sales improved as well, and the reasons were similar to those in North America, the slower stop of deterioration in age and the size of customer machine fleets and dealer rental fleets.

Okay, let's turn to first quarter profit for a moment. It was a record at $1,225,000,000, and that was almost $1 billion higher than the $233 million from the first quarter of 2010. Profit per share was $1.84, more than 5x the $0.36 a share from the first quarter of 2010. Higher sales volume was the primary reason that profit improved in the first quarter of 2010. Price realization was also a positive at $295 million. Now partially offsetting the higher volume and improved price realization, manufacturing cost were $219 million higher. Most of that increase was the result of higher period costs to support the large volume increases, and from higher incentive compensation. Material and freight costs were also slightly higher. Considering the size of the volume increase, the scale of capacity increased projects we're working on and commodity-related pressures on material costs, cost control in the first quarter was good.

SG&A and R&D cost were also up $219 million, and driven by higher incentive compensation, cost to support new product development programs, and the impact of the much higher sales volume. While costs were up some, as a percent of sales in our Machinery and Power Systems businesses, the combined SG&A and R&D went from about 15.9% of sales, down to a year ago, down to about 12% of sales of this year, and that reflects our continued focus on controlling period costs.

Now currency, at an operating profit level, was also negative. It was positive to sales $94 million, but the impact on operating costs was negative $118 million. In total then, it was negative to operating profit, $24 million. Below the operating profit line, other income was $17 million. And that was down $46 million from the first quarter of 2010. And most of that reduction was mark-to-market losses on interest rate swaps that we put in place in preparation for the Bucyrus acquisition, and cost for bridge financing related to the Bucyrus acquisition.

Moving down the income statement to taxes, there are 2 points of interest to note on income taxes. First, the quarter reflects an estimated annual rate of 29%, back a point lower than the 30% rate from the first quarter of 2010 but at the point higher than the 28% level that was in our full-year outlook that we released back in January. Now the second point on taxes is that the first quarter of 2010, that's a year ago, included a discrete charge of $90 million, and that was in addition to the taxes at the estimated annual rate, and that charge was related to the enactment of the U.S. healthcare legislation last year.

I'll cover one final point, and then move onto the outlook, and that point is incremental margin, the subject I know many of you are interested in. Now we put a Q&A on incremental margins in our release this morning, it's question 14 on Page 17 of this morning's release. And consolidated sales and revenues were up $4.7 billion. Consolidated operating profit, and these were off the page of the statements, were up $1,325,000,000. That's an incremental margin rate of about 28%. But to do it apples-to-apples, you need to exclude the acquisition of EMD and if you do that, it was more than 29%. Incremental margins were good in Construction Industries, Resource Industries and in Power Systems segments. We executed well in the quarter, and did a good job of controlling costs. As a result, consolidated operating profit as a percent of sales was 14.2%.

Okay, that's a quick review of the quarter, let's move onto the outlook. To start, I'd like to clarify what's in the outlook and what's not. In 2010, we announced 3 acquisitions that were large by CAT standards: EMD, MWM and Bucyrus. We closed EMD in the third quarter of 2010. It's in our results today, and it's in our full-year outlook. Because we have not closed either MWM or Bucyrus transactions, neither was included in our outlook, and that's our long-standing policy. We don't include acquisitions until after they close.

With that in mind, this morning, we raise the outlook for 2011. We now expect sales and revenues to be between $52 billion and $54 billion. In our previous outlook, expected sales and revenues to exceed $50 billion. In our new outlook, we expect profit in a range of $6.25 to $6.75 a share, and that's up from our previous outlook of net expected profit near $6 a share. While our 2011 outlook has improved, the increase would have been greater, if not for the impact of the disaster in Japan.

Our facilities in Japan were not damaged by the earthquake and tsunami, but many of our suppliers in Japan were. As a result, we are experiencing sporadic production disruptions at many of our facilities around the world. These disruptions are having a negative impact on the sales, factory efficiency and costs like premium freight. While the situation has steadily improved in the aftermath of the disaster, it will likely have a negative impact on 2011 sales of about $300 million, and negatively impact operating profit by about $100 million. And the most significant impact is expected to be in the second quarter.

In terms of the improvement in the profit outlook, higher sales volume was, by far, the main driver. Overall, the net of price realization and operating costs isn't much different than our original outlook for 2010. Price realization will likely be a little bit better, but material and freight costs a little worse. On balance, though, the big driver in the profit outlook is sales volume. Below operating profit in the outlook, we do expect more headwind on the tax rate. And again, we raised our full-year estimate from 28% to 29%.

