CAT - Caterpillar Inc. (CAT) Bernstein's 39th Annual Strategic Decisions Conference 2023 (Transcript)
2023-06-01 17:59:07 ET
Caterpillar Inc. (CAT)
Bernstein's 39th Annual Strategic Decisions Conference 2023
June 1, 2023 02:30 PM ET
Company Participants
Ryan Fiedler - Head of Investor Relations
Jim Umpleby - Chairman and Chief Executive Officer
Conference Call Participants
Chad Dillard - Bernstein
Presentation
Operator
Hi. Good afternoon, everyone. My name is Chad Dillard. I'm the lead analyst here at Bernstein for the Machinery, Engineering, and Construction sector. And I'm really excited to have Caterpillar here today to have a conversation. And joining me is Jim Umpleby, CEO of Caterpillar and also Ryan Fiedler, the Head of Investor Relations. And so, the way that we're going to work this is basically like a fireside chat. We're just going to have a good question-and answer-session. And if you -- if those of you on the audience have any questions, please feel free to type it out in the Pigeonhole link, and I'll be able to ask the questions on your behalf.
But before we get started, let me just hand it over to Ryan to give a little disclosure.
Ryan Fiedler
Thanks, Chad. Really appreciate it. So during today's meeting, we'll make forward-looking statements, which are subject to risks and uncertainties. We'll also make assumptions that could cause our actual results to differ from the information we're sharing with you today. Please refer to our recent SEC filings, and the forward-looking statements reminder in our releases for details on factors that individually or in aggregate could cause our actual results to vary materially from our forecast. Any detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings.
Today's meeting will also refer to non GAAP numbers. For reconciliation of any non GAAP numbers to the appropriate US GAAP numbers, please see the appendix of our earnings call slides. Lastly, we'll post a transcript, which will be available on our website as soon as we can at investors.catterpillar.com.
With that, I'll turn it over to Chad. Thanks.
Chad Dillard
Great. Thanks, Ryan. All right, Jim. Welcome, thanks for joining us.
Jim Umpleby
Thank you. Good to be here.
Question-and-Answer Session
Chad Dillard
Great. So first, I want to talk about the cycle, then I want to talk a little bit more about just labor productivity and how Caterpillar impacts that, spend some time on the energy transition and how Caterpillar influences that theme, and then finish up on just services and just get an update on how you guys are thinking about reaching your $28 billion target.
But first off, I guess you've been the CEO for, I guess, almost seven years now?
Jim Umpleby
Yes.
Chad Dillard
Okay. So the first question is just about how Caterpillar has changed under your leadership then versus now?
Jim Umpleby
Well, it's great to be here, Chad. And we've been asked to speak up, so I'm going to try to do that for all of you. So we rolled out a new strategy in 2017, and we started by telling our investors that we were going to achieve higher operating margins and higher more consistent free cash flows at different levels of revenue. And we laid out a new strategy to accomplish that. That strategy was based on three key elements. One is, operational excellence, which is safety, quality, lean and a competitive and flexible cost structure. And that competitive and flexible cost structure is something we've worked very hard on the last two years. Really worked on removing structural costs, really worked hard in ensuring that we receive a return on every dollar of capital that we invest in and I believe our results have demonstrated that that has paid off.
Another major area of focus was services. And I can talk a lot about that, we invested heavily in services. That's something -- services represents everything we do for our customer after that initial sale. And done right, it's good for the customer, it increases their productivity and efficiency, it's good for our Caterpillar dealers, and it's good for us.
Another area was expanded offerings, investing in different products to ensure that we have the right products to meet customer price points, different kinds of customers, the most productive piece of equipment was typically sold by Caterpillar, but oftentimes, we'd have to discount that product to capture what we would call life cycle value customers, customers that couldn't afford or didn't need the most productive piece of equipment. So now we're designing products, not only those most productive pieces of equipment, but also products that allow us to capture those life cycle value customers. And then we've added more recently, sustainability, and it's a wonderful opportunity for future profitable growth, and I can talk more about that.
But one of the things we utilize is what we call the operation and execution model, which drove us to understand our business at a much more granular level than we had in the past, understanding by product, by market, by application, where we’re creating shareholder value and where we weren't. And what that allowed us to do is to shine a light on those underperforming products and challenge our leaders to improve the profitability of those products. In some cases, we concluded that we should exit certain products because of the investment and the time it would take to make them exceptionally profitable.
But even more importantly, the O&E model leads us to bias our resources towards those areas that represent the best opportunities for future profitable growth, which led to investments in things like services and some other products I can talk about. But we talked about those margin targets and we were met by a bit of skepticism from the investment community when we first rolled those out in early 2017. But we actually were able to achieve those 2017, 2018 and 2019 as our market -- as our business improved. And then in 2020, we ran into the COVID, as everyone knows, and due to the pandemic, our top line dropped 20%. And I think we surprised a lot of people by the fact that we were able to still achieve our margin target in 2020 and produce $3 billion of free cash flow in that year when we had that downturn.
With the exception of 2020, between 2017 and 2022, we've achieved $5 billion to $6 billion of free cash flow. And part of that new strategy that what's changed is, we have committed to return essentially all free cash flow to shareholders over time through a combination of dividends and share repurchases. So again, we've changed a lot in the company. I can -- I can talk for 45 minutes about just that issue, but I know you have other questions for me. But that's an overview.
