Caterpillar Inc. (CAT) Earnings Call Transcript & Summary

Okay. Good afternoon once again, everyone. I'm Jerry Revich from Goldman Sachs and really pleased to have with me Andrew Bonfield, Chief Financial Officer; and Jennifer Driscoll, Investor Relations Director. Thank you so much for joining us.

Thank you, Jerry.

Andrew and Jennifer will step us through a few minutes of prepared remarks, then we'll go into Q&A. Andrew, Jennifer, the floor is yours.

I'd just like to mention we may make forward-looking statements this afternoon. They are subject to risks and uncertainties. And for a complete list of those risks and uncertainties, please refer to our 10-Q and 10-K available on our website. Thank you.

Thank you, Jennifer. So for those -- just to give you a little bit of background about Caterpillar, for those who are joining us. Obviously, when you come to some of our CONEXPO, you really do see how iconic the brand is, Caterpillar. We obviously now are in a situation where we have about 1 million connected assets globally, and technology is a big part of what we've been talking to customers about at the show this year. Overall, our strategy is determined by the Operating & Execution Model that has 3 key things to it to drive profitable growth. Profitable growth is to increase OPACC dollars over time, absolute OPACC dollars over time. Those 3 elements are operational excellence. That really has been a focus of actually making sure we improve operating margins by between 3 and 6 percentage points through the cycle versus where they were in the 2010 to 2016 time frame; taking out about 25 million square foot of factory capacity; reduce structural costs by about $1.8 billion, which is a key part of what we've done to improve the overall structure of the business. Same time, we continue to work on expanded offerings. We've launched 13 GC models. Now we have another 15 or so in NPI, or new product development, which is about trying to make sure we give customers the options of having a slightly less-configured machine to actually -- to meet some more of the utility needs that they may have in their workspaces. Those GC machines, there are some, again, on show here in CONEXPO. Same time, we're focused on services and driving services revenue. As we disclosed at the year-end, we generate -- just services revenues in 2019 grew by just over 2% to just over $18 billion. Our aim is -- the target is still to drive -- to double services revenue to $28 billion by 2026. We believe this is the single biggest organic growth opportunity that we have and is one where we are really focused on making sure we can deliver those targets. And connectivity, as we talked about a moment ago, is a key part of that strategy, actually to make sure that we connect the machines, connect to the customer to help drive those service opportunities. As you know, last year, we generated sales and revenue of just under $54 billion. We expect '20 -- when we gave guidance in January, we talked about the fact that we expect our end-user sales to users to be down between 4% and 9% in 2020. And at the same time, we expect revenues to decline as a result of destocking by dealers between $1 billion and $1.5 billion as we go through 2020. Overall, though, cash flow still remains strong. We talk about cash flows being between $4 billion and $8 billion through the cycle. That cash flow generation is strong even in down years where we do expect to actually have working capital inflows, which will help mitigate the low operating profit as we move into 2020. So what's here at the show? There's a lot of things. Actually, the highlight of the show was our global operator challenge. This was where we had 10,000 operators around the world competing in a challenge -- set of -- series of challenges as they operate machines, be it an excavator or the mini ex. HEX was part of that as well. But based -- and also bulldozer, but doing certain activities. That is out on the fairgrounds. It's webcast, for those of you who would like to see it, but -- including things like taking a golf club out of a golf bag and actually going through an obstacle course and then putting the golf club back in the golf bag. That is what these guys are able to do. It's on the -- we have about 60,000 square feet of booth out there. It's really worth going to see. And obviously, a lot of that is online as well for those of you who aren't able to make the trip. We actually had the winner interviewed in this morning for -- we do an employee segment each quarter and he came from Canada, Jaus Neigum. Actually, it was a really, really interesting -- so he's the first-ever winner of the Cat Global Operator Challenge. But also out there, we're having a lot of demonstrations. And actually, just before I came over, I would say we were doing a technology demonstration and is packed out. So it is one of the good features for us has been the success of that outdoor arena and outdoor facility where they're actually doing product demonstrations, things like the next-generation excavators, which we're showing 5 here. The show -- the 313 GC model, which is, again, part of that GC line; the 315, the M318, the 325, and the largest of all, the new 395, which has a very strongly reinforced [ boom ], which, again, is out there on the grounds to be seen. So again, much more productive machines, again, and continuing that next-generation launch of excavators as we move out. So as we look into -- look last year, obviously, I talked about sales and revenues. Operating margin last year was up 20 basis points to 15.4%. I mentioned the services revenue. The 3 segments, obviously: Construction Industries last year had a record year in terms of revenues of $22.6 billion, 17.4% segment margin. Resource Industries had sales of $10.3 billion, still significantly below its last peak, at a 15.9% margin. And Energy & Transportation had sales of $22.1 billion with a 17.7% margin. So with that, why don't just move into Q&A? And Jerry, I hand back over to you.