Okay, that's it for the outlook, and sales and profit in the quarter. Before we take your questions, I'd like to quickly touch on 3 additional points and they are employment, cash flow and investment in capacity. Since the end of the first quarter of 2010, we've added almost 21,000 people to our global workforce. About half are full-time Caterpillar employees and about half are in our flexible workforce. In total, that represents an increase of over 19% in the total global workforce. That's very positive news for employees and the communities that they're located in. In terms of cash flow, Machinery and Power Systems' operating cash flow improved over 50% from the first quarter of 2010, and was over $1.6 billion in the quarter. Our Machinery and Power Systems debt-to-capital ratio dropped from over 47% at year-end 2009 to 34.8% at year-end 2010, down to 30.4% at the end of the first quarter of 2011. That's a drop of almost 4.5 points from year end. Cash and short-term investments on the balance sheet were almost $4.9 billion at the end of March, as we're accumulating cash in our effort to minimize or eliminate the need for new equity to fund the acquisition of Bucyrus. All in all, a very good cash flow for the quarter.

Finally, investment and additional capacity is very high on our list of priorities. In fact, our current outlook for 2011 is capacity constraint for some products such as excavators and many of our large Mining products. We are investing in capacity increases around the world to be prepared for 2012 and beyond, including substantial investment in the United States. In fact, more than half of the $3 billion that we expect to spend on capital expenditures in 2011 is being invested in the United States. Expansions that have been announced around the world include capacity expansion for mining trucks in Decatur, Illinois, a new loader power training facility in the U.S.; expansion of our BCP products in North Carolina; a new engineering design center in the United States; a new excavator facility in Texas; a new factory to manufacture locomotives in Muncie, Indiana; capacity expansion for mining trucks in India; significant increases in excavator capacity in China; a new factory for small wheel loaders and backhaul loaders in Brazil; a new mini excavator factory in China; an new internal logistics center in China; and a new factory to produce 3,500 series engines in Tianjin, China.

As we move forward, we'll continue to evaluate capacity needs based on our expectation of future demand. Okay, that summarizes this morning's release. And with that, Doug, Ed and I are ready to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is coming from Stephen Volkmann.

Stephen Volkmann - Jefferies & Company, Inc.

It's Jefferies & Company. I'm wondering, I guess, if I could just start with a little bit of a philosophical question, Mike, you talked about how sales is being driven by some replacement in the fleets and that as you pointed out, a lot of the fundamental drivers like Construction spending and so forth haven't really kicked in yet. How long do we think we can continue to drive these types of strong sales just based on that type of demand? And when do we need the actual end markets to really start to kick up for us?

Mike DeWalt

Well, I don't know if I would give a -- put a time on it, but what I would tell you right now is, I think we're in a position where dealers would like to increase rental fleet sizes. I think they would like to improve the quality of fleets. For a lot of product, we are producing as much as we can like excavators, for example, where we're capacity constrained. So I still think there still needs to be more, I think, upgrading of the fleets even before thinking about real, I would say, Construction-led demand from Construction spending. Now this is going to sound like an idiom, an odd comment but in a lot of ways, this has been pretty good for us. I think that had the U.S. roared back with big housing starts, a highway build and improvement in commercial construction, it would have been very, very tough, given the strength in emerging markets, I think, for us to deal with that. That's why, given my little intro there, that's partly why we have all those investment capacity additions going.

Douglas Oberhelman

Yes, I'll just add to that, Mike. It's Doug Oberhelman here, and I'm not going to put a timeframe on it either. But if you really look at what's happening in the U.S., it's a very slow recovery from very low numbers for us, which means all that is in front of us. Rental fleet rebuild, customer aging fleet rebuild, and in construction activity. So Mike is exactly right. We're in a very good position in this recovery, where we can really get our factories an order. We can apply our CPS, Cat Production System disciplines to get this going, so that when the Construction activity rebounds in the developed world, call it the U.S. and certainly, Western Europe, we're going to be ready, but I don't know. The economists on the call would have a lot better view of when that's going to happen than I am, but that day is coming.

Stephen Volkmann - Jefferies & Company, Inc.

