Caterpillar (CAT) Management Presents at Evercore ISI Industrial Conference

Caterpillar (NYSE:CAT) Evercore ISI Industrial Conference March 6, 2018 8:00 AM ET

Executives

Amy Campbell - IR Director

Matt Hohulin - IR Manager

Analysts

David Raso - Evercore ISI

David Raso

Thank you for coming. It’s nice to start the conference today with the bellwether in the sector, Caterpillar. So, I know we’re all set to get feedback from CAT and a lot of things. Obviously, the last week has brought a lot of interesting wrinkles to the sector. So, I really couldn't think of a better company to kick off the conference with. From Caterpillar today, from Investor Relations, we have Amy Campbell and Matt Hohulin.

So without further ado, let me turn it over to Matt and Amy and then we’ll open it up to Q&A.

Amy Campbell

I’d like to just make a couple of comments on the year, on 2018 or what do you [ph] like me to start.

David Raso

Maybe just how things are progressing at the start of the year and obviously the, I won’t say elephant in the room, but the issue over the last week or so on price costs, with tariffs and so forth, how the management team is thinking about it would be great?

Amy Campbell

Yeah. So I think as everyone knows, 2017 ended what had been the toughest downturn in the company history with sales down for four years. 2017 turned that around, all three primary segments’ sales up. We started the year seeing strength in China, strength in onshore North American oil and gas and we started to see mining equipment get put back to work. As the year progressed, that strength in the construction market moved into North America and also continued to expand in other parts of the world. I’d say still some areas are soft and I think it starts getting worse, but if we look at, say Brazil or the Middle East, those are still areas I think that have some room to continue or maybe are still challenged is the right way to describe that.

The resource industries, as I said, we started to see equipment get put back to work. As the year started, we really started to see aftermarket parts sales increased to support overhauls and rebuild and the equipment, just putting in a lot more hours about mid-year. By the time we exited the year, we started to see new orders and sales for new equipment. And for energy and transportation, the story was primarily around North American onshore oil and gas and a lot of that has to do with really two areas, continued strength in gas compression for solar turbines, really a surge in demand for reciprocating engines used in gas compression applications, as the wells coming out of -- mostly out of the Permian Basin have a lot of gas and that gas needs to be captured and sent to gathering stations. We really saw 5, 6, 7 times increase in the reciprocating engines used in those applications. And then also started to see a lot of parts demand again for overhauling well servicing rigs that are used to service wells and get the oil out.

David Raso

Can we talk a bit about how is management thinking through the rising steel prices we've seen and when it comes to pricing moving forward, how do we think about the response to that, and maybe some of the fundamentals behind where you purchased the majority of your steel and some of the quantification that we try to run through.

Amy Campbell

Yeah. You have to keep me answer all the follow-up questions, but as we put the outlook together that we came out with in the fourth quarter, we were clear that we thought steel prices would go up this year. 2017 saw the first year in about three of rising material cost and with that, it was actually still quite light. So in the first half of 2017, material costs were flat. In the back half of ’17, material costs were just slightly unfavorable and really very slightly unfavorable.

We saw that continuing into 2018. And as we commented in the fourth quarter outlook, we believed that we could get enough price realization to more than offset that -- slightly more than offset that. So, we do think that there is some pricing power in the marketplace right now. Certainly, demand is high. Availability is tight across the industry. But we are seeing some material cost increases. Now with the news last week, that put some more pressure on material costs. I think we’re continuing to assess the impacts of that and how we would respond.

David Raso

The, I think maybe putting in weeks or months or quarters, what percent or what lead time do we have on costs that are already somewhat locked in for CAT when it comes to work in process for raw material inventories and where you've lost it on any contracts for purchasing?

Amy Campbell

Certainly, it really depends and it is extremely complex, which is why it’s a difficult question to answer. I mean we have steel that we buy for our factories; we have steel that we buy for suppliers, so that we can leverage our steel buys to get the lowest cost. We have steel that our suppliers buy for themselves or will be with their own challenges. I would say that generally speaking, we would tend to have, in most cases, probably three months for sure locked in, I think in a lot of cases, three to six months locked in.

