康明斯 (CMI) 2002 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Cummins third quarter 2002 earnings release conference call. At this time, all participants have been placed in a listen only mode, and we will open the floor for your questions and comments following the presentation. It is now my pleasure to turn the floor over to your host, Karen Battin.

Welcome, everyone, to our teleconference today to discuss Cummins results for the third quarter of 2002. Each of you should have received a copy of our press release with the copy of the financial statements. If you've not received these copies, please let us know, and we will fax them or e-mail them to you at the end of the teleconference.

Participating with me today are our Chairman, Tim Solso, our Chief Financial Officer, Thomas Linebarger, our Corporate Controller, Sue Carter, and our Executive Vice President and President of the Engine Business, Joe Loughrey. We will all be available for your questions at the end of the teleconference. This morning, I'll take you through a summary of Q3 results and then Tim has a few remarks about the business, and finally, we'll have a question and answer period.

This teleconference will include certain forward-looking information. We will talk about power generation markets, the outlook for the North American heavy-duty truck market, and other end use markets for our products. We will talk about the prospects for our business in Asia, Europe, Latin America, and other regions.

We will discuss product costs, product coverage or warranty cost, and profitability improvement initiatives. Any forward-looking statement about these and any other topics involves risk and uncertainty. The company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about forward-looking statements begins on page 20 of our 2001 Form 10-K, and it applies to this teleconference.

Let me begin by summarizing Cummins third quarter results. In the third quarter of 2002, Cummins recorded sales of $1,648,000,000, 17% higher of sales than $1,408,000,000 in the third quarter of 2001, reflecting increased sales in the North American heavy-duty truck market and our Dodge Ram business. This was Cummins' highest sales quarter since the second quarter of 2000.

Earnings before entrants of taxes for the quarter was $78 million, compared to $30 million in Q3, 2001.

Net earnings in the third quarter were $39 million, or $1 per share, compared to $3 million or 8 cents per share in the third quarter of 2001. I will discuss each of our four business segments. First, I will begin with the engine business.

Total sales for the engine business in the third quarter were $1,033,000,000, a 35% increase over sales of $767 million a year ago. Revenues in automotive markets which, as a whole, were up 54% year over year, reflect increases across many segments. Overall, revenue from industrial markets was down 7% year over year, with decreases in mining, marine and rail sales, partially offset by improved sales in agricultural markets. Operating income for the quarter was $50 million versus a loss of $18 million in the third quarter of last year. This improvement in profitability was attributable to the increased volume with better fixed cost absorption at our heavy-duty plants and our continued focus on cost reduction. Product coverage costs as a percentage of engine business sales remained essentially flat despite the higher percentage of heavy-duty truck sales in the quarter. This is the result of improved product quality in most of our products.

Turning first to the heavy-duty truck business, revenues for the heavy-duty segment as a whole were up 70% in the third quarter from a year ago, while unit shipments globally were up 114%. Unit shipments in North America were up 139%, reflecting increased OEM sales in advance of the October emissions standard. Our unit shipments to the rest of the world were up 11%. The increase in international shipments was due to higher sales in Mexico, partially offset by a drop in sales to European OEMs. In the worldwide medium-duty truck and bus market, total revenues increased 41% for the third quarter year over year. Medium-duty truck engine shipments were up 43% in North America, primarily due to the new emissions standard. International shipments were up 8%, with higher OEM sales in Latin America and China. Global bus engine shipments were up 25%, with a 138% increase in North America due to the change in emissions standards and a 56% decrease internationally, primarily in China.

In the light-duty automotive and RV business, revenue was up 43% this quarter, compared to a year ago. Engine shipments to DaimlerChrysler for the Dodge Ram pickup truck were up 4600 units, an increase of 21% from third quarter last year, resulting from the launch of Chrysler's new model pickup. Unit shipments for RV engines increased 103% year over year, from very weak levels, reflecting continued strength in consumer markets, growth in the diesel powered segment of this market, as well as Cummins increased share with OEMs. The new emission standards also increased demand in the third quarter. Sales to industrial engine markets in total were down 7% from a year earlier. In the construction equipment market, worldwide sales were flat, compared to third quarter 2001. Unit shipments of engines in North America were down 7%, reflecting the continued weakness of construction equipment markets. Shipments to international markets increased 9%, compared to the third quarter of 2001, due to higher sales to China, Europe and Australia, more than offsetting sales declines in Korea. Sales for the agricultural equipment market increased 25% from last year, off a very low base, with increases in North America and Latin America. Revenues for marine markets decreased 14%, compared to third quarter last year, while unit shipments were down 25%. The decline was due to the formation of the Cummins MerCruiser joint venture. All marine sales of mid engines are now recorded on the joint venture's book. The revenue decline was less than the unit decrease, with a mixed shift to more high horsepower engines that have higher per unit prices.

Revenue in the mining segment decreased 15% year over year, reflecting continued weak demand, resulting from lower commodity prices.

Turning to power gen, sales in the power generation business for the third quarter were $315 million, down 15% from the third quarter of 2001. In North America, revenues also were down 15% compared to a year ago, with continued weak demand in our commercial gen set business. This decrease was partially offset by increased demand in our consumer business, primarily recreational vehicle sales. Consumer business revenues increased 27% compared to the third quarter of 2001. Outside North America, revenues decreased across all markets except Australia and southeast Asia, compared to the third quarter of last year, due to lower demand.

In the third quarter of 2002, power generation had an operating loss of $1 million, compared to an operating profit of $29 million last year. There were several factors that led to this variance. First, power generation had several large power projects in the third quarter of 2001 that were not repeated in 2002.

