開拓重工 (CAT) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Caterpillar third-quarter earnings results conference call.

At this time all participants have been placed on a listen-only mode and we will open the floor for your questions and comments following the presentation.

It is now my pleasure to turn the floor over to your host, Mike DeWalt, Director of Investor Relations for Caterpillar.

Sir, the floor is yours.

Thank you.

Good morning, everybody, and welcome to Caterpillar's third-quarter 2005 results conference call.

I'm Mike DeWalt, the Director of Investor Relations.

With me on the call today are Group President, Doug Oberhelman, and Company CFO, Dave Burritt.

This call is copyrighted by Caterpillar, Inc. and any use, recording, transmission of any portion of this call without the express written consent of Caterpillar is strictly prohibited.

If you would like a printed copy of my prepared remarks, you can go to the SEC filings in the investor section of our Website where they're filed as an 8-K.

They'll also be available on the SEC's Website.

To leave more time for Q&A today, I don't intend to reiterate too much of what was in this morning's release, but I do want to make a few key points before we start the Q&A.

First, certain information we'll be discussing today is forward-looking and involves uncertainties that could impact our expected results.

A discussion of those uncertainties is also in a Form 8-K filed with the SEC today.

Okay.

A few key points about third-quarter results.

First, I'm very pleased to report the very best third quarter in Caterpillar's history.

Sales and revenues and profit per share were both records.

Sales and revenues were just under $9 billion and profit was $667 million, or $0.94 per share.

Sales and revenues were about $1.3 billion higher than the third quarter of 2004, and that is an increase of 17%.

Profit was 34% higher.

Machinery and Engines operating profit as a percent of sales increased from 7.9% a year ago to 10.5% this quarter.

The margin pull-through -- that is the increase in Machinery and Engines operating profit as a percent of the increase in sales -- was about 26%.

And that is our best in over two years.

The improvement in Machinery and Engines operating profits was driven by better price realization, which was up 503 million compared to a year ago, and higher sales volume.

Core operating costs were up 303 million, partially offsetting the favorable effect from higher sales.

This was the best quarter-over-quarter comparison of core operating costs this year.

In our previous outlook, we'd expected the quarter-over-quarter comparisons for the back-half of the year to improve, and they have.

As you consider the 303 million increase in core operating costs, you need to put it into perspective.

About half was variable manufacturing costs; things like direct material, variable labor, variable overhead costs and freight.

Material cost pressure inefficiency related to the very high volume levels we're operating at are certainly a challenge, and material costs for us and others as well.

Energy and freight costs are also up.

The other half of the 303 million were period costs; that is period manufacturing, SG&A and R&D expenses.

And volume was a significant driver for the period manufacturing costs, and we have managed the increase to a level lower than the increase in sales and revenues.

In total for the quarter, our sales and revenues were up 17% and our period manufacturing costs were up about 10%.

SG&A and R&D combined were lower as a percent of sales than a year ago, and that is despite the fact that we are in the midst of an ambitious new product introduction program for Machines and Engines.

Over the next few years we're going to see the most significant introduction of new and improved products in our history.

Let's move on to Financial Products for a second.

Our third-quarter results included lower operating profit than the third quarter a year ago for Financial Products, and that's not something that has happened very often.

Financial Products did have higher profit as a result of an increasing asset portfolio.

That was positive about 36 million, but it was more than offset by 12 million of operating costs related to the portfolio growth, some Cat Financial asset impairments, and last year, in last year's third quarter we had significant favorable reserve adjustments at Cat Insurance.

And we mentioned that in last year's third-quarter release.

One other point about the third-quarter results, we raised the estimated annual tax rate to 30%.

And the third quarter includes the effect of bringing year-to-date expenses to that level.

In summary, for the third quarter, we posted record sales and revenues and record profit per share for any third quarter, improved operating profit as a percent of sales, and the Machinery and Engines margin pull-through was 26%.

And we have done it in the midst of extremely challenging business conditions.

Volume is up significantly over the past couple of years.

And we're working to increase our capacity and deliver machines and engines to our customers.

To put to the volume context over that period in context, if you look at our nine-month sales and revenues for this year and compared them to the first nine months of 2003, you would find sales and revenues up about 64%.

That's a lot of growth in a two-year time period.

Also in that two-year time period, material costs are significantly higher than they were two years ago.

Energy costs are up and the increase in volume has certainly stretched our production system and our supply chain.

Bottom line for the third quarter, while it wasn't quite as good as many of you expected, we posted pretty good results.

Let's turn for a moment to the outlook. 2005 continues to shape up as a great year.

We have firmed up the sales and revenue forecast at the top-end of the previous outlook range.

We now expect our 2005 sales and revenues to be up about 20% from 2004.

