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Caterpillar Inc
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Good morning, ladies and gentlemen, and welcome to the Caterpillar 2Q 2019 Analyst Conference. At this time, all participants have been placed on a listen-only mode. And we will open the floor for your questions and comments after the presentation.
It is now my pleasure to turn the floor over to your host, Jennifer Driscoll. Ma’am, the floor is yours.
Thanks, Catherine. Good morning, everyone, and welcome to Caterpillar second quarter earnings call. Joining us today are Jim Umpleby, Chairman of the Board and CEO; Andrew Bonfield, CFO; and Kyle Epley, Vice President of our Global Finance Services Division. We’ve provided slides to accompany the presentation. You can find them along with our earnings news release in the Investors section of the caterpillar.com under Events & Presentations.
Today, we will make forward-looking statements, which are subject to risks and uncertainties. We will also make assumptions that could cause our actual results to be different than the information discussed. For details on factors that individually or in aggregate could cause actual results to vary materially from our projections, please refer to our recent SEC filings and the forward-looking statements reminder in today’s news release. As indicated on last quarter's call, we're not reporting adjusted profit per share again this quarter, as restructuring costs are expected to be lower in 2019. It’s our intention to report adjusted profit per share at the end of the first -- fourth quarter of 2019 to exclude any mark-to-market gain or loss for the re-measurement of pension and any other post-employment benefit plans, as well as any other discrete items.
As a reminder, our U.S. GAAP-based guidance for profit per share continues to include the benefit of the $0.31 discrete tax item we recognized in the first quarter. Please keep in mind that Caterpillar has copyrighted this call. We expressly prohibit use of any portion of the call without our written approval. Before I turn the call over to Jim, let me inform you about a change we're making due to investor preferences around the timing of earnings calls. Beginning next quarter, we plan to shift our earnings call to begin at 8:30 AM Eastern Time. This timing allows us to conclude our call before the U.S. stock market opens. Accordingly, we also plan to accelerate the news release timing to 6:30 AM Eastern Time beginning next quarter.
And, with that, I now turn the call over to Jim.
Thank you, Jennifer. Good morning to everyone on the call. Please turn to slide 3 for our second quarter highlights. Sales and revenues this quarter rose 3%, to $14.4 billion. Operating profit rose 2% to $2.2 billion. Profit per share of $2.83 was slightly ahead of last year's record second quarter of $2.82. We delivered strong operating cash flow of $2 billion in the quarter. At our Investor Day in May, we announced our intention to return substantially all free cash flow to shareholders through a combination of dividend growth and more consistent share repurchases.
As previously announced, we recently increased the quarterly dividend by 20% to $1.03 per share or $4.12 on an annualized basis. So far in 2019, we paid dividends of almost $1 billion. In addition, we repurchased about $1.4 billion in company stock this quarter, which brings the total to about $2.1 billion for the year. From a top line perspective, we experienced strong sales in the quarter.
Overall, demand remains positive. While some customers appear to be more cautious about making large capital expenditures, including in oil and gas, we continue to expect modest sales growth for the year. We are only two-and-a-half years into our recovery in many of our end markets. While we had strong top line sales, we experienced some unfavorable changes in mix and higher-than-expected restructuring charges. Andrew will discuss both of these items later in the call. Although, we are guiding you to the lower end of the profit per share range, we still expect 2019 profit per share to be higher than the record we set in 2018.
Now, let's review over 2019 expectations for the external environment on Slide 4. In Construction Industries, we expect -- we continue to expect North America will be a positive for us. This is due in part to infrastructure spending at the state and local level although we expect that to be partly offset by weakness in residential construction.
Turning to Asia-Pacific, we expect continued pressure from competitive pricing in China, partly offset by growth in other areas in Asia-Pacific. EAME is a mixed bag. Sales in Europe are projected to be steady, while Africa and the Middle East remain weak. Latin America continues to improve from very low levels.
We expect demand for heavy construction as well as quarry and aggregate equipment to remain strong in Resource Industries this year. Most commodity prices remain at investable levels. Mining equipment sales continue to improve and large mining truck sales have further room for growth to reach their normal replacement levels. We continue to anticipate that miners will remain disciplined in our capital expenditures in these early stages of their multiyear recovery.
The Energy & Transportation space is more mixed amid continued volatility in oil prices and tightened oil and gas capital spending. In reciprocating engines, we expect our sales into the Permian Basin will strengthen in the fourth quarter as takeaway capacity improves. We expect solar turbines to have a strong fourth quarter as well Progress Rail. Power generation continues to be an area of expected growth.
Please turn to Slide 5 for a progress update on our strategy for profitable growth. We continue to execute our strategy by investing in services and expanded offerings, while improving operational excellence. We've been working hard to improve product lead-times. Due to the significant increase in volume during the past two and a half years, we struggle to keep up with demand for some products. This was primarily due to ramp-up issues at our suppliers.
We're pleased that product lead-times have improved even though volume remain strong. We have achieved or are close to achieving target lead-times for the vast majority of our products. In Resource Industries, for example, our current scheduled average lead-time now is just 12 weeks, more than a 50% improvement compared to March of 2018 and we had a weighted average of 26 weeks for the entire portfolio. Shorter lead-times allow customers and dealers more flexibility on when to initiate orders.
