Caterpillar Inc. (CAT) Q4 2010 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Caterpillar Year-End 2010 Earnings Results Conference Call. [Operator Instructions] It is my pleasure to turn the floor over to your host, Mr. Mike DeWalt. Sir, the floor is yours.

Thank you. And good morning, and welcome, everyone, to Caterpillar's year-end earnings call. I'm Mike DeWalt, the Director of Investor Relations. I'm pleased to have our Chairman and CEO, Doug Oberhelman; and our Group President and CFO, Ed Rapp, with me on the call today. This call is copyrighted by Caterpillar Inc. and any use, recording or transmission of any portion of this call without the expressed written consent of Caterpillar is strictly prohibited. If you'd like a copy of today's call transcript, we'll be posting it in the Investors section of our caterpillar.com website and it'll be in a section labeled Results Webcast. This morning, we'll be discussing forward-looking information that involves risks, uncertainties and assumptions that could cause our actual results to differ materially from the forward-looking information. A discussion of some of the factors that individually or in the aggregate, we believe, could make actual results differ materially from our projections can be found in our cautionary statements under "Item 1A. Risk Factors" of our Form 10-K filed with the SEC on February 19 of 2010, in Part II of our Form 10-Q filed with the SEC on May 3, 2010, and it's also included in our forward-looking statement language contained in today's release. Okay. Earlier this morning, we reported results for the fourth quarter, the full year for 2010 and we provided an outlook for 2011. To start this morning, I'll summarize the financial results and the outlook, then Doug and Ed and I will take your questions. Now with the quarter, the year and the outlook, there's a lot to cover and I'll start with a quick review of the full year. 2010 sales and revenues were $42.6 billion. That's a $10 billion or a 31% increase from 2009. Profit per share was $4.15, a significant increase from $1.43 in 2009, as we reported it, and $2.18 a share in 2009, excluding redundancy costs. I'll cover the increase in sales and revenues from two perspectives. First, I'll run through the sales change by geographic region, then by line of business; and by that, I mean Machinery, Engines and Financial Products. Starting with sales by geography, we were up in all regions. Total sales and revenues in Latin America were up 58%; Asia/Pacific, 43%; North America, up 30%; and Europe, Africa, Middle East was up 13%. In general, strong economic growth in the developing world drove sales in many of those countries near or above 2008 peaks. Sales in the developed economies of North America and Europe also improved, but from depressed starting points in 2009. While sales rose, they're still far below previous highs with room to improve as economic growth and construction activity picks up. New machine sales in the U.S., for example, are still less than half the prior peak, which was in 2006. So from a geographic standpoint, sales are improving in every region and are at or near records in the developing world. In North America and Europe, they're better than '09, but still at depressed levels. Okay, I'll switch gears and talk about our lines of business; that's Machinery, Engines and Financial Products. Compared with 2009, Machinery sales were up $9.6 billion or 53%, while Engines were up just 6% and Financial Products revenues dropped 5%. For Machines, we benefited from higher end-user demand, absence of dealer inventory reductions of $3.4 billion from 2009 and we had a modest $800 million inventory build in 2010. In addition, price realization was positive, and EMD, which we acquired in the third quarter of 2010, added $573 million. Engines were also up, but much less than Machinery, and that's because Engines didn't fall as far as Machinery in 2009. Particularly during the first half of 2009, order backlogs for large reciprocating engines helped sales through mid-2009 and our Turbine business didn't decline in 2009. They had a record year and they held that fairly steady in 2010 with the help of a large order from Latin America. Financial Products revenues declined about 5% and that was a result of the smaller portfolio of earning assets. Essentially, for most of the year, business that was written a few years ago was rolling off faster than new business was being added. And as a result, the portfolio and average earning assets and revenues declined. That said, near the end of 2010, we reached a point where new business was at about the same level as what's rolling off. So Machines up 53%, Engines up 6% and Financial Products were down 5% for the full year. Profit in 2010 was $2.7 billion, triple the $895 million in 2009, and profit per share was at $4.15, up from $1.43. Significantly higher sales volume was the most important reason that profit improved in 2010. However, the profit impact was mitigated somewhat by a very negative shift in sales mix compared with 2009. Sales mix in 2010 was more than $1 billion, unfavorable to operating profit, and there were three major reasons why. First, Engines have a higher operating margin than Machinery, but Engines were up just 6%, while Machinery sales were up 53%. Second, Integrated Services have higher margins than new equipment and new equipment sales increased at a rate about three times than that of our Integrated Services business. And the third reason that mix was negative was that even within the Machinery and Engine categories, it turned down. The increase in Engines was more concentrated in smaller, lower margin products, and the sales of smaller, lower margin machines grew faster than larger, higher margin machines. Now that might not make sense to you when you think about the strength of areas like the mining industry and weakness in areas like U.S. housing. But our sales of small equipment from our Building Construction Products division more than doubled. Much of that impact was a result of significant cuts in dealer inventories back in 2009 which were disproportionate to small machines. After volume, the most important positive driver was price realization and that was a favorable $954 million. Manufacturing costs were also favorable, $909 million. And that's despite the absence of $300 million of LIFO decrement benefits that we had back in 2009. Variable labor and burden efficiency improved, we had lower warranty cost and material costs were lower in 2010. Production was up, manufacturing costs were favorable, delivery times were reasonable given product demand. We stocked Lane 1 inventory at our products distribution centers and we produced enough in the fourth quarter to help dealers build some inventory. 