Okay. And if I could just follow-up, Mike, I understand the new segment reporting is closer to the way you guys look at things, but it leaves us a little bit high and dry, as we try to think about forecasting and modeling. And I'm wondering, based on the margins that you guys reported for this quarter, are those the right type of margins to think about going forward? Was there anything big seasonally, or any other type of special situations that would mean maybe that 29%, for example, in resources, isn't what we should think about going forward, or any help you can give us with the segments?

Mike DeWalt

Sure. I'll just point out one thing on the segments. The operating profit numbers that we're reporting, that's how we're looking at it internally. Now in the sales numbers that we're reporting by segment, that's external sales, sales to outsiders. The profit numbers include some intercompany sales as well. And you'll notice in the sales table, we have some footnotes below that, that show the intercompany sales numbers as well. So if you're calculating actual margin numbers to match up the sales to the operating profit number, you probably want to include the intercompany as well. That's why we provided it in the footnote. In terms of the quarter, anything unusual, I'd make -- I'm not sure I would qualify this as unusual or not, but -- we've said this before, this is not a new comment. Fourth quarter is usually seasonally a high-cost quarter for us, and the first quarter is usually seasonally a low-cost quarter for us. And we certainly saw in that the fourth quarter of '10, and we saw that in the first quarter of this year. So typically, it's a pretty light quarter for cost. We got R&D programs that will ramp up. But in terms of -- there were no redundancy costs that we called out. There were no big unusual items that we called out.

Operator

The next question is coming from Henry Kirn.

Henry Kirn - UBS Investment Bank

It's UBS. Could you talk about inventories at the dealer level? How much room is there to still grow there, and how do you expect the wholesale and retail sales to compare as we go through the year?

Mike DeWalt

Yes, on dealer inventory, there is a usually -- and when I say usually, you kind of have to temper that a little bit, depending upon where you are in the cycle. But usually, the seasonal pattern is that dealers will build some inventory in the first quarter. Their big selling seasons, particularly in the northern hemisphere, is spring and summer when contractors are out working there. So generally, they'll build some inventory in the first quarter. Historically, they might then use some inventory, maybe in the use from inventory in the second quarter, where they have bigger sales. Now for the full year, our view is that inventory will probably go off a little bit from where it's at now, but nothing on the order of the quarterly increase that we saw in the first quarter. On the retail sales numbers, we started to pickup in the first quarter of last year. In fact, you'll see the Asian numbers, percentage-wise, look lighter than maybe North America. And I think that probably surprises people in terms of the thinking that North America's weak and Asia's strong. I think when you look at the retail numbers, you kind of have to step back and look at when recovery started. Recovery in Asia started earlier than it did in the U.S. and Europe, and so they're starting to lap now very good numbers. And I think as we move forward, in the kind of the impacts of the 2009 recession are those low, low, levels get behind it, I think the retail comparisons will get tougher as we go forward.

Edward Rapp

Henry, this is Ed. The only thing I'd add is that if left to their own devices, dealers would want to take that inventory level up. But in a lot of cases, we're allocating product, and moving more of that inventory into the PVCs and then to the lane configurations, and it's a real effort to make sure we have the right product in the right places, very different than the way we managed the upturn last time around.

Henry Kirn - UBS Investment Bank

That's helpful. Is it possible to talk a little bit about the supply chain outside of Japan, where you maybe seeing some tightness?

Mike DeWalt

Yes, this is Mike. We've got a lot of factories around the world, a lot of products. And I'm sure if we went into any one of our factories, the product manager could rattle off a dozen components that they would like more of. But I think, on balance, our suppliers have just done a fantastic job of ramping up. I mean, if you look where we came from in the depth of, let's say, third and fourth quarter of 2009, production is significantly higher than it was, then we tried to communicate as far forward as we can with our supply base. And I think for the most part, they've reacted. So we don't have anything specific to call out. It's tightened a lot of areas, but our suppliers have done a great job.

Operator

The next question is coming from Robert McCarthy.

Robert McCarthy - Robert W. Baird & Co. Incorporated

It's Robert W. Baird. One of the things that -- you were just talking about capacity. One of the things that I've been concerned about is the time lag in being able to close the Bucyrus acquisition, and the fact that they're sold out for at least this year, and their hydraulic shovel business which is, of course, very important asset that you're acquiring. And as you know, they're landlocked in Germany. So from their end, capacity is just flat static right now. Are you already in the process of trying to -- I mean, is this part of what Texas is? Are you in the process of building capacity, so that you'll be able to quickly add to their existing capacity once you take control of the business?

