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Executives

Mike DeWalt – Director of Investor Relations

Edward J. Rapp – Chief Financial Officer, Group President – Corporate Services

Douglas R. Oberhelman – Chairman and Chief Executive Officer

Analysts

Jerry D. Revich – Goldman Sachs

David M. Raso – International Strategy & Investment Group, Inc.

Andrew Kaplowitz – Barclays Capital, Inc.

Henry Kirn – UBS Securities LLC

Robert Wertheimer – Vertical Research Partners

Seth R. Weber – RBC Capital Markets Equity Research

Ann Duignan – JPMorgan

Jamie L. Cook – Credit Suisse

Robert Mccarthy – Robert W. Baird & Co., Inc.

Caterpillar Inc. (CAT) Q2 2012 Earnings Call July 25, 2012 11:00 AM ET

Operator

Good morning, ladies and gentlemen, and welcome to the Caterpillar’s Second Quarter 2012 Earnings Results Conference Call. At this time, all lines have been placed on a listen-only mode, and we will open the floor for your questions and comments following the presentation. It is now my pleasure to turn the floor over to your host Mr. Mike DeWalt. Sir, the floor is yours.

Mike DeWalt

Thank you very much, and good morning, everyone, and welcome to our second quarter earnings call. I am Mike DeWalt, the Director of Investor Relations. And I am pleased to have our Chairman and CEO, Dough Oberhelman; and Group President and CFO, Ed Rapp with me on the call today.

Now, this call is copyrighted by Caterpillar Inc., and any use, or recording, or transmission of any portion of this call without the expressed written consent of Caterpillar, is strictly prohibited. If you would like a copy of today’s call transcript, we’ll be posting it in the Investor Section of our Caterpillar.com website, and it’ll be in the section labeled Results Webcast.

This morning, we'll be discussing forward-looking information that involves risks, and uncertainties and assumptions that could cause our actual results to differ materially from the forward-looking information. The discussion of some of those factors that, individually or in the aggregate, could make actual results differ materially from our projections, that can be found in our cautionary statements under Item 1-A, Risk Factors, of our Form 10-K filed with the SEC back on February 21 of this year, and also in the forward-looking statements language in today's release.

In addition, a reconciliation of non-GAAP measures can also be found in this morning’s financial release, and that will again be posted on our website at Caterpillar.com.

Okay. To start-off this morning, I'll do a few bullet points that summarize this morning’s release. It was an all time record sales quarter, in fact the best of the 87-year history of Caterpillar, and up 22% from the second quarter last year. A little over 12% of that was organic growth, and a little under 10% from our acquisitions.

Sales and revenues rose about 9% sequentially from the first to the second quarters. It was a great quarter for profit, and also an all-time record at $2.54 a share, and operating profit was over 15% in sales and revenues. We had very good incremental operating profit pull through at 44% excluding the impact of our acquisitions.

We did however make a downward revision of $2 billion to the top-end of our sales and revenues outlook range. About $1 billion was a result of negative currency translation and about $1 billion because of weaker world economic growth that we previously expected. We did not change the bottom-end of the range, so that means the sales and revenues at the midpoint are down about $1 billion. And we increased our full-year 2012 profit outlook from $9.50 to $9.60 at the middle of the sales and revenues range.

Okay, those were the high level points, I’ll add a little more color then Doug and Ed and I will take your questions, and I’ll start with sales. Again, sales and revenues up 22%, excluding Bucyrus and MWM acquisitions, which we didn’t own last year. Organic growth again a little more than 12%.

The largest increase was in our Resource Industries segment, which is primarily mining. Sales were up 68% from a year ago, about 37% from the acquisition of Bucyrus and about 31% organic growth. Sales were up in all geographic regions both with and without Bucyrus.

Our Power System segment was up 12% and that was 8% organic growth and about 4% from our acquisition of MWM. The strongest growth was in North America and the strongest industries were petroleum and rail.

Our Construction Industries segment was up 8% and that increase was essentially all volume with negative currency impacts about offsetting positive price realization. Construction sales were up in North America, about flat in Europe, Africa, Middle East and that’s where most of the negative currency impacts were. Latin America was down 3%, and Asia-Pacific was off 11%. And of that 11% decline in Asia-Pacific, more than all of that was China.

Speaking of China, over the past quarter, it’s been very topical; what’s happening there, what are we doing about it, and when do we think it will get better? And with most of the sales in China relating to construction, this is a good place to address it. So, in terms of what’s happening there, the construction equipment industry remains very weak and it really hasn’t shown much in the way of signs of improvement yet. In addition to the weak demand, there is still quite a bit of inventory available on the ground in China.

Now, while the industry is still pretty weak, it did turned down at about this time last year. So we are at about the point where the comparables are starting to get easier. So, on a year-over-year basis, the numbers will likely start looking better than the first half of 2012, even though the industry isn’t seeing much improvement yet.

So, the question is, what are we doing about it? And the answer is, we’re actually doing quite a bit. First, we’re working with dealers to actually sell more products. Over the past couple of months, we took new programs in place to get that done. And we expect to start seeing results of those programs in the third quarter and expect to get more of the available market.

Second, we and our dealers are actively addressing inventory. During the second quarter, Cat dealers in China reduced machine inventories and that’s a good thing. However, with weak end-user demand and dealers cutting inventory, it’s resulted in a very low level of shipments from us to dealers, and that make it tougher to reduce inventory.

We’ve already lowered production in China and expect to reduce it even more in the third quarter. That along with the higher level of exports from China to other parts of the world should help lower inventory there. However, because the sales volume levels in China haven’t begun to improve much, we expect it will take a couple of more quarters to get inventory levels in China where we like them to be.