We also continue to focus on enhancing operational excellence including safety. Our safety goal is always zero incidents. We want our people to return home safely every day. One of the metrics we track is the number of recordable injuries per 200,000 hours worked. May and June were two of our best safety months on record. We intend to keep the momentum going and make it a great year for safety. Earlier this year, we announced a goal to double ME&T services sales to $28 billion by 2026. Services increased customer value by improving asset utilization and availability, while reducing owning and operating costs. We continue to invest to expand our digital capabilities enabling services growth and we remain on track toward our goal of one million connected assets by the end of the year.
Product rebuilds and reap hours are just one of our services helping customers to be more successful. Progress Rail recently won a contract to repower several locomotives for our U.K. rail customer. The new E&P engines will meet EU emission standards and the first three powers is expected to be delivered next year. Repowers and modernizations are both areas as our locomotive customers seek greater utilization of existing fleets.
Many of our meetings with mining customers these days include discussions around technologies like autonomy and automation and how they improve safety and productivity. We have recently been selected for three greenfield projects that will further grow our penetration of autonomy with mining customers in South America and Australia. More than 220 tracks have accumulated 50 million kilometers of autonomous driving in fleets already deployed. Our autonomous solutions are now being utilized by seven customers across 11 sites and three continents. We believe that we are at a tipping point for adoption of autonomy and mining.
For example, this quarter we announced that we will be working with Rio Tinto to create a technologically advanced iron ore mine in Western Australia. We will supply and support mining machines, automation and enterprise technology systems for this project. Working closely with WesTrac, our local dealer, Rio Tinto plans to create an automotive mine operation using data analytics and integration to enhance safety, optimize production, use mining machine utilization and lower costs.
We also continue to expand our offerings, enable us to continue to grow by addressing the diverse needs of our customers around the world. This year we introduced the first Cat-articulated truck GC model the 740 GC. As you may know the GC designation means the machine target segment that we refer to as life cycle value. This segment is for customers who have lighter duty applications or work in less extreme conditions. They value simple, tough machines that perform well with Caterpillar quality and product support. The 740 is particularly attractive in the North American rental market where it offers an additional value proposition in its size class. That said the machine is also gaining traction in every region of the world. Interest in the 740 GC has been strong with year-to-date demand exceeding our initial forecast.
With that, I will turn the call over to Andrew for a closer look at our financials.
Thank you, Jim, and good morning, everyone. Starting with slide 6, I will begin with a closer look of results. Then I'll touch on backlog and dealer inventories before turning to our outlook for the second half and full year. Starting with the headlines. Sales and revenues for the quarter totaled $14.4 billion, up 3% from last year's quarter, driven by Construction Industries and Resource Industries. Overall operating profit increased by 2% or $46 million to $2.213 billion.
Second quarter profit per share was $2.83 was up by $0.01 versus the prior year's record second quarter. There were a number of factors, which impacted the overall performance of the quarter. First, negative mix had an unfavorable impact on profits. This has bolstered the product and the segment length of level. Second, oil and gas sales remained weak as we wait for the Permian takeaway issues to be resolved. We now expect this to occur in the fourth quarter. Finally we booked significant restructuring expenses in the quarter, which means that we expect this spend to be immaterial for the rest of the year.
We completed $1.4 billion in share repurchases in the second quarter and paid $492 million in dividends as part of our commitment to returning substantially all of our free cash flow to shareholders. We also announced a 20% increase in the dividend effective from the third quarter, which reflects our confidence in the company's ability to continue to grow cash flows. We ended the quarter with strong liquidity including $7.4 billion of cash on hand.
Let me dive deeper into the top line on slide 7. Consolidated sales growth was 3%, reflecting price realization in ME&T of 3% with gains in the three primary segments. Volumes grew by 2% and the demand environment remain strong. As we reported this morning, machine retail sales to users grew by 4% during the quarter.
Looking by segment, construction industry sales and revenues rose 5% led by price realization including the 2019 mid-year increase as well as the increase on the 1st of January. Sales and revenues from Resource Industries increased by 11% fueled by higher equipment demand and favorable price realization. Energy & Transportation sales and revenues declined by 4%, primarily due to continued softness in oil and gas as well as timing challenges and project in locomotive deliveries.
Our financial product segment revenue rose 5%. Currency pressures reflected the dollar strengthening principally against euro and Australian dollar. Overall, our top line growth reflected the customers and dealers confidence in the value proposition of our equipment. If you move to slide 8, I will walk through the changes in operating profit. As shown on the chart, price realization and low SG&A and R&D expenses closed the operating profit increase contributing $427 million and $118 million respectively. Financial Products also added $14 million to operating profits for the quarter.