Second, the substantial volume decline in North America and Europe impacted our margins and resulted in underabsorption of fixed overhead costs, especially in our high horsepower plants. Third, excess inventory in the marketplace continues to create pricing pressure, forcing heavier discounting to retain market share. Fourth, we had a mix impact with fewer sales of high horsepower gen states and G drives, which typically have higher margins. Lastly, utilization in our rental fleet is lower than last year due to overall weaker demand, reducing profitability in our rental business. At this point we do not expect recovery in power generation markets until at least mid-2003, especially in North America and Europe. Revenues for the filtration and other segments were $236 million for the quarter, a 12% increase compared to the quarter of 2001. Filtration business revenue was up in North American with both some demand improvement and increase market penetration. Revenues at the Holset Turbocharger business also increased from a year ago with continued strong business in China.

This segment's operating earnings for the quarter were $19 million, versus $11 million last year. This improvement is due to the volume increase, discontinuance of goodwill amortization and cost reduction benefits from restructuring and six sigma initiatives. In addition, the company funded incremental expenses for the segment's new admissions solutions business.

Sales for the international distributor business were $152 million in the quarter, an increase of 12% compared to sales of $136 million last year, with improvement across most regions and significant increases in Australia. Operating earnings for the segment were $10 million this quarter, compared to $8 million in the prior year's quarter. This increase was primarily driven by the higher volume, particularly in parts sales.

Returning to the corporate level, I would like to review our total sales by region. In the third quarter, our sales mix was 61% U.S. and 39% international, compared to 53% U.S. and 47% international in the third quarter of last year. This change is primarily attribute to increased automotive U.S. markets.

For the third quarter, compared to a year ago, sales in the U.S. increased 35%, while international sales in total decreased 3% the international sales variances were mixed, with decreased sales in Latin America and Europe, and revenue increases in Canada, Australia, and Asia. Sales to Latin America were down, due to less power generation demand, following the energy crisis there and the generally weak economy.

European sales declined across the majority of our market. Sales to Canada were up due to higher shipments to automotive OEMs. Australia's sales were higher year over year, with increases in engine, power generation, and international distributor sales. Business in Asia was up across most regions, except for Korea, where construction sales were down.

Revenues in China increased with higher sales in construction, medium-duty truck, and power generation markets, more than offsetting declines in bus sales.

Next, I'd like to discuss corporate gross margin. The gross margin percentage for the quarter was 18.8%, compared to 18.1% in the third quarter last year. Product coverage costs was 3.6% of sales, or $59 million, compared to 3.2% of sales, or $45 million a year ago. This increase resulted from a higher concentration of heavy-duty engine shipments in the quarter.

Excluding warranty costs, gross margin for the quarter was 22.4% versus 21.3% in the third quarter last year. In dollar terms, gross margin was $369 million, up from $300 million a year ago, a difference of $69 million. The higher sales volume accounted for roughly two-thirds of this increase with the remainder of the improvement coming primarily from our cost reduction effort.

Total SAR spending in the quarter increased $15 million. The entire $15 million increase was in selling and administrative expenses, where we had some volume variable expenditures, funding of focused growth initiatives and higher variable compensation accruals due to our improved profitability.

Research and engineering expenses remain flat compared to last year, and are expected to decline going forward, as we have now completed the development work on our new emissions compliant engines.

Our income from joint ventures and alliances in the third quarter was $9 million, compared to $2 million in the third quarter last year. This increase was primarily attributable to our North American distributor joint ventures, and improved earnings across several of our China joint ventures. Other income in the quarter was $4 million, compared to income of $3 million a year ago. This change was primarily related to the discontinuance of goodwill amortization.

Interest expense for the quarter was $15 million, which was flat compared to the third quarter last year. Net earnings for the quarter were $39 million, or $1 per share on 45 million average shares for EPS purposes. This compared to earnings of $3 million or 8 cents per share a year ago on $38.5 million average shares. The increased average shares used in the diluted earnings per share calculation this quarter reflect the assumed conversion of our convertible preferred securities. The conversion feature of those securities becomes dilutive at around $25 million of quarterly net income.

The assumed conversion had a 3-cent per share delusion to our earnings for the quarter.

Let's turn to cash flow. Free cash flow from an operations perspective for the quarter was an in-flow of $82 million, compared to an out-flow of $65 million a year ago. Our statement of cash flows that you should have received indicates the cash outflow on a year-to-date basis of $2 million from operating and investing activities. This includes a $10 million in-flow for the third quarter of 2002.

To arrive at the $82 million free cash in-flow for Q3, we remove the effects of items we consider to be financing activities for free cash flow purposes. First, is a $70 million out-flow from receivables as we decreased the funding under our receivables securitization program, and a $2 million net out-flow related to the acquisition and disposition of business activities.

The biggest driver of the cash in-flow was the level of earnings, adjusted for depreciation and amortization, providing $95 million for the quarter. Receivables, excluding the securitization program, used $83 million of cash for the quarter due to the high level of September sales, but was partially offset by a $28 million decrease in inventories and an increase in accounts payable.

Inventory turns increased to around 7.5 turns for the quarter and the sales and receivables were the lowest since last year-end.

Capital expenditures were $20 million for the quarter, and $54 million year-to-date, compared to $158 million last year-to-date, as we continue to aggressively manage capital spending.

We now expect capital spending for the full year 2002 to be only a little over $100 million. We had an in-flow of $12 million for the quarter from fixed asset dispositions, including the sale of the facility in Charlestown. Investments in and advances to joint ventures and alliances for the third quarter of 2002 represented an in-flow of $12 million due to working capital reductions at several of our joint ventures.