While we’re actively working to get inventory down in China, we’re trying to keep a balanced view. One of the few certainties in this business is that markets go down and then markets go back up. In China, we’re encouraged by the recent actions the government is taking to improve economic growth. They’ve cut interest rates, they’ve lowered bank reserve-requirements, and we expect they’ll increase infrastructure spending later this year. So we do need to be a little bit careful.

The construction industry in China had a history of turning quickly. And when it does, we do need to be prepared. We are actively working the plan to lower inventory there, but we don’t want to go to the other extreme and take it down to a point below where we’d have difficulty reacting when improvement does inevitably come.

So, bottom line, we think there is a good chance that signs of better economic growth in China will start later in 2012, and well, that’s our view. Our 2012 sales and revenues outlook does not rely on any material improvement in China sales this year. Okay, that’s enough on China, construction and sales, let’s shift to profit.

And it’s a great story to talk about. It was a great quarter, and in fact again $2.54 a share, our best quarter ever with operating margin just over 15% of sales and revenues. That was also one of our best performances ever.

Cost control was very good. Material costs were about flat, freight cost were not an issue, variable labor productivity more than offset, labor cost inflation, and period cost control was very good, with period cost increasing at well less than half the rate of the sales increase. All in all, a very well executed quarter.

However, on the negative side there was a tax rate. We increased our estimated annual tax rate from 30% for the full year to 30.5% mostly related to the geographic mix of where our profits are earned from a tax perspective. That’s means that after tax profit in the second quarter was about $24 million lower than it would have been had we not made a change to the estimated tax rate.

Okay. That’s our quick review of the second quarter results; let’s move on for a moment to the outlook. Now, as a starting point, remember our previous outlook was a sales and revenues range of $68 billion to $72 billion and profit of about $950 million at the midpoint of that range. This morning, we did tighten up the sales and revenues range by lowering the top-end from $72 billion to $70 billion. Now we first introduced that $68 billion to $72 billion range at the end of January with our year-end 2011 financial release and we held it steady last quarter in April when we released our first quarter.

This morning’s $2 billion decline at the top-end of the range was a result of two things: negative currency translation and weaker global economic expectations than we had previously thought. The currency impact as a result of the stronger U.S. dollar, its translation, our sales that are denominated in non-U.S. currencies are translating into fewer U.S. dollars and certainly the most significant negative impact is in the Europe.

Now, we did not change the bottom-end of the range and as a result the midpoint is down $1 billion. And at the midpoint of that new range that $68 billion to $70 billion sales and revenues range, we expect profit to be about $9.60 a share. That’s up $0.10 from $9.50 a share to midpoint of the $68 billion to $72 billion sales range that we previously had.

A few points about the outlook, profit is higher despite the increase in the estimated annual tax rate. Operational execution has been very strong and we expect that that will result in better profit despite the tax increase.

Currency while impacting sales has had little impact on the profit movement from $9.50 to $9.60. Our global manufacturing footprint and broad cost base provides an offset to the impacts from sales. And on that point, I frequently read media commentary about Caterpillar when exchange rates moved, and it’s frequently off base.

And because of that, I think it’s worth making this point one more time. We work hard over the past 30 years to get a better balance on currency exposure and because of that, we are in a much better currency position than we were historically. Rates can move and do move sales, but when they do, the cost impact is usually in the opposite direction and mitigates the overall profit impact.

So in summary, we had a great second quarter. We are a little more cautious of the top-end of our sales and revenues outlook and we’ve raised the profit guidance to about $9.60 at the middle of the sales and revenues range.

Another point before we move on to the Q&A, and that’s the level of uncertainty in the world economy. It’s hard to pick up a newspaper today and not read about troubles in Europe with Greece, Spain and Italy. They’re annexed with growth rates in GB and China. There is concern about political polarization in the U.S. and what will happen at the end of the year with the fiscal and tax cliff. But those are the facts of life that we’re all dealing with today, and there is no doubt that there have been a negative for business and consumer confidence. We see it, and we understand that some of these issues like Europe’s debt problems could take a while to fix.

That said, we expect that over the next couple of quarters that some of those clouds will clear a bit and we can start forming a little bit better picture of 2013. And while none of us know at this point, what those outcomes will be, we do know that the U.S. elections will be over in the fall, and we think chances are good, there will be a resolution to the fiscal cliff.

The leadership changes in China will also happen later this year. and after another quarter or two, we’ll get a better sense of the effectiveness of the easing measures that Chinese have already taken and any additional measures they may take to improve growth.

We know that in Brazil, they’ve started easing late in 2011, and we are seeing some improvement in our business there today, and we expect that improvement to continue to unfold as we go through the rest of this year. We also do think that Brazil’s preparations for the World Cup and the next Olympics will be positive for them moving forward.

Bottom line, we believe that some of the uncertainty that’s facing the world economy today will at least be a little less cloudy by the time we get to the end of 2012. and as a result of numerous monetary easing actions that have been taken around the world, we’re cautiously optimistic that the world economy in 2013 will be better than in 2012.

One last comment and then we’ll start the Q&A. and as a seasonality reminder, we have numerous vacation shutdowns around the world built into our third quarter that's normal that happens every year. and as a result, the third quarter is usually a weaker, seasonally, a sales quarter. The fourth quarter is usually a seasonally high quarter for sales. So for those of you that are trying to model our quarterly results, please take that into consideration. The third quarter is usually the weaker quarter of the second half.

So that’s a review of our results. and with that, we are ready to take your questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, the floor is now open for questions. (Operator Instructions) Our first question today is coming from Jerry Revich. Please announce your affiliation, then pose your questions.

