Good morning, everybody, and welcome to Caterpillar's year end earnings conference call. I'm Mike DeWalt, the Director if Investor Relations, and I'm pleased to have with me today two group presidents, Doug Oberhelman and Ed Rapp, and our CFO, David Burritt.

Jim Owens, our Chairman and CEO is a participant at the World Economic Forum in Davos, Switzerland today and isn't with us, but he does look forward to talking with you at our analyst's meeting at CONEXPO in Las Vegas on March 11. Just a reminder, this call is copyrighted by Caterpillar, Inc.

Any use, recording or transmission of any portion of this call without the express written consent of Caterpillar is strictly prohibited. If you'd like a copy of today's call transcript, you can go to the SEC Filings area of the Investor section of our CAT.com web site or to the SEC's web site, where it'll be filed as an 8-K.

In addition, certain information relating to projections of our results that we'll be discussing today is forward-looking and involves risks, uncertainties and assumptions that could cause actual results to materially differ from the forward-looking information. A discussion of some of the factors that, individually or in the aggregate, we believe could make our actual results differ materially from our projections can be found in our Cautionary Statements under Item 1A, Business Risk Factors, of our Form 10-K, filed with the SEC in February of 2007.

Earlier this morning we reported fourth quarter and full year 2007 results, and I think the headline of our release was very positive and it did a great job of summing up the essence of what's happened over the past year and what we expect in 2008. It read: Global Strength Powers Caterpillar to Record Sales and Profit; Company Reaffirms 2008 Outlook for Another Record Year of Sales and Profit.

I'll summarize the quarter, the year and out outlook for 2008 in just a minute, but the big points are these: The fourth quarter was the best ever of any quarter for sales and revenues. In terms of profit, it was our best fourth quarter ever.

2007, the year, was our fifth consecutive record of sales and revenues, and our fourth consecutive year of record profit. Machinery and Engine's operating cash flow increased in 2007 $800 million to $5.4 billion, and we're maintaining our positive outlook for 2008 and are expecting another year of improvements and new record results.

With that, let's get into the fourth quarter numbers. Sales and revenues in the fourth quarter were $12,144,000, and that's an increase of over $1 billion or about 10% from the fourth quarter of 2006.

Profit per share was $1.50, and that's up $0.18 from Q4 of 2006. Again, the fourth quarter was our best sales and revenues quarter ever and our first to exceed $12 billion in sales and revenues.

And it was up 6% from the third quarter, which was the previous record. A couple of points about sales and revenues in the quarter.

First, unlike the first half of 2007, this comparison is apples to apples with Progress Rail. We acquired in mid-June of 2006, and it was included in our third and fourth quarter results in '06.

It was a great quarter for sales and revenues, with growth driven by continued and significant strength in sales outside North America and continued strength in a number of key global end markets like mining, oil and gas, electronic power generation, marine, and industrial engine applications. In fact, sales and revenues increased 34% in the Europe, Africa, Middle East region, 36% in Asia Pacific, and 17% in Latin America.

On the other hand, sales and revenues in North America were down 11%, and interestingly, this quarter-over-quarter change by region is remarkably consistent with what we saw in Q3. From an end market standpoint, inside North America it was a weak picture for many of the industries we serve.

U.S. housing was down significantly, nonresidential construction was weak, and on-highway truck engines were down substantially from last year's very huge fourth quarter.

From an end market perspective outside the United States, almost everything was up and some end markets, like mining and oil and gas, are booming. The sales story, though, was more than volume.

Price realization also improved and was up $392 million compared with the fourth quarter of 2006. And a weaker dollar in the fourth quarter versus the fourth quarter last year was positive $334 million for sales.

To cap off this quick review of fourth quarter sales, it's important to summarize what happened to dealer inventories. Overall, dealer machine inventories were about flat in the fourth quarter.

No region had an increase or a decrease of over $40 million from the end of the third quarter, and in total, for all regions the change was less than $50 million. The bottom line is that dealer inventory changes did not have much of an impact on the fourth quarter of 2007.

However, if you go back to the fourth quarter of 2006, dealer inventories were up a little in an order of magnitude of about $200 million. Okay, let's turn to fourth quarter profit.

Profit per share was $1.50. That's $0.18 a share ahead of Q4 2006 and again, our best fourth quarter ever and our second best all-time quarter.

The improvement versus last year was largely a result of the $392 million of price realization and the impact of higher physical sales volume, and those improvements were partially offset by higher core operating costs of $296 million. The core operating cost increase was primarily related to manufacturing costs, and it was in three major buckets: efficiency, material costs, and higher depreciation.

The impact of currency on our operating profits was also negative in the quarter $24 million, and what that $24 million reflects is that our sales were benefited $334 million but operating costs were up $358 million as a result of currency changes, and operating profit as a percent of sales was hurt about half a percentage point as a result. Okay, that's a quick summary of the quarter.

Let's move on to the year. Without a doubt, 2007 was a remarkable year for Caterpillar.

U.S. economic growth was weak.

The U.S. housing industry essentially collapsed.

The on-highway truck engine business suffered a dramatic decline, and the word dramatic doesn't really cover it. Coal mining activity in the United States declined as a result of weak coal prices and abundant inventory, and our machine sales to the coal fields dropped significantly.

As a result of this rather gloomy picture, dealer sales in North America were down double digits in 2007. On top of the decline in dealer sales, Caterpillar sales of new machines and engines were down even further, as our dealers in North America shed $1.1 billion of machine inventory during the year.

