康明斯 (CMI) 2004 Q2 法說會逐字稿

Good morning, ladies and gentlemen and welcome to the Cummins second quarter 2004 earnings release conference call. At this time, all participants have been placed on 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. Ma'am, the floor is yours.

Thank you, Pete. Welcome everyone to our teleconference today to discuss Cummins' results for the second quarter of 2004. Each of you should have received a copy of our press release with a copy of the financial statements. If you have not received these copies, please let us know and we will fax or e-mail them to you at the end of the teleconference. Participating with me today are Chairman, Tim Solso, our Chief Financial Officer, Jean Blackwell, President of our Engine Business, Joe Loughrey and President of our Power Generation Business, Tom Linebarger. We will all be available for your questions at the end of the teleconference. This morning, first Tim will make a few remarks about the business.

Next, I will review the details of our income statement and business unit results, then Jean will cover some cash flow and miscellaneous items and finally we'll have the question and answer period. This teleconference will include certain forward-looking information. We will talk about Power Generation markets, outlook for 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 cost, product coverage or warranty cost and possibility improvement initiatives. Any forward-looking statements about these and other any topics involves risks and uncertainties. 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 48 of our 2003 form 10K and it applies to this teleconference. During the course of this call, we will be discussing certain non-GAAP financial measures and we refer you to the attachment to our press release and to our web site for the reconciliation of those measures to GAAP financial measures. I want to remind you that when we discuss earnings before interest and taxes or EBIT in our call today, that measure also excludes minority interest and preferred dividends. In response to guidance provided by the SEC, we will use GAAP measures where at all practical and will limit our forward guidance to GAAP measures or those that can be readily reconciled to GAAP financial measures. Now I will turn it over to Tim for some remarks about the business.

Good morning. Cummins had a solid quarter, setting records across many parts of our business. Our strategic initiatives and focus on cost reduction over the last several years has positioned us well to deliver these strong financial results. Each of our four business units had record sales in the second quarter, with improved demand and increased market penetration, the Engine Business reported very good earnings.

The Power Generation Business continued to improve profitability through ongoing cost reduction efforts and higher volumes. The international distributor business achieved record profits in this quarter. Joint venture earnings and cash also were at record levels and cash from joint ventures surpassing distributions received during all of 2003. Second quarter sales were 38% higher than the second quarter of 2003 driven by strong demand across our businesses. Earnings before interest and taxes for the second quarter were a record $148 million or 7% of sales compared to $46 million or 3% of sales last year. This performance is well within our targeted financial goals of 6 to 9% EBIT margins that we have communicated over the last several years, demonstrating the leverage we can achieve with our improved cost structure. Net earnings for the quarter were $82 million or $1.76 per share compared to net earnings of $14 million or 34 cents per share in the second quarter last year. Engine business sales were strong with increased demand across nearly every market sector.

All automotive segments reported significant increases and construction and mining demand improved sharply. We expect volumes in each of these markets to remain solid throughout 2004. The Engine business reported a segment profit of $91 million or 6.5% of sales, achieving returns well within its targeted range of 5 to 8%, excluding the segment reporting change discussed with our first quarter results, EBIT margins were 7.2%. Our emission compliant products continue to perform well for our customers. Their confidence in our products is enabling us to gain market penetration as a result. Through the first five months of 2004, we have gained over 5 points of share in the North American heavy-duty truck market, increasing from 21.5% to 26.8%. For the month of May, Cummins had 31% share, taking the lead in the market and recording our highest market share since 1999. We believe this is a confirmation that our strategy for the North American heavy-duty truck engine market that we implemented in 2000 is working.

A key element of that strategy is our long-term agreements with our OEM partners, NaviStar, Pack Car (ph) and Globo (ph) which have enabled us to strengthen our customer relationships and grow our business. For example, our agreement with Pack Car helped us to gain market share at both Kenworth and Peterbilt and allowed us to align our field offices and distributor dealer organizations to achieve a greater success for both companies. We have more than 56,000 ISX and ISM ERG engines in the field with over 3.6 billion miles of proven experience. We're adding more than 15 million miles of service per day and continued to demonstrate the reliable performance of our engines and exceptional service operations. Our extended uptying guarantee program provides added assurance to our customers and reflects our confidence in these products. We had another record quarter for the Dodge Ram pickup, selling over 40,000 engines. This is 30% higher than unit shipments in the second quarter of last year.