Douglas Oberhelman

Doug Oberhelman here, Rob. We are only going to comment on Bucyrus today about the closing that we still expect in mid-2011, but I will tell you the factory that you've referred to in Texas has nothing to do with the Mining business. That's a construction excavator plant, only -- call it 25 to 35-ton machines, unrelated entirely to Bucyrus. And that's just about as far as we'll go -- that is as far as we'll go today with Bucyrus. Everybody's working hard to get it closed. We expect in 2011 to get it done.

Robert McCarthy - Robert W. Baird & Co. Incorporated

Okay. And then my follow-up has to do with your expectations for dealer inventory growth. I'm interested in both the $800 million in the quarter, and your expectations for the full year. Can you talk about where that will be concentrated by segment within the new segments? I'm guessing most of that would be at BCP, Construction, in other words?

Douglas Oberhelman

Yes. I think that's -- I mean that's where most of it is. There's not a lot of Mining inventory, so that's a pretty easy one to say yes to. I think geographically -- well, I'll just start off, the $800 million that were already up in the first quarter, our expectation is that we'll probably not going to end the year a lot higher than that, somewhat higher, but not a lot higher than that. So I wouldn't expect big changes from the end of the first quarter by the time we get to year end. Now there might be some up and down during the year. Again, the second quarter is usually a big quarter for sales to users in terms of actual volumes until it's not unusual for dealers to take a little bit, take inventory down a little bit in the second quarter. But I don't think for the full year -- at least, our view is it won't be a lot higher than what we ended in the first quarter.

Robert McCarthy - Robert W. Baird & Co. Incorporated

And you were going to say something regionally, Mike?

Mike DeWalt

Regionally, all regions were up in the first quarter except Asia Pacific. Asia Pacific actually declined just a touch, and I think that reflects a point that Ed made earlier. Dealers would like to take more inventory if they could. If you take Asia, for example, our excavator production in China is -- will go in full out. And I think if we could get more products at some things like excavators, we can certainly put more in our Lane inventory, and I think that dealers could -- even though we're trying to put as much as we can in Lane inventory to get it distributed well, you could probably make a good case for some dealers needing a bit more.

Operator

The next question is coming from Ted Grace.

Ted Grace - Susquehanna Financial Group, LLLP

Susquehanna. So I think speaking for myself and then probably for a lot of people, trying to calibrate our expectations around the new reporting format, but as it relates to the incremental margins for what historically was the Machines business and now, I guess, we'll call it the Construction Industries and Resource Industries, one more quarter into the recovery,it would be great to kind of get your updated sense for how you think the opportunity on incremental margin side is, and kind of as the second part, whether it's Doug or anybody else on the call, could you just compare and contrast the opportunity that you see within Machines relative to Engines when you took over that business, and made the dramatic improvements there?

Mike DeWalt

I tell you what, I'll start with the first part of that. When we came into 2011, if you go back to our original outlook, we said we expected incremental margins in the neighborhood of 25% this year and for the full year. And if you look at our outlook today, we revised the sales number up, and we revised the profit number up. And I think the incremental margins embedded in that are a lot different that what we said before. We did a little better than that in the first quarter. And if you look at the year-over-year sales increase, the first quarter of a year ago was still coming off of, let's just call it, recession lows, and sales really started to improve through the last year. So if you look at first quarter to first quarter, it'll probably have the most significant year-over-year comparatively increase in volume. And the bigger your volume increase in a lot of ways, the easier it is to get a high incremental margin. So I think it's not surprising that the first quarter is a bit better than what we were expecting for the year. On balance, I don't think our expectations for incremental margins for the year are significantly different than how we started out the year.

Douglas Oberhelman

I'm not sure -- Doug Oberhelman here, I got your back end of that question vis-a-vis Engines, but what I will tell you is that we have the entire leadership team of the company, and we communicate with employees constantly on this idea of incremental margins and profit pull through. It's a big deal inside our company, and it's a motivator to many. The segmentation presentation that we provided this quarter is what our fleeters use internally as well. That's the document we all are motivated by. What you see is what we see, and how we manage. Now having said that, Mike is exactly right. The 25% incremental margin we want for the rest of the year in our outlook is what we expect to deliver, and that's one of the better years in the last many in terms of year-over-year improvement, which we're pretty happy with. But it's something that is a key core metrics of ours internally. The executive office, that is all the Group Presidents and myself, look at this continually, and that's how we do our business planning and so on and will into the future. Because the history of '06, '07, '08 is still pretty fresh and the success we had, I think, your point on the engine businesses is the one we modeled the machine business after, and we're seeing that here in the last couple of quarters as well. Certainly, the first quarter is very rewarding to that.