However, our profit expectations have changed.

We now expect profit for 2005 to be between $3.85 and $4 per share.

That is down from the prior outlook which was $4 to $4.20 per share.

Two new factors are a part of that change -- first, the potential for about 100 million of pre-tax charges in the fourth quarter related to dealer distribution software and a product realignment, and the increase in the estimated annual tax rate from 29 to 30%.

For 2006 we've done something that's a first for us.

We're not only providing a preliminary outlook for sales and revenues, we're providing an outlook for profit per share for the coming year.

Compared to 2005, our 2006 sales and revenues outlook is up about 10%.

The profit per share outlook for 2006 is up 15 to 25% from the midpoint of our 2005 range.

Before we move to the Q&A, I would just like to mention that more information concerning the outlook for 2005 and our 2006 outlook is in our release.

Okay, let's move on to the Q&A portion of the call.

In the interest of time and in fairness to everyone on the call, please limit yourself to one question and one follow-up.

Could we have the first question?

(OPERATOR INSTRUCTIONS).

Alex Blanton, Ingalls & Snyder.

You know, it's quite amazing what's going on with your stock; it's down to barely more than 10 times your guidance for next year at the midrange.

And I am sure you feel that flow, but I'm not going to ask you about that.

But I do want to point out there was some errors in the media's reporting when they said that 8.98 billion in sales compared with an expectation of a 8.47 billion.

That expectation did not include the finance company.

So, it looked as if, if you read the reports, that there had been a big disappointment on the margin side.

And that's not really the case, as you pointed out.

But I wanted to ask you about the increase in the materials costs and steel prices and other costs that you mentioned.

You had expected to be caught up on price versus cost increases by the end of the year.

Because of the lagging effect of the price increases and the inability to apply those to the backlog, it would take some time to do that.

Do you still expect that by the end of the year?

Are we going into next year with -- fully caught up in terms of price increase?

And if there are further price increases or cost increases next year, what is going to be the situation?

Well, Alex if you look at our third-quarter release, we had 503 million of price realization in the quarter.

And that was actually 200 million above the total for core operating costs.

And that is more than material.

Material is only a portion of that.

You can kind of tease out of our question eight in the Q&A that relates to the breakdown of the core operating costs, and in the range of 70 to 75 million was material costs.

So, for the quarter, price way exceeded material costs.

Let me add to that, Mike.

Doug Oberhelman here.

Looking forward.

We, as you know, announced the last couple of price increases very early, both for machines and engines, to hopefully minimize the impact of the backlog.

We expect to see that and are seeing that come through as we expected.

We announced an '06 price increase way early and we expect the price protection to come and be in our favor more than we have ever seen in the past.

We commented about 2006 prices and costs; right now we're very optimistic that we are seeing material costs where we want to be vis-a-vis our price increase for January '06.

But I will tell you as I did a year ago or so, that we will evaluate that almost on a daily and monthly basis.

And if we see material costs continuing to climb, including inputs for our customers, we will take another look at it as we have in the past.

But right now that is too early to call.

But we are prepared to do that as we have demonstrated the last, really, the last couple of years.

A follow-up question.

The effects of 123-R stock option expense -- when do they start for you and how much do you expect them to be?

In our second quarter 10-Q, I think it was, Alex, we said that we think next year will be about $100 million.

For the year as a whole, Parker Hannifin just had to take half of their expected costs in the first quarter because people over 55 had to be expensed right away.

Have you looked at that?

Is that what you expect, the same kind of pattern?

We see it front-end loaded for 2006.

Gary McManus, JP Morgan Securities.

Good morning Mike and Doug.

A question on operating costs.

You know, it was 303 million in the third quarter.

And if you look at in your second-quarter release, backing into what you expected for the second half, your expectations were 285.

So, my first question is how come the third quarter was more than what you expected for all of the second half?

And secondly, your expectations for operating costs in the fourth quarter, I believe, is 182 if I strip out the $100 million charge.

So, that's a fairly big decline than what you saw in the third quarter.

So, take me through the assumptions there.

Okay, Gary.

We didn't actually provide a split between third and fourth quarter in the last outlook.

But I will say if we had, we would have seen a lot higher cost comparison in the third quarter than the fourth.

So, we never really viewed it as sort of a 50-50 split between the third and the fourth.

Now, that said, if you -- and you did the math correctly, the 182 for the fourth quarter excluding the 100 million; so, good job.

For the year, we are up about 200.

If you do the math on the bucket, you take out the 100 million, year-over-year it's about 200 million.

And most of that 200 million is in the fourth quarter.

We'd expected costs for the fourth quarter for the most part -- there were some in the third quarter -- but for the most part we thought costs in the fourth quarter were going to go down more than it looks like they are.