Manufacturing cost increased by $328 million, due to higher material costs including $17 million in tariffs, variable rate on burden including the loss of Brazilian incentives and warranty expense. Unfavorable sales volumes about $190 million, primarily due to mix changes in both Construction Industries and Energy & Transportation. In Construction Industries, the mix of sales reflected an increase in smaller products in North America. The mix in ME&T reflects the changes in the application mix including smaller engines. Importantly, price realization more than covered higher manufacturing cost this quarter an improvement versus Q1. We also continue to expect price realization to fully cover higher manufacturing cost for the full year. It's now been a year since tariffs were implemented, and input prices are moderating. Freight costs have also stabilized. Currency lowered sales by two percentage points and reduced operating profit by about $20 million.
Moving down the P&L. Lower short-term incentive compensation expense impacted SG&A and R&D favorably, while also benefiting manufacturing costs. We expect 2019 short-term incentive compensation expense to be about $600 million lower than in 2018. Before taking a look at the segment results, I want to comment on how the second quarter trended against our first quarter performance.
Second quarter sales rose versus the first quarter driven by seasonal trends higher North American construction industry sales, sales of original equipment in Resource Industries, and higher rail service revenue. From an operating profit perspective, the second quarter was about flat compared to the first quarter.
The favorable sales performance was offset by negative mix and a negative operating leverage due to lower absorption cost into inventories driven by the reduction in production levels as we reduce Caterpillar inventories. The operating profit margin contracted by 110 basis points. From a segment perspective, the sequential margin deterioration was highest in Resource Industries which as you know had a very strong first quarter. The change in Resource Industries operating margin is due to unfavorable operating leverage from inventory changes coupled with higher warranty expenses.
To keep it in perspective Resource Industries in the first and second quarters had the highest profit margins since 2012, a year when sales were twice as high as they are now. Year-to-date restructuring charges are $158 million. We don't expect these to recur at these levels in the second half. We still expect the maximum of $200 million of restructuring expenses for the full year.
Now let's look at the performance of each segment in the second quarter versus the prior year beginning with Construction Industries on slide 9. Construction Industries had a record quarter for both sales and profit. Sales from revenues totaled $6.5 billion again a 5% versus the prior year. Construction sales increase in North America by $774 million due to demand changes including dealer inventories and price realization. Sales were flat in the Latin America where construction remained at low levels. Declines in Asia-Pacific reflected continued aggressive competitive pricing the timing of the selling season as well as unfavorable currency index. Weakness in EAME was primarily due to a weaker euro.
Construction industry's profit increased by $93 million or 8% to a record $1.247 billion, the segment profit margin of 19.3% increased by 60 basis points. The favorable impact of higher volume and price realization was mostly offset by higher manufacturing costs plus unfavorable mix. Now let's go to slide 10 and look at Resource Industries. Resource Industries sales were $2.8 billion up 11% from the second quarter of 2018. The $274 million sales uplift reflects increases in demand and favorable price realization. Sales growth in Resource Industries was driven by strong mining market nonresidential construction and quarry and aggregate customers.
Segment profit of $481 million rose 17%. Resource Industries profit margin improved to 17.2% up 90 basis points. The improvement was primarily due to favorable price realization and higher sales volume. Growth in original equipment remain strong as miners look to replace aging equipment. If you turn to slide 11, Energy & Transportation sales in the second quarter were $5.5 billion down 4%. Power generation sites increased by 3% on continued demand to large piece or reciprocating engines. The other applications were lower sales volume and unfavorable currency impact.
Of note sales into oil and gas applications decreased by $162 million or 11% due to the timing of turbine project deliveries in North America in last year's quarter, lower demand from new equipment in the Permian Basin -- which were partly offset by higher turbine sales and production applications in EAME. Industrial sales declined by 1% with gains in most regions, more than offset by currency-related impacts in the EAME. Transportation sales declined by 3%, primarily due to the timing of locomotive deliveries and reduced marine activity in North America, partially offset by higher sales trough rail services.
Segment profit for Energy & Transportation totaled $886 million, down $126 million, or 12%. The segment profit margin contracted by 150 basis points to 16.2%. Energy & Transportation margins reflected lower sales volume, including an unfavorable mix of products and slightly higher manufacturing cost, partially offset by price realization. Turning to slide 12. Let me touch on dealer inventories and backlog, which play into our assumptions for the year. Dealer machines and engine inventories increased by about $500 million during the second quarter compared with an increase of about $100 million during the second quarter of 2018.
The largest impact was in Construction Industries, where dealers decreased inventory in the prior year's period. We previously have projected that total dealer inventories would be about flat to the full year. Based on current inventory levels, we now expect that dealer inventories will increase for the full year by about $900 million, driven by Construction Industries and Resource Industries. Whilst dealer inventory levels are closer to the top end of our range, at this time we are comfortable that this level is supported by positive end-user demand.
At the end of the second quarter of 2019, the order backlog was $15 billion, about $1.9 billion lower than the first quarter of 2019 and down $2.7 billion from the balance at the end of the second quarter of 2018. The order backlog decreased across three -- all three primary segments with the largest declines in Construction Industries and Resource Industries. In Construction Industries, we connect the backlog to client to slowing orders due to growth in dealer inventory. Also, keep in mind, the Construction Industries had a record quarter and it's not unusual for backlog to decline in CI in the second quarter itself.
