康明斯 (CMI) 2003 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Cummins incorporated first quarter 2003 earnings conference call. At this time all participants have been placed on a listen-only mode and we will open the floor for questions and comments following the presentation. It is now my pleasure to turn the floor over to your host, Karen Battin. Ma'am, you may begin.

Thank you, Jen. Welcome, everyone, to our Teleconference today to discuss Cummins' results for the first quarter of 2003. Each of you should have received a copy of our press release with the copy of the financial statement. If you have 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, Chief Financial Officer Jean Blackwell, our Vice President Finance, Sue Carter. Our Executive Vice President and President of the Engine Business, Joe Loughrey and Vice President and President of the Power Generation Business, Tom Linebarger. We will all be available for your questions at the end of the Teleconference.

This morning I will take you through a summary of Q1 results, then Tim has a few remarks about the business, and finally we'll have a question and answer period. 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 costs, 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 effected 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 10k and applies to this Teleconference.

Let me begin by summarizing Cummins first quarter results. In the first quarter of 2003 Cummins reported sales of $1,387,000,000, 4% higher than sales of $1,333,000,000 in the first quarter of 2002, reflecting decreased sales in most North American automotive markets and our power generation business, offset by higher sales in the Dodge Ram segment and our filtration in international distributor businesses.

Earnings before interest and taxes for the quarter was a loss of $14 million compared to a loss of $15 million in Q1 2002. Net earnings in the first quarter of 2003 was a loss of $34 million or 86 cents per share, compared to a loss of $26 million or 68 cents per share in the first quarter of 2002. Excluding the cumulative effect of a change in accounting principle in the first quarter of last year, the net loss was 29 million, or 75 cents per share.

I will discuss each of our four business segments. First with, the engine business. Total sales for the engine business in the first quarter were $816 million, a 5% increase from sales of $776 million a year ago. Revenues in automotive markets were 13% higher than Q1 last year, primarily due to increases in our light duty automotive business. Overall revenues from industrial markets was down 10% year-over-year, with the most significant decreases in marine and rail sales.

Operating income for the quarter was a loss of $23 million versus a loss of $19 million in the first quarter last year. This decrease is the result of lower gross margin due primarily to the launch of a complete line of new automotive products and several one-time costs incurred during the quarter. Benefits from cost reduction programs were more than offset by the shift from mature engines to new engines where margins are typically lower at product introduction. The margin decrease was partially offset by significantly lower research and engineering spending. We anticipate that gross margins will improve across the remainder of the year as we increase manufacturing efficiencies and do not expect a one-time cost to be repeated.

I will briefly review each of the engine business markets, turning first to the heavy duty truck business. Revenues for the heavy duty segment as a whole were up 8% in the first quarter from a year ago, while unit shipments globally were down 6%. The revenue increase was the result of higher pricing for the new products. Unit shipments in North America were down 10% as the markets continued to be impacted by the October emissions standard-change by unit shipments to the rest of the world were up 16%. The increase in international shipments was due to higher sales to OEMs in Mexico.

In the worldwide medium duty truck and bus market, total revenues decreased 12% for the first quarter year-over-year. Medium duty truck engine shipments were down 54% in North America, primarily due to the new emissions standard. International shipments were up 16% with higher OEM sales in Latin America. Global bus engine shipments were down 37% with a 71% decrease in North America where the market is still depressed following the change in emissions standards and in 3% increase internationally.

In the light duty automotive and RV business, revenue was up 41% this quarter compared to a year ago. Engine shipments to Daimler-Chrysler for the Dodge Ram pickup truck were up 12,000 units, an increase of 60% from first quarter last year resulting from the launch of Chrysler's new model pickup. Unit shipments for RV engines decreased 40% year-over-year, again due to the emissions standard change. Sales to industrial engine markets in total were down 10% from a year earlier, with decreases across most segments.

In the construction equipment market, worldwide sales were down 2% compared to first quarter 2002. Unit shipments of engines in North America were down 24% with reduced capital spending driving continued weakness and construction equipment markets.

Shipments to international markets were up 2% compared to the first quarter of 2002, with higher sales to China offsetting sales declines in Europe.

Sales for the agricultural equipment market decreased 20% from first quarter last year, with higher sales in North America, more than offset by sales declines in Latin America and Europe. Government financing incentives are expected to boost sales in Brazil in upcoming quarters.

Revenues from marine markets decreased 28% compared to first quarter last year, while unit shipments were down 32%. The primary reason for this decrease was the formation of the Cummins MerCruiser joint venture in March 2002, where recreational marine sales are now reflected on the joint ventures books.

Revenue in the mining segment increased 2% year over year, despite continued weak demand resulting from lower commodity prices.

Sales in the power generation business for the first quarter were $267 million, down 6% from the first quarter of 2002. In North America, revenues were down 9% compared to a year ago, with continued weak demand in our commercial Genset business. This decrease was partially offset by increased demand in our consumer business, primarily marine sales.

Consumer business revenues increased 4% compared to the first quarter of 2002. Outside North America, revenues decreased 4% in total with decreases in Latin America and parts of Asia, partially offset by increases in India and Australia.