We continue to gain share in the diesel pickup market with an excellent performance, quality and a brand image of our engines. Our joint ventures continue to be significant contributors to our financial performance with $29 million of earnings in the second quarter. Our China joint ventures provided over half of these earnings but our North American distributor joints ventures, our joint venture with Mercury Marine and our Indian joint ventures also added to our result. We had an excellent quarter for cash from joint ventures, receiving $36 million with established dividend policies, we expect our joint ventures to continue to provide substantial cash flows. Power Generation sales were 52% higher than the second quarter last year, with increases across all market segments. Business in Asia, particularly China, is very strong and we expect that trend to continue into 2005.

In North America, where we still have not seen broad recovery in the commercial gem set market, sales increased 33% compared to last year. The consumer business continues to perform at record levels driven primarily by sales for recreational vehicles. Power Generation reported earnings of $19 million or 4.1% of sales compared to a loss of $15 million in the second quarter of last year. We are clearly seeing the benefits of focus on cost reduction in this business coupled with the increased demand. The filtration and other business had sales of $369 million this quarter compared to reported sales of $265 million last year. Excluding segment reporting change, sales grew $51 million year-over-year. Segment earnings were $24 million compared to $25 million last year.

Segment results continue to be affected by the impact of higher commodity prices, cost related to the business growth initiatives and heavy sales mix of OEM versus smart sales. In addition, the filtration business is experiencing inefficiencies due to capacity constraints, particularly at our exhaust plants. This is driving higher expenses in the form of expedited freight and overtime and delaying closure facilities being replaced. We are also making some small investments in new equipment. The business has achieved significant sales growth as a result of its strategic initiatives and is still generating solid profit for the Company. However, profit margins are expected to remain below targeted levels in the short-term as the business works to address these inefficiencies.

International distributor business had a very good quarter recording both record sales and profits. Sales were 30% higher than last year with increases across all geographic earnings. Segment earnings were $14 million or 6.4% of sales compared to $12 million or 7.1% of sales last year. Sales mix with a lower percentage of parts and service revenues and a higher percentage of Power Generation sales compared to last year's second quarter, had a negative impact on EBIT margins. One of our strategic initiatives is focused on growing parts and service revenues across our distributors, which should provide a more favorable sales mix in the future. This business is generating profit within its targeted range of 6 to 8% while continuing to invest in new growth areas such as Russia and Eastern Europe. We continue to see improved demand in almost all of our end markets. With significant increases in many areas. We now expect total revenues for 2004 to be at least 25% higher than 2003. We are forecasting the North American heavy-duty truck market to be up at least 40% and expect that shipments for Dodge Ram pickup will be at least 15% higher than record volumes we had last year.

We are seeing improvement in almost all of our industrial markets with increases ranging from 10 to 50%. We expect sales growth in international distributor business to be around 20% for the year and Power Generation and filtration and other businesses to be 30% or more for 2004. The increasing demand if our continued focus on cost reduction will allow us to deliver strong financial results for the remainder of 2004. We are, however, facing a greater net impact from rising commodity prices and with a significantly higher volumes we are experiencing production inefficiencies at some of our plants. In addition, several of our key OEM customers, including Chrysler and similar North American heavy-duty truck OEMs have scheduled plant shutdowns in the third quarter. This will result in somewhat lower volumes compared to the second quarter.

We expect earnings in the third quarter to be in the range of $1.30 to $1.40 per share and we are raising our earnings guidance for the full year between $5.55 and $5.75 per share. We are generating significant cash flow with our continued tight management capital spending. We are well positioned to fund our debt maturity in March of 2005 with cash generated from operations. We have experienced a steep improvement in demand in nearly all of our end markets. Our cost reduction work over the last several years has significantly improved our cost structure and we are achieving strong operating leverage as a result.

I am very pleased with the work that our employees have done to lower our costs, improve our products and meet our customers' needs. All of our businesses are generating a solid profit. We continue to have very positive feedback from our customers regarding the performance of our products and we have won new business as a result. I believe the right things are in place for Cummins to deliver good returns for our shareholders well into the future. Now I will turn it back to Karen to review the details of our results.

Thank you, Tim. In the second quarter of 2004, Cummins recorded sales of $2,124,000,000, 38% higher than sales of $1,539,000,000 in the second quarter of 2003. Our revenues continues to benefit from a broad market recovery with increased volumes across all of our businesses with particular strength seen in the North American heavy-duty truck market and international Power Generation markets.