In Resource Industries, we improved throughput in factories and improved lead times, as Jim has described. And remember, orders do tend to lumpy. As a point of reference, the total decline in the backlog of $2.7 billion since Q2 last year is about offset by the increase in dealer inventories for the same time period.
Now let's walk through our assumptions for the 2019 outlook. We now expect profit per share to be near the low end of our range of $12.06 to $13.06, assuming a recovery in oil and gas near the end of the year and dealers working through part of the higher machine inventory levels. Quotation activities unchanged, the assumed price realization offsets manufacturing costs and as I've said, restructuring costs for the remainder of the year will be significantly lower with the maximum spend of $200 million.
Other key assumptions are broadly unchanged, including $250 million to $350 million in tariffs for the year. We expect short-term incentive compensation to be a tailwind of about $600 million. We now project capital expenditures of about $1.3 billion. The estimated annual tax rate is unchanged at 26%, excluding discrete tax items. Consistent with our intention to return substantially all free cash flow to shareholders, we are now projecting share repurchases in the second half to be similar to the first half. In fact including all shares repurchased since the 1st of January, 2019, we expect to reduce our total shares outstanding by about 9% by the end of 2019, all the while executing our strategy and investing for long-term profitable growth. This reduction in share count is fully reflected in our guidance.
Looking ahead to the third quarter we will continue to execute our strategy including making appropriate additional investments for longer term profitable growth. We anticipate stronger results in the fourth quarter including increases in demand from oil and gas and rail customers. So, finally, let's turn to Slide 13 and recap today's key takeaways. We grew sales 3%, operating profit rose 2%, profit per share was comparable with the second quarter of last year.
We have maintained our profit per share outlook, although we expect it to be at the lower end of the range of $12.06 to $13.06. Again this adjustment reflects mix changes, a fourth quarter recovery in oil and gas, and dealers working through higher machine inventory levels, partially offset by lower restructuring charges in the second half of the year. We still expect modest sales growth this year and profit growth on top of last year's record results. We are also on track including 2019 buybacks to retire a total about 9% of our shares outstanding by the 31st of December and our financial position remain strong.
With that, let me hand it back to Jennifer to begin the question-and-answer portion of the call.
Catherine, thank you. If you could now queue up the questions.
Certainly. Ladies and gentlemen, the floor is now open for questions. [Operator Instructions] Your first question is coming from Rob Wertheimer from Millennium Capital. Sir, your line is live.
Thank you, and good morning, everyone.
Good morning.
Good morning, Rob.
So, thanks for the color on the dealer inventory. I think that will be something investors want to talk about. I wanted to ask for just a little bit more clarity around it. I mean obviously you don't control what the dealers do and it's their own decisions. But do you have a sense of what led to the change of the building a little bit of inventory through the year versus the prior expectation? It doesn't seem like sales have inflected up sharply since then.
And then just wrap my follow-up into it. I mean is the $900 million gap between what you thought and what sounds like it will be, is that the difference between your ideal level and where it may end versus the downtime risk for ongoing? Or maybe if you just characterize how big that gap is versus ideal? Thanks.
Hey Rob, it's Jim, I'll take the first part of that question and maybe ask Andrew to do the second part. So, as you mentioned dealers are independent businesses and they control their own inventory levels. Inventory levels were lower than they normally are and with that increase, we're back up to what is considered more of a normal level.
I did talk about the fact that we had -- we have been successful in reducing our product lead times which also has an impact here as well. So, that gives dealers a lot more flexibility in terms of where they place orders. Andrew I'll let you have the second.
On the $900 million reduction, we expect for the remainder of the year, reduction to about $900 million. I mean we are slightly at the high end; we'd like to be in the middle of the range. We keep a range for each segment. We're always comfortable being at sort of midpoint in the range. This gets us around about the midpoint from our perspective, Rob. So there would be potentially further reduction, but we were very low in that range previously. And as Jim indicated they did have some impact on availability. Ultimately at the end of the day, we want to make sure that dealers have the right amount of inventory to be able to meet customer demand and probably there was given that the challenges we've had previously there may have been some loss of sales at dealer level as a result of not being under supply quickly enough.
Okay. I beg your pardon. So with the -- I guess reduction from here to the end of the year, you're saying you're going to be roughly in the middle of the range not certainly low of where you'd like to be? Is that what you're saying?
Yeah, that would characterize it. Yes, Rob.
Okay, thank you.
Your next question is coming from Jamie Cook from Credit Suisse. Your line is live.
Hi, good morning. I just wanted to follow-up on the mix issues in the second quarter, how much that hurt earnings and what's implied for the back part of the year. And then just within oil and gas specifically I think before you said you had expected orders to pick up in the back part of the year in the second half now you're seeing the first -- fourth quarter. I guess just, sort of, what gives you confidence that you should see that acceleration? And how much cushion could we potentially get from solar in the fourth quarter? Thank you.
Good morning Jamie, it's Jim. So our oil and gas guidance for the year is dependent on certainly solar having a strong fourth quarter. Solar has as you know the lead times are relatively long. They have the orders in hand to -- for the new equipment side to execute that. There's always some variability in service, but we are expecting a big fourth quarter from Solar and fully expect them to make that happen. We are also expecting in the fourth quarter some recovery in recip engine sales in North America as the Permian constraint issues continue to be resolved.