In the first quarter of 2003 power generation had an operating loss of $17 million compared to an operating loss of $15 million last year. While we made progress with our cost reduction actions, those benefits were more than offset by further weakness in the North American commercial business, particularly in high horsepower products and continued pricing pressure. Revenues for the filtration and other segment were $254 million for the quarter, an 11% increase compared to the first quarter of 2002. This reflects higher filtration business sales with some improvement in demand as well as increased market penetration. This segment's operating earnings for the quarter were $20 million versus $18 million last year. This improvement is primarily due to the higher volume.

Sales for the international distributor business were $136 million in the quarter, an increase of 10% compared to sales of $124 million last year, with modest improvement across most regions.

Operating earnings for the segment were $6 million this quarter, compared to $1 million in the prior year's quarter. This increase was primarily driven by higher parts and service sales and lower exchange losses.

Returning to the corporate level, I would like to review our total sales by region. In the first quarter our sales mix was 53% U.S. and 47% international compared to 54% U.S. and 46% international in the first quarter last year. For the first quarter compared to a year ago, sales in the U.S. increased 2%, while international sales in total increased 6%. The international sales variances were mixed with decreased sales in Latin America and parts of Asia, more than offset by increases in India, Japan, Australia, Canada, Africa and the Middle East. European sales were flat year-over-year, with increases in filtration and international distributor sales offset by declines in engine sales. Sales to Latin America were down provide mayoral in power generation -- primarily in power generation. Sales in India increased in all businesses.

Next I would like to discuss corporate gross margins. The gross margin percentage for the quarter was 15.4% compared to 17% in the first quarter last year. Product coverage cost was 3.9% of sales, or $54 million compared to 3.5% of sales or $46 million a year ago. This increase resulted from a higher concentration of new product engine shipments in the quarter. Excluding warranty costs, gross margin for the quarter was 19.3% versus 20.5% in the first quarter last year. In dollar terms, gross margin was $268 million, nearly flat with margin of $272 million a year ago. The primary driver of the gross margin percentage decrease was product mix where we transitioned from mature engines to new engines with lower margins at product introduction. As well as having a lower percentage of high horsepower and heavy duty engine sales in this quarter's results.

Total selling admin and research and engineering spending in the quarter decreased $1 million compared to first quarter last year. Selling and admin expenses increased $9 million, largely due to unfavorable currency impact and funding of growth initiatives, primarily in the filtration business.

Research and engineering expenses decreased $10 million compared to last year, and are expected to remain at lower rates 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 first quarter was $7 million, compared to zero in the first quarter last year. This increase was attributable to improved earnings across most of our joint ventures.

Other income and expense in the quarter was income of $6 million compared to income of $1 million a year ago. This change was primarily related to favorable currency impact compared to the year ago quarter.

Interest expense for the quarter was $20 million compared to $14 million last year. The increase is due to higher borrowing rates particularly with the issuance of our 9 1/2% notes in November.

The income tax provision for the quarter was the benefit of $10 million compared to a benefit of $9 million in the first quarter of 2002.

Net earnings for the quarter was a loss of $34 million or 86 cents per share on $38.9 million average shares for EPS purposes. This compared to a loss of $26 million or 68 cents per share a year ago on 38.5 million average shares.

Let's turn to cash flow. Free cash flow from an operations perspective was an outflow of $95 million for the first quarter of 2003, compared to an outflow of $102 million for the first quarter of 2002. This follows our normal seasonal pattern of using cash in the first part of the year. Our statement of cash flows that you should have received indicates the cash outflow for the quarter of $96 million from operating and investing activities. To arrive at the $95 million free cash flow for Q1 we adjust for the net 1 million dollar change in marketable securities now shown in the investing section of the cash flow statement. These are primarily debt-neutral fund investments in India that due to the absence of a stated maturity date have to be reflected as investment versus shown as cash in our financial statement. These funds are available for the company's use the same as our cash balances. The biggest drivers of the net cash outflow for the quarter was the use of cash for payment of accrued expenses and capital expenditures.

Changes in working capital represented a net cash outflow of 14 million dollars for the quarter, accounts receivable increased during the period, but day sales outstanding decreased from 54 days at year end to 51 days for the first quarter. Inventory also increased during the period, but was more than offset by an increase in accounts payable.

Capital expenditures were $16 million for the quarter compared to $18 million for the first quarter of '02 as we continue to aggressively manage capital spending. Investments in and advances to joint ventures and alliances for the first quarter of 2003 represented an outflow of $6 million due primarily to our investment in new North American distributor joint ventures. Thank you. Now I will turn it over to Tim.

Good morning. First quarter was a challenging quarter, with demand across most of our markets continuing at weak levels. Power generation markets remained depressed with some regions experiencing even further deterioration. Power generation sales were 6% below first quarter last year. North American automotive markets continued to be impacted by the emission regulations change last year. Sales to nearly all industrial markets were below first quarter last year. The filtration and international distributor businesses, however, continued to perform well despite these current market conditions. With this operating environment, earnings before interest and taxes for the quarter was a loss of $14 million compared to a loss of $15 million last year. Net income for the period was a loss of $34 million or 86 cents per share, and this compares to a net loss of $29 million or 75 cents per share in the first quarter last year. A primary driver of increased loss this year is the higher borrowing rate of some of our debt.