As I look back, I cannot think of a time in my 27 years with this company that I could rattle off a list of negatives like that about business in the United States and follow it with the statement, "We're pleased to report record sales and revenues and record profit for the year." 2007 demonstrates a lot of what we've been saying now for a long time.

We have an increasingly diverse international business. In fact, about 60% of our sales and revenues were outside North America in the fourth quarter.

And remember, in our categorization of North America, that includes Canada, and if you were just looking at the United States, the number would be closer to 70% than 60%. From an employment perspective, 2007 was the first time in our history when we had more employees outside the United States than inside.

From an end market perspective, we are very diverse - housing, non-residential building, infrastructure, mining, waste, energy, electric power, marine, and the list goes on. And let me give just one example that illustrates that diverse end market point.

Who would have thought that in a year when on-highway truck engines were down so dramatically that we'd be reporting record levels of operating profit for our collective engine businesses? And integrated service businesses are an increasing piece of Caterpillar, and that's helped stabilize sales and profit, even in North America.

Our total sales in North America were down 11% in 2007. That's an overall drop that's quite a bit less than our sales of new machines and engines in North America.

Okay, the numbers for this remarkable year: Sales and revenues of just about $45 billion. That's up 8% from last year, 2006, and 123% over the past five years.

Profit per share was $5.37, up $0.20 from '06 and up 367% over the past five years. That's positive news, but we did have our challenges in 2007.

While physical sales volume was up modestly, it certainly was not uniform throughout the company. We were operating well below capacity at our engine facilities that make on-highway truck engines, and that hurt efficiency.

We were down at our U.S. factories that make small and compact machines for North America, and that hurt efficiency.

On the flip side of that, we were and still are very tight on large machines and engines where demand is high and the backlog is long. We worked hard to get incremental production up in 2007, and that, coupled with a very tight supply chain in general, didn't help efficiency.

In total, core operating costs were up $1.2 billion, with virtually all of the increase related to cost of goods sold. SG&A and R&D spending were very well managed in 2007 and were about flat with 2006 despite inflationary pressures and higher volume.

Manufacturing costs increased as a result of unfavorable factory efficiency. Higher material costs increased just under 1.5%, lower than inflation but higher than we expected when we started the year.

As in most of the economy, we experienced wage and benefit cost inflation. Warranty costs were higher, largely a result of the number of new products we've introduced, and depreciation was up, a result of increasing Capex.

I started this discussion with the point that 2007 was a remarkable year, and while we've had our challenges, overall it was very positive. Price realization improved over $900 million in a very tough pricing environment.

Progress Rail added almost $800 million in sales. Physical sales volume, excluding Progress Rail, was up about $0.5 billion.

Currency impacts added $900 million to sales, and financial products revenues were up almost $350 million. Machinery and Engines operating cash flow was $5.4 billion, up $833 million from 2006.

We raised the quarterly dividend in 2007 20%. We repurchased over 33 million shares of Caterpillar stock with a net reduction in shares outstanding at year end of almost 22 million shares.

We spent $1.7 billion in our Machinery and Engines businesses on capital expenditures, much of it to increase capacity. And we ended the year with a very strong financial position.

Our Machinery and Engines debt-to-capital ratio was 31.2%, and that's down from 38.6% at the end of '06 and our lowest debt-to-cap ratio in 20 years. Let's turn to the 2008 outlook.

In this morning's release, we were very pleased in these uncertain times to reaffirm our outlook for 2008. We expect sales and revenues to be up 5% to 10%, and profit per share to be up 5% to 15% from 2007.

Earlier I said that 2007 was a remarkable year, and it certainly was, but our outlook for 2008 reflects what's possibly even a more remarkable year. The decline in the U.S.

economy continues and our forecast of full-year GDP growth is just 1%. U.S.

housing should continue its slide, and the on-highway truck market should get a little better but not back to anything that you'd consider normal. But we expect continued growth throughout most of the rest of the world, albeit at a slower rate than 2007.

We're starting the year with a record order backlog that's up more than 20% from the end of 2006. And I'm not giving guidance for 2009, but it is possible that 2008 could be the bottom of the North American machinery cycle.

If we continue this decline, as is included in our 2008 outlook, this decline will have lasted around two and a half years starting in the second quarter of 2006. With the interest rate cuts that the Fed has already made and our expectation that there are more rate cuts to come, and presuming that the U.S.

government implements a timely stimulus plan, it is possible that after more than two years of decline that 2008 could be the bottom of this North America machinery cycle. And the idea that Caterpillar is expecting higher sales and profit and a record year at what could be the bottom of a North America machinery cycle - well, to those of you that have followed us for a long time know, that's truly remarkable.

Let me quickly summarize the plusses and minuses for 2008, then we'll get to the Q&A. In terms of the top line, North America, we're looking for flat to up 5% in terms of top line.

And I know that may sound very bullish at first glance, but remember, dealers took out $1.1 billion of inventory last year. We're expecting a little improvement in on-highway truck engines sales.

We expect sales to coal mining to be up coming off a very depressed 2007. And sales in Canada, particularly the oil sands, should continue to improve, and sales related to metals, mining and oil and gas in general should still be in good shape.

Outside North America, the picture still looks good, with sales up 5% to 10% in Europe, Africa, Middle East, 10% to 15% in Latin America, and 10% to 15% in Asia Pacific. That's good growth to be sure, but at a slower rate than 2007.

For profit, we're expecting an increase in EPS of 5% to 15%, and the key positive profit drivers are better price realization and sales volume somewhat offset by higher costs. We expect core operating costs to be up 2% to 2.5% in 2008, but with a little different profile than 2007.