And that's not just material costs; it's material costs, it's the R&D we have to support our programs, it's SG&A to support the volume and it's the period cost and efficiency in the factory.

It's actually spread across most of our cost categories.

Let's just take the second half in total.

You're now saying it's 485 and previously it was 285.

The $2 million increase is due to what?

How would you break out how -- much is -- it doesn't look like R&D and SG&A are a problem.

They're not -- as you said, it's below the revenue growth.

So, it seems like it's more in the manufacturing inefficiencies and material costs.

So, what happened to take that number up 200 million from your previous forecast?

How confident can we be in you guys protecting this number to begin with?

Gary, you are right;

I don't think SG&A and R&D are a big problem per se.

They are as a percent of sales lower.

But all I was trying to comment on, and if you look at our outlook, we had expected -- or I will say that a different way.

If you look at the 200 increase in costs, it's across all of the categories; it's not just material.

Our expectations for the full year for most of our cost categories are all up a bit.

So, I guess the message I'm trying to give you -- if you think about the 200 million cost increase in the back-half of the year, it's spread across most of the cost categories.

Ann Duignan, Bear Stearns.

My question is over the engine revenues.

I am struggling a little bit, and maybe I've missed something in the details here.

But traditionally your retail sales, both on machinery and engines, have been pretty close to your reported sales in both of those segments.

But this quarter, retail sales as far back as August were up about 23%, and yet you only reported 11% growth in engines year-over-year.

What is going on there and how should I think about that going forward?

I will make two comments and then we will kind of take it from there.

First off, when you look at retail sales and you compare that to our sales overall per category, just a few things you need to remember.

One is when we say engines, that's just engines.

In the retail sales number it's not parts or service-related -- we don't do service, dealers do -- but it's not parts related to engines.

So, if the parts piece of the equation is up or down, you will miss that.

Turbines could also be a factor in the difference.

And there's also dealer inventory.

If you look at dealer inventory for engines, for example in this third quarter -- and it might have been a little bit of a confusing paragraph there on engines -- but dealer inventory in the third quarter was down.

So, that kind of -- the sum of all those facts can make the retail sales number look a little bit different than our reported number.

Can you just clarify what you meant by turbines could be a factor?

Are they not reported in these Cat engine retail sales?

Yes, they don't go through dealers.

Okay.

And I knew that;

I just wasn't sure that they were captured in the retail sales that you give us.

That helps to explain that.

On the $100 million of incremental costs that you think you might have to absorb going forward, you mentioned that one of them was due to realignment of a product line perhaps.

Could you give us a little bit more color on that and what is, and how would we know whether that is actually going to happen or not?

I will give you the short answer and then the long answer.

The short answer is no.

No, you're not going to answer or no (multiple speakers)

Let me help you on this one, Mike.

And I will comment generically about the 100 million.

As we said the release composed of two items.

Both are being contemplated.

Both involve some outside communication that we'll need to make after we make a final decision that we think we might make in the fourth quarter.

So, with all of those ifs, ifs and ifs, we'll be getting back to you sometime relatively soon with the specifics on both of those.

But we're just not in a position to do that today.

That was the long answer, Ann.

So, before the end of next quarter we will know whether that should be in our numbers or not?

That's right.

David Raso, Salomon Smith Barney.

A question about the production bottleneck.

I'm just trying to think through looking out into '06.

What is baked into your thoughts on the earnings growth expectations for '06 when it comes to fixing these bottlenecks, and why should we look at it as something that is correctable near-term when overall, obviously, costs and production issues have been an issue now for the Company for probably over a year?

Can you help us flush that out a little bit?

A couple of things about that.

One, in terms of -- let's just think about capability to make the sales for a moment.

A little while ago, Gary did the math on our core operating costs at 182.

If you do the math on the sales and revenues for the fourth quarter, it's around 9.6 billion.

So, in other words, we are looking for rough capability to do most of next year's forecast kind of based on a fourth-quarter run rate.

We're working on capacity increases at a large number of our facilities, and we're not talking about big investments in brick and mortar.

But it's the kind of things we've been talking about throughout the year.

It's factory rearrangement.

It's some machine tools.

It's working with our suppliers.

I think in terms of capability, when we put out an outlook, the 10% up sales and revenues, we have full expectations that we will have the capability to produce at that level.

So, that's that point.

On the efficiency level with '06 and kind of where we have come over the past couple of years, I think that we have been constantly -- not constantly -- but we have been surprised, I think, as we have gone through this year at the increases in our volume.

I mean, we started out the year looking for sales and revenues up 10%, and now we're talking about up 20%.

So, I think it's fair to say we have been surprised this year by the strength of 2005, how it has come through.

And to a degree then, we have been chasing that volume in our factories.