It has a lot to do with – it’s really where steel prices are. That's one of the reasons why we were able to offset a lot of the steel prices to date as we had a lot of long contracts enabled us to avoid the impacts. We have the ability to move a fair amount around. We are a big purchaser of steel. So, I think one to two quarters is a pretty general rule of thumb to think about how much steel cost protection we would have.

David Raso

When I think about your machines being on allocation with -- in a way being able to cherry pick a little bit on where to sell and so forth, what does that speak to in the sense of if you have say a three plus month window to start to digest eventually higher input costs, how quickly do you think you can pass that on or maybe even more than just pass it on, given the position you're in on lead times being long and machines on allocation.

Amy Campbell

There are certainly lots of levers to pull to try to offset that. I mean we always have merchandising programs that are -- some of them are more fluid than others that you could start to pull back on if you needed to, to offset price. There are opportunities to take price increases if that's appropriate. I think if we're thinking about timing, I think that there probably would be some misalignment. It's probably a quarter and probably no more than a couple of quarters if that's the path that we chose to take. If we felt like that was appropriate that the market could absorb those kinds of changes, I think you get everything probably in alignment in three to six months.

David Raso

I know it's a hot topic for a lot of people. Anybody like asking questions on price cost or import tariffs? Well then, we’ll get back to it later then. On the demand profile, obviously, we know from the backlog implied orders, demand has been pretty robust. Anything you're seeing incremental or even detrimental in the demand profile be it geographically, be it maybe some form of impact of tax reform or deregulation showing up as we move a little further into the year.

Amy Campbell

I think the deregulation and tax reform certainly are positive for the US economy and a positive for our end markets. Demand very strong as you mentioned David coming into the year. I don't know that we have seen a measurable change for those things, but certainly I think that there -- that they may, I think in best case scenario, push out the length of the cycle and again things are very strong. Those largely impact construction industries, which we have on managed distribution, which means we're managing the intake of orders. So it's a little bit difficult I think to take the temperature on exactly where we're at.

I was with Bob De Lange who is the Group President of our construction industry segment last week and he was telling investors and myself about the Beavers Conference at the end of January I believe that he was in attendance, the largest 2000 contractors in the United States, many of them talking about how having the largest backlog they've had in years, a lot of optimism taking place. So it certainly continues to be optimistic there. I think we all read the latest research on mining, which continues I think to look favorable. If oil prices continue to stay above $60 a barrel for West Texas, that’s I think a positive at this point for North American oil and gas. So, I think there's a lot of signs out there that continue to be -- continue to show a lot of strength.

David Raso

Obviously, China always gets a lot of scrutiny and China with the Chinese New Year swing from this year February, last year January and then you get a lot of noise around the January, February data, any update in particular related to China?

Amy Campbell

Yeah. I haven't seen the Chinese numbers, maybe, I think actually Matt must be on email, I didn’t get yesterday. So, there is certainly a lot of excitement. I think the sales numbers were up well over 100% in January. They were down a little bit in February, but keep in mind that the Lunar New Year was in February, not January like it had been in 2017. So, there is I think first of all some comp issues that you have to be a little bit careful of. The other thing I would say is the China market, much like in some ways the US market, they have some uniqueness, but that selling season is really March, April and May.

So we won't be able to really assess the strength of the Chinese market until we get really kind of halfway through the second quarter or maybe I think March will put a good temperature on it. So I wouldn't put a lot -- I think regardless of whatever the numbers were in January, February, we’re going to put a lot of weight on that. I think March is the month that will be very important than April and May as well. As we look at the Chinese market, we continue to see strength.

We originally thought that we would see some softness in 2018, but we now have the market up 8% for the full year, reverting back to more of a normal seasonality where 60%, 65% of the sales are in the first half, 35% to 40% in the second half. Last year, we actually saw sales accelerate all year, which was extremely unusual. So, a lot of strength coming in. We do think that the fundamentals in the Chinese market, number of excavators being sold is a little bit higher than we would think it needs. And so we continue to keep an eye on that. That market can change pretty quickly on a dime and so we need to be ready to respond if that happens.

David Raso

And sort of going back to the pricing power question, the way you’re able to secure component supply and simply ramp up at your facilities, there's always some seasonality in how the dealers handle their inventory, but at this stage, is inventory increasing? Is it loosening up a little bit or are we, as on allocation now as we were 2, 3, months ago?