Ted Grace - Susquehanna Financial Group, LLLP

Yes, exactly. What I was going to ask is when you think about the longer term opportunity, not as much as 2011, if you were to look at the Engine segment between '02 and '09, sales growth is similar to your peer group, and yet your margin expansion was 1,200 basis points, pure average is 200. And so if we try to apply that kind of construct to the opportunity within what was historically the Machines business, I'm just curious to get a sense how do you think about the increased opportunity from here longer term, so over 3 to 5 years?

Mike DeWalt

Sure, and I'm not going to -- we don't really -- I'm not going to talk about that 5 years out, but we certainly have talked about it internally in where we want to be, and that is one of our metrics. And as we've talked to all of you in New York at the exchange last year, at 2015, the goals we laid out for that really get us to this kind of a profit pull through. So yes, I think you can -- I don't know what it is vis-a-vis the peer group, but certainly, in terms of where we want to be by the end of '15, that's a key piece of getting us there.

Operator

The next question is coming from Eli Lustgarten.

Eli Lustgarten - Longbow Research LLC

Longbow Securities. Can we go back and talk a little bit more about the profitability you gave us one quarter in comparison, I hope you'll give us your stated quarters quickly for last year. And Resources, the one that's exact, when you show a 28.8% margin, I guess, given the exact sales is 26%. That doesn't seem to be like a normalized profitability to some, and I think it's a question we're trying to get a sense of what the normalized profitability. And when you put it in the context with the guidance that you gave us, because what you effectively said for the rest of the year, assuming that you're not being ultraconservative, is that the sales number for the rest of the year doesn't change a lot. But your quarterly profit report goes down 10% to 20%, on average, from this huge first quarter. So I'm just trying to reconcile the 2, and it has to be, at some point, it suggests that the operating profitability would be lower in this segment versus what we saw in the first quarter. So I'm trying to get an idea what more normalized numbers would be.

Mike DeWalt

Okay, a couple of things. It is our intention to restate the quarters of last year, and we'll do that as quickly as we can. I would expect that it's likely that we'll have that done before we talk and disclose it before next quarter. I think we'll be able to do that. So that might give you at least some quarterly perspective from a year ago. Resource Industries includes Mining, which is, shall we say, more profitable than the total. One thing you need to remember, though, when you're thinking about the numbers in total, there's a line within our segments that has corporate costs, and there are some costs in our business, things like -- I'll give you some examples: our Corporate Treasury group, our tax group, part of our Human Resources group, our legal group, some of the pension costs that aren't related to service costs. They are not included in the individual segments. So you'll see those as a negative when we sum up the segments, plus that, to get to the total. So if you were looking at Machinery, for example, before, as we reported that we would've allocated all that to Machinery and Engines, and now we're not. So I think it probably will help you when we give you a little bit more historic data. But again, Resource Industries is the more profitable than average segment, no doubt about it. Now in terms of the first quarter versus the rest of the year, I kind of touched on this. The first quarter is usually a pretty light cost quarter. Fourth quarter is pretty heavy. First quarter is pretty light, and we saw that. Now in addition to that, I think what we're going to see as we move through the year is probably a little bit more headwind on material costs. And on the first quarter, we didn't say much about it in the release, because it was just slightly negative. It was not a big deal in the first quarter. But as we go through the year, that will likely be more of a headwind as we go forward. And things like R&D costs, for example, I think that'll probably go up. And then, of course, in the second quarter, that's where we would expect to see the vast majority of the impacts from the disaster in Japan. So that's having a little bit of a negative on the rest of the year, particularly in the second quarter as well.

Eli Lustgarten - Longbow Research LLC

I guess what I'm driving at is when volume goes up a little bit from the first quarter and we're looking at a somewhat lower quarterly report, can we get some calibration of where the decline is coming from in profitability? Is it in the segment stuff, or is that cost the consolidated corporate cost numbers? Can you give us some idea of how to handle that for the rest of the year?

Mike DeWalt

Yes, I think it would be in the segments. Material cost would be in the segment. The impact from Japan would be in the segments. So yes, it would be most likely in the segments.