Before I turn it over to Tim, I would like to take a few minutes and review with you some data related to our pension plans. While we have not completed our pension valuation work for this year, I can provide you with estimates that will help you assess the impact of pensions on our financial performance.

First, we are revising our asset return assumption downward from the 10% assumption we used last year for the U.S. plans to 8.5% for 2002, and from 8.5% for U.K. plans used in 2001 to 8% for this year. This will decrease earnings by roughly $30 million pre-tax next year. Historically we have realized better returns than this, but we feel it is prudent to take a more conservative approach at this point, given the market performance during the past three years.

Next, in terms of understanding the impact of pensions on your balance sheet, accounting rules require companies to record a charge to equity in their financial statements to reflect any underfunded status of their pension plans. Cummins recorded a net of tax adjustment to equity last year of around $135 million.

Due to the decline in the stock market this year, coupled with the decline in interest rate, our underfunded status has increased, and we will need to record an additional charge to equity this year of approximately $300 million. This charge reflects only a snapshot view of our pension plan funding status and it's charges adjusted in subsequent years as the funded status changes. Lastly, I would like to discuss our pension funding. First of all Cummins has been funding above required levels and above expense levels for the past couple of years. We developed a funding strategy that would increase the funding status of our plans on a more smooth basis that funding on minimum required levels. We had already planned on funding around $75 million for 2002, which we still intend to do, and we intended to fund at this level for the next several years as well. The stock market performance during the last year will now cause us to increase the level of funding going forward by around $30 million per year.

We previously provided free cash flow guidance for 2002 to be in the range of $60 million to $80 million. This is including the $75 million of pension funding I just reviewed. We now expect to generate around $100 million of cash in 2002. This increase in cash flow guidance is primarily due to the lower level of capital spending. Thank you.

Now I'll turn it over to Tim.

Good morning. As Karen reviewed with you, third quarter was a good quarter for us, delivering earnings at the top end of our previous guidance. Revenues for the quarter were the highest since the second quarter of 2000. The majority of our end markets are still at very weak levels, with increased demand primarily limited to the North American heavy-duty truck market and our Chrysler business. Yet, we delivered $1 a share for the quarter.

We are continuing to meet our commitments. We have made much progress with our cost reduction work, as demonstrated by our operating performance. The engine business reported earnings before interest and tax margins of 4.8% for the quarter, their best quarterly performance since the second quarter of 1999.

The filtration business is making steady improvement, delivering EBIT margins above 8% for the quarter, and the international distributor business provided solid earnings with EBIT margins of 6.6%.

A number of our businesses, however, continue to face very tough market conditions. High horsepower markets, where we have strong share, are very depressed, with mining sales down 15% for the quarter. Power generation markets are weak, with no near-term sign of improvement. There's still excess inventory in the marketplace, and nonresidential construction spending, a primary economic driver in the commercial gen set business, is not expected to rebound in the near future. Construction markets, our largest industrial segment, also remain depressed, down 30% from their peak.

The fourth quarter of 2002 will undoubtedly be a tougher quarter. Order rates for heavy-duty truck engines will be off significantly. Power generation demand and pricing will continue to be depressed.

We do, however, have some positive segments of our business to help mitigate these declines. The filtration business is performing well. The international distributor business is providing strong, stable earnings. Our aftermarket and remanufacturing businesses continue to deliver consistent earnings at good margins, and Chrysler's launched their new Dodge Ram pickup, and volumes for their trucks are improving and should continue to do so.

In addition, we have taken actions to reduce cost in the power generation and engine businesses, and we will take further actions in the fourth quarter. In power generation, we reduced headcount in our Minnesota plant by nearly 400 people, or 20% of their workforce, outsourced additional component work, which will reduce headcount by another 220 people. Reduced headcount at our alternator plant in the U.K. by 260 people or 25% of their workforce. Additionally, reductions on nearly another 100 are taking place this quarter, reduced headcount in our U.K. gen set manufacturing plant by 15%. We deployed one-third of our technical people to work on improving operating and reducing costs of our base business products and started moving production to lower cost manufacturing locations, including India, Mexico, Brazil, Romania and China.

In the engine business, we continue to make progress on cost reduction. We recently announced the consolidation of our heavy-duty assembly and test operations into one facility at our plant in Jamestown, New York. This consolidation is expected to be complete by the end of the first quarter, 2003, and will provide savings of $15 million in 2003, and $20 million annually thereafter. This is just one of the many actions we are taking in our continued commitment to restructure the heavy-duty engine business.

Unfortunately, due to the continued weakness in power generation markets, we are lowering our guidance for the full year of 2002 to around 40 to 50 cents per share. This will mean that in the fourth quarter, we expect to report a loss in the range of 5 to 15 cents per share.

These continue to be the worst market conditions that I've seen in my 30 years with the company. These are very tough times. We have responded aggressively to improved performance, and we've used this downturn as an opportunity to position Cummins well for the market upturn.

We will deliver a profit in 2002. We will generate sufficient cash, while maintaining our dividend, and that will allow us to pay down some debt. We were the only engine manufacturer to receive unconditional certificates on all three of the engines we submitted to the EPA. Our filtration business returned to the high single digit margins in 2002. They reduced headcount by over 800 people since the market peaked.

They closed five facilities and consolidated office locations. They achieved significant savings through direct and indirect cost reductions, and they outsourced warehousing operations, all of which substantially lowered their cost structure.

