Caterpillar Inc Q2 FY2021 Earnings Call

Welcome to the Second Quarter 2021, Caterpillar Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jennifer Driscoll. Thank you. Please go ahead.

Thank you, Whitney. Good morning, everyone. Welcome to Caterpillar's Second Quarter 2021 Earnings Call. With me here today are Jim Umpleby, Chairman of the Board and CEO; Andrew Bonfield, Chief Financial Officer; Kyle Epley, Vice President of Global Finance Services Division; and Rod Rengle, Senior IR Manager. During our call this morning, we'll be discussing the earnings news release we issued earlier today. You may find our slides, the news release, and the video recap at investors.caterpillar.com. Simply click on Events and Presentations. Moving to Slide 2. The forward-looking statements we make today are subject to risks and uncertainties. We'll also make assumptions that could cause our actual results to be different than the information we're sharing with you on this call. Please refer to the recent SEC filings and the forward-looking statements reminder in the news release for details on factors that individually or in aggregate could cause our actual results to vary materially from our forecast. Caterpillar has copyrighted this call, and we prohibit use of any portion of it without our prior written approval. Today, we reported profit per share of $2.56 for the second quarter of 2021, compared to $0.84 of profit per share in the second quarter of 2020. We're showing adjusted profit per share in addition to our U.S. GAAP results. Our adjusted profit per share was $2.60 for the second quarter, compared with second quarter 2020 adjusted profit per share of $1.27. Adjusted profit per share for both quarters excluded restructuring costs. The second quarter of 2020 also excluded a remeasurement loss of $0.19 per share, resulting from the settlement of pension obligations. We provide a non-GAAP reconciliation in the appendix to this morning's news release. You also can find information on dealer inventory and backlog in our slides. Now, let's flip to Slide 3 as we turn the call over to our Chairman and CEO, Jim Umpleby.

