Finning International Inc

TSX:FTT

Earnings Call Transcript 2018-Q2

[Operator]

Thank you for standing by. This is the conference operator. Welcome to the Finning International Inc. Second Quarter 2018 Conference Call and Webcast. [Operator Instructions] And the conference is being recorded. [Operator Instructions]I would now like to turn the conference over to Mauk Breukels, Vice President, Investor Relations and Corporate Affairs. Please go ahead.

[Mauk Breukels]

Thank you, operator, and thanks to everyone for joining us. On the call with me today are Scott Thomson, President and CEO; Steve Nielsen, CFO; and Anna Marks, Senior Vice President, Corporate Controller. Following the remarks by Scott and Steve, we will open up the line to questions. An audio file of this conference call will be archived at finning.com.Before I turn over to Scott, I want to remind everyone that some of the statements provided during this call and information on the slides is forward-looking. This forward-looking information is subject to risks, uncertainties and other factors as discussed in our annual information form under Key Business Risks and Forward-Looking Information and in our MD&A under Risk Factors and Management and Forward-Looking Disclaimer. Please treat this information with caution as Finning's actual results, performance or achievements could differ materially from current expectations. Except as required by law, we do not undertake any obligation to update this information.Scott, over to you.

[L. Scott Thomson, CEO, President & Non]

