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Caterpillar Inc. (NYSE:CAT)

Q2 2007 Earnings Call

July 20, 2007 11:00 am ET

Executives

Mike DeWalt - Director, Investor Relations

James W. Owens - Chairman of the Board, Chief Executive Officer

Douglas R. Oberhelman - Group President

David B. Burritt - Chief Financial Officer, Vice President

Analysts

Daniel Dowd - Sanford Bernstein Research

Alex Blanton - Ingalls & Snyder

Andy Casey - Wachovia Securities

Jamie Cook - Credit Suisse

David Raso - Citigroup

Seth Weber - Banc of America

Robert McCarthy - Robert W. Baird

Stephen Volkmann – JP Morgan

Presentation

Operator

Welcome to the Caterpillar Incorporated second quarter 2007 earnings results 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. Good morning, everyone and welcome to Caterpillar's second quarter conference call. I’m Mike DeWalt, the Director of Investor Relations, and I’m pleased to have with me today on the call Caterpillar's Chairman and CEO, Jim Owens; Group President, Doug Oberhelman; and our CFO, Dave Burritt.

This call is copyrighted by Caterpillar Inc. and any use, recording, or transmission of any portion of this call without the express written consent of Caterpillar is strictly prohibited. If you’d like a copy of today’s call transcript, you can go to the SEC filings area of the investor section of our cat.com website, or you can go to the SEC’s website later today where it will be filed as an 8-K.

In addition, certain information relating to forward-looking projections of our results that we’ll be discussing today is forward-looking and involve risks, uncertainties, and assumptions that could cause actual results to materially differ from the forward-looking information. A discussion of some of those factors that individually or in the aggregate we believe could make our actual results differ materially from our projections is discussed there and can be found in our cautionary statements under item 1A, business risk factors, of our Form 10-K filed with the SEC back on February 23rd of 2007.

On to the results -- earlier this morning, we reported our second quarter. Sales and revenues were $11.356 billion and profit per share was $1.24. From a top line perspective, it was a good quarter considering that North American dealer inventories declined about $800 million, we’re in a severely depressed industry for on-highway truck engines, and we are facing a tough environment for machine sales in North America, including a very weak U.S. housing sector.

We were pleased to report that despite these headwinds, sales and revenues were up 7% from the second quarter of last year. In dollars, the increase in sales and revenues was $751 million, and the key positives were a significant sales increase outside North America; sales and revenues were up 31% in Europe, Africa, Middle East. They were up 21% in Latin America and 22% in Asia-Pacific. In the aggregate, outside North American sales and revenues increased 27%.

In last year’s second quarter, North America accounted for 53% of our top line and 47% was outside North America. This year, if we pull out Progress Rail to get an apples-to-apples comparison, North America dropped from 53% of the total to 43% and that’s a pretty big shift in the geographic mix of our top line.

Thankfully, we have a very global business and growth in other regions were able to offset declines in North America. In terms of the numbers, sales volume -- that’s the change in sales excluding currency effects and price realization -- was up $943 million outside North America. The acquisition of Progress Rail added $411 million, and just a reminder here; this is the last quarterly comparison where Progress Rail’s numbers won’t be in the base period.

Currency impacts from a weaker U.S. dollar increased sales $198 million. Price realization was $168 million, and that included an unfavorable effect of geographic mix and that was about $47 million.

In general, realized prices outside North America are lower and a significant increase in sales outside North America, coupled with the volume decline in North America, was the main driver behind the negative geographic sales mix and price realization.

Now, to round out the positive items affecting out top line, financial products revenues were up $94 million.

Now, on the downside, physical sales volume in North America excluding Progress Rail, was off about $1.1 billion from last year’s second quarter. That $1.1 billion is despite continued strength in engine sales other than on highway and gains in metal mining.

The decline in volume was driven by a substantial reduction in North American dealer inventory and again, dealers reduced inventory in the quarter by about $800 million. But this wasn’t a surprise. It’s been an element of our 2007 sales outlook since we released our preliminary view of 2007 last October. We’ve been jointly working with our dealers this year to help them cut inventory.

Sales of on-highway truck engines were down $366 million in North America, again a result of the severe industry decline, and we’ve had weakness in most of our North American machinery end markets other than metals mining -- notably, those related to housing.

Overall, and this is a point that I’d really like to emphasize, this was another quarter that really demonstrated our global and industry diversity, with strength outside the U.S. offsetting demand, weaker demand in North America, and a diverse engine business that generated growth in other end markets to offset the severe decline in on-highway truck engines, and continued growth in our diversified services businesses.

While the overall picture for sales was, all things considered, a pretty bright spot, profit was not. Profit per share was $1.24 and that was $0.28 down from last year’s $1.52. As we get into the profit comparison with last year’s second quarter, we do need to remember that the second quarter a year ago was very, very good. In fact, in last year’s second quarter call, I mentioned that the first-half of 2006 was our best ROS in the last 40 years and in the first-half of last year, the second quarter was better than the first. And that makes it a pretty tough comparison, and I mentioned that it would be a tough comparison at the end of the first quarter call three months ago.