Eli Lustgarten - Longbow Research LLC

Okay, and a follow-up. Can you give us some idea of how much capacity space you have left for increased volumes in your reporting? I mean, are we pretty full out at this point in resources that you can't expect much change in volume from the first quarter, and the rest would come from Construction? Can you give us a sense of where the volume changes that we're seeing pretty much this year can from?

Mike DeWalt

That's a little bit of a hard question to answer, partly because some of the ramp-up issues that one would have, particularly in the short-term, aren't necessarily capacity driven. I'll just give you an example. If you look at big diesel engines, we're definitely not at capacity. We're off yet to do more, but there's a fairly long supply-chain on some of the big key components, and you can't change that production on a dime. So for that, we couldn't take up production rapidly within a month, but that doesn't mean that we're at capacity. For things like excavators and much of the large products, products like bulldozers, we're running pretty well flat out right now. We're actually doing better. I mean we've been able to get out more, I think, in both of those kind of product areas than we did last year. We got more investment going in place to try and get that up. So I don't know how to quantify it, because you'd have to look at it product by product and then figure out what that meant for the supply chain to get it back to the number this year.

Operator

The next question is coming from Jerry Revich.

Jerry Revich - Goldman Sachs Group Inc.

It's Goldman Sachs. Mike, the high end of your sales guidance implies low production increases from your seasonally weakest sales quarter. Is that a contingency for Japan and broader supply-chain tightness? And I'm wondering if you can touch on where your supply on-time deliveries were in the quarter.

Mike DeWalt

Yes, I think it does reflect, again, for a lot of products, we are producing all we can today, again, the big product, lot of the big product, underground mining trucks, and excavators, which is our priority product. It also reflects fairly long lead times for some of the other products, and it also reflects Japan. And we expect the second quarter to be negative there. And a lot of that is in products that we effectively don't have capacity to make up later on in the year, again, like excavators, for example. So we do have increases built into the rest of the year in our sales outlook at the midpoint end or at the top end, but they are limited somewhat by our ability to produce. And I mentioned this in my lead in. Our sales forecast, if it weren't so much capacity constrained from a demand standpoint, could be higher.

Jerry Revich - Goldman Sachs Group Inc.

And it looks like your inventories were up nicely in the quarter. Can you give us an update on your Lane strategy fill rates, and what are your updated targets for this year?

Edward Rapp

Yes, Jerry, this is Ed. If you look at Lane performance in the first quarter, like 70% of the volume went out within 10 days, and so we're seeing good performance in that area. As I said earlier, dealers would take more inventory, but we continue to turn it into Lane to make sure we have the right product in the right place. In fact, we actually increased Lane inventory during the quarter. As we continue to this commitment that we made and this ramp-up of making sure we have the right product in the right place. There's more build out of the PDCs to come in the second quarter, and we've got products diverted into the lanes to make sure we have good product visibility, and we can maximize those end user sales. And I think you're seeing the benefits of that with the rolling 3-month data we've been providing on end-user sales. I think the Lane strategy is moving ahead. There's strong demand, puts that under pressure, but we remain committed to it. It's one of the things that's going to help us manage this upturn far better than we did the last

one.

Jerry Revich - Goldman Sachs Group Inc.

And, Ed, just to clarify, what proportion of your Lane 1 target products are you stocking within that 10 day period? Is that, that 70% number, or are we talking about out of the product that you saw stock 70% is within 10 days?

Edward Rapp

That would be with -- the 70% would be across the spectrum of our product lines versus that target.

Operator

The next question comes from David Raso.

David Raso - ISI Group Inc.

ISI. A quick question on the rest of the year implied guidance. Essentially, it looks like your implying incremental margins of only 10% year-over-year for the rest of the year. Can you give us a little more granularity on what -- I mean what sort of -- roughly some of the cost issues, but it just seems like a very low incremental margin for the rest of the year, can you...

Mike DeWalt

Yes, I won't. I mean I'm not going to go through the math, but I don't think it's quite that low. And remember, you need to deal with EMD in whatever calculations you're doing because that's adding to sales at least for the second and third quarter without adding much to the profit. And then remember, we've got Cat Japan in the second quarter. But I think there's no doubt, at least in my mind, that we have the most significant volume increase in the first quarter. And just on a quarterly basis, that gives you the most opportunity to, I think, to show really good incremental margins. In quarters where there's less volume increase, I think it's tougher. But I think that 10% number's pretty -- it's too low. I mean we're looking for about 25% for the year. We had 28% to 29% in the first quarter.