These financial results reflect the continuing downturn in many of our markets that began in the second half of 2000. However, I remain confident that we are providing the products that are right for our customers, that position us well in the marketplace, and as we gain production experience with our new products, and as the markets recover and our cost reduction initiatives continue, we are confident our financial returns will improve. Even in this challenging environment, we achieved a number of successes during the quarter, including our new emissions compliant products, are performing very well in the field, we have now shipped over 8,000 ISX and ISM heavy duty engines at the new standard with a total of over 71 miles of trouble-free service accumulated. We're adding over 2 million miles of field experience a day and by the end of May our proven engines will have close to 160 million miles of service. Order rates are continuing to improve and with the positive performance of our products we think we have an opportunity to gain market penetration.

Our uptime guarantee has provided reassurance to our customers while also demonstrating our level of confidence in our new products. As a result of our confidence, we recently extended the program to cover purchases through the end of this year. To date we have only had to rent 8 trucks for customers and none of those repairs were related to exhaust gas recirculation components. Our new engine for Dodge Ram pickup is performing very well and continues to have strong acceptance in the marketplace. Shipments this quarter for the Dodge Ram were 12,000 units higher than first quarter last year. We expanded our joint venture with Don Fong (ph) Motors, the second largest struck manufacturer in China, we combined our existing joint venture, Don Fong's licensing agreement and manufacturing assets to form a more extensive arrangement with our partner. This agreement increases joint venture profits and cash flow and continues to expand our market presence in China. Specifically this will generate $10 million of incremental earnings for Cummins this year.

The filtration and other business had a good quarter. They achieved 11% growth in sales and profits from the first quarter last year, even in depressed markets. They have secured long-term supply agreements with major OEMs including Deere, International and Comatzu (ph) and are progressing on additional agreements with other OEMs. These supply agreements expand current business and more importantly, lay the foundation to achieve future growth targets. Their emissions solutions business after one year is already delivering a profit, even while funding key initiatives needed to provide significant growth opportunities going forward.

The international distributor business delivered a solid profit despite Q1 being a seasonally weak period for them. Together the filtration and international distributor businesses while accounting for roughly 25% of the revenue again provided 50% or more of the company's EBITDA, these businesses are more stable, less cyclical, and less capital-intensive than some of our other businesses. Cummins was named number two among a nation's 100 Best Corporate Citizens according to Business Ethics Magazine. We have been named to this list each of the four years that it has been in existence, moving progressively higher each year. We think this is quite an honor and we are very proud of the work we do to support our communities and provide value to all of our stakeholders.

Recently there has been speculation about future market positions and potential major shifts in market share in the North American heavy duty truck market. We believe this speculation is based on marketing claims and not necessarily engine data. The debate over which engine technology is superior continues to get a lot of play in the marketplace and the financial street. At Cummins we believe in speaking to the issue with product performance, not promises. We did what we said we would do. We kept our commitment to the EPA to the environment and, most importantly, to our customers. Others have only made promises about what they have yet to deliver.

Here are some questions we believe you should be asking about ours and our competitor's product performance and availability . We think you should ask the OEMs and the fleets: Whose products are and have been available for purchase and testing. How long have the emissions compliant engines been available and how many test engines have they received? How have those products been performing in the field? How many service miles do they have with those engines? What is the comparative data regarding new products introduction issues? For example, horsepower ratings, heat rejection, reliability, especially as it pertains to turbo chargers, the weight of the engine in the truck and fuel economy. Where some competitor's engines are just becoming certified, how long will it take to complete integration work and have product available in trucks? We have a number of fleets who have already placed significant orders with us, including U.S.A. trucking, FedEx freight, Tyson foods, PAM transport, U.S. Express, Knight Transportation, Southeastern Freight Lines, Celladon (ph), CR England, and Summit Trucking. These customers are delighted with the performance and reliability of our new engines. And are telling us that we have delivered on our promise to provide the industry with the best products at the new standard. Get the data from these customers that use the products. We think the facts are more convincing than promises.

Now let me speak to the resolution of our accounting adjustment. As we recently announced, the accounting adjustment we identified during our fourth quarter 2002 earnings release will require a restatement and reaudit of prior year's financial statements. The total adjustments amount to $15 million after tax and are spread across a several-year period. The amount attributable to any given year is not significant. After reviewing the matter with PWC and the SEC, we have concluded that it will be necessary to restate our prior period financial statements. We do not believe this approach benefits our shareholders, however the accounting rules require the statement and since Arthur Anderson is no longer available to provide an opinion on prior years, PricewaterhouseCoopers will need to conduct a reaudit of the years 2000 and 2001. I can assure you, though, that we will work with our auditors to complete the reaudits as quickly as possible. We would like to point out that after an extensive investigation conducted by our own internal personnel and by outside advisers to our audit committee, there is no fraud or willful misconduct on the part of any Cummins employee. These adjustments are a result of accounting errors, not a lapse of integrity.