Good morning, and thank you, Mauk. I will start by reviewing our financial results and outlook for our 3 regions. Our financial results were strong this quarter. Five things stand out to me. First, earnings torque. While revenues increased by 9%, earnings per share was up 44%. Second, strong top line momentum in our 2 key markets. Canada's revenue was up 15%, and Chile experienced 24% revenue growth year-over-year. Third, profitability improvements. Canada's EBIT margin of 8.5% as we continue to leverage higher revenues on a fixed cost base while maintaining tight cost control and, in the U.K., profitability in excess of 5%, which is the highest since Q3 2013. Fourth, working capital velocity in a difficult environment. Working capital sales of 26.9% is 220 basis points better than in Q2 of last year. Finally, return on capital improvements. 14% was the highest return on capital we have seen since the commodity downturn. Most importantly, I believe there is much more to accomplish on our operational excellence journey, particularly in Canada and South America. This will result in even more benefits to customers and shareholders in the years to come.Turning to each of our regions. In Canada, mining producers and contractors continue to drive strong demand for parts and service, including equipment rebuilds. We are projecting an increase in sales of mining equipment this year and are encouraged by strong quotation activity for future orders. We agree with Caterpillar's assessment that we are in the early innings of the resource industry's upturns.We are making good progress introducing autonomous, ultra-class trucks. In June, as part of an ongoing pilot with Imperial and Caterpillar, we completed the first fully autonomous load haul dump cycle to move waste and overburden at Kearl using a 400-ton Caterpillar 797 truck. This is the largest autonomous truck put into a productive operating environment globally. A customer is working with us to ramp their testing program to include a trial fleet of 7 autonomous trucks by the end of the year. As you know from our Investor Day, we're also working with Teck on autonomous haulage solution. There is strong interest in new mining technologies, and we expect more autonomous haulage system implementations over the next couple of years, both in Canada and South America.We're also seeing strong equipment sales and product support in construction and expect large infrastructure projects to provide further upside. The federal government buying Trans Mountain pipeline should be helpful, and we believe LNG Canada will proceed as well, creating incremental future demand for construction equipment and product support.In Chile, business confidence has improved significantly, translating into strong revenue growth in the quarter. Increased copper production and fleet utilization are having a positive impact on mining product support, including component rebuilds. We do expect improved demand for mining equipment to follow. The government's plan to invest in infrastructure underpin our positive outlook for construction equipment sales and product support. In Q2, construction revenues in Chile were up 36% from last year. While the trade war between the U.S. and China has impacted copper prices, macroeconomic conditions in Chile remain strong.We are monitoring the progress of labor negotiations at copper mines. Similar to last year, we have a mitigation plan in place to manage through any negative impacts. Longer term, we believe addressing the industry cost equation in Chile is important to ensure that the mining sector is well positioned to capitalize on the significant growth potential inherent in increased copper demand.The Argentinian economy has weakened following the devaluation of the peso. This resulted in a significantly reduced government infrastructure spend and lower demand for construction equipment. Despite current economic uncertainty in Argentina, we expect oil and gas development to proceed and provide meaningful upside over the long term. We remain optimistic about growth opportunities in South America. With market conditions improving, we expect South America's profitability to accelerate in 2019. Regarding the U.K. and Ireland, proposals concerning U.K.'s economic partnership with the European Union are generating significant debate. Despite significant economic uncertainty regarding the impact of Brexit, activity levels in our key markets remain robust. We don't see lower Q2 revenue as a trend and expect to grow at a rate modestly higher than GDP for the remainder of the year. We expect the government's investment in large-scale infrastructure projects such as HS2 and the Heathrow expansion to generate steady demand for construction equipment and product support. Despite the very positive financial and operational performance, I want to pause and reflect on a tragic safety incident that occurred during the quarter. In May, we had a fatality in our South American operations. Our employee, Roberto Venegas Casanga, suffered a fatal injury while performing equipment maintenance at a customer mine site in Chile. Our priority has been to support Roberto's family and fully understand why this tragic event occurred. We're committed to implementing changes that will reduce the likelihood of this occurring in the future.I will finish with a few comments on the leadership changes we announced this morning. In the past 5 years, we have made tremendous progress on our talent agenda to enhance our capabilities. We have developed a strong talent pipeline with succession in place for every dealer principal and functional leader. This morning, we announced that Juan Carlos Villegas, President of Finning Canada and Chief Operating Officer of Finning International, will retire at year-end. On behalf of the board and the 13,000 Finning employees, I want to personally thank JC for all that he has done for Finning in his distinguished career. Five years ago, I asked Juan Carlos to lead the turnaround of the Canadian business. This quarter highlights the progress we have made and is a testament to JC's commitment, passion and perseverance.As we move forward, we are all excited to have Kevin Parkes move from the U.K. to lead our Canadian business. What Kevin has accomplished in short order in the U.K. is impressive. His background with Finning and as a CEO of a private equity-owned rental business gives him an intuitive understanding of the key drivers of return on capital, and his experience in our most competitive region with a heavy focus on digital will allow us to take Canada to the next stage on our journey.Lastly, Dave Primrose will be a great addition to the U.K. and Ireland business. Dave has worked in the U.K. and, therefore, knows the business, customers and employees well. Dave's leadership skills, operational experience and Caterpillar relationships will allow us to continue the momentum we have in our European business. I'm excited about what we can accomplish in the next few years at Fanning, and I know Kevin and Dave will continue the momentum we have established.I will now turn it over to Steve.

[Steven M. Nielsen, Executive VP & CFO]