We expect that SG&A and R&D costs will rise in 2008, and remember, in 2007, they were about flat. R&D costs are going to be up significantly as a result of work on emission and Tier IV products begin to ramp up.

And after holding SG&A pretty flat and offsetting inflation in 2007, we do expect some increase in 2008. That said, we don't expect that SG&A as a percent of sales will be up.

And we're forecasting material costs to increase something like 2007 - up, but probably less than inflation. And we believe that manufacturing, labor and overhead costs will be about flat with 2007, with the impact of inflation about offset with modest operating improvements from the Cat Production System.

Okay, let's just punctuate a couple of points, and then we'll end here. First, more of our sales are outside the United States than are inside.

We see continued growth outside the United States in 2007. We see a tough economic picture for 2008 in the U.S., but our sales in North America should still perform better than 2007.

And again, that's because of the dealer inventory impact, more truck engines, better coal mining, and continued strength in the commodity related sectors. We are very tight on capacity and expect to increase our Capex in 2008 to about $2.3 billion.

We are very confident in the need for world infrastructure growth over the next 10 years, and we simply need more capacity. We're starting 2008 with the highest order backlog in our history, again, up over 20% from the end of '06.

We are confident in our comprehensive approach to improving operations, and that's the Cat Production System. And we expect more progress in 2008.

Our financial position and cash flow are very strong and give us great flexibility to take advantage of opportunities that may arise. In short, we have a lot we need to work on, but all in all, we're in a pretty good position.

With the growth that we think will occur in the developing world over the next decade and the need for basic infrastructure to support it, the world will need more of what we make. Okay, that's it for the prepared remarks.

We're ready to move on to the Q&A portion of the call, and we want to get as many questions in as we can in the remaining 40 minutes, so please limit yourself to one question and a follow up, and we'll try and be quick on our answers.

Hi. Good morning.

Jamie Cook from Credit Suisse. Mike, I guess my first question - the R&D up 15% to 20% was surprising to me.

You did give some color on emissions and new product introductions, but I guess can you elaborate on that increase, and should we be concerned that any of that is being used for legacy issues, perhaps on the engine side or even on the machinery side?

No, I think the bulk of it is really what we said in the release. We are in an environment where Tier IV A, quickly followed by Tier IV B, will be upon us in a few years.

We have more spend to do on emissions. No, I think it's new products.

Yeah. Doug Oberhelman here.

I'd just like to add to that. There's virtually no material increase if any increase in any legacy product, specifically truck engines.

We are in a major ramp up for Tier IV around the world. We feel we want to and will nail that with technology that's better than we've ever released, and we're doing that.

In addition, we're kind of behind - not behind necessarily, but we've been on the lower end of where we wanted to be the last few years in overall R&D, so this recognizes with the volume opportunities we have out there in the next few years that, in the various geographic regions where we want to be, that we've got to do some extra things. And that's really what it is.

But I want to emphasize, there's virtually no - and certainly no material - increase for any legacy products of any kind.

All right.

Follow up? Do you have a follow up, Jamie?

Yeah, my follow up question. Mike, you know, just in terms of disclosure of how you're - on the outlook for operating profit, you used to have the waterfall chart.

In order to get to - in order for us to make - you have to make a lot of assumptions, I guess, to see what your core operating costs are going to be up on a dollar basis, whereas before you disclosed that. So why change the disclosure, especially when this has been such an issue with Cat?

Should I read into that, you know, how should we measure your success, I guess, on the manufacturing and supply chain side?

Well, it's pretty easy to calculate the number. There's a definition of core operating costs in the glossary, and essentially it's cost of goods sold, R&D and SG&A, and we normalize out the impacts of volume on variable costs and the impacts of currency.

So if you take SG&A, R&D and cost of goods sold and apply the 2% to 2.5% number, that'll give you a pretty good idea of where we're at. And if memory serves me right, I think it's in the $850 to $1.1 billion, in that kind of range.

The reason for the change in the disclosure is really a couple of things. One, I think the waterfall implied a lot more precision on the individual elements in the outlook than there really was.

And what we decided to do is move to a little bit more of an explanatory mode. In fact, if you look at our disclosure, you know, we're talking a lot more about the individual elements, and putting ranges around them because projecting the future's not a very exact science and we actually feel a little more comfortable with ranges.

All right.

Be sure on an actual basis, though, we're going to continue to show those bucket charts for clarity.

Right.

All right. Great.

I'll get back in queue. Thank you.

Okay.

Wachovia Securities. Good morning,

Good morning, Andy.

I guess a follow up on Jamie's question. With the operating cost outlook to grow in the 2% to 2.5% range for '08, is that kind of equally weighted first half, second half?

I'm trying to gauge the improvement that you expect in Cat Production System.

I think improvements in the Cat Production System - and this is kind of consistent with what we've said before, you know, we expect some gradual improvement - so I fully expect that second half of the year, we'll get more than we have in the first half. I don't really have a forecast of operating profit by quarter.

Heck, we don't even give overall guidance by quarter, so I'm going to beg off on that a little bit. But I would suggest to you that I think that we'll have a continuing ramp of benefits from Cat Production System.

Okay, thanks. And then the second question, diving into the power generation piece of the business on the outlook, what are you seeing in North America?

Is that kind of booked for '08, or is there still room in the second half?

Yeah, I don't know specifically what the order backlog is on EPG for North America, but I can tell you in general the big products have - particularly the 3500 series products, the Solar big power gen products, have pretty extended backlogs right now. So I think for almost all applications of big engines, there's a lot of impact of how much can we actually get out.

I'll just add to that, at about 250 to 300 kW and up, there's no change from what we've been saying. It's a backlog; it's solid, driven significantly by data centers and the drive for power quality.

Below 250, the smaller you go down, we had a slight [inaudible] last year. That's come back a little bit.

Some of that's housing related I think and non-res, but generally that's a pretty stable situation at the moment, as we're looking into '08. So EPG is kind of the same story that we've been on, but maybe with a little bit different variable on the low end.

Okay. Thanks a lot.

Good morning. Daniel Dowd, from Bernstein.

Let me actually follow up on Cat Production System as well. So, you know, the Solar business has already successfully made a transition to almost 100% whole, and obviously that has - you know, I realize you don't disclose margins there, but that certainly has improved their margins, presumably pretty dramatically.

Can you talk about other places in the business where you made a lot of progress on the Cat Production System, and can you talk about some places in the business where you still have a lot of room to run.

I'll just make a couple of generalities. You know, I think we have room to improve probably in all of our facilities, but certainly there are some that are further ahead.

And to use Solar as an example, we could put in Cat Brazil, we could put in Sagami and a Kochi in Japan, who were facilities that were, oh, you know, part of the blueprint for what we decided to do in the rest of the company. So they are farther ahead.

I think if you were to look at our large, older facilities in Europe and North America, we probably have more room to go in those facilities.

Okay, but let me turn to the issue of the core operating costs, particularly the operating and efficiencies category. You mentioned that new product introductions, there's going to be some of that ongoing.

It strikes me that given the regulatory cycle, that net new product introductions over the next several years should be relatively lower than they have been over the last several years. Is that correct, and secondly --

Yeah, that's absolutely correct. I mean, it's not that there's nothing in 2008, but if you look at the breadth and depth and risk of the 2008 introductions as compared with '05 and '06, it's very small by comparison.

So yeah, I think if you look at just sort of the scope of new products, Tier III is for the most part largely behind us, and Tier IV A, we still have a couple of years to go before we get there. So, yeah.

I think we have much more stability, at least in terms of the product in the factories and product changeover. So that ought to be a benefit, a positive to our operating efficiency over the next few years.

Yeah. I think that's a good point.

Okay, so what we should expect is that at least the operating and efficiencies category of the core operating costs should be net declining?

Absolutely.

Okay.

Thanks, Dan. Next question?

Hi, good morning. Mark Kosnerick at Cleveland Research.

Hey, Mark. Good morning.

Morning. Mike, my question involves the capital spending cycle because it's really surging this coming year, $2.3 billion versus $1.7.

And obviously, you know, you stated why, you need capacity, but I'm wondering if this is a oneyear surge or can you describe what your entire spending bubble looks like, and how much more we might expect in '09 and even '10?

You know, I'm not going to get too far out beyond the outlook that we have, but I will say that if you go back to a few years ago when we laid out our 2010 goals, you know, we said $50 billion. And, you know, since then, I mean, we're going to - mid-point of our outlook isn't too far from that in 2008.

And we have, I think, a better view of the sales increase going forward than we had a couple of years ago. We're aggressively moving in areas like China.

We're kind of out of capacity on big engines and a lot of big machines. So I think the need for capacity is there, particularly in locations where we see future growth coming.

The increase in Capex is about 35% from this year, and based on our view of the future, we need it. But I'm not going to get too predictive, I guess, on the future.

I mean, I think there's still a lot of water to go under the bridge.

Well, the follow up to that, Mike, is that you're putting up some greenfield facilities, but I imagine most of the spending is going to be in existing plants, which means there is the probability of manufacturing disruptions as you're applying and installing all this capital. So I'm wondering, you know, will '08 sort of be the peak of this and we really get a benefit in your efficiencies in '09, or is this likely to be a more extended spending cycle and the inefficiencies kind of drop away gradually?

Mark, it's Doug Oberhelman here. I'll take a shot at that one.

You'll recall all the way back to 2004 we were still in '03 and '02 and '01 and back to the previous peak in '98, we were kind of at the low end of our historical rate of Capex to sales, and we have found through this ramp up that we're paying the price for that in everything from machine tools that are wearing out that we put in place from the POF days in the '80s to needed capacity for mining trucks and large engines and you name it. We stepped it up in '08 to about 4.7% of sales.

I think '07's number was about 3.8%. I'm not going to make a prediction, either, past that, but I would think that with the outlook that we have and the capacity we're going to need in our Vision 2020 and objectives past 2010, we're going to be at probably the upper ends of that range now for a little while as we go forward.

You are exactly right. A lot of this $2.3 billion in '08's going to go in existing facilities, and that's a big piece of Cat Production System - more modern tools to really increase our efficiency within those plants.

What we have found in Lafayette as we've put the two phases of 3500 capacity increase over there is that we have not paid any price in terms of operating efficiency as we've essentially redone that plant inside. And it's a city within a city over there right now as they add that capacity and straighten out what it is they're doing, and we're ramping up those units almost every month.

So we have examples where we can do that and that's our intention, but I really think this is a Capex cycle like a business cycle that we're going to be stepping up to for awhile.

Thanks, Mark.

Thanks a lot.

Citigroup. Regarding the guidance, I'm just trying to think through the midpoint of your sales guidance and making some pretty reasonable if not conservative assumptions below the operating profit line.

Right.

It looks like you're implying, using your $5.90 midpoint for EPS, you're implying about 40 basis points of margin improvement. And given we just came off a year where sales were up, even if you back out the Progress Rail two quarters of benefits, sales up 6%.

Obviously a very tough year operationally, and you saw EBIT margins go down 110. When I think through next year, only 40 basis points of improvement baked in, obviously I can appreciate being conservative on the operational improvement story, but when it comes to the mix, obviously everything we're talking about, what is currently strong, historically has been a net positive for the margins.

And I'm just trying to think through, are we still capacity constrained or are efforts going on, thinking about '09-'10, can I no longer think of oil and gas and mining and so forth as outside the margins relative to the company average the way we used to? I'm just not figuring exactly why, coming off such a weak base of '07 margins, with that mix and that kind of revenue growth, why am I getting almost no leverage?

A couple of things, David. A couple of things.

One, if you look at about a point and a half of our sales growth next year, it's related to an average weaker dollar in '08 versus the average of 2007. So we've got about a point and a half of sales that are going to have slightly more of an impact on costs.

Kind of like this year, you know? We had about almost $1 billion impact on costs and only about a $900 million impact on sales, and that brought down the margin rate and that'll be negative for the rate again next year.

Your presumptions about oil and gas and mining being good for margin, absolutely true. Those are positive.

But what we also saw in a situation that we have is that we also have a geographic mix, and that geographic mix has been negative. Our margin rates generally speaking outside the U.S.

are lower than in North America. I shouldn't say the U.S.

And we had a mix shift from a geographic standpoint in 2007, and that's likely to continue a bit - although not quite as dramatic - into 2008. One thing that negatively impacted, I think, the '07 comparison a little more than what we have in the '08 comparison, too, is price realization versus cost.

I mean, it was a net negative in 2007, and it's a little more - that relationship's a little bit more neutral in our outlook for 2008. But, you know, it is a case, when you think about, you know, we're adding a percent and a half of sales with currency with no margin coming with it, actually not a huge volume change, we have positive mix on products, we have negative mix on geography, you know, it's a recipe for, I think, modest improvement in operating profit.

I've got to say here, David, you know, if - from a broader perspective, we've got a significant amount of our end markets in a very depressed state in the U.S. And we've had, you know, in the past a lot of discussions with investors and you all about diversifying our business into services, into geographies and elsewhere, that in the event we had a downturn in the U.S., we would report improved earnings.

And I would hazard to say with you, David, if you and I and others - maybe some of our own employees - sat down in 2002 or '03 and said that we'd see the truck engine market where it is, the housing market where it is, non-res where it is in the U.S. and $100 oil and we'd report record sales and earning in '07 and '08, nobody would have believed it.

But yet here we are.

Let me say, I appreciate that. But one thing I would take difference to what Mike just mentioned, your geographic mix in '08 is better than it was in '07.

In '07, North America, Machine and Engines, were down over 12%. Given your geographic guidance, your adverse geographic mix will be less in '08 than in '07.

Well, the amount of change year-over-year is, but we still have sales outside the U.S. up 8% to 13%, and we have sales inside North America flat to up 5%.

I totally appreciate that, but given the dramatic drawdowns you were having in some production in North America in '07, the same way, for example, dealer inventory reductions are less in '08 than '07 and that's a positive, I have to believe the hit operationally in '08 - I mean -

I agree with that.

If there's upside to the guidance, that's great. But, I mean, to give 40 BPS with that '08 top line would be a bit interesting.

And the one last thing, your stock right now is at a free cash flow yield at almost 9%. Unless I missed it, I know the Capex is going up $5 - $600 million or $700 million.

Have you given an operating cash flow guidance? I'm just trying to get a feel for what's the trading on '08 free cash flow.

No.

Do you wish to?

No.

I don't think we ever have, David.

Thank you very much.

Thanks, David. Next question.

It's Morgan Stanley, and good morning, everyone.

Hi, Rob.

I wanted to ask you about your pricing, which was obviously very solid in the quarter, and bifurcate it into international and North America. And effectively, was there anything in particular that allowed you to take more pricing internationally?

Is it just trying to normalize that geographic differential? Is it that costs have gone up for your competitors as well as you?

Or is it just the markets are hot? And then also in North America, obviously we understand why it's been weak.

It was better this quarter, and what was able to pop that up?

Yeah, in fact, this is a good, good point. I should have brought this up, I think, in the preamble.

You know, we had an improvement in price realization quarter-over-quarter, so if you look at third versus third and fourth versus fourth, it looked like something happened in the fourth quarter. And in fact, what happened was the fourth quarter of '06 deteriorated from the third quarter of '06.

If you're actually looking at absolute levels of price realization and you were comparing, you know, forget about the '06 comparison. If you just look at fourth quarter versus third quarter, price realization actually declined slightly in our fourth quarter because of geographic mix.

We had more outside. So I think the issue and what made this sort of fourth quarter price realization look so good was that fourth quarter of '06 really started seeing some deterioration, particularly in North America.

And your point about price realization being better outside the U.S. than inside the U.S., absolutely that's the case.

I mean, even in the fourth quarter where we had, let's say, easier comps in North America, outside North America was still quite a bit better. In fact, you know, for the full year, in North America we got less in dollars, in fact, from machines than we did in Europe, Africa, Middle East, and Asia Pacific, despite the fact that it's such a relatively speaking, a bigger market.

I'm sorry. That was very helpful.

Can I ask a follow up just on the materials side as it relates to pricing?

Sure.

You started the year in '07 looking for sort of flattish and you got 1 up to 1.5, so I don't know whether your raw materials - or your materials cost, rather - were getting worse towards the end of the year, and if that's the case, what gives you the confidence in the 1 to 1.5? Is that based on what you've already got locked in, or is it based on sort of trends in 4Q?

Yeah. I think if you look at, versus our expectations, where we came into 2007, we actually had commodity prices lower than they actually turned out to be, just that sort of one impact.

And, you know, we're looking for next year, just kind of based on what we've seen over the last few quarters, our discussions with suppliers, our prediction about commodity prices next year, it just looks to us like it's going to be more of the same. You know, as this year could be higher, if commodity prices go down more than we think, it could be lower.

But, you know, it's kind of based on what we know today, what we see coming through. That's what we expect.

Great.

In retrospect, we clearly misjudged '08 by predicting flat - or, I'm sorry, '07 - by predicting flat material cost increases for '07. And we realize that.

Obviously, we reported it all through the year. We've taken, I think, a little more conservative look at that for '08 and called it the 1 to 1.5.

Thanks very much.

Next question.

It's Robert W. Baird.

Morning, guys.

Good morning, Rob.

Clarification, following up again, on these manufacturing cost calculations, can you give us an idea of what you're looking for in terms of an increase in depreciation and amortization in '08, and can you give us an idea of what kind of percentage increase was represented by the $300 million material cost impact in '07?

I'm sorry. Just under 1.5%, Rob, the $300 million in '07.

Our purchasing base is somewhere between $20 and $21 billion.

Okay.

I'm sorry, what was the first part of that question again?

Depreciation in '08, how much of an increase?

Oh. Depreciation in '08, something up probably a bit more than $100 million.

Okay. And then I just wanted to check my understanding of this calculation.

With full-year manufacturing costs up $1.225 billion, materials costs up around 300, depreciation 150, the implication, then, would be that inefficiencies would be the remainder, 775.

There were higher warranty costs as well.

Okay. Is that the only other bucket that I need to adjust that number, and is this all currency neutral?

That's all currency neutral. We were taking currency out.

Actually, currency was almost $1 billion, but that's taken out.

Right, okay.

Yeah, if you adjust for warranty - which is a number we haven't actually disclosed - the rest would be a combination of for the most part inflation and efficiency.

Okay.

I mean, we did have higher labor costs per person.

Right. Okay, thank you.

Merrill Lynch. Just a question on the impact of Cat Production System.

I mean, I appreciated the fact that it will take some time to see the impact on the margin eventually, but as I looked at your cash flow for the quarter, which was pretty good, it seems like most of the improvement in the quarter was driven by changing payment terms rather than inventory reduction. And if I look at a company that is so focused on lean as you are and putting in the time and effort, I'm just surprised that it's been over a year and we're still not seeing the cash flow where I would expect to see it first.

Yeah, I think, Andrew, I think inventory performance this year has been a disappointment for us. We expected an improvement in turns during the year that we didn't get, although I will say in the fourth quarter we did pretty well, particularly near the end of the fourth quarter, inventory came down.

You know, with the Cat Production System, you know, consultants tell us the first thing you see is safety, then quality, and then you start seeing capacity, velocity and costs. And, you know, we actually have an expectation that inventory turns are going to improve.

We think we're doing the right things to drive that. Stability in terms of the point we talked about earlier in terms of, you know, NPI and product change should help.

You know, our expectation is that we're going to have an improvement in turns in inventory in 2008. But to your point, 2007 was a pretty flat year relatively speaking on turns, and we had hoped to do better.

Andrew, and as Mike said, most people who have been down this journey - this is Ed Rapp - have seen it come first in safety, then in quality, then in the velocity side. And we've seen some good movement in terms of safety and quality in '07, so that's what - you know, that combined with the fact that we do have some facilities that are well down this path - Solar, Cat Brazil and others - who are also seeing it on the velocity side.

So we're optimistic that it's going to come. We recognize the fact it hasn't come as fast as we earlier predicted, but it's out there.

Let me ask a follow up question. If I look at your volume metric alone, it is surprising how little volume benefits you get given your revenue growth number.

Even accounting for negative business mix between North America and the rest of the world, what is driving this very low operating leverage in this particular quarter, if I strip out pricing and if I strip out operating inefficiencies?

Andrew, I tell you, we can go through the math maybe offline.

Okay.

I did a quick calculation of - short of Q4 - Q4 Machinery and Engines operating pull through, and if I neutralize it for currency, I get about a 19% pull through. But maybe if we can talk later today we can go through the actual numbers, you know, what you're pulling out and which numbers you're picking up.

Okay. Thank you very much.

Hi. It's Barry Bannister at Stifel Nicolaus.

How are you?

Okay, Barry.

You mentioned in your press release that Western European - there was an 8% decline in housing permit. We know that Japan has been soft.

Has there been any spill over from the U.S. into the mature Western economies in terms of a slowdown?

And the second part of the question is: Any progress on the Shin CAT Mitsubishi, where the margins are much lower than ours and we're worried about the price being too high?

Okay, I'll start with the first. And I don't know if I would call it spill over, but certainly in Western Europe it looks like housing there is certainly off from its highs, and I think that's not a surprise to anybody.

Interestingly point about our EAME region, though, you know, if you look at the growth that we're expecting in EAME, more of the growth is in CIS, Africa, the Middle East, where there's big infrastructure spending and commodity related spending for mining and oil and gas. So really, I think, we do see a weaker picture for Western Europe than we do for the entire EAME region.

Another point that I'll just sort of bring up. In our release, you know, we talk about an overall growth rate for Europe, and sometimes people confuse that or think about that as Euro-land, but we also include Central Europe in our Europe numbers, so places that are outside of, you know, the Euro zone, and growth in Central Europe is a bit better, so that kind of brings the average up a little bit.

On SCM, it's progressing and we would like to be in a position here pretty soon to talk about it with you in more detail, and we're certainly trying very hard not to pay too much.

Okay. And then just a point of fact on the comment that was made earlier for Doug, if you include the expenditure for equipment leased to others of $1.34 billion in '07 and assume the same in '08, then your consolidated capital expenditures as a percentage of consolidated revenues would be about equal to the post-World War II average, so that does back up what you said about just reverting to a normal spend.

It is - you have to be a little careful with putting the Cat Financial number in there as well. Remember, they're still - that is essentially for their leasing business, and their volumes are growing faster than the rest of the company.

So we'd expect that and hope that and like that to go up.

Thanks.

Thanks, Barry.

Hi, good morning. Bear Stearns.

My question is around your 2010 goal. Mike, you noted that you could hit your revenue target of over $50 billion two years early, but in that context you'll be about $2 to $4 short of your earnings goal.

Should we expect an update on that earnings goal when we meet with Jim at CONEXPO?

Yeah. We'll have a - Jim's planning on a thorough download of the state of the business and update on 2010, and we'll address that.

There's no implication of any changes of that today, but that will be under his speech at that time, Ann.

And is it something you talk about internally in terms of, you know, you hit the revenue target but not the earnings target?

Well, we haven't hit the revenue target yet, nor have we hit the earnings target. And our goals are as we have said, and we're pretty excited about them so I know he's excited to give you an update at that time.

Okay, and then just a follow up on the gross margins going forward, if indeed your Capex spend is going to increase significantly over the next couple of years, depreciation will also increase. Why wouldn't we expect, then, that structurally your gross margins will be lower going forward?

Well, I think you have to look at that increase in relation to our volume growth. I mean, we're talking about, you know, an order or magnitude of about $100 million increase next year, and we do have higher sales.

Even though some of the capacity we're going to get from Cat Production System and [inaudible], so not all of the increase in volume is going to come from, you know, higher spending on capacity. So, I mean, there's so many factors that are involved, Ann - how we do on costs in the Cat Production System - but we did have I think below trend spending on Capex in the early part of this decade, and it's going to be a little more than that for a little while.

Did you have a follow up, Ann? I'm sorry.

Yeah, just a quick follow up. Doug, you noted earlier that your R&D spend as a percent of sales is still low, I think you said, initially.

But 4% of sales for R&D is - that's well above kind of pure average of 3% to 3.5%. What kind of normalized spend rate do you expect to have on R&D going forward?

Yeah, well just to clarify, that was on M&E only, not consolidated, just for everybody's benefit. That's how we tend to talk about that.

We don't include Cat Financial in that. But, you know, in the last few years we were at the low end of a long-term historical average and now we're pushing that up, frankly.

We've got lots of 2010 goals and beyond for sales around the world that frankly we don't have capacity in place for. And a classic example -- and I know Jim's going to talk about this at CONEXPO - is what we're doing in China and India.

You know, we were just woefully short of capacity to address that market, which today is a huge part of the potential for us in the next 10 or 15 years. So that alone will drive a significant piece, as will the modernization piece inside our existing factories as we catch up from what now is the aged machine tools in M&E from the POF days.

But normalized spend as a percent of sales, what do you think it's going to be going forward?

On R&D?

Yeah.

I mean, last year it was in the mid 3s. I think '08 we're looking at just under 4.

And, you know, I don't know. I'd say probably higher than 2007 at 3.3 - which was 3.3., I think.

We're not going to put 4 - 4 may be as high as it gets, but it may sustain itself in there.

I mean, just, you know, one thing on R&D, I'll make one editorializing comment, and that is, you know, these emissions regulations off highway are coming at a pretty regular rate, and that is an R&D cost driver. I mean, we just through a big Tier III, now we're going to a big Tier IV.

So they come pretty regularly and, you know, as opposed to the days when we  when there weren't those kind of regulations. It is a driver.

Yeah. I guess the thing I'd add, Mike, is on Tier IV - and one thing that you will see a bit different, we're going to pull some of that spend forward.

Spend a lot more time upfront in terms of developing common platforms that can be leveraged across multiple product lines so you'll probably get more of a level spend over the period as opposed to some of the peaks toward the end of emissions like we've had in the past.

Okay. That's very helpful.

I appreciate it. I'll get back in line.

Thanks.

Okay.

Yes, Wall Street Access. In view of the huge and ramping Capex, can you give us some more definition on that just by telling us what the two or three big projects were last year and what the two or three big projects are this year?

For example, is last year 3500 Lafayette? That kind of detail?

Well, that was a big piece in '07. It will be a big piece in '08 and a fairly equal piece in '09, in that example, for Lafayette.

Charlie, there's not any one or two, you know, jumbo items that do the whole thing. I mean, in Aurora, for example, they've been on about I think a two-year program to replace all their robotic welding capacity.

So it kind of depends upon the facility you go in. For this year, we've got greenfield sites in China coming up.

We've got an engine facility starting in China. We've got a component facility in China starting.

We're building a wheel loader facility in [Sujo]. So, you know, it's not any one or two big things, although to Doug's point, Lafayette, that was pretty heavy spending last year and this year.

But it's all over.

And my follow up final question, why did you bring up the question rhetorically about your position on the on-highway truck engines when you weren't going to say anything about it this time?

Who you talking to, Charlie? Me?

Either one.

Doug?

I'm not sure rhetorically what I said.

No, no, no, no. In your press release.

You said that -

Oh. Oh, oh, I see.

I'm sorry, Charlie. It's a - I think the reason we do that kind of in the Q&A there is that it's a big strategic issue that's facing us right now.

We need to come to a conclusion. We get asked about it all the time.

But, you know, it's sort of in process. It seems to be accelerating, but we're not quite to the point yet where we can talk about it.

Okay. Maybe at CONEXPO?

I would sure hope so.

Okay. Thank you.

Good morning - almost good afternoon, I guess.

Hi, Eli.

Just a couple - one clarification, and then could we go back to this core stuff. I mean, you had $932 million of price realization, which was about $300 million under the core manufacturing costs, and your 2% pricing and core manufacturing costs suggest that you're not catching up on those numbers.

Is there an intent there at all to catch up the cost-price squeeze that's going on within the corporation at this point?

Well, yeah. I think [inaudible] is always there.

It's marketability to make it happen. We were a little underwater in 2007.

You know, we had less price than we had cost. It looks like a little more bounce picture as we go forward to '08.

If we look at Q4, it was net positive in Q4. We had 392 at price, and I think about 293, if memory serves me, for cost.

So, you know, it looks to us like that situation will get a little bit better, but not a lot better in - it's still a pretty, pretty tough pricing environment out there. I mean, North America is weak.

Small machines in Europe are kind of tightening up, you know, with the housing down there. So it's kind of a different picture depending upon the region and the price, and we certainly push it as far as we think we can.

It looks like what you're saying to us is you're taking the benefit improvement from the Cat Production System and putting it back into R&D so you don't let it out.

Well, I guess that's one way you could say it. We expect benefits from Cat Production System, and we need to spend more in R&D.

I'm not quite sure it's one pocket out of another.

And a question - on truck emissions at back, have you at any point given any indication whether or not you're going to be using urea on big engines at all, or are you going to be able to avoid going to SCR reduction? Is there any decision on that?

Yeah. Eli, by big engines you mean the heavy duty on-highway?

Heavy duty on-highway and even make the same assumption for Tier IV A and IV B. It's the same issue.

Yeah. We have not talked about on-highway urea at this point in time, but we will shortly.

Thanks, Eli. We have time for one more question, and then we're going to wrap it up.

Hi. Good afternoon.

Ingalls & Snyder. I just made it in.

People have been dancing around this I think most of the day, but if you look at the incremental margins in the fourth quarter, they were down both - they were poor both year-over-year, 8% on the increase in sales year-over-year, and 6% on the increase in sales quarter-over-quarter. So the gross margin is what I'm talking about.

It was down 134 basis points year-over-year and 100 basis points quarter-over-quarter. So it wasn't that you came into the quarter with the lower margins.

You had something happen there and you've touched on it before, but can we get even more specific on what was different about the fourth quarter versus the third quarter and versus a year ago?

Yeah, very quickly. Fourth quarter versus third quarter, a couple of things.

Actually price realization was a little bit lower - just fourth versus third.

You mentioned that before, yes.

I'm looking sequential. Geographic mix was negative.

Product mix going from third to fourth was negative. Sales were up, but it was mostly new machines and engines; less of an after market component.

The after market piece is a lot more stable, so product mix third to fourth was a little worse. And costs, actually, in terms of absolute dollars, fourth quarter is kind of seasonally a high-cost quarter for us.

There tends to be a run up right at year end, followed by -

In cost of goods sold?

In all costs, factory period costs - not so much variable labor costs, but in the period side - SG&A, R&D, factory period costs.

Well, we got -

Generally a seasonally low quarter in Q1.

Those are all the factors?

Off the top of my head, Alex. If you call me later, I'll pull out what I have and maybe we can talk about it a little more.

Okay, now Rob McCarthy went over the breakdown of the $1.225 billion in costs for the year, and I think you said that in the efficiency part, which would be 775, there were some other things - warranty?

Yes. Well, I'm just saying in addition to efficiency, warranty costs were higher.

Okay.

And then when we say efficiency, I mean, we're looking at, you know, sort of factory period costs, machine repair, rearrangement, you know, kind of the whole bailiwick there.

Okay. Can we have that breakdown for the fourth quarter, which was 355 in total, the same breakdown - materials, efficiency and department?

Yeah. I think there were three main buckets.

I don't remember the exact numbers, but I think it's reasonably equally divided between depreciation, material costs and - I said it in the preamble; I can't remember what the third item was. Oh, yeah - efficiency, material costs, and depreciation.

Okay, equally divided. All right.

And finally -

Roughly, Alex, roughly.

In the third quarter, you had a table - sales and revenue outlook midpoint of range for 2006 and 2007. I didn't see that table in the fourth quarter report for 2008.

Yeah, we replaced it with a graphic that showed percent change ranges.

I saw the graphic, yeah. But we have to then calculate the numbers from that, is that -

Sorry, you have to use your calculator.

Okay. That was a very useful table, one of the most useful in the report.

Thank you very much, everybody.

Doug Oberhelman, I'd just like to conclude and wrap up here today. Again, coming back to a point I made earlier, this company has worked hard for really since the last trough in 2001 and 2002 to get to the point where we can announce record sales and record earnings in 2007 and 2008 with what has happened to us in the North America.

We're pretty proud of that, and in fact, we all know that there's improvements out there before us that can take it even further beyond what we've talked about a la our 2010 goals which Jim will update in Las Vegas. But I think it's remarkable.

It's a story we're telling our employees that just five years ago, who would have guessed where we are today in '07 and '08 with results like this and still knowing what's before us? So more to come, but we're just extremely pleased we can report to our shareholders record sales and record profits with the state of the economy in the United States.

Thank you very much.