That said, even though it was, as we knew, a tough comparison profit in the second quarter this year was lower than we expected and lower than most of you expected. And as Jim said in the release, we were disappointed.

Let’s address the factors that contributed to the decline from last year’s record profit levels. First, the drop in machine sales in North America, where our margins are generally higher than average. Sales in North America in our geographic mix were very strong last year. U.S. housing wasn’t in steep decline and coal mining was still very strong. In fact, last year virtually all of our U.S. end markets were positive. The pricing environment, particularly in North America, was more favorable than it is now and a direct result of weak demand.

Demand for truck engines was significantly higher last year, and our factories that make on-highway truck engines and related components were humming. Today, the heavy duty truck market is way down as a result of the new emissions requirements that took effect in January and we are operating engine component and assembly facilities at levels significantly below last year.

The result has been a sharp drop in truck engine profitability -- a drop in the range of $150 million.

Production and supply chain inefficiencies are a more significant challenge than we had expected. On the surface overall, volume excluding Progress Rail was relatively flat with last year and with that kind of stability, you would expect more efficient factories. However, if you were to visit many of our factories, you wouldn’t see flat volume. Machine plants outside the United States are seeing substantially higher volumes and are experiencing very stretched supply chains, and the cost issues that come with it.

Inside the United States, we have some facilities, particularly those that produce truck engines and components, and small machines where volume is off a lot.

2007, particularly the first-half of the year, is seeing a number of new products being introduced in our factories and we are having some ramp-up issues with cost inefficiencies.

Material cost pressures in this year’s second quarter were tougher than we had planned. Some from commodity cost increases, some from more aggressive pricing from component suppliers than we expected, and some related to lower-than-planned production of on-highway truck engines and related bracket pricing increases.

The scale of the work we’re doing to implement the CAT production system is substantial and it’s absolutely the right thing to do, and it’s fundamental to our future and the achievement of our 2010 goals.

However, the impact has been more costly in the short-term than we expected, with widespread stop-and-fix disciplines and the transitional disruption in costs related to changing our procedures.

Additionally, our core operating costs in the quarter included a $44 million charge for pension expense of one of our subsidiaries and our share of affiliates profit was off $13 million after tax as a result of adjustments we made at Shin Caterpillar Mitsubishi. And these two items we hadn’t anticipated in the quarter.

However, all the costs news isn’t negative. We are doing better than we expected so far this year on our period costs. That’s the combination of our period manufacturing, SG&A, and R&D expenses.

Now, the bottom line on the change in profit versus last year is this -- we did have a $751 million increase in sales and revenues. $198 million of that was from the currency impacts. The profit effect from that was about offset by a similar negative currency impact on costs. Remember, we are purposefully in a fairly balanced position on sales and costs in non-U.S. currencies.

$411 million of the sales increase was from Progress Rail and while it’s doing better than we expected, its rate of profitability is below our machinery engine’s average.

Sales volume excluding Progress Rail was slightly negative. The volume increase outside North America offset most but not all the decline in North America, and our core operating increase, for the reasons I mentioned a few minutes ago, were up more than our $168 million of price realization, which in and of itself was negatively impacted by our geographic sales mix.

Well, that’s the quarter. Let’s just take a few minutes and look forward to the full year. First, a reminder; 2006 sales and revenues were $41.5 billion and profit per share last year was $5.17. For 2007, our previous outlook, the one we issued at the end of the first quarter, was for sales and revenues in a range of $42 billion to $44 billion, and profit per share was a range of $5.30 to $5.80.

This morning’s outlook for 2007 is sales and revenues of about $44 billion and no change in the outlook for profit per share. We are maintaining at $5.30 to $5.80 a share.

Now, from an economic perspective, we seem to have a two-track world economy, with continued weakness in the U.S. and continued strength in most of the world outside the U.S. There’s a pretty comprehensive review of our economic outlook in this morning’s release but some of the highlights include again, the weak picture in the U.S. We’re forecasting GDP at just a little over 2%, and that’s driven to a degree by our expectation of strong growth in the second quarter, followed by weaker growth in the second-half.

We’ve taken our forecast of FED rate cuts out of our forecast for 2007. We’ve lowered our full-year expectation for U.S. housing starts to about $1.4 million. On the plus side, we do see continued strength outside North America and we are very encouraged by solid economic growth and continuing commodity prices at levels that encourage additional investment.

Just one final point on our outlook before we move to the Q&A. Core operating costs in general and variable manufacturing costs in particular were higher than we expected in the second quarter and we’ve raised our full-year cost estimate at the midpoint of our profit range to $700 million for core operating costs.

While that increase is lower than we’ve experienced over the past few years, it is higher than our previous outlook. From a cost perspective, the mid point of our outlook does reflect some improvement in core operating costs in the second-half of the year compared with the second quarter.

If we look back to last year though, and this is important when looking at cost comparisons, second-half 2006 core operating costs rose significantly from the first-half. What that means is the comparisons between second-half 2007 and second-half 2006 should be easier than what we’ve seen in the first-half.

Okay, in summary, we had a pretty good quarter at the top line, up 7% in the face of some pretty serious headwinds in North America but we have work to do in terms of manufacturing costs and we expect to make improvements.