Earnings before interest and taxes for the quarter were $148 million or 7% of sales compared with $46 million or 3% of sales in the second quarter of 2003. Net earnings for the quarter were $82 million or $1.76 per diluted share on 48.8 million average shares for EPS purposes. This compares with net earnings of $14 million or 34 cents per share in the second quarter last year. Our convertible preferred securities had an 18 cent per share dilutive effect on earnings for the quarter and based on our expected level of earnings will continue to be dilutive for the remainder of the year. I will provide comments regarding each of our four business segments beginning with the Engine business. Total sales for the Engine business in the second quarter were $1,393,000,000, a 57% increase from sales of $889 million a year ago.

As we discussed last quarter, our change to market-based transfer pricing results in increased sales in the engine and filtration and other businesses with the corresponding offset in elimination, along with somewhat lower EBIT margins for those businesses. For the Engine business, the segment reporting change added $128 million in sales for the second quarter. Excluding the change, Engine business sales increased 42% compared to the second quarter of last year. Revenues in automotive markets were 48% higher than Q2 last year, with increased demand in all segments, driven by the broad market recovery. Overall revenue from industrial market was up 28% year-over-year with increases in all segments.

Earnings before interest and taxes for the quarter were $91 million versus $24 million in the second quarter last year. This improvement was primarily driven by the significant volume increases, the associated leverage and the business's cost structure improvement. Revenues for the heavy-duty segment as a whole were up 67% in the second quarter from a year ago while global unit shipments were up 95%. The variance between the revenue and the volume increase was due to the mix of engine versus parts sales. Part sales increased 35% compared to second quarter 2003 but were a lower percentage of overall revenue in this year's second quarter.

Unit shipments in North America were up 105% driven by the growing acceptance of Cummins products among truck fleets that are purchasing new equipment and replacing older tractors. We also continue to benefit from our long-term agreements with our OEM partners and have seen increased penetration under these agreements. Unit shipments to the rest of the world were up 47% with higher sales to OEMs in Europe, Asia and Mexico. In the worldwide medium-duty truck and bus market, total revenues increased 36% for the second quarter year-over-year. Medium-duty truck engine shipments were up 100% in the U.S. and Canada with strong volumes with several key OEM customers. International shipments were up 26% with higher OEM sales in Latin America and Mexico.

Global bus engine shipments were down 19% with a 12% decrease in North America due primarily to lower municipal spending and down 21% internationally due to lower sales in Europe. In the light-duty automotive and RV business, revenue was up 33% this quarter compared to a year ago. Engine shipments to Daimler Chrysler for the Dodge Ram pickup truck were 40,500 units, up 30% from the second quarter last year. Dealer orders in states with stringent air quality standards are especially strong as the high output rating is now available in all 50 states for the first time in several years. The percentage of heavy-duty Rams with Cummins engines is now 80%, up from 73% in 2003.

Unit shipments for RV engines increased 10% year-over-year as demand for RVs continues to be strong and Cummins remains the clear market leader for RV engine sales. Sales to industrial engine markets in total were up 28% from a year earlier with increases across all segments. In the construction equipment market, sales increased 25% compared to the second quarter of last year. Unit shipments in North America were up 56% and shipments to international markets were up 40% compared to the second quarter of 2003 with particular strength in China and Southeast Asia. Demand from new customer relationships secured last year as well as increased sales of our new products, such as the "A" series and B-3.3 series, contributed to the increase. The difference between the revenue and the volume increase was driven by part sales which were relatively flat compared to last year.

Sales for the agricultural equipment market were 13% higher than the second quarter last year. Unit shipments in North America drove the increase as international shipments were down 3%. Revenue in the mining segment increased significantly at 43% quarter-over-quarter with improved demand for mining equipment driven by increased commodity prices. The Russian mining market is very robust due to increased coal and steel production and is the region of Cummins largest mining customer. Sales in the Power Generation business for the second quarter were $468 million, up 52% from second quarter of 2003. The Power Generation market recovery, which has occurred faster than expected, was driven by large increases in demand from power shortages in China and Argentina and economic development in the Middle East. In the U.S., the commercial markets are showing some improvement despite the lack of any meaningful increase in non-residental construction spending. The RV business continues to be robust and posted record sales. Our generator sales could increase by 25% to reach nearly 100,000 units due to continued market share gains and increased penetration in the non-motorized RV segment.