2010 was a year in which employees at Caterpillar factories around the world executed the Cat Production System. It wasn't perfect, we have plenty of room to improve, but we certainly moved in the right direction in 2010. In addition to favorable manufacturing costs, the absence of 2009 redundancy costs, which were $706 million, was also a positive. Now partially offsetting the positive items, SG&A and R&D costs were higher by $986 million, and that was due to provisions for employee incentive compensation and increased R&D spending. Now in terms of incentive compensation, we set $2.50 per share as our trough of the business cycle profit goal over five years ago. We were committed to the goal and we set it as a trigger point for 2009 incentive pay. But with economic problems in 2009 worse than expected, we didn't make the profit threshold and there was no provision for incentive pay. In 2010, our financial results were much better than our original 2010 outlook, and as a result, we did provide for incentive pay, nearly $800 million across the company. Okay, currency impacts were also unfavorable to operating profit by about $200 million. Below the operating profit line, other income and expense was unfavorable, $250 million, and that was mostly due to the absence of currency hedging gains from 2009 and some hedging losses in 2010. Income taxes for the year were very unfavorable compared with 2009. The provision for income taxes of $968 million for 2010 reflected a tax rate of 25%, excluding $30 million of discrete items. In 2009, taxes were a benefit of $270 million and that was driven primarily by a favorable geographic mix of profits and losses from a tax perspective, along with tax benefits related to prior-year returns of $133 million. Now one final point on the full year of 2010, and that's incremental operating margin. It's a subject I know many of you are interested in. We put a Q&A on incremental margin in our release this morning. It's Question 18, it's on Page 31 of the release. It includes a table that starts with our consolidated sales and revenues and operating profit, then it adjusts for three items: 2009 redundancy costs, we didn't want to take credit for that; 2009 LIFO benefits; and the acquisition of EMD. On that basis, incremental operating margin for the full year was 30%. And remember, that was despite over $1 billion of negative sales mix. Operationally, 2010 was a good year. Okay, let's move on to the highlights of the fourth quarter. Sales and revenues were $12.8 billion, up 62% from the fourth quarter of 2009. Profit was $968 million, about 4x 2009's fourth quarter, and profit per share rose from $0.36 to $1.47. Machinery sales were up 88%, Engine sales up 36%, and Financial Products revenues declined 6%. We raised production levels in every quarter of 2010 to the point where, in the fourth quarter of 2010, we shipped new machines at more than double the rate of the fourth quarter of 2009. In terms of geographies, sales and revenues in North America were up 78%; Latin America, 59%; Asia/Pacific, 55%; and Europe-Africa-Middle East, 49%. And that better sales volume was, by far, the major positive factor related to the profit increase. However, like the full year, it was mitigated by over $400 million of unfavorable sales mix, the most negative year-over-year sales mix of any quarter in 2010. Price realization was favorable compared to the fourth quarter of 2009 by $333 million. Absence of 2009 redundancy costs and operating profit in 2010 from EMD were also favorable. Now partially offsetting those favorable items, manufacturing costs in the fourth quarter increased. Excluding the impact of 2009's LIFO decrement benefits, manufacturing costs were $45 million higher than the fourth quarter a year ago. It was a small, low-cost increase and it was driven by higher period manufacturing costs, a result of incentive compensation, much higher volume and the programs we're pursuing to increase production capacity. Although we think of period costs as fixed, in reality, volume has an impact. In our analysis of period costs, we don't adjust for volume. So when you have a quarter with a volume increase as significant as we saw in Q4, it does tend to have a negative impact on our analysis of period manufacturing costs. While period costs were higher, I'm pleased to report that our variable labor and burden costs continued to improve and offset much of the period cost increase. Moving on, SG&A and R&D costs were also up and the reasons were similar to the full year: Higher incentive compensation and higher R&D. Below the operating profit line, income taxes were unfavorable compared with the fourth quarter of 2009, but that did include a benefit of about $75 million related to a lower tax rate than we'd previously expected. The improvement in the tax rate versus our expectation was primarily due to the renewal of U.S. tax benefits, including the research and development tax credit. We also had a bit more favorable geographic mix of profits from a tax perspective. Okay, that's the quarter. I'll move on to the outlook. To start, we need to clarify what's actually in the outlook relative to our announced acquisitions. In 2010, we announced three acquisitions that were large by Cat standards: EMD, MWM and Bucyrus. We closed EMD in the third quarter of 2010 and had about five months of EMD in our 2010 results, and EMD is included in our 2010 outlook. Because we'll have them in our 2011 numbers for the full year, it's expected to be positive for both sales and profit. We haven't closed either Bucyrus or MWM, and as a result, neither is included in our outlook. That's our long-standing policy: We don't include acquisitions