Chad Dillard
That's helpful. So it's certainly been a strange cycle over those last couple of years. How do you make sense of just where we are in the cycle? On one hand, you've got a wall of stimulus that's coming. On the other hand, you're seeing some emerging signs that the hallmarks of linked cycle. So maybe you can talk about how are you thinking about that and how you're thinking about managing Cat through this next leg of the cycle?
Jim Umpleby
So in our first quarter results, we talked about the fact that due to the strength of those results and just as an aside, so in the first quarter, our sales increase -- sales and revenues increased 17%. Our adjusted profit per share increased 70% -- 70% compared to the first quarter a year earlier. And based on the strength of our first quarter results and the strength that we see in most of our end markets, we told investors that we believe 2023 would be better than we had previously anticipated. And I think what's important is one of the ways Caterpillar has changed is we serve a variety of markets. It's not just about just one market. So when we talk about the cycle, we have to think more -- I think, more diverse than that and think about the various markets that we serve.
Just to run through a few of those, the one that people think about most naturally is construction. So in North America, Construction Industries is quite strong. Globally, about 75% of our Construction Industries revenue is from what we call nonresidential, 25% is residential. To start with the residential, that represents, again, 25% of CI. It's -- the growth rate has started to moderate a bit, but it is still growing. Nonresidential is very strong. And a lot of that, of course, is driven by the pieces of legislation that have passed over the last few years, the CHIPS Act, the IRA and the IIJA. We're already seeing some of that stimulus manifest itself into orders for us, particularly from the states, but as I'm sure you all know, permitting takes some time. So we believe that, that stimulus will result in improved business for us over time.
But it isn't just a North American story. We're seeing strength in a number of other areas around the world as well. The Middle East is a great example. A lot of strength, there are a lot of construction in Saudi Arabia is one I would highlight, a lot of construction activity. Sticking with CI for a moment, we have said that China has gotten weaker, and we predicted that going into the year. It's been a bit weaker than we thought it would be. And the market for us in China is mostly excavators, 10-ton and above, and that market is relatively weak. But the good news is, even with that market weak, we're still having a very good year in Construction Industries and overall. Typically, we say China is 5% to 10% of our sales. This year, it will be less than that range. So there's construction.
Other markets we serve as well. Energy & Transportation is a very important segment for us. I start with power generation. A lot of it is driven by data center strength, but our power generation business is quite strong, and we haven't seen any kind of a slowdown there. Oil and gas is also a slowed down. Many observers believe there's been a 10 or 12 year underinvestment in oil and gas infrastructure, and that business is strong, both for Cat-branded oil and -- engines used in oil and gas, whether it's well servicing or drilling and our solar gas turbines, which are used for natural gas compression in offshore as well.
Caterpillar plays across a wide portion of the natural gas value chain. If you stop and think about what's happening with LNG, those large LNG facilities have to be fed with gas. And Cat engines are used for drilling. Cat reciprocating engines drive reciprocating gas compressors for gas gathering near the wellhead. We're very involved in well servicing. We made actually an acquisition where oil and gas or SPM, back at the bottom of the cycle there. I think when we're in the process of negotiating that deal, oil prices went negative. So that was good timing when we bought that company. And that has enhanced our ability to have a wider range of products and services for our customers in well servicing.
And then again, solar gas turbines driving solar -- significant natural gas compressors. That's again one of our Caterpillar brands. Solar gas turbines compress gas on the pipeline into the LNG plants. That business is quite strong and has shown no sign of slowing down. Transitioning to mining, one as you talked about is the energy transition and what an opportunity that represents for Caterpillar. If you look at the projections by the automobile manufacturers for the amount of EVs that need to be built and government policymakers, there's no way around the fact that, that will increase commodities that are required for those electric vehicles. The average EV take 6 times as many minerals versus an internal combustion engine car. And of course, our mining customers use our products to produce the commodities to meet that demand.
So again, when we talk about the cycle, we serve a variety of diverse industries. And so, I think it's more helpful to think about each of the end markets we serve and what's happening in each one of those.
Chad Dillard
Great. So actually just picking up on a couple of the end markets, mainly the commodity producers, like one unique element of the cycle has been just like the extreme level of just capital discipline. How long do you think this could potentially last before they truly ramp up to a more sustained like replacement rate? And maybe you can talk about what's different about Caterpillar now versus the last commodity-driven cycle?
Jim Umpleby
So although -- when we talk about the capital discipline that our customers are displaying, we typically talk in terms of our mining customers and oil and gas customers, probably the two.
Chad Dillard
Exactly.
Jim Umpleby
Right. And those two groups of customers are displaying capital discipline. However, that doesn't mean that they're not ordering more from us because they are. So, our oil and gas customers are ordering more products from us, and our sales are increasing. As a matter of fact, particularly with our larger engines, we're struggling a bit, which we had shorter lead times. We're struggling a bit meeting all of the demand that's out there. And we, at this point, don't see that slowing down. Yes, capital discipline. What that means really for us is the wild, wild swings that we saw in the past are much aren't there. So it's more of a muted demand increase, which, quite frankly, I think is better for our customers, and it's better for us.