In the second quarter of 2004, Power Generation reported earnings before interest and taxes of $19 million compared to a loss before interest and taxes of $15 million last year. The profit improvement compared to last year resulted primarily from the benefits of the higher volume and the significant cost reduction actions taken during this past year. Revenues for the filtration and other segment were $369 million for the quarter, a 39% increase compared to the second quarter of 2003. Excluding this segment reporting change, sales increased $51 million or 19%. North American sales continued to comprise nearly half of the revenue increase but the business saw improvement across most markets. This segment's earnings before interest and taxes for the quarter were $24 million versus $25 million in the second quarter last year.

The profits generated by filtration's increased volumes were adversely affected by steel price increases, the mix shift between OEM and after-market sales and criminal costs to fund the segments targeted growth initiatives and costs related to production and efficiencies resulting from capacity constraints and the significant increase in volumes. Sales for the international distributor business were $220 million in the second quarter, an increase of 30% compared to second quarter last year. Sales were strong for Power Generation products, particularly in the Middle East and Hong Kong. Earnings before interest and taxes for the segment were $14 million this quarter compared to earnings of $12 million last year. Profits were somewhat negatively impacted by mix with a lower percentage of higher margin product and service sales. Returning to the corporate level, I will review our total sales by region.

In the second quarter, our sales mix was 52% U.S. and 48% international compared to 53% U.S. and 47% international in the second quarter last year. For the second quarter compared to a year ago, sales in the U.S. increased 37% while international sales in total increased 40%. The U.S. sales increase was primarily attributable to increased market demand for heavy-duty truck and Dodge Ram engines. International sales increased in all regions. Sales to China were more than double those of last year led primarily by strength in the Power Generation and international distributor businesses while sales to Asia in total were up 63%. Sales in the Middle East were up sharply at 86% led also by significant increases in the Power Generation and international distributor businesses. Canadian sales rose by 74% due to the recovery and heavy-duty engine volumes. Sales to Latin America were up 32% compared to last year with higher sales in all businesses, particularly the Engine business. Next I'll review corporate gross margin.

The gross margin percentage for the quarter was 20.2%, up from 17.9% in the second quarter last year. The absorption impact of the higher North American automotive shipments and increased volume across our businesses benefited margins. This is Cummins highest gross margin percentage since the first quarter of 2000. Product coverage cost was 3.6% of sales or $76 million in the second quarter compared with 3.3% of sales or $51 million a year ago. Most of the absolute dollar increase was in the Engine business driven by volume and a higher percentage of heavy-duty engines, which typically have a greater per engine warranty cost. Total selling, admin. and research in engineering, or FAR spending in the second quarter increased from a year ago but declined as a percentage of sales.

SAR spending for the quarter was $310 million or 14.6% of sales compared to spending of $250 million or 16.2% of sales last year. Research and engineering spending as a percent of sales was 2.8%, considerably less than our average spending over the last decade. Approximately 1/3 of the year-over-year SAR increase was increase variable compensation accruals. $8 million was currency impact. $8 million was the result of FIN 46 consolidation of additional entities and $3 million was increased pension expense. In addition, we had increased spending to fund our growth initiatives as well as volume variable spending. Our income from joint ventures and alliances in the second quarter was $29 million compared with $17 million in the second quarter last year.

The increase in income was broad-based across all joint ventures especially our China and North American distributor JVs. Part of the year-over-year increase was attributable to a $2 million catchup of royalty and taxies in the Dong Kong joint venture. We still expect 2004 joint venture income to reflect a solid increase over the 2003 level of $70 million. Interest expense for the quarter was $27 million, compared to $20 million of reported interest expense in the second quarter last year. Beginning in the third quarter of 2003, we now reflect the dividends on our preferred securities as interest on our financial statements.

With both items combined, interest expense increased $2 million compared to the year-ago period primarily related to capital leases. The income tax provision for the quarter was $34 million, compared with $5 million in the second quarter of 2003. The increase was driven by the increased tax accrual based on higher earnings. We still expect our effective tax rate for 2004 to be 28%. Thank you. Now I'll turn over to Jean.

Thank you, Karen. As we mentioned in our last call with you, we consolidated three operating joint ventures last quarter, which were reflected on our balance sheet as of the end of the first quarter. This quarter's income statement now reflects that consolidation, which, in summary, resulted in a $49 million increase in sales with no change to the Company's net income or earnings per share in the second quarter or in future periods. Also during the quarter, we restructured some of our -- some of the rental equipment leases in our Power Generation business with the agreements now being accounted for as capital leases.

The results of this transaction was to record an additional $52 million of fixed assets, $57 million of debt and a decrease of $5 million in long-term liabilities on our balance sheet. Change is not expected to have a material impact on net earnings. Next, commodity prices continued to impact our businesses. Let me provide an update. At this time we have not seen any significant improvement in our commodity price levels, this is having a negative impact on profitability, particularly in our filtration business.