Jerry D. Revich – Goldman Sachs

Good morning, it’s Goldman Sachs. Mike, can you tell us on how you're thinking about pricing heading into the back half of the year compared to the price realization we saw this quarter, and also comment on where you expect to see company and dealer inventories at year-end?

Mike DeWalt

Yeah, I'll start with pricing. We've actually done better on pricing through the first half of the year than we expected it. It's really held up pretty well. Earlier in the year, we'd expected that we would get maybe 1% to 1.5% price for the full year. We’re at probably between 2.5% and 3% right now through the first half.

We think it will probably go down a little bit in the second half that's what’s baked into our guidance, we’ll probably end up the year somewhere around 2%. Remember one of the points I mentioned was, we’re working with dealers for example to sell more product in China, so there will be certain merchandising programs, for example related to that. So, I think a lot better year than we thought, it was going to be even including the economic impacts that you see today, but probably a little less in the second half than the first half.

In terms of dealer inventory, we did have a little bit of an increase in the second quarter more than all of that was mining. Now, when you look at dealer inventory for mining, you have to be a little careful, but it’s not a case where dealers are loading up 400 ton trucks on their vault and hoping for a customer. It’s a case where we pass title to them and then they have to get the product to their customer. They have to get it assembled and commissioned. So usually when our shipments go up like they did in the second quarter versus the first, the pipeline for mining inventory increases a bit and that’s just a function of us shipping more through dealers to customers.

In terms of our inventory, we did have a bit of an increase, about 800 million in the second quarter. And there were four reasons for that; one, and I’ll start from the smallest to the largest, in-transit inventory that’s basically where we sold the product – it wasn’t sold. We have a product that’s been shift, but it’s an export, it’s on the high fees essentially and it’s best in for customer, but we haven’t passed title yet.

When our shipments and exports go up in-transit inventory, usually goes up. We had a 9% increase in sales between the first and second quarters and in-transit went up a bit. That’s to be expected based on the sales increase. About 20% of the increase in the second quarter was components, working process, after market parts, and that’s very related to sales. And again, we had a 9% increase in sales from first to second quarter.

20% of the inventory increase was from the acquisition of Siwei and Bucyrus. Siwei was an acquisition and Bucyrus inventory went up in the quarter and again that’s not very surprising. We have businesses like Solar, like Bucyrus where they have seasonably big four quarters, they build a bit of inventory all year along, they have a big fourth quarter that usually goes down. And again, Siwei contributed about $100 million of the increase, not just an acquisition.

About half of the increase was finished goods and more than half of that was on our Excavator division in China. And I tried to cover this a little bit in the release this morning. It’s a case where we are cutting production there, where more declines are going to come in the third quarter, but dealers are cutting inventory there as well. And if you start with a slow market and dealers reducing inventory, now there are not a lot of shipments going on from our factories to dealers then. So it’s pretty hard to take inventory down.

So even with the reduction in production that we had in the third quarter, it wasn’t quite enough yet to offset the impacts of a really slow market. So we are going to take it down a little bit more in the third quarter, we are exporting a higher percentage of the business in China, outside of China. So that should help there.

Edward J. Rapp

Hi, Jerry, this is Ed. The thing I would add on Cat inventory looking for the balance of the year, between now and year end, I’d be disappointed if we didn’t take $1 billion, at least $1 billion out of inventory. But we’re also trying to be very thoughtful in terms of how we manage the full supply chain. If you think about what the supply chain has done and with $32 billion in ’09, your midpoint of the outlook $69 billion and if you look at the basic outlook that says, there is some drivers out there, that says 2013 could be positive versus 2012. We want to be very thoughtful about how we take that inventory down, but we are now in the end of the year, getting $1 billion out is something we ought to be able to do.

Jerry D. Revich – Goldman Sachs

Okay. Appreciate the color. And I’m wondering if you could talk about how much visibility you have in your gas compression business and whether that business can continue to outpace the slowdown we’re seeing in U.S. pressure pumping and in electric power, can you just on which regions are driving the weakness that we saw year-to-date and what you expect to heading to the back half? Thanks.

Mike DeWalt

Yeah, I mean, we don’t break our petroleum business out in quite that much detail, but what I would tell you is the largest sort of application segment for oil and gas business is gas compression. So contrary to popular belief, it’s not drilling and fracking, it’s gas compression. So the more gas you have, the more wells you drill, the higher consumption of gas goes, the more need that you have for gas compression, so that business is actually doing quite well and looking up.

We do a lot of gas compression with Solar, and with Solar, we have a very good long-term visibility. So I’d say oil and gas – your point about fracking is right. Fracking is slowing down, but gas compression is doing very well. So our general view of the oil and gas industry is actually pretty good right now. Jerry, we’re going to have to move on to the next person in line. Thanks.

Operator

Thank you. Ladies and gentlemen, the next question today is coming from David Raso. Please announce your affiliation, then post your question.

David M. Raso – International Strategy & Investment Group, Inc.

Hi, ISI. I’m just trying to look at the inventory guidance. Ed, you just mentioned $1 billion coming out ideally by the end of the year. That would still imply the next couple of quarters that inventory will be growing faster than sales year-over-year. So just coming off the last five quarters of inventory still growing faster than sales, I’m just trying to a) just understand why we continue to grow inventories faster than sales or b) is the answer and everybody can have their own macro view, are you guys in fact confident, 2013 is an up year to continue to grow inventory at this rate?

Edward J. Rapp

David, two things; first of all on inventory growing faster, I mean, if you really look at our guidance in terms of mid point of the outlook, we had sales in second half actually slightly up versus first half. And so you’ve got a slight increase in sales and a lower inventory level. So you don’t have inventory growing at a faster pace than sales.