We launched the international distributor business, and have many improvement initiatives under way, and we've completed 526, 6 sigma projects so far this year, providing over $100 million in savings. As we look forward into 2003, it is clear we will have another challenging year. There continues to be uncertainty about the timing of a broad economic recovery. We do expect recovery in a number of our markets in 2003, but growth is likely to be modest.

For example, Chrysler demand is expected to improve with the new model pickup. Early press is very positive on both the truck and the engine. Filtrations margin should continue to progress towards our target of 11 to 13%.

We expect slow improvement in mining markets, with coal prices having bottomed, orders are improving. The oil sands of Canada offer the best prospect of growth in mining equipment demand.

In the North American heavy-duty truck market, we feel the near term recovery is basically inevitable. Full year 2002 Class 8 truck sales will be around 150,000 units. While up from 2001, it is still a very low level of demand for this market. Several factors make me believe that the market is poised for significant recovery. Interest rates are very low right now. Used truck inventory is down. There are essentially no used trucks available with 100,000 miles or less.

Inventory of new trucks is at a low level, around two months of demand. When retail demand picks up, dealers will order new trucks. In 1997 and 1998, a total of 480,000 trucks were sold. By 2003, those trucks will be five to six years old. They will need to be replaced.

Current fleets are 83% utilized. Freight demand is improving, with an expected 2 to 3% increase in freight demand, the fleet utilization will reach 89%. The fleets will order. In addition, drivers will move to those fleets with the most modern equipment. Average Class 8 build, truck build over the last five years is over 240,000 units. We are well below historical demand.

Finally, as our products demonstrate performance and reliability, the reluctance to invest will be reduced. As a result, the fourth quarter heavy-duty engine build rate will be lower than the first quarter build rate this year, which was the lowest quarter in at least 25 years. The first quarter 2003 build rate is forecasted to be higher than Q1, 2002. The industry forecast for 2003 is 160,000 trucks, which is still low, but higher than the 150,000 trucks this year. We have lowered our heavy-duty engine business break even by 40%, and expect to lower it an additional 25% by next year. Our new business model for this business is working and positions us well for the future. There has been a tremendous amount of misinformation regarding our new emission compliant engines. Some of our competitors, as well as the trucking industry, have been trying to get a delay in the standards. They have created a greater crisis than actually existed. Our new products have extensive testing, as much or more so as in past new product introductions. We are confident in the performance of our products, and believe we have the right products for our customers. We expect our warranty expense as a percent of sales for the year to remain constant with last year's percentage, despite the introduction of new emission compliant products.

Power generation markets are very weak levels, but we feel they are not worsening. We do not expect significant recovery in these markets until at least mid-2003, and maybe not for all of 2003, especially in the United States and Europe. In order to improve our performance, we are aggressively going after cost reduction opportunities, as we have done with our other businesses. We expect to see similar results.

As I reviewed with you earlier in 2002, we will have reduced our power generation headcount by over 800 people, and when our outsourcing work is complete, the headcount reductions will total 1100 from the same time markets began to fall off.

At the same time, we made focused investments in growth businesses, including natural gas power gen sets and the long-term gen set rental business, which will provide incremental revenue business next year. These markets presently account for less than 10% of the total power generation sales, but their growth will help in 2003.

We also expect to see growth in China, India and South Asia, where we have leadership in market share. The longer term prospects for this business remain very good. The need for reliable and cost effective power will continue to drive distributed generation demand. With the growing strength of our distribution network and our leading product line-up, and integration capability, we expect to gain business in the marketplace.

These, combined with our cost reduction actions, should allow us to improve power generation performance in 2003 and beyond. In 2003, we expect top line growth of 5 to 10% above 2002 levels this. This assumes modest economic recovery in the second half of the year.

Our earnings expectations for 2003 is the range of $2.10 to $2.30 per share. Cash flow for the year is expected to be in the range of $70 million to $80 million. Capital expenditures are expected to be around $135 million. As we continue to tightly manage our capital investment. Working capital is projected to use cash in the range of $30 million to $40 million, due to the forecasted revenue increase.

Now, a couple of comments on the company's liquidity position. At the end of the third quarter, we had over $700 million of available and unused liquidity. We have a revolving credit facility and $125 million in bonds maturing in the first quarter of next year. We are in the final stages of completing a three-year revolving credit facility to replace the current one.

We expect to close on the transaction by the end of the month, with our new revolver in place, existing credit facilities, and strong cash flow in the fourth quarter, we will have more than adequate liquidity to retire the maturing bonds and meet the financing needs of the company.

In addition, we are also considering other financing options to further enhance the company's liquidity position. Next, I want to address the dividend policy.

Last week, we announced the declaration of quarterly dividend to be paid in December of this year. While the dividend is reviewed and must be declared by our board of directors on a quarterly basis, it is our philosophy that our dividend provides a valuable element of return to our shareholders. Especially in this market environment, we believe it is important to maintain our current rate of dividend. As I just reviewed with you, we are generating cash sufficient to pay our dividend, and we intend to continue to do so.

Thirdly, Karen reviewed with you information regarding our pension plan funding. While this is an issue affecting a large number of companies, given the current stock market, we feel many people are applying a short-term view to very long-term liabilities. Prior to this year, Cummins had adopted a strategy to provide additional funding into our pension plans over a several year period.

The stock market performance in 2002 will increase that level of funding by $30 million next year. While this is not an insignificant amount of money, it is very manageable for the company. We are also taking a more conservative view of asset performance going forward by reducing our return assumption in the U.S. from 10 to 8.5%. While this reduces our earnings next year, we feel it is a prudent thing to do in this market environment.