Amy Campbell

Yeah. I mean, as we talked about in the fourth quarter call, we would expect that dealers will build inventory in the first quarter as they traditionally do to prepare for the spring selling season and so we come out of the fourth quarter with a high production rate, continuing that in some products, continuing to expand that like the 3600, but sales demand, especially in January and February almost always tend to be lighter in the colder parts of the world. And so that gives an opportunity for the dealers to build that inventory and we would expect that to happen this year as well.

David Raso

Can we document exactly why we did not give sales guidance? I get that question. Why would they do that?

Amy Campbell

Why would we not give sales guidance? If you go back and look at Jim’s strategy that he rolled out at Analyst Day, the goal is not just growth. It's profitable growth and really pushing the business to grow profitably. And I think in the past, maybe a couple of things, maybe too market share focused when it wasn't always profitable market share and also -- and I think important maybe in our historical performance when the markets turned around, everybody took a breath as that being focused on cost control and on continuing to move the strategy so that we could have the things in place that we needed for the next cycle. And so Jim’s focus is really on continuing to deploy the strategy.

When we talk about margins and margins continuing to expand and even hitting some of the margin targets that we talked about in Analyst Day on much lower sales and much sooner than we thought they would, so a focus on -- it continues to be a focus on margin expansion, on profitable growth. But I think you want to take that focus off of just sales and just be in the cyclical company where it's all around the industry and really push back the importance of growing profitably for the long term.

David Raso

I’m trying to think of a day like today with all the companies here, the companies we split maybe in two buckets, ones that might be want to forego some demand, demand is rather plentiful, but they're going to [indiscernible] and other companies that market share or whatever may be, about truck market where it's not going to give up an ounce of share. Do we take that approach to guidance this year and obviously the way Jim articulated margins at the Arizona meeting as, you’re not looking to give away share, but the margins, priority one for Jim this year more so than revenue?

Amy Campbell

I don't know that I would -- I think that profitable growth, which we define as OPAC or operating profit after capital charge is the way that Jim thinks about growing the business and a short term focus on incrementals that’s too short term or just on sales growth can take away really investing in the things that you need to do for long term operating profit growth. I think specific, in answer to your question, what the O&E model does, the operating and executing model does that seem simplistic and obvious, but is actually somewhat difficult and the company is speaking global with Caterpillar to execute is, it is not about not growing, it's about growing in the most profitable places.

So it's about having the granular data to know where your profit pools are and to take away investments in those less profitable pools and push that to your more profitable pools. So, it is all about growth, but it's about investing in the most profitable growth, which is why you see a segment like construction industries who started deploying this five, six years ago, able to deliver 17% operating margins last year on 19 billion in sales when originally thought they'd be able to do that on 21 billion in sales and continuing to expand that as we move into 2018. And so it's -- I wouldn’t say it's about walking away from growth. It's really about placing your dollars, and you’re growing where you're most profitable and you really get huge leverage on your margins when you do that.

David Raso

Speaking of investing in capital allocation decisions and so forth, the update on the CFO search. The other day the date of Brad stepping down was pushed to a later date. Can you give us an update on why that is?

Amy Campbell

Yeah. I don't have a lot of inside information on that. I do know that the search continues. It’s an extremely important position as we can all appreciate and we're just making sure that we do it right.

David Raso

Good enough answer. Thank you. [indiscernible] through then where we stand with Jim and also the CFO selection might shed some light, but the company is obviously in a very strong position financially. Jim's focus, I would argue a little more on margin than maybe prior management a little more focused on share. How do we take that thought process in to how to allocate what should be a lot of leverage you can put on to the balance sheet from where it is on the equipment company, besides the incremental cash flow?

Amy Campbell

Yeah. We're currently updating the capital allocation and cash deployment strategy. We'll have more to share first quarter results in April. I think with that, I think the fundamentals aren't going to change all that much, which is continue to be focused on the strength of the balance sheet, important with Cat financial and the Finco that we have a strong balance sheet and so that's where the focus is. Growth continues to be our second focus. Growing, we've been pretty transparent though that we don't think we need a lot of bricks and mortar and facilities in order to continue to grow sales. We think we have more than enough capacity for the foreseeable future, which is a hard time to quantify, but I do sometimes remind people that in 2012, when we hit 66 billion in sales, we spent over $3 billion in capital that year.