Seals prices in May reached levels roughly double that of the fourth quarter of 2003 and we expect seals to remain at elevated levels for the remainder of the year. Copper, which primarily affects our Power Generation business, has increased more than 50% in the first half of the year. And we thing theses prices will remain high for the rest of the year, as well. We continue to employ effective relationship management with our suppliers to ensure the best price and delivery we have. We have adjusted and will continue to adjust pricing where possible to mitigate these costs. We believe the net earnings impact to Cummins overall in 2004 will be around $30 million, higher than the full year impact we told you last quarter. We put that into perspective, that's still a very small percentage of the 4 to $5 billion in material purchases we make per year. These increases while fairly significant, are already built into oar guidance for the year. Finally for a few comments on cash flow, we were extremely pleased with the strong cash flow for the quarter.

Cash and flow from operating and investing activities for the quarter was $147 million and $174 million year to date. While some of the inflow was due to the timing of payments, these results reflect very good cash performance. Changes in working capital represented a net cash outflow of $101 million for the quarter driven by the increase in volume. Working capital, including receivables, inventory and payables, as a percentage of sales for the quarter, was 16.5% the same as the prior quarter. Accounts receivable increased $120 million during the period with day sales outstanding at 50. Inventory increased $65 million during the period and our inventory turns improved to 7.7 turns. Accounts payable increased $85 million in the quarter.

Capital expenditures for the quarter were at a more normalized level of $28 million as compared with the atypically low $9 million last quarter. Our year-to-date CapEx is $37 million, we now expect our capital spending for the year to be in the 135 to $145 million range with the recent consolidation of new entities. Investment in and advances to joint ventures and alliances during the quarter were $3 million, and $21 million year-to-date. We expect only modest additional investment during the second half of the year. We have substantial liquidity and currently have no borrowings outstanding under our short-term credit facilities, which have a combined availability of $480 million. In addition, at the end of the quarter we had short-term investments in the U.S. and U.K. of $263 million. We announced several months ago our intention to repay the $225 million of notes due in March 2005 with available cash from operations using our existing short-term credit facilities if necessary. Our continued strong earnings and cash flow generation give us continued optimism regarding our ability to pay down this debt. Now we will take your questions.

Thank you. Ladies and gentlemen, the floor is open for questions. If you have questions or comments, please press the numbers 1 followed by 4 on your touch-tone telephone at this time. Pressing 1, 4 a second time will remove you from the queue should your question be answered. We ask while posing your question you pick up your handset if listening on speaker phone for optimum sound quality. Please hold while we poll for questions. Thank you. Your first question is coming from Peter Nesvold at Bear Stearns.

Hey, guys, I'd like to focus on the JVs first. Can you tell us what -- what JV income is discounted into your upwardly revised annual guidance?

Peter, we've said that, you know, without giving an exact number for the year, we expect kind of a -- kind of a solid improvement over the $70 million in '03. We don't expect to be able to keep it at the same level that we had the earnings that we saw in Q2, those were a record for the Company. And we did call out that we did have one item, $2 million of non-recurring royalty fees in the second quarter. So, we're also expecting some slight softening in income from China. So, I guess that's about the best we can give you right now.

Okay. A follow-up question on the JV. My understanding is that the JV income is included in your EBIT margins, in your segment EBIT margins. How much unconsolidated JV income would be in the truck EBIT in second quarter '03 versus '04?

Ooh, I -- I don't have a good number for you on that, can I work with you on that on the phone after our call, please?

Yeah, sure. I guess just directionally, though, I guess I'm trying to understand the 6.5 EBIT margins you had in truck. It maybe the highest you've ever done. I'm trying to get a sense of how much of that was just from JVs and how much was a result of the restructurings?

Most of that comes from the restructuring. The JV income, as we said three months ago, is going to run roughly about 20% of our total EBIT and roughly half of that comes from China and most of that that comes from China is -- is an automotive plant that -- the results from the Engine business were, you know, from the heavy-duty volumes, cost reduction, the -- the Chrysler business and basically every other business was up. So, you shouldn't read that JVs or the JV income is impacting the Engine business that much.

And just to help you with that, Peter, the actual increase in JV income for the Engine business is $8 million this quarter compared to second quarter of last year.

That's right. Very helpful. I guess the last question and I will hand it off. Any update on the Power Gen margin guidance? I think it was 3 to 4% last time?