David Raso - ISI Group Inc.

I definitely appreciate that, but the math is implying equipment company EBITs around $5.9 billion for the year.

Mike DeWalt

Yes, we don't -- we're not. I mean, we don't -- we do profit per share, but I don't think that math works.

David Raso - ISI Group Inc.

Okay. We'll talk offline. And then on the cash flow, I saw something I don't think I've ever seen Cat do. On the equipment company, first quarter, working capital, actually a source of fund. Now that hasn't happened since '98. And '98 was even an anomaly, because that's when you were first selling receivables in the equipment company over Cat Financial. So maybe it's never happened for at least my data. Obviously, very impressive. Can you give us some thoughts on how you're viewing cash flow for the year on equipment comp -- again, it's a unique start to the year to have working capital as a source of fund.

Douglas Oberhelman

Dave, I'm going to let Ed answer that. But you're seeing the increasing number of numbers before in front of your eyes, and this is one of them. And we like that part, and that's where we're headed as we talked to all of you last year, that we're going to be in territory here the next couple of years where we've never been before, and we're starting to see the results.

Edward Rapp

Yes, and David, it ties into a number of things. One, when we rolled out the strategy, we've talked a lot about the balance and the focus on the P&L and also on cash flow, and moving it to the top-tier metric. And as we really driven this and cascaded it down into the organization, I'd say, number one, we're getting good traction on that. Secondly, we talked about our desire to minimize the need for equity related to Bucyrus, and we've got the organization clearly focused on what it has -- what we collectively have to do as a group to make that happen. And in fact, if you look at that, you'll measure it from a debt cap perspective. We finished the first quarter with the strongest balance sheet we've had in more than 20 years. So I think you're seeing the traction come from the deployment of strategy, the focus on cash flow, and really driving it down through the organization. It came through with good numbers in the first quarter. And if you think about the opportunities that we have ahead of us in terms of the industries we serve, the capacity increases we've talked about, we've got the organization clearly understanding that generating strong cash flow is where we're going to find that growth going forward.

David Raso - ISI Group Inc.

And I know, obviously, there's a lot of positive to this trend, but that was probably the most impressive. Are you willing to, at least, give us some kind of range, and how you're thinking about operating cash flow for the year?

Edward Rapp

David, we've historically not given guidance on that. What I would say is that based on what we clearly articulated, relative to the top tier metrics, we rolled out the strategy, the balance of our focus, zero equity in terms of the target, if you would, on Bucyrus, we're going be all over cash flow.

Mike DeWalt

I guess I would -- yes, I might just chime in here a little bit that in one metric that we watch, and that's working capital of sales, we're benchmarking the best in the capital goods industries. And that's our target here over time and granted, it's going to take maybe to 2015 to get there, but we're seeing a down payment on that. So I would just generally think about that in the best in capital goods as where we intend to be no later than 2015.

Operator

The next question is coming from Ann Duignan.

Ann Duignan - JP Morgan Chase & Co

JPMorgan. I'd like to just follow up on David's question and ask it a little bit differently. Doug, would you be disappointed in the businesses if they did not deliver 25% incrementals in each quarter, going forward, other than maybe Construction next quarter because of Japan?

Douglas Oberhelman

Well, I'm really focused on 2012 and '15. I would expect the Group Presidents in charge in those businesses, in this case, Rich Lavin and Steve Wunning, to use those, and they are as our top-tier metrics, and that's a question that they would have for their teams. I know they're concentrating highly on it, but in terms of quarter-to-quarter stuff, there's so much, so many variables and change. I'm really trying to get us to '12 and '15 in a big way, and they handle the day-to-day quarterlies and everything in their business, Ann. That's the way I look at it.

Ann Duignan - JP Morgan Chase & Co

Okay, that's good color. I appreciate that. And then a separate kind of question, it's kind of a tough question to ask, but Japan is a headwind right now. At some point, I think we would all anticipate that, that could turn and could become a tailwind. The way we look at it is we would likely see demand for power generation for the Engine business to pick up first and then later, perhaps much later, demand for rebuilding equipment may pick up. Is that the right way to think about it, and how do you guys think about it internally?

