Caterpillar Inc. (NYSE:CAT) Q1 2020 Earnings Conference Call April 28, 2020 8:30 AM ET
Jennifer Driscoll – Director, Investor Relations
Jim Umpleby – Chairman and Chief Executive Officer
Andrew Bonfield – Chief Financial Officer
Conference Call Participants
Rob Wertheimer – Melius Research
Mircea Dobre – Robert Baird
Jamie Cook – Credit Suisse
Ann Duignan – JP Morgan
David Raso – Evercore
Adam Uhlman – Cleveland Research
Steven Fisher – UBS
Ross Gilardi – Bank of America
Jerry Revich – Goldman Sachs
Courtney Yakavonis – Morgan Stanley
Joe O’Dea – Vertical Research
Ladies and gentlemen, thank you for standing by and welcome to the Q1 2020 Caterpillar Inc. Earnings Conference Call. At this time, all participants are in a listen only mode.
I would now like to hand the conference over to your speaker today, Jennifer Driscoll. Please go ahead, ma’am.
Thanks Jacqueline. Good morning, everyone. Welcome to Caterpillar’s first quarter earnings call. Joining the call today are Jim Umpleby, Chairman of the Board and CEO; Andrew Bonfield, CFO; Kyle Epley, Vice President of our Global Finance Services Division; and Rob Rengel, Senior IR Manager.
Our call today expands on our earnings news release, which we issued earlier this morning. You can find the slides that accompany today’s presentation along with the news release in the Investors section of caterpillar.com, under Events & Presentations.
The forward-looking statements we make today are subject to risks and uncertainties. We’ll also make assumptions that could cause our actual results to be different than the information we discuss today. Please refer to our recent SEC filings and the forward-looking statements reminder in the news release for details on factors that individually or combined could cause our actual results to vary materially from our forecast.
Caterpillar has copyrighted this call. We prohibit use of any portion of it without our prior written approval.
This year’s quarter included a $0.38 per share benefit from a re-measurement gain, while last year’s quarter included a discrete tax benefit of $0.31 per share. There is a non-GAAP reconciliation in the appendix to this morning’s news release. In a moment, you’ll hear from Andrew about the first quarter results, the actions we’ve taken to boost our liquidity, and a few key financial assumptions for the rest of 2020, but first please turn to Slide 3 as we turn the call over to our Chairman and CEO, Jim Umpleby. Jim?
Thank you, Jennifer. Good morning and welcome to Caterpillar’s first quarter earnings call. During this difficult time, our thoughts are with those affected by COVID-19. We extend our deepest sympathies to those who have lost a loved one, during the pandemic. We thank those individuals in healthcare, as well as the first responders helping fight the pandemic on the frontline.
I also want to thank Caterpillar’s global workforce. This month we are celebrating 95 years of operation at Caterpillar. For nearly a century, we have faced and overcome many challenges. As in the past, our employees are rising to the occasion. I appreciate their commitment to support our customers while keeping our facilities and co-workers safe.
As the COVID-19 pandemic spread around the world, many governments classified Caterpillar’s operations as essential activity for support of critical infrastructure. Working with our dealers, Caterpillar is delivering products and services that enable our customers to provide critical infrastructure that is essential to support society during the COVID-19 pandemic.
Customers use our products to provide prime and standby power for hospitals, grocery stores, and data centers; to transport food and critical supplies in trucks, ships, and locomotives; to maintain clean water and sewer systems and to mine commodities and extract the fuels essential to satisfy global energy demand. While we are serving these important needs Caterpillar remains dedicated to the safety, health, and well-being of our employees.
The Caterpillar team achieved our best safety performance on record in 2019 and we are leveraging our strong safety culture during the pandemic. Employees who can work from home are doing so. In our facilities that remain open, Caterpillar is implementing safe guards to protect our team members in accordance with regulatory requirements and guidance from health authorities.
We’ve also introduced a number of enhanced employee benefits to help them deal with the pandemic. These benefits vary by country based on local medical care systems in various regulatory requirements. Since Caterpillar was founded, a world-class global dealer network has provided us with a competitive advantage. And during this pandemic, our 165 dealers and their employees around the world continue to support our customers as they maintain critical infrastructure.
Our team at Cat Financial also continues to support our customers as Andrew will describe in more detail. Cat Finance supports our customers through good times and challenging times, which is one of the reasons we have so many loyal customers. The Caterpillar Foundation has also committed $10 million to support COVID-19 response activities being taken by organizations around the world.
Now, turning to Slide 4. Caterpillar is well-positioned to navigate the COVID-19 pandemic. Our financial position is strong and we are confident in our ability to continue serving our global customers. We will continue to execute the strategy we introduced in 2017, which is based on growing services and expanded offerings while improving operational excellence. The execution of our strategy during the last three years positions us well for these challenging times.
Our disciplined management of structural cost will help us weather the storm created by COVID-19. We held our period cost of SG&A, R&D, and manufacturing along with our salaried and management headcount flat from the end of 2016 to 2019 even though sales and revenues increased 40% during the same timeframe. While this leaves us less to cut in the downturn the lower cost base and the need for significantly less restructuring costs mean that our absolute margins and cash flow will be higher than they would have been had we allowed period cost and salaried management headcount to increase during the last three years.
