Caterpillar Inc. (CAT) Earnings Call Transcript & Summary

Hi. Good afternoon and good morning and good evening, everyone. My name is Chad Dillard. I'm the lead analyst for Bernstein in the machinery sector. And today, I'm very pleased to have Caterpillar speaking with us. I will have Jim Umpleby, CEO of Caterpillar; Jennifer Driscoll, Head of IR; and Rob Rengel as the manager of IR. The format of today is going to be a fireside chat. But first of all, we're going to just kick it off for a couple of minutes with Jim doing a few words. So before -- without any further ado, I'll pass it over to Jen. You're on mute. I think you're still on mute, Jen.

Yes, Jennifer, we can't hear you.

Here we go. Sorry. I hit the -- I needed to hit an okay. Good morning, good afternoon. Thanks for your interest in Caterpillar and your patience as I got that unmuted. I'm Jennifer Driscoll, and I welcome you, and I have a couple of housekeeping items. We may make forward-looking statements today that are subject to risks and uncertainties. For a full list of the risks and uncertainties that could cause our actual results to vary materially from any forward-looking statements that we make, please refer to our most recent SEC filings, our 10-K for 2020 and our 10-Q for the first quarter, which we filed on May 5. We also may refer to some non-GAAP numbers. For a reconciliation of those non-GAAP numbers to the closest GAAP number, please refer to the appendix in our slides today. We'll be posting those on the site later today and a transcript as soon as it's available. And with that, now let me turn it over to Jim, our Chairman and CEO.