Lastly, our board meeting last week, the board and its committees conducted a comprehensive review of how the company's corporate governance practices were aligned with requirements of the Sarbanes-Oxley Act and the New York Stock Exchange listing standards recommendations. That activity also provided us with an opportunity to review and update our internal code of conduct and all of our internal policies related to ethical and legal compliance.

As a result of that assessment, the company adopted a set of corporate governance principles, including director selection guidelines and standards for independence applicable to our full board audit committee, compensation committee and nominating and organization committee, which we now call our governance and nominating committee. We will be publishing these principles, along with conforming charters for the committees on our company web site by the end of this month.

The company has also adopted a more robust internal management representation process to assist Tom and me in our certification of annual and quarterly financial reports. The new policy establishes a disclosure review committee, chaired by our corporate controller, and requires each of our business unit heads to conduct a representation and certification process within their own businesses.

Finally, we've decided to begin expensing our grants of employee stock options on a prospective basis beginning next year.

We'll be glad to take your questions, and I remind you, we've invited Joe Loughrey this time, because I'm sure there are questions about the heavy-duty truck market, and he's prepared to answer those.

Thank you. Ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press the numbers one, followed by four on your touch tone phone at this time. Pressing one-four a second time will remove yourself from the queue should your question be answered.

While posing the question, please pick up your hand set for optimum sound quality. Please hold while we pool for questions. First question, David Raso. Please state your affiliation and then pose your question.

Salomon Smith Barney, good morning. The question is on cash flow. Bear with me, I'm trying to understand the full year free cash flow guidance. Did I hear correctly it's now expected to be $100 million?

Correct.

So far, year to date, we're at negative 22?

Positive 22.

I'm trying to understand, the 80 million pop in the fourth quarter, given we're going to have a negative net income number, I'm just trying to understand, is there that much coming out of working cap., basically shutting down production and collecting receivables during that quarter, getting that high?

That's most of it and a typical pattern for the company. That's not new for this year. That's really typical. We generate a lot of cash and working capital in the fourth quarter, and as we mentioned our capital spending levels remain below plan as the other part.

Now does that include any cash contribution because that is going up in the operating cash flow numbers, the accrued and the accounts payable, accrued expenses line item, that's where the cash contributions go on the pension.

Yes, they do go to that line item. There will be no more funding to the pension plans in the forth quarter of any significant amount. There may be a little bit in the UK, but I'm not even aware of that.

The expectations in the first half of next year, I understand you're kind of battening down the hatches right now trying to get the cash flow stronger and try to sway some of the concerns on liquidity around the company. I'm just trying to understand where the first half is shaping up. Obviously the truck will be weak to start the year, power gens weak to start the year, payables are stretched out, it's over 40 days already, like last year, I think it was like 33 days in the third quarter.

CAPEX has already been cut to the bone. We're running about a third of D and A. Full year is probably half of D and A. What's the thought on cash flow on the first half of next year? I understand the revolver, the refinancing you're doing is very helpful, but what is built into the first half cash flow assumptions and where's the cash coming from?

The cash flow, I mean, it's not a new prospect for Cummins. We are definitely squeezes cash flow aggressively. We're managing working capital tightly and really have been for the last two years, and that will continue next year. The seasonal pattern for Cummins is we use working capital in the first quarter and generate a lot in the fourth quarter. The second and third, there's not as clear a pattern. Generally we generate some some quarters and use some some quarters. So we expect that general pattern to continue next year. We expect we'll use some cash in the first, and probably generate some in the second with regard to working capital, but the overall trend is the same. We are keeping capital under wraps. We are managing inventory, receivables and payables aggressively to make sure we generate as much cash as we can, and we'll continue to manage profits aggressively to make profits a contributor to cash.

The pension contribution, is that something you have to make in the early part of the year or is that at your discretion to pay it out in the second half of the year?

At our discretion.

The last question, I apologize. On heavy-duty trucks, you mentioned the break-even point's been reduced. If we have a flat industry build rate next year, which, given the first part of the year, start off weak, second half does picks up, I know it's not a smooth line. I know it's not an easy question to answer, but a flat build rate next year, what's the projection on the margins year over year, given the cost savings you've discussed?

David, we're really not counting on a large pick up in heavy-duty trucks for this next year. So our guidance really has, you know, close to flat markets built into it.

Okay, I'm trying to understand, obviously, if you throw in the pension on the EPS - also, what's the option hit next year? As far as the expense and the option?

The option is not expected to be significant next year. We haven't given - because we haven't finished our work on exactly what assumptions we're going to use. We've agreed we're going to expense, and we haven't done all of the - we have not agreed on all of the assumptions, but under all the assumption possibilities, it would not be a significant increase, not a significant hit to earnings.

So all I was trying to back into, if the top line is, you mentioned 5 to 10% total company, but it sounds like you're not expecting a lot from heavy. Clearly, heavy or engines in total, I should say, but heavy in particular, I assume there's a pretty material margin improvement you expect off similar heavy volumes next year.

Our margins will improve in heavy-duty. As I said, we have lowered the break-even point by 40% already, and with the existing plans in place, it will be another 25%. So on a flat market, a very modest market, without increase in market shares, we should be profitable. I think the number that's impressive is that last year, the engine business lost $91 million, and this year, on a very similar deal, we'll make money, and that's really the story. I think I should give the phone open to some other people.

Sure, thank you very much.

Thanks, David.

Thank you, our next question is coming from Joanna Shatney. Please state your affiliation and then pose your question.