In response to the pandemic, we’ve taken actions to improve our already strong financial position and increase liquidity. On a consolidated basis, Caterpillar ended the first quarter with $7.1 billion of cash and available global credit facilities of $10.5 billion. In April, we raised $2 billion of incremental cash by issuing new 10-year and 30-year bonds and arranged $8 billion of additional backup facilities to supplement the company’s liquidity position.
We’ve reduced discretionary expenses, including consulting, travel, and entertainment. We suspended 2020-based salary increases and short-term incentive compensation plans for most salary management employees and all senior executives. We are also reducing production costs to match customer demand. We continue to focus on improving operational excellence, which includes making our cost structure more flexible and competitive.
We are working through a number of operational challenges related to the pandemic and have suspended operations in certain facilities due to a combination of supply chain issues, weak customer demand, and government regulations. As of mid-April, approximately 75% of our primary production facilities across our three main segments continue to operate. Some facilities that were temporarily closed have reopened, such as in China.
We have worked quickly to mitigate disruption to our supply chain by using alternative sources, increasing air fright as needed, redirecting orders to other distribution centers, and prioritizing the redistribution of the most impactful parts. Our employees and dealers continue to serve our customers.
Now, I’ll give you a summary of the first quarter’s results on Slide 5. Sales and revenues at $10.6 billion decreased by 21%. The decline was mainly due to lower sales volume, including lower end-user demand and the impact from changes in dealer inventories. End-user demand was below our internal expectations for the quarter. Sales to users for the first quarter declined by 16%. The decline was most pronounced in Asia-Pacific where we compete primarily in construction industries and in North America, which had weakness from machines in energy and transportation engines.
Oil and gas declined 24% for the quarter. Small bright spots included construction in Latin America, mining in Asia Pacific and EAME and power generation. During the first quarter of 2020 dealers increased inventory by $100 million in anticipation of normal seasonal demand from end-users. This compares with $1.3 billion increase in dealer inventory during the first quarter of 2019. The year-over-year change of $1.2 billion in dealer inventory also placed pressure on our sales.
Our first quarter operating profit margin was 13.2%, down 320 basis points. The decline was primarily driven by lower sales volume. Favorable SG&A, R&D, and manufacturing costs, partially offset the world decline. The R&D decline was mostly due to lower short-term incentive compensation as most of our R&D projects are proceeding consistent with our strategy. Profit per share was $1.98, compared with $3.25 in the prior year’s period. This year’s quarter included a $0.38 per share benefit from our re-measurement gain, while last year’s quarter included a discrete tax benefit of $0.31 per share.
Now, moving to Slide 6. In the first quarter, we returned $1.6 billion to shareholders through dividends and share purchases. In addition, we declared our normal quarterly dividend earlier this month and we continue to expect our strong financial position to support the dividend. As a reminder, Caterpillar has paid a quarterly dividend every year since 1933 through a variety of challenging business conditions. We remain committed to returning substantially our free cash flow to shareholders through the cycles.
We are temporarily suspending our share repurchase program upon completion of the 10b5-1 program that we established in January. We retained the balance sheet to do M&A for compelling opportunities. Our focus on operational excellence, shorter lead times, and flexibility in manufacturing operations will allow us to react quickly to future changes and market conditions either positive or negative. The ultimate impact of the pandemic on our 2020 results remains uncertain and will be based on the duration of the virus and the magnitude of the economic impact on global demand for our products.
We expect the impacts of the pandemic on our results to be more significant in the second quarter and to linger until global economic conditions improve. Due to the uncertainty associated with COVID-19 and its affects, we withdrew our financial outlook for 2020 in March 26, and are not providing one today. At our Investor Day in May 2019, we discussed our strategy based on services, expanded offering to an operational excellence.
We highlighted our focus on operational excellence and our goal to be profitable and operate more efficiently through the cycles as we leveraged our foundational strengths, our competitive and flexible cost structure, lean processes, safety first culture, and quality including product reliability and durability. We described our success delivering the targets we had set out during our 2017 Investor Day and we laid out new targets based on the improvements we’ve made in structural costs that I described earlier.
One was to improve annual adjusted operating margin by 300 basis points to 600 basis points versus 2010 and 2016 when margins ranged from 7% to 15%. The second was to increase annual ME&T free cash flow by $1 billion to $2 billion above our actual 2010 through 2016 performance to a range of $4 billion to $8 billion per year. However, the impact of COVID-19 on our business has been significantly more severe and chaotic than any cyclical downturn we had envisioned.
Governments have closed suppliers with little or no notice impacting Caterpillar’s operational efficiency. Importantly, while we have taken actions to reduce costs, we have made a conscious decision to continue to invest in enablers of services growth and expanded offerings key elements of our strategy for long-term profitable growth.
As a result, in 2020 depending upon how the pandemic unfolds while we expect our margins and free cash flows to be better than our historical performance of 2010 to 2016 it will be challenging for us to achieve the margin and cash flow targets communicated during our 2019 Investor Day. Our goal is to emerge from this crisis as an even stronger company, better positioned for long-term profitable growth.
Now, let me turn the call over to Andrew for a recap of our first quarter results, short-term actions we’ve taken, and the strength of our balance sheet.
Thank you, Jim and good morning everyone. I’ll begin on Slide 7 with our first quarter results then I’ll discuss some of the actions we’re taking in response to the COVID-19 pandemic before turning to our cash and liquidity position. In total, sales and revenue for the first quarter declined by 21% to $10.6 billion. Operating profit decreased by 36% to $1.4 billion.