Thank you, Scott. We delivered significant operating leverage in Q2 with EBITDA up 30% on 9% revenue growth year-over-year. Led by Canada, all operations reported higher profitability. In Canada, customer activity was strong across all sectors. Robust demand in construction and some large mining deliveries drove 29% growth in new equipment sales. Product support was up 13% with the most notable increase in construction. Used equipment sales were 16% lower compared to Q2 of last year, however, flat on a year-to-date basis, impacted by limited availability of quality used equipment.EBIT margin was 8.5%, up 150 basis points from last year, driven by the leverage of growing revenues on operating efficiencies and cost discipline. Canada achieved adjusted return on invested capital of 15.1%, the highest in the last 3 years, reflecting improvements in both profitability and invested capital turnover. In the second half of 2018, the revenue mix in Canada is expected to shift to new equipment sales, reducing overall gross profit margin. Nevertheless, we expect to maintain solid profitability levels and deliver continued improvement in return on invested capital.In South America, we saw strong revenue growth in Chile compared to last year, up 24% in functional currency, with increases across all industries and most lines of business. Chilean mining revenues were up 21%, driven by product support. Construction and power system revenues rose by 36% and 20%, respectively, reflecting improved demand for new equipment. This market recovery in Chile was partly offset by a challenging quarter in Argentina. The economic concern, being reduced government spending on infrastructure, negatively impacted construction activity and equipment sales in the second quarter. We are actively managing through market volatility and the devaluation of the peso. We expect to see some stability in customer demand in the second half of the year. As Scott mentioned, labor negotiations at Escondida, one of our largest mining customers, could result in a strike. Our team in South America has developed a mitigation plan with the customers, similar to what they did in 2017. We estimate the potential negative impact on EBIT to be between USD 5 million and USD 10 million in the third quarter. Although somewhat painful in the short term, the benefits from reducing the mining cost in Chile will be beneficial to the Chilean economy as well as our business in the long run. FINSA's EBIT margin was 8.5%, in line with our expectations. We are well positioned to manage through the temporary headwinds we're experiencing in Argentina, and our longer-term outlook for this region remains positive.In the U.K. and Ireland, construction and power system markets continue to be bouyant. Some delays in equipment deliveries from the second to the third quarter resulted in lower-than-expected new equipment sales compared to last year. At the same time, improved margins in most lines of business, a higher proportion of product support revenues, and more part sales through e-commerce channels help lift our EBIT margin to 5.3%, the best we've achieved in the last 5 years.Subsequent to the quarter-end, we took the first step in reducing our exposure to Energyst. As you know, Energyst has not met our performance expectation over recent years and has been a drag on our overall profitability. We have worked diligently with Energyst team over the last 18 months to restructure the business. As part of this restructuring, Energyst sold its subsidiary in Argentina in early July, which will result in a loss of approximately $10 million for us in the third quarter due to a reclassification of cumulative foreign translation losses to the income statement. The ultimate objective is to reduce the scope of Energyst to focus on power rental in Europe. Post this initial step, our investment in Energyst will have a $20 million carrying value. We continue to assess Energyst's fit with our strategy.Our reduced footprint, improvements in working capital from continued progress on supply chain initiatives and our successful e-commerce strategy are driving capital efficiencies as revenues increase. Invested capital turnover of 2.13x was up 8% from the second quarter of last year and is at the highest level since the end of 2012. Free cash flow was $28 million of cash used, significantly less than the cash outflow in the second quarter of last year due to an increase in EBITDA and higher collections. We continue to expect positive annual free cash flow for 2018.I will now turn it back to Mauk for the question-and-answer period.

[Mauk Breukels]

Operator, that concludes our remarks. [Operator Instructions] Operator, can you please open up the line?

[Operator]

[Operator Instructions] Our first question comes from Jacob Bout with CIBC.

[Jacob Jonathan Bout]

Hoping to get a little more disclosure on the impact of tariffs and maybe talk a bit about the prospect of higher pricing? And is that impacting customer decisions right now?

[Steven M. Nielsen, Executive VP & CFO]

Jacob, this is Steve. We don't see that impacting customer decisions right now. As Scott announced, we are expecting price increases, but we are very used to managing through these increases. It's a dynamic market. The demand for our products is strong. So we would expect to navigate this successfully.

[Jacob Jonathan Bout]

All right. And then maybe the second question on backlogs. Backlog level's down slightly quarter-on-quarter. But what's the expectations going into the back half of this year, maybe talk a bit about the mix, what are you seeing in Canada, South America and U.K.?

[L. Scott Thomson, CEO, President & Non]

Sure. Jacob, it's Scott. So we've got a lot of momentum right now. And if you think about -- you start with Canada and new equipment, year-to-date, is growing at about 40%, just over 40%. Product support is grown at 12%, and those sort of growth rates we're expecting for the back half of the year. And so we don't see -- to your -- even your first question, we don't see any decrease in customer demand. Customer order intake is actually very strong when you look at it year-over-year. So that's good news. In Chile, revenue is up 25% year-over-year, and you look at that construction business, and it's up 35%. And mining, I think it's very small, still a very small part of the overall business. So when I look forward, I think Q3 is going to be modestly lower from an earnings perspective because of the one-off of Escondida, $10 million, which I think, long term, is good, but it's a $0.05 impact and a little bit higher effective tax rate, probably $0.02 or $0.03. So same with Argentina, the devaluation. But as we look longer term, up to '18 and into '19, I'm more positive today than I was 6 months ago when I look at that activity and revenue growth, both on the new equipment side and the product support side.