Well, thank you, Jennifer, and thanks to Chad for hosting Caterpillar today. It's great to be here. I'll just try to spend a few minutes here setting the stage, talking about very briefly our strategy, our financial targets and very briefly discuss our sustainability journey and talk a bit about opportunities we see in the mining sector before taking questions. Just if you look here at Slide 3, we introduced a new strategy in 2017 that we remain committed to. That strategy has 3 main pillars: services, expanded offerings and operational excellence. Just to give you a sense of what those 3 pillars are all about. Operational excellence is safety, quality, lean and a competitive and flexible cost structure. So we're continually looking for ways to improve our operations, to reduce our structural costs, to become more lean, and it's really become a way of life. Expanded offerings is all about new products, but not just in the traditional sense. Caterpillar has always been known for having the most productive and the highest-quality equipment. But sometimes, we didn't have the right products to serve what we call life cycle value customers. We were very focused on the premium customers. And what that necessitated is for us and our dealers to sometimes discount our premium products to capture those life cycle value customers. Now we have a life cycle value product line, which is still very high quality but might not be quite as productive, and it allows us to capture those customers without discounting our premium products. And then finally, services, which is a key element of our strategy, which I'll talk a bit more about. But basically, services is everything we do to help make the customer successful after the sale. Our aim is to drive long-term profitable growth. And the measure that we use for our leaders is what we call OPACC, which is operating profit after capital charge, really allows us to be laser-focused on ensuring that we get a return on every investment that we make. All right. Let's move on here to the next slide. Moving to Slide 4. So we put out some Investor Day targets a few years ago, and I just wanted to spend a few minutes talking about that. So what we told investors is that we can't predict the exact cycle, but what we can do is we can control our own performance. And what we told investors we would do is to perform better than as we did in the historical past. And at that time, we defined that historical past between 2010 and 2016. And what we said is that we would achieve 300 to 600 basis points higher operating margin than we did during that period based on different levels of sales. Very pleased that in 2018 and 2019, we, in fact, met those Investor Day targets. And even last year when the pandemic hit and our top line dropped 22%, and we told investors that we were making a conscious decision to continue to invest in our future, to invest in new products, to invest in services, we still make that operating margin target last year. Moving on to the next slide. We also talked about better cash flows. We told investors that we expected to achieve between $1 billion to $2 billion of incremental free cash flow based on what we had done during that period between 2010 and 2016 at various levels of sales. And I think one of the things that investors are starting to appreciate is our ability to generate relatively stable cash flows even though we do serve a number of cyclical industries. You can see that between 2017 and 2019, we achieved between $5 billion and $6 billion of free cash flow. And even last year, during the pandemic when our volume dropped -- top line dropped 22%, we achieved more than $3 billion of free cash flow. So free cash flow is certainly something that we're very focused on. One of the things we've also told investors is that we intend to return essentially all free cash flow to shareholders through a combination of dividends and share repurchases through the cycle. We are a dividend aristocrat, 27 years of higher dividends, and it's something that certainly, again, we intend to keep going. Next slide, please. A few words about services. Again, services are everything that we do to serve our customer after the initial sale. We set out an aspirational bold target to double services revenue between 2016 and 2026 from $14 billion to $28 billion. And we're doing a number of things to make that happen. We're investing in our digital capabilities. We brought in a new Head of Digital from outside of the company, putting a whole new team, investing in AI. We've got 1 million connected assets. We have doubled the number of products we have, what we call CVAs, Customer Value Agreements. We've launched a new Reman organization. We're taking a whole variety of actions to make this happen. We did say, when we put out the target, it wouldn't be linear. It wouldn't be a straight line. It would be relatively back-end loaded because we do need to make investments to make this happen. But again, so far, so good. Next slide, please. Just a few words about sustainability. We did introduce a new sustainability report within the last month, and we established new goals for 2030. And we had previously put out a sustainability report a number of years ago that set goals for 2020. And so the new report let people know how we did against those goals and put out new ones. So we have some aggressive goals for our own operations. And we are also very committed to helping our customers achieve their sustainability objectives as well. We're doing a whole variety of things there. And let's go on to the next slide, please. And these are just a few of those examples. On the left there, you've got a trolley assist large mining trucks that allows a customer to reduce their carbon footprint by using available electricity at a mine site. We received an award from the EPA for what we call our Dynamic Gas Blending Engine, which allows customers [ such as ] -- primarily used in oil and gas applications to produce oil and gas, but to substitute up to 85% diesel fuel with natural gas. And we've actually now demonstrated the ability to introduce hydrogen to displace some of that natural gas to even further reduce our customers' carbon footprint. So customers are very excited about that. And we're doing a number of things in hydrogen. We have the ability to burn hydrogen blends, both in our reciprocating engines and in our gas turbines, and we recently received a research award from the DOE to help advance that even further. Next slide, please. Just a few words about mining. One of the things that we are excited about with the energy transition is the opportunity that, that provides for Caterpillar and our dealers in mining. I think everyone on the call is aware that commodity prices are very strong. Based on the amount of time it will take for the energy transition, that should drive strong demand for a number of commodities for quite some time. And Caterpillar has a leading product and services portfolio in mining. We have what we're absolutely convinced as the best autonomous solution. We have hundreds of trucks in autonomous operations at various mine sites around the world. And it's not just about the trucks. We're actually putting autonomy into our other products at the mine site as well, and those are operating. So again, we're very excited about the opportunities in mining moving forward. And the nice thing about this is it isn't being driven. Last time, there was a cycle in mining, an upward cycle, it was driven primarily by China. And this time around, again, if one thinks about the energy transition and what's going to be required from a commodity perspective to make that happen, we're quite excited about what could be a very long, healthy cycle here in mining. All right. Next slide. And so with that, I think I'll turn it over to Chad for the Q&A.

Great. Thanks, Jim. I definitely appreciate it. [Operator Instructions] So Jim, the way that we're going to run this conversation is I'll start out with a couple of high-level questions, dig into a few near-term questions and then expand out to sort of like the larger themes that you've touched on during your presentation. But first of all, so it's been a little bit more than 4 years since you transitioned from running E&T to becoming CEO of Caterpillar. Of the best practices that you brought over and expanded into the rest of your organization, can you tell me just what's been successful? What hasn't? And what do you think takes a little bit more time?