Profit per share for the quarter decreased by 39% to $1.98. The decline was driven by lower volume as the cost reductions taken to mitigate the pandemic were offset by the impacts of the higher tax rate and negative currency movements. This year’s quarter included a $0.38 per share re-measurement gain that resulted from the settlement of an international pension obligation. Last year’s quarter included the $0.31 benefit from a discreet tax item.
As you see on Slide 8, the results this quarter were up primarily driven by volume. Currency and price had a small impact, but volume decreased sales by $2.6 billion. The volume decline reflected weaknesses in end-user demand coupled with changes in dealer inventories. Geographically sales declines were led by North America and Asia Pacific. Machine sales to users, including construction industries and resource industries decreased by 17% for the quarter, while energy and transportation sales to users decreased by 12%.
You may recall that we expected a decline of 4% to 9% for the year with a stronger second half. Nevertheless, first quarter sales to users where below our expectations. Demand in Asia Pacific was weaker than we expected, including a direct impact from COVID-19 on sales to users in China. In January, we indicated that we expected a small seasonal build of dealer inventory in the first quarter.
Dealers increased their inventories by about 100 million this quarter, compared with an increase of – in dealer inventory is of $1.3 billion in the first quarter of 2019. This resulted on a $1.2 billion swing in revenues, which was nearly half of our sales decline. Also, it is important to note that we reduced shipments to dealers in the quarter because of the lower sales to users.
Order backlog increased by about $400 million since year-end, again following our normal seasonal pattern. Compared with the year ago, backlog was down by $2.8 billion. As I’ve said before, I view our retail sales data as a better indicator of demand than backlog and whilst there is a lag in sales to users, I believe that data better represents underlying customer demand for machines and engines.
Moving to Slide 9, operating profits for the first quarter fell by 36% to $1.4 billion. Volume declines where the main driver of the $803 million decrease in operating profit. Operating margins fell by 320 basis points. Favorable short-term incentive compensation expense and lower manufacturing costs only partially offset the impact of the lower volume. For comparison, incentive compensation expense in last year’s first quarter was $220 million.
Now, I’ll discuss the individual segments results for the first quarter. Starting on Slide 10, first quarter sales of energy and transportation declined by 17% to $4.3 billion, driven by 24% decline in oil and gas sales. Demand for reciprocating engines in North America slowed significantly as oil prices fell. Within oil and gas, solar sales remain steady with the prior year’s first quarter.
Power generation sales weakened as well, primarily in Asia Pacific and North America. Industrial and transportation sales both decreased. Profit for the segment decreased by 28%, driven by lower volume, partially offset by the lower short-term incentive compensation expense. The segment’s operating margin declined by 320 basis points to 13.8%.
As shown on Slide 11, resource industries sales decreased by 24% in the first quarter to $2.1 billion. Changes in dealer inventories and lower end-user demand drove first quarter sales decline. Dealer inventories decreased in the first quarter of this year after increasing in the same period of 2019. We experienced lower end-user demand across most of the industries we serve. Specific to mining, sales were lower as miners remain disciplined in their CapEx deployment amid commodity volatility.
However, fleet age is the highest since we began tracking it and utilization rates remain high. While we expect that this current uncertainty may delay fleet replacements, we remain positive in mining prospects in the medium and long-term. In addition, we saw declines in heavy construction and quarry in aggregates, particularly in North America. During the first quarter, Newmont’s Boddington became the first gold mine to move completely to autonomous hauling.
We expect to begin shipping Newmont the first of its Caterpillar 793F autonomous trucks next year. Currently Caterpillar has 282 trucks running autonomously using Cat Command for hauling. Recall that Resource Industries’ profit margin in the first quarter of 2019 was very high as we saw the benefits from double-digit volume growth and favorable price realization. Lower volume is a primary driver of the 47% profit decrease. That resulted in 630 basis point decrease in the segment’s profit margin, which finished at 14.6%.
Now turning to Slide 12. For Construction Industries, sales decreased by 27% to $4.3 billion. The lower volume was driven by lower end-user demand and a change in dealer inventory movements. Sales to users declined by 18%, compared with the prior year, including a 28% decrease in Asia-Pacific, driven by China.
Although dealers increased inventories during the quarter, the increase was much lower than in the prior period. This had a particularly noticeable impact on sales in North America. The segment’s first quarter profit decreased by 41%, due to the volume decrease and negative mix. Lower short-term incentive compensation expense and favorable material and period cost provided a slight offset. The margin declined by 360 basis points to 14.9%.
Moving to Slide 13, financial products revenue decreased by 4% to $814 million on lower average earning assets. Profitability decreased by 50% in the first quarter to $105 million led by the mark-to-market impacts on equity securities in the insurance services portfolio. Cat Financial has taken important steps to support our dealers and customers during this challenging time.
As shown on Slide 14, we launched customer care programs in all regions allowing customers to apply for payment relief through a simplified and streamlined process. It’s an approach we’ve learned from helping customers of the natural disasters. Typically, we provide principal and interest deferral for 90 days. Interest continues to accrue and the deferred payments added to the end of the loan.
When we took similar actions in 2009 there was a noticeable boost in customer loyalty. Past dues did increase in the quarter to 4.13%, and we increased our loan-loss reserve moderately this quarter due to elevated risk associated with COVID-19. However, there are two points to keep in mind. First, most of our customers went into the downturn financially healthy, and current on their loans.