[Operator]

Our next question comes from Cherilyn Radbourne with TD Securities.

[Cherilyn Radbourne, Analyst]

I wanted to ask, in terms of Argentina and the volatility that you're managing through down there, was the reduced government spending on infrastructure sort of fully in the Q2 numbers, if you will?

[L. Scott Thomson, CEO, President & Non]

Yes. Cherilyn, it's Scott. I mean, definitely, if you look at the growth in Chile in the quarter, the revenue growth was -- in Chile, it was 24%. But overall, FINSA was much less, and that was because it was offset by Argentina. So Argentina came down pretty significantly. And so both product support and new equipment for the overall business was growing. And the construction market, it was, I think, up 36% in Chile. So strong growth in Chile, offset by a pretty significant reduction in Argentina, and we don't see Argentina increasing off of that base for a while. We see that reduced spend staying with us probably through '19.

[Cherilyn Radbourne, Analyst]

Okay. And then just on supply chain. Continued good performance in the quarter, but you certainly alluded to a more difficult backdrop. We've got strong demand and production constraints at the OEM level. Maybe you can just speak a little bit more in detail about how you're managing those dynamics?

[Steven M. Nielsen, Executive VP & CFO]

Cherilyn, this is Steve. So we continue to work closely with CAT on coordinating and integrating our supply chain. Lead times have improved somewhat, but they do remain an issue. But we see demand, and we're pleased with the market -- our improvement in market share and our participation in the market. So we think the demand is strong. Our performance on market share is improving and that lead times are improving. But it's all slow progress but continued progress.

[Cherilyn Radbourne, Analyst]

Great. That's my 2. Before I pass it over, I just wanted to very quickly recognize Juan Carlos and wish him our best in his retirement.

[L. Scott Thomson, CEO, President & Non]

Thank you. I'm sure he'll -- I'm sure he's listening and will appreciate those sentiments. And from us, too, I mean, he's done a great job in Canada, not only in Canada and FINSA, and we will miss him. He's put a strong foundation in place for Kevin to build on.

[Operator]

Our next question comes from Michael Doumet with Scotiabank.

[Michael Doumet, Analyst]

So starting the year, I think you had the expectation of stronger Canadian revenue growth in the first half compared to the second half. I think the easier comp was the factor. It seems like you're pointing to increased mining equipment deliveries, saw pretty robust construction sales. I think you also mentioned lower gross margin expectation due to mix, which we didn't see in the second half. I'm just trying to put together what your sense for revenue expectations for the second half are.

[L. Scott Thomson, CEO, President & Non]

Yes. It's a great question. I mean, if you go back 6 months and what we [ set ] is exactly what we said. We said we were positive. But given the harder comps, we thought that growth would decelerate a little bit in the second half, and that's not the case. I mean, as we look forward, I think we see growth in the second half being pretty similar to the first half. And there's a little bit more new equipment deliveries in that back half of the year. So you're not going to see the same type of margin improvement. That being said, from an earnings perspective, it's going to be beneficial. And so really positive on the Canadian end markets and the Chilean end market.

[Michael Doumet, Analyst]

Okay. That's helpful. And maybe just on the Canadian rental business. There's been a significant investment in the rental fleet, but we haven't really seen an equal size increase in revenues, which suggests to me that financial -- your dilution rates are down comparatively. So I mean, can you give us a sense if it's seasonality or if it's just the lack of a pickup from the macro side? Just to get a better sense there.