Thanks, Jennifer. Good morning, everyone. As we close out the first half of 2021, I'd like to thank our global team for their strong performance in a challenging, dynamic environment. We continue to execute our strategy for profitable growth, and remain focused on the safety of our employees. We're encouraged by higher end-user demand in the majority of our end markets. Before turning over the call to Andrew for a detailed review of our results, I'll briefly cover three topics this morning. I'll share my perspectives on Caterpillar's second quarter results. I'll then review our end markets before discussing the sustainability report, including our new climate and energy statement that we published during the second quarter. On Slide 4, we're pleased with the strong sales and profit performance during the second quarter. Sales and revenues increased 29%, primarily due to higher sales volume. The two main drivers of our topline were strong end-user demand and the impact of changes in dealer inventory. Compared to the second quarter of last year, sales to users rose roughly 15%, and changes in dealer inventories provided about a $1 billion tailwind. During our first quarter call, we mentioned that growth in sales to users would be significantly higher than the 8% we saw in the first quarter. Sales to users rose about 15% versus the second quarter of last year, and trended better for the fourth consecutive quarter. We had gains in all three of our primary segments. Machines rose 20% with similar increases in both construction industries and resource industries, with improvement in all regions. Demand from residential construction remained strong, and demand related to non-residential improved. Mining was also up. Quotation activity for miners remains strong, and we've seen a significant improvement in orders through the first two quarters. We were also pleased that Heavy Construction and Quarry and Aggregates strengthened, as did several end markets within Energy and Transportation. Energy and Transportation sales to users turned positive, rising 1%. Keep in mind that the slowdown in end-user demand in 2020 affected the Energy and Transportation later than the other segments, as some of the applications are impacted by timing of large products. From a geographic perspective, we had strength in sales across all regions. North America was quite strong, as expected. The EAME and Latin America also showed double-digit sales growth. Asia Pacific saw good growth in most areas outside of China. China declined modestly in the quarter after rebounding strongly beginning in the second quarter of 2020, leading to a tougher comparison. We also had modest benefits to sales this quarter from currency and price. As we noted in our first quarter call, second quarter 2020 saw a decline in dealer inventory of $1.4 billion, but we did not expect a significant change during 2021. Dealer inventory declined $400 million during the second quarter. Similar to the first quarter of this year, dealer inventory remains near the low end of the normal range. I'll now provide an update on Caterpillar's supply chain. In spite of the unprecedented challenges impacting the industrial sector, I'm proud of the work by our team to minimize disruptions, which were relatively modest during the second quarter. For the majority of our products, availability remains within our normal ranges. We mentioned on the last earnings call that the supply chain situation, including transportation, was challenging, and that our team was preparing contingency plans such as alternative assembly processes at our facilities. During the quarter, our team implemented some of those plans, and continue to work closely with our suppliers to mitigate supply chain impacts on production. We still anticipate that supply chain challenges will remain throughout the year, and our role is to minimize the impact on our ability to meet improving customer demand. In addition, as we mentioned during our last earnings call, we do not expect a significant benefit from dealer restocking during 2021. Operating profit in the second quarter increased 128% to $1.8 billion. Volume growth, price realization, and strong results from financial products drove the improvement. We did have some favorable price flow through this quarter, mostly in construction industries. We also saw higher short-term incentive compensation expense and higher material costs, including steel and other commodities, as expected. Andrew will discuss margins in more detail. The adjusted operating profit margin improved to 14.1% versus 9.3% in the second quarter of 2020, as we expected. Operating margins increased in both Construction Industries and Resource Industries, despite headwinds from short-term incentive compensation and supply chain challenges. Profit per share was $2.56 versus $0.84 in the second quarter of 2020. Adjusted profit per share was $2.60 versus $1.27 in the second quarter of 2020. Moving to Slide 5. Free cash flow for Machinery, Energy, and Transportation was another highlight of the quarter. We generated $1.7 billion of ME&T free cash flow with higher profit, partly offset by an increase in Caterpillar Inventory. We resumed share repurchases in the second quarter. We also announced we're increasing our quarterly dividend by 8% to $1.11 per share. We have paid a higher dividend annually for 27 consecutive years. We returned about $800 million to shareholders in the second quarter via the dividend and share repurchases. We expect to repurchase sufficient shares between now and the end of the year to, at least, offset absolute dilution from shares issued this year. In light of the highly fluid environment, we will continue our practice of not providing profit per share guidance. However, we will share some high-level assumptions for the upcoming quarter and the full year. For 2021, as we said on the last earnings call, we expect to achieve the targets for adjusted operating profit margin that we set out at our 2019 Investor Day of 300 basis points to 600 basis points of improvement versus our performance during the 2010 to 2016 period at similar levels of sales and revenues. We also expect to achieve the free cash flow targets we set for ME&T at Investor Day of an incremental $1 billion to $2 billion at all points in the cycle. Andrew will elaborate with a few of our assumptions for the upcoming quarter in a few moments. Please turn to Slide 6, and I'll walk through our expectations by end market. Overall, we're becoming more optimistic about our end markets since our last earnings call. We're pleased that many end markets continue to improve and demand continues to strengthen. Global demand is strong and the outlook is positive. In construction industries, for example, we're optimistic about the industry as we expect end-market demand to show continued positive growth. Residential and non-residential construction demand is expected to remain strong, led by North America. In China, we expect the industry for excavators above 10 tons to be about flat in 2021 compared to a very strong 2020. Please keep in mind that demand was very strong in this market during the first quarter. Our newly introduced GX models continue to perform well and we're still receiving positive customer feedback. In the balance of Asia-Pacific, we believe stronger-than-expected commodity prices, housing strength, and government infrastructure expenditures will support continued sales growth. In the EAME, we see end-market demand regaining momentum on strong construction activity, higher commodity prices, and improved confidence. Latin America should also show continued strengthening due to increased construction activity. Switching to resource industries. In mining, we continue to expect improvement in miner CapEx, as commodity prices remain supportive of growth. Parked large mining trucks decreased in the quarter and remained at relatively low levels in all regions as utilization increases. Customer interest in Caterpillar's autonomous mining solution remains high, and customers now autonomously operate or are deploying CAT machines on 18 sites around the world. While our mining customers continue to display capital discipline, we expect mining to continue to improve over the long term as the energy transition drives higher demand for commodities. In Heavy Construction and Quarry and Aggregates, we've seen improvement in the second quarter, particularly in North America and the EAME. We expect continued strengthening in this part of the portfolio. Finally, in Energy and Transportation, we expect oil and gas to continue to strengthen gradually. We expect customers to continue to demonstrate capital discipline when pockets of excess capacity remain. In Power Generation, strength in data center demand should continue. Industrial demand is expected to improve along with the global economic recovery. Transportation should see strength in rail services and growth in international deliveries for locomotives, and marine demand is projected to grow modestly while remaining at low levels. Now on Slide 7. Since our last quarterly earnings call, we published our 2020 Sustainability Report to establish and report progress against our environmental, social, and governance goals. We also released a new climate and energy statement. Caterpillar shares the concerns of governments and the public about the risks of climate change, and supports global efforts to mitigate its impact. We are committed to contributing to a reduced carbon future. This commitment is reflected in our sustainability vision to improve the quality of the environment and our communities. Some of the ways we do this are by further reducing greenhouse gas emissions from our operations and helping customers meet their climate-related objectives by investing in innovative new products, technologies, and services. Our 2020 sustainability report highlights seven new environmental, social, and governance goals we've set to achieve by 2030. These goals, which address issues most relevant to our customers and other stakeholders, are focused on the climate and environment, in addition to safety. One of these goals is to ensure that 100% of Caterpillar's new products through 2030 will be more sustainable than the previous generation. It's an inspiring time to be a Caterpillar employee. I'm pleased with all the good work already underway across the Company. We're developing products and services that facilitate fuel transition, increased operational efficiency, and reduced emissions to help communities thrive, and to help our customers achieve their environmental goals. By establishing and reporting progress on our ESG targets, we provide transparency about our progress and innovation. In order to further increase transparency, we will strive to provide an update, or example, during our earnings calls. This quarter, I'll close with an example. Recently, Nouveau Monde Graphite, or NMG, announced the collaboration with us to fully power their Matawinie graphite mine with zero-emissions machines by 2028. Caterpillar will be the exclusive equipment, technology, and service provider for NMG. We'll be developing, testing and producing CAT zero-emission machines for the project in Saint-Michel-des-Saints in Quebec, Canada. In conclusion, we continue to execute our strategy for long-term profitable growth, by investing in services, expanding our offerings, and improving operational excellence. It was a strong quarter from a financial and operational perspective, and a good first half. Looking forward, we're optimistic about our ability to mitigate supply chain challenges and are encouraged by customer demand that's strengthening and is broad-based across all regions. Now, I will turn the call over to Andrew.