We have taken a number of actions to improve our controls and we believe these actions, combined with existing control structure, are sufficient to prevent this from reoccurring. We have also obtained waivers from our banks through November 30th regarding a delay in providing our audited financial statements. Again, let me remind you that this adjustment is a small amount of money spread over several-year period. It does not effect current operations, we are caught in an unfortunate position due to our former auditor's lack of availability. We will work with PricewaterhouseCoopers to complete this work as quickly as possible and we assure you we are committed to providing the greatest clarity in our financial information to investors.

In light of the current market conditions, our first quarter performance and additional costs we will have to incur associated with the reaudit work, we are lowering our guidance for the full-year to $1.20 to $1.40 per share. We expect second quarter results to be a profit in the range of 10 to 20 cents per share. Our cash flow guidance for 2003 remains the same at around 70 to $80 million, which we plan to achieve through reductions in capital spending and improvement in working capital. We still expect to generate enough cash to fund our dividend and provide modest debt reduction in 2003.

We remain confident that we have taken the right actions to position us for success going forward. We will continue to tightly manage spending and take additional actions wherever needed. From the depressed market conditions we are operating in today, we still think the outlook for Cummins is very promising. Let me remind you that the first quarter is a seasonally weak quarter for us. We expect improvement across each remaining quarter. We believe the worst is behind us and we remain positioned for the upturn. Now we will take your questions and I want to remind you that I asked Joe Loughrey and Tom Linebarger to attend this. So if you have any specific questions about those two businesses, we have a little more expertise here.

Thank you, ladies and gentlemen. The floor is now open for questions. If you have any questions or comments, please press the numbers 1 followed by 4 on your touch tone phone at this time. Pressing 1-4 a second time will remove you from the queue, should your question be answered. While posing your question, please pick up your handset if listening from the speaker phone. Please hold while we poll for questions.

Our first question is coming from Gary McManus. Please state your affiliation, then pose your question.

JP Morgan. Hi, Tim. Just on the performance on the engine side where you loss a little more money than you did a year ago, obviously the Dodge Ram had to be a strong plus in profitability year-over-year. You talked about lower R&D expenses, you got some pricing on heavy trucks. So talk, you know, give a little more elaboration on why you had a little bit worse loss. I think Karen talked about several one-time costs. What were they? And what it was magnitude of that? And just the profitability of the new engines, vis-a-vis the old engines.

Okay. I can speak to the one-off issues, which were somewhere between 15 and $20 million. The first is that we had one of our casting vendors really go out of business and there was about $3 million associated with changing that out. That's subsequently been resolved. We also had a vendor quality problem with a component of our high horsepower engines and that's one of the reasons there was an increase in product coverage that was in the amount of about $4 million. There was also about a continuing $2 million one-time expense in the move from the engine plant to Jamestown. We think that we will get the cost savings now from that move of about $5 million a quarter. And there was somewhere around 7 to $8 million of manufacturing inefficiencies really associated with our high horsepower business and your David Tree(ph) plant. That also hit our power generation business.

As far as the profitability of the new engines, obviously the product margins of a new product are lower than a more mature product. We still continue to conservatively provide warranty accruals. We need to do that for at least five quarters to document the experience before we can adjust those accruals, those are just the rules that we have. I will say that, you know, it's still too early to declare victory, but this so far has been the most reliable product launch that I can remember in a long time with both the heavy duty and the midrange new engines.

So if you have presumably the price increases are sticking, right, and they were quite substantial, right, 3 to $4,000 per unit?

The price increasing has stuck and also I'll remind you that we have in the heavy duty business, we had these long-term agreements with Volvo and International and PACar(ph) so we're not involved with the transaction pricing and discounting in the marketplace that, you know, was so pervasive over a year ago. So we changed our model and again to remind you what we're trying to do is take the cost out of the business so that even at modest market share we earned 5% EBIT through the cycle at the top of the cycle we can get up to 8%. We're on track. I think in one of these conferences a year ago I was asked, you know, when will we be able to see that and we talked about the end of 2003, the beginning of 2004. But so far we're on track there.

Okay. But the cost, is it just related to warranty or is the manufacturing cost of the new engines inferior to the older engines?

No, I wouldn't use the term inferior. You're in a new product introduction and also moving from the Columbus engine plant in Jamestown so any time you move a product you have one-off inefficiencies. But when that engine is at a higher volume, which is growing now, we'll get the manufacturing as we go, manufacturing efficiencies as we go up the curve. We expect our margins overall to improve on that product.

One last question. The 15 to 20 million of what you call like one-off type of things, was that embedded in your prior forecast? Or is that a reason why you had to lower guidance?