in our outlook until after they close. That said, our outlook does include about $50 million of expense for bridge financing related to Bucyrus, and it includes some costs related to integration planning. We included those items in the outlook because they're in place and will begin incurring the costs before the deal closes. With that in mind, our outlook for 2010 sales and revenues is to exceed $50 billion and profit to be near $6 a share. Key points related to the outlook for the top line include our expectation of continued positive economic growth in the developing world overall. While we don't expect those economies to grow quite as rapidly as they did in 2010, they should still grow fast enough to support an increase in machine sales. We expect world growth and relatively tight commodity supply to continue to provide a very positive environment for our Mining customers. Demand for Mining remains strong and we would expect Mining sales to increase in 2010. Over the past quarter, we've become somewhat more positive about economic growth in the developed economies of North America, Europe and Japan. And we're now expecting the U.S. economy to grow about 3.5% in 2011. We're expecting continued growth in our Machine sales in developed economies despite our expectation of a relatively weak recovery in construction spending. That's because we believe that customer fleets have deteriorated over the past few years. End-users in the U.S., Europe and Japan cut their machine purchases more than construction activity declined, particularly in 2008 and 2009. While machine sales in the developed world improved in 2010, it was from a very low base, and we don't believe the increase was enough to stop the deterioration of fleets. Cat dealer rental fleets are a good example. In 2010, dealers purchased significantly more new machines for rental fleets than they did in 2009, but despite that, fleet size declined in 2010 and the average age of machines in their fleets went up. In short, for Machines, we expect continued growth in sales in 2011, continuing growth in the developing world, some economic improvement, coupled with an increasing need to refresh customer and rental fleets in the developed world and positive conditions for mining. The outlook for Engines isn't quite as positive. We expect 2011 Engine sales to improve, but most of our top line improvement will be Machinery. We expect sales of reciprocating engines for oil and gas, electric power and industrial applications will continue to improve, but later cycle areas like turbines and engines for large marine applications are expected to decline. As a result, we expect only modest overall sales growth in Engines in 2011. We expect profit again to be near $6 a share, an increase from $4.15 in 2010 and above the 2008 record of $5.66 a share. And recall, the $5.66 from 2008 included large favorable tax items that resulted in a tax rate that year near 19%. So on a before-tax basis, we expect to do even better than the headline number would indicate relative to the prior 2008 peak. The most significant reason for the expected profit improvement from 2009 is higher sales volume. We do, however, expect continued negative sales mix in 2011, with Machines growing faster than Engines. While we expect the mix to be negative, the year-over-year impact should be less than 2010. We expect a small improvement in price realization, coupled with material costs that we expect to remain relatively flat in 2011. We also expect variable labor and burden efficiency to continue to improve. We're expecting an increase in period manufacturing costs, and that's a result of higher volume and implementation of a number of initiatives to increase capacity. The capacity initiatives are programs that we announced in 2010 such as mining capacity in the U.S. and India; excavator capacity in the U.S. and China, a new engine facility in China for 3500 Series engines; and a new backhoe and loader facility in Brazil. In addition to capital, these capital investments will drive expense in 2011. We have to push them forward. We need more production capacity to be ready for 2012 and beyond. Now in addition, R&D expense is expected to rise about 20% in 2011. And again, primarily related to the continuing implementation of emissions requirements, SG&A expense should rise modestly in 2011, and mostly activities to support higher sales, SG&A as a percent of sales should continue to decline. We expect a slightly higher tax rate, mostly from an unfavorable geographic mix of profits from a tax perspective, and we're using a 28% rate. Finally, the outlook includes bridge financing costs of about $50 million related to Bucyrus and some additional costs related to the integration planning that I mentioned earlier. From an incremental margin standpoint, we're expecting about 25% of incremental operating profit on incremental sales and revenues in 2011. Now that 25% number excludes acquisitions, and in that context, it excludes EMD because it wasn't in our numbers in 2010 for the full year. Okay, to summarize, 2010 was the first year of sustained recovery from a tough year in 2009. 2011 looks better and we're expecting record profits. We're investing in capacity increases around the world to be prepared for 2012 and beyond, including substantial investment in the U.S. Of the $3 billion of capital expenditures in our forecast for 2011, more than half are being invested in the United States. 2010 cash flow was also good news as well. Our Machinery and Engines operating cash flow was an all-time record at $5.6 billion. Our debt-to-capital ratio dropped from over 47% at year-end 2009 to 34.8% at year-end 2010. And we raised our dividend again in 2010. In fact, for 17 consecutive years, Caterpillar has paid higher dividends to stockholders. Machine sales to end-users improved throughout 2010 and ended the year strong. And finally, excluding acquisitions, we increased our total workforce by about 19,000 people in 2010, with about 7,500 in the U.S. In a tough employment environment, we added about 15% to our total U.S. workforce, and that includes full-time employees and our flexible workforce. On that positive note, Doug, Ed and I are ready to take your questions.