Same story applies to mining. That business, if you look over the last few years, with the exception of 2020 and the pandemic-induced downturn, that business has been -- our Resource Industries has been improving year-on-year. Not wild swings up, but -- and we've talked about this for a number of years, I think, Chad, you and I've talked about this before. What we anticipate is more of a gradual increase in sales, and we've been predicting that for the last four years or so, and that's exactly how it's played itself out. So I think that's a positive thing for them and for us.
To answer your question about potential changes there. Again, we feel good about the way we're positioned with our customers. We now have 1.4 million connected assets. We have a very good handle on utilization rates and just talk about mining for a moment. The good news is that the number of parked trucks is low, this some of the factors we look at to kind of predict what's going to happen with demand for our mining products. And oftentimes, we talk about large mining trucks because that's so important to our mining customers and it is an important part of our business.
So the number of parked trucks is low. The utilization of those trucks that are operating is high and the age of the fleet is -- it's relatively old. And so those three factors lead us to believe that there is room to run here. If you go back to that period, that's a really difficult period for the industry between 2012 and 2016, all three of those were the opposite. Utilization was low in mining, there's a lot of parked trucks, and the fleet was not very old. So now we have those three things.
And just to talk about -- to pull on the string a moment, talk about aged trucks. Customers make decisions about replacement for a whole variety of reasons. They think about, how much life is left in the mine, what are their capital needs, where they want to invest? And sometimes, they'll replace trucks. And sometimes they'll decide to rebuild trucks, which is -- either way, it's a good thing for Caterpillar because we're there to support our customers with parts and work with our dealers, parts and service to rebuild those trucks. It's not a bad thing. If they buy new ones, that's great as well.
Chad Dillard
Great. So Cat has been enjoying pretty stellar pricing power in the supply constrained world. What does that look like when input costs come off? Do you think you'll be able to hold price? How sustainable do you think that will be?
Jim Umpleby
A whole variety of things go into our pricing decisions. We, of course, look at input costs, as you mentioned. We also look at the competitive situation, what's happening in the various markets that we serve, and there isn't kind of one size fits all. It's a variable.
As of today, we have -- with the exception of freight costs, which clearly have come down, we haven't seen our input cost, meaning, the components that we buy from our suppliers come down. So we haven't seen that yet, right? Maybe we'll see it, maybe we won't, I don't know. But certainly, again, a whole variety of factors goes into pricing decisions that we make. We look at the competitive landscape, we look at our input cost, and we make one-off judgment calls based on what we see. So we'll see what happens.
Chad Dillard
Got it. Okay. So in terms of how you help dealers manage their inventories, can you talk about what's changed versus the prior cycle? And how much of your construction business remains on allocation today? And where do you think there is the greatest mismatch on the construction equipment side, supply versus demand?
Jim Umpleby
And we'll start with by saying that dealers are independent businesses and they decide what they buy from us. So we start -- but we can, in fact, have conversations with dealers and make suggestions. But at the end of the day, it is their call.
We do have a new S&OP process where we look -- work much more closely with our customers. We look at things like utilization rates. We have a lot of units that are connected. So we -- when we get an order, we have a conversation with a dealer to say, are you sure you really need that? How -- what's coming, and we have a conversation. But at the end of the day, they make that decision.
To answer your second question, as we look at our inventory in Construction Industries, there are some products where dealers wish they had more inventory and a couple of examples would be earthmoving and some of our building construction products they wish they had more. In certain products, they have enough inventory. An example of that would be excavation. So again, it's a mixed bag depending on the product.
Chad Dillard
Okay. So a question for you on China. I think you alluded to a little bit earlier. Can you just talk about what you're seeing in that market, the 10-ton and up excavator market? And then I guess, outside of China, probably more like the emerging markets, are you seeing some of the local Chinese OEMs, I guess, become a little bit more competitive in some of those regions?
Jim Umpleby
So as I mentioned earlier, we expected China to be down this year. We had a couple of really strong years in China in 2020 and 2021, and 2022 was lower than 2021. And we expected 2023 to be lower than 2022, and it is and actually it's a bit worse than -- a bit lower than we thought. And when I say lower, I mean in total industry, I don't mean any kind of share. It's just the total industry is down more than we had anticipated.
Having said that, it's still an important market for us, and we still build products in China. We have a vertically integrated supply chain. We highly value our customers, our dealers and our suppliers and our employees in China. Competition, I've been doing this for more than 40 years, and I'm always focused on the competition. We'll always have competition. My assumption is, the competition across all of our businesses, across all of our products will always get better. Having said that, we've certainly demonstrated the ability to effectively compete over a long period of time.
So one of the advantages of being in China and competing with Chinese OEMs in China is what makes us better. We vertically integrated our supply there. We have local leadership. We've learned how to design products instead of defeaturing premium products to build new products on a clean sheet of paper, so they have the right price point. So it's made us better. And one of the advantages we have at Caterpillar is we have a very well-established dealer network, which has taken us decades to build and is very, very difficult to replicate. So I think that's an advantage we have as well.
But having said that, I always take all of our competitors seriously, whether it's in Energy & Transportation, engines, construction, mining, it's something we always need to be focused on.
Chad Dillard
Got it. Okay. Kind of a number of questions from the audience. So first one, can you discuss what the impact of increased penetration of equipment rental in the construction is and the consolidation in this space as well?
Jim Umpleby
So we do believe rental is an area for growth for Caterpillar and our dealers. We created -- in recognition of that, we created a new division led by a senior -- very experienced Senior Vice President to lead our rental division.
And so, we don't have a rental business. Our dealers have a rental business, but what we do is, we help our dealers getting better at rental, adapt best practices, things like that. So we have some dealers that are quite good at rental and have been doing it very well for a long period of time. Some aren't as focused on it and aren't quite as good at it. So our job is to help make them better. But we think it's a growth opportunity for us and our dealers moving forward.
Chad Dillard
So what kind of ROI or reduction in total cost of ownership does an autonomous truck generate? And what's your win rate on autonomy?
Jim Umpleby
Yes, we're very excited about our autonomous solution in mining. We've had mining customers publicly state that they've seen up to 30% productivity increase against their best manned sites. And you just happen to think about a mine that operates 24 hours a day, seven days a week, it's all about how much you can produce, and obviously do it safely and environmentally responsibly. So if a customer can get a 30% productivity increase with our autonomous solution, that is a game changer.
And we believe that pretty strongly that we have the best autonomous solution. And I would argue that our customers are voting with their dollars. We're getting a lot of business, autonomous business and we can do retrofits and we can do new as well. So it's in a really exciting area. And one of the things that's changed in autonomy since we first introduced it about a decade ago, is it used to be a mind head to be quite large to be able to justify the capital investment for autonomy, 70 trucks or more and probably only about 10% of the mines around the world had 70 trucks or more.
Now by working with our suppliers by getting better ourselves, we've gotten that down such that if a mine only has 15 to 20 trucks, it can pencil out to make it worthwhile to put autonomy in their operation. And it's again, it's just a very exciting development and one that we think is -- it's been a game changer for our customers and for us as well.
Chad Dillard
Great. Actually I want to pull on that thread a little bit. So 70 trucks addressed maybe like 10% of the market, maybe around, I guess, 15% now. Just want to get a sense for just how much does that expand the TAM? And then secondly, can you talk about how you're expanding that autonomous capability into your quarry and aggregate business?
Jim Umpleby
Sure. We -- so by reducing the amount of trucks required to make it feasible economically, we've gone from about 10% of the mines around the world to 50% or more, which expands that opportunity.
We do certainly receive our first order from a company called Luk Stone. It's the country's largest family-owned sand, gravel stone supplier-to-quarry company where they're going to put our autonomous solution into quarry. So it's the first time that we put autonomy -- full autonomy outside of mining. So we're very excited about that opportunity. One of the things we're also doing in mining as well is, we're putting autonomous capabilities and other products beyond trucks. So we started with big mining trucks. Those are the most visible, of course. We also have autonomy now in things like water trucks, in drills. And we've also put semi-autonomous capabilities in construction equipment as well. So Chad, you could sit here today from this room in New York control four or four dozers on the other side of the world, it's -- remotely semi autonomously.
So you get one going that's doing this pass, you get the other one going, you get the other one going, you have a screen, and you can monitor all of them. So those are some of the technology changes that are occurring. And I know you'd be an outstanding operator but because of some of the technologies that we put in our machines, it makes you a much better operator, great control, things like that.
So there's a lot of exciting technologies that are going into our products, and that's one of our competitive advantages. We're working very hard to invest in those new technologies to keep ahead of the competition, as you mentioned earlier.
Chad Dillard
Got it. And just following on aside from just all of the original equipment that you can sell with providing autonomy, what sort of incremental service opportunities does that present or additional kind of support equipment at the mine site does that generate? And maybe you can talk about what sort of margin uplift would you get going autonomous versus a traditional, I guess, manual piece of mining equipment?
Jim Umpleby
Yes. So when we put an autonomous solution and one of the things we're doing, obviously, is we're very focused on making our customers more productive. And if, in fact, we can help them become -- again, one customer is saying 30% more productive against the best manned site. That creates all such of opportunities for us. When we put a large autonomous solution and there are Caterpillar employees that are actually at the mine site helping our customers. So it's our dealer employees there as well. And so by being at the site with our customers, it moves us more from a supplier to a partner in their operations.
And if we do our job right, and we have to, it's not a birth right, we have to earn it every single day, what that allows us to do is to be an outstanding position to get the next sale when it comes up. It also puts us in an outstanding position to capture more of the aftermarket to be able to help our customers be successful in services.
Yes, there's a recurring charge, there's a hardware charge, there's a software charge, those little kind of charges that go into it. But the most important thing for us is that we can make our customers significantly more successful that will drive higher market share, it will drive higher aftermarket opportunities. And again, there'll be a win in it for the customer, for the dealer and for us. That's the way we really view it.
Chad Dillard
Got it. So can you share with us key learnings for managing a business through an inflationary period? And what might you do differently if inflation comes back?
Jim Umpleby
Some would say inflation hasn't gone away completely, but there's different views there I know in New York about that. Certainly, a lot of leaders haven't lived through an inflationary period, and I'm embarrassed to say I'm old enough that I do remember the '80s. I was in the workforce, but I wasn't in a senior leadership position. But one of the things that's really important to do is to, of course, really not be complacent and be on top of what you're doing with your suppliers to understand when you need to take price increases, all those kinds of things.
I probably won't go into the lessons learned, the things I wished to do differently. We don't have enough time for that. But I'd argue that we have demonstrated the ability, right, through an upturn, through a down -- a severe down period in 2020, through an inflationary period, to have the business perform at a much higher level than we have in the past.
Again, if you look at all of our stats, if you look at, again, the free cash flow that we're achieving much more consistently, if you look at our operating margins, I'd argue that we've changed the business fundamentally and are operating at a higher level, and I think the numbers bear that out.
Chad Dillard
So another question from the audience. How comfortable are you with inventory levels? And is there evidence of double ordering and what does it mean for pricing?
Jim Umpleby
Yes, I assume the question is dealer inventory. And so we -- the typical range is three to four months of dealer inventory. That's where we are today. So it's kind of in the typical range. As I mentioned earlier, with some products our dealers wish they had more inventory, some of the BCP products, and the earthmoving. With some inventory, they have enough like excavators, and a lot of that is driven by the downturn in China. So we have enough of that. But I am comfortable with the dealer inventory that we have. And one of the things that we've said is, we did see an increase in dealer inventory in the first quarter, not unusual because we typically dealers build inventory ahead of the spring selling season. We expect inventory -- dealer inventory to come. Again, they're independent businesses, they make these decisions. But we anticipate that dealer inventory will come down in the last half of the year and that we'll end the year about where we came in the year in terms of dealer inventories will be about flat January 1 to January 1.
Chad Dillard
Okay. So I want to shift gears over to the energy transition. Can you describe Caterpillar's role to play in there? Maybe you can talk about all the segments from construction industries to resources to E&T?
Jim Umpleby
I will. One of the things we told our investors last May at Investor Day is that, we believe the energy transition and growing global energy demand is increasing Caterpillar's total addressable market. And we haven't discussed -- we haven't used the TAM figure that I can remember ever, right? But we're very excited about the opportunities that this represents. Again, stop and think about the commodities that need to be produced to support the energy transition.
Average electric vehicle, again, takes 6 times as many minerals as an internal combustion engine car. You can decide how much of the -- what you think the rate of the energy transition will be. Look at the projections by automobile manufacturers about the shift to EVs and what government officials say as well, that there's no way around that requiring a large increase in companies that need to be produced.
And again, our mining customers use our products to produce those commodities. Those commodities are also used for things like wind turbines and solar panels and transmission lines. So that should all benefit our resource industries or our mining business, construction, think of it all the construction that has to go on to build the high-tension lines to put in the infrastructure to support the energy transition in a whole variety of ways.
Again, that's positive for construction, wind turbine construction, all the rest. And in Energy & Transportation, some great opportunities there as well. As more -- first of all, global energy demand continues to increase, and our customers use our products to produce the commodities to meet that growing global energy demand and energy demand isn't just increasing in the developing world, which is classic over the last 40 years. As standards of living increase, energy demand goes up. But even in the developed world, we stop and think about all the new uses, new, over the last decade or so. We all plug in four or five devices now. The amount of data centers that are going in, AI, everything moving to the cloud, that creates energy as well -- energy demand as well. And again, our customers use our products to produce the commodities for that.
As more renewables are added to the grid, we're seeing grid instability issues. So grid instability issues used to be what we've seen in the developing world and not so much in the developed world. Now we are seeing it in the developed world because renewable energy sources are intermittent [indiscernible] noise. China the wind is noise below.
That is creating an opportunity for us, which we're already starting to see a bit of, but we think it's going to grow over time for us to sell generator sets and distributed power applications. So that's both reciprocating engine generator sets and gas turbine generator sets. And our gas turbines and our engines and those generator sets can burn a whole variety of fuels that can burn natural gas, that can burn biofuels, landfill gas, hydrogen blends and all the rest.
So we believe that, that growing global energy demand and the effect that renewables are being added to the grid is also expanding our total addressable market. And we're already starting to see some of that happen, but we think it's going to accelerate over time as more renewables get added to the grid. So we're quite excited about what we see with the energy transition.
Chad Dillard
So as we go deeper into the energy transition, how does -- say like your service in the aftermarket? How does your FinCo need to adapt to that new world?
Jim Umpleby
So again, for our traditional products, it will be much as it is now, of course, but we're continuing to invest in our digital capabilities and services, and we can talk more about that later, if you would like, but a lot of things that we're doing there.
If the purpose of your question is just think about maybe batteries and machines, which is maybe where you're headed, we do believe there is plenty of opportunities there in terms of -- think about a battery in a machine. Well, first of all, let's step back a minute. People often ask me, well, isn't this like a car, you just put a battery in and replace a diesel engine and move on? Well, what people often don't understand is the amount of power required in a piece of -- a large piece of construction or mining equipment is very different than what it is in an automobile. As an example, a fully loaded mining truck, that battery will degrade to zero in about 90 minutes. So think about the fact that, that large mining truck operates 24 hours a day, seven days a week. The typical automobile, how many hours is it used today? I don't know, four, maybe something like that. So think about a mining truck operating 24/7. We're very excited about the fact that last November we demonstrated to a group of our customers, a fully loaded mining truck battery power, it's a prototype, operating at diesel performance, going up a grade, going on the flat.
But what we really need to do is to find a way to dynamically charge that mining truck as it operates. And that creates some really interesting challenges, but also some opportunities as well. In that we believe we have a competitive edge because we have an energy and transportation portfolio.
We sell generator sets that are [recip] (ph) driven. We sell gas turbine gen sets. We have micro grids. We do -- we have that capability. So one of the things we're doing, and I'm taking a bit of a tangent but I'll come back to your question. One of the things we're doing in Tucson at our mining side is developing the mind site of the future for electrified mine sites. We think that's a -- there's an example as that moves forward, it's an opportunity for us to sell more energy and transportation products, but also we think there are service opportunities around better replacement battery management and things like that as well. Right now, as we look at the pull from customers for battery-powered machines, the biggest pool is from our largest mining customers. They're really focused on reducing their Scope 1 and Scope 2 emissions. So that is impetus and we're committed to help them through that transition. We see less coal, quite frankly, in construction equipment, a bit in Northern Europe, but it's quite minor.
So I suspect it's going to take some time for that to manifest itself. If you stop and think about the different applications that our construction equipment goes into, one can very much see a situation where a lot of it is really going to be driven by government regulation to, let's say, a city, say the city of New York says, all right, no more diesel engines and automobiles, and construction equipment and anything, everything has to be battery powered.
I think construction products, building a new building here in New York, you could probably figure out a way to certainly charge that piece of construction equipment overnight. I think it's really feasible. Just have to think about the challenges, though, if you're in the middle of Texas or Nebraska or New Australia or someone you're building a highway in the middle of nowhere, there's no grid. Where do you plug something in 2:00 in the afternoon, the machine is dead. Do you fire up a diesel gen set for a fast charge? Well, that negates the reason of having batteries in the first place instead of a diesel engine in the machine. Do you try to change batteries in a really big machine? Do you try to move that machine back to a place where you can get a charge?
So there's a lot of complexity that have to be worked out. So my own sense with the exception of mining, this is going to take quite some time before those widespread adoption of batteries and machines. Everybody can have a prediction in the room, my sense, it's just going to be a quite a long extended period that takes decades. And it will -- that adoption rate will vary by geography. And what happens in Amsterdam and New York and London is probably different than what's going to happen in some other countries around the world, and we're a global manufacturer. And it will depend upon application as well.
Again, it's in an urban application where it's relatively easy to charge something, or is it a situation where much of our business is, which is nonresidential -- it's out in the middle of nowhere as we build new infrastructure. So again, it remains to be seen how this manifests itself over time.
Chad Dillard
Got it.
Jim Umpleby
But we think there's opportunities there embedded for us that we'll work hard to be positioned to move forward. We created a new division within Caterpillar, about 1.5 years ago, to focus on electrification, alternative drive range. So they're doing things with hydrogen, we think it's longer term. Doing things shorter-term in batteries
And the recent CONEXPO Show in Las Vegas, we showcased 4 prototype construction machines with batteries in them. So our strategy is to have the products ready when the customer is pulling them. So we'll continue to invest in our traditional machines that are diesel powered. We'll have -- continue to have more technology there. And we'll have the battery-powered machines and our customers will decide what that rate of that transition will be.
Chad Dillard
Got it. Thanks. So maybe on the mining side, when you do make that transition to electrification, like what do you think that does to parse intensity if you compare that to...
Jim Umpleby
To what intensity?
Chad Dillard
Parts.
Jim Umpleby
Parts.
Chad Dillard
Yes, parts intensity compared to your internal combustion.
Jim Umpleby
And so again, it's a mixed bag. So one of the things that people often make, again, the analogy to automobiles, which isn't that appropriate given you think about something that digs in the dirt. There's still lots of things that we're out. We still have hydraulics. We still -- there's still lots of -- plenty of opportunities to replace parts. And also, we also see the opportunity, as I mentioned earlier, to have more equipment at site. We'll have our energy and transportation products at site, which exists in a relatively small way today.
We also believe there's opportunities will mining customers really want to deal and deal with, let's say, batteries and battery change and battery disposal and battery service. We think there's an opportunity for us there as well. So again, it will play out over time, and we think there's plenty of opportunities there as we move forward in the services as batteries are adopted.
Chad Dillard
Great. So let's actually switch over to service. Can you talk about where you are in your journey to attaining $28 billion of service revenues by 2026? And then secondly, can you lay out the road map to closing that gap over that time frame?
Jim Umpleby
Certainly. So again, as I mentioned earlier, when we rolled out our strategy in 2017, service is a big integral part of that. Why? It's good for our customers. It's good for our dealers and it's good for us. We established a bold goal of doubling services sales between 2016 and 2026 to, as you say, $28 billion. We started at $14 billion. Last year, we were at $22 billion. And we increased services sales last year, and we've told our investors that we are increasingly confident in our ability to achieve that goal.
So we're doing a whole variety of things to capture that business. We've invested heavily in our digital capabilities, whether it's e-commerce. We've also recently rolled out an app for your phones. If you're a small construction customer, you may have not gotten the same attention as maybe a big customer has.
Our dealers do a very good -- Caterpillar dealers do a very good job taking care of some of their biggest customers, be it construction customers, mining customers, oil and gas customer. But if you're a relatively small company, a small contractor, say you own 12 machines, and you do -- again, you're relatively small, you probably haven't gotten the attention from a Caterpillar dealer that a large customer has.
So one of the things we're doing is making it easier for customers to do business with us and our dealers by having an app on your phone. We're putting serialized QR codes on machines now. So when those small contractors can take their phone, scan that QR code, and they can pull up an app, and they'll know exactly what part to purchase to get the right part for their machine. That saves time.
They don't have to make the call. They don't have to do any checking, it's all right there. they Can have that part delivered to them or they can push a button and have the dealer come and help install that part for them. They're in the right country in the world, they can use a Cat card, we'll have loyalty programs. All those things are being rolled out and developed as we speak. So we think that's a big opportunity for us to increase services sales. We're also using AI. We have what are called prioritized service events.
Because we have 1.4 million connected assets, we know the number of hours those assets have. We know if they're running or not, if in some cases, we're actually monitoring more features than that. So we can actually give our dealer leads and our dealer can go to our customers proactively to sell them parts to give them service to make sure they know when maintenance is coming up.
If there's more sophisticated monitoring to let them know that some things out of -- maybe out of tolerance, they need to have a service call. So again, we're investing in a whole variety of things, and we're quite excited about the progress that we've made, again, $14 billion to $22 billion between 2016 and 2022. When we did tell our investors when we rolled out that target that it would not be a straight line and be back-end loaded, but we feel good about the progress we're making.
Chad Dillard
Great. So a question for you on construction technology. Can you lay out the product road map and talk about the level of adoption that Caterpillar is seeing on the current products, such as Command, the smart [grading] (ph)? I think you've recently launched Vision Link?
Jim Umpleby
Yes. So it's one of the things as I mentioned earlier, we're investing technology, which is one of the things that we are doing to maintain and strengthen our competitive advantage. So a whole variety of new technologies is going into a product now, I mean to things like grade control. 1 of the examples we like to use is in digging a basement for, let's say, residential to build a house or to build a new building. A pretty challenging thing to do because it has to be done well. Now with the operator shortage -- shortage of trained operators, with the technology, Chad, we could train you in one day or two, and you could dig a really good basement, right, with the technology that we have. Grading, again, much better.
We have -- I talked earlier about semiautonomous machines that -- and you can operate them halfway around the world or you can stand off and do line of sight load operation as well. And that's often used for hazardous kinds of applications where an operator can be out of harm's way, can control the machine in a hazardous way.
So we're doing a lot of things with new technology. That's one thing we're very excited about. In terms of R&D, one of the areas that we said we're going to invest more in is what we call ACE, which is autonomy, alternative fuels, connectivity in digital and electrification. And we're investing more in those areas because, again, we really do believe that, that's a great area for a competitive advantage.
Chad Dillard
It's actually a good segue to the next question. Okay. So can you talk through Cat's approach on building its technology stack? Where do you excel and where do you need to improve?
Jim Umpleby
So we develop technology in a variety of ways, both internally with our own folks, and a great example of that is autonomy. Autonomy was -- we had a -- we started an atonement journey long before the automobile manufacturers many, many years ago. And we developed most of that in-house. Obviously, we bought LiDAR and things like that, but a lot of that technology was developed in-house. But in some cases, we make acquisitions as well. We make selective acquisitions to get certain kinds of technology.
So we bought a company called Marble Robotics to help us with autonomy. We bought other companies as well. We look across the landscape and there are certain technologies that we believe we need to advance our journey. We'll go ahead and buy those companies. Sometimes we make venture capital type investments to stay close to those companies, and sometimes that results in an acquisition later on, sometimes it doesn't.
But again, we're doing a whole variety of things and we -- it's a combination of developing things internally, but also having a keen eye on the outside as to what technologies are developing and again, acquiring those when it's appropriate.
Chad Dillard
Okay. So where does the incremental dollar of R&D go today? What do you consider the highest ROI opportunity ahead for you?
Jim Umpleby
Yes. So we use -- again, back to that O&E model, that's what we use. And we allocate those R&D dollars to those areas that we believe represent the best opportunities for future profitable growth. And so I've talked about ACE. That's an area we're growing again, autonomy, alternative fuels, connectivity and digital electrification, that's an area that is growing in terms of investment. We invest a lot in services. as well because, again, we believe that's an excellent area for future profitable growth.
So those are a couple of areas. Obviously, we continue to invest in the areas that you not talked about earlier. We're on construction, continue to make our autonomous solution I think about autonomy is just you develop it once and you're done. We're continually making it better to make our customers more productive to maintain what we believe is a lead in technology against our competitors there. So again, and we're -- and the good news is that our financial results give us the wherewithal to make those investments. We have a strong balance sheet.
To answer your question, you didn't ask here, but we have a strong balance sheet. And we went to the pandemic, unlike many other companies, we didn't have to worry about securing funding to make payroll, worked out very well for us.
We have that strong balance sheet for investment and for opportunities. But also we have committed to return essentially all free cash flow to shareholders over time through a combination of dividends and share repurchases. And we've -- a number of dividend increases over the last few years, high single digit, and we've also hit our 20 years of dividend [indiscernible].
Chad Dillard
So here's another question from the audience. So with connected equipment, are you seeing any step function changes in the ability to do more with, say, like the second or third-generation owners of that equipment?
Jim Umpleby
Yes. It's one of -- there's an advantage of connecting the asset because when a customer sells a piece of equipment, that's connected, that [indiscernible] the dealer in the past didn't know if a piece of equipment showed up in their territory. So that's helped us. So -- yes, it has made a difference.
Chad Dillard
Got it. Okay. So can you -- just assume this is a construction question -- construction equipment question. Can you discuss the long-term drivers of owning versus rent? And what are you seeing in terms of, I guess, near-term impacts related to, I guess, the credit tightening and rates being higher?
Jim Umpleby
Yes. So customers make different decisions. Some prefer to own, some prefer to rent, many prefer to do both. So we'll have a certain amount of a certain number of units that they own. And then if they need a piece of specialty equipment, they'll go out and rent it.
So again, I can think of a number of our big construction customers, they do both. We're not concerned about tightening credit markets. So if you stop and think about at the beginning of our talk here, Chad, I described the end markets that we serve. So if you stop and think about the customers, whether it's -- let's start with construction and infrastructure. Those infrastructure funds are coming, so the -- my sense is that those projects that are government funded will not be impacted by tightening credit.
Oil and gas customers, my sense is that ExxonMobil, Chevron, ConocoPhillips and others will have the wherewithal to buy our equipment without concerned about [indiscernible] credit conditions, same with BHP and [Rio Tinto] (ph), our mining customers. Same with some of our power generation customers for data centers, Microsoft, companies like that, AWS.
So okay, where could those tightening credit conditions impact customers, conceivably smaller customers, if, in fact, a regional banks tighten lending standards. Well, we have a captive finance arm and we are not dependent upon deposit deposits. Cat Finance is very conservatively managed. They match duration risk, and they're very -- in a very good position to step in and help our customers buy our equipment. Our equipment shows as the collateral. All that equipment is connected, so we know where it is. And our past dues in Cat Finance are near or at record lows at the moment, 2% or less. So again, we -- at this point, we feel good about that situation. We're not concerned.
Chad Dillard
Okay. Another question from the audience. Is there a view on allowing consolidation of the dealership network in the U.S. to improve dealer performance by bringing some of the best practices in from the others?
Jim Umpleby
So we continually try to have our dealers share best practices with each other. I won't predict consolidation. There has been some in North America over the last five years. And again, that will play out over time based upon individual dealers' interest and performance and all the rest. As a reminder, dealers are independent businesses. We certainly have a role to play in that, but they are independent businesses. but there has been some consolidation over the last few years.
Chad Dillard
Okay. So maybe moving over to the oil and gas business. there is this interim period between kind of fully, I guess, zero emissions and where we are today. Can you talk about some of the products, some of the opportunities you see from maybe you can talk about like dynamic gas blending and to what extent are you seeing that level of uptake from your -- some of the new customers right now?
Jim Umpleby
You bet. We certainly believe that oil and gas, and particularly natural gas, will be around for a long time. Think about the investments that are going in the LNG facilities. And one of the things that our oil and gas customers are very focused on, and we believe we have a competitive advantage in, is helping them reduce their Scope and 1, 2 emissions. So they're reducing their carbon footprint as they produce more oil and gas. I mentioned dynamic gas blending allows customers to substitute up to 85% of diesel with natural gas. we have -- in well servicing, we have what's called [indiscernible] now. So instead of having much of diesel engines, you can have either gas turbine-driven or reciprocating engines that burn field natural gas, electricity is produced in a generator, And now through the acquisition we made where oil and gas SPM, we have electric-driven track pumps that can operate on the site.
We've developed a new control system to help our customers with frac trailers, let's say, if it is a diesel engine, a Cat transmission, a Cat [indiscernible] pump that we make, we have a floor in and around it. And oftentimes, operators would not operate at the right transmission speed. It's kind of like buying a Ferrari and driving it to work every day in first gear. And that creates a situation where you're not very efficient. So you're burning more fuel. So what we've been able to do with this control system is it automatically controls the speed of the transmission, and it dramatically improves the emissions profile of that trailer because you're now running at the right speed.
Lots of other things we're doing in terms of investing in gas compressors to help customers put out flares by compressing gas. So a whole variety of things that we're doing with the oil and gas customers to help them reduce their greenhouse gas emissions. And again, that business, as we sit here today, is quite strong.
Chad Dillard
Okay. So I guess got 40 seconds left. One last question for you. So you talked about your capital allocation priorities. Right now, it's basically returning virtually the majority of cash back to shareholders. But maybe looking beyond that, from an M&A perspective, are there any particular strategic gaps that you think you would need to fill as they look towards these kind of large-scale mega trends over the coming one to two decades.
So we ask all of our business leaders to continually evaluate the landscape, and there's always companies we're thinking about. And we don't make those public, obviously, we think about what could be helpful to us from a technology perspective.
Sometimes it's a product gap and where SPM is a great example of that. And so again, we think about the capabilities we have internally, we look at the external landscape, and we look at valuations. Always obviously want to get a return on an acquisition that we make. Sometimes we'll do it for technology's sake, but there's a whole variety of things that we follow. And oftentimes, it comes down to waiting for the right time to do it.
Chad Dillard
Okay. We're all out of time, Jim. Thank you very much.
Jim Umpleby
Thank you, Chad. Thank you all.
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Caterpillar Inc. (CAT) Bernstein's 39th Annual Strategic Decisions Conference 2023 (Transcript)