Jamie on the mix issues, obviously, the mix did have quite an impact in the quarter. If you look at we saw a small increase in volume, the sales level but a negative move in the operating profit level. Principally in CI that was mostly due to the fact that we also sold more small machines in the quarter while they have similar margins that can be quite sensitive to be able to mix impact.
And then, obviously, there's also a segmental mix and those mixed within E&T similar mix issue in E&T particularly with low smaller engines being sold. And then also there's a segmental mix impact, obviously, because E&T does have very strong margins and obviously the margin deterioration impacted the reported mix as we look at variable margin in that business.
All of those factors have been built into our guidance, so we have put that into why we expect to be at the low end of the range along with a delay particularly in oil and gas sales.
Okay, thank you. I’ll get back in queue.
Your next question is coming from David Raso from Evercore ISI. Your line is live.
Hi, good morning. I'm trying to think through the second half implied guidance. Just so we set the framework. It looks like you're implying revenues down say about $500 million first half to second half. But the EPS grows about $0.25 to $0.50. And I'm just trying to understand I can see about $0.15 from lower restructuring sequentially. It maybe about $0.05 from a lower share count so it's about $0.20. But then I would have figured rest would have been you see better price cost second half than first half, more than offsetting some overhead absorption issues with the lower volume. But I thought earlier you made a comment price cost maybe I missed it. So it's sort of neutral the rest of the year. Can you clarify that? Just trying to get the EPS walk first half to second half.
Yeah. Thanks, David. And – yeah, so first of all, we don't give sales guidance, so your assumption around sales maybe slightly different from our assumptions. So that may have been part of the impact that we're seeing. As Jim indicated, we do expect both rail and solar and oil and gas to pick up in the fourth quarter. All of those will have an impact and remember that obviously E&T is down for the first half of the year, when you look at that. So as you think about it from a top line perspective, there maybe some variability, we see versus where you are on your top line.
With regards to margins and operating margins obviously there are seasonal factors that come into play. As we did indicate, we're all starting to see a little bit of relief from pricing – from underlying manufacturing cost increases. Obviously, the tariffs we saw – start now anniversary-ing freight costs, started to pick up in the second quarter of last year. So those factors will have less of an impact on overall manufacturing cost.
Offset against a little bit will be some variability, if we do actually take down some production. Obviously, we'll have a little bit lower inventory absorption. So those are all factors, which we weighed into our guidance. Then, obviously, we are starting to see some things like steel cost come down, steel obviously we do a lot of our steel buying on a contractual basis, and there is a lag, but we're all starting to see some of those things flow through as well into the second half.
And then trying to set-up the look into 2020. We've already discussed the inventory but for the backlog. Seasonally, you can see how CI might continue to go down. But when you think about your commentary, the rest of the year on mining and engines E&T are we making the assumption into the backlog is somewhat bottoming out here, because RI and E&T offset CI sequentially? We're just trying to sort get a baseline kind of exiting the year. Have we seen generally speaking the bottom of the backlogs with this $15 billion?
Yeah. I mean, I think David one of the problems with focusing very much on the backlog is remind you that this is reflected about dealer demand. There would have been some elements of as a result of an ability to delays in supplying orders availability of product that dealers may actually have been putting slots in the queue and we have seen that happen before and that may have happened this time as well.
Obviously, what does happen with the order backlog is it is lumpy, particularly in places like RI, rail, solar. So we are keeping an eye on it. There's nothing indicating that from a retail, if you look at the retail stats just remind you they are up again. So there's nothing indicating underlying customer demand is changing. This maybe behavior by dealers and their ordering patterns as well.
And, again, just to expand upon how you think about the lumpiness in Solar and Rail. Obviously, if you have a big fourth quarter, there is a lot of shipments that were in the backlog, obviously the backlog will go down. Again, that's – it happens every year that's the nature of the beast.
Okay. I'm sorry, Jim. So a part of the $15 billion, you would argue is reflective of why you're confident in the fourth quarter shipments of those businesses, but at the same time it could help the backlog down from here there aren't new orders to fill it in so to speak?
Yes. And certainly and again that happens every year. So -- I say every year typically, Solar in particular has a big fourth quarter, so we would expect again shipments occur, backlog goes down. But again the business continues to be healthy and good quotation activity. So we would expect that there'll be a normal seasonal pattern in Solar in terms of backlog and inventory.
Terrific, thank you very much.
Your next question is coming from Ross Gilardi from Bank of America. Your line is live.
Hey good morning, guys.
Good morning, Ross.
I was just wondering if you could give a little more color on the three new Greenfield sites for autonomous, you know the timing there. Are these retrofits or new trucks and equipment? And is that a positive driver into 2020? Or is it much further out?
Yes, it's a multiyear. We're going to make deliveries over a number of years and so they are new trucks. Again these are Greenfield sites. So again a lot of new technology, but the deliveries will occur not just in one year, it'll be over more than one year.
Okay. And then can you talk a little bit about your confidence in the China excavator outlook for the second half of 2019? I mean, it sounds like your full year outlook is broadly unchanged and as you’ve cited there is some competitive pressure there. I mean, how much visibility do you have on that business for the rest of 2019?