Thank you, Jim. And good morning, everyone. I'll start by walking you through second quarter results, including some color on the segment performance. Then I'll turn to the balance sheets, and afterwards to the third quarter. Beginning on Slide 8, as Jim noted, sales for the second quarter increased by 29% to $12.9 billion due to higher volumes. Operating profit of $1.8 billion increased by 128%, reflecting margin expansion primarily due to higher volumes. Second quarter profit per share was $2.56 compared with $0.84 in 2020. Adjusted profit per share more than doubled to $2.60 compared with $1.27 last year. I'll start with the top-line in Slide 9 where we continue to see strong volume gains. Sales and revenue growth was in the double-digits percent for all three of our primary segments, and on a consolidated basis for every region. Growth in North America, our largest region, is up 30%, reflecting strong results in construction industries and resource industries. Growth in the EAME was also robust, up 33%. Latin America rose by 67%, albeit off its low base. And Asia Pacific sales grew by 12%. Overall sales to users increased by 15%. The acceleration from the 8% rate in the first quarter was in line with our expectations. It was a significantly higher percentage as we discussed last quarter. Sales to users in Construction Industries rose by 20%, led by North America. Residential construction continues to be strong in North America and the EAME. Non-residential construction in North America is recovering well as well. Latin America showed very good growth in sales to users off a low base. Asia-Pacific was lower due to a modest decline in China. As Jim mentioned, the Chinese market started to recover earlier in 2020 than other countries, leading to a tougher comparative. Overall, we still expect China to have another strong year with the industry in the above 10-ton excavator market about flat, retaining last year's large gain. Sales to users in Resource Industries increased by 21% reflecting growth from Heavy Construction and Quarry and Aggregates. Demand for equipment and mining also improved this quarter. And as Jim mentioned, we remain encouraged about the upside potential in mining. In Energy and Transportation, sales to users rose by 1% in positive territory, despite the fact that E&T sales to users were impacted to a lesser extent than other segments in the second quarter of last year due to the timing of large deals. Now, turning to Slide 10. Operating profit increased to $1.8 billion. The 128% improvement reflected high volume in our three primary segments, favorable price, and higher profits from financial products. That was partly offset by the impact of restoring short-term incentive compensation. The assumption for short-term incentive compensation in the quarter was also raised by about $100 million compared to the first quarter to reflect our strengthening results. We now expect our full-year charge to be about $1.5 billion. This quarter, we had $25 million in restructuring expense, over $100 million lower than a year ago. We now expect around $250 million in restructuring expenses this year. We also had a full quarter impact of SPM Oil & Gas, including some M&A-related costs which I'll cover in a bit more detail when we discuss Energy and Transportation. The adjusted operating profit margin rose 480 basis points to 14.1%. As we expected, research and development, and selling, general and administrative expenses rose. These increases reflected not only the impact of incentive compensation, but also investments in key priorities, such as growing services and investing in product development to help our customers achieve their common objectives. As we explained in April, we did expect a sequential decline in margins versus the first quarter. Margins were broadly in line with our expectations. As we said, price realization turned positive in the quarter while material and freight costs were a negative. We did see a lower margin reduction than expected from absorption as production rates remain strong. However, the increase in short-term incentive compensation more than offset that. The global tax rate remains about 26%. Adjusted profit per share of $2.60 excludes $0.04 of restructuring expense versus $0.24 of restructuring expense, as well as $0.19 for the settlement of pension obligations that occurred in second quarter of last year. Moving to Slide 11, let's take a look at segment performance, starting with Construction Industries. Sales increased by 40% to $5.7 billion, primarily driven by higher sales volume and favorable price realization. The improvement in volume was due to higher end-user demand, and the impact from changes in dealer inventories. As I mentioned earlier, the increase in end-user demand was led by North America, where residential construction remained strong and non-residential construction strengthened. Overall, dealers reduced their construction equipment inventories less in the second quarter of 2021 than in the second quarter of 2020. The segment's second quarter profit increased by 98% to $1 billion. The near doubling came from higher sales volume and favorable price realization, including geographic mix. Cost absorption and efficiencies were positive in the quarter. That was partly offset by two items: the impacts of short-term incentive compensation, and we started to see the impacts of unfavorable material costs although this was modest in the quarter. The segment operating margin increased by 530 basis points to 18.1%. Turning to Slide 12, Resource Industries sales increased by 41% in the second quarter to $2.6 billion. The increase was mostly due to higher end-user demand for equipment and aftermarket parts, and changes in dealer inventories. As we expected, Heavy Construction and Quarry and Aggregates began to improve, and we expect continued improvement from here. End-user demand in mining also continued to improve. Sales were up in all regions. Second-quarter profit for Resource Industries more than doubled, increasing by 138% to $361 million. The increase was mainly due to higher sales volume, partially offset by the impact of our short-term incentive compensation expense. Price was slightly negative, mostly due to changes in prices for Australian dollar denominated off-the-market parts. These were reduced to reflect currency movements versus the U.S. dollar. The operating margin increased by 570 basis points to 14%. Now on Slide 13. Energy and Transportation sales increased by 20% to $5 billion. That included an 11% sales increase in oil and gas, largely due to higher sales of reciprocating engine aftermarket parts, driven in part by the addition of SPM Oil & Gas. Power Generation sales improved by 18%, reflecting increased sales for large reciprocating engine applications, primarily for data centers. Industrial sales increased by 33% with demand across all regions. Transportation rose by 10% on higher rail services and marine sales. Profit for E&T increased by 17% to $731 million. The improvement due to the higher sales volume was partially offset by a couple of factors, including the impact of short-term incentive compensation and