[Operator Instructions] Our first question today is coming from Seth Weber.

It's RBC. I'm a little confused as to the -- I was surprised at the strength in the pricing in the fourth quarter, and I'm just trying to understand why your outlook isn't a little bit stronger for 2011. And then secondly, I guess a follow-up question would be on the supply chain. Can you talk about what you're seeing there and whether you're continuing to bring outsourced work internally? And can you just talk about the health of the supply chain as you ramp production?

Seth, this is Mike. I'll just start out with that. If you look at price realization in the fourth quarter, what we report is fourth quarter over fourth quarter, and so you have to kind of look at what was the situation in both quarters. Now usually we get a tick down in price realization in the fourth quarter and that actually happened last year fairly significantly and this year as well. If you were to compare to the third quarter, price realization was actually down a little bit, and that's not unusual. There's usually a little bit more merchandising programs and variance in the fourth quarter. So it actually ticked down versus the third. It just didn't go down as much as it did in the fourth quarter a year ago. With respect to next year ...

This is Ed. I think the thing is, if you look at the pricing environment, it really gets down to our value equation versus our competition and we're going to price in the market. Our business model's pretty straightforward and machine population, which leads to parts and service, which leads to dealer capabilities, I think you know that fairly well. There is a lot of noise in the system in terms of commodity prices. We're very close to that. And to the degree we see more pressure in that area, we also have the ability to turn the dials on price. On the supply chain side, first of all, I think we really got to recognize how our supply chain performed in 2010. I mean, with a largest year-over-year increase in the company history, I'd say they performed exceptionally well. There are areas where it's under strain, and what we're doing is, working very closely with our suppliers. We're marshalling resources into those key areas where we do have some bottlenecks to make sure that we can deliver the volume that we've got in the 2011 plan. But I'd say all in all, our supply chain has performed very well, coming off of a tough bottom in 2009.

And just going back to the material cost question, how much confidence do you have that you can keep your input costs flattish there?

Seth, I think the confidence comes from probably taking a look back to 2010 when, with some of the similar-type noise in the system relative to commodities, we indicated we thought we could have it down year-over-year which, at the end of the day, we delivered. So we go into the plan with the confidence level, we can keep it flat year-over-year, but if you think about the markets we serve and how we play on both sides of this equation, serving those industries, as well as having material costs, we keep a very close eye on it and if we have to adjust, we will.

Our next question today is coming from Andrew Obin.

BofA Merrill Lynch. Just in terms of capacity expansion, one region I want to focus on is China. I know that you guys can't comment to what the competition is saying, but it does seem that everybody in China is sort of increasing capacity. And it does seem that the Chinese competition is able to increase capacity quite a bit faster than you guys. So I guess the question I have, how should we be thinking about pricing environment in China; and b, what are you thinking about PINS [percent of industry sales] in China going forward? And how should we be thinking about the pace of capacity expansion that you guys are following in China? And I do understand there are very real reasons why you guys sort of pursuing the pace that you are in terms of supply chain, but if you could just talk a little bit about this key market.

I'll start it off, Andrew. We actually did include at least an excavator comment about China in one of the Q&As in the back of the release. A year ago or last year, we announced pretty significant increases, or at least planned increases, in capacity in China, quadrupling from capacity of excavators of around 6,000 to around 24,000 in 2012, with some progress along the way in 2011. So we're actually increasing capacity there a fair bit. We were at capacity on excavators in a hot market and in a market that we think is going to continue to grow. And we need it to add capacity to gain share there. Now excavators frequently gets all the headlines, but we're also building a new facility there for mini-excavators. We're expanding capacity in our wheel loader facility there and we announced the addition of a new factory to produce 3500 Series engines in China. So China is a huge focus for us, it's a big market, it's a growing market, it's a robust economy. There's a lot of development there that still needs to happen. So I would say, and I won't comment on what all the competitors are doing, there are so many of them there, but we're definitely focused on it.

And is the goal in China to increase your PINS over time? Is that the idea behind the capacity expansion?

I would just add, Doug Oberhelman here, that we have an intense focus on industry leadership inside China by 2015. And to get there, it's going to take, as we said in the Q&A, at least 24,000 excavators being produced in China for China by the end of '13. We're on a path to deliver that and I'm hopeful we can get it done even a little bit early. We've also ramped up the wheel loader production both in our Sim [Simulator] product line, as well as our Cat product line in Suzhou. And I am optimistic that everything we have going, including our CapEx, our marketing and distribution in the organization is on a path to get there and deliver leadership PINS in wheel loaders and excavators by 2015. Everything we're doing is aiming at that.

But just so far, you feel okay in terms of pricing environment given the demand in China?

Yes.

Our next question today is coming from Mark Koznarek.

It's Cleveland Research. I've got a question on the outlook with regard to the exposure to residential construction because that's one area that still remains very lackluster in terms of both your own outlook and everybody else's, where it's such a sharp decline versus prior peak in North America. What kind of headwind is the residential side creating for the company? And conversely, once we get out of this storm, what kind of opportunities does that present?

