Finning International Inc.

Mauk Breukels - VP, IR and Corporate Affairs Scott Thomson - President and CEO Steve Nielsen - CFO Anna Marks - SVP, Corporate Controller

Cherilyn Radbourne - TD Securities Jacob Bout - CIBC Michael Doumet - Scotiabank Derek Spronck - RBC Mark Begert - Raymond James

Thank you, operator, and thanks to everyone for joining us. On the call with me today are Scott Thomson, President and CEO; Steve Nielsen, CFO; and Anna Marks, Senior Vice President, Corporate Controller.

Following the remarks by Scott and Steve, we will open up the line to questions. An audio file of this conference call will be archived at finning.com.

Before I turn over to Scott, I want to remind everyone that some of the statements provided during this call and information on the slides is forward-looking. The forward-looking information is subject to risks, uncertainties and other factors as discussed in our Annual Information Form under Key Business Risks and Forward-Looking Information and in our MD&A under Risk Factors and Management and Forward-Looking Disclaimer.

Please see this information with caution, as FINSA’s actual results, performance and achievements could differ materially from current expectations. Except as required by law, we do not undertake any obligations to update this information.

Scott, over to you.

Good morning. I would like to start with a few notable highlights in the quarter.

We delivered strong operating performance in Canada in Q3. Canada’s return on invested capital is now at 16%, up 400 basis points over last year.

We continue to make solid progress towards our goal to deliver 20% return on invested capital over time. Our equipment backlog remained healthy at $1.5 billion.

In Canada, September order intake was the highest monthly intake in 2018. Chile’s equipment markets continue to recover.

Our new equipment sales in Chile more than doubled from last year. And we expect significant equipment deliveries in Q4, particularly in Canada.

This will drive strong free cash flow for the remainder of the year. I will now turn to a review of our regions.

In Canada, we are seeing solid demand for equipment and product support across all sectors, and our order intake and backlog remain strong. We are pleased with the recent announcement that LNG Canada is proceeding.

We expect the related earthmoving, pipeline and gas compression activity to generate $500 million in incremental revenues over a multiyear timeframe. The project status of Trans Mountain is disappointing, but we are encouraged that customers and ordered equipment for this pipeline have kept their machines, which is indicative of strong activity levels, and we believe the project will ultimately proceed.

Before I close off on Canada, I want to reflect on a fatality which occurred a few weeks ago in Saskatchewan. We lost an employee in an incident on our customer’s site.

Our heart goes out to his family. Safety is a core value at Finning and our whole organization is impacted by this tragedy.

Our commitment to the health and safety of our employees remains unwavering. The investigation is ongoing and we will share our learnings around the company and continue to keep safety top of mind in all we do.

In South America, Chile’s results were overshadowed by Argentina’s performance. As you know, the peso devalued significantly in Q3 and Argentina’s economy has weakened.

As a result, our revenue in Argentina dropped sharply in Q3, with construction new equipment sales down almost 80% from Q3 2017. We are taking the necessary steps to right size our operations, costs and capital in Argentina to align with lower activity levels.

During the quarter, we had negative EBIT in Argentina which weighed on Finning’s results. With the right size cost base, we expect to return to profitability in Argentina in Q4.

In contrast, activity levels in Chile remain robust. The government’s policies have strengthened business confidence, and Chile’s central bank forecast GDP growth of 4% to 4.5% this year.

In the third quarter, we sold 30% more new construction equipment than last year. And we are encouraged by the government’s commitment to investing in the country’s future through their infrastructure agenda.

In addition, copper production is up over last year, and the copper commission is forecasting increased copper production again next year. At current prices, copper mining is profitable, and large mining equipment is back at work.

As customers are generally running aged equipment fleets, we expect significant replacement demand over the next few years. We had a meaningful increase in the sales of new equipment in Q3 and continue to see strong quoting activity in mining.

We subscribe to the view that global demand for copper will outstrip supply in the medium term. As long as U.S., China trade in tariffs do not disrupt, we believe mining in Chile will continue to recover.

Our technology investment in South America this year are expected to improve working capital velocity and reduce costs. We should start seeing the benefits next year.

With the technology spend behind us and an anticipated pickup in equipment replacement, we expect profitability in South America to improve significantly in 2019 with the objective of returning to historical EBIT margins in a relatively short order. I am also pleased with the ongoing progress we are making with the implementation of our digital agenda.

Today, 26% of parts outside of service jobs are ordered online. This is up 5 percentage points since last year.