acquisition-related expenses, primarily SPM Oil & Gas. Higher freight costs were offset by manufacturing efficiency. The segment's operating margin declined by 30 basis points to 14.7%. With regards to SPM Oil & Gas, we do expect this to be a modest drag on margins for the remainder of the year. This was the first full quarter since the acquisition, and it will take some time for the synergies to be realized. We're very pleased with the acquisition, and expect to see the full benefits of the acquisition as we move forward. On Slide 14, Financial Products revenue increased by 1% to $774 million, as the portfolio remained relatively constant. Segment profit remains strong, increasing by 64% year-over-year to $243 million, which was about flat compared to the first quarter of 2021. The year-over-year profit increase was due to a lower provision for credit losses at CAT Financial compared to the year-ago quarter, which reflected the absence of forecasted COVID-19 related impact. In addition, we had higher net yields and average earning assets due to a favorable change in weighted average interest rate. And a favorable impact from return to repossessed equipment, benefiting from higher demand for used equipment. Our credit portfolio remains in good shape as indicators of customer health hold positive. Past dues continued to improve to 2.58%, down 116 basis points year-on-year and down 32 basis points compared to the first quarter. Credit applications remained strong as well, up 5% compared to the second quarter of 2020, and up 9% compared to the first quarter. New business volume continues to trend up, led by North America. Requests for loan modifications have returned to historical trends. Moving to Slide 15. We're confident that in 2021, we'll achieve our Investor Day target for ME&T free cash flow of $4 billion to $8 billion. ME&T free cash flow was $1.7 billion in the second quarter compared to $500 million last year. The increase in ME&T free cash flow reflected higher profit, offset in part by a $500 million sequential increase in Caterpillar Inventory in the second quarter of 2021. The inventory increases primarily in components and work-in-process inventory, and reflects strengthening end-user demand and our response to supply chain challenges. ME&T free cash flow has been $3.4 billion year-to-date, benefiting from higher profits as well as the absence of paying short-term incentive compensation in the first quarter. We continue to maintain a solid liquidity position in support of our strong mid-A credit rating. The Company ended the period with $10.8 billion of enterprise cash. We've said that we intend to return substantially all of our ME&T free cash flow to shareholders through the cycles. We've said that we will do it through a combination of dividends and share repurchases, reserving our balance sheet to fund additional growth initiatives and mergers and acquisition. In the past three years, we've returned on average 106% of our ME&T free cash flow to shareholders. This quarter, we announced we'll increase our quarterly dividend by 8% to $1.11 per share, which is about $600 million a quarter. I'm happy to say we expect to extend our status as a dividend aristocrat for another year. We repurchased about $250 million of our common shares this quarter. We have about $4.6 billion remaining under the current share repurchase authorization. We expect to continue to repurchase shares in the second half and intend to at least offset absolute dilution from shares issued during the year. As Jim mentioned, there's no change to our current practice relating to guidance. However, as we've been doing, we are providing color on the upcoming quarter to give you a sense of what we're expecting to happen. Moving to Slide 16. Again, we expect to achieve our Investor Day targets for adjusted operating profit margins in 2021, despite reinstating the short-term incentive compensation program. That's now projected to be a headwind of $1.5 billion for the year or about 300 basis points of pressure on margins. We expect stronger sales than normal seasonality would imply. The growth rate in sales to users should continue to accelerate in the third quarter when compared to the prior year, and should be significantly higher than the 15% rate we saw in the current quarter. In construction industries, we expect improvement in residential and non-residential construction demand to continue. As we discussed last quarter, we see tougher comparisons in China. Resource Industries end-user demand should see support from both mining and Heavy Construction and Quarry and Aggregates. We also expect Energy and Transportation sales to increase on stronger underlying demand. All of this is expected to lead to good volume growth in the third quarter, even while we manage supply chain challenges. As we told you last quarter, and as Jim mentioned today, whilst dealers are independent businesses and make their own decisions about their inventory, we don't expect a significant benefit from restocking in 2021. Third quarter margins are expected to be stronger than the prior year, with leverage from strong volume more than offsetting the impact of reinstating short-term incentive compensation. However, we anticipate third quarter margins to moderate versus the second quarter, as we see some cost headwinds in the second half of the year. Within Machines, we currently expect price to offset higher manufacturing costs in 2021. In the second quarter, price was strongly positive, reflecting strong geographic mix benefits and higher price realization. We did put through price increases for machines at the end of the second quarter, which will be positive. The geographic mix will be less of a benefit. Although we did take pricing actions, we do expect higher manufacturing costs, which means that our gross margin percentage will be moderately lower in the second half of the year versus the first half. We should also see accelerated spend in SG&A and R&D in the back half of the year, as business gets back to normal. Specifically within Energy and Transportation, we expect some margin headwinds in the second half of the year. As E&T is a lumpy business with varying margin structures across its applications, we expect variability in both price and mix, particularly as larger deals are recognized into revenue. In addition, as many of the E&T applications are experiencing different levels of demand, we did not put through additional price increases in the second quarter. So this means material and freight costs increases will be a headwind for that segment. In summary, on Slide 17. Demand continues to strengthen in the quarter, leading to strong volume growth. Adjusted operating profit margins improved by 480 basis points, driven by higher volumes, which more than offset the nearly 300 basis point headwind for short-term incentive compensation, and the small headwinds of supply chain disruption and material cost inflation. Adjusted profit per share more than doubled in the quarter. We are confident in the outlook for EAME markets and expect to achieve our Investor Day margin and free cash flow targets. And with that, we'll take your questions.