March was, you know, March is normally the best month of the first quarter and quite frankly the volatility of March. not only in the engine business, but also power generation. was unusual. I mean we were seeing week to week, you know, a thousand engines taken out of our build rate due to changes with the OEMs and I don't know whether, you know, that volatility was associated with the war or other things that are going on. But it was a very unusual and so that's why when we started to see some of this manufacturing inefficiency show up in our gross margin, that's why we elected to talk about our earnings earlier.

Thank you.

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

Midwest Research, good morning.

Good morning.

Question on the power generation business that seemed exceedingly weak, you know, and that seemed to be one of the key things you highlighted in the pre-announcement as well. But can you give us a sense, especially I think either you or Tim mentioned price deterioration, you know, which always makes me nervous but can you give us a sense of how much price is down? And also what's the inventory situation either for Cummins or industry wide, how much more inventory do we have to burn off to get to normal kind of inventory levels as a percent of current market demand rates?

You know, as I mentioned, Tom Linebarger, who is now President of our Power Generation Business, is with us and so I'm going to let him give you a little more detail than we normally do.

Good morning, Mark. These are the questions I used to be able to pound Jack Edwards with, now I need to answer them. Let me get to your question one by one. First of all, the market was slightly weaker in Q1 this year than Q1 a year ago, which was you'll recall quite a weak quarter for PowerGen. Seasonally weak in Q1 but also that's really last year at this time was really when we saw the significant drop-off from prior year highs. So we were disappointed by the results this quarter in terms of revenues.

Almost all the decrease in demand is coming from North America. So similar to last few quarters, North America is by far the weakest market. It's commercial generator set fails, which also impacts our alternators and power electronics, we build and sell all those products that go with our generator sets so there's knock-on effects there.

With regard specifically to pricing, pricing has been competitive for the last three or four quarters. In fact, discounting in the market kind of on average has sort of worsened slightly each quarter that we have been tracking it. It wasn't significantly worse in Q1 than Q4, but it wasn't improved either. And it kind of discounting that we see is at the high end of the market, the sort of one and two megawatt sets, there is quite a bit of volatility in pricing. Some of the times the pricing is pretty reasonable, other times it's quite aggressive and it's just project by project would be the way I would say it. Overall on average, it's very aggressive.

On the lower end of the market, we have a very strong position in some parts of that market, particularly the consumer market that Karen highlighted and their pricing is strong and holding. In some of the construction markets where it's more of a bid-and-spec kind of market, pricing has always been a pretty tight and it's tighter now than ever because the competitors like ourselves and Caterpillar and others who had bigger projects before, are all competing for those smaller projects now, lower-end of the market. So pricing is a little more competitive but it's been trailing that way since really the beginning of last year.

With regard to inventory, I would like to give you hard data, but I really can't. It's a very difficult inventory numbers to track. I can give you some anecdotal data we track. Our own distributors in the field inventory is way down, it's really back down to normal levels. We also go around and check other dealers just look around, see what's out there and our observation is that inventory has been coming down steadily and that it is returning to reasonably lower, normal levels. However, pricing competition would suggest there's still inventory out there so I wouldn't say we're through it. But I would say that through this year we expect inventory to get back to normal levels.

Okay, Tom. If you could clarify a couple things. Number one is that last statement, if your own dealer inventories are back to a normal level, does that mean Cummins manufacturing rate and sale-through rate to the dealers is going to improve from here on out? Because most of the inventory slashing is behind us. And then secondly, if you could give us a idea of, given that pricing has been deteriorating sequentially for four, five quarters, cumulatively how far are we off of from, you know, prior peak kind of prices? Are we off, you know, 10% in total or, you know, order of magnitude number like that that? Thank you.

Okay. The answer to the first question is that our sell-through rate and manufacture rate are pretty similar in the PowerGen business for the reasons you said. How the sell through rate will go, how the end demand goes is relatively volatile and difficult to say. But, yes, our sell-through and manufacturing rate are very close.

With regard to pricing, I think a sort of 10 to 15% number is reasonable. The problem is it's not a very useful average because discounting at the higher end on the big projects is much larger than it is at the lower end. So your averaging two very different numbers. At the higher end, depends on where you look but might see discounting as more 20 to 30% depending on the size. At the lower end it might be much smaller, so it's a range depending on the market.

Okay, Tom, thank you.

You're welcome.

This is Tim again. One wildcard that I would like to add, though, is that in terms of inventory and demand could be significantly impacted with the reconstruction of Iraq and I think it's too early to, you know, make any comment about, that but there's a lot of inquiries that are out right now on all kinds of power generation projects.

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

Credit Suisse First Boston. Good morning. I wanted to just a couple follow up. Tim, I wanted to actually make sure I understood your answer to Gary's question about the 15 to 20 million. How much of, you perfectly delineated it as perfectly understandable but how much that 15 to 20 million was a surprise to you now as opposed to in January when you gave guidance for the year and the quarter?

Well, clearly I had not anticipated or we had not anticipated the manufacturing inefficiencies, you know, again, I have seen our own internal estimates at somewhere around $7 or 8 million. And a lot of that was really associated in two areas, one was our high horsepower plant in England and then the move associated from CEP to JEP.

I thought that was the 2 million. Is that a different?

That's 2 million on top of the other.