The next three years, we’ve spent another $6 billion in capital. We're now averaging about 1 billion a year. So we spent a lot of capital at the top of the cycle and actually for a few years past that, and at the same time, implementing lean, which gives us a lot of organic capacity. So we believe we have all the capacity we need, so it's not going to be a huge capital need going forward. M&A is always important, but it's finding M&A that fits our strategy that has the right return to shareholders, which is actually a lot harder thing to do and I think we sometimes appreciate.

We've had several deals that we're proud of in the last few years, but they are small. A rail business, just recently acquired two services business, one in Australia, one in Italy that continue to expand their progress rail service -- services about 16 months ago, we bought Kemper Valve, which does flow wire and for well servicing applications and other expansion of that -- coverage of that market that we're proud of. Those are the kinds of things I think to think about going forward where our M&A activities will be, although I think we're always looking at everything and we'll be opportunistic if something comes up. And then after that comes returning capital to shareholders and we continue to look at that and figure out what makes sense as we move forward.

David Raso

Anybody have a question? Well, I know I have a question about the incrementals for ’18. CI was obviously a nice surprise last year. There was absolute margin levels. You would think that would be a tough business to provide significant incrementals on, given the comp, but maybe I'm missing something that there's a next leg to the profitability there. Resource industries you would think would maybe be a lead, but we know that industry as much as volumes coming back still, a lot of overhang capacity from last super cycle. So pricing is a little maybe less robust than you think. Can you take us through the three segments on how to think about incrementals for ’18? Don't smile. I asked that --

Amy Campbell

I don't give incremental at a consolidated level, will I break it down by segment?

David Raso

I can do the math if you give me all three.

Amy Campbell

If I give you all three, you can handle. I'll try to help, probably not specifically to the incrementals question, but maybe walk through the three segments and provide some color that may or may not be helpful. So construction industry, as I said, 17% operating margins last year and we said that all three segments will see growth and improvement in operating margins in 2018. And so that'll put construction industries above that range that we came out with at the Analyst Day. I think a way to think about that, the closure of the Gosselies, Belgium facility really not completely realized last year.

We came out in the 10-K, 250 million of savings from our restructuring plans this year and so there do continue to be some restructuring savings impacting really construction industries most notably in 2018. Some of the other restructuring actions kind of more back end loaded will impact resource industries that would probably propose next year. So, a lot of good activity going on in construction industries. As we were with Bob, I mentioned last week meeting with investors, really talked about his goal. Last year, he was able even with sales up I believe 20%, I mean I have that number perfect. The costs were flat and that's certainly a challenge he set for himself out there. So, we moved into 2018, almost able to pull that off, but that’s the kind of mindset he is thinking about.

Resource industries, certainly coming off of a much lower base than construction industries. I honestly don't even know what their incrementals are. So as I talk about this, it's not with those numbers in my head, but one of the things to think about resource and as we did talk about continued expansion of their margins, I think that makes -- certainly makes a lot of sense at this point in the cycle. Probably some mix impact however as we move into 2018. As I mentioned, when we kick off a lot of aftermarket parts activity, really strong growth last year and this year, that growth will be more weighted towards new equipment.

Still strong aftermarket parts activity, probably still some growth, but much more measured than what we saw last year and that most of the strength will come from new equipment and so that will put some pressure on incrementals. That said and I think sometimes, there's some confusion. We're not in a razorblade business, especially resource industry. So there still are good healthy margins on new equipment. They just typically -- and even this isn't 100%. Just, they typically are as strong as aftermarket parts. And then energy and transportation, they continue -- really continues to be a story of North American onshore oil and gas. I think you’ll see a lot of -- 2018 probably not look too dissimilar to 2017 and that's going to be transparent, not having those numbers in my head as to what their incremental are.

Matt Hohulin

I would say too David, on all three segments, in 2018 and beyond, we’ll be looking to continue to invest in our product. So some of the tailwinds you might get from restructuring and even short term incentive pay will be offset by very specific and targeted investments on digital, on a new product for example. We just introduced the next generation excavator. We'd expect that to continue to broaden as well. So those are the types of things will offset many of the benefits we’ll get on the obviously on the variable cost side.