Goldman Sachs. Good morning. Joe, can you talk about what the experience with fuel economy's been like on the new engine and how reliability's been, and also what your expectation is for heavy-duty warranty over the next couple of quarters?

Okay, Joanna, I think from a heavy-duty engine point of view, let me sort of just try and frame a little bit how we're feeling about things right now. I mean, we look at the third quarter. We think very pleased with the third quarter from an engine business point of view. In terms of showing the earning power of the engine business as markets eventually return and reinforcement of all the work we're doing inside to drive costs down. Specifically, as it relates to the heavy-duty business, I think it also demonstrates the potential earning power of the heavy-duty business.

How is the performance on the engine? You have these out in test, now they're actually readily available in the market. How is the fuel economy doing? How is reliability?

Right now, the introduction - bottom line, while it's a little early to tell, drivers love the performance. We are not having reliability programs. Our uptime guarantee program is going over very well with end users, and as a demonstration of our confidence in the program, and fuel economy, right now, is kind of early to tell, but people are feeling reasonably good about fuel economy they are getting on the new engines compared to the old, and it will be a little while before we actually see the results, but we are very confident that our product is very competitive, the new ISXO2 will be very competitive to the old product that's been running in the marketplace up to October 1st.

You're comfortable saying the warranty expense for heavy is not going to go higher than it is today?

Joanna, we don't really talk about - we don't give specific numbers about warranty broken down by segments of the business. What we are clear in saying is that we are not expecting overall warranty expense for the company as a percent of sales to really increase. We've got improvement on other products. We're going to apply higher warranty accruals for the new products, as we always do at product introduction, and that we don't expect an increase.

Joanna, it's important to understand here that the team that led this effort, very experienced team that led the reliability work for this engine, feel as though they beat their target by more than a little at introduction, and we are - based on the work, the testing we have done, 140,000 test hours, 6.4 million miles, based on the experience of the fleets that have worked with us since 1999, we are confident that our reliability of our product will meet customer expectations, and at the end of the day, people will find that our product, the 'O2 product that meets the '02 standard will be the best product on the market, bar none.

Now, the other - the activity right now for us is significant. We are beginning to see signs that the story we've been consistently telling for years is sticking. We have over 100 end users who have actually placed orders for shipments of the ISX02 and ISM engines in the fourth quarter and the first quarter, names you'll recognize like Penske leasing, Schneider, people like Night, Tyson Foods, I mean you can make a long list of folks who have placed orders for engines; used U.S. express, WalMart, etc. that have placed orders for our product. Quoting activity is significantly greater than it was a year ago. People who haven't bought engines from us in quite a while are in hear, wanting to talk to us and get clearer about what we have and how we're doing. Given so far, I think things are boring out pretty well versus the story we're been telling over the past couple years. So right now, while it's a little early to tell, we feel good go where we are from a cost point of view, and where we are from a product point of view, and that things are, lots of indications that things are strongly falling in place, consistent with the strategy we've adopted, to enable us to be profitable in the heavy-duty engine business, even with low share and not so good markets.

Let me ask one more question and then let someone else go. Can you talk about, if you assume the 160,000 units for next year, what's your share assumption for Cummins and, Tom, can you talk about the revolver, what we should be looking for in terms of size and what types of covenants we should have?

The share assumption is flat. Would you re-ask the revolver question?

How big is it going to be and are there any restrictions on it? The other revolver you have expiring in January is pretty nonrestrictive.

We'll have more restrictive covenants in it, and we expect the size to be smaller than our current one. Our current one is 500. We expect the size of this to be 385. We don't use all of our existing ones. So that's not a significant issue for us, but there will be more restrictive covenants, and the interest costs, the rates will be higher.

What's the restrictions you think might come into play?

I don't really want to go into details of it, because we just can't finished it yet but it's more restrictive, I don't think that will affect the financial performance of the company, though.

Thanks.

Thank you, our next question is coming from Mark Koznarek. Please state your affiliation and then pose your question.

I apologize. I only have one question here. That is on power gen, can you get into some of the market dynamics a little bit further with regard to the large power gen market with regard to inventory, where we stand today versus beginning of the year, and you also mentioned discounts, if you could quantify that and what the trend in discounts have been over the course of the year?

I think - this is Tim - that if you look at our core business, which is about half of our power gem business, not the commercial or consumer markets or some of the other things. It's probably off about 25%, and has been throughout most of the year. There is still considerable excess inventory, particularly at the 1 megawatt level. There is many of the telecommunication companies created a boom, as they've run into problems. They're taking their generator sets and selling them into the use market at 50 cents on the dollar.

So the industry dynamic, at least through the first half of next year, and we're running our business assuming it's going to be like that all next year, is not going to change, and as a result, our absorption or our margins will go down because of the absorption, and I think we will continue to see pretty fierce discounting and price competition. I do think that, at least as our business is concerned, the consumer business is really at record levels and continues to operate that way, and we think we're going to see some increase in China and India in particular, where we are the market leaders in market share, and we're assuming we might get 10% to 15% improvement going forward. The basic dynamics of power generation are not good right now.

Mark, the only additional comment I'd like to add is that the market, the size of the inventory, and therefore, the price dynamics are not identical across the board. The worst note that Tim talked about is the 1 megawatt. There are some smaller generator set levels where we also have strong share, there is still pricing pressure but it's less. The other comment I would make is that the pricing pressure has not really worsened. What's been disappointing to us is it hasn't improved really since the first quarter this year. We haven't seen pricing numbers get better. They're pretty much the same.