Okay.

And then the problem that we had with the vendor, we had to do a campaign and we're still in discussions with that vendor. But we booked the $4 million in coverage, so that was not necessarily certainly anticipated at the beginning.

So the only one that you know might have been, the only one that was your model might have been the 3 million to the casting September?

We got slapped with, you know, a doubling of prices, so we knew that we were going to be changing vendors and I'm not sure we knew it was going to be that total amount. But we knew we were going the make a change.

Let me help a little bit on that. Tim was also talking about the fall-off in demand in March. So we got part of the earnings shortfall was due to volume that we were expecting to see in March that did not come through. So as well as the cost issue, we had lower volumes. So none of those were individually significant, but together kind of, you know, caused earnings shortfall.

The 15 to 20 million, if you take a midpoint is 30 cents a share. So what you're saying is maybe 3 million of that or 20% of that you knew about, the castings vendor. Are you saying this 20 to 25 cents from those factors you did not, I mean that was unexpected and then the rest of the shortfall was volume?

Yes.

I'm sorry?

Yes.

Okay. I can understand problems with new engines. But how do you have manufacturing inefficiencies in Davonder (ph). You've been making those engines forever there. What happened?

The volume was low and the volumes, the engine that's come out of there are mining, large marine engines, oil and gas, and power generation. And all of those markets were more depressed than what we had planned on, that they hadn't come back and there's a lot of fixed cost in making those large engines, that's where the inefficiencies are. We're now, we're seeing some of the volumes come back, so we don't anticipate those issues and we think we are manned precisely to demand we have right now.

In other words, what happened was not only was there volume shortfall but volume shortfall was in your most, your highest margin businesses.

Well, I'm not sure I would say they're all highest margin but they're good businesses when you throw in -- they all have a high usage and high usage you get good parts business it with, particularly in oil and gas and mining and marine. Stand by generator sets don't use parts, prime power does. So it is a very good business for us when it's at the right levels.

And the product coverage going up to 3.9 versus 3.5, that is picked up in these numbers?

Yes. I think there's three things on the coverage that we also had a 2 million, I think it's around 2 million in power generation that is a really one-off kind of -- part of it had to do with our consumer market and the other had to do with the electronics that we moved from one plant in Minnesota, the Friedley (ph) plant and there's some quality problems. Those have been fixed but there was a one-off adjustment. There was the vendor thing in the engine business and then we are accruing at a higher rate with our newer engines just as a matter of our warranty policy. I still think that our coverage cost for the year are going to be somewhere around 3 1/2%.

But what I'm trying to understand, I guess, is the difference between the 3.5 and the 3.9, that 4/10 of a percent. Some of that is captured in the 15 to 20 million, but there's others of it that's not?

Right, John, only the warranty parts are in the 3.9. The other, the vendor and other things are not part of warranty.

What I'm saying is, how much of the difference between the 3.9 and the 3.5 is not captured in the 15 to 20 million?

I don't know how to answer the question. Let me give you the warranty deal is, we anticipated that we would have higher warranty cost it is first quarter for our new product introductions, that came in as we expected. We also had a couple of these one-time things that were a little bit more than we expected and as Tim said, we're still on plan to have our warranty be at 3 1/2% for the full-year. I don't exactly know how else to answer yet.

Fair enough. Let me, could you talk to currency? You mentioned it a couple times, once as a negative, once as a positive. What was the overall effect on the quarter?

Overall, John, it was pretty neutral. We were comparing a lot to last year where we experienced some significant currency losses, particularly in Argentina. So year-over-year it was a positive, but net for the period it was pretty neutral.

Neutral. Then with regard to, I'm just trying to be absolutely clear, on the new engine, the cool DGR engine, are the costs of that engine, I mean forgetting about the vendor issue, I mean okay, $3 million on a vendor, that's fine. But I mean aside from that, are the costs on the new engine, as you're producing it on the October '02 engines, are those costs in line with what -- I'm hearing different things in the marketplace and I want to absolutely make sure I fully understand it. Are those costs on those engines in line with what you thought or are the costs higher than what you thought?

John, since I have Joe here, I'm going to ask him to answer that and also elaborate on the points I was making in my remarks about how it's performing and how it's perceived because I think there's been an awful lot of chit chat that doesn't necessarily reflect what's going on, so Joe, would you take that one.

Thank you, Tim. John, it's basically in line. The one issue we have is I think if you look back a little ways, volume in the first quarter was a little less than maybe we were hoping it would be several months ago. That's our one issue as it relates to the new product itself. Separate from that as Tim has already mentioned, we did do the transition which went very well from CEP to JEP and we're-- we have gone through the learning curve in the first quarter and believe we're through it and now as a result of that begin to achieve the benefits we outlined in the last Teleconference.

As it relates to the product itself, as Tim has already said, I mean basically our story has been pretty simple. We said we're going to hit the deadline and we're going to deliver to customers a product that drivers will love, that meet the reliability expectations and perform as we told them it would. And basically that is checking out. Drivers love the product, reliability is very good at this point, the uptime guarantee program that we introduced and have now recently extended has been working very, very well in terms of supporting customers and any issues that they have. And all-in-all the feedback we're getting from customers is that the product is running well and as we told them it would.