I think we're still within that range, Peter, somewhere for the year. We haven't been very specific -- you know, we talked about improving that and working toward our financial targets over the next couple of years but I -- I think, you know, you're in the right kind of range.

Just to remind you that the cost reduction program that Tom put in now over a year ago is now getting about between 7 and $8 million a quarter so roughly 32, maybe $35 million a year better cost reduction or improvement on margins in his redesigned sets. And the other improvement is coming from the increased demand. So, I think we'll see some improvement but as time goes on, just because he's taken cost out of the business.

Okay, thanks for the time.

Thank you.

Thank you. Your next question is coming from David [INAUDIBLE] at Smith Barney.

Hi, good morning.

Good morning, David.

I had a question about the -- a couple of quick ones, if you don't mind. The shut down comments on some of the big OEMs. Are any of those not the typical summer planned shutdowns? Is anything related to capacity constraints, component constraints? Anything causing the --

The Chrysler week off is due to a model change over and then there's all kinds of mixture of the OEMs in terms of -- of how much vacation days they're going to do. It ranges from a few days to a two weeks. But most of that is due to, as far as I know, is due to, you know, the normal kind of shutdowns that they have.

Okay, that's fine. Also, just trying to figure out the earnings power of the Company. The engine margin goal of 5 to 8%, you're obviously ready this quarter, I know it's a big quarter, the second quarter, but you're already halfway there, I mean in the halfway point of that range. Any thought at all, trying to help us out? I mean we're all trying to figure out [INAUDIBLE] truck, you're pretty much down to one big plant doing the volume instead of split between Columbus and New York. Just trying to get a feel at all on that range, now that you've seen the first quarter of big truck builds in North America. Clearly England is doing well now with the high horsepower engines coming out of there for mining. Can you just give us an update on where you think the 5 to 8% range falls versus what you're seeing already?

I'd stay with the 5 to 8% range. You know, the Engine business had very, very good results but we've had, you know, as we said, very, very good business conditions right now. Probably the best I've seen in a long time. So, for us to be upping their targets at this point in time, I think would be premature.

David, one thing I can we can tell you is that with the lower EBIT margins in first quarter, we still expect to be within that range for the business for the full year.

Okay. And just related to that and the last thing, the -- the cost pressures we're seeing, obviously I understand some of the different commodities impact from the businesses more. But, again, excuse my ignorance of the business on the engine side, but why are we not seeing more cost pressures within engine? I mean are the -- are the engines made of something I'm not -- I mean --

No --

I'm just not sure why. Obviously there's a lot of metal in making an engine and we're not ever addressing the cost pressures there. Are they just being overpowered that much by volume?

Yeah, this is Joe. Yeah, we're seeing the same kind of commodity pressures from steel commodities as the other businesses are, but a couple of things. One is as a percent of our buy, steel is a lower factor, lower percent than the filtration business or the Power Gen business. Number one. Number two, because our global sourcing program is -- is slightly ahead of schedule, we're able to recoup some of what we're losing on steel prices from better pricing from global sources. So, the net difference is impacting us may be a little less, but still impacting us than the other businesses.

It's kind of ironic, given your customer base, it might have less chance to pass on prices to big OEMs than you would selling smaller filtration product at the after market. As you know, filtration a little more heavy after market than OEM. I was thinking if there's more of a squeezed risk with an engine given a customer base. You're basically purchasing better, essentially? Than the other divisions.

Well, I wouldn't -- I said I think we're a little bit ahead on global sourcing in terms of our program, number one. And number two, as I said, steel is a lower percent of our buy than the other businesses, so, it's less over-- less of a significant impact, still an impact.

It's that much smaller?

Yes.

Yeah, okay.

And David, your comment on filtration. Keep in mind we have entered into long-term agreements in that business similar to what we've done in the Engine business. So, don't assume that pricing is all that easy to get in filtration.

I appreciate it. Thank you.

Thank you. Your next question is coming from Gary McManus at JP Morgan.

Hi, good morning, everybody.

Good morning, Gary.

I'm looking at your third quarter guidance, if I take the mid point, that's about 40 cents down from the second quarter or about $25 million of EBIT. Can you talk, you know, which of the segments, you know, are -- you know, how we'd reconcile the $25 million with each of the different segments? And I hear you talking about, you know, shut down, but, you know, looking at the ATT numbers, they expect heavy truck production North America to be up 10% in the third quarter versus the second quarter, so, if you could comment on that, as well.