Your first question comes from the line of Jamie Cook from Credit Suisse. As a reminder, management asks that we limit to one question per analyst. Your line will be muted after you ask your question. However, if your question is not answered for any reason, or clarification is needed, please get back on to the queue. Jamie, your line is open.

Hi, good morning.

Thanks, Jamie. And firstly, we really appreciate the efforts of our employees to manage the challenges in the supply chain. One of the things that we're seeing over the course is an improving end-user demand which is adding pressure in the supply chain and on freight as well. Some of the supply chain challenges are more broad-based than occurred in a normal upturn. You may think about the last upturn we had casting issues and some other individual component issues. This time, it's more broad-based than is typical. Having said that, again, as we said in the last call, our team is working very hard to avoid or minimize those supply chain challenges that would impact our ability to fully meet improving customer demand. And we think that the impact to the second quarter was modest. And again, we're working very hard to try to limit them. We haven't had some of the large factory shutdowns for weeks that you've read about with some other industrial companies. We've also taken some actions to do things like with resins, we changed our material spec due to shortages that were out there and it helped us to keep production going. Again, majority of our products for end-users are delivered within the normal ranges of availability. Some of the bigger challenges have been on the smaller products, such as PCBs; a lot of those products are used in residential in North America. So those are some of the bigger challenges we're having in terms of availability. But, again, the majority of our products for our end users are within the normal ranges, and we're working very closely with our dealers to try to ensure that we meet actual customer demand.