And then your second point is, is far a little bit as well. It is my kind of walk around the world and you look at what 2013 should look like versus 2012. I can’t imagine the degree of uncertainty we have in the U.S. so that we don’t have greater clarity in ’13. I can’t imagine what the steps that China has taken in terms of monetary policy, pay cuts, reserve-requirement cuts, you don’t see a better 2013 than 2012. I can’t imagine with all the moves that Brazil has taken as well as the upcoming of the World Cup, the Olympics; you don’t see a ’13 better than ’12.

So part of our thinking is making sure we are very thoughtful across the supply chain. The other one to keep in mind and I think second quarter really demonstrated it, there are also some benefits to the inventory position we have, our point of use availability, our quality, our delivery performance, our pull through, we are all very, very strong. And so I do think there is some benefits as to how we worked with our supply base to ramp up and I think you are seeing it in some of those operating metrics.

David M. Raso – International Strategy & Investment Group, Inc.

And I appreciate the math sequentially, but I was speaking about year-over-year and the math is, you are still planning on inventory growing faster than sales year-over-year and obliviously, it sets up a little more risk on how much retail you need in ’13 to continue to grow your production. So I guess, end of the day, I mean obviously you will give 13 top line guidance I assume Mike will give it on October, but the way you are handling the CapEx for the rest of the year essentially no cut, the way you are guiding the inventory I guess base case we have to be thinking, you’re thinking ’13 and up year, otherwise you would be taking a bigger cut through your inventory and even maybe even in the CapEx?

Edward J. Rapp

And David, that’s why we try to give you some color as to why we saw ’13 being better. The other one to keep in mind on the CapEx is that in spite of the numbers that we reported today, which are an all-time record on both sales and profit, keep in mind that our traditionally strong markets U.S., Europe, and if you go back in history even Japan, are in the neighborhood of 40% off prior updates. And if at some point in time, those markets are going to turn. And when they turn, we want to be ready. And those places where we’re taking and slowing down some of that CapEx, China being one example. But we’re going through a business-by-business, industry-by-industry really looking at what the long-term prospects are going to be.

Mike DeWalt

Okay, David, I’m just going to add one more comment in there…

David M. Raso – International Strategy & Investment Group, Inc.

Sure.

Mike DeWalt

…on the year-over-year. That is you almost have to look at it by the type of inventory that we’re talking about. we’ve increased parts inventory for example faster than sales. Part of the reason for that is we’re putting additional Bucyrus inventory into the system. We’re doing that to increase delivery performance there. That was a – that’s the key part of driving higher part sales and profit out of Bucyrus. Now if you look at our actual production inventory, it’s performed a lot closer to sales. if you look at the PDC that's where we’re holding finished inventory. on purpose, we call it lane one inventory, that’s up $1 billion or actually a little bit more than $1 billion year-over-year. That’s very purposeful, I mean the problem was, a year-ago we didn’t have enough capacity in place to get it where we need it. So we’ve added more than $1 billion to PDC inventory on purpose, that was all a part of the plan, and we’ve been able to do that really over the last six to nine months as productions come on stream.

Mike DeWalt

So, it’s not just that simple, how much did sales go up, how much is inventory going up? And then we also had acquisitions. roughly, half of the FIFO inventory increases, Bucyrus, MWM and Siwei, just acquisitions.

David M. Raso – International Strategy & Investment Group, Inc.

Okay, thank you very much. I appreciate the color Mike.

Operator

Thank you. Our next question today is coming from Andrew Kaplowitz. Please announce your affiliation, then pose your question.

Andrew Kaplowitz – Barclays Capital, Inc.

Barclays. Good morning guys, nice quarter. If I could ask you about backlog, Mike, I know you’ve talked about in the past, you didn’t kind of rue the day when it would go down. I think we all expected it to go down sequentially here. But how do you look at the backlog decline in terms of mining, and with your comments in the release about mining, customers extending investment over the next few years. How is it affecting your business now, and if mining CapEx is down significantly can you grow your business?

Mike DeWalt

Couple of things, one, say how they are affecting our business now. Well, organic sales were up 31% in mining in the quarter. If you look at our year-over-year backlog, how well we do it on backlog versus year ago, it’s up 11% not down. If you look at the change from the end of the first quarter, I mean there are a couple of things that are definitely going on there, one and this particularly effects construction, we took quite a few products off managed distribution. We've been on a situation for the last couple of years where we couldn't supply enough, and we had dealers on managed distribution for quite a few products. We've been adding production capability over the last couple of years, that situation, delivery times has improved a lot, and when that happens it's almost like clock work dealers take – they don't have to be quite so cautious, and because we can deliver quicker. So that was definitely a factor for construction.

On mining, customers did – we shift more than we took in new orders and the backlog did go down. But you almost have to look out in perspective. I mean we were getting very large orders, really over the past couple of years, and we’re increasing every quarter. And it’s a function of – we’ve been putting in more capacity to deal with that. I mean we wanted for long time to get the order book for mining to a more reasonable level, delivery times for customers to a better level. And that’s why we’ve been putting capacity in place to do that.

That said, there’s a lot of uncertainty in the marketplace today, customers are – just like my comments in the opening, we’re all trying to get a better picture in terms of what’s going on economically. Central bankers have done quite a bit, but that takes a while to actually materialize in the economy.

And I think people are taking a little bit of wait and see to see how 2013 is going to shape up, and I think orders reflect that. That said, mining order book is quire long, we have very good visibility into 2013. For a lot of the big trucks, we’re still taking orders into ’14. So it’s not as though, all of a sudden the backlog is dried up and we don’t have any visibility.