David Raso

And some of the businesses that have been at the low ebb, but could provide decent incrementals on the way up. What are we seeing from the rail business, I mean locos are still pretty tough, but some of the service end of the business, some of the rail car and also on power gen and marine?

Amy Campbell

Yes. So to start with rail services, so, you're exactly right. The locomotive end still continues to be challenged and we would expect that to still have a year or two or so left of a challenging environment. We talked about transportation being up slightly this year. That was mostly on those couple of acquisitions that I talked about. Progress rail largely tracks with rail traffic and so I think that’s the best indicator to look at where the strength will be for progress rail. If we see a robust environment with increasing rail traffic, I think that would be a positive for progress rail.

Marine continues to be pretty challenged. A lot of that business supports offshore oil and gas and that continues to be a pretty challenged market. Powergen slightly. Some of that is coming from some large projects, two that come to mind in Indonesia and Bangladesh for some prime power in the developing world. But it has also seen some strength and data centers in the US and in Europe and some of that, that marketplace changing a little bit. So some good backup power in that regard, continue to see challenges though. It's in other parts of the developing world that the Middle East, parts of Africa that their economies are still challenged. So I think I covered all three.

David Raso

When it comes to Cat Financial and we can all debate where yields are going and so forth, but how should we think about either book of business right now. The past dues were a little more heavily weighted in to LatAm. LatAm is getting better. So the provisions are already pretty low, but is that an area of potential upside, but how to think about the business right out, the book they have and also the yield environment.

Amy Campbell

Yeah. When we think about Cat Financial, I will say generally speaking without any kind of shock in the system, we tend to think of them as a pretty steady as it goes, reliable generator of pretty steady profits that actually help dampen some of the cyclicality of the machine business and that's how I would think about Cat Financial as we move into 2018. As you mentioned, some of the weaknesses in LatAm, hopefully some strength in that business will help that past due book, but generally I would say, they are in really good shape. They continue, the strength of the North American construction market, which is a big part of their portfolio, good for their business.

We are seeing -- one of the ways to think about Cat Financial is about a four year book of business. So, you're seeing some good years and ’13, ’14 drop off and we're starting to have some good years pick up and so I think there's some real stability there. When it comes to spreads, Cat Financial really manages their risk profile so tightly that you may get a quarter or so of mismatch in spreads, but they're really pretty quickly going to hedge their exposures, so that you're not going to see much impact, at least in this environment, which is pretty stable I think from –

David Raso

[indiscernible] maybe the leases come off a little bit and there's more purchasing than –

Amy Campbell

It could be and if they finance to Cat Financial, I don't know if that would have too big of an impact on the bottom line. We have not seen, I know some others have, but if you go back five, eight years, the percent of their portfolio that leases has really been very steady and has not moved very much. And so we've seen very steady lease activity by our customers over the last eight years or so.

David Raso

Discussing tax reform, what behavioral changes have you seen if any at all since tax reform and to end markets?

Amy Campbell

Yeah. I've asked that question a lot and what I get is I don't feel like anyone is sensing an immediate change in our customer base’s activity. Like I said, we started the year, I mean I guess, we had the tax oriented end here. But we ended ’17, we started ’18 with a very optimistic construction and market activity. And so how do you measure an increment on top of that optimism I think is difficult. It may be there, but what's driving it I think is hard to take a ruler and figure out. So, I think what's important is that end market continues to be very optimistic, backlogs for some of our contractors are at all-time highs. Is that because of tax reform or deregulation? I think that's hard to measure. It could be, but we do continue to see a lot of strength in the end market there in North America.

David Raso

We have mics, so anybody would like to ask a question? We've got Cat in front of us and we just had import tariffs announced by the President. Come on.

Amy Campbell

Early. See, I told you. It’s too early.

David Raso

I know there is only so much you can say, but back to the idea of, on allocation, Jim's about investing profitable growth and so forth. How should we walk away from today with, Cat obviously has say more pricing power than the average -- than the average player in the industry. Inventory is low. It doesn't sound like besides normal seasonality, it's not like always on the floodgates are out in Lafayette or you name the factory, inventory is going to be pretty tight on a seasonal perspective even the end of March and June.