We now have 68% of all machines connected globally. This is up 10 percentage points over last year.

And we are on plan to connect 80% of machines by the end of 2019. Digital incremental revenue and lower cost to serve contribute to the bottom line.

We have now reached the tipping point where our investment in digital is accretive to EBIT, a year earlier than we planned. Looking ahead, with the exception of Argentina, we are pleased with the end-market activity and the outlook for our regions.

End-market demand in Chile, Canada and the UK remain strong and we expect that to continue through 2019. At the same time, we are keeping a close eye on macro development that has the potential to reduce global GDP and impact customer activity.

For the balance of 2018, we expect a sequential increase in revenues and gross profits, albeit at lower margins due to significant new equipment sales in Q4, principally driven by mining deliveries in Canada. Losses in Argentina in Q3 reduced our EPS this quarter by about $0.03.

Our actions to-date have stabilized Argentina and will result in improved EBIT margin in South America relative to Q3. We expect a strong finish to the year, both from an earnings and free cash flow perspective.

Given the strong delivery of free cash flow in Q4 and the discrepancy between the current stock price and the fundamental value of our shares, we plan to repurchase up to $100 million of our stock before the end of the year. I will now turn it over to Steve.

Thank you, Scott. Our third quarter results reflected strong performance in Canada and the UK and Ireland, continued market recovery in Chile, and extremely challenging economic conditions in Argentina.

Adjusted earnings per share of $0.45 was up 35% and adjusted EBIT of $123 million was up 23% from the prior year, on a 14% increase in revenues. We adjusted our results for two significant items.

First, following a review of our investment in Energyst, we determined that this investment no longer fits in our business strategy. As a result, we recorded a $30 million or $0.18 per share write-off of our investment in Energyst.

Second, the negative tax impact of the sharp and rapid devaluation of the Argentine peso amounted to $20 million or $0.12 per share in the third quarter. This was comprised of $0.02 cash tax as we communicated during our second quarter earnings call, and $0.10 of non-cash tax as a consequence of the non-controllable revaluation of deferred tax balances, which principally represent book tax timing differences.

Moving to regional highlights. In Canada, strong customer activity continued across all sectors.

New equipment sales were up 62%, driven by large mining deliveries and increased demand in construction and gas compression. Product support revenues were up 10% with favorable market conditions in construction, and oil and gas as well as higher volume of component rebuilds in mining.

Rental revenues increased by 8% year-over-year and were up 35% sequentially. Although there is still work to do, our rental strategy is working.

We are achieving better pricing, utilization has improved, and customer loyalty scores are moving higher. EBIT in Canada was up 37%, and EBIT margin improved by 90 basis points to 8.6%, despite a shift in revenue mix to a higher proportion of new equipment sales.

SG&A as a percentage of revenue declined by 230 basis points, reflecting a leverage of incremental revenues on fixed costs and disciplined spending. Return on invested capital of 16% improved by 400 basis points from last year, driven by higher profitability and improved invested capital turns.

Our results in South America were negatively impacted by challenging economic conditions in Argentina, including a significant devaluation of the Argentine peso and reduced government spending. In functional currency, South America’s total revenues were down 3% and EBIT was down 25% due to a 56% decline in revenue in Argentina and the resulting EBIT loss.

The negative EBIT margin in Argentina reduced South America’s overall EBIT margin to 6.7% in the quarter. Profitability in Chile, however, remained solid and in line with our expectations.

Due to significantly lower profitability in Argentina, we do not expect to achieve the previously communicated EBIT margin target of 8.5% in South America in 2018. We completed some rightsizing in Argentina earlier this year, and as Scott mentioned, we are taking additional actions to align with lower activity levels and manage our currency exposure.

As an example, we have moved almost $50 million of our inventory into Chile. In Chile, we are encouraged by continued recovery in equipment markets.

Our new equipment sells more than doubled from the third quarter of last year, driven by improved demand in all sectors, but most notably in mining. In the UK and Ireland, we saw a strong activity in power systems, steady levels of product support, and improved margins in most lines of business.

Revenues were up 10% in functional currency and EBIT margin increased by a 160 basis points to 5.1%. Return on invested capital was up a 110 basis points from the third quarter of last year to 14%, driven by higher profitability.

We are closely monitoring the latest developments on Brexit, but we have not seen any impact on activity levels. Our equipment order intake and backlog remained strong, particularly in the industrial and electric power segments.