Your next question is from the line of Jerry Revich with Goldman Sachs.

Good morning.

Thank you, Jerry. You mentioned autonomy, and the demand for autonomous products continues to be quite strong. A lot of quotation activity going on. As I mentioned earlier, we currently are deploying autonomous mining equipment in 18 different sites, across 10 customers and three continents for a whole variety of commodities: iron ore, copper, oil sands, gold, and coal mines. And so again, we believe that will continue to grow at a rapid pace. We're also expanding our autonomous solutions to other support equipment like dozers, drills, underground equipment, and water trucks as well. In terms of zero-emissions products, we're very focused on working closely with our customers to meet their needs. We talked about the NMG announcement during the call earlier this morning. That's a great example of one where the customer has a need, they have a date they have to meet, and we're working very closely with them, as their exclusive supplier, with product technologies to make it happen. Again, we're working very closely to develop products to meet customer demand. It's a big topic of discussion and focus by our leadership team, and something that we'll continue to do moving forward. And, yes, some of the goals we put out in our Sustainability Report: we talked about 100% of our new products through 2030 will be more sustainable than the previous generation in some manner. We're very focused on doing that. If you look at our climate and energy statement, it talks more about some of our approaches in our specific goals for reducing greenhouse gas emissions in our own operations. Again, our strategy here is to work on greenhouse gas emissions and be more sustainable in our own operations and to be very focused on helping our customers meet their goals as well.

Your next question is from the line of Rob Wertheimer with Melius Research.

Hi, thank you. Good morning, everybody.

Yes. Thank you, Rob. That 30% productivity increases is actually something that was stated by a customer and not us. On our view, our customers are in fact seeing productivity gains, which is one of the reasons that adoption continues to move forward. So I believe it's also accelerating, so it's clear that our customers are seeing the benefit or they wouldn't be continuing to put an autonomous operation. There's a variety of models that we have that we use with our customers. Typically, there's a monthly kind of fee that we receive. Of course, we sell the equipment to them as well. But again, commercial models are very dependent upon individual customer negotiations.

Your next question is from the line of David Raso with Evercore ISI.

Hi, good morning.

Thanks, David. Hi. Yes. Obviously, what we are seeing though, is this is an atypical year. And as we've indicated, we don't necessarily expect a normal seasonal pattern between Q2 and Q3. Underlying volumes, and particularly end-user demand, we do expect to grow significantly; that rate of growth to be higher in the third quarter than the 15% we saw in Q2. So that will mean that we probably don't expect that normal pattern. That's the factor which we have to look at. And obviously, at the moment we haven't updated about the fourth quarter. But we'll give you an update probably in October.

Your next question is from the line of Stephen Volkmann with Jefferies.

Good morning, guys. My question is on Resource Industries, and I'm curious if you can give us any color in terms of the growing backlog there on machines relative to parts. I'm just trying to think about the mix of that business going forward.

Thank you, Stephen. As we've mentioned over the last few quarters, we're bullish on the trend in mining. We're seeing robust quotation activity, and we are seeing increased orders. We have seen strength in aftermarket for mining, but we also see strength in OEM as well. So again, as utilization improves, as the energy transition drives higher commodity prices, that is driving activity for us in both parts and OEM.

Your next question is from the line of Ross Gilardi with Bank of America.

Good morning, guys. Jim, I just had a question on pipeline activity in general. There seems to be pretty limited new pipeline activity despite the run-up in energy prices. Would you agree with that? Are you seeing that across your business? Maybe just talk about what you're seeing with pipeline activity. And then comment on the choice not to raise prices in E&T despite cost pressure; is there too much excess capacity out there to risk losing market share in the second half? Thanks.

Thank you, Ross. Our customers are displaying capital discipline, and we expect that to continue. In terms of pipeline activity, our business was actually up in the second quarter. That is one data point. We'll see how the future unfolds in terms of Oil and Gas. We feel good about a gradual turn in the business. Oil prices are supportive of investment. But again, our customers are displaying capital discipline. There was a lot of strength in natural gas pipelines for a few years, and that tends to be a cyclical business. If you look back over the last 30 years, you go through periods of very strong activity followed by periods of lower activity. Again, it's a cyclical business, it goes up and down. But for our business, we did see an improvement in the second quarter in pipeline versus the first.

And on the price increase side, given that the nature of the recovery within E&T is slightly different from where we are seeing recovery in CI and RI, where there's obviously a much stronger underlying demand signal, machines sales to end-users was high about 20%, E&T was up 1%. They are at slightly different paces. Therefore, it is a logical decision to take the view that you don't want to put the recovery within the E&T markets at risk. So you will take a little bit of paying on price in the short term. However, within construction businesses, we do expect overall price to more than offset manufacturing cost increases. And just to remind you, a significant amount of the manufacturing cost increase is actually steel, which we would not price for as well. Some of that is going to impact E&T.

The next question is from the line of Mig Dobre with Baird.

Hi. Thank you for the question. Good morning, everyone.

Overall, as we've indicated, we do expect the third quarter to be strong. That will drive higher revenue. The rate of growth of revenue will be higher in Q3 than Q2. We don't give specific guidance on absolute revenue numbers, but we're giving you that color. As far as the margin, yes, margins will moderate. There will be some impact from not putting price through. Within CI and RI, in the machines businesses, we've seen price benefits; part of that price benefit is geographic mix. Geo mix will come off a little bit, so there will be an offset between Geo Mix and price. That's due to the mix of sales between different geographies which impacts geo mix. So price won't improve as much, but you will start seeing some material cost increases and probably some increasing freight cost based on what we're seeing in the market today. That will be where the margin pressure is on the machine side, both CI and RI. Also, we do expect some increases in the underlying SG&A and R&D spend as work normalizes, travel opens up and some of those expenses come back.

Your next question is from the line of Jairam Nathan with Daiwa.

Hi, thanks for taking my question. I wanted to try to get your strategy on batteries and fuel cells. Recently, Wabtec announced an agreement with GM where they will be sourcing GM's fuel cells. Could you describe Caterpillar's strategy on that? Could it be more internal or would you be open to external sourcing?

Thanks, Jairam. You may recall that we introduced last year the first Zero-Emission Switch Locomotive. We sold that to a couple of customers, something we're excited about. We're very flexible: we will do certain things ourselves, and we'll do certain things with partners and suppliers. Those discussions are ongoing and we'll come up with the best approach. As we do with all of our products, some things we'll make ourselves, some things we'll get from suppliers, and some things we'll get from partners. We're working our way through that.

Your next question is from the line of Stanley Elliot with Stifel.

Hey. Good morning, everyone. Thank you for taking the question. Quick question around infrastructure and the timing of when you would see that. There's lots of discussion here in the U.S., but really elsewhere. Those monies take some time to flow through the system. Do you end up seeing end-market demand pick up ahead of that and more concurrent with it? Just trying to get a frame from when we can see that benefit. Thanks.

Thank you for your question. We already are seeing stronger heavy construction activity; it's something we saw in the second quarter, and we expect that improvement to continue. That is irrespective of an infrastructure bill in the U.S. being passed. We're seeing improvement in that business being driven by a whole variety of things. If in fact there is an infrastructure deal, it's always difficult to estimate timing. Typically, that helps the confidence of our customers, which helps our business. But we are already seeing an improvement in our heavy construction activity, and we expect that strength to continue moving forward, regardless of a deal or not.

The next question is from the line of Ann Duignan with JPMorgan.

Hi. Good morning. Maybe just your comments on geographic mix in CI and RI being less positive going forward. I don't fully understand the CI comment given the strengths you're talking about, particularly just your comments on the non-residential sector. RI I can appreciate geo mix. Could you walk us through the comments on the change in mix in both of those segments as we go forward?

Sorry for the confusion, Ann. It's not negative, but it's sequentially lower—the benefit of geo mix. Last year, there was a big move in geo mix because China in the second half of the year was a very strong recovery. The U.S. saw inventory reductions and softer demand which was a negative drag on geo mix. In the first quarter, China was very strong in CI and the U.S. slightly weaker. Now in the second quarter, we've seen that turnaround quite significantly, and that gave us a big benefit of geo mix in Q2. That will moderate because the gap of North America versus the other geographies will diminish. That's how it works. That's why we think it will still be a benefit, but will be less positive than it was in Q2. However, we do expect the price increases we put through to offset that; we'll see how price realization mitigates that impact.

Your next question is from the line of Nicole DeBlase with Deutsche Bank.

Yeah, thanks. Good morning, guys. Can we talk a little bit more about what's going on in China construction, and what's driving your confidence in a flat outcome for the year given the tough comps throughout the rest of the year? Also, what are you seeing from a pricing perspective in that market? Thank you.

You bet. Last year was a very strong market in China, and we saw a very strong first quarter this year as well. We did see the industry decline modestly in the second quarter, and that's, as we expected, some policy normalization there drove that weakness. Based on everything we see, we are expecting the full year to be roughly flat to last year. But as a reminder, that's a very healthy level because last year was so strong. Our GX models have been well-received; we're very pleased with that product introduction. It is a competitive market, and pricing is competitive. But by introducing new products and continuing to build a better dealer network, we're confident in our ability to continue to compete in China.

Your next question is from the line of Joel Tiss with BMO.

Thanks for giving me a chance here. Can you give us an idea how much dealer inventory is needed to get back to more normalized levels? I know it's a moving target. Also, is that more of a catching up in 2022, or might some of that leak into 2023?

Joel, thanks. Obviously, as we said, we don't expect this year to see any significant benefit from dealer restocking. Given some of the supply chain challenges, our prioritization is absolutely meeting end-user demand. We'll need to see how things pan out in 2022. We will always prioritize making sure that we are meeting end-user demand over increasing inventory in the dealer channel. Obviously, that will be something we will continue to work with our dealers on, making sure that they do it. It's way too early to predict when dealer inventory will rise. We'll continue to monitor that, and we'll update you each quarter.

Your next question is from the line of Noah Kaye with Oppenheimer.

Good morning, everyone. This is Christine Antonella. Thank you for taking our question. I wanted to follow up on the mining activity and some of the quoting that you talked about. You indicated that heavy construction is driving some strength more than mining. Given the commodity basket near historic highs and high utilization, conditions seem ripe for a significant mining cycle. As you talk to your customers, what's holding the end market back at this point? And when do you think that spending breaks loose? Thank you.

Good morning, Christine. As we've been discussing for several quarters on mining, we've been bullish on the long-term trend. We are seeing an improvement. It's going to be lumpy, but the trend is quite positive. I wouldn't say anything is holding it back; it's manifesting itself much as we've been predicting for the last three or four earnings calls: steady improvement in mining, and it's continuing to happen. There's a lot of quotation activity. Our customers are always very focused on capital discipline. But utilization is high, parts inventories are low across all regions, and commodity prices are strong. So it's turning out as we expected, a steady gradual improvement in mining, which we believe is better than sharp spikes and drops.

And your final question for today comes from Chad Dillard with Bernstein.

Hi. Good morning, guys. Thanks for squeezing me in. A couple questions: First, more near-term, can you quantify the material and freight costs for the second half of 2021? And then longer term, can you talk about conversations with mining customers on electric drive equipment: by when do you think there's broader adoption, parts intensity versus internal combustion, and any new revenue streams from that transition?

We do not give guidance on exact cost amounts. We do think costs will be higher in the second half. For the full year for machines, we expect price to more than offset increases in manufacturing costs. Those manufacturing cost increases include short-term incentive compensation, which is higher this year. There are many moving parts: absorption rates, material cost moves, freight, etc. Overall, they are increasing and are a pressure, but we saw strong favorability in Q1 on some manufacturing costs, and in Q2 price was strongly positive with only modest manufacturing cost increases. That means manufacturing costs will be greater in the second half and will mitigate some of the price we're seeing. That gives you a range to work with.

On the mining electric drive question, we're working very closely with our customers to help them achieve their sustainability goals. There is a wide variety of approaches between customers and geographies. There's no one answer. Since we announced the NMG collaboration, that's an example of the kinds of projects we're working on. Adoption rates will vary by geography and customer, and we're working closely to support them.

Okay. And with that, we'll conclude our Q&A session. Now, let me turn the call back over to Jim Umpleby.

Well, thanks, everyone. Really appreciate you joining the call this morning. We thank you for all your questions. We continue to focus on executing our strategy for long-term profitable growth, which includes services, expanded offerings, and operational excellence. Congratulations to our team. We had a strong quarter. We're pleased that there's strength in demand coming from all regions. We're optimistic about our ability to solve the challenges that arise and to continue supporting our customers as they move forward. Thank you again.

Thanks, Jim. We'll close with a few final reminders. A replay of our call will be available online later this morning. We'll also post a transcript on the Investor Relations website later today. If you look there now, you'll find a second quarter results video with our CFO, and an SEC filing with our sales to users data. Click on investors.caterpillar.com, and then click on Financials to view those materials. If you have any questions, please reach out to Rob or me. You can reach Rob at rengel_rob@cat.com, and me at driscoll_jennifer@cat.com. The Investor Relations general phone number is (309) 675-4549. We hope you enjoy the rest of your day and have a fun weekend. Now I'll turn it back to Whitney to conclude the call.

That does conclude today's conference call. Thank you, everybody, for joining.