Andrew Kaplowitz – Barclays Capital

That’s helpful, Mike. And if I could shift gears for a second, I mean in the first of the year you’ve done almost 15% margins; in the second half of the year, if you look at the implied guidance, you would do much lower margins. You talked about lower production in China, incentive comp is going up, I mean we see all the things that are in the release. But the question I have is, is this some conservatism in the guidance?

Mike DeWalt

Well, what I’d tell you is this, many of the comments that we’ve actually made here today more in the release, price realization is probably not going to be quite as strong in the back half of the year. Seasonally, the fourth quarter is usually a higher cost order. So those things will certainly impact the second half of the year.

But you’re right, the first half’s execution, has been very, very good. So I think our outlook is, I mean we raised the outlook today from $9.50 to $9.60 on midpoint of the sales range that went down $1 billion and we’re looking at a higher tax rate. So I think actually the profit story for the rest of the year is pretty positive.

Andrew Kaplowitz – Barclays Capital

Thanks. Appreciate it guys.

Operator

Thank you. Our next question today is coming from Henry Kirn. Please announce your affiliation, then post your question.

Henry Kirn – UBS Securities LLC

Hey, good morning guys, it’s UBS.

Douglas R. Oberhelman

Hey, Henry.

Edward J. Rapp

Hi, Henry.

Henry Kirn – UBS Securities LLC

In the release, you called out the dealer rental inventory results. How much opportunity is there to refresh the fleets, and if we went through a pause, do you think the dealers would take the opportunity to start a refresh?

Edward J. Rapp

Yeah. Henry, this is Ed. Yeah, I think we’re already seeing some of that in terms of dealers refreshing those rental fleets. But if you look at it in terms of the total fleet size, it’s still below kind of historic levels, historical peaks and on average the age is older. And I think it’s not only a view of the rental fleet, but I didn’t get a pretty good proxy for customer fleets are, especially in the developed parts of the world.

They were in a period of uncertainty, they just delay the decision to make that, an upgrade to the fleet that new purchase. And so like I said, as we talk about moving forward, I didn’t get the point in time, they get greater clarity. So one in that helps is that, we did finally get a passage of a highway bill. We are starting to see some – the bottoming out and improvement in housing. I think as those issues get a bit clear, the opportunities for not only rental fleet replenishment, but also the upgrade of customer fleets is one of the opportunity that lies ahead.

Henry Kirn – UBS Securities LLC

That’s helpful. And could you share your latest thoughts on Cat Financial and your appetite to take risk there, gain share or use this competitive weapon?

Edward J. Rapp

Henry, it’s – Cat Financial has been a competitive weapon since we launched it back in the 1980s. And the thing that we do with Cat Financial is, we stay very close to home. so it’s there to support and pursue the growth of the Caterpillar business. and if you think about the ‘08, ‘09 financial crisis and how well it performed, I think it shows the benefits of staying very close to home in terms of the way you manage your capital finance company.

I think with the uncertainty that you have today in the financial markets having a capital finance company has become, I think even a bigger strategic advantage. I think the other place where we’re going to see it play out is the strategic advantages, drive the full integration of Bucyrus, is we’ll really be – the only full line provider in that mining industry and plus with the captive finance company, I think there’s a real strategic advantage there. But we’re not going to significantly alter our risk appetite. We think we manage that part of the company well, I think you’ll see us consistently manage it moving forward. But as you saw with the results, they had a good quarter, they’re a great part of the company.

Mike DeWalt

Thanks, Henry.

Henry Kirn – UBS Securities LLC

Thank you.

Operator

Thank you. Our next question today is coming from Robert Wertheimer. Please announce your affiliation, then pose your question.

Robert Wertheimer – Vertical Research Partners

Hey, it's Vertical Research Partners, good morning. I wondered, you mentioned rail was strong in the press release, and I wondered if you could break that down into a pre-buy maybe North America versus – I know rail has been booming in mining globally. is that a business that’s gotten up into a solid double-digit profit margin or is it still lagging?

Mike DeWalt

Yeah. A lot of the rail increase that we’ve seen so far this year has actually been in North America, and to your point, a few years from now, there will be a move to new emission standards in rail. And I think there are certainly some buying that’s going on ahead of that. We’re actually doing a bit better than the industry, when we acquired EMD, it had lost a lot of its business over the years to GE, and thankfully we’ve taken some of that back now. So actually we’re doing pretty well.

In terms of profitability, in general, that business is actually doing quite a bit better than when we bought it. We’ve got the new factory going in Indiana right now in Muncie. They have come up on production remarkably well. We had a good quarter despite the fact that we essentially shifted assembly in the first of the second quarter from Ontario to Indiana. So they’ve done a great job.

Robert Wertheimer – Vertical Research Partners LLC

Okay, great. And then if I could ask another, Power Systems follow-up, just on electric, one of your competitors had cited some weakness I know, you have some tough comp issues that maybe are fading. Is it possible for electric power gen to be up for you guys this year? Do you have an order book that would support that or is it looking a little softer?

Mike DeWalt

Well, a couple of things. One, if you look at our overall power systems business versus that competitor that we’re talking about, thank goodness for rail and thank goodness for oil and gas, it’s good to have a quite vary business, so we have some end markets that are weaker, we have some that are stronger, and we happen to have a very good balance.

So in total, you saw our sales to end users accelerate the three-month moving average from overall plus 2 to a plus 7 in June, and that was a good thing. But I do, there are comments about Power Systems in general, particularly the smaller diesel end of it. We're definitely seeing that in the marketplace. And so, certainly at the smaller end of electric power, it will likely be a negative year. At the big end and the turbine end, we had some really tough comparables in the first quarter that were with us throughout March.