I’ll provide you with the comparison. Past dues in both North America and China, at the end of 2019 were 1.3%, whereas at the start of the financial crisis, past dues in those regions where 4.3% and 8.5% respectively. Second, our loans are secured by machines. These are working assets and are critical to our customers businesses, which means they normally prioritize payments to Cat Financial.
From a funding perspective, the strong action from central banks around the world means we are maintaining a broad and diverse mix of global liquidity sources, including access to global commercial paper and debt financing. On a positive note, our new business volume rose 17% quarter-over-quarter in North America, and was flat across all regions as we continue to provide financial solutions to qualified customers around the globe.
Turning to cash flow. ME&T free cash flow for the quarter was slightly positive was lower than last year. Lower profits, as well as higher Caterpillar inventory levels, which increased from the year-end, were partly offset by benefits from lower short-term incentive compensation payouts. The first quarter is typically our weakest of the year from a cash flow perspective, due to the payout of annual short-term incentive.
We paid out approximately $700 million in short-term incentive compensation this quarter about half the amount paid in 2019. Caterpillar inventory levels rose as we brought in production stores in anticipation of higher production levels to the quarter. We will now work these down.
Now, turning to Slide 15. As Jim mentioned, the pandemic and its impacts were unprecedented in their speed, depth, and level of complexity. Here is more color on some of the actions we have taken thus far. From a demand perspective, we’ve executed business continuity plans and work to optimize availability in areas where demand remains relatively strong, such as for parks.
We are managing our production by segment to ensure we do not over produce while as we take care of our dealers and customer needs. We are adjusting our workforce by facility and by segment. From a stewardship perspective, we have completed a scenario analysis aiming to ensure that we’re prepared for different potential lengths and depth of this pandemic. We’ve also taken steps to strengthen our cash position and I’ll describe more about those in a moment whilst reducing capital expenditures and delaying R&D projects with less visible returns.
From a cost-control perspective, we reduced discretionary expenses, including consulting, travel, and entertainment. Given the COVID-19 environment we suspended 2020-based salary increases, and short-term incentive compensation plans for many employees and all our senior executives. We will continue to look for ways to make our cost structure more flexible and competitive.
Turning to our suppliers, we will keep a closer eye on their financial health as well. In the event that a supplier faces financial distress, we will identify solutions to support them whilst also ensuring supply for Caterpillar’s products. In particular, our suppliers have access to working capital support through a partnership with one of our third party banks. This can provide quick access to cash flow to help them cover their payment commitments all at no risk to Caterpillar.
Separately, as we stated last quarter, in addition to a normal restructuring programs, we continue to address our challenged products those that don’t meet our goals for OPACC. We recently began a contemplation process that could potentially result in the closing of two mining facilities in Germany. We have also taken an impairment charge against one of the other challenged products. By addressing these challenged products, we can move forward with a slightly smaller portfolio and deliver a higher level of performance, including better margins and better cash flows.
Meanwhile, we continue to strive ongoing cost reduction efforts, including preparing for the outsourcing of certain back office functions and launching a program to reduce our procurement cost, although as we said in January, these benefits will be more impactful in 2021.
Let’s turn to Slide 16 and while we aren’t providing profit per share guidance I’ll talk about a few key thoughts for 2020. We remain focused on working with dealers to optimize their inventory levels. Our expectation, the decline in dealer inventory by the year-end, will be at the higher-end of our prior range, which was $1.1 billion to $1.5 billion. We now anticipate a higher tax rate in 2020 as well due to changes in the expected geographic mix of profits and the impact of certain U.S. tax provisions on non-U.S. income.
As you model the second quarter, please remember that dealer inventory grew by $500 million in the second quarter last year setting up a different comparison in the short-term. Also Jim said, the impact of the virus will be greater in the second quarter. All-in-all, the situation remains very fluid, until it becomes clearer we do not anticipate being able to provide guidance as per our normal practice.
Turning to Slide 17, I’ll touch on our capital allocation and our cash and liquidity position. We recently declared annual and quarterly dividend. Due to uncertainties associated with COVID-19, we temporarily suspended our share repurchase program in mid-April upon completion of the 10b51 program that we established in January. We said at our Investor Day in May 2019 that we will return substantially all our free cash flow to shareholders through dividends and more consistent share repurchases.
In the first quarter, we returned $1.6 billion to shareholders through dividends and share repurchases. We ended the first quarter with a strong financial profile, including $7.1 billion in enterprise cash. Given the environment, we have had incremental $3.9 billion short-term credit facility in addition to our existing $10.5 billion revolving credit facility. Both of these liquidity resources remain undrawn.
In addition, we’ve registered the $4.1 billion in commercial paper support programs, now available in the United States and Canada, which could provide supplemental liquidity should the need arise. After the quarter-end, we leveraged our strong balance sheet to raise $2 billion of incremental cash by issuing bonds at very attractive rates. Specifically, we issued $800 million in 10-year notes at 2.6% and $1.2 billion in 30-year bonds at 3.25%, the same coupon as our 2019 debt issuance.
We currently have $11.2 billion in long-term debt with no maturities until 2021. Also, we’re not required to make contributions to the U.S. pension plans for the foreseeable future. Following meetings with the credit rating agencies earlier this month, we retain our strong credit ratings. All of this gives us confidence in our ability to weather the storm and emerge from it an even stronger company.