We are ready to move on to the Q&A portion of our call today and while there are four of us in the room, and we’ll all likely participate in the Q&A, I’ll likely take most of the questions on the second quarter; Jim will take most of the questions related to our view of the full year and our path to 2010; and Doug will handle the engine related questions.

Again, to save time for as many of you as possible, we are going to pretty strictly adhere to the limit of one question and one follow-up, so please consider that as you ask your questions.

We are ready for the first question.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question today is coming from Daniel Dowd. Please announce your affiliation, then pose your question.

Daniel Dowd - Sanford Bernstein

Good morning. This is Daniel Dowd from Bernstein. Mike, can you comment on your transition to the CAT production system, which is likely to be so important to your margins over time? Can you talk about why you had the incremental costs in the transition and when you expect it to start delivering consistent margin expansion?

James W. Owens

I’ll maybe touch on that one. As you know, we’ve talked a lot about the CAT production system we have in a couple of our major analyst meetings. Our vision 20-20, a big portion of that was focused on operational excellence. That’s kind of a class A operational excellence, but a very consistent deployment of our manufacturing strategies globally across all of our manufacturing operations.

Coming out of that strategy rollout to the company, we created a whole separate division to work on the deployment and driving that across the company. ’06 I’d say was heavily consumed by benchmarking [Tiota] production system and other best-in-class world-class production systems and really documenting what we wanted in the way of a Caterpillar production system, a recipe book, if you will, that we would follow extensively worldwide, and developing training programs for that, including CPS black belt coming off of our six sigma disciplines to drive that process across each of our divisions.

We rolled it out with a lot of fanfare and great vigor in the first-half of 2007, so I would view this as the first I guess half-year, if you will, of what I perceive to be a three-year journey and every consultant we’ve worked with suggests that would be world-class performance in terms of rolling out something so extensive and so pervasive as this.

It involves a lot of management systems changes, cultural changes, as well as just operating systems, but we are very encouraged about where we are in terms of the rollout. We’ve had a tremendous amount of work with value stream mapping, rapid improvement workshops, moving to fixed production schedules for defined 20 day windows, migrating from push to pull in a lot of our -- how we draw material into facilities.

We are seeing a lot of positive progress and enthusiasm across our employee base as this is rolling out but a lot of new stop-and-fix disciplines. When we’re running virtually at or near capacity in most facilities we have worldwide, and our supply base is right there, we’ve been encountering over the last two years a lot of material shortages and we’re moving more to stop-and-fix, so just a lot of transitional things that I think adversely affected our variable manufacturing costs in the second quarter.

We’re seeing a lot of signs of progress, a big element of our confidence in being able to deliver 15% to 20% earnings per share growth and really a very strong cash flow over the next several years is the gradual realization of this process excellence across the company.

We know we can do it. Some of our divisions are there already, a couple, but we’ve got close to 300 manufacturing facilities scattered across 40 countries. So this is a complex transition, it involves a lot of work with our supply base and our dealers and it's a simultaneous lift.

Daniel Dowd - Sanford Bernstein

So should we reasonably expect to start to see benefits from this in the back half of '07 or is your view that this is really is three to four years and probably the benefits start to roll out in 2008?

Jim Owens

I think you start to see a steady -- and it's going to be in pockets. We're as anxious as you are to see it bubbling down to the bottom line. But I think we'll start to see some improvement. We made a pretty big investment in getting this thing kicked off, rolled out and done consistently and right across the enterprise and a lot of training going on in all of our facilities. That will continue over the next couple years, but I think we'll be steadily beginning to see some benefit and we look for some of those to come through in the second half of the year.

Mike DeWalt

As long as we're looking at the second half of the year, not all of our issues in the second quarter were related to Cat production systems.

Jim Owens

Very small I'd say really, Mike.

Mike DeWalt

In terms of costs we do expect some of the problems that we had in the second quarter to go away in the second half or be diminished in the second half. We had, for example, a fairly key supplier in Europe go bankrupt and that was very disruptive for one of our machine plants in Europe. It looks like we've got an alternate supplier in place now and that situation is largely behind us.

We had another example where in the second quarter one of our own key component facilities was in the middle of a very large restructuring; consolidating buildings to improve material flow, become more efficient, reduce their footprint, cut costs. Well, it ended up being more disruptive in the quarter than we thought, they missed some deliveries to internal machine plants and that was an issue for us. That should be behind us.

In addition to that, if we're just thinking about the cost impacts on efficiency in the second quarter, let's just turn to truck engines. In the first quarter we actually did better than we did in the second quarter on costs around truck. We were mobilized in the first quarter to take out costs.

In the second quarter, based on our expectation that schedules were going to start rising, we brought some people back and we added some cost to ramp up production. Production for us in the second quarter was a big start/stop and volumes right now are lower than we thought they were going to be, and so we have to take some of the cost out that we added in the second quarter anticipating higher volumes.

So there are a number of things in the quarter that stack up and look like they will improve in the second half of the year; NPI as well. We had probably more NPI, new products introduced, in our factories in the first half of the year than certainly we expect in the second half of the year. In fact, there are no really big major new products going in in the second half.