Now Tom for clarification, the 1 megawatt where there is a problem in the inventory, where would you see we are today at the end much third quarter versus the beginning of the year in terms of units or percent change or however you could quantify?

It's a very difficult market to get numbers on, but I'll give you our qualitative feel. It's improved some, but not a lot. In other words, there's still way more inventory than the market can bear, and that was true in Q1. So while some is selling off, there's still enough extra out there to depress the market significantly.

So we're maybe only a third through the bulge, rather than half or three quarters?

I just don't have a feel for the percentages but it's big enough, as Tim says, we don't think it changes significantly until the middle of next year.

Thanks very much.

Next question coming from Andrew Casey. Please state your affiliation and then pose your question.

Prudential Securities. Good morning.

Good morning.

Tom, I guess just if you could clarify on the cash flow guidance that Tim gave for '03, the 70 million to 80 million. Is that post CAPEX or pre CAPEX?

That's post. Same definition, before financing activities and dividends are the main things after that. It's everything else is in there, working capital, capital, pension funding, et cetera.

Okay, and then if we could dig in a little bit further on the power gen market, if I recall correctly, original expectations were for a profit, small profit or break-even in the year. It looks like that's not going to happen. Is pricing the main culprit there or is there something else that needs to be fixed that won't recure in '03?

I think that there are a couple of things that happened this year where, frankly, we screwed up. I think when we moved the electronics from one facility in Minnesota, St. Peter, into the Friedley operation, we didn't do as good a job as we needed to. As a result, we got back orders and the cost didn't come down. Also, we've moved alternators from Friedley to Mexico, and that should have gone better than what it has, and then the third thing, I think there's room for improvement in terms of how we manage our rental fleet. All of those are fixed now, and we would not expect those mistakes to be made next year.

The other thing I'd say just to the high level, Andy, as your numbers again, we do expect a small loss or break even for the year for power gen. The big things that won't repeat, we had expected second half recovery in power gen from the start of the year, and of course, as the year's gone on, we've seen that wasn't going to happen. So in the second quarter.

We started taking cost out of the business, as Tim went through in his talk, and we're taking more costs out this quarter. So we expect next year to have significant improvement in margins, strictly even on the same sales, based on the costs we're taking out. We're just reducing capacity and improving efficiencies at a bunch of our facilities, because we are producing a lot less. The third thing is under absorption which Tim talked about. So catching up with that under-absorption is a lot of what this cost reduction is about.

I would say our power-gen business has been the most aggressive in terms of moving either component supply or production of finished product to low-cost manufacturing areas. I mentioned China and India; we've just moved large alternators to Romania; we're expanding production out of Minnesota to Mexico and we should see some benefits from that next year as well.

Okay, and last question, again, on power gen, can you talk about the size of your rental fleet right now, specifically in the 1 megawatt category, and has that reduced since the beginning of the year, and then second part of that is, if we can come back to Mark's question on the inventory, specifically for 1 megawatt, where do you stand, not necessarily the industry, but have you reduced your inventory in North America? Thanks.

Speaking about the 1 megawatt specifically, we don't have a large rental fleet in that size. We definitely have some, and we have reduced it over the course of the year. On the inventory side, we have also reduced inventory in the 1 megawatt side, but not as much as we'd like.

We're still trying to reduce our inventory in that end size of the rental fleet in that area, but the market has been slower than we wanted. So we're still working that down, but neither - that size is not the biggest part of our market. As you know, we were actually more recently into that size. That's sort of where our cap's been the strongest over time. We've grown up into that size. So in fact our rental fleet and the rest of our production is larger below that size.

Thanks.

Thank you, our next question is coming from John McGinty. Please state your affiliation and then pose your question.

Credit Suisse First Boston. Good morning, I guess. Clarification. When we look at next year, you talk about a $30 million pre-tax penalty from the pension because of the change in the pension fund earnings assumption. Where is that $30 million going to show up in each of the businesses or on a one line item?

In each of the businesses, John, and it's actually spread through the P&L, depending on what piece of the business is actually recording it.

In other words, when we're thinking about the operating income for these businesses, one of the things we have to do is at least take the $30 million and distribute it either by sales or assets or something.

It should be on - exactly. It will go across all the business units as well.

Okay. In - power generation, a very technical question. Seasonality, because I'm not sure we have enough history, looking at your business, not that many fourth quarters to look at, but seasonally, your fourth quarter was supposed to be better. The third quarter was supposed to be better. It was obviously very disappointing. You've lost $18 million for the year. To say you're going to break even in power generation implies a hell of a fourth quarter. Is there that much seasonality, or could you give us an idea so we can get a base to start?

: The seasonality of the business is typically weakest in the first quarter, and then the second and fourth tend to be stronger. Having said that, you know, we have a goal of breakeven. As with said, our view is we'll have a small loss. So we don't expect to make up the full amount so far.

But it will be meaningful profitable in the fourth quarter. You're losing $18 million, to make that to a small loss, it has to be fairly significant, 5 to 10 million profit in the fourth quarter? Is that what you're looking at?

True.

When we look at next year, I guess I'm trying to get a handle on Tim's comment, and I would agree with it, that the safest thing to plan is that the commercial power generation market isn't going to change. Just one question. Did you put a bunch of large stuff - do you have much in the way of sales in the first quarter of this year of the large commercial stuff? Because that's going to be a very weak market all the coming year, and is it, do we have any tougher comparisons in the first part of the year or has it been pretty weak all year long?