Mark, this is Ed. I think all the headwinds on the residential side of it already had been in there. If you look at housing starts, '09 or '10 or even our projection in terms of housing starts for '11, will be the three worst years dating back to 1945. So a lot of that headwinds is there. If you look at our retail sales which we released this morning, though, you're going to see good growth even in North America that, I think, is being driven by a number of factors. One, our sales peaked at the end of first quarter '06, so we've been in an extended period of a downturn in North America. You also see it in the average age of our equipment. This is primarily a mature market in North America, so it's a replacement cycle, demand-driven, and you're starting to see that replacement cycle getting very long in the tooth. And I think that's why you're seeing some of the growth in our North American retail sales. In addition to that, if you go back and look at rental fleets, back to the last recession, if you would, of kind of the '02 timeframe versus kind of where we're at today, you'll see rental fleets are down considerably versus that last trough and the average age of equipment has extended. So I think the point you raise is a good one. When we start to see a more robust growth in North America, there's quite a bit of pent-up demand there yet to come: The growth as the residential construction comes back, growth as dealers replenish their dealer inventory levels, and in growth as they replenish rental fleets. So I think all the headwinds are already in. I think the tailwinds come as we get more robust growth in North America.

Well, then, as kind of a follow-up to this, if we're in sort of the beginning stage of a cyclical recovery in North America, presumably Europe as well, where we've got healthy secular growth going on in the emerging markets, which is likely to be the stronger driver of growth in '11 between the two?

I think in '11 in terms of outlook, we're projecting growth in both of those. I think, at least based on the current growth in the developed parts of the world, the emerging markets are going to be the primary drivers. We talked earlier about China. It's not only important in terms of the growth within the country, but it's that growth and the pressure it puts back on commodities and how that leads to growth in other parts of the world. So I'd say the primary driver for this year, similar to what was in 2010, will be the emerging markets.

Now I would just add, Mark, a comment. Personally, I'm a bit more optimistic on housing because while I don't see it today, and we talked to a lot of our contractors and our dealers in the U.S., and there's absolutely nothing happening today, but it's a function of -- I think a direct function of the unemployment rate. And as the year goes on, I think we may see that unemployment rate come down and drive some housing more than anybody's expecting today. But yet to be seen. There is no way you can call it at this moment because everything's negative, everybody we talk to says it's not going to happen. But we do have record low mortgage rates that still persist. We get people back to work in the U.S. and maybe Western Europe, I think things will start to happen. So we'll watch that and see how it plays out. But it has yet to be seen because right now, you can't see it. But I think we'll see that later in the year at some point and beyond.

Our next question today is coming from Jamie Cook. Jamie Cook - Crédit Suisse AG: Credit Suisse. I guess a quick question. Struggling with your last quarter, your sales outlook, if we run rate the back half of the year, sales were $48 billion. I know you're saying north of $50 billion for 2011, any color on that and what we assume for dealer restocking in 2011? And then I guess the other part of that is just, I guess if I look at your sales forecast, is it a function of your view on the market or are you capacity-constrained?

Jamie, this is Mike. I'll start out with that. We did have a good fourth quarter. If you take the fourth quarter and multiply it by four, though, there are a few things that you'll need to think about. One is, the fourth quarter is usually seasonally a pretty good quarter. You have some customers that are maybe corporations that are trying to take advantage of maybe year-end tax breaks depending upon the country they're in. Sometimes they're trying to get capital spending into a particular year. Or in some years, they'll try to maybe avoid a January price increase. So in the fourth quarter, we usually get a little bit of a seasonally high quarter. The second quarter is usually a seasonally high quarter as well. In addition to that, in this fourth quarter and we talked about this in the release, we were able to increase production enough to let dealers build $700 million worth of inventory in the fourth quarter. And so if you were to extend that $700 million times four, that would imply something close to a $3 billion inventory build, and we don't think that's going to happen. There will be some inventory build in 2011, but that will still be well below where dealer inventory was in 2008 and it certainly won't be anything near $3 billion. So I think you need take a little dealer inventory build out. Solar, fourth quarter is usually a big quarter seasonally for Solar. It's been that way. We've talked about that a lot. So I think you kind of have to tone that down if you're going to multiply it by four for Solar. And then for Engines in general, a couple of big Engine categories, large marine and Solar, we're expecting actually to be down in 2011. And I think, finally, we do have, in some areas, our forecast right now is constrained by production. In big mining trucks, I think delivery times range for most big mining trucks right now between eight and 18 months. And if we could produce more mining trucks in the short-term, for example, we could sell more. Excavators are pretty tight right now and for both of those in particular. That's why last year, we announced capacity increases. We saw this coming and we need to be ready for the volume that's going to come in 2012. So we're trying to get more capacity in place for those key products right now. Jamie Cook - Crédit Suisse AG: Mike, you can get to your $48 billion just run rate in the second half of the year. It's not just Q4. But I guess that being said, let me ask you this. In North America, let's assume 2011 is just a restocking year and we have no material improvement in resi, even though Doug seems to think that could surprise us. Traditionally, coming out of a cycle, how much are we up in North America on restocking? And then if we get the help from any end market recovery, traditionally, what are you up?

Well, this was not a very traditional decline, what we saw in 2009. If you just go back through, I think, the last two or three cycles before that, I think three cycles, if you just look at new equipment sales -- now this is not the service-related businesses. But I think in the U.S., a decline would normally be between 40% and 50% from peak to trough, and it would take a couple of years to get back to that. What we saw in 2009 was a much more dramatic peak to trough reduction. I mean, from the '06 peak to the '09 trough in the U.S., new machine sales were off close to 80%. So I think on a percentage basis, we're probably getting a much more robust increase than historically. But that's just from a percentage basis. I think in dollars, the improvement is much more modest. So I think what we are seeing right now in a roundabout way, I'm trying to say is, we are seeing improvement today. It's as you said. It's not really related to a robust construction equipment market, housing is weak, there's some life in commercial, but it's still very depressed. What we're seeing is, customers cut purchases so far, they're at a point now where they have to do some replacement buying, both for rental fleets and customer fleets. So that's what's driving the numbers, not robust construction.