Based on everything that we see, we believe that overall the market demand will be stable. We have mentioned the fact that we have some competitor pricing pressures from local competitors. We're certainly taking steps to ensure our competitiveness long term in China. We're introducing a number of new GC products that will help us compete as well. But again we are -- we feel good about our forecast there in China.
And then just lastly Andrew, you mentioned your share count should be down 9% by the end of this year with the buybacks. Beyond 2019, if you did 4 billion to 5 billion in buybacks, I think that will retire about 6% of the share count at today's price.
I was just wondering how much of that 6% is fair to assume for -- is offset by share issuance for employees options et-cetera. Just net of equity issuance, I'm just trying to get a better sense for how much the share count should be falling each year beyond this year?
Yes. So obviously the 9% -- around 9% is a net number. So that's niche of new issuance. So effectively given that we'd spend 3.8 last year, we expect somewhat to be in the sort of at least the 2.1 in the first quarter -- first half something similar in the second half. If you're doing about 4, you generally retire about 4.5% of the share capital each year.
Okay. So share count just sort of this base case assumption at the current stock prices is probably falling 4% to 5% a year beyond 2019?
Yes. Yes.
Okay. Thank you.
Your next question is coming from Joel Tiss from BMO Capital. Your line is live.
Hey guys, how is it going?
Good. How are you?
So just -- it sounds like some pieces you're setting up 2020 to be a little bit more of a difficult year with the incentive comp down, so much this year and the dealer inventory is up a little more. Can you give us some of the pieces that to kind of balance that out? What would be on the other side of that? I'm not asking for forecast just kind of a couple of factors -- bigger factors to think about.
Yes. I mean let's remember that we have had quite a tough year in E&T so far. Obviously, Permian takeaway issues are resolved and drilling activity goes up that would be one area where we'd see some upside in 2020. I think if you look also at underlying demand for machines, it remains strong. So, again that's other opportunities for us as we move into 2020.
We will always retain our focus on a flexible and competitive cost structure. We want to invest in the right things for the business to drive long-term profitable growth but we still always do need to make sure that we are operating as efficiently as possible and those are other areas where we will continue to see some opportunity to drive growth as we move forward.
That's great. And then my second question is about something you mentioned there too. The cost reductions like it's you guys have done a lot a lot of work there. And it seems like the cost structure is seemingly not as responsive to the fluctuations like quarterly fluctuations in the business. Is that more structural? Or is it cyclical just your kind of scrambling to get stuff out the door? Or can you give us any color behind the scenes of what to think about? Or are those kind of more long-term changes to the company and we can't worry about the near-term results?
Yes. I think we don't respond to quarterly -- by quarter movements we're trying to drive the business for the long-term. So, Joel as we look at the cost structure we do try to make sure we got a long-term focus on that and don't do things just for short term cost-cutting measures. We can all do those. We've all seen people do those. Longer term it's not what drives you well because what tends to happen is investment then gets cut off which isn't the right thing to do for long-term shareholder value creation.
But I would say that Joe we certainly challenge all of our leaders to find ways to become more efficient to reduce cost. So, we still believe we have opportunities over next few years to continue to improve our cost structure. So, again, while -- as Andrew mentioned while continuing to invest in those areas particularly like services like our digital capabilities to drive long-term profitable growth.
And so Joel just add one thing on 2020 which I did forget was about Resource Industries. I mean obviously mining we are only in the start of recovery phase and replacement cycle. There is a lot of potential still but there is to run as miners start actually bumping up CapEx. All commodities remain at investable levels so we do expect that to continue to improve as we look out as well.
That's awesome. Thank you so much.
You're welcome.
Your next question is coming from Jairam Nathan from Daiwa Capital. Your line is live.
Hi thanks for taking my question. My question was regarding rail. You mentioned a strong 4Q, but you're seeing some of the implementation of PSR on the railroad side, they are cutting down a number of locomotives they use. And at the same time volumes are starting to decline as well rail volumes. So, I'm just wondering is this expectation of the U.S. or more international?
Yes, it's really based overall on the backlog that we have in rail for new locomotives. But certainly I mentioned earlier the one example we gave of repower. As our rail business is a direct business and there's a large service element to it as well. So, it is not completely dependent upon new locomotives sales.
Having said that, of course, we are expanding internationally. We've shipped our first transit locomotives since we made the acquisition of EMD a number of years ago. So again we are not totally dependent upon new locomotives in North America. We certainly understand the environment, in which we're operating. But again what we're not talking about is an expected strong fourth quarter based on backlog on hand for the rail.
Thanks. And my last question was on margins on resource, you mentioned warranty expense increased. Can you expand on that? Is that more volume related? Or is there something…?
It was a particular issue with a particular product that happened, these things do happen they do tend to be lumpy and that's been a driver in this quarter.
Okay, thank you. That’s all I had.
Your next question is coming from Sameer Rathod from Macquarie Research. Your line is live.
Thank you for taking my question. There are some -- have been some interesting developments made in electrifying the frack. So my question is how does Caterpillar see this market evolving? Do you think it can post a risk longer term to the diesel engine and parts business? Or do you think the applications are limited? Thank you.