And large infrastructure projects such as HS2 and Heathrow are expected to provide further opportunities. In the fourth quarter, we expect sales momentum to continue across our regions, resulting in higher revenues and gross profits, albeit at lower margins due to a higher proportion of new equipment sales and the revenue mix.

We remain focused on advancing our supply chain and ecommerce initiatives to drive capital efficiencies. Working capital to sells of 26.7% improved by 190 basis points from the same quarter last year, and invested capital turnover of 2.14 times was the highest since 2012.

Free cash flow was a use of $49 million, mostly due to higher inventory purchases to meet demand. Our backlog is up by about 65% from a year ago, and new equipment sales increased by almost 35% from the third quarter of last year.

While we continue to experience long lead times on some equipment and parts, we have maintained working capital efficiencies. We expect significant equipment deliveries in the fourth quarter to generate strong free cash flow.

I will now turn it back to Mauk for Q&A.

Operator, that concludes our remarks. Before we go to the Q&A, we request everyone on the line that as a courtesy to your colleagues, please ask no more than two questions in your turn.

Please go to enter the queue, if you have more questions. Operator, can you please open-up the lines?

Thanks very much and good morning. In terms of the business opportunity that you outlined related to LNG Canada, I assume that there’s an earthmoving piece that’s relatively short-term in terms of the timing, and then kind of an engine piece that’s a little bit more back-end loaded.

So, maybe you can speak to just the cadence of that opportunity a little bit, and remind us how PLM functions as we think about the pipeline portion.

So, you’re right. There’s a lot of earthmoving when you have to make site prep for example, and we’ve got a lot of our good customers have -- are going to be involved in that business.

And you go out further and looking at what Chevron has done down there with that road in Kitimat and you see the amount of diggers and earthmoving equipment. So, there’s a big component but it’s relatively short-lived.

And so, the long term -- any other relatively short-lived, and I am talking multi-year period, relative to pipeline, and that is through PLM. So, we have a 25% interest in PLM and that has served us well given all the pipeline activity through North America over the last few years.

And so that pipeline equipment will be sold through PLM. And then, we’ll -- will provide the product support.

So, good opportunity there. And then, lastly, and the long-term nature of this is the engines, and the rebuild and the product support that comes with that.

And the engines come in twofold, One is gas compression, so all of the engines that customers, like Enerflex sell from a gas compression, would come from us. And that’s good, both upfront and product support revenue.

And then, second, the emerging business opportunity that I am really excited about is the frac rebuilds. And you’ve heard me talk a lot about frac trucks and the progress that Cat has made over time in terms of increasing the content.

So, engines, pumps, transmission, and all of that has to be rebuilt. And we’ve got a great facility with OEM that helps us do that.

So, we actually started a lot of that unrelated to LNG. But, Joel and the team on the Power Systems have done great job capturing that opportunity with two or three big frac companies.

And I think that opportunity will only grow as you think about the amount of fracking that’s going to have to be done, to feed those trains for shale.

And then, switching gears, I wanted to ask, in Argentina, how do you sort of downsized that business to current business conditions while also staying nimble to capture the Vaca Muerta opportunity?

It’s a great question because I believe Vaca Muerta is a significant opportunity for us. In fact, we’re here in Chicago with Cat with our Board and had dinner with a lot of the Cat folks last night.

And Jim Umpleby sits on the board of Chevron, and they’re actually active down there right now. And so, we were just catching up on the opportunity.

And it is a massive opportunity. It’s Permian like, Eagle Ford like opportunity.

And so, the challenge here is, we need to have the right sized cost structure. And that’s primarily in the mining and the construction side.

But, we really have to focus on developing and being first mover in the Vaca Muerta. And so, we are not going to let that opportunity get away from us.

We are going to really think about segmenting our business. When you think about what happened here in Argentina is interesting as we’ve segmented the market.

A lot of the downturn would have been mining. And so, a couple of the mining customers have shut up shop and gone away.

And we’ve seen a real decline on product support through this little transition period. And then obviously, you haven’t had a lot of the construction infrastructure spend that we were expecting, and that reflected in sales down.

But in no means does our rightsizing in Argentina take my focus away from Vaca Muerta.

First question on Cat. Talk about any supply chain challenges for the quarter.

And then, with the pricing increases that they are talking about in January 2019, any impact on demand at all?