Thanks, Andrew. Yes, I'm told that you folks had a Cat executive operator challenge where you had a pretty strong showing. Must be some -- [ with operator ] features there.

Yes. I was very pleased to say that I won the bucket challenge, and I had the largest load in the bucket on medium wheel loader. They actually allowed me to get loose on a machine which -- and I managed not to do too much damage. So that was the most important thing.

Great. And out of the [ pull-through ] what really jumped out is the customer value agreement push. Can you talk about over what time do you think you could scale that? How meaningful could it be? Talk about the financial products tie-in.

Yes. So the CVA product we're talking about mostly actually relates if you think about BCP machines. That is the highest-volume machine generally sold to a person who has up -- maximum, probably 3 machines in their portfolio, in their fleet. And the challenge often with those customers is the fact that we lose contact with them. So connectivity, which is obviously a key part of the digital strategy, is a key part of that. And then also offering them a CVA as part of that to actually maintain that customer touch point is really important. We've been going through some pilots this year with a number of dealers. And we're starting to see actually increased penetration, the CVAs versus the old product we used to have before. That penetration has almost doubled in those areas. So again, starting to see some success. A long way to go to clear victory, but we do think it's a great opportunity for us to continue that customer connection. And the interesting thing in a lot of those small machines is they do change hands a number of times during their working life. These are machines that probably have low-volume hours on them and, therefore, may actually be in operation for a number of years and actually through a number of different operators over that time period. So again, the CVA push is part of making sure you have those deeper customer connections. And financial products, obviously, is key part of that because you'll do that in conjunction with an extended warranty, where we've been doing those through Cat Financial for a number of years. And Cat Financial can help make that -- effectively, by doing the contract, the CVA contract with Cat Financial, it becomes portable and transferable. So it's portable from one dealer network to another, and it's also transferable from one customer to another. So again, that's all part of this push to ensure that we actually do keep those deep customer connections over the years.

And in terms of the doubling in the take rates, are we talking from 20% to 40%? Or can you...

No. Lower than that. It's a lower percentage rate than that. But I think what it is, is it's about starting that process and getting bigger uptick. Obviously, in the big -- one thing about CVAs, not one size fits all. So remember, for a large mining customer which has very high utilization, effectively, the CVA will -- you'll have a very strong association contract with some of our large mining customers. And that will vary down. As we say, this is principally aimed at the small equipment where we actually have had very weak penetration over the years.

And in terms of your business structure today compared to the last 2 periods of meaningful slowdown in your end demand, can you talk about the most meaningful differences and your expectations for your performance in this cycle? We'll try to have that conversation without decremental margins.

Yes.

Thank you.

I said try.

Obviously -- yes. I mean one of the things -- having taken out significant amount of fixed costs through the last down cycle. What that does mean, obviously, is leverage works much stronger on the way up and obviously much more negatively on the way down. What we are focused on is the absolute level of margin. So that's why we talk about the 3 to 6 percentage points improvement in the margins versus the 2010 to 2016 point -- time frame. Obviously, if you think in that range of 3% to 6% and probably you're more towards the top end of the range when sales are increasing because you're getting the benefit of volume leverage. Obviously, if you're in a downstream, you are going to be at the bottom end of that range as you think about the margins target because, obviously, you don't have as much structural costs to take out. And also, you don't necessarily want to rip the heart out of the business. One of the things we're trying to do better at Cat is about resource allocation and making sure -- historically, what would have happened is if you went into a down cycle, cuts would have been across the board. We are still wanting to invest in services and services growth. We're still wanting to invest in new product development. So all of those are -- we'll -- obviously, you will have some impact in the downturn, but we'll try and mitigate that impact as possible because if you think about the O&E model and that whole concept of growing OPACC dollars, you want to be in a position where you can take advantage of the next cycle. So again, it's that balancing act, but it's absolutely. The other thing, which, again, we just keep reinforcing is around the cash flow and the fact that we are able now to expect to generate $4 billion to $8 billion of cash flow -- free cash flow through the cycle. That enables us to grow the dividend. As you know, last year, we grew the dividend by 20%, the quarterly dividend. This year, we expect to grow that for the next 4 years. We expect to grow the dividend by the high single digits percentage even though we are in a slightly negative turn. Even that, by the time we finish, we think the dividend will represent between 50% and 60% of free cash flow in a trough scenario. So again, that shows how that strength then enables us to be in the market on a more consistent basis for share buybacks.