So we ought to see some benefit as some of those situations that we had in the second quarter have started to resolve themselves. So there are several things just that were maybe in the second quarter that should start to improve a bit as we go forward.

Operator

Your next question comes from Alex Blanton.

Alex Blanton - Ingalls & Snyder

First question is on the inventory. It wasn't clear in the press release whether you were talking inventory reduction quarter over quarter or year over year. You need to make that clear. Also, what's the total global reduction? You said North America was down $800 million.

Mike DeWalt

A couple of things, Alex. One, what we said in the release was that in the quarter North American dealer inventory was down $800 million.

Alex Blanton - Ingalls & Snyder

I know what you said, but my question is, is that quarter over quarter?

Mike DeWalt

In the quarter. From the beginning of the second quarter to the end of the second quarter.

Alex Blanton - Ingalls & Snyder

That's what we want to know.

Mike DeWalt

During the quarter, it was down $800 million. During the second quarter --.

Alex Blanton - Ingalls & Snyder

That's roughly $0.30 a share right there.

Mike DeWalt

During the second quarter of last year, it is common for dealer inventory to decline in the second quarter, that's not unusual. It's usually a big quarter in terms of selling to end-users, dealers tend to build inventory a bit in the first quarter.

In the second quarter of last year inventory was down $200 million in North America, so the impact, the quarter-over-quarter sales comparison would have been more like $600 million.

Alex Blanton - Ingalls & Snyder

But what about the rest of the world? What was your global inventory picture?

Mike DeWalt

Overall inventory outside the U.S. was up a little bit. We didn't quote a number. In terms of months of supply, I think almost everywhere --

Alex Blanton - Ingalls & Snyder

Well, can you give us a number?

Mike DeWalt

I don't have a number in front of me, but as I recall the number outside the U.S. the increase was less than $200 million.

Alex Blanton - Ingalls & Snyder

So it was a net reduction of $600 million overall?

Mike DeWalt

Order of magnitude, yes.

Alex Blanton - Ingalls & Snyder

Second question is this -- and you might have partially answered it, but let me ask it a different way -- your sales were up from the first quarter by 1.292 and your profit was up $128 million; I'm talking gross profit. So your incremental margin on the sales increase quarter-over-quarter was only 10% and as a result your gross margin was 21.8% versus 23.4% in the first quarter.

So what were the main contributing factors to that quarter-over-quarter decline in gross margin and very low; I mean incremental margin would typically be 30 to 40% quarter-over-quarter like this and yet it was only 10% this time. So what got worse and specifically which one of those were worse than expected?

Mike DeWalt

I think the discussion that we had on operating efficiency and manufacturing costs first to second quarter, it's a similar discussion as year over year. The same things that we've discussed in terms of supply chain disruption.

Alex Blanton - Ingalls & Snyder

Worse than the first quarter?

Mike DeWalt

Yes. The cost increase compared with the first quarter was sort of in the range of the cost increase year over year.

Jim Owens

Alex, there's one other thing, too. We had a little bit higher material cost in the second quarter than we did in the first. Our expectation going into the year business planning wise was zero material cost increase on the year. We're now expecting about 1%. That's still, I think, pretty good management of global material cost in our industries, but it's higher than our planned level and that gives a little margin compression.

That, coupled with less than expected price realization, particularly in NACD in the quarter and we are essentially flat there, so that caused a little bit of margin compression.

Doug Oberhelman

Can I comment on one other thing? Alex, I know you are questioning the inventory reduction in North America. I want to be clear, this is, if you will, part and parcel of our vision and migration towards the Cat Production System as far as the distribution side. We work very closely with dealers; I was a little disappointed last year that inventories in North America continued to grow and that globally inventories have grown almost in line with sales since this boom started.

So while they were low in terms of months of sales, we wanted to begin the process while volumes were very strong of managing that inventory level down to appropriate levels, improving our delivery capability. We have been working, NACD, with dealers and of course they're independent companies, but to help them get that inventory adjusted and with some softness we've been very successful. We targeted taking out close to $1 billion in U.S. inventories this year and it's going to happen.

Mike DeWalt

Okay, we need to --

Alex Blanton - Ingalls & Snyder

You're there, aren't you? You're there. Will there be any effect in the second half?

Jim Owens

Yes, we'll continue. I think we're on track to realize the inventory targets that we had established together with the marketing companies in the year, so --

Alex Blanton - Ingalls & Snyder

You've already done it.

Jim Owens

-- a little more reduction. We're close.

Alex Blanton - Ingalls & Snyder

Okay. But it does cost you some earnings in the short run.

Jim Owens

It may, but it'll help us in the long run.

Mike DeWalt

We need to move on.

Operator

Your next question comes from Andy Casey.

Andy Casey - Wachovia Securities

Wachovia Securities. Good morning, everybody. A couple clarifications before I get to the question. The two non-recurring charges you said in the monologue were not expected in the quarter. Were they in the prior guidance for the annual forecast?

Mike DeWalt

No.

Andy Casey - Wachovia Securities

Then the other clarification was the $44 million charge in engines, is that included in the $150 million truck drop or is that different ?

Mike DeWalt

No, it wasn't related to truck. Just to help clarify a little bit, about half of that was in SG&A and about half of it was in manufacturing costs.