Well, I think the first thing is that our volumes for the third quarter are going to be lower than what they were in the second quarter -- second quarter, primarily in the Engine business. But our international distributor business tends to have a softer third quarter versus the second quarter, as well. And then I think when we look at the -- the margins that can go back to what Jean was talking about on the commodity prices is that, you know, we're expecting $30 million after-tax hit this year. It was probably, you know, we were saying $20 million before, so, we're going to see higher steel prices. [INAUDIBLE] for $5 million in the -- in the second quarter. So, we're not planning on getting a lot of pricing to recover that and we're not planning on our commodity prices to go down. And then finally, we -- you know, like others with the kind of demand where it is right now, we've had some premium freight, some overtime and some temporary hires. We've been able to manage that, I think very well and have met all of our customer demand as a result of it. But we're going to have to work through those inefficiencies and we estimated that that was probably about $10 million in the second quarter and that's certainly not going to go down in the third quarter. So, we're kind of working through that right now.

And, Gary, the one other item I might add, is on the JVs. We said we don't have that same level of JV earnings in Q3. So that will go down.

Okay. And just a follow-up. The -- you know, Tim, you talked about, you know, heavy truck share in May was -- was 31%. Do you think that's sustainable for the rest of the year? I mean not every month, but just on average?

I'm going to let Joe answer that one.

We feel very good, obviously, about the share number in May. But I think I just want to remind -- remind you guys that our -- our focus in the heavy-duty truck business is returning to profitability and sustaining that return. So, hitting market share in numbers like this are clearly icing on the cake but it's not the cake and I think the numbers, however, clearly represent a couple of things that we think are going well for us. The product is getting better. The cost reduction program's working. Relationships, as Tim mentioned, with our -- our partner OEMs and with our OEM dealers and with our distributors, a lot of great joint work going on between them, which is improving. The customer service sides of things. The customer service side of things, in addition to the great joint sales effort going on between our factory folks and the OEM factory folks. So, you know, there's a lot of things that affect share number, but -- but we're working hard to do the best we can in an environment where it's very important for to us have a solidly profitable business going forward.

But I would think you have a lot of visibility here because, you know, pretty much every truck is spoken for that's going to be produced in the second half of the year, you must have, you know, you can look at your orders versus the industry orders. Don't you think you have pretty good visibility on what your share's going to be this year?

A lot moving around in the order board between OEMs and engine suppliers right now, Gary. So, I'd rather not say. But because it is not clear and we're working that through with the OEMs, but we think we're going have a good year on share. I'll leave it at that.

Okay, great, thanks.

Thank you. Your next question is coming from John McGinty at Credit Suisse First Boston.

Good morning. Just one question -- a couple of numbers, Karen, I don't think you gave us a number in the Power Generation, which was up 52%, of which portion the change in -- in the inner company, what the impact was on that one? You gave us the other adjustments.

No change to that, John it just increased sales in engine and then the filtration and other business, but no real change to the Power Generation revenues.

Okay, and then when you gave us, for example, automotive up 48 and industrial up 28, I assume you're working off of the 42. You're working all of your adjustments off of the -- off of the adjusted number, not the reported number?

We would be working off -- in -- in the Engine business, John, the only increase to the sales there are our sales to Power Generation markets and I've excluded that.

Okay. I just --

All numbers excludes the impact of segment reporting change when we talk about specific markets.

Okay. Fine. I just wanted to make sure I understood that. Just a question and -- I -- I don't at all -- I mean it was a fabulous quarter, obviously much better than expected. If I'm looking at the incremental margins and the problem is, obviously when we're looking at incremental margins, it's a little bit dicey because we have to figure out what we're excluding and what we're including. If the incremental margin, at least as I've got it in the first quarter was like 27 -- for -- for the Engine business, the incremental margin was like 27, 28% it was only 18, 19% in the second quarter, which is still very good, but my question is: Is that a mix issue? Or was there just coming from a loss to a profit in the first quarter that much more umph or as the heavy truck comes up, is that the lower margin kind of -- I'm not complaining about the margin, but trying to figure out why the second quarter incrementals were lower than the first quarter incrementals?

I think the way I'd like at it, John, if you go Q1 over Q1 a year ago, the incremental margin was about 23%. Q2 over Q2 was about 17.5%.

Yep.