And I think it's a fair comment that we have -- as a result of that, our efficiency levels in the factory haven't been as good as we thought they were going to be early in the year.

And a lot of that has been driven by the continued increase in the sales.

I was just going to say about 2006, we characterized it as a preliminary outlook in our release today.

And that's because we haven't completely finished our planning process for 2006.

And so, we're going to try to avoid talking too much about the details of what makes up the '06 outlook beyond what is in the release.

Let me just add to that, Mike, on two things.

One about our '06 outlook.

This is the first time in my, I guess, 11 years involved with this that we have ever talked about profit per share this early ahead of the next year.

And I will either tell you or warn you we may not ever do that again either.

But we thought it was appropriate this time given what we see in '06.

So, I'd just tee that one up.

Secondly, a little more, I think, color on this production increase.

All of us here, and I think most of you on the phone, were surprised back in 2003 from a standing stop essentially that rate of increase and growth we saw in virtually all of our industries around the world.

We have done very, very well, in our opinion, ramping up some very big production facilities.

And some of our big plants have ramped up to 70% in two years; that is throughput; that is complete machines out the factory door. 80%, 150% -- lots of numbers that are huge in a 24-month period or maybe slightly less.

Our engine facilities -- same kinds of numbers.

Big-time ramp-ups in two years.

So, we think we have done pretty well with that given a supply base and our own view over the previous five to six years that was wilting away in front of us.

So, while we are a little bit defensive on our -- what we have been putting up in the last few quarters, our operating margins really came through in the third quarter.

And we have got product out the door like I don't think anybody would have believed back in 2003.

If we would have said in 2003 that we expect two years out some of our plants to increase production 80%, nobody would have believed us.

So, we have done, I think, pretty well.

I'm maybe being a little bit defensive here, but we have just had exceptional performance from our employee base, our supply base, to get the amount of production out the door we have been able to do.

Now we're fine-tuning to make it even better going forward.

This is Dave.

Let me just add to what Doug just said.

In addition to those challenges, though, we recognize we have to do better.

And in fact, you saw some announcements that went out recently that put a structure in place with manufacturing production and order fulfillment division that was recently formed to address these issues moving forward.

So, we know it's an issue and we're going to be better at it.

Great point, Dave.

I can appreciate it's a good problem to have and demand beyond expectations.

But what I'm trying to digest is this entire cycle we've seen your supply base, and for that matter, I suspect, even the message we will get from you in New York a week from Monday is you're not going to throw capital at this cycle; you're going to be very efficient in how you de-bottleneck.

But at the same time we're having demand exceed expectations.

And you and the whole supply base is still pretty reluctant to spend the capital necessary to really serve this demand efficiently.

So, looking out to '06 and serving the demand, starting from your own thoughts on CapEx and the whole supply chain doing the channel checks, the supply base doesn't seem willing to de-bottleneck and essentially spend the money to make sure we can serve this demand efficiency.

So, I'm just trying to think through how do we not have this conversation again in a quarter or two, unless it's because demand slows down, which is a problem on the other side of the fence.

So, are you seeing your suppliers step up and actually put the capacity in place to not have this issue into the next couple of quarters?

Again, unless demand rolls over, which is a separate problem.

Great question.

In fact, we have seen our supply base come to the party with capital, albeit maybe not as fast as we have seen in prior periods.

I think all of us remember, essentially less than three years ago, we were in the depths of struggling at the bottom of a very tough, long period of time.

And as I said a minute ago, this thing came out of the blue in 2003.

And we are glad it did.

We've stepped up our CapEx 50% or so this year over '04.

I'm not going to tell you what we're going to do next year because we haven't added it up, but I'd almost assure you it's going to be up again.

We have put CapEx in a, I think, very deliberate way into our -- some of our factories to make this production capacity.

We have got some pinch points we have been talking about all along that are coming along.

Tires, for one, come to mind.

We have been all over our tire suppliers together to make this happen.

It's not just big tires; it's the trucking industry and everybody else that is short.

But they are coming.

Are we going to have this question six months to a year from now?

Two things could change it -- one, demand could be greater and we still can't keep up; or demand could be less and we are overinvested.

And that's what we are trying to really call going forward to get absolutely the best pull-through we can get given what we see in terms of how long this could last.

The big mining products we are going to be pinched on.

Yes, we're going to have that conversation probably next year and maybe a couple of other of the big items as well.

I can appreciate the difficult decisions, but when I look at your fixed costs, if the numbers are correct, you cite in question eight in the Q&A section that your period costs -- which you refer to as fixed costs -- were up $90 million, or 10%.

That implies year-ago third quarter your period costs were only 16% of your COGs.

Now for Cat -- tell me if I'm wrong -- is it true your fixed costs are only running at 16% of total COGs?