And so year-over-year, that part of the businesses has been a little – comparably a little pressed because we had such big turbine sales in the first quarter a year ago. But on balance, I would say the bigger stuff is a little better than the small stuff. And the competitor that you referred to is probably relatively speaking stronger than the small stuff.

Robert Wertheimer – Vertical Research Partners

Yep, true. Thanks, Mike.

Operator

Thank you. Our next question today is coming from Seth Weber. Please announce your affiliation, then pose your question.

Seth R. Weber – RBC Capital Markets Equity Research

Hey, good morning. It's RBC.

Mike DeWalt

Good morning, Seth.

Seth R. Weber – RBC Capital Markets Equity Research

Good morning. Back to the mining business, you gave some good color on the trends in the truck side. Can you give us – can you comment why you're seeing more in the underground side?

Mike DeWalt

Underground hard rock or underground coal? Underground hard rock has amongst the longest backlog of all of our products. You mean underground coal, Bucyrus underground coal?

Seth R. Weber – RBC Capital Markets Equity Research

Yeah, the old DBT business.

Mike DeWalt

Yeah, that's probably weaker than the rest. We talked a lot about that, I think in the first quarter, where we were seeing some decline there. We haven't broken out on Bucyrus, lot of detail separately in the outlook, but I think the overall sales for Bucyrus this year are going to be lower than we had originally thought, and really for two reasons. One is, underground coals are bit weaker.

Thankfully, we don’t have as much of our business tied up in U.S. underground coal, maybe our largest competitor does, but it’s still going to be a bit of a negative. And on the flip side of that, we’ve now sold four of the distribution businesses to Cat dealers. Those are in our numbers now, and in our outlooks. So that will probably take a little bit off the top line for Bucyrus as well, and that’s baked into our outlook as well.

Seth Weber – RBC Capital Markets

Okay, thanks. If I could follow-up on Europe, on the construction equipment business, can you just comment, did it accelerate to the downside through the quarter, I mean are you seeking trends get weaker there during the quarter?

Mike DeWalt

Yeah, I think it’s probably fair to say. I mean, if you just look at Europe, Africa, Middle East rolling numbers, you’ve seen that monthly get weaker. And I think that’s definitely, that’s certainly been the case in Europe. Europe has moved from – Europe, Africa, Middle East has moved from up to being about flat, and it’s moved that way throughout the quarter.

Seth Weber – RBC Capital Markets

And do you think that, that continues to deteriorate through the year or is that kind of stabilize at a low level here?

Mike DeWalt

It’s – again, we don’t provide our outlook in that, quite that level of detail. But to Ed’s point earlier, we have a decent sales outlook for the back half of the year. We’re not looking for a big deterioration. That said, there are pluses and minuses. We’re seeing for example, better business in Brazil, that’s turning up a bit. And you also would have seen that in the Latin American numbers, it moved from I think down 6% to down 3%.

So, I know you’re seeing that move a little better. It was actually positive later in the quarter. And in fact, our machine retail sales also (inaudible) in June, we report the three month moving average. But from a monthly perspective, June was the best month we’ve had since January, in terms of month-over-month increase. It was one the best months on a volume basis we’ve ever had.

Seth Weber – RBC Capital Markets

Okay. Thanks very much guys.

Operator

Thank you. Our next question today is coming from Ann Duignan. Please announce your affiliation and then post your question.

Ann Duignan – JPMorgan

Hi, good morning; JPMorgan.

Mike DeWalt

Good morning, Ann.

Ann Duignan – JPMorgan

Good morning. Can we take a step back again and look at U.S. construction. Doug, you noted on CNBC this morning that, you are seeing more broad-based recovery in housing starts across the country. Is there thesis out there that the rental channel is secularly going to grow versus kind of a contract or ownership. What are you guys seeing out there right now and Doug, when would you anticipate that your contract customers would start to purchase equipment again rather than rent, which they usually do at the beginning of a cycle. But as we get into the cycle, they usually prefer to own their own equipment. What are you guys seeing out there, and what do you think happens over the course of the next year or two?

Douglas R. Oberhelman

Well, my comments earlier on broad-based housing recovery is relative. I mentioned that I was on the West Coast in California specifically, and I met with several contractors and all of them had for the first time in five years, a subdivision underway. And none of them were massive projects like we saw in the 2000. But it was fairly widespread in that subdivision here, a subdivision there in different areas of California. I was impressed with that but from a very, very small base. I’ve heard that elsewhere around the country as well. I think the housing statistic support that as we look at that. There is no question that rental market, the multifamily is booming I guess in some parts, and I – we can take advantage of that.

I don’t really see our contractor base significantly kicking up orders based on housing probably until at least next year. If anything happens, it will be the transportation spending and some degree of clarity on that through the highway bill we just saw as opposed to the next two and half years, and I would say that, if we see it, when we see, it’d really be spring is too late in this construction season to get much underway.

We’ll see it first in the rental market for sure, and depending on the prospects of the debt cliff and everything else in this country, and how that settles out this winter, that will impact the spring greatly. So I see a couple of those things coming together that could be positive and (inaudible) itself up as some of the politicians are threatening, I guess it would be negative.

Ann Duignan – JPMorgan

Fair enough. And then on the operating side, you noted that material costs were flat in the quarter, should we anticipate or why wouldn’t we anticipate that material cost should not be a tailwind going forward from here, particularly, even if the pricing weakens there, but it’s still a positive, shouldn’t then it be a positive for Caterpillar going forward?

Mike DeWalt

Yeah, and this is Mike. Even when commodity prices were moving up, the impact on our actual material cost was quite muted. If you go back to the first quarter, we were up about 1%. Last year, we went up much more than 1%. So it was – the impacts on those are quite muted and part of that is because – for a lot of our purchase volume, we agree prices annually, we’re not – the majority of our material purchase are not actually commodities. So I think broadly speaking, your sentiment is correct, obviously, the portion of our business, it is commodity related, the pricing is a little bit easier, but I wouldn’t get carried away in terms of order of magnitude there.