Meanwhile on the other side of the coin, you've got our friends in Peoria and their story and I think, you know, you know better than I, John, there are they're a good company and a tough competitor and I think they will eventually recover their form for some bad choices they have made and I think they know, they know they're in trouble and they have created a smoke screen through aggressive marketing with no evidence to try and give them cover to get there. I think from my point of view, the fact of the matter is they couldn't get EGR to work in a way that would meet current standards, they're primarily a construction equipment company and they were working on an engine which wasn't going to be ready in time, that didn't use EGR, they saw it having no choice but to go with that product. They then did two things and you know it: They tried to push for a delay politically and legally. It failed after a lot of hard work and money spent on their part. And they created I think primarily as a result of what they did and what they said, they're the primary creator of the pre-buy that took place in the industry. And now panned significant amount of fines The other thing they did was announced, created an acronym called assert, announced it would be break through technology but since then, the facts are that recipe has changed several times. They have different fuel system, significantly increased weight, they have had increased displacement, using premium parts to do it, they got two turbos with a charge air cooler, they got both a jacket water aftercooler and charge air cooler on it. They got now dual oxidation that are there. And at the end of the day what they're really doing is using something all of us in the industry know as the Miller Cycle and in fact some form of internal EGR. It ain't break through in any way, shape or form and the other part of the issue right now, if you talk to the OEMs and if they open up with you, it ain't working very well either. The OEMs have just been getting their engines around MidAmerica, I think you know Cat did a big pitch in Florida and Arizona in February about their technology. They had no running engines at either of those sessions. They started delivering engines to OEMs around the MidAmerica truck show, I don't know if you were there, John, but if you got yourself around and actually looked at the engines in the installations and looked at the data tags, et cetera. But right now what we hear from the OEMs is that they're way off rated power on many OEM Dino tests, engines running very, very hot even with fans locked on paint is burning off both the turbo compressor housings, off the inlet to the charge air cooler and it's discolored on the pre-cooler. The chrome exhaust pipes that come out below the cab are turning blue, which is saying it's very, very hot coming out of the exhaust. They're creating a lot cooling issues and installation issues with the OEMs and they have a very complicated installation. And we also know that significant number of reliability issues on the few engines OEMs have right now, turbos, ejectors, wiring harnesses you name it, and a lot of complaints from drivers about the sluggishness of it. So there has been a lot of propaganda out there, reasonably aggressive-- very aggressive marketing campaign. I think we were very clear on what we were going to deliver and we did that. And I think evidence will show over time in addition to doing what we said last year, I will also say in the final analysis once assert is finally out, there whenever that turns out to be, our product will be better than theirs at this current standard. Our product is the basis for our 2007 and 2010 solution, we have engines running in cells, we have engines running in OEM partner trucks, we are working with the OEMs on solutions to meet those standards. And while Caterpillar is still worrying about trying to get an engine to meet the '02 standard. So we're feeling very good about where we are. A little disappointed about the impact, the pre-buy has had on the ability and the propaganda around the pre-buy and the ability for or willingness of some customers to take a look-see. But the word has spread, more customers are ordering and taking a look-see and as we get in to next year or whenever Caterpillar comes out with the cert, I think we will compare very favorably in the end user mind.

Are you able to meet '07 now in the lab?

We having engines running at the '07 standard, not only in the lab, but in trucks.

In trucks, okay. And one final question, the accounting, the reaudit, what is the cost of that?

We're estimating that to be all in legal plus audit fees and all that, about $8 million.

All right. Thanks very much.

Thank you.

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

Good morning, Goldman Sachs.

Good morning.

Can you guys, I know the volumes kind of fell short in the first quarter, but and you lowered the outlook because of that. But still implies pretty aggressive recovery in the earnings numbers in the second half here. Can you just kind of help us with how you get there? What types of volume assumptions you're making in some of the businesses, what types of market share changes you're expecting and you already gave us the warranty expense, if you could just flush that out, how will go from 3.9 in the first quarter down to 3 1/2 by the end of the year.

I think that from the increased volume and you can look at heavy duty, medium duty, power generation, I think their lowest quarters historically have been the first quarter, the Dodge Ram pickup and all that is that we're estimating 75 million dollars of incremental margin from the volume. We think that in terms of cost reduction, we have already talked about heavy duty consolidation at 15 million. In power generation, we're expectation of $30 million with cost reduction programs and layoffs that have already taken place. Tom is also putting in to place a new 100-day plan that should capture more than the 30 million and hopefully we'll get it sooner. We think again included in the 75 filtration in the international distributor business should be worth 20 combined. And I think the JV income, especially from the China deal, will go up. So all of those contribute to a better second half.

What are you making in terms of assumption on market share? You guys kind of, you know, I guess what are you going to have assume for your class a truck market share, kind of flat last year at 24%?

I think that's a good range.