Well, thanks, Chad. And we're looking for best practices, not just from E&T, but from across the organization, things that have been employed for a number of years. We talked about the new strategy already this morning, and one of the things that we've been very focused on in Energy & Transportation is that services strategy. And we have a well-established services -- a lot of well established services activities, both in solar and in rail, and we're working hard to increase those services for the balance of the company. Of course, as I mentioned, digital is a big enabler in that, something that we've been investing in. And we're doing a number of things, everything from -- we have what's called a PIC program, which is Parts Inventory Collaboration, which allows us to see the parts in our dealer network and then to use AI to make recommendations to them for what parts they should have on hand. So when you couple the fact that we have over 1 million connected machines and engines, 1 million connected assets, with that program, it really allows us to ensure that our dealers are in good shape to support our customers. We talked about the O&E model. That's one of the things that we did in E&T and in solar as well as ensuring that we have a very good understanding of where we're creating shareholder value and where we're not. Oftentimes, with a large company -- and the way it worked in the past at Cat, we may have a division with 12 or 14 products, and as long as the division was performing acceptably, that was good enough. Now what we're doing is really peeling the layers off the onion and understanding by product, by market, by application which products are creating shareholder value and which are not. And we have a laser focus on improving those that aren't and, importantly, also investing more bias in our resources in terms of capital, expense, management attention and those areas that represent the best opportunities for future profitable growth. And that's why again, we're really pushing services so hard.

Okay. And just a big-picture question. So machinery companies create value for customers by increasing productivity. And as the source of productivity shifts from mechanical to digital, how are you positioning Cat to capture a bigger share of the value in such a world? And I'd love if you could spend some time talking about this on the original equipment side.

You bet. And again, digital, as I mentioned, you've heard a couple of times this morning, digital is a very important part of the strategy. We concluded we didn't have the right talent within Caterpillar to really move us as quickly as we needed to move, so we hired someone from the outside. He brought in a whole new team. Again, we've invested to connect to 1 million assets. We've really been using digital as an enabler to that services growth strategy. We're doing things like providing insights to customers and dealers that we had never done before, again, given the fact that we have the connected asset, given the fact that we have AI that we didn't have in the past. Maybe just a few examples of some of the things we're doing. We have what are called PSEs, or Priorities (sic) [ Prioritized ] Service Events, where we actually use AI to give a dealer a lead on providing services or parts to a customer based on that connectivity, based on our model of when it's going to be required. And we're -- it's all about -- everything has to be rooted in customer success. So it's all about making the customer more successful, doing things like avoiding unplanned downtime, increasing availability, increasing utilization, which in our industry isn't that great. So if, in fact, we can increase utilization of the equipment, that certainly has a big impact on our customers. Continuing to look at artificial intelligence, machine learning to drive predictive maintenance, we're doing a whole variety of things there. But again, everything is always rooted in customer success. If we find a way to make our customers more successful, it will be a good thing for Caterpillar and our dealers.

Great. So what's the case for Caterpillar generating higher pricing power? And I'm talking about across the cycle in this cycle. Is there anything from like an operational or product standpoint you can point to that gives you confidence you can do that?

Well, a whole variety of factors are used when we determine pricing. So obviously, we always have to be competitive. But I've talked about some of the things we're doing around autonomy, by having the best autonomous solution, by having the most productive piece of equipment about serving our customers. And that does provide us a competitive advantage and can help in pricing as well, but we always need to be competitive. One of the things we're always doing, as I mentioned in my prepared remarks, is we've challenged all of our leaders to continuously find ways to reduce our structural cost. We've done a number of things over the last couple of years, everything from outsourcing some finance activities that were previously done internally in a relatively high cost way and outsourcing those, using a partner, and those are now being done in India. We put in a new HR system that's allowed us to reduce HR headcount. We've done some things on the purchasing side. But we're starting to do more engineering in low-cost countries. So we're very focused on continuously improving our structural costs. Now having said that, getting back to pricing, we did have a price increase here that we've talked about that will impact prices in the second half of the year. And also our price can be impacted by geographic mix as well as things move back and forth between different areas. But again, one of the things that we also often think about is the fact that even if our -- with commodity prices go up, even if our input costs go up a bit, given the fact that commodities are strong and that customers use our products to produce those commodities, generally higher commodity prices are a net positive for Caterpillar because it increases volume, it gives us more operating leverage, provides the services revenue and everything that comes along with that.