How is the management thinking about and you said if the market will bear, there is some pricing power out there. Is there any reason to think with inventory low, lead times long, your position in the market that you would not be able to pass along. These steel price increases be a plate hot rolled. The last week obviously, we've seen a pretty unique spike in [indiscernible] $100 a ton, just making sure we are understanding the position you're in?

Amy Campbell

I think that the marketplace right now, given the strength and as you said really availability has pushed out for us and most of our competitors, there's a lot of optimism, there's a lot of demand that if there were good market conditions or in those good market conditions right now and so I think that's a favorable, but price increases are always a function of your competitive environment. And so are competitors going to be willing to use the tax reform benefits to try to take market share or keep prices down, I don't know, I’m not sitting in those boardrooms with those competitors.

So I think that there are -- our ability to take price is a function of what the entire marketplace allows and where the marketplace goes. I think it is an environment, a much more favorable environment than maybe it was two years ago for pricing action to take place across the industry, but again, we're just going to have to see and feel out I think where the market goes, where these tariffs ultimately go. I mean they're still being finalized. We’re just still trying to assess the impact. So there's still a lot of unknowns. But to your point, the fundamentals are certainly more favorable at this point than they were a year or two ago.

Matt Hohulin

You almost have to look at it end market to end market too, right. So if you think about resource industries for example, it’s two big competitors that are planned for the same guy and although there's of course some ramp issues as we gear up our factories, there's still quite a bit of capacity out there for both of us to go after that market share. You think about locomotives, kind of the same thing, you've got 12%, 13% at locos in North America right now and that’s a pretty competitive place. So it's going to be end market by end market that we’re going to take a look at how we price and what we're able to accomplish.

Amy Campbell

Yeah. Because I think my comments have largely been around North American construction and thanks Matt for clarifying. I think when you look at resource industries, which again industry wide capacity for that is still very -- there's still a lot of capacity left in those end markets. So what will be the competitive pricing action to try to grow share I think is not an easy question. Everyone still wants to fill up their factories, so that will be a little bit. Locomotive still challenged. So it is – I mean as we talk about where are the strengths in the market, there's probably more pricing power where markets are still weak. There's probably not as much pricing power.

David Raso

And the mechanics that we should see and what meetings you’ve set in the last couple of weeks on this issue internally, will this be just general price increase, surcharge, selective, just pulling a few program discounts here and there. I'm just curious just given the uniqueness of this?

Amy Campbell

Yeah. I mean I don't know and I don't get to sit in those executive office meetings, like get the downloads. I would say from what I know is that we're still trying to assess the impacts and we're still assessing and talking about what makes sense going forward. And so I would say that no decisions have been made yet certainly.

Question-And-Answer Session

Q - Unidentified Analyst

The legacy Bucyrus businesses, is there any difference in the trajectory of your recovery versus say truck, is it behind, is it ahead, is it in line with that?

Amy Campbell

I think a way to think about that is to think about the size of equipment. So the largest the draglines, the big equipment certainly not coming back as quickly as the mobile equipment, a much smaller equipment and so you're seeing demand on the smaller equipment side. I think across the board, even if you talk about off highway trucks versus large mining trucks, you're seeing a lot of strength on the smaller size and I would say underground mining also probably actually started the turnaround first for new equipment. We started to see some strength there at the back end of 2016. And so to the extent that some of that was the legacy Bucyrus equipment, but all in the smaller side, so it’s really a -- I would say it's really a message of the size of the equipment, not smooth the manufacturing of equipment that was a decade ago.

Unidentified Analyst

And has the aftermarket stabilized there or is it -- did it jump up after the initial move up in ’16 or is it still kind of trending higher?

Amy Campbell

I don't have the split out in aftermarket kind of in that vein. We don't have two different businesses anymore. I mean just generally speaking, aftermarket kind of stabilized in ’16 and then really was very strong in ’17 largely recovering some of the weakness we've seen in the year prior. So, but that's across all products, I don't have it split out specifically by model or anything.

David Raso

We still have 120 seconds. All right. Well, you get the morning slot. You got off easy. I want to think Caterpillar for kicking off our conference. Thank you very much, Matt and Amy. Appreciate it.