[L. Scott Thomson, CEO, President & Non]

Actually, we're pretty happy with rental, but there's a little bit of a seasonality focus. So there's a couple of things going on. One is if you look Q1 to Q2, I think we're up 15% on the revenue side. Year-over-year, we're flat to slightly up. But I think there's a few things going on: one, get to the back of the lead times, come in and get some of this equipment. It came a little bit later than we thought, and then you have to really separate the heavy rents business from the TCRS business. In the heavy rents business, we're seeing high financial utilization and pretty good returns. On the TCRS business, there's a little bit of a mix issue going on in that we've -- adding new equipment, which we're pretty pleased with, but we've also been changing the strategy and taking out some of the allied gear. And so we lost some revenue associated with that. So -- I mean, all in all, we're pleased with where we're heading. That being said, it's been a little bit slower, given lead times. And I guess the third thing to add to that would be the used market. It's a pretty constraining market right now. You see our used sales, I think, down 16% year-over-year. I don't think that's the right metric. I think you should look year-to-date. Year-to-date, we're about flat. But it does highlight that it's a very constrained market on the use side.

[Michael Doumet, Analyst]

And Scott, just any sense on the rental rates in Western Canada, whether you're seeing an improvement there or maybe any historical contacts in terms of where they're at versus previous years?

[L. Scott Thomson, CEO, President & Non]

Yes. Rates are improving a bit. So we are seeing rates are improving. Utilization has increased. I think what is masking this a little bit is TCRS and the mix of fleet. And so again, I think third quarter is going to see, again, sequential improvement relative to the second quarter. Part of that's seasonality. Part of that is getting equipment and starting to see the impact of rates and utilization moving up.

[Operator]

Our next question comes from Ben Cherniavsky with Raymond James.

[Ben Cherniavsky, Managing Director of Industrial Research]

Scott, it's been a couple of years now or 18, 24 months since you executed the reformatted footprint and closed some branches, downsized physical presence, et cetera. What's been -- are you feeling now, with the market coming back, that you've got the right kind of physical infrastructure? I assume some of these markets you're not going back to. But are there any places where your competitor has maybe taken some share when you left the market? I know, for example, Komatsu went into your old facility in Sparwood. So I assume things like that come in some kind of market share cost. So I'm just wondering how you're feeling about that trade-off now with a little bit of perspective?

[L. Scott Thomson, CEO, President & Non]

No. I'm feeling good. I think these are difficult decisions, but I think, in general, 95% of them were the right decisions. And if you look at both the U.K. and in Canada, we probably reduced the footprint by 30% to 40%. We took a more centralized approach. We didn't reduce service base, but we did lighten up the bricks-and-mortar bed. And I think what we're seeing now was the benefits of that. So you're seeing labor utilization, facility utilization up significantly. You think about the OEM facility or the Fort McKay facility. Both of those are really busy right now but with the ability to expand if we need to. So we're taking those assets, and we're working them really hard. And I think the good news is our [ NTS ] is up, our customer loyalty are up -- is up, and our market share has not been impacted. And so we have -- as Steve said, our market share has been improving this quarter. We had a little bit of a slow start to the year on market share. But it was -- and I think it's more associated with equipment lead times and equipment availability as opposed to any coverage issues. And then the last thing I would say is this is an omni-channel approach, right? And what omni-channel means is bricks and mortars are important part of it but so is the e-commerce delivery piece. And if you look at our e-commerce delivery, you take the U.K. as an example, 40% to 50% of our addressable market in parts right now are being done through channels other than over-the-counter. And that's a big change from a couple of years ago. So that's going to be one channel, additional channel, that will allow us to get to some of these markets that are hard to get to from across -- or some of these customers that, traditionally, we haven't been able to get to because of our cost structure. So I think all of us are pretty pleased with the way this has played out over the last few years.

[Ben Cherniavsky, Managing Director of Industrial Research]

Do you see that going in the same direction in Canada, like to that extent of omni-channel and online transactions at the U.K.?