Andy Casey - Wachovia Securities

Thank you. Now on to the question. The $150 million truck related profit drop, that was bigger than I expected even with the drop in the industry volumes. I suspect some of that was related to the slower transition to year '07 engine solution. When you look on a go forward basis, are all of the bugs out of your new product today and is it just basically adoption at the OEM and customer level?

Doug Oberhelman

Great question and one I was going to get to whether anyone asked it or not. The '07 product that's out there, the new engines that we have shipped since January 1 with the latest and greatest full dress including the Cat regeneration system, our CGI lines, everything else, and we've shipped right around 11,000 of them so far, are performing better than we expected.

Now this is production iron, the latest product and the anecdotes we're getting back although early, and I think the most mileage we've seen is 200,000 or 250,000 miles, are all better than any other product we've introduced with this magnitude of change in engine history.

We monitor the call centers, we monitor everything, every engine that's out there. Right now there aren't all that many on the road because the truck makers are still getting them out, but we're happy. We won that J.D. Power Award six years in a row and this introduction with production material has gone smoother than any of the others.

Now, the implication of bad product, the implication of your question applied to a number of engines we had out and were updating on the fly in the fourth quarter primarily around the Cat regeneration system which allows the after treatment to be regenerated on the fly. We're very proud of that system, it took longer than we thought, it was problematic in the experimental iron. The production iron today is wonderful and we're very happy with it. I would expect and do expect that once all this sorts out we'll be in the hunt for more J.D. Power Awards, especially on that 15 liter. But the production iron, the production engines that are out there today we're extremely happy with.

Andy Casey - Wachovia Securities

So just to follow-up on that, the $0.09 or so of the restructuring in the $150 million truck, we should view that as pretty much contained in the second quarter?

Doug Oberhelman

Yes, I fully expect that to be the bottom of all this, yes. If that's your question, Andy.

Andy Casey - Wachovia Securities

Yes.

Jim Owens

Doug, you expect a big significant turn in the second half. You might just comment on the truck.

Doug Oberhelman

We deliberately, and I think we've discussed this with all of you before, we deliberately ran our production lines and '06 engines right up until New Year's Eve last year. Different than we've ever done a model changeover in the past because we expected '07 to be pretty tough in the market. In fact, our forecast for '07 truck build was lower than anybody else's and it's turned out about where it was.

So we deliberately delayed the model changeover into January. We got caught a little bit in March/April with a big ramp up that turned out to be a head fake and now truck build is back down again, particularly in May and June and July. But we are hearing signs and seeing signs of some general recovery, particularly at the end of the year.

So I would expect that as we've taken out and had to really deal with all the labor and all the costs in the second quarter, as we build that back in gradually towards the end of the year, get our supply chain going again and on into '08 we'll see a pretty satisfactory result of that late this year, early next. But it is worse than we anticipated.

Operator

Your next question comes from Jamie Cook.

Jamie Cook - Credit Suisse

Mike, just a clarification. Obviously when you look at your second quarter, the second quarter was quite below where The Street had estimated. I guess what I'm trying to get a feel for is I understand that the quarter came in below your expectations because of the on-highway production engine issues, the supply chain, weaker North America, all that stuff, but I'm also guessing that The Street might have miscalculated the second quarter because of the tough comps. So is there any way you can quantify that or give us just a little bit more color? I'm just really trying to get comfortable with the full-year guidance. I'm trying to get a feel for how much I was off versus Cat-specific?

Mike DeWalt

Okay. I'm going to do my best to answer this without getting into talking about our quarterly forecasts. It was below what we thought, we'll start out with that, we've already said that.

If you look at our outlook for the year, there are really two main things in the midpoint of our outlook for the year that have changed the most. One is an improvement from volume because we moved our sales outlook from a mid point of $43 billion to our expectation of about $44 billion for the year.

So volume was an improvement and costs were higher by about $400 million. Now not all of that was in the second quarter, but certainly a disproportionate share of that was. So I think a lot of the change in our outlook; not all, but a lot of our change was in the second quarter. What I'm trying to say is it was certainly below our expectations, but I don't want to break it down by quarter.

Jamie Cook - Credit Suisse

But is it fair to assume that The Street was a little aggressive as you look at it? You don't have to quantify how much, but is it fair to say we were ahead of where you guys thought you would be?

Mike DeWalt

Yes, if I just go back to the end of the first quarter, near the end of the preamble on the first quarter, I tried to kick in some caution on the comparables because last year's numbers were so good. I mean it was a huge quarter for us in the second quarter a year ago. Last year we were at $1.52 and consensus was $1.49, so consensus was pretty close to last year. I'm sorry that's not a very satisfactory answer for you, but we don't do quarterly guidance and I really don't want to get into that.

Jamie Cook - Credit Suisse

All right, I figured I'd try. Just one more thing. You guys raised your forecast overseas, part of that was EAME. I just want to know your thoughts as you look at 2007, and not getting into specific items for 2008, but the thing that concerns me is you're starting to hear from some other companies that have reported that there are signs of weakness in Europe or in other areas overseas and that's a big part to the Caterpillar story, the overseas spending.