Ann Duignan – JPMorgan

Okay. And just a little quick follow-up on that one then. You’re looking at taking $1 billion out of inventory by year-end, what would the target be for days on hand or inventory turns, once we get through all the sales out there, do you see distribution businesses, et cetera, et cetera. What should we be looking at a year from now in terms of the right kind of inventory levels for Caterpillar?

Edward J. Rapp

Anne, if I was going to look out and net out all the acquisitions and all that and look out into 2013 type time frame, something around a three turns would be a place I’d fall.

Ann Duignan – JPMorgan

Okay, thanks.

Mike DeWalt

And that would be sort of – think of it as FIFO, not LIFO.

Ann Duignan – JPMorgan

Okay, thank you. I appreciate that.

Douglas R. Oberhelman

I want to just comment here a little bit on our inventory outlook, run rates, et cetera, going forward. And I will tell you that we are playing the game here on a world that grows maybe anemically, but grows between now and let’s call it the next 12 to 24 months, we are not playing for an implosion, we are not playing for a drop like we saw in ’08. The (inaudible) that we see based on the monetary conditions that exists right now and the easy money flows should loosen up the economies a year from now, what we’re seeing today is, are the effects and impact of pretty tight monetary policies a year ago. These things take time to wind through.

We have only in our dreams arrive at an availability position that we have today where we can concentrate on market share and pricing, which we’re doing. I’m very reluctant to take too bold of a move on inventory in China, because we have seen this China show before many times in the last 25 years. We’ve seen it in terms of an absolute stop in demand for excavators and wheel loaders probably three times beside I’ve been watching China in my career maybe four. And within a year, we’ve seen a recovery sometimes blooming recovery and some just a nice recovery.

We are in a position today where if we miss that and have insufficient inventory with an amount of competition we have there, we will be out of that game and it will be hard to get into a leadership position that we want. So we are watching China very carefully, there is no question we have too much inventory for today's run rate of sales, but again, I’m not at all convinced that a year from now or less or a little more, we’ll see China back on its feet as we have seen so many times in the past. And everybody can argue that this is different in China’s change and maybe it has, but I suspect there will be some amount of recovery, we will be in a position where we have availability and we can build pans in our distribution model that will work for us long-term.

That’s not a dissimilar place where we are with PVCs. We arguably are a bit heavy everywhere today at the run rate, but we are in a position where we finally have availability that we build capacity around that we didn’t have in the last two recoveries around here. And certainly that’s been part of our strategy is to take market share with availability. Our quality levels are as good as we’ve ever seen them, our efficiency levels are as good as we’ve ever seen them. and we now have availability in the marketplace. We’re not playing for implosion, we’re playing for arguable growth maybe anemic, but as I said here today and we look at ‘13 as Ed said is almost got to be better on economic basis. GDP growth in the world, and that’s what we’re playing for.

So well, yes we are watching inventory. Yes, I was very worried inventory turnover, we’re doing all we can with our supply chain and it is on the improving. we don't want to call this the wrong way with too little inventory and I would say, get stuck with too much, so it’s all hands on all levers everyday with inventory and run rate, we’ve got schedules in the third quarter that are very much reduced with maintenance shutdowns, with vacation shutdowns around the world and will manage production to sales that way as well. But inventory levels are important, if we believe the world is going to grow, which we do maybe anemically. I guess that would be my strength around all of that, which is a little late and I apologize for that. but it is something we’re managing, we're being very, very cautious and guarded with both on the upside and the downside when it comes to working capital specifically inventory.

Ann Duignan – JPMorgan

Fair point, Doug, thanks for the color.

Mike DeWalt

Thanks, Ann.

Operator

Thank you. Our next question today is coming from Jamie Cook. Please announce your affiliation then post your question.

Jamie L. Cook – Credit Suisse

Hi, good morning, Credit Suisse and a nice quarter. Two questions, one Doug with regards to the economic outlet, you just sort of laid out and obviously you guys are a little more constructive on 2013 related to what the market is saying, or relative to what your stock is saying. I guess just beyond 2012, and given the environment you just laid out, how do you think about CapEx? I mean do we need to say at this $4 billion number to meet your targets in an okay macro, but slightly weaker than what you’re calling for? And then I guess how do you think about share repo in that context given where your stock is?

And then I guess my second question is, can you just talk about your comfort level with dealer inventory levels outside of China? And I guess my thought or concern would be as I talked to dealers and just given the weaker macro and just given your ability to deliver and given the fact that your lead times have come in. Do you think the dealers can sit there with less inventory than they have been historically, one, because they’re concerned of the macro is weaker; and two, they’re not as worried as they were historically that Cat can’t deliver. They have the actual confidence that Cat will deliver the equipments, they don’t need to sit this much, with this much inventory that you’ve had historically?

Douglas R. Oberhelman

You got a lot of there Jamie; let me take the CapEx one right off the bat. We are on track to get close to $4 billion, but I will tell you also that each of our groups whether it’s construction or resource, or our aftermarket business are looking at that very carefully. We’ve significantly, I’d say delayed. Some of our plants and most of our plants in China for the time being as a result of that market to see how that’s sorts out. We have an aftermarket distribution business that is very antiquated that needs upgraded. And most of the CapEx you can argue is capacity related, but I would also equally argue that it’s cost reduction related, all of the Victoria, Texas excavator plant, small dozer plant in Georgia that we’re expanding to bring production back here. Those are cost reduction activities as well.