If that is the case, that means your supply base is even more critical than ever before.

I mean, you're not doing as much in-house; you don't have as much fixed costs as before.

We know that.

But am I reading that number properly, that up 10% is only $90 million on the fixed cost?

Yes, the up 10% is $90 million.

But that's not the only fixed cost we have.

That's fixed manufacturing cost.

That doesn't include R&D and SG&A.

And that's not everything (multiple speakers) nonmaterial.

We can talk off-line.

That's got to be a low number. 16% of COGs.

I'm not even throwing in the SG&A.

But we can talk about that off-line.

It just seems like a low number.

Hopefully it's not that low, because obviously you want some leverage.

Last question;

I apologize.

Engines -- the volume was a little disappointing, especially (indiscernible) sales in North America and Asia-Pacific.

Can you give a little more color on that?

I mean, power gen is a bit weak in Asia; we know that.

But can you flush that out a little bit?

I will talk about the power gen, and Doug may chip in here as well.

The power gen in Asia is mostly a China phenomenon.

If you look at all of the brands that we sell into China, whether it be Cat brand, F.G.

Wilson, Perkins, Solar, MaK, all of the sales into -- EPG sales in China were down.

Third quarter last year was a really big quarter.

There was an anticipation that last year that China was going to run short on electric capacity, and there were a lot of sales in the third quarter of last year.

And that same situation did not exist this year.

So, that is Asia.

There's no truck engines to speak of in Asia, and so EPG and marine and petroleum make up most of the market there.

Yes, I will just add a comment on North America that you mentioned.

We saw double-digit increases just about in all segments with the exception of truck engines.

And in truck engines it's kind of a bifurcated story there, I guess.

Heavies are going great.

Mediums -- heavies being Class 8, mediums being Class 5 through 7 -- are not as robust as Class 8.

That's what is driving that.

But we have had, as you have seen through other outside material, market share increases in our Class 8.

Our very good customers are feeling and seeing that.

And our partnership with Takar (ph) is working very, very well.

Joel Tiss, Lehman Brothers.

Two areas; maybe I will just ask them both at once.

Can you talk a little bit about the number of products that you still have on managed distribution and how that compares to the second quarter?

And second, can you also put the 1 to 5% price increases for 2006 into context?

I know it sounds more like the productivity side is where the shortfall is.

But can you talk about the cost versus the price outlook for '06 as well?

Thank you.

First, we will go back to the models on managed distribution.

About 60, and it's roughly the same as it was into the second quarter; no big change there.

In terms of the price increase for January, if you look at our outlook for '06, Joel, we haven't really split the sales out for you between price and volume.

So, I'm a little reluctant to get more specific about the 1 to 5.

That's fairly consistent with the language we have given over the last few price increases.

In terms of cost versus price next year, I guess I will just say at this point that we have -- our outlook is sales and revenues up 10, profit up 15 to 25.

So, I think that points to a favorable relationship.

Sorry I can't be more specific.

John McGinty, Credit Suisse First Boston.

The first question I have relates to your overall core consolidated operating profit.

The waterfall chart on page 14, which is the full-year outlook for '05, comparing it to the full-year outlook for '05 last quarter.

The operating profit is down by 195 million. 100 million of that, as you said, is the write-off of DBSI and the forestry, or whatever it is.

The other 95 million, if you look at it, your sales and your price are up 150 million.

The other core operating that you've talked about is up 200 million.

So, that is 50.

But there's a $45 million swing in other.

And so, half of the swing is in other from where you were a quarter ago.

Could you just talk about what that is?

You bet, John.

No problem.

First, in general, on this bucket chart, I'm just going to set it up a little bit and then I will get right to your question.

This is -- this reflects operating profit at the midpoint of the range, midpoint of the sales -- of the range.

Last time the midpoint of the sales range was up 19, and this time we just have a single point on sales and revenues at 20.

So, on this midpoint chart, the volume number is up.

The price realization number is also a little bit better.

And we've talked quite a bit already about the core operating costs going the other way.

The other bucket -- it's really made up of two things.

One is all of the rest of the buckets are Machinery and Engines.

So, to the extent that Financial Products is down, that would go in that other bucket.

And in the third quarter, we had a couple of the asset impairments that we mentioned in the release.

That was, I think, 14 million in the third quarter.

Then if you look at all the rest of the bars, they are all pretty neatly rounded -- 1.1 billion, 1750.

Rightly or wrongly, we have taken a convention here of rounding all the buckets to the nearest 50 million.

And we put whatever rounding difference that needs to make the total work out into others.

So, I will tell you a little bit of it is rounding because we've smoothed off the other buckets, and the rest of it is Financial Products.