[L. Scott Thomson, CEO, President & Non]

I think the U.K. is a little bit easier than Canada because of the smaller geography and little bit close to the supply stores. And we can have a situation where, I think, 95% of our parts are in a central location. But in Canada, the momentum we've seen on e-commerce is pretty significant as well. I might get these numbers slightly wrong, but I think we're at about 25% right now of our addressable share, the e-commerce. So it's -- I think it's good from a customer experience, it's good from a cost to serve perspective. But we've always got to remember, it's omni-channel, and the bricks and mortar and branch will play a role on this. You can just be a little bit more thoughtful [ onto ] where those branches have to be located. So I think we're feeling pretty good about the strategy and where we are so far.

[Operator]

Our next question comes from Derek Spronck with RBC Capital Markets.

[Derek Spronck, Analyst]

Just on the electric drive and autonomous vehicles. Are you feeling comfortable around the competitiveness of Caterpillar's products in those 2 aspects and as it relates to your markets? And as that increases in the marketplace, are you able to leverage your digital services more in that regard?

[L. Scott Thomson, CEO, President & Non]

That was a great question. So on the autonomous side, I think we went through this in Investor Day. We're feeling really good about the competitive positioning of CAT's autonomous system, and I think we're hearing a lot of feedback from customers on the benefits and the scalability of that platform. I think we've now got 2 pretty good use cases. I mean, early days but pretty good use cases, which I detailed in my opening comments with Imperial and Teck, which we'll continue to try and scale over time. So I feel good about that. On the electric drive truck side, this is primarily, in the first instance, a Chile application. And there are applications in Chile that are more suited to mechanical, and there's more suited -- there's others that are more suited to electric. And so CAT's positioning, which we welcome, is to introduce an electric drive truck, and we are -- we're doing that. We're going to do that in the back half of this year with a couple of customers. And that's why there's a little bit of uptick on CapEx, by the way, this year versus last year. So -- and by the way, early reviews on that electric drive truck, we've seen it in action, both in the U.S. and in Peru, and the availability and competitive positioning of that truck versus the Komatsu is very positive. So I guess yes to both questions. Lastly, you said digital services. Well, that's interesting because autonomy is more than just taking people out of trucks. A lot of what autonomy is about is the data that you get and the insights that you can drive to improve the customer's productivity. And one of the reasons that we're spending a lot of time thinking about digital and thinking about domain expertise and data analytics and data insights is because of that exact issue which you raised. We've introduced the Integrated Knowledge Centre about 2 years ago in Chile. We've seen great improvements in availability of the truck for customers. Customers are pretty excited about that. And this quarter, actually, we just introduced the same Integrated Knowledge Centre in Canada, and that's just starting to ramp up. So I suspect that will have the same sort of impact for our Canadian customers as it has had for our Chilean customers. So I'm pretty excited about that development this quarter as well.

[Derek Spronck, Analyst]

Okay. That's great. Just one last question. Just -- as you see the current demand outlook in your backlog, and if everything kind of holds as is, do you expect return on invested capital should continue to expand? I mean, you've shown some fairly strong expansion on return on invested capital. But should we expect that to continue to move higher as we move into 2019 as the current demand outlook stands today?

[L. Scott Thomson, CEO, President & Non]

Absolutely. The whole strategy here is about improving return on invested capital. And when you look at those charts that we showed in Investor Day, we feel strongly that that's -- those are achievable. And if I think of the U.K., we're close to 15% return on invested capital. I'm actually in the U.K. right now taking this call, and there's a significant opportunity to continue to be lean and agile and continue to drive product support and, frankly, even to continue to drive velocity on the supply chain. When I think about FINSA South America, once we get through this ERP implementation, which we will, in fact, we went live in Argentina earlier this week, and so far, so good. So we're pleased with that, we're going to see enhancement and profitability, both because of benefit realization of the ERP but also because of lower costs associated with some of that technology spend. And so when I think about 2019, you're going to see margin expansion in South America. And then in Canada, there's more to go, right, I mean, 8.5% today. This quarter is the highest quarter since, I think, Q2 2014, before the commodity downturn. But there's lots more to do on both the profitability side and the capital efficiency side. And I'm really looking forward to Phase II of this journey, led by Kevin, bringing the discipline and the ROIC, the intuitive understanding of ROIC that's going to help push that increase into Canada.