Again, we’re playing for growth albeit slight growth. And significant cut backs in CapEx would only hinder us in ’14, ’15, you may have to do it. Sure as I’m sitting here today, if something happens on a macro scale between now and year-end and we have to take actions. We will and we will do it. But right now, we are planning for some kind of growth in the next 12 months to 24 months. That’s kind of around the CapEx, that’s kind of around the inventory questions. I think there is no question that builders are gaining confidence and our ability to supply equipment and our PVCs are at optimum levels. Hopefully that model will work. They will carry less, we will carry more, the chain takes cost out. That’s what we are seeing, but again depending on if we see growth, we’ll have to adjust that model, I forgot what you had in the middle in there Jamie.

Mike DeWalt

Share repurchase?

Jamie L. Cook – Credit Suisse

Yeah, share repurchase.

Douglas R. Oberhelman

Yeah, how could I forget that one.

Jamie L. Cook – Credit Suisse

Especially, the $82.

Douglas R. Oberhelman

I know it’s a little cheap at $82, but having said that we have a balance sheet today with debt-to-debt and cap at 40 and net debt position when we consider our cash and securities at somewhere around 34, 35, and I want to be sure that as we go forward in this very uncertain world, although I have painted it somewhat rosy with anemic growth. Then we have a bulletproof rock solid balance sheet that we never have to worry about our credit rating or dividend, which I don’t think we do. Share repurchase is not on our radar screen today, it’s the last of our priorities. I have said before, I think I’ve said to all of you that I hope in my career, which has a few years to go, I can buy one share back, but right now, we’ve got other priorities and I think we are investing them wisely.

Jamie L. Cook – Credit Suisse

Okay. Great, thanks. I’ll get back in queue.

Operator

Thank you. Our next question today is coming from Robert Mccarthy. Please announce your affiliation then pose your question.

Robert Mccarthy – Robert W. Baird & Co., Inc.

Yes, Robert W. Baird. Good morning everybody.

Mike DeWalt

Hey, Rob.

Robert Mccarthy – Robert W. Baird & Co., Inc.

Jamie basically asked my question, but the other side of that coin is, with valuations to press, they have been recognizing them certainly as well to do with that. How tempted our user try to take advantage of that and may continue what so far it look like pretty successful external investment program, and tell me about acquisition?

Edward J. Rapp

Well Rob, this is Ed. I mean, we played out kind of our cash deployment strategy, and I think you’re going to see us consistently, stay focused on it. We think the number one is the opportunity for growth, we moved aggressively in terms of the acquisition space, we try to do it early in the cycle, because it is easier to integrate as you work through the cycle.

I think on the acquisition front today, our primary focus is what I would describe to slowdown to digest. We feel good about where we are at with the integration of Bucyrus, with lot of work. We feel good about where we’re at in terms of EMD, and Mike talked about the operating performance there, but there's still more work to do, as well with MWM and Siwei. So, I think you're going to see us stay clearly focused on integrating what we have in the acquisition space.

Robert Mccarthy – Robert W. Baird & Co., Inc.

Ed, if that's the case, you're not showing any appetite really to try to reduce the absolute level of debt on the balance sheet. So, should we just then expect to see cash continue, I mean you’re generating significant free cash flow, we’re just going to watch that accumulate on the balance sheet over the next two quarters to four quarters?

Edward J. Rapp

Maybe, and we’d like to get that debt-to-cap gross number, not the net number down into the low-30s. And I think that that types of stuffs to have inflexibility we want in a downturn, for acquisition, for any growth opportunity that comes along. So I would say that the concentration on the balance sheet while it’s generating cash and making sure our poster numbers are at that 25% levels exactly where we would be in the next two years, particularly the level of uncertainly out there.

Robert Mccarthy – Robert W. Baird & Co., Inc.

All right. My follow-up has to do with, I guess disclosure, if that’s the right way to characterize it. but we’ve now anniversary to Bucyrus acquisition, so two subquestions. One, does that mean next quarter, you are going to stop providing visibility into its performances differentiated from the rest of resources? and second, Doug, do you have some plans to maybe quantify the company’s progress towards its existing synergy targets when we see you at MINExpo?

Mike DeWalt

I’ll handle the first part of that.

Robert Mccarthy – Robert W. Baird & Co., Inc.

Okay.

Mike DeWalt

And probably, I’ll handle the second part too.

Robert Mccarthy – Robert W. Baird & Co., Inc.

Yeah. That would be fine.

Mike DeWalt

The first part is yeah, we’ll probably continue to report Bucyrus just as we are throughout the rest of this year.

Robert Mccarthy – Robert W. Baird & Co., Inc.

Right.

Mike DeWalt

They are for example not in our monthly dealer statistics from a disclosure standpoint. and we would plan on doing that for example, at the beginning of 2013 where you have good comparables. So we’ll continue to break it out, certainly for the rest of this year. And in terms of MINExpo, we have an outline of at this point what we’re thinking about in terms of material to share at MINExpo. Since it is MINExpo, it will probably be a little extra emphasis on mining and Bucyrus is a piece of that that we’ll talk about that.

Douglas R. Oberhelman

Yeah. We’ll put some definition around that and beside that our synergies plan and the business case is ahead of schedule as of today. And we’ll talk, we’ll get into some detail on that in the September for sure.

Robert Mccarthy – Robert W. Baird & Co., Inc.

We’ll look forward to that. Thanks Dough.

Douglas R. Oberhelman

You bet.

Mike DeWalt

We have time for one more question.

Operator

We have no further questions in the queue at this time.

Mike DeWalt

All right, well thank you very much everyone. We are happy to report a great quarter and then increase in the outlook. With that we’ll sign off.

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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