Our next question today is coming from Robert Wertheimer.

It's Morgan Stanley. My first question is just checking in on Cat Production System and labor cost. You've talked about that having been a pretty good driver as you bounced back and hopefully a little bit, though, less in the future. In '07, I think you ended with 101,000 full-time employees. You're now at 105,000. I know there's variable employees, so that's not the best metric. But the question is sort of, was 4Q loaded up for growth and, therefore, a little bit depressed by excess employees? Are you still feeling on track with variable labor savings in your enhanced production system?

Employment, Rob, is always a little dicey to deal with. We have had acquisitions since 2007; two really big ones. We acquired a controlling interest in Cat Japan and that added several thousand -- I can't remember the number, but I think order of magnitude, 5,000, 6,000. And then we added EMD which was pretty good. So probably between EMD and Cat Japan, you probably have, I don't know, 7%, 8%, 9% of our total employment. So I think if you were to just look at the rest of the business, we've actually done a pretty good job on efficiency. We did add back 15% to the total U.S. workforce this year, a lot of that driven by export demand. So that was an increase in employment. But if you look at sales, sales went up quite a bit more than that. And that's essentially what drove the efficiency.

And the second question, I don't know if you intend to keep disclosing the Lane shipments quarter by quarter, but it wasn't in the PR, I wonder if you can give us any kind of an update. I guess what you're hearing from dealers that you're saying you should be fully up to where you want to be in a couple of quarters, but aren't there yet.

Yes, we were able to raise Lane 1 inventory levels in the third quarter. We had a concerted effort to do that. We allocated more production to feeding Lane 1 in the fourth quarter. But sales went up so much in the fourth quarter that we kept Lane 1 inventory actually fairly flat with the third quarter as a result of that. It's been very popular. We've had in the range of 22% to 25% of total shipments come out of Lane 1. I think we ended up with around 60% out of Lane 1 and 2. We've had -- I can't remember the exact number, but over 60% of Lane 1 shipments we've gotten out in two weeks; and I think in four weeks, the number is closer to 90%. So I think it's successful. I think dealers like it. I think in some ways it's probably been a little bit more successful than we might have thought and demand out of Lane 1 is actually very strong.

Our next question today is coming from Andy Casey.

Wells Fargo Securities. I'd just like to return to the pricing commentary, net of costs. Could you provide a little more color about that, especially given the relatively long lead times in some of your product areas and the pricing for content complexity of the Tier 4 transition for some of your regions?

So you're talking 2011, Andy?

Exactly.

Andy, this is Ed. On the 2011, one of the Tier 4, as we announced previously, comes with a pretty sizable price increase based on the cost of meeting emissions. The thing I'd say in terms of our overall results, though, it's kind of a net neutral because we're just kind of looking at maintaining a margin rate on that additional content. The other reason that it probably doesn't stick out is, if you think about it, that Tier 4 is only applying on a part of the product line based on the horsepower ranges that go to Tier 4 this year and it only applies in parts of the regions because there's a lot of part of the world that aren't taking Tier 4 equipment, especially the emerging markets which is becoming a bigger and bigger part of our sales mix. So the Tier 4 launch, we think, is on track. We feel good about where we're at in terms of the product development and design. And like I said, we've got the pricing built into the plan to maintain that margin right.

On the commodities side, you guys know better than most about the escalation that we've seen through the second half. Are you able to kind of keep the contracts in place that you have given some of the experience you had early last decade or are there some pricing escalators built into most of the contracts that are kind of extending out? You mentioned the mining, but there are some others.

Andy, we are actively involved in terms of managing material cost out in front of us. The other thing you got to keep in mind, while the commodity price pressure is there, in most cases, what we're buying in is considerable levels of value add. And so the commodity price increase is just one element of it. If you think about the other drivers, like labor, we talked earlier about unemployment rates. There's not a tremendous amount of inflation pressure on that part of the content. So yes, commodity prices are there driving some upward pressure, but a lot of other factors, in addition to labor, some product design work we're doing, there's some simplification work we talked earlier in terms of Lane. There's some other things we're doing to make sure we can hold down that material cost. And I think our 2010 numbers demonstrated that we were pretty successful with that.

Our next question today is coming from David Raso.

ISI Group. Just big picture question here. Now that you have an '11 guidance, can you take us through your thoughts on the long-term '12 target of $8 to $10? And within that, if you can maybe give us at least some indication of the accretiveness you see from the Bucy [Bucyrus] and MWM, assuming, of course, they close at least some point in '11 to make them a full year impact on '12?

Mike, why don't you start, and then I'll back up the comment?