So finally, let’s turn to Slide 18 and recap today’s key points. We have a strong financial position and are confident in our ability to continue serving our global customers during this difficult time. Our enterprise cash on hand is $7.1 billion and we have a total of $20.5 billion in available liquidity. We remain committed to returning substantially all our free cash flow through dividends and repurchases through the cycle, including $1.6 billion returned in the first quarter.
We’re actively monitoring customer demand and working closely with dealers on their inventory needs. Our factories remain agile, leveraging lean principles. We continue to manage our operations to respond to positive or negative changes in demand. Our strategy is unchanged, focusing on operational excellence, services, and expanded offerings.
We are energized by our role as a company that supports from the critical infrastructure enabling the transportation of essentials such as food and medicine and satisfying global needs for energy. And once again, we thank our employees for how well they have been navigating this global pandemic and serving our customers.
With that, I’ll hand it over to the operator to start the Q&A session.
[Operator Instructions] Your first question comes from Rob Wertheimer from Melius Research. Your line is open.
Thank you and good morning everybody. I think some of us had already started the sort of trend towards lower-end or below some of your 2019 margin targets, just given the uncertainty with the buyers, I’ll be curious to hear what, among the various uncertainties, may have kick you off that trend, whether it’s aftermarket falling further you thought or mining doing something. And then I just – I wanted to see if you could talk about the trade-offs you are choosing to make. Some companies have done salary cuts, temporary or otherwise. You’re choosing to continue to focus on investment and growth, and I’d like to hear the positive trade-offs you expect to see from that and whether you might return to cutting more if you need to? Thanks.
Yes, good morning Rob. Thanks for your question. The first part of your question about margin targets really comes down to the chaotic nature of this downturn. It was not in normal cyclical downturn. So, really there wasn’t so much a downturn in one area of our business versus another, it’s just the way it happened. So government shutdown suppliers with little or no notice, which had an impact on our operation in efficiency, now we’re continuing to serve our customers and work our way through it by redirecting things, but it really has created havoc with our manufacturing operations that we’ve overcome, but it’s not again a normal cyclical downturn.
And as we’ve looked at the various levers we could pull, we are striking a balance that we think is appropriate between short-term performance and investment for the long-term. We have taken a number of actions to reduce discretionary costs and one things I will remind you of is, I mentioned in my remarks as we really have managed the business differently during the last 3, 3.5 years.
We kept our period cost flat and our salaried management headcount flat between the end of 2016 and the end of 2019 even though our sales went up 40%. And we talked a lot in our Investor Day presentations about the fact that we’re driving to produce higher absolute margins and higher absolute cash flow at all points in the cycle, compared to that historical performance between 2010 and 2016 and we still intend to do that.
Just – but, again given the chaotic nature of this downturn what’s happening with suppliers, we’re saying that it will be challenging for us to achieve those new targets that we established in May 2019, but we do expect absolute margins and cash flow to be higher, and I believe our strategy will serve us well during these times. Cash is obviously king in this environment, and the fact that we will not incur large amounts of severance costs, with large restructuring, I think will serve us well. So the fact that we maintain cost and headcount between end of 2016 and 2019 I think again positions us very well.
Thank you. And for clarity, has that supply chain disruption seemed to have reached temporary maximum or is it still rising or ongoing?
Yes, we’re working our way through it. I mean, obviously the situation – it’s geographic – the situation in China has obviously improved as the pandemic has lessened in that country, and so all of our facilities are operating in China again and our suppliers are doing much better in China as well, but it’s a rolling kind of situation, so depending on how the pandemic unfolds across the world, but again we are finding ways to continue to serve our customers, continue to ship products and parts. Our dealers are supporting our customers, but it is making it more challenging and it’s having impact on our operational efficiency as you would expect.
[Operator Instructions] Your next question comes from Mircea Dobre from Robert Baird. Your line is open.
Yes, thank you. Good morning everyone. Just to maybe follow-up on Rob’s question there, as you look at the second quarter, you provided some color and detail there, but maybe you can out it – the second quarter in – within the context of the full year, is it fair to assume that this is maybe the most challenging quarter from a production standpoint? Or do you sort of foresee these effects lingering beyond the second quarter given, you know, the changes in backlog and what you’re seeing in terms of demand? Thanks.
From a financial performance perspective, we certainly expect the second quarter to be weaker than the first quarter, and as we said, we believe that the impact – the financial impact on Caterpillar will linger as long as the pandemic continues until those effects wear off. In terms of trying to quantify or give you description of Q2, Q3, Q4 in terms of our operations, it really is a fluid situation, so it’s very difficult for me to make a judgment. But again, we’re finding ways to work our way through it.
Your next question comes from Jamie Cook from Credit Suisse. Your line is open.
Hi, good morning. I guess my question centers around dealer inventory, you cited that the declines will be the higher end of the range that you provided last quarter, but I guess why not more significant and is the goal still to be able to produce in line with retail as you exit 2020? So that goal I guess, you know, could we see bigger declines in that? Or maybe you could just comment on what you saw in April to support what we’re saying about the dealer inventory declines? Thank you.