So I'm just trying to get a feel for if you guys are seeing any signs -- I'm assuming you're not seeing signs of weakness -- but how do you look at the overseas spend longer term?

Jim Owens

We raised our outlook. At the end of the second quarter, certainly with all of the sub-prime issues here and some concerns about the global economy we were maybe a little less confident than our collective business units. At this point of the year, at the midpoint, we feel very confident about the 44 guidance in terms of top line sales. It looks like the Europe, Africa, Middle East, Latin America and Asia Pacific markets are all very strong, our order boards are strong in those areas. Our dealers are scrambling for product, and particularly for the larger ends of our product line.

Pretty much everything in the large truck category from 100 tons to 400 tons. Even in the European theater, our new backhoe loader line, our new wheeled excavator line and mid-range excavators are essentially sold out; as well as globally large engines, that 3500, 3600 series, MAK series.

So we're working very hard to increase production. We've got some capacity scheduled to come on at the end of the year which will help us. But at this point we're feeling very confident about the strength of the markets that we're serving outside of the United States and in these key global markets we've been highlighting, particularly global mining, global oil and gas related business, marine and power generation on the engine side.

Jamie Cook - Credit Suisse

But Jim, do you have an order book that extends into 2008? Because when we were speaking to you last year you would.

Jim Owens

With most of the large products, the answer is yes.

Operator

Your next question comes from David Raso.

David Raso - Citigroup

Citigroup. My question relates to the guidance, particularly the price realization. Using the waterfall chart you're looking at price realization in the first half of only 273. Full year, you lowered it a bit, but we're still at 850; looking at the revenues maybe a little higher, but roughly the same in the second half as the first half. Why are you going to get twice as much price realization in the second half than the first half unless there's some price increase I'm not hearing in the channel check?

Mike DeWalt

David, that one's not too bad. If you look at our 850, that's for the full year. So if you look at what we did in the first half that's compared with the first half. What happened last year is we had a deterioration in price realization second half of last year versus first half of last year.

That was really driven by a couple of things last year. Geographic mix started to shift last year, in other words we had increasing sales outside the U.S. and declining sales inside the U.S., particularly in the fourth quarter last year. So some of the same things we're feeling now we started to feel in the fourth quarter of last year.

U.S. housing and some of the other U.S. markets started to weaken in the second half of last year. Our U.S. sales were down 10% and that kicked off merchandising programs a bit in the second half of last year.

So the bottom line is the second half of last year was weaker than the first half. So our comparables are going to get a little bit easier as a result of that.

In addition to that, this year we had probably higher merchandising expense in the first half in North America than we expected in the second half and a lot of that had to do with the effort that we had with dealers to try and clear out some old inventory.

So I think comparables are a part of the story, geographic mix later in the year that's more comparable than it's been in the first half of the year, and some improvement in expense for merchandising programs, particularly in North America.

David Raso - Citigroup

The most logical answer is that the North American delta is less of a drag in the back half this year than the first half, because second half last year North America began to fade already a little bit.

Mike DeWalt

Right. That's correct.

David Raso - Citigroup

But on your new North American guidance you're implying the second half is down 12% year over year and the first half was down 12%. So that doesn't really fly on mix. So I'm just trying to understand why would we think we're going to get better ? There's got to be some pricing that you feel you're going to get somewhere because nothing is going on in the market North America suggests your discounting is going to get less.

Mike DeWalt

Yes, in our particular case it is. We're really trying to hold a pricing discipline in North America. But remember, we helped dealers take down inventory in the second quarter $800 million, and that came at some expense.

Jim Owens

David, I may just add a little bit to that. I think Mike's covered the essential points here, but it always is of course a function of how competitors behave in the marketplace. But NACD we expect to see some better comparisons certainly in the second half than we did in the first, as Mike has alluded to.

Outside the United States where product, where markets are very strong and our capacity is very constrained we expect to see sales variances further decrease a little bit. That's reflected in the modest numbers that we have for the balance of the year on price realization and gives us reasonable confidence, again subject to how the competition behaves particularly inside the United States.

David Raso - Citigroup

That sort of dovetails into my follow-up. You mentioned the idea of the inventory reduction. You helped some of your dealers in deals we heard of on some better financing and so forth. If we look at your volumes this year in North America -- I'm just talking machines -- it looks like it could be down well over 20% for the year. Year-to-date they're down nearly 24%, 25% and while your dealer retail is only down about 14%, so you're under producing retail pretty significantly.

Jim Owens

Intentionally.

David Raso - Citigroup

Exactly. Should we continue to see that level of under production for the rest of the year? If so, does that set you up at the end of '07 going into '08 inventory reduction is not part of the equation in '08?

Jim Owens

I think the short answer to that is largely yes. We will see less of an inventory reduction impact in the second half than you saw in the first half and by the end of the year we should have the inventories about where we want them and there will be much less of an impact of inventory managing down in '08.

David Raso - Citigroup

Jim, I'm trying to balance managing the company for '10, structurally changing how your dealers handle inventory versus can I do the job in '07 and I go into '08 clean? Or is there still a philosophical structural lowering of inventory that's still necessary in '08, almost regardless of where retail is?