My other question is on market share data, your view on what's going on here. I guess we all kind of know Detroit Diesel is gone much further south than we all expected but big surprise to me is actually that International and Mercedes-branded engines had market acceptance here. Can you comment on if you think that penetration rate they have been able to achieve will stay there? You know, is this a permanent change in the market? And does that permanently switch the size of the class a market downward for everybody, including Cat?

There's still a lot of unknowns. This is Joe, I will try to give you a couple perspectives. I think early on this year one of the things still going on, some OEMs still consuming engines frankly that were pre-October 1. So that's distorting the data, particularly in the first quarter.

Secondly, this is Mercedes opportunity and they are aggressively going after it. I think significantly using price as the lever to go after it to get an engine that doesn't meet the '02 standard in to people's hands to get some experience to see how it does. So they have gone very aggressive right now in trying to accomplish that because what they know is they have to change their engine to meet the January 1 '04 standard. So they have to get some engines out there running and get some experience and try and build some customer acceptance and they have aggressively gone after that through price. But knowing, as I say, they're going to have to change their recipe and our understanding is they will be using EGR on the Mercedes engines come January 1 of 2004.

I think what we'll see in the marketplace as things unfold and in fact have already seen in a year to year comparison, if you think of our partner OEMs, our share year to year has grown at International, grown at Volvo, even grown at Kenworth and though not at Peter Built. I think Kenworth and Peter Built our share will grow there if after a lot of experience they become convinced that our recipe is better than Cat's at this current standard and I already mentioned to you that I believe that's exactly what we will do. So I think we're going to have to see how things unfold particularly by following how well the Mercedes engine does, whether or not they will capture, how much share they might capture looking to the future. I think that's still very much a question mark, even though freight liners obviously working very hard at it.

Okay. And I guess the move in Navistar is that they're putting more percentage of (inaudible), increasing, if you look at Navistar as a blended number, you guys, I guess their branded engine has gone to a third of their business. Is that something that reverses? You think it's temporary?

Well, Navistar is their strategy as well in terms of what they're trying to do and expand volumes of their engines. I think the data is sort of law of small numbers and I think this is not a big indication of volume splits in the future.

Okay Okay. Just to switch gears and I'll get back in queue, the revolver got renegotiated in the fourth quarter and we haven't been able to see the details that go along with that because the 10-K hasn't been filed. Can you just talk about what restrictions there might be on that revolver? You know, just to help us feel comfortable with what liquidity you have out there, not that I'm that concerned about it but if there is a warranty issue double-dip, it becomes kind of important. Since you have had to have a higher cost of debt, it kind of implies maybe there are restrictions on the covenant.

Well, Joanna, let me help on that one. The covenants are primarily the same ones we had under the old revolver which are net worth covenant and coverage covenants. You know, I mean net worth and leverage covenants. We also have a coverage covenant in this one but we have a lot of room on that covenant at this point.

Okay. And does this agreement overlook any of the restatements? Or is the restatement not big enough to have any impact on this?

Yes, that is correct. It does not have any significant impact at all.

Okay Okay. Great, thanks.

Thank you. Our last question is coming from David Raso. Please state your affiliation, then pose your question.

Smith Barney, I'll keep it quick. With the marketing machine out there right now on the truck wars, the engines, have you seen any of your customers delay or cancel orders or finding it harder to close orders to get a book because the natural tendency if you look at the market material on the assert, you have to stake a step back and think about and try to get more comfort around. Is it right to step up, right decision to step up and buy a large amount of the EGR-based engines? I'm just common sense, take a peak at the cert it might take some delay here in the next couple months, pause, reevaluate now that the cert is out there. Can you seen that?

First of all, cert is not out there.

It's out there more and I think the mind of a customer.

Right. I think two things driving what's coming in to this year, I think are pretty clear, a lot of propaganda last year about the fact that EGR engines wouldn't be reliable was in addition to concerns about where are we going to have a war and were we not? Therefore, should we invest were two big factors coming in to this year. One of which is at least gone away. The other one of which is going away based on our demonstration of the fact that EGR engines are very reliable and as in-use truckers talk to one another they're finding how reliable they in fact are.

But something like that will take a few months. Have you seen any change in your customer behavior?

No, in fact what -- the change we have seen has been a positive one. The change we have seen is a lot of end users who haven't bought at all or much from us in many years, who have not only asked us to sit down and talk with them with our partner OEMs and quote, but have actually in some cases not only placed orders, but received engines. And so there are a number of customers that we haven't supplied engines to in a long time that are now buying engines from us and that's a definite behavior change we have seen.

Lastly, same point, have you structured your deals any differently over the last month or two now that the competition has heated up even more so on the he said, she said, which engine is better?

Are you talking about incentives, David? .

Just open-ended question. Have you changed the structure of your deals at all?

No.

Great. Thank you very much.

Thank you.

Jen? Were there other that's had not had a chance to ask questions? .

No, there appear to be no further questions in the queue.

Thank you. Thank you for joining us today.

Thank you ladies and gentlemen. This does conclude today's Teleconference. You may disconnect your phone lines at this time. Have a great day.