Okay. So actually, let's shift to some of the, like, near-term questions. Let's talk about the supply chain tightness that Cat as well as the rest of the industry is really facing. Have you started to see any change in component availability in the last 2 months? Is it better than expected? Worse than expected? The same?

Yes. So it's yes. So it depends on the actual component that we're looking for. One of the things that we did talk about in our earnings call is that we made a conscious decision last year. And actually, at the time, we shared this with our investors, that in -- during 2020, that we held a bit of extra inventory within Caterpillar to do a couple of things. One is to try to guard against pandemic-induced supply disruptions, of government shutting down a supplier in a foreign country, those kinds of things; but also to prepare us for a potential, and of course in 2020, no one knew what 2021 would look like, a potential increase in volume and sales in 2021. And that decision has served us very well. Now having said that, demand is increasing quite strongly, that's the good news. And so we are dealing with many of the issues that other companies are dealing with, whether at semiconductors or other components. And we're working those issues very hard, and we're working hard to try to minimize the impact on meeting -- improving customer demand. But it's clearly a challenge, and we're working our way through them. I think there's lots of well-known issues out there in the industry, semiconductors being one of them, that we're just working through every day. And we're working hard to try to minimize the impact on our customers.

So next question is on price cost. Assuming commodities stay where they are today, I know that's a very big assumption, when do you think your price increases will catch up to the cost inflation you're seeing? And then secondly, how much more latitude do you have to raise prices further in the interim this year?

Yes. As I mentioned earlier, a lot of things go into our price decisions, right? So we're thinking about our competitive situation, a lot of that goes into it. We typically have -- like our steel contracts have, typically, have a lag of 3 to 6 months, which is a consideration in our pricing. I've talked about the fact that commodity price increases are generally net positive because of the volume in our mining business. But we expect price and cost to be about a wash for the year.

Got you. Okay. So just let's move on to some of like the longer-term themes. Particularly, you're talking about [ the addition ] of life cycle value products. Can you talk about when you actually started that journey? And how much further do you have to go today?

Okay. It's not my dogs, so everybody knows.

Sorry about that.

My wife has my trap -- my dog trapped upstairs. So he can't make -- that's okay, but he's happened to be playing at times. And Chad, with that, with the dog, I'm going to ask you to ask your question again. I'm sorry. Would you repeat that for me?

Yes. Sorry about that. My dog...

Sorry. No, no worries.

Yes. Just a question on price cost. So just assuming commodities stay where they are today, like when do you think the -- actually, sorry, a prior question. This is actually about the life cycle value in terms of the products. So when did you start this journey? And can you talk about how far along you are on today?

Sure. Well, we started the journey about, I guess, about 3 years, 3 or so years ago. And again, if you stop and think about it, maybe the way -- the best way to explain this to people is you think about a customer, even the one customer in the location might want both premium products and life cycle value products. For the machine that operates at the job phase that operates 24 hours a day, 7 days a week, customers are willing to pay more to buy a product that moves more dirt during a 24-hour period. In the back of the job site, they may have a wheel loader that operates 3 hours a day. There, they don't need the most productive piece of equipment, so they're willing to have one that maybe has less bells and whistles and moves less dirt. So that's an example of that. So we've been -- to answer your question, we've been on it for about 3 years or so. We're expanding those products. We recently introduced what we call a new GX product line in China, which improved our competitiveness there, better fuel efficiency, better productivity at a lower price point. So it's something that we're continuing to do across the board, and it's serving us very well. That GX product line in China, I mean, it was 15% lower fuel consumption, 25% lower maintenance cost than our previous models. So again, we're very excited about how that's going. And I'm very proud of how our team developed those products very quickly. One of the things we're doing is learning ways to introduce products more quickly as well, which, of course, is all about becoming more nimble.