And I'm sorry, I can barely hear you. Did you say electrification and fracking? Is that the question?
Yes. Electrification and fracking.
You bet. So we have been very involved working with customers both on the recip engine side and on the gas turbine side and what people called the e-fracking opportunity. So we are well-positioned to participate in both of those areas.
We have sold some gas turbines, which are generator sets that allow customers to do e-fracking. We're also working on recip solutions as well, working with customers. So I believe it will be a mix market with both and we'll see, which one is stronger in the end but we participate in both ways, both for electrification and now also both in our recip engines and with gas turbines. So we're well-positioned to play directly across the value chain.
Okay. Thanks.
Thank you.
Your next question is coming from Jerry Revich from Goldman Sachs. Your line is live.
Yes hi, good morning.
Good morning, Jerry.
Good morning.
You folks have sounded more positive tone on large mining truck order cadence than I think we've heard from you in a while. Can you just talk about what in your view has driven a slower replacement cycle in this recovery so far? Is it the autonomous decisions that have to be made? And can you just expand a bit more Andrew on your comments that there's a scope for move towards replacement as you think about moving pieces around2020? So it does sound like you expect order decisions to be made, obviously, in advance of 2020 for that to play out. So maybe I can get you to expand on that too?
Hi, Jerry this is Jim. I'll take it. So we see strong quotation activity on a global basis for all commodities. So as we work directly with our customers and with our dealers there is increasing quotation activity. There's a lot of projects that are being developed. We've talked about some orders that we received. Certainly I believe and I actually hope there’ll be less volatility than will be -- that there has been in the past it will be more of a slow steady ramp up. But the quotation activity is quite strong. And again it's across all commodities.
Okay.
And just to add, I mean the pulp feed is at an all-time low since we've been tracking that number in 2013. So, it is an opportunity. Definitely, we do believe that now we will be starting to see replacements solvency come through.
And we do expect our mining customers to be disciplined in their capital expenditures. So, again, that ties into my earlier comment about more of a slow steady increase than a volatile increase. And they will be again cautious and disciplined. But we expect the business to continue to improve on a slow and steady basis.
Okay. And in Construction Industries, you folks have worked really hard to get the cost structure to where it is today. Given the dealer inventory builds both across new equipment, used equipment and the utilization pressures, I guess, can you talk about what's the potential for you folks to more actively manage orders. You mentioned there are some slots that are potentially placeholders et cetera, so what's the opportunity for you folks to get ahead of the eventual order declines given what some of the leading indicators are doing, cut production earlier to keep the swings from being really painful on the manufacturing base.
Yes. Just to be clear, so firstly, let me start with the -- we released our retail stats this morning. And so, business is improving. So let's start with that. But certainly shortened lead times is very important. We've been on this for lean journey for a long time and having shorter lead times allows us to respond much more quickly to changes in demand.
Andrew, the count was I guess more focus on North America than overall. So the retail sales were up 7%, the company sales were up 28%, so we're building inventories in North America specifically. So, I'm wondering what the potential to get on in front and cut production early in the cycle?
Yes. So we did -- so Jerry part of -- as we -- as I spoke in my comments, we did see some takedown of Caterpillar inventory, finished goods inventory, so we do continue to focus on that. Obviously with lean manufacturing, we are obviously -- we don't hold a lot of finished goods inventory. Most of the inventories held actually in the component levels are actually both in. So actually that is the one thing we continue to focus on. But obviously, we will look at making sure that we don't -- as we said, we will take down dealer inventory in the second half and then we'll have some impact on production base.
Okay. Thank you.
You’re welcome. Next question please?
Your next question is coming from Ann Duignan from JPMorgan. Your line is live.
Hi, good morning. If I could turn back to oil and gas, I'd like to really understand your confidence in the fourth quarter pickup in sales. Is this products that dealers have ordered? So it's shipments to dealers? Or is it the rail end-market demand? And if you could just talk about your mix in oil and gas well completion versus drilling, so we know which one is more important to demand for your products. Thank you.
Ann, so good morning. Again starting -- part of the oil and gas pickup as I mentioned earlier is due to Solar where we have the backlog and the orders on hand. It's a matter of executing always some variability in service, but we feel good about that. So that is part of it. If you go to the Recip side of it, gas compression remains strong. We are expecting an increase in end-user demand for fracking that will impact our business towards the end of the year.
And on the fracking side, is that actually drilling or is that well completions? I'm trying to understand if this one's right or if there's more.
It's mostly well service.
Okay. Appreciate that. And then my follow-up question is more, if you look back at year-to-date performance, sales are up but in fact adjusted net income is down. So Jim, should we be growing concerns, should investors be growing concerned about your commitment to profitable growth? I mean, I know you can say you're at record levels, but net income is actually down and just the basis year-to-date.