Yes, thanks Jamie. It’s Andrew, and good morning. So, yes, obviously what we’re pointing is we had the range at the – in January of $1 billion to $1.5 billion. Based on what we see from a demand perspective, obviously, we expect that to be at the higher end of that range. Always remember, when dealers are looking out, they’re making their plans based on what they’re see going forward. So, it depends what happens in 2021 and what their viewpoint is of 2021, which is far too early as Jim just said, for us to have any view even beyond the end of this quarter that will determine their final number. So, yes, it may be more flexible, and obviously, depending on what the outlook is, that may determine whether they would like to go lower, but we’re just pointing out we would expect, at the minimum, it would be at the higher end of that range.
And sorry, can you comment on trends you saw in April, if you’re able to?
I mean it’s really too early to say. I mean obviously, you know, we are still in April, we don’t have April result yet. You know with remote working, it’s hard to get data, but obviously, you know, we are expecting that April will be a challenging month and just purely given the lockdown impact and the impacts are – particularly things like oil and gas. Remember, we are in a situation where for reciprocating engines, oil and gas prices have been negative in the month.
Okay, thank you. I hope everyone stays healthy.
Same to you Jamie, thank you.
Your next question comes from Ann Duignan from JP Morgan. Your line is open.
Thank you and good morning.
Maybe on the oil and gas, can you talk about your expectations for permanently impaired – impairments in that business and talk about the impact of oil and gas across your various businesses, we’ll say, oil sands and resource and construction equipment and the construction segment, you know, if you could just give us what your contemplating in terms of the longer term outlook in those businesses and how weaker oil and gas may impact you more permanently?
Yes. I’ll start with the – maybe the short-term impact and I’ll talk about some of the longer term. On the short-term, obviously, that we’ll have an – the oil and gas decline, particularly in WTI, will have an impact on our reciprocating engine businesses for North America and things like oil servicing, drilling, gas compression. And so, we – you know we went into the year expecting that our 2020 recip oil and gas sales would be lower. And now obviously, we’re expecting they would be even lower than that.
So our solar turbines business, mid-stream is holding up well. You should stop and think about the last downturn we had I oil and gas, the solar turbines compression business continued to hang in there, and of course the large part of solar’s sales are services related and the turbines continue to run even during low oil prices. So that provides a cushion there. I don’t anticipate a permanent impairment in our business, you know the old, I believe if it is my fifth, I think oil cycle in my 40-year career. And when things are really good people think it will never get worse again, and when things are really bad, they think it will never get better again. I do believe that the market will recover at some point. It might take a while, but I don’t perceive there will be any kind of permanent impairment on our business.
Not even in non-oil and gas like oil sands?
Yes, there certainly could be an impact in terms of a short-term impact on our business, but again, I don’t see anything major that is significant that will be a permanent impairment on our business. And yes about construction as well, so we do sell a certain amount of construction equipment in North America that is related to oil and gas, so obviously that business will be slow as well.
Okay, thank you. I appreciate that.
You’re welcome Ann.
Your next question comes from David Raso from Evercore. Your line is open.
Hi, good morning. Related to your comments, chaotic nature, the decremental margins, the first quarter at 29% were a little better than I would have thought. I assume the second quarter with a shutdown to be more challenging, but can you up us a little bit how to think about the decrementals versus you saw in the first quarter and related to that Cat nature question related to the margins, what are local and national governments telling you about the reopening. How are you planning for those reopening, things that we should be thoughtful about on your ability to ramp up a bit as things open?
Maybe, I’ll your second part of your question first, so the closures we’ve had are temporary and they are due to a combination of supply chain constraints, weak customer demand and government mandates. So, many of the facilities that have – that were closed have reopened, we’re probably going to close some that aren’t reopen now again. We look at the customer demand and we look at supply chain constraints. Even in the non-pandemic situation, we sometimes have facility closures just to align production with customer demand. So, this is not new for us. We understand how to bring facilities up, so we really don’t see a big issue there. And so, we’ve been able to work with local governments and implemented the guidelines that they have provided to us and also best practices by authorities around the world in term social distancing.
We’ve done things like staggered shifts. We’ve extended lunch hours. We – and we’re taking temperatures. We’re doing a whole variety of things that are – that have been recommended as best practices. So, we’re continuing to implement those as they come out. And as I mentioned earlier, we’re really focused on achieving higher margins at each point in the cycle, compared to what we did between 2010 and 2016. And so, rather than think about it from an incremental and decremental perspective, what we laid out at our two Investor Days in 2017 and 2019, was our ability to achieve higher absolute margins and absolute cash flows at each point in the cycle. And as I mentioned earlier, I believe that will serve us well in a period where cash is king.
And David, good morning, this is Andrew. Just to add to that, obviously, the volume decline in the first quarter was somewhere around about 20%. Obviously, operating leverage is still the biggest factor in what your incrementals and decrementals would be if you think about it in that terms because leverage is the single biggest factor. Also just remind you that obviously in the first quarter last year, the actual amount of short-term incentive compensation was slightly higher than the average for the remainder of the year. So that will be slightly negative on margins going forward because obviously you won’t have as much offset against that as we go through the remaining quarters of the year, so it will vary a little bit.
So, to clarify what you’re saying, a little bit related to last May’s Analyst Meeting, whatever we think the revenues will be this year versus history, similar revenues, you would expect the margins to be higher be it, you know, 2016 when equipment sales were $36 billion or 2017 when they were $42 billion, $43 billion, what you’re saying is, you expect your margins to be higher at the same revenues this year versus then, is that fair?