So, the supply chain or lead time issues and parts availability issues have been well documented and we’ve worked really well with Cat to address some of those issues and they are getting better. And if you look at our -- some of our inventory levels in Canada, we’ve had some inventory.

Fortunately our inventory turns have stayed pretty consistent and sales to invested capital has actually increased. So, I think we’ve been able to manage that well.

We’ve seen -- I might not get these numbers exactly right. But, I think year-to-date in Canada our new equipment revenue was up 49%, so a big increase in revenue.

And we’ve been able to hold market share, which is I think another significant accomplishment. Where it has impacted us a little bit is on rental fleet.

And I think we’ve said in earlier quarters, we were about a quarter late on loading into a rental fleet. And so, you saw in the second quarter rental revenues were relatively light year-over-year.

I think what was pleasing to us this quarter is we’ve got the fleet, and our rental revenues sequentially are up 35% relative to the second quarter. And now, as we are here in the fourth quarter, I know I can see the delivery schedule.

We’ve got a pretty robust delivery schedule through the end of the year. We actually feel pretty good about where we are with equipment, inventory and deliveries.

As it relates to the price increases that Cat announced, I think this is just normal course of business that we deal with all the time. So, not something that I’m concerned about at all.

And the strong new equipment sales that we saw in Canada, can you just talk about the sustainability of some of these big numbers that we’ve seen, was there few mining contracts that boosted results or…

Not really, I mean it was broad-based. I mean, we’ve seen broad-based across all sectors.

I guess the one area that was a little weak was power systems on the gas side which you can see based on where that’s tracking, but other than that it is board based support. And I think it’s going to continue into Q4, as you think -- actually, I think we are going to see a little bit more mix towards new equipment in Q4, and the backlog is strong.

Just to put it in perspective, September order intake was the strongest month of the year in Canada. And so, we’re feeling pretty good about that backlog right now.

Hey. So, I mean, it looks like we’re seeing a lot of strength in mining across your geographies.

I mean, the fleet in Canada and Chile also pretty old as well, and utilization rates are higher. Presumably replacement demand should continue through 2019.

So, I am just wondering, with lower WCS and copper prices and increased concerns around commodities, I mean is there a sense like customers are being somewhat more cautious now or how are you reading the market there?

So, I think we’ve got two big trends that are happening in both Canada and Chile. In Canada, I think there’s been a real deferral of overburden removal over the last four, five years, and we’ve got our customers trying to catch up and that’s resulted in a lot of contractor demand, which lot of demand from our customers.

So, that’s I think a helpful interplay. The Western Canadian Select differential, the $50 is impactful, and we need to watch it.

It doesn’t impact all of our customers equally. And so, I think there’s a still a number of our customers that have upgraders that allow them to avoid some of that impact.

I know others like Cenovus and MEG get hit pretty hard on it. But, I think some of our other customers have been able to mitigate that pretty effectively.

And so, I don’t suspect, I think oil sands, it’s going to continue. And that is a really competitive market, given that differential.

And we have to be really thoughtful about how did our customers navigate through it, and we’re doing that. So, lots of work with our customers to make sure that these are win-win, and they’re competitive going forward.

In Chile, a little bit of a different story. Trucks hard to do activity, copper production up, equipment age, which is resulting in fleet renewals and trucks going back to work.

And if you look year-to-date, our product support is 13% up year-to-date in Chile, which is -- that’s a good healthy number. And we’re starting to see some quoting.

You’ve seen stronger equipment demand. So, I feel good about that.

That being said, copper prices and commodity prices do have an impact. And so, when you see copper price down 15% or 16% and hear you all the noise around Trump, tariff, China, I am sure the -- our customers are sitting there being thoughtful about that.

And I am hopeful we get through all that. I know Chile is increasingly cost competitive, 35% of the world’s copper demand.

And I think, we all feel good about the demand, supply dynamics for copper long-term. But you do have to navigate through with the short-term impacts of lower commodity prices.

And just maybe on one of the comments you made around overburden removal. Is your sense that we’re sort of caught up at this point or is there activity there that you think moves into 2019?

No. I think there’s a lot of activity continued on overburden removal and rebuild activity.

And just on Argentina, as it relates to your outlook. I just want to make sure that I understood your comments in the prepared remarks.

So, you’re reducing the cost structure there, you’re expecting profitability in Q4. It looks like that you’re downsizing to the current demand level without leaving too much room for a recovery in FX oil and gas.

I am not sure if I am reading that correct. You’re expecting margins in South America to return to sort of normal levels sometime early in 2019 is what I read from your comments.