[Operator]

Our next question comes from Devin Dodge with BMO Capital Markets.

[Devin Dodge, Analyst]

Just to start with FINSA here. Just with copper prices pulling back, do you think this has impacted the timing of some of the new mining investments in Chile? Just -- I'm hoping to get a sense for what customers are saying and what quoting activity has been like and whether you think some of the larger mining orders could come forward over the next 12 to 18 months?

[L. Scott Thomson, CEO, President & Non]

Yes, no. It's interesting. I mean, if you look at the Chilean growth at 25%, a lot of that was construction so 36% of construction and then good product support, too. I think product support was up 10% to 15%. It hasn't been driven yet by big, new mining orders, and our expectation is that is going to happen over the next few years. I think this tariff war and trade war is -- had put a little bit of a pause in that because a lot of the copper demand comes from China. But I think this is -- I'm pretty confident that as we look out medium to long term, and you think about worldwide GDP growth and the requirements for copper, it's a pretty positive story, and Chile is going to be a big part of that. That's why this Escondida thing actually, although a little painful in the short term, I think it's beneficial in the long term because it makes Chile even more competitive. So I feel good about Chile. We're going to continue to invest behind that business. I think it's going to see outsize growth for us in the next few years, and we've set it up for success during the downturn by enabling it from a technology perspective. And that will allow us to see margins expand as we capture that growth opportunity.

[Devin Dodge, Analyst]

Okay, okay. Then maybe switching to Canada. Just given the pickup in activity levels we've seen there, is it becoming harder to hire technicians in that market? Just wondering what you're seeing in terms of labor turnover, like wage inflation, et cetera?

[L. Scott Thomson, CEO, President & Non]

I expect that, that will become more of an issue. To date, it hasn't been -- I think we've done a good job with our employees. I think we've treated them fairly through wage discussions over the last few years. I think our employee engagement scores are higher, and I think we've got a good value proposition for our employees. And the morale seems to be getting better. That being said, when you see this type of growth, labor and availability of labor is top of mind and so something we definitely need to consider going forward.

[Operator]

Our next question comes from Ross Gilardi with Bank of America.

[Ross Paul Gilardi, Director]

I'm a little surprised you didn't see better margins in South America because you had 14% growth in product support. You talked a little bit about the margin outlook in the next year. But are there structural factors keeping the margins in FINSA going back to 10% in a few years? Or is -- the fact that we're still in the kind of mid-8s more of -- just the reality that Chile is barely off of trough. Any thoughts on that?

[L. Scott Thomson, CEO, President & Non]

Yes. No, there's absolutely no reason why we should not go to historic profitability levels. And I think the challenge this year, which we've been very open about, we've said it was going to be 8.5%, is because of some of the technology spend that we're doing, enabling that business, which will be behind us in the next month or so. So that's the good news. I think this quarter, 8.5% with higher product support, I can see why you think that we should have done a little bit better on the margin. It was held back a little bit by Argentina. And so with the -- if you hadn't had Argentina in the mix, you would've seen a little bit higher than 8.5%, I agree with. I guess the point is as you look forward, this is going to get back to historic profitability.

[Ross Paul Gilardi, Director]

Next year?

[L. Scott Thomson, CEO, President & Non]

You know what? There's going to be a big uptick in profitability. I'm not into the AOP process yet, and I'm not going to forecast. But you are going to see a pretty significant improvement in profitably as we go into 2019 in South America.

[Ross Paul Gilardi, Director]

Okay, good. Where do you -- where are you guys on new equipment inventory right now? I mean, obviously, you've had this long-held, concerted effort to improve working capital terms and have had some success there. But do you feel like you're struggling to catch up on inventory? So I think the $1.97 billion of inventory is almost back to prior levels, prior peak level in absolute dollars, but you also had some restatements, and there might be some seasonal distortions. But just wondering if you feel like you're back in balance on inventory or still sort of struggling to play catch-up.