Just a couple of things. If you think about our 2012 target, we said $55 billion to $60 billion top line, that was without acquisitions, and $8 to $10 a share. And we said that back in August of 2009 when it looked like things were pretty tough. In 2010, we moved up the curve. We raised profit from $1.43 to $4.15 this year. Sales went up $10 billion. Our outlook for '11 is now over $50 billion at the top line again without Bucyrus and MWM. And we're looking for near $6 a share. So I think in terms of progress so far and expectation for '11, we're definitely well on the path. This past August, we said that over the three-year period of '09, '10, and '11 -- from '09 to '12, that three-year period, we needed incremental operating profit, excluding acquisitions of 25% plus. We had 30% in 2010, and excluding acquisitions, including Bucyrus, we're looking for something around 25% this year. So I think in terms of the goal, what we did in '10, what we're projecting right now for '11, are definitely on the path.

I'll just add here, I would say we were met with high levels of skepticism, if not guffaws, when we first rolled out that $8 to $10 in 2012, kind of at the bottom of the worst recession. Mike has kind of calibrated the walk to 2011 and near $6. We are sticking by our guns on the $8 to $10 in the sales ranges that he mentioned without the acquisitions at this point in time. The key thing we are focusing on very much is that incremental operating margin. And I think all of us really felt good about 30% in '10 and the outlook calls for 25% in '11. And that gets us there just based on the numbers that we have provided all of you back in Wall Street, both at August of '09 and August of '10 when we updated it. So that's the one to watch. We've gotten our outlook, it's a step on the way to '12, and we are sticking by our guns on those numbers.

And on the incremental margins of price versus cost, it's pretty clear that you're a little more focused on market share than, say, the prior few years, especially in the developed world. I'm just trying to think through the cost escalation potential. You did a great job in '10 on product design costing down, so it offset truly market material price increases. Can you give us a feel on the magnitude of product design cost-out that you did in '10 and how do you see that for '11? Because I think that was probably a little bit of the stealth cost savings that you were able to pull out. These obviously are the material cost trends. It doesn't seem that logical that your material costs will be down or flat in '11. You would think that they'd be up. So can you help us with the product design end of it?

I'll let Mike kind of handle the specifics on the numbers and let him think about that a minute. But you mentioned that we have a PINS focus more than we've had the last two years. That is definitely correct. And we have some aggressive targets over the next few years, worldwide PINS leadership in 2015 as we've communicated before and we're ramping up to get there. So we are balancing that, and we are often asked how are we going to do that? Part of that's your cost structure improvements and you saw some of that in 2010, and we're talking more about that in 2011. So market share drives our business model. Steel population allows our dealers to invest in good times and then thrive through the bad times and we're going to continue to do that, and yes we have ramped that up. And, Mike, I'll let you get back to the other specifics in David's question.

David, I'm going to answer probably not directly the question you asked, but I think kind of getting to the point. If you look at incremental margins, it's a very hot topic. It's important, I think, right now considering the volume increase that we have in front of us. Pricing and material cost were a tailwind in 2010 and we're not expecting that much of a tailwind in 2011. However, we had two major headwinds in 2010 that will be much more neutral in 2011. We went from zero incentive compensation to about $800 million incentive compensation between '09 and '10. That was an $800 million drag to incremental margins. Our product mix going from a very favorable mix in 2009 to something more approaching, I think, what you would expect in 2010. That hurt operating profit by more than $1 billion. Between those two items, that more than offset the kind of net benefit of material costs and pricing. And next year, I think it's highly unlikely, unless we far exceed the outlook, that incentive compensation would be a headwind. At the outlook level, it's actually a small tailwind. Sales mix, probably still a little bit negative, but nowhere near as negative as it was in 2010. So we've got some tailwinds in 2010 as well. On the material cost question, sometimes, I think that people believe that 100% of our purchases are steel. In fact, most of our purchases are not that raw, if you will. They're not commodities. The vast majority of what we buy are highly engineered components that have mostly value-added, and we don't see the kind of increases there that you do on commodities. We historically have done a lot of good in cost reduction to the point that you made product redesign. That is definitely a component of the material cost. If all we were looking is commodity, what we're doing was looking at commodities and talking about material cost, it would be an increase. The commodity portion of material cost, I think, unless there's some turnaround in where commodities are today which we don't expect, the commodity portion is going to be up. But other cost reductions, sourcing, product redesign, holding back the commodity increase for as long as we can, that should all help.

Our next question today is coming from Ann Duignan. Ann Duignan - JP Morgan Chase & Co: It's JPMorgan. My first question is just, I'm an equal opportunity cynic, so I just had to ask this question. Since you had zero variable compensation in 2009 because you missed the trough earnings expectations, should we anticipate the same in 2012 should you not meet the $8 to $10 target?

Well, we haven't set the short-term profit metrics for 2012 yet. We do it for the following year each year. So it's normally based on a stretch goal related to the outlook.