And on that note, it's tougher to pull the trigger on corporates generally, on the buyback program when you're in an environment like this where visibility is low. It's a lot easier to pull the trigger when you're generating record free cash flow on the upside. Can you talk about your willingness to have a consistent buyback program without getting caught in that trap of buying back the stock in its highs and not buying back in its lows?

Yes, yes. So I mean one of the things -- we do expect to have much more consistent cash flow. And what we've said is we will return substantially all free cash flow to shareholders. So that means we -- and we do have a very strong balance sheet. As you know, we had about $8 billion of cash at the end of last year and virtually no net debt out in the ME&T business. So very low net debt. That gives us a very strong position to operate in even if we do move into a downturn scenario. So that does give us that flexibility, but it does mean we will be much more consistent. It's about being that consistent. I think it's more important, Jerry, and that's what the policy is designed to do, which is to just be -- to be in the market and not try to second guess. We do, do mixture of what we call an ASR program, accelerated share repurchase, plus then we have a grid scheme, which does enable us then to buy back at different stock price levels based on market conditions. So we look at that and base that around things like intrinsic value. But that does not necessarily -- it means that we will be in the market on a more consistent basis. That consistency is really the key for us.

Yes, Dave?

David Raso. A kind of open-ended question just with the recent situation with oil prices and obviously the virus. Inventory reduction this year has been a key focus in the targets. How have the recent developments impacted how you're approaching hitting those inventory targets?

Yes. I mean, David, I would say, we obviously continue to make sure we're flexing production to meet end-user demand. And we will have a new set of retail stats out tomorrow, which will give you an idea of where demand is. End-user demand is a key factor of us -- for us. And as we've said, we expect -- we would like dealers to be in a situation by the end of the year, although dealers are independent businesses and they make their own inventory decisions, where they do not need to see further destocking as we go into 2021. We want to be in that position. So obviously, what we'll need to do is we'll need to continue to monitor the situation as we go through the year, continue to flex our production, either positively, slightly optimistically or negatively, depending on market conditions, both with the aim ultimately of actually starting 2021, we're in a really good place from an inventory perspective. Obviously, that depends on what the outlook is for 2021. By the time we get there, we'll have a better position on that. So that will also finalize the final view as to what the nventory is. But let me just be very clear. It is still our intent this year to take down the inventory levels to a more lower level of debt. We do have a range. We expect dealers to be within -- to a lower level in that range as we move into 2021. So we're not in that situation as we move forward.

So is it fair to say that's the main priority? As much as retail flexes up or down, your ability to get that inventory out is sort of priority 1 to set up '21 -- 2021...

Yes. And obviously, what you also have to weigh up as you think through that is the costs of changing production schedules. So you just have to balance that slightly out, but we expect to be there or thereabouts as we go through the year. We would not expect that to be materially different from the number just because of changing external circumstances.

Yes, [ Adam ]?

Could you talk a little bit about OPACC PV and how the organization is using OPACC PV and incorporating that with the OPACC mindset that the business has used previously?