We discussed, we had hoped to have a bunch in the first quarter and remember, they got pushed out to the second quarter. There were a bunch of orders in Brazil. Comparison wise, we had very little large commercial products in the first quarter. I can't remember any of the substance. Second quarter we had some in Brazil.

So the question is, could you give us something, in other words, you've obviously made a forecast of 220, 210 to 230. Are we looking at power generation being 40 to $50 million of operating profit? I'm trying to see how much we're looking for there, because that's a tough one for us to gauge.

I apologize, we can't give more segment. We're not prepared to yet, but I can give you the general comments. All of the businesses are expecting some improvement in sales, including some in power gen, though we've talked about, it's not going to be a boomer, and all are expecting improvements in profits. Power gen from a percentage basis is expecting by far the most improvement in profit not on sales, but cost reduction, because this was the business that looking at growth, significant growth and then second half recovery and now basically resizing itself and getting costs out for a much lower level. So it will generate significant profits in that business from our small loss this year on same kind of sales. So I can't give you numbers by segment, but I can tell you, the profit improvement is coming mostly from cost reduction and some from some smaller increases in sales.

Again, on the cost reduction for power generation, I mentioned you may not have caught it. It was quick, is that of the engineering staff, they have taken one-third off of new product development in other things and are focused on cost reduction, resourcing, improving the current product lines, and that will have a significant impact at least in the second half of next year, in addition to their resources and other programs. That's a big change.

Well, let me ask you slightly differently. You mentioned, Tim, that you had hoped for, and everybody does, some business in China and Asia. On the other hand, we've had, unfortunately, times in the past where anyone has expected that, and for whatever reason, it doesn't come. If we don't get that kind of sales increase, do you still get the profit improvement?

You get profit improvement, but not as much.

Can you - is there any way to quantify - on the one hand, they've been good about moving to low cost areas, consolidating and everything else, but at least from what they've been saying, Christ, they've been shooting themselves in the foot. If they had done any more cost savings, you would have gone broke. How much was the nonrecurring - how much would you say was nonrecurring self-inflicted wounds in '02 that are gone in '03, if everything else is still identical, do we pick up $20 million?

I can't give you a direct figure. I want to make one thing clear. Those restructuring actions we did were good and incredibly helpful. Tim's point, we didn't execute them as well as we could.

But they cost you money.

They did.

I'm trying to figure out, if we get no improvement, what do we save?

Right. I would say, you know, your kind of number is probably a little bit on the high side. There might be 5 or 10 million on it that just on that alone. It's guessing. There's definitely an execution cost that are there. The biggest benefit is re-sizing the business and working on the cost part of the product. Remember, this is a business with almost 1.3 billion in sales, so the cost leverage is significant if you can resize it, and we've demonstrated we can do it through the work we've done in the engine business and filtration.

One final question. You talk about 150, you talk about 160 and that's close enough to flat I would agree. What is your forecast; you're using the industry forecast, but could you give us the forecast for the fourth quarter build, the first quarter build, and what you guys are assuming for the second quarter build. I think the only debate anyone has, no one disagrees with anything you said, Tim, the only issue about the market coming back is how soon, not that it will. So I'm trying to figure out, when you're looking at your numbers, are you assuming it's a second quarter event or second half event in terms of recovery of the market?

I'm going to ask Joe to be very specific here.

John, I think at least in terms of what we're seeing next year is actually from the fourth quarter of this year is pretty much a steady increase over the course of the year.

So the fourth quarter is what level, Joe? 30, 32?

From an industry truck build point of view, between 28 and 29,000 heavy-duty trucks kind of what we're looking at. I think the first quarter will go up to around 30, and then we'll see basically a bump-up in the second, and up higher second and third by being roughly equal and up higher in the fourth quarter is kind of how we're seeing it right now, John.

Letting up to like 50 in the fourth quarter? You almost have to to get up to 160 if you start at 30.

That depends obviously on the bump-ups as you go through the course of the year, right? So obviously - and I don't think we're seeing quite 50 in the fourth quarter of next year.

And as you look at Tom or anybody wants to take this, do you guys make money in the first quarter? I mean, can you make money in the first quarter?

We just haven't finished our forecast in the first quarter, which is why we didn't provide guidance today.

Wouldn't it be highly unlikely to make money, just because of the timing and the uncertainty and everything?

I would never say it's highly unlikely, no.

You have to understand, our Chrysler business is getter better. Our filtration business, although it tends to be softer in the first quarter is very good right now. Our international distribution business is good. Our aftermarket and remanufacturing is good. We think the heavy-duty will be better in the first quarter than it is in the fourth quarter, and power generation is primarily soft. That's probably an unknown, but you know, clearly our target, you know, even this quarter, even though we gave guidance, we're doing everything we can to break even in these kinds of environments.

Right, believe me, I fully understand that, and I'm not disputing anything. I'm just looking at it on a logic basis bus I see what you're saying. Okay, thanks very much.

We'll take one more.

One more, please.

Next question from Joanna Shatney.

Tom, you can see that the receivable securitization is shrinking. Can you say what you think that's going to be and what the weighing downgrade means yesterday for the turns on that?

Right, it doesn't impact the terms of that agreement at all. The reason it's paid down, it's low is because we paid it down from cash flow. And we expect not to need to use it at all in the fourth quarter either.

Can we keep that facility at something below the 200?

Right. We didn't change the facility at all. So the facility remains the same. It's just not borrowing against it, because it's like revolving credit. We can borrow more or less against it. Thank you.

Thank you for joining us today.

Thank you, ladies and gentlemen. This does conclude today's teleconference. You may disconnect your phones at this time and have a great day.