Got it. Okay. So one big theme that everybody is grappling with right now is just the transition from internal combustion to zero emissions. I guess, just a blunt question, I mean, is Cat ready? And can you talk about just where in your portfolio you have new opportunities and just in terms of just where you think you see the adoption materializing first?

You bet. Well, again, start with what I mentioned earlier is that we're excited about the opportunities that are presented by this transition, particularly in our mining business. You think about the amount of copper, nickel, lithium, just for EVs, as an example, that will be required, all the other things as part of this transition, that's going to require a lot of commodities that customers use our equipment to produce. We have the leading product portfolio from a product perspective and a services perspective, thinking about autonomy in mining. So we're very excited about that. Our autonomous solution, we've had customers talk about, publicly, about enjoying a productivity boost up to 30% compared to the best man in site. We're excited about that. Having said that, we are investing in our own products as well to help our customers achieve their goals for reducing their carbon footprint. So we've introduced a number of products, and we have a lot of -- be more coming, but things like a locomotive that our rail division introduced that zero emissions, the battery-powered switch locomotive that works in the yard, one of the first of those that was introduced. We've -- I talked earlier about what we were doing in terms of our Dynamic Gas Blending, dynamic gas engines. It allows customers to substitute up to 85% diesel with natural gas. And we're now introducing hydrogen as well. We're using hydrogen blends in our gas turbines and our engines. And we will -- we have a mining underground loader that is completely battery-powered for underground. We will -- we are investing in, and we'll have more battery-powered products across the product line. We're talking to our mining customers about different ways that we can allow them to achieve their sustainability goals. And one of the -- I think we're very well positioned. We bring so much to the table. We stop and think about our mining customers, our big customers, given our services support, given our -- the amount of money that we can spend, right, on R&D, our long-term technical capabilities, we -- and the fact that we're integrating autonomy into a number of our products as well, we can bring all that to bear to help make our customers more successful. So again, we're really excited about the opportunities that the energy transition presents for Caterpillar over the long, long haul.

And just to stick with this theme and just want to understand a little bit more about the investment you did. And by that, I'm talking more about on the service side, on the dealer side, what exactly do you need to do [indiscernible]?

Certainly. So we're working very closely with our dealers. We're -- we have some businesses that are direct, like our rail business, our solar business, but we also have dealers for our Cat-branded products, and we're working very closely together. I talked earlier about connected assets, CVAs, the things we're doing around our digital capabilities. Some of the investments we're making as well are things like acquisitions. So we acquired Weir Oil & Gas, that SPM acquisition, and that allows us to offer a more complete solution from trailer to wellhead. And that is both a services play and a products play because it came with both. We recently established a new remanufacturing division. Of course, remanufacturing is a big part of sustainability as well for Caterpillar because if, in fact, we can remanufacture a product, that requires less energy, a much lower carbon footprint than manufacturing a new product. So we've introduced a new division with a new Vice President to help work with our dealers to grow that business as well. Our dealers are using what we call the Customer Value Agreements or CVAs and pairing them with Caterpillar-certified used machines, and that pairing drives alignment with our aftermarket parts strategy and also provides additional touch points for our dealer to our customer. In Resource Industries, we're doing things like extending truck life through rebuilds, which really we believe gives us a competitive advantage there because it provides value to our customers and also helps the services revenue as well. And we're expanding those rebuild options to address customers' varying needs. And again, so a lot going on. But we are making investments. And this is a never-ending journey here, but we're pleased with how it's going so far.

So just actually move on to mining. And again, sorry about the dog. So your customers have been very vocal about decarbonizing starting in 2030. Can you just talk about Cat's role in that whole process and some of the products you have? And how does this change like your service or parts intensity here?