Jim Owens

I think we'll have the inventories pretty close for the interim future to where we want them at the beginning of '08. But as a key thing there and thanks for reminding me, Doug, is that we're very now much going to be focused on driving down in-house inventories. There we have excess inventories and that's the big thrust is as we move to full deployment of our Cat Production System, more of a pull system basis, we should melt away a lot of the work in process inventories that have built up with these recent year supply chain disruptions.

David Raso - Citigroup

That's the kicker on the cash flow?

Jim Owens

That's a big kicker on the cash flow and in cost improvement.

David Raso - Citigroup

Okay, I appreciate the color. Thank you.

Doug Oberhelman

I'll just take that chance to add on to Jim's comment there, David. We've got some very aggressive asset turnover, particularly in inventory turnover goals out to 2010 and virtually all of that comes back in cash. So the sooner we can get that in the better we can use it and that's the goal of this whole transitional period that we're going through that we think now is the time to take rather than wait until later. You're seeing some of the good and the bad of that right now.

Operator

Your next question comes from Seth Weber.

Seth Weber - Banc of America

BofA. Good morning, everybody. I just wanted to try and flesh out some of the mixed commentary if you could about the U.S. nonresidential construction market. On the one hand you're talking about some positive supporting factors which are consistent with what we've heard from some of your peers over the last couple weeks. But on the other hand, it sounds like you're maybe not seeing a better environment here through the rest of the year?

Mike DeWalt

Well, a couple of things. One, when we talk residential and nonresidential, for the most part when you're talking structures you're really talking about the same machines. So if you have a rental fleet for example the dealer could use that rental fleet with customers who were either residential or nonresidential. So there's probably some bleed through there.

Another factor for us has been dealer rental fleets. Dealers spent the last couple of years increasing a bit and adding new product to the rental fleets. The average age of products in rental fleets is relatively young right now. So actually our decline in sales through rental is a bit more than through the sales channel. So there's probably some bleed through there.

Plus, in the U.S. right now, despite the fact that some of the underlying factors that drive the construction industry are reasonably positive for nonresidential, a lot of the buzz in the economy overall is weakness, higher interest rates, unlikely rate cuts. I think that weighs on the minds of our customers and they have a choice of when they spend their money on replacement demand.

So I think there's probably, in addition to the rental factor and some bleed through from housing because the machines are the same, there's probably some impact on our customers of just the overall state of the economy.

But you're right, many of the fundamentals around nonresidential aren't too bad.

Seth Weber - Banc of America

Okay, but if you had to call a bias, I know you're not talking about '08 at this point, but if you had to bias '08 do you think the trends are in place for that business to get better or do you think it just continues to bleed and just get weaker here?

Mike DeWalt

I don't know, Seth. We'll talk about probably '08 I would guess some time a little bit later this year.

Operator

Your next question comes from Robert McCarthy.

Robert McCarthy - Robert W. Baird

Robert W. Baird. I really have follow-ups I think to questions that were asked earlier. In line with the conversation that you had about reducing North American dealer inventories this year and the potential to accomplish most of what you want to happen this year, in the release you talk about expected inventory declines in EAME in the second half as traditional seasonal sell through pulls a lot of that out of dealer inventories.

Does that mean that there is not a significant strategic component of inventory reduction in EAME this year and that we'll face that in '08 or '09 as sales trends start to slow down there at retail?

Jim Owens

We're trying to work hard with the marketing companies all over the world -- the operative word is to work with -- our dealers to manage inventories to jointly agreed-upon targets based on our expectation of improved delivery times out of factories. Quite frankly, the dealer inventory swing has aggravated our business cycle virtually every cycle throughout the history of time. So to the extent we get leaner on that dealer inventory we'll reduce total value chain cost and reduce the cyclical swings.

So it's absolutely the right thing for us to be doing and we're basically in terms of months of sales because rapid sales growth, we're relatively low in the boat in terms of months of sales of inventory in most of the non-U.S. markets. We have historically financed a lot less dealer inventory for dealers outside the United States. We've changed the commercial arrangements in the United States now so we're moving away from financing a lot of floor plan dealer inventories to sit out there and encouraging dealers to have excess inventories which we later then have to move around.

So the focus is deliver it better, faster, on time and gradually work the level of total dealer inventory in the world down. The biggest impact of that reduction I think is going to occur in '08 in NACD. Hopefully it will be pretty gradual over the next few years in the other markets and if we're fortunate it could be offset by good sales growth so it will be a lot less painful.

Robert McCarthy - Robert W. Baird

Although I understand the point that CPS was not a major cost driver in the second quarter, I do have a couple questions related to that dialogue. One, if the effort is broadening out across the business and you have a philosophical orientation towards stop/fix, why would inefficiencies trend down going forward rather than at least stay at the kind of level that they were at in the second quarter?

Jim Owens

We're reviewing this thing weekly, literally, with our business units all over the world. For example, our internal component divisions, their on-time delivery performance to our Big Three we just reviewed this week, has improved markedly just in the last couple of months. We've had some transitional things going on in one of our big hydraulics units with closing a number of buildings, consolidating into one that caused some disruption in the first half of the year. It looks like we're largely getting that behind us.