Yes. So we are so very committed to profitably growing our business and we're making investments to make that happen. And we are -- we talked about this at Investor Day as well that we do expect quarterly variability in our performance, but we are very much focused on improving year to year. We've talked in our call this morning about some of the issues we had in terms of lumpiness in restructuring charges and we had some inventory impact. We do have some mixed impact and we will have just given the nature of our business, we will have quarterly deviations in our performance. But we're really driving for is medium and long-term profitable growth and we're investing to make that happen. We're committed to take on -- to continue to improve our cost structure structurally. I talked about that earlier and we believe we have opportunities there over the next few years to take that on and we're very committed to that profitable growth story. But again, we will have quarterly deviations. There's no question.
And yes, but if I look at six of the last seven quarters your stock has underperformed. So, is there something you can do structurally going forward to help us understand this variability?
Yes. Again, what we're driving towards is profitably growing our company. And if we profitably grow our company, I believe that will be reflected in the stock price. And we're going to have -- again as we talked earlier, we expect to have another record year in earnings per share this year. It’s another record year.
Okay. I'll leave it there. Thank you.
Thank you.
Your next question is coming from Timothy Thein from Citigroup. Your line is live.
Thank you and good morning. The first question is on RI and specifically, Andrew, you had mentioned earlier that OE was a big driver or a driver for growth in the quarter. So, I'm not sure exactly what that means for part sales. But really the question relates to the sustainability of pricing which was up against some pretty tough comp again in the second quarter. And just, as you see basically the question is the trade-off on as your OE volumes presumably capture a bigger part of the total within mining, how should we expect that trade-off to play out in terms of pricing on OE relative to parts?
Yes. So obviously, we did have -- in the first quarter, actually, we had really strong quarter. I think it was a record quarter for part sales within Resource Industries and part of that was driven by the fact obviously, its rebuilds are still continuing. Yes, there will be a mixed impact. It depends on what equipment we’re selling and the relative mix of parts versus and services versus OE. That will be part of why -- how we manage that business. Obviously, the advantage we have on OE is as you improve throughput, you do improve operating leverage.
And as I say, we actually have seen these two quarters, the first and the second quarter have been the two best quarters in our eyes since 2012 when actually sales revenues were nearly doubled what they are today. So I think we will see lumpiness, we will see movement that's the nature of that business particularly given the way we actually deliver our products to customers, but we're quite comfortable with the sort of the relative margin performance. And again, we will look at them over time rather than just purely quarter-to-quarter.
Okay. Got it. And then Jim maybe one last one on oil and gas, and specifically your comments to the question recently just on well servicing. A number of the big service companies have commented just in the past few days about cutting CapEx budgets some of them pretty significantly. So I'm just – I just want to come back in terms of kind of what's underlying that assumption that we do get this pickup of recovery in the fourth quarter.
Yeah, again it's our perception of what's going to happen as the takeaway issue in the Permian are resolved. So I'll leave it there.
All right. Thank you.
And thank you. I think we have time for one last question.
Your last question is coming from Courtney Yakavonis from Morgan Stanley. Your line is live.
Hi. Thanks. Just a couple of clarifications. First on restructuring, can you just help us understand I think the first quarter you said was pretty minimal? So how much of that $158 million was hitting this quarter? And in which segments it was showing up? And then if you could also quantify the warranty charge that was in resources. And then just more broadly when we think about your China business with APAC sales down as much as they were this quarter in construction. How should we be thinking about the margin for that business as you're continuing to introduce these GC products relative to what you had been getting in light of all these competitive pricing pressures?
Yes. Courtney, maybe start with restructuring. The charge in the first quarter was $48 million and the second quarter was $110 million. The $48 million is inactive, so you can now always refer back to that. Most of it actually was incurred and is held within the corporate item. There is some move back into the business but very limited and very small not materially impacting their reported margins. With regards to warranty expense, we don't actually break down the analysis and manufacturing cost, but the fact we’re calling out to shows it was a significant item in the quarter. But obviously, and it did have an impact on the overall performance in RI in the comparison in Q1 versus Q2.
China new products?
Yeah, sorry. On China new products, obviously GC products are in lower price point, but had similar margins as we said before. So overall this shouldn't impact reported margins as much. Obviously, the most important thing is making sure we retain a good competitive position. This quarter was impacted in part – the reported revenues were impacted part by timing of the Chinese New Year. We did see the benefit of that in Q1, which did have a negative impact in Q2.
Okay. Thank you.
And with that, we'll turn it back to Jim.
Well, thank you everyone for joining us on the call today. Just a few closing comments. We view our competitive position is very strong. We're continuing to invest to achieve our strategy of a long-term profitable growth including doubling services sales in ME&T by 2026. We had – we expect record profits this year, our second consecutive record from an EPS perspective.
And as we talked about we continue to generate strong cash flow, which underpins our commitment to return substantially all free cash to shareholders through our buybacks and dividends. And as Andrew talked about if you take new account 2018 and 2019 by the end of the year, we expect to have a 9% share count reduction by the year -- by the end of the year.
With that, I, thank you, for your questions and we look forward to chatting with you next quarter.
Thank you, Jim and thanks everyone who joined us today. We appreciate your interest in Caterpillar. If you have any questions please reach out to me or Rob Rengel in IR and e-mail at driscoll_jennifer@cat.com or rengel_rob@cat.com. And now let me ask Catherine to conclude our call.
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.