That is correct. That’s what I said.
Alright, thank you very much. I appreciate it.
Thank you, David.
Your next question comes from Adam Uhlman from Cleveland Research. Your line is open.
Hi, good morning, everyone. Hope you’re all staying healthy. I had a question about the service sales, could you explain your thoughts on what you’re seeing there, how the revenues are holding up and with the growth efforts that you have in place, do you think you could keep the sales declines there in something like a mid-single range? Or does it get dragged down a bunch like the new equipment sales? Thanks.
Hi, Adam. It’s Andrew. Actually, you know the services sales in the first quarter were down marginally, part of that was due to inventory movement’s year-on-year. Last year, we saw a small build in services and parts revenues in [indiscernible] channels, and obviously, a slight decrease down. Obviously, we anticipate that services revenues will hold up better than original equipment revenues as we go through the cycle.
Obviously, you know, if you look at the history that has always been the way. This stage is too early to predict what percentage they will change by, but, obviously – and it’s going to depend on customer-by-customer, where they are open, are they able to use – what machine utilization rates are and so forth. So, we need to see how all that pans out and get a few more data points before we start making predictions in that regard.
And your next question comes from Steven Fisher from UBS. Your line is open.
Thanks, good morning. Just wanted to ask you about pricing, is it seemed to be a little be more resilient than I would have expected really across the board, but particularly in E&T. So, maybe can you just give us a sense of where that strength came from in E&T and how sustainable you think it is and then maybe just some other comments about competitive dynamics in the other various segments?
Yes, Steven. It’s Andrew. So, obviously overall, if you look at pricing, it was negative in the quarter. Most of that was mostly in construction industries and that was really geo mix rather than actually pricing per say although we did see some competitive pricing pressure in China. Just again to remind you, geo mix does come to which does distort the pricing mix, so obviously if you do see favorable sales in different regions that does have an impact on the mix. So, we have don’t go down to that level of granularity by discussing by segment, but generally it has been – it has held up. We did put pricing increases through on 1st of January, but the geo mix was what we were expecting competitive position and Asia-Pacific hasn’t changed.
Thanks, but in E&T it was actually up, so I was just curious, I mean…
Yes. Well that’s relating to the price increase – that is the price increase across that was put through in the 1st of January.
And also in the E&T things are going to get lumpy as well. So, [indiscernible].
Okay. Thanks very much.
Your next question comes from Ross Gilardi from Bank of America. Your line is open.
Hi, good morning guys.
Good morning, Russ.
I had a question on capital allocation, in the presentation you stated you are going to return all of your cash, but yet you are suspending the buyback program for now, does that mean that free cash flow is unlikely to exceed the 2.3 billion that gets paid out in the dividend this year? And then the follow-up question to that is, are you still committed to raising the dividend via a high single-digit percentage for the next four years given this unforeseeable situation that you couldn’t have predicted when you made that commitment? Thanks.
Yes, so I think, I’ll answer the dividend question first and I will put you back to Andrew. So, obviously the dividend is a priority for us. You saw that we raised our dividend already this year even in this situation. We are not making a prediction as to what we’ll do with the dividend for the rest of the year. Obviously, it’s a priority and we feel comfortable in our ability to support the dividend, but in terms of future increases we’ll keep you posted. It’s obviously a board decision and we’ll make a recommendation to the board later in the year and we’ll keep you posted.
Yes, Russ and as far as free cash flow, so if you look in the first quarter, we actually paid out $1.6 billion if you take the buyback into account plus the dividend, if you then extrapolated by across the remaining three quarters of dividend that implies free cash flow of over – around about $3.5 billion for the full year or 3.5 billion of distribution to shareholders for the remainder of the year.
Question at the moment is, while we are uncertain as to what free cash flow will be, we’ve decided to put a pause on the buybacks because obviously we’re not yet certain whether we are in that position whether we are distributing substantially all or maybe even slightly more than our free cash flow to the – sort of that’s the uncertainty which causes us to put a suspension. As things become clearer, we’ll make decisions. We are in strong financial position. As I say, we had $7.1 billion of cash on the balance sheet at the end of the first quarter and if you remember last year we actually distributed slightly more than our free cash flow for the year.
Thanks very much.
[Operator Instructions] Your next question comes from Jerry Revich from Goldman Sachs. Your line is open.
Yes, hi good morning everyone.
Good morning, Jerry.
Andrew I’m wondering if you could expand on your prepared comments on the restructuring program, presumably the range of restructuring spending is wider than we were contemplating a quarter ago, can you just expand what the range of investment could be this year and what kind of payback periods are we targeting and for the discontinued product lines, what are the plans to repost those product lines to provide continuity for your dealers? Thanks.
So, first of all, our expectation at the beginning of the year was that we would have somewhere in the region of $100 million to $200 million of normal restructuring expense and we put up a placeholder in place for the $200 million of restructuring for the challenged products. At this stage, we don’t see that it’s going beyond that at this stage, but that’s obviously we’ll update you and keep you posted as time goes on.
Obviously, again, the timing of these issues – timing of these actions is a significant factor on the charge for the year. So, for example as we said in my remarks, we started the contemplation process in Germany, that may take a while and that will determine how much we charge in the financial year relating to those challenged products. Similarly, the impairment was taken along the lines of actually the asset, we do view the asset as being impaired in value and sort so the action we took that action in Q1.