But is the rest -- just to clarify -- the rest of it is not -- at Financial Products -- is not just the 14 million of asset impairments, but it's other things as -- in other words, the rounding is not $34 million, or is it?

Actually, I don't know the split between the rounding.

I don't think Financial Products is down.

Certainly, it's not down 50 million.

Okay.

My second question has to do with your '06 outlook conceptually, based on what we know.

And it's really the topline;

I don't want to get into the earnings.

But you've got a 10% volume gain.

You've got -- the price increase was 3.5.

You've got about a point and a half carryover.

So, let's say you've got at least 4.5% price.

So, that's really only a 5 to 6% volume gain.

What I don't understand is your dealers domestically, your districts were telling them to forecast up 10% real.

Europe's starting to turn.

The Third World is strong.

All the dealers want to reload their rental fleets if they were able to.

And so the question is, to look at only a 5, 6, 7% real gain next year with those drivers, are you assuming weakness somewhere in the world that we are missing or are you assuming that that is in fact the capacity constraint that you have of real volume up 5 to 6%?

Because if you just look at the pieces around the world and you look at some of the underlying things like the dealer inventory, like the fact that there are no power modules anywhere in the country -- they have been all sucked up into the Gulf -- it would seem to me that your sales should be higher unless there's some markets overseas or somewhere that are going to start collapsing.

I don't see what they were.

I wondered if you could talk to that.

Is this the typical Cat conservatism where you started the year at 10 and ended the year at 20?

Should we be looking at this the same way?

Wow.

I almost don't even know how to answer that.

I'll start back at the beginning, John.

First, I'm not going to split the 10 million between price and volume; we've not disclosed it.

We'll just kind of work off of the 10 a little bit.

Are we being overly conservative?

What are the factors that might be holding the volume number down?

I think there is no doubt that on some of our product lines -- and you mentioned a couple of them -- big engines and big mining product, and a lot of the other big machines, we do have capacity constraints that we're trying to get the numbers up.

So, certainly in some areas capacity is an issue that we have to deal with.

Beyond that, you know, there's -- this is early in the year.

It is our best shot right now of how things look.

We -- again, I kind of characterized this as a preliminary outlook, and we said that in the release body itself.

We're still going through our internal planning process.

And you know, certainly, if we have a different number we'll share that in January.

But I think that kind of based on where we sit right now, what we see in terms of production, markets around the world, we think about 10% is the prudent forecast.

John, I'll just add to that.

As you know, it is early.

We have got 14, 15 months until the end of '06.

You sit here and think you can paint a very optimistic picture, and one not so optimistic if you want to.

We have got energy prices.

We have got all kinds of uncertainties out there.

We talk about those, I guess, in the fine print.

But at this point in time, the 10% is our best shot.

And as usual, I think your analysis is right on.

Well, just as clarification to that -- if you were up -- and I'm going to pick a number; 15 or 20.

In other words, not -- without trying to put a number on it.

Can we assume that the operating -- your operating leverage is 10 and then your sales up 15 to 25.

So, (indiscernible) midpoint 10 to 20 -- can we assume that within reason that same operating leverage would be there?

Or as we squeeze out higher sales, is that operating leverage going to start to come down as you have to gear up more period, more fixed costs?

I'm not going to get that specific.

We haven't even done our business plans yet.

But certainly that would be management's expectations.

Why would we expect anything less from the troops?

I think that's probably directionally correct.

Andrew Obin, Merrill Lynch.

I just have a follow-up on Dave Raso's question.

I think Ingersoll-Rand yesterday talked about the fact that they're moving away from single-source supply agreements to dual-source supply agreements, and also sort of co-investing with their suppliers, and maybe even taking stakes in some of their core suppliers.

I'm not sure if you can comment on any specifics, but given what is going on in this ramp-up -- A., how do you think you are now thinking about your supply chain?

And B., do you think it's possible, I guess, to do anything until we hit the next downturn just to fix these issues, because they seem to be really structural in nature?

I can tell you that we have never looked at our suppliers as much as we do now as partners.

There are basically two models out there the way I see it.

One is kind of the North American automotive model of suppliers where everybody loses.

And the other one is partnership, 6 Sigma -- how do we take costs out of the entire chain?

And frankly, we are going the latter.

You know we formed a global purchasing division a couple of years ago.

What great timing that was to get started on it.

They've helped us ramp up so well, as we have shown the last couple of years.

Kind of the next plateau is how do we get closer.

I don't know if we will invest in them or not, but certainly we have got to be very close with our supply chain.

And that's the emphasis of a lot of our purchasing work today.

That's a great question and, I think, exactly where we are headed.

But do you think it's fixable?

I mean, given -- I understand why you're ramping up production just to secure the aftermarket revenue five to 10 years from now.

But, do you think we can do anything if revenue continues to go up 15, 20%?

It's a high-class problem to have.

I was going to say, I just hope beyond hope that we have that for about the next 10 years.

And as sure as I am sitting here, we will address it well.

We would love to be strained like this for the next 10 years.

Another question sort of unrelated.

On ACERT, talking to suppliers we sort of hear more that the industry is moving more towards thinking about SCR (ph) models for 2010.

How do you -- A,. how does ACERT fit if the industry does go with the SCR?

And B., how do you think about your competitive position if this takes place, vis-a-vis players like DaimlerChrysler and Volvo that all of a sudden will have a global engine platform, if that is the case?

Great question.

A lot of that is unknown.

As you know, Western Europe is going -- will be going the route of SCR with their Euro 6 and beyond.

We are -- at this point our technology is still developing.

Through -- I guess four years ago we were asked why are you going alone with ACERT while everybody else is going EGR?

I think the success story of ACERT is in.

We are glad we did it.

As I said earlier, our market shares in heavy are going up again.

Our 2007 engine, the early ones are performing very well.

We're very comfortable with our position being the sole non-EGR provider in the world, comparable to if we are the sole non-SCR provider after 2010.

All that is to be played out.

We just feel that a cleaner burn is the way to go rather than all the other things you have to do to an engine.

And I guess in a nutshell, if that's the way to coin it, that's what I would do.

We just feel it's going to be clean coming out the exhaust deck after what we do within the chamber and within the engine.

And that basis will form our 2010 and Tier 4 off-road engine in 2011.

I apologize if there's an obvious answer to this that I should know.

Is SCR compatible with ACERT technology?

Can you integrate SCR with ACERT?

I understand the value of ACERT, that the emissions come out of the engine cleaner (indiscernible) in theory you don't need anything.

But can you integrate SCR with ACERT if you choose to?

Yes.

Mark Koznarek, FTN Midwest Securities.

Yesterday Ingersoll-Rand talked about a pretty sharp collapse in the China road-paving market.

And I'm wondering if you can update us on what is going on with regard to the overall construction equipment market there and change in expectations for this year, and even to the extent you can comment on what sort of general outlook is in the 2006 assumption regarding that region?

If you look at China, we've kind of talked about some of this a little before.

I'll just sort of stage set.

One of our biggest products there is excavators.

And excavators were a booming product in the first half of 2004.

And then much of the market shut down from credit constraints in the back-half of '04, and we have been recovering pretty steadily since then.

Now, notwithstanding the EPG issue that we talked about a little bit ago, our Machinery and Engines -- or machinery sales in China are moving up.

Now, we're not big in the road-paving business there, so I guess I don't know quite how to answer that, Mark.

But I think that we see pretty decent activity there.

One other thing that is a help for us is Cat Financial.

Cat Financial went into China earlier this year and are actually doing pretty good business now.

And that is a help for us.

So, our sales as a result are pretty good.

I would just add to that, in China in general, I mean, we have seen our own excavator business go from boom to bust to boom in about an eight-month period.

Based on what the Central Chinese authorities want to with the state of the construction business, I think we're going to see that for a long time to come.

When you track the growth in China in all of the industries, even road-paving, which maybe is taking a breather now -- it, frankly, is not one we follow closely because we're not a big player in paving over there as yet; we just introduced a couple of pavers recently -- but the trend is clearly up and probably will be for a long time, as it has for the last 20 years.

So, generally, we're pretty optimistic in China.

But realistically, we're going to have fits and starts as that thing -- as China continues to evolve.

Stepping back a little bit.

Doug, I think you mentioned yourself a little bit earlier that this is the first time you guys have ever offered an earnings outlook here at the third quarter.

What is really the motivation for doing that given the volatility of the outlook that we have seen over the last four or five quarters here?

Why reach out early and try and nail down something even with a broad range, with so much uncertainty with your own internal manufacturing processes?

And then, certainly, the external economic environment has got its own share of concerns.

Could you comment on that please?

Well, you have framed the debate internally we have had for about 60 days on whether to do this or not.

And we did step out.

It's not, as I said earlier, not Caterpillar-like in being out in front so early on something like this.

We did give it a broad range.

But, we feel we have got in front of our ownership base in the next few days and weeks a number of iterations that we just felt we ought to talk about with 2006.

There's a lot of opportunity and a lot of risk, and we just wanted to be able to talk about that more openly, which we plan to do.

Is part of it that your backlog is so substantial right now with the number of machines on allocation?

Is it the fact that your order book is so substantially booked up for next year at fixed prices that you feel you can comment much more confidently now than you have ever been able to in the past?

No, that really didn't enter the discussion.