[L. Scott Thomson, CEO, President & Non]

So let me start. I don't think so. I mean, I think if we look at our working capital to sales and see the improvement over time and then the ICT turns, I feel like we're heading in the right direction. And the fact that we've been able to continue to generate free cash flow despite the top line, I think it highlights that. It has been a little bit of a challenge to get new equipment, given the kind of the global growth, and CAT's been open about that. But I feel like we're catching up. I feel like we've got a lot of equipment either on-site or coming, and that will, again, help us with our market share a little bit in the second quarter. And it will result in more new equipment sales in the third and fourth quarter. I think this last quarter was a very significant delivery quarter for us. So I feel pretty good on the new equipment side.

[Operator]

[Operator Instructions] Our next question comes from Maxim Sytchev with National Bank Financial.

[Maxim Sytchev, Managing Director and AEC]

I had a clarification around the 8.5% EBIT margin guide. Does that include or exclude Escondida?

[L. Scott Thomson, CEO, President & Non]

No. The 8 -- if Escondida goes on strike, that could be a $10 million impact in Q3 for us, and that's not in the 8.5%.

[Maxim Sytchev, Managing Director and AEC]

Okay. And then given the free cash flow generation, especially in the back half of the year, how should we think about the capital allocation priorities on a going-forward basis, especially maybe -- not necessarily over the next kind of 3 months, but I'm talking about 12 to 18, if it's possible?

[L. Scott Thomson, CEO, President & Non]

Yes. Well, I think a couple of things. One is, frankly, not much different than what we've told you before, Max. I mean, the balance sheet's in great shape right now. We're trending under 2x. You saw us when the stock went into the low-30s this last quarter, active in the share repurchase market. You've seen us continue to increase the dividend. We're looking for complementary opportunities to always be weighed against share repurchases. And so we're just going to continue to focus on generating free cash flow to the cycle, and that will create a lot of optionality for us and for shareholders. So not much change from what we've told you in the past.

[Operator]

Our next question comes from Michael Doumet with Scotiabank.

[Michael Doumet, Analyst]

So yes, I know, nice uptick in the Canadian margin. I remember -- I don't know if it was last call or the call before, that the expectation was for an improvement in the latter half of 2018. So I'm just thinking, did the improvement come a little earlier than expected? Or as we sort of go into the second half, can we see operating leverage offset the gross margin pressure due to mix?

[Steven M. Nielsen, Executive VP & CFO]

Yes. I think -- I mean, we're pretty pleased with the first performance. The 8.5% came probably a little earlier than we thought, and we weren't expecting the type of new equipment sales and accelerations in the back half of the year. So I think what you're going to see is continued type of revenue or new equipment growth that you've seen in the front half of the year, and that mix will offset some of the internal improvements we're making. So the type of margin you saw in the second quarter is probably a pretty fair representation of what you'll see in the third quarter.

[Operator]

Our next question comes from Ross Gilardi with Bank of America.

[Ross Paul Gilardi, Director]

Me again. So just -- on the used equipment, sales down 19%. Is that mostly -- is that more you? I mean, are you making a conscious effort to hold on to used because lead times from CAT are increasingly extended and because of their managed distribution efforts?

[L. Scott Thomson, CEO, President & Non]

The answer is no. We've actually -- and I think -- again, I don't think I would focus on the quarter, down 16% in Canada. I think I'd focus on the year-to-date, which is 0. We've introduced this new strategy, the rental used and new. And what we've seen in -- so far is just there's not very much equipment out there. And so if we could do more, we would.

[Operator]

This concludes today's conference call -- this concludes the question-and-answer session. I would like to turn the conference back over to Mr. Breukels for any closing remarks.

[Mauk Breukels]

Well, thank you very much, operator, and thank you, everyone, for listening. We'll talk to you again after next quarter.

[Operator]

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.