Douglas Oberhelman

I'll comment here and you're right, this is a tough one to talk about. This will profoundly change the country of Japan for decades. It will profoundly change the way that industry is viewed inside Japan for a long time as well. And well, there will be rebutted opportunities down the road and certainly, we've seen power as we would typically do after a disaster of this kind lead the way. It's hard for us to really talk about that. We're still making sure our supply chain is right. We were so fortunate that our own Japanese employees and facilities were not hurt but having said that, everyone of our Japanese families have either a relative, friend or something that has been touched very deeply with this. So we're not pushing it too hard. I'm going to shy away from that answer, and accept that, generally, and in all of the disasters, that's the kind of the flow in which we've seen recoveries.

Operator

The next question is coming from Jamie Cook.

Jamie Cook - Crédit Suisse AG

Credit Suisse. 2 questions, Mike. I'm going to try the guidance one more time. Your first quarter, you came in at $1.84. Q1, seasonally a weaker quarter, which implies at the midpoint. We're only going to do, on average, about $1.55 a quarter. I get we had high volumes. Japan's only $0.10. Your R&D was up 30% in the quarter. You're seeing 20% for the year. I understand that dollars get bigger, but is material cost that material, or is it we're only in the first quarter, so why set the bar high? And then the second question, just broader commentary on Tier 4. Tier 3 was a big issue for Caterpillar last cycle. I'm just wondering how that's going relative to expectations.

Mike DeWalt

Yes, you're right. Normally, season -- first quarter is a pretty seasonally low quarter for our sales. I'd think that, that trend is probably a little bit muted in situations where you're constrained on production. So I think, again, if there weren't any production constraint, there weren't any capacity issues, I think our sales number, as we said, would have been higher and you might have seen more of a seasonal pattern. But I think, probably, because of production constraints on excavators in large products, our expectation is the seasonal variation won't be quite so much. And it is early in the year, there's a lot you don't know, and we do expect that material cost will go up somewhat from here. We expect -- you're right, year-over-year, R&D was up. But if you look at it sequentially, as we go throughout the year, it's going to go up from the first quarter as it did last year.

Douglas Oberhelman

And Jamie, I'll cover Tier 4. I'd say at this point in time, it's in the early innings, but I'd say we're cautiously optimistic. If you think back to when we first got into it, a lot of people were talking about Tier 4 being a sacrifice on fuel economy. I think almost across the board, our Tier 4 machines are actually going to act -- offer improved fuel economy. There was a lot of fear about the need for operator intervention. We've almost completely removed that from the equation, so any customer feedback from that has been positive. I think the team's done a good job of using technology in terms of getting immediate feedback back in terms of any issues in the product development cycle, and we've leveraged our supply base in a number of areas across the platforms of our machines. So I'd say early days, but much more confident in terms of where we're at in Tier 4 versus where we're at with Tier 3.

Operator

The last question is coming from Robert Wertheimer.

Robert Wertheimer - Morgan Stanley

It's Morgan Stanley. My question is from the outside, the margins obviously look extraordinary this quarter and really impressive. I wanted to ask from the inside, when you look at your internal metrics, whether that be rework, quality or the outlook quality, all the things you talked about in '09, whether it feels just as good, better or whether you're seeing some of the signs of strain that you saw at last peak in '07, '08?

Douglas Oberhelman

Yes, I'll be happy to take that one, Rob. It's Doug Oberhelman here. Generally, across the board, on internal metrics that we use, those that you mentioned and others, but the biggest one is the external metrics, and that's the incremental profit pull through, which in my mind, is the culmination of all those things that have to happen internally. We are seeing vast improvements from '06, '07, '08 and '09. Now having said that, we are running -- more and more of our plants had capacity. As we go up that chain, we're working through those. We have a far different, and I'm going to say, far better global purchasing and supply chain management team around the globe that learned from the prior experience, and put in processes that have changed. So without question, our CPS metrics are better. Every single metric that we would use, you would see on our -- inside our factories as you go through that we put up on our metric boards, and they were, say, 3, 4, 5 years ago. We're not where we want to be. Our goals are still down the road for us from where we want to be, but we're getting there. And I think I've often said that it's probably going to be late '11, '12 before we really see a lot of those internal metrics get to the goals that we wanted as we continue to do investments to make the changes that we have to, to get them where we want to be. So there's some of that improvement in front of us, but there's no question we are moving up the scale operationally and internally. And I'm very, very pleased with our team on that.

Mike DeWalt

Okay. With that, I'd like to thank you all for joining us on the call today.

Operator

Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.

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