We've got really a joint effort with our global purchasing group in each of our manufacturing operations, putting more supplier development people on site with key suppliers and working with everybody on just in time delivery of materials. But we think we're going to at least get marginally better in the second half than we were in the first and continue that with steady improvement until we get to the world-class excellence we look for over this what I described as a three-year journey.

Robert McCarthy - Robert W. Baird

Related to that, you talked before about starting to see some benefits in the second half of the year, but I think probably from investors' minds, keenly interested in knowing even roughly when those benefits might start to more than compensate for the incremental costs you face to implement?

Jim Owens

You know, we've staked out some very, I think, bold and yet achievable goals for 2010. With everything we're seeing with the Cat Production System we have great confidence that we'll be in that $8 to $10 a share range and generate 15% to 20% per annum growth in earnings.

The Cat Production System, the operational excellence associated with it, what we've seen in a number of our own divisions we know we can achieve across the board. I'm confident we're going to deliver it, but I don't want to get into telling you exactly the cents per share how much you can look for each quarter. I think that's a losing equation. There are too many other variables and balls moving in terms of price and volume to try to break it out at that level of granularity.

Robert McCarthy - Robert W. Baird

But would it be fair for us not to expect to reach that point until perhaps at least halfway through a three-year process?

Jim Owens

My own drive is certainly going to be to realize it on a steady-state basis annually as seeing some of that benefit in '07, some in '08, and some in '09. And by the end of '09 I expect to be pretty well towards our target of operational excellence as we've got it very precisely defined.

Robert McCarthy - Robert W. Baird

We're looking forward to watching your progress. Thanks, Jim.

Operator

Your final question comes from Stephen Volkmann.

Stephen Volkmann - JP Morgan

On the truck engines, the data that's out there regarding market shares, I sort of understand what happened in the first quarter where you weren't really producing much, but it looks like you've continued to kind of lag your traditional market share even in April, May and going forward and I'm just wondering how you read that?

Doug Oberhelman

Steve, I read it the same way. The good news is that May over April was up about a point, I think about 22.5%. The data though, I think you'd agree, is still complicated. There's still an inventory of '06 engines in trucks out there both at truck dealers and customers. That's sorting out. Truck production has been up and down. I fully expect between now and year end we'll be back up where maybe not as high as our peak was at one point, but up several more points in market shares.

As the market comes back we steadily increase our penetration with some of our customers. It's just this first half and even into July and I suspect August truck production is irregular. Until that sorts out, it's going to be hard to see where everybody really is. But my goal is several points higher than where it is now by year end.

Stephen Volkmann - JP Morgan

Can we just touch briefly on SCM? When is this going to close? Briefly, Mike, what does it look like on the income statement and then maybe strategically from Jim?

Mike DeWalt

When it's going to close, it's hard to say. We're still negotiating the details of that with MHI. We're on a path to get it done as soon as we possibly can, but I certainly wouldn't want to forecast a day.

In terms of the effect on our overall results, at the time we actually conclude it we'll try to give you a little bit more info than this, but in general if you think about SCM's sales they fall into three buckets: product that they produce in Japan and sell in Japan, and that piece of it will be all incremental for us at least in terms of sales, that doesn't hit our sales today at all in our consolidation of SCM.

Stephen Volkmann - JP Morgan

Order of magnitude?

Mike DeWalt

Then there's a piece of SCM sales that they produce in Japan and sell to the rest of Cat, Inc. and are sold outside of Japan. Those sales are already in our top line numbers because we're selling it. The profit isn't in our numbers but in terms of sales it is.

Then of the product that's sold in Japan that's produced outside of Japan, we have a portion of the sales in our numbers already. Cutting through all that, and again this will depend upon how volume is going at the time, et cetera, but if you were to think of SCM overall as a company with around $3.5 billion of sales, order of magnitude a third to maybe a little more than a third of that would likely end of being incremental top line for us when we get it done.

The profit picture is a little bit more clouded because of what we sell to them we have a piece of the profit in our numbers, what they sell to us that we sell on through the marketing companies we have a piece of the profit already in our numbers and we do have a 50% share of SCM today. So the profit piece is even a little more convoluted, I guess. So I know that doesn't help you a lot, but order of magnitude in the range of $1.5 billion top line.

Stephen Volkmann - JP Morgan

Probably slightly dilutive on profits?

Mike DeWalt

On the rate certainly because we already have half of the profit in our numbers today.

Jim Owens

Just in terms of strategic importance, this is a 45-year-old joint venture company, we know the company well and it's been of major importance to us in terms of giving us a strong presence in the Japanese domestic market, particularly with hydraulic excavators, and a product to sell in Southeast Asia in direct competition with our Japanese competitors.

Strategically, once we've acquired full ownership and can be more seamless, this allows us to integrate our Japanese operations, our Japanese supply base and some of the key component technologies that we have developed there into our Asia Pacific theater manufacturing presence which will include operations in China, principally, but India and Indonesia as well.

So it will be a much more integrated presence, we think we can do a better job with it and it will facilitate the kind of growth we're looking for in that theater going forward.

Mike DeWalt

Thank you all very much for joining us on the call today.

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