Yes. So let me try and explain. Obviously, OPACC, which is operating profit after capital charge, we also measure something called OPACC PV. And OPACC PV takes into account the present value of future parts sales, services revenues relating to that equipment. And why that is important is because what you're trying to measure is the aftermarket impact as we go forward. So one of the challenges on a pure OPACC basis is often, if somebody comes to you and says, a third-party supplier says we have a great opportunity to reduce your costs of a -- let me take a piece -- a hose by 35%, and that's a cost saving for the product manager, he could look at that purely on an OPACC lens and say that's a good thing to do. However, when you look at the potential aftermarket impact because if that hose manufacturer is in competition to sell hoses in the aftermarket, what will then end up happening is they may cut their price for their first fit and then actually take away the aftermarket away from you, taking away thus the aftermarket opportunity. So that's why we measure PV as well so that when we're making those decisions, we are looking at the right decision versus just not necessarily that "outsource at all costs" decisions. So that is why we do the 2 measures. And it's to help try and make sure that when somebody is thinking about something, there is -- the impact of future services revenue is bought into the -- taking into account in that decision-making process. And that is something that we look at from -- when we're doing NPI, new product introductions, when we're doing what we call our green books, which are investment proposals. All of that is built into that so that we can actually look at that and make sure we're making the right trade-offs because ultimately, at the end of the day, there may be times when you're looking at a part for a component, for a product, where you'd say, actually, it makes sense to outsource because it's not necessarily -- say, for example, cabs, where there's not necessarily a huge aftermarket for cabs. That would be something you would sort of say, well, that -- you would want the lowest manufacturing costs for that. Something where you think there's an aftermarket for, you may not -- you may either want some form of IP, some form of aftermarket protection as part of that before you would necessarily accept the first-fit costs.

Great. And just one follow-up. So you've spoken a lot about technology. Certainly, at the booth, you're highlighting that. There was an announcement at the show about yourselves and your joint venture with Trimble. And just curious from an organizational perspective how you guys think about investing heavily internally and doing things on your own as opposed to partnering with other folks.

Yes, yes. And I think as much of that was -- is around -- we are building some very strong digital capabilities. And we believe that there's some competitive advantages for us owning VisionLink ourselves and having that control over it and the future direction of it. And so that was part of the rationale. Obviously, during early-stage development, occasionally, we have gone out previously. We've had other alliances in that regard. We just thought this was the right time to bring it in-house given that we have the scale and we believe the -- now the digital capability under Ogi to actually do that and driving Cat Digital to drive that faster and in direction, which actually focuses very much on the Cat end of things as well and integrate that better into the whole digital process. And as we've spoken to investors, the digital platform is the key for us now on building these new applications and helping customers. So I don't know if you have been out to the booths. There's some software where we should -- highlighting the catproductivity.com, which, again, just starts giving customers more of that data, more of the access to that data and helping them to see some of the productivity of the machines that they've got, they are operating and how that works again. So all of that is part of where we think our customers want to go. And that's really important for us to do that. We do believe we have enough capability now in-house, and we don't need to effectively have the lines for that.

And Andrew, we just got an e-mail question here. In terms of the consolidation that you folks have taken, do you -- the question is: So now you have a network of higher-scale manufacturing, so in a downturn, presumably, that means less under-absorption at smaller facilities. So the questioner is asking, why doesn't that mean less operating leverage to the downside because you're not under-absorbed in your worst facilities?

Yes, yes. Yes, that does help and helps mitigate some of that, obviously, the absorption issues. However, still -- we still have a very large network, and there's a lot of fixed costs associated with that network and just is impossible to mitigate the full impact. And our absorption rates are pretty high still. So if you look at the absorption costs as a percentage of machine costs, it's a significant number of that -- in that. So -- but that, again, is just part of the challenge of -- which we will have in the downturn. I mean just -- again, just to remind people, I mean, one of the things we haven't done through this up cycle -- well, this up cycle is build a lot of new capacity. So again, that helps us. Yes, it means we don't have that capacity loss in the down cycle, but we also don't have the restructuring associated with that, which we would normally have. We have, as you know, talked about our challenged products. We talked about those in January. Those are products where we are not achieving our OPACC goals. And you will have seen -- you may have seen that we have actually started, for example, in Germany a contemplation period with the workforce around some of the facilities there. So again, that is looking at -- again, we are continuing to look at this all the time, but you shouldn't expect to see a very large-scale restructuring program in the event of a downturn than like we did in the last one.

Yes, David?

Just given the nature of the company is so global, you can sort of swing a little bit between vendors or sister facilities that make similar products. You're obviously a big customer for most all your suppliers, so they're going to try to treat you well. But can you give us some sense of ranking of where you feel your supply chain risk given the recent macro developments, rests? Just some sense of geographic, business segment, however you want to do it.