Let me jump in there. The trough target of $2.50 was a key piece of our performance in '09, and we agreed going into that year, we're going to hold it: if we didn't make it, we wouldn't pay. What we try to do is, when we stake out a business plan as we have done for '11 in terms of profit per share, and actually our incentive plan effectively runs off an ROA [return on assets], so we recalibrate it to return on assets. But about the plan, whatever that turns out to be and it's usually fairly close to our outlook, that becomes our target payout. If we don't make that number, it just slides down the percentage. But we'll keep in 2011 the $2.50 bottom end for that, and we expect around $6, whatever the ROA equivalent to that to be our payout then for 2011. No comments on '12, but the process and system has been in place for many, many years. Ann Duignan - JP Morgan Chase & Co: And my follow-up question is just a little bit on mix being a headwind, maybe not as big a headwind in 2011 as it was in 2010, but we should see a significant improvement in mix going into 2012, maybe 2013. So shouldn't we expect incrementals, all other things being equal, incrementals to accelerate in the 2012, 2013 timeframe? And then I just wanted to throw in there also, is there any risk, are you hearing anything from your dealers that maybe they'll pull forward some large purchases towards the end of '11 given the tax benefits, the 100% depreciation on equipment purchases?

I'll start with the '12 and we're not going to make any comments. But we are sticking to our $8 to $10 forecast we put out back in '09 and refreshed in '10, at that $55 billion to $60 billion range, I think, without the acquisitions, and that's all we're going to say on '12. As far as the bonus depreciation of 100%, Mike, I'll let you comment and add. We've worked some of that in. I don't know if to the extent that's going to be successful. It really depends on where the economy is in the U.S. at that point in time.

Yes, Doug, I think you're right. Ann, as we talk to our customers, the thing that really kind of holds up, if you would, a pull forward of purchases in that regard, it's just the lack of clarity in terms of where our highway bill goes. And I think if we get to a point in time when there is clarity, duration, size, then you may see some of our major contractors being confident and do some of that. Ann Duignan - JP Morgan Chase & Co: So a highway bill as opposed to an acceleration in something like the nonresidential construction side, do you think that, that would be a bigger driver, a pull forward?

I tell you, Ann, for each market segment, there's going to be a different driver; for a small contract homebuilder it's going to be residential construction; for the highway construction guys, it's probably a highway bill. It's going to vary by the different segments we serve. Ann Duignan - JP Morgan Chase & Co: Yes, I appreciate that. I was just curious what you're hearing from your customers out there.

It varies by region, Ann. You've got emerging markets, Brazil, with great clarity, relative to infrastructure projects out in front of them. There, you have a high level of confidence; in North America, a lot more uncertainty. But still improvements on a year-over-year basis. Ann Duignan - JP Morgan Chase & Co: Do you plan to take your Second Tier brand product out of China into somewhere like Brazil?

We have a limited number of countries outside China where we would offer the Sim brand of wheel loader around the world. And as we expand capacity in China to make more wheel loaders, we'll do that. Right now we're doing all we can to satisfy demand in China with just a few limited exports to a few developing countries where there's a demand for that. It will be a very minor number.

Our next question today is coming from Jerry Revich.

It's Goldman Sachs. Mike, can you talk about where the factory on-time delivery rate was in the quarter relative to the three-month production schedule compared to the 96% we saw last quarter? And also, roughly how much dealer inventory stocking does your guidance assume and is supply-chain capacity the key variable there?

Sorry, Jerry, but on the first question, I didn't gather up that data for the end of the quarter, so I don't know. I do know that production levels continue to go up quite a bit in the fourth quarter, and variable labor and burden productivity improved. And over the last few months of the quarter, we actually saw some slight improvements actually in delivery times. But the statistic you're looking for, I don't know. What was the second part of the question?

Mike, the second part was, how much dealer inventory, stock inventory.

We added $700 million, I think, in the fourth quarter, about $800 million for the year. We do have, let's just say, a limited inventory build built into the forecast for 2011. We have not quantified it, but it would be far less than $800 million times four or $700 million times four.

And Mike, can you give us an update on the EMD integration and how that's going, what type of margin run rate do you expect by year-end, if you're willing to discuss that? And what's your assessment of cross-selling opportunities now that you've had the business under your belt for almost six months here?

I'll just say a couple of things about that. We're going to try not to get into reporting margin down to that level. It's not a segment. So I won't comment on the actual numbers, but what I will tell you is, we've been very pleasantly surprised on the positive side with the acquisition. Their results this year were better than we expected. We've essentially bought them around a trough in the cycle. I think '10 and '11 are probably likely to be the low years for sales. If you just read kind of in the papers, I think you would see railroads getting a little more bullish. So I think all in all, it's gone very well. To be prepared for additional volume in sales, we announced a new assembly facility in Indiana, actually. So I think all in all, it's going pretty well, but we'll refrain from actually doing a deep dive on profit at that level.

I'm not going to do a deep dive on profit, but we are absolutely thrilled with our purchase of EMD, what we found inside EMD and the opportunities that we're looking at, which are rosier than our business case projection when we bought that company; particularly with the freight railroads picking up as they are and some of the things that we can bring to EMD from our distribution that we have not exactly contemplated. So we are absolutely thrilled with it.

Okay. With that, we'll wrap up just one final comment, and that is, we are doing our worldwide Analyst Meeting at CONEXPO on March 23 in the afternoon. We sent invitations out about a week ago. We do have limited seating, so if you want to attend, please respond to the invitation that you got. Thank you very much.

Thank you, ladies and gentlemen. This does conclude today's conference call. You may now disconnect your phone lines, and thank you for your participation.