Just some color there and…

Yes. So, when we look at -- I mean, we’ve done a great good job -- the team in South America has done a great job, keeping that 8.5% tight margin from last four years.

And this quarter with an 80% decline and unit sales in Argentina, we actually lost money in Argentina, negative EBIT, I think we had about the $0.03 impact on the overall results. And so that brought the margin for FINSA down.

If you’d excluded that Chile’s, would have closer to the same or approximately there. So, I actually feel good about the Chilean market.

So, then the question is how do you improve Argentina. And it’s complex because I do think the government there’s doing the right thing.

You do have Vaca Muerta but you also have to recognize you have to be profitable. And so, one, we’ve moved a of inventory out given the reduction in sales to Chile in order of $50 million; and we are going through a rationalization process of cost.

And just to keeping the flexibility to respond to demand that comes, but getting to the point we’re we not unprofitable in Argentina, and we think we will get to that point in the fourth quarter where we will be unprofitable -- will be stabilized. So, we’ll be losing money and then as we go into 2019, one, both improve in Chile given the technology spend that is behind us and improve in Argentina to see much higher profitability than what you’ve seen this year.

And maybe one last question as it relates to free cash flow expectations for 2018, I mean you commented Q4 is going to be a good free cash flow quarter, but just to get a view on the year?

Yes. So, we -- you’ve seen us the last five years, it’s kind of been a pretty similar story.

Q1 is very free cash outflow, Q2 and Q3 are kind of stable, and then Q4 is strong free cash flow delivery. And that’s the seasonality of our business.

And we told you at the start of the year we’re going to be free cash flow positive. Revenue has grown a little bit more than we expected.

I think we’re growing to 14% relative to what I thought it was 10%. But, our sales to invested capital has stayed the same or improved.

And so, our expectation is that we deliver a positive free cash flow for the full year.

Just on Argentina, are you able to kind of size the overall contribution of Argentina to your consolidated revenue and EBIT?

Well, we should be able to. So, if I may catch it off the top of my head, but it was a $300 million business -- 250 to $300 million, so it went upto $500 million in revenue and we are now back down to that kind of 250 to $300 million.

The other comment I made was EBIT loss $0.03 impact. So, hopefully that gives you some guideline.

And then, the third things I said was Chile, and Bolivia were relatively consistent year-over-year from a profitability perspective, yet to see the FINSA results this quarter, which I think our EBIT margin was 6.7%. So, those three numbers hopefully allow you triangulate the overall impact.

And I guess part of it, but you’ve indicated previously that you feel that -- and hopefully I’m quoting you correctly that there’s $100 million cost opportunity that you can drive out of the business going forward. Any progress on that front?

And is that broad-based -- is it a broad-based opportunity or is there anything specific that you’re targeting?

Yes. I think what we said at Investor Day is we thought we would get to 18% SG&A.

And what I am actually -- we are down six or seven months into it and I am pretty pleased with where we’re heading. I look at the Canadian SG&A results, and again nothing gets this exactly right, but I think this is 200 basis-point improvement year-over-year.

We’re around 19%. And the next phase of this process improvement; data, driving better decision-making; e-commerce, which is a lower cost to serve, significantly lower cost to serve.

Now, we want to do that in the context of an omnichannel approach, but as we move more parts online, that will reduce cost structure. And I think that all leads you to a more leaner and agile company that can get to that 18% SG&A.

And if we can do that, I mean I think that’s a big part of driving the role up in Canada to that 20% level, and at the same time providing more competitive services and win-win propositions for our customers.

Just out of curiosity, when you guys talk about Finning’s fundamental value, how are you thinking about that? And what sort of things you look at when you think about the fundamental value of the Company?

So, probably not unlike what you do. We think about the just kind of cash flow value, we think about the growth opportunities that we have in front of us.

And essentially, we look at various ways to allocate capital. And there’s -- we’ve talked about this at length.

You can -- investing organically, which we have been doing; you can do acquisitions, which you saw us do some of that, or you can repurchase your own company, which I think essentially, it’s like buying another Cat dealer. And as I said, we kind of do a little bit of all three.

It seems right now in the short term, you’ve got a little bit of equity disruption that’s driving down the share price disconnected for where we think it should be. So, it’s a great time to buy our own stock and move forward from a smart capital allocation perspective.

Well, thank you very much, operator. That concludes our call.

Thank you everyone for listening.