So let me try. I mean, obviously, during the last up cycle, like -- us, like many of our competitors, we were chasing supply, and supply constraints were a real factor for us. We're in a good situation now where that obviously has mitigated quite significantly, and that is clear. We've talked about if you look around the supply chain, I mean, the issue for us around the supply chain, where there potentially is risk in the current environment, probably is not necessarily our Tier 1 suppliers. It would tend to be your Tier 2, Tier 3 because these are smaller enterprises are feeding into the larger manufacturing -- manufacturers. So in that top 25 suppliers, for example, at the moment, only 3 of those are Chinese vendors. So that is a signal that obviously -- but obviously, we don't know with the other 22 where their supply chains go. And so obviously, if you're thinking about a coronavirus-type impact, particularly on the supply chain, at this stage, we haven't really seen anything. But obviously, we are planning on the assumption at some stage some of those smaller Chinese manufacturers will have some impact somewhere along the line, and building our contingency plans ready. I mean, obviously, where we are sole sourced, that is the greatest area of risk, and that's obviously going to get the greatest degree of attention in the short term. Those places where we have alternative supply choices, we will continue to monitor those as well and obviously flex those through over the next few months. But obviously, what we don't want to do is end up in a situation where we either can't produce or we are constraining ourselves on production. We have lived with that a little bit over the last couple of years. That has been a big challenge for us, so there's a really big opportunity for us to unleash the supply chain a little bit better than we had done recently.

And as we think about your oil and gas exposure, the solar business has not been cyclical over the past decade. Can you just talk about what's enabled that business to be a steady performer even as we've seen swings in pipeline, CapEx and just expand on that, please.

Yes, yes. So let me talk about oil and gas generally and then talk about solar in particular. So obviously, the significant reduction in oil price in the last week -- a couple of days, obviously, will have some impact on our business. Now this year, as we've moved into 2020 on the reciprocating engine side, we did assume about a 20% reduction in CapEx in the Permian Basin. That was based on external information from what we were picking up. Obviously, in the current environment, that probably will be cut back further, so we will see some further impact. However, offsetting that is, obviously, we do also do a lot of parts and servicing into that business as well, which does help mitigate some of that OE-type risk, but that obviously will have some impact as we go through this year. As yet, it's too early to quantify. Hopefully, by the time we get to our first quarter results, we'll be able to give you a bit more of a flavor, although by that time, who knows what will have happened in the world and what will have changed? Russian, China -- -- Russia and the Saudis could actually end up talking to each other. We could end up having oil prices stabilize. We'll see. We're not banking on everything. We always have to plan for the uncertainty. As regards solar. I mean the reason why solar obviously is not as impacted, I mean, we've seen the bifurcation of the gas versus oil market, as you know, over the last several years. And solar obviously plays much more into gas market. So that hasn't seen the same swings you've seen in pricing as you will have seen within the oil markets, one reason. Secondly, solar is much more a -- is much stronger as a business around its services, and services are really, really critical for solar. And those are going to continue. So people will still want to operate. I wouldn't expect gas volumes, natural gas volumes to vary that much. And that obviously will mean, I think, that solar's compressors are still working. The turbines are still working. Those are going to be used as much as they would be otherwise. So again, that generates that service revenue key part of it. Obviously, we'll need to see if there's any OE impact. Again, it gets way too early to see that yet.

And on the OEM impact, how have you avoided swings in pipeline CapEx? Because that's been much more volatile than your OEM sales...

Yes. And it's, I mean, to be honest, probably I'm not the best person to answer that question. But just generally, I think, generally, just having that strong customer relationship has been solar's really key competitive advantage. And actually being within the company, effectively, we have field service personnel with the reps within most of our customers' facilities, actually helping them operate and run their equipment as efficiently as they can. So I think that's been the biggest driver of that change and actually helping that -- helps drive service revenue and helping them optimize their equipment and the maintenance of that equipment in the right way. And obviously, sensor technology, digital has been a key factor in that as it moved through the years.

Good. Andrew, Jennifer, thank you very much for joining us. Please join me in thanking Caterpillar Inc.

Thank you, Jerry.

Yes, thank you. Thank you, Jerry.