Because we really didn't want to get into a situation where in good times we do it and bad times we don't.

This is kind of a onetime-only deal, based on what we see as a lot of things gyrating at the moment into end of '05 and into '06.

I mentioned energy.

I mentioned these hurricanes, interest rates.

There's just really a lot of variables to play with that we thought we ought to be talking about as we go into the end of the year and on into '06.

We will screw this down pretty well in our January 4th quarter release, and hopefully refine it even further.

What does the backlog look like right now for '06?

I'm going to ask Mike to comment on that.

We don't disclose backlog numbers, but I think it's -- we've talked quite a bit about capacity in the big products.

I think it's safe to say that for big machines and big engines, it's well extended beyond normal.

Sorry about that, Mark, though; we don't talk about the actual dollar amount.

I think we will take one more question and then we will wrap.

Actually, I think we have time for two more.

Barry Bannister, Legg Mason.

Around three or four years ago, Chairman Barton brought the global mining business back in-house and signed -- I believe you signed some alliance agreements.

And one of the characteristics of those agreements was predetermined price escalators that were various.

And I'm looking at some of your competitors in light to medium construction machinery, and their margins year-to-date are higher than Caterpillar's machinery margin.

And I wonder if perhaps your big machines by deduction are what is lagging in terms of profitability versus past cycles, and do these agreements have anything to do with it?

I think the agreements are actually very positive.

They put you in a very close relationship with these customers.

It's positive for machine sales.

It's positive for volume.

You are right, though; many of those agreements do include pricing provisions.

And they vary agreement to agreement.

But I think -- I don't think in terms of price those agreements are hurting our overall margins at all.

On the contrary, I think those closed and tight relationships with those customers are a positive.

I would add, Mike, we have plenty of pricing opportunities within the agreements.

But this has just been a brilliant win for Caterpillar.

And I would hope that those dozen or so alliance members on the mining side would tell you it has worked for them as well.

I can't think of a better win-win for this company than those mining agreements overall.

And there may be some timing issues;

I'm not even aware of that.

But there is plenty to work with there.

And we really get close to these customers that are so important to us over time.

So, this has just been a brilliant piece of business for us.

And I would hope -- and I guess in what we hear, the miners would tell you the same thing.

But notwithstanding the extraordinary volume that has led to some inefficiencies, has the pricing provision of such agreements restrained your ability to price through this equally-extraordinary increase in costs?

I don't think so, no.

Just as a related follow-up.

In talking to dealers about issues, has warranty expense as a percentage of sales, now that Caterpillar is running flat out, has it increased?

And are you hearing things like dealers, loaners, frequencies going up?

Quality and related inventory expense is something that we look at very closely.

And I think when volume goes up, you hear more, just because there is more out there in the field -- more product in the field.

But overall, I think we are pretty proud of our quality overall.

I think we have a reputation for quality.

In terms of warranty to sales ratio, that is not something we normally comment on.

But I don't -- it's certainly not spiking.

Has your warranty exceeded what you expected?

It's not really something we disclose, I'm afraid, so I will pass on that.

It's a bit more detail than we normally put out.

Mercedes Garcia-Ayuso, Goldman Sachs.

Last quarter you guys talked about trying to decrease field inventories.

Can you give us an update on where we are at the end of the third quarter versus the second quarter on an absolute level, not -- I mean, not as a ratio as relative to sales, and what your expectations are for year-end?

If you look at what happened in the third quarter -- Mercedes, I don't have the numbers in front of me.

They should be actually going up on the Website, in terms of the months of supply.

In fact, they're probably up now.

In terms of absolute terms, engine inventory went down in the third quarter.

Machine inventory went up.

We are working really hard to try and keep both machine and engine inventories at dealers down.

We would like to see them come down.

And I guess I don't know what our forecast is between now and the end of the year.

But it's certainly our desire to take them down.

I will just add again kind of a broader perspective to this.

We are working hard on the chain of inventory turnover.

And the chain being all the way from dealer yards and rental fleets, back to our finished inventory, back to our production stores and work in process.

And we have got lots of efforts underway in working at that.

We really feel that there's some opportunity there.

And going forward that's going to be a key strategic piece of our plan, to get that under control, which should afford us some real good opportunities in terms of both P&L L and cash flow.

Okay, that should wrap it up.

We are out of time.

It's been a pleasure sharing our results with you today.

I just want to remind you we're hosting the analyst meeting in New York on October 31 where Jim Owens, our Chairman and CEO, is going to roll out our new strategy.

Details of that can be found on our Website.

Thanks for your interest in Caterpillar.

Have a good day.

Thank you, ladies and gentlemen.

This does conclude today's conference call.

You may disconnect your phone lines at this time.

Have a wonderful day.

Thank you for your participation.