So, we’ll keep you posted. Obviously, and make sure if we do believe it’s outside that range we will update at this stage, we’re still within the original range we talked about in January.
And maybe just to add additional comment about cost and we continually ask our managers to focus on cost to find ways to be more efficient and obviously during this environment we vamp that up, so whether or not that falls into a restructuring bucket regardless we are really focusing on finding ways to be more efficient and reduce costs.
And the dealer product line part of the question?
What are the plans to replace the product lines he said? Of any exited businesses?
The point is, actually we haven’t made decisions to exit any of those businesses at this stage. So that’s why as far as dealers are concerned, obviously it’s not an issue for them at this stage.
Okay, thank you.
And there are ways to restructure without exiting. So, just leave it there.
And your next question comes Courtney Yakavonis from Morgan Stanley. Your line is open.
Hi, thanks. Just wanted to Bob, Jim with some of your comments on the positive or the medium, long-term positive outlook for mining, but you seem some uncertainty in the near-term and more restrictive CapEx from some of the miners so can you just comment on that? And then I think you did see dealer inventories decline in resources this quarter, so if you can just help us understand how big of an impact that is and how big the overhang in resources, the pressure on the heavy construction and quarry in aggregates side? Thanks.
Sorry, Courtney it’s Andrew and good morning. On the dealer inventory side, actually the dealer inventory reductions quarter-on-quarter where the most significant impact on RI sales, it was a small majority of it. We don’t disclose a specific number, but it was over half of the decline in revenues for the quarter.
And maybe just a comment on mining, it wouldn’t be surprising if the pandemic would have an impact on our mining business short-term. However, based on the state of the industry, the replacement cycle, we still feel positive about mining in the medium and long-term?
Okay thanks. And then just, can you give us any more color on just the geographic discrepancies you are seeing between North America and Europe, I think some of your peers have talked about European a little bit weaker because of some of the more or worst restrictions over there, but seemed like Europe has actually being holding up fairly all for you based on your retail sales data. So, if you can just share on what you’re seeing there in April or not in April, just in general?
Yes, I think Courtney there are a couple of factors. One, which is obviously is dependent how strong the comparative period was, and if you remember last year Europe was not particularly strong in the first quarter of last year. So, I think that is why year-on-year some of that data looks a little bit better in Europe. On the retail side, obviously, we’re starting to see in the U.S. where we obviously had a very strong, particularly non-residential construction cycle that has started to diminish. We hadn’t seen the strength in non-residential construction in Europe, which is another factor.
This is Jim, just wanted to make a statement, I have been informed that I mistakenly used the word raised when I talked about the dividend earlier this year, we did not raise a dividend, we maintain the dividend. So, my apologies for that mistake.
And we now have time for one more question before we go to Jim’s wrap-up.
Your final question is from Joe O’Dea from Vertical Research. Your line is open.
Hi, good morning. Can you just comment on financial services with past dues up about 100 bips sequentially and allowances up 20 bips and your comfort level overall with where that allowance figure stands, and I think most importantly your thoughts on the direction of provisions over the next quarter or two whether it’s more likely that those provisions are moving up before they start to move down?
Hi Joe, it’s Andrew and obviously I’ve meant to cover this a little bit in my remarks, but the – if you look at the 4.13% of past dues at the end of the quarter, significant drivers of that were the legacy Cat Power Financial portfolio, and then also some hot spots around Middle East and Latin America, both of which were issues which we were dealing with historically and have been factors were actually the reserve has been quite significant in the past.
So, those are ongoing issues, which we’re dealing with. As I mentioned in my remarks, actually our customers came in to the crisis in a very healthy position. So past dues in North America at the end of last year were 1.3%. At the end of the time of the financial crisis they were 4.3% so that gives you an indication of the health of that customer base and in China they were 1.3% versus 8.3% in the financial crisis.
So again, that is a very different scenario. We did modestly increase the reserves in the quarter, obviously the difference is obviously, we now have the CECL process that we are required to reserve against. The reason why our loan reserves will be lower than you would see in many other financial institutions is because the security we have over the loan, which is the loan is secured on the machine itself and that reduces your risk from a write-off perspective. So that is again, gives us comfort, yes we do expect, we would inevitably will see some write-offs as we go through the remainder of the year. We do think that will be a lot lower than it would have been historically.
And I’ll turn it back to Jim for closing remarks.
Well thank everyone for your questions. I just have a wrap-up here. Caterpillar has been an operation for 95 years, and we faced it, overcome many challenges. We have a very strong financial position which we described to you this morning. We’re continuing to pursue our strategy focused on services, expanded offerings and operational excellence.
Once again I’d like to thank my Caterpillar colleagues around the world for staying focused on their safety and for working with our dealers to deliver products and services that enable our customers to fight the good fight against COVID-19. Our goal is to emerge from the pandemic even stronger than before, better position for long-term profitable growth. Thank you again and with that, I’ll turn it back to Jennifer for some closing reminders.
Thanks Jim and Andrew and everyone who joined us today. If you missed any portion of the call, you can catch it by replay online later this morning. We will post a transcript on the investor relations website within one business day. If you have any questions, please reach out to Rob or me.
You can reach Rob at firstname.lastname@example.org. I’m at email@example.com. The investor relations general phone number is 309-675-4549. And now let me ask Jacqueline to conclude our call.
Thank you. Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect.