Caterpillar: Big trucks, big sales, big attitude

(Fortune Magazine) -- Bugs. From the rim of the vast open pit, the trucks, bulldozers and road scrapers far below look like scuttling yellow insects. Descend the dirt ramps that spiral a third of a mile down to the floor of the pit, though, and those bugs are transformed into Caterpillars - as in the ubiquitous machines that are as much a feature of the mining landscape as muck.

Giant trucks are loaded by mechanical shovels that can scoop up 130,000 pounds of dirt and rock at a time. Three teeth-rattling dumps and the trucks are filled. Then these mechanized beasts of burden - now weighing more than a fully fueled and loaded Boeing 747 - rumble across the barren landscape to their next destination. This industrial ballet goes on every hour of every day here, as Cat machines carve out massive amounts of copper and zinc from the earth.

High up in the Peruvian Andes, monster trucks like this 793C operate around the clock.

CEO Jim Owens is driving big manufacturing changes - even as revenues break records.

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More than a mile in length, the Antamina mine sits 14,100 oxygen-deprived feet above sea level in the Peruvian Andes. With copper selling for about $3.60 a pound, five times as much as when the mine opened in 2001, Antamina is a cash machine - both for Australia-based BHP Billiton, which operates it, and for Caterpillar, the company based in Peoria, Ill., that does the heavy lifting.

Forty-nine of those yellow bugs are Caterpillar 793C and 793D trucks, 43-foot-high machines that are powered by a diesel engine with more oomph than a tank. Made in Decatur, Ill., each truck is shipped in pieces to Lima, hauled to the job site in nine tractor-trailers, and then assembled. Like sharks pursued by pilot fish, the big trucks are surrounded by a bevy of smaller Caterpillar equipment - wheel loaders to fill them, motor graders to keep the roads cleared, and bulldozers to clean up the spills. All told, BHP uses more than $200 million worth of Caterpillar machinery at Antamina - and will spend another $200 million servicing them over their working life.

There are lots of Antaminas in Caterpillar's portfolio, ranging from North America, which accounts for a little more than half its revenues, to the vast expanses of Russia, to mines deep Down Under in Australia, to holes in China's wild west, to excavations in the tip of Africa. The largest heavy-equipment manufacturer in the world - No. 2 Komatsu is less than half as big - Cat makes machines that excavate mines, clear forests and build highways and bridges, plus the engines that power them.

In the most recent quarter, weak construction activity in the U.S. sent profits down 21 percent. Even so, Cat has been on a great run over the past five years, revelling in a global moment - booming commodities, infrastructure-hungry markets and a weak dollar - precisely suited to its strengths. Double-digit growth overseas in both mining and construction equipment helped propel it to record exports ($10.5 billion), profits ($3.5 billion) and revenues ($41.5 billion) in 2006. Net profit margins have also improved, from 4 percent in 2002 to 8.5 percent in 2006.

And shareholders have joined in the fun. Shares are up more than 20 percent in the past six months, and the stock has outpaced the S&P by 100 percent over the past two years. Overwhelmed by business, Cat cannot keep up with demand, taking orders into 2009 and beyond. Yet the boom obscures something more fundamental - and potentially threatening.

Caterpillar (Charts, Fortune 500) prides itself on being the biggest, the best, the most ethical and even the coolest - the Cat cap has become an emblem of urban chic. Its factories, however, win few awards for efficiency and productivity. So Caterpillar is launching a major effort - its third since 1985 - to raise its manufacturing game.

If the effort fails, the risk is that Caterpillar goes down the same disheartening road as General Motors (Charts, Fortune 500) - becoming another iconic American company with a dominant presence that failed to step up in terms of manufacturing innovation and performance, allowing other competitors to chew into its markets.

Academics and consultants figure that Caterpillar's production system operates under the same philosophy used in Detroit in the 1970s - production is pushed by the availability of parts rather than pulled by the demands of customers - and we know how that story turned out.

Here's another unhappy parallel. Embittered by three major labor disputes in the past three decades, many of Caterpillar's employees are leery of buying into the new overhaul, much as autoworkers resisted changing work patterns at GM in the 1970s and '80s.

And just as in Detroit, which put off change because it made so much money for so long, instilling a sense of urgency is not easy. "Getting people to change is easier when you've got a burning platform," concedes chairman and CEO Jim Owens. "There's a fear factor."

Formed in 1925 from the merger of two California-based tractor companies, Caterpillar started with the product that remains its staple - a farm tractor equipped with treads that were later used on Army tanks.

At first the company grew slowly. When World War II ended, Caterpillar had two plants, one in East Peoria, Ill., the other in California. Starting in 1950, it added 15 plants in 15 years, including overseas in England and Brazil. By the end of the 1950s, Caterpillar was a truly international company, its distinctive yellow adding a flash of color to work sites all over the world.

Lulled by prosperity and lack of competition, Caterpillar became bureaucratic and stodgy. When sales reps in Australia wanted to offer a customer a discount, they had to fill out forms and justify the action with Peoria. Each division jealously guarded its price data; decisions took weeks. Rudimentary financial information, such as what countries or products were the most profitable, was closely guarded.

When an outside threat arrived in the form of Japan's Komatsu, Caterpillar nearly collapsed. Komatsu entered the U.S. market in 1967 but got serious in the early 1980s when, propelled by the cheap yen, it undercut Caterpillar's prices by 30 percent. Caterpillar had to slash its own prices in response.

In 1982, it took a 206-day strike to restructure its union contract. In 1983 and 1984 it lost a million dollars a day. The following year, recognizing that its production was inefficient, Cat launched a factory-modernization program called Plant With a Future (PWAF), spending $1.8 billion to combine just-in-time inventory with a network of computerized machine tools and a flexible manufacturing system.

As former CEO Roger Smith discovered at General Motors, automation alone is not a substitute for disciplined processes and workflows. But along with expanded product lines and the strengthening of its independent dealers, who represent Caterpillar to its customers, PWAF was enough for Caterpillar to keep its hold on the U.S. market.

The improving global economy of the late 1980s lifted Caterpillar out of the red, and the company shifted gears. In 1990, Peoria loosened its grip, decentralizing power and distributing it among 17 business units organized by product line. The idea was to speed up response time and provide more accountability. Instead, Caterpillar got anarchy, as every factory went its own way.

Decentralization coincided with another business downturn. Caterpillar lost $404 million in 1991 and $218 million in 1992. Relations with the unionized workforce worsened as Caterpillar tried to change its pay structure. A United Auto Workers official described the battles with the company during this period as the "single most contentious in the history of the union." Caterpillar was hit by a five-month strike beginning in 1991 and then a 17-month walkout that started in 1994. To keep the factories running, it used replacement workers. The bitterness of that era persists to this day.

"This is a company that has been willing to bet the farm," says Caterpillar manufacturing expert Jim Waters. In 2001, Caterpillar adopted Six Sigma in an effort to boost profits by improving quality. Owens, then head of a turbine-engine subsidiary, was an enthusiastic backer; today he boasts that the company has trained 5,200 certified instructors in the discipline.

But while Six Sigma helped Cat to fix problems and improve individual processes, it wasn't much good at devising breakthrough strategies or developing new products. Management decided it was time for another big bet.

Two of them, in fact. In 2004, Caterpillar put its strategic planning committee to work to create Vision 2020, a set of specific goals for improvements in products, operations, and growth. From that came a fresh look at manufacturing.

Conclusion: Even after two major overhauls, Caterpillar was treading water. New products were slow to get out of the factory because production ramped up haltingly; shipment delays and inventory bulges tied up billions of dollars. During peak production, glitches were common.

Based on its research, Caterpillar decided in 2005 to try to reintegrate the company's manufacturing - in effect, going back to the pre-1990 model - instead of having each of its nearly 300 facilities operating under its own rules. Waters led a team that spent several months benchmarking companies ranging from Boeing (Charts, Fortune 500) and General Electric (Charts, Fortune 500) to Sara Lee (Charts, Fortune 500) and Pella Window.

What suited Cat best, Waters decided, were the principles of lean manufacturing exemplified by (surprise, surprise) Toyota (Charts) - things like eliminating waste and running at a steady rate. Then managers participated in continual improvement workshops to put the principles to work. The new Caterpillar Production System - even the name is a nod to Toyota - is designed to deliver higher efficiency and better quality, allowing Caterpillar more room to maneuver when the business cycle turns against it.

Revamping production as factories are running full out is akin to overhauling the engines of an airplane while it is still in the air. If Caterpillar gets it right, it believes it could become the heavy-equipment industry's version of Toyota.

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