And I would guess a third of that has to do with premium freight overtime and just managing the inefficiencies that are created in the supply chain as a result of the increased demand. Another big chunk of it happens to be variable compensation. You remember the first half of last year, we weren't really accruing that much for variable comp because we weren't making a profit. Now we're making a profit and we're starting to accrue for that. And if you look at, you know, the anticipation right now is that our variable comp would be up about $65 million year-over-year and over half of that has been booked in the first -- in the first half. So I would say that's a fairly significant impact. And then if you look at the fact from FIN 46 we added, I don't know, $50 million worth of sales with no margins, that would be bringing it down, as well.

That's mostly in engines?

I think it's a cross the board. I wouldn't tie it to -- Go ahead, Jean.

I think that probably is in engines. And John definitely on the variable comps, the biggest impact there, because, you know, so many of our employees are in the Engine business, which would be seen in the -- in the Engine.

Okay and then -- and then when -- when we look at -- could you kind of, you know, you give pieces of it, could you kind of tie what -- on the Engine business, given, you know, the -- the range of this, the Dodge of this, the heavy truck up that, the mediums and so on, could you kind of tie together what kind of a sales gain that translates to on mid point in engine for -- for the group? I mean you've given Power Generations in the other ones, but you've given pieces, I'm just trying to make sure that I understand what you're looking for the engine group on a full-year basis to be up in a percent in round numbers?

I think it will probably be up close to 30%, something in that range

30% in that range. Okay, thank you very much.

Thank you. Your next question is coming from Andrew Casey of Prudential. Sir, your line is live.

Good morning.

Good morning, Andy.

I guess a follow up on John's question. The 50% of the incremental within engines that was muted because of premium freight inefficiencies and all of that, that's what, roughly about 10 to $11 million or 15 roughly cents a share. Is that about right?

Yes, I think you've got it right.

Okay. And then in response to I think it was Gary McManus's question, Tim responded about $10 million of inefficiencies in 2Q '04, did that all fall in the truck -- excuse me, in the engines?

No, no that was -- that was across-the-board and I would say probably half of that was in the filtration group.

So I guess I misunderstood the response to John's question. I thought he was asking about engine incremental X, the new revenue reporting thing.

Right, right, Andy. I think we've kind of mixed answers there. On the inefficiencies there across the business, probably split almost equally between engine and filtration. The variable comp increase, although across all businesses, was most significant in the Engine business.

Okay. And then as a follow-up, raw material impact you talked about $5 million in filtration. Is there a -- is there a net number across the Company that you gave? If you did, I missed it.

I think in -- in the second quarter I think we got -- let me get back to you on that number. Hold on just a minute. Do you have any other questions?

Yeah, just a detailed question on cash flow. The -- it looks like there was an acquisition --did that have to deal with FIN 46? Or was there something else there?

We did an additional investment in North American distributor JV. That was what you're looking at, on the acquisition line.

Yep. Okay. Do you have an answer on the raw material?

No, but I'll -- I'll update you when I find the answer, Andy.

Okay, I mean the point I'm trying to get at is the quarter was very good and I'm just wondering what the head winds were that you encountered, you know, to -- to potentially make it even better?

I -- I think our number for the total company would probably be close to $15 million on a pretax basis for the quarter.

That was $15 million for raw material?

Yeah.

Okay. So -- so you had something like a 30, 35 cent head wind in these things?

Yeah.

Okay. Thank you.

Uh-huh.

Thank you. Your next question is coming from Brian Rayle at FCN Midwest Research.

Good morning, great quarter.

Good morning, Brian.

Quick question on the Power Gen since we've talked about the engine here. Given that China appears basically to have a structural deficit of Power Gen capacity, how long and I guess -- how long is this growth sustainable? And sort of what do you look at over the next couple of years with regards to growth in that region?

Yes, this is Tom, Brian. China is and has been strong now for a couple of quarters and you are right to say it's -- it's a shortage of capacity, particularly given its -- its very, very strong economic growth. Over last several quarters. And our expectation is that they will have a structural deficit for some quarters going forward. It's -- it's difficult to say how many. The range that I hear in the marketplace is between sort of middle of next year and maybe a year after that. There are a number of -- of -- of projects that -- that the government is working on to put in central capacity. They also have distribution and transmission issues to work out. Longer term there are also even a larger number of -- of projects to put in central capacity. So, it's -- it's unlikely it's sustainable, inevitably. That's not our experience in the other market. But we do think it will run through some part of next year, where they will have a deficit and they will be relying on purchasing distributor generation and generator kind of solutions. Our view of the region, though, remains that Asia will continue to be a big buyer of generator sets. You probably know that Cummins has a really strong position there. The India market, the China market and most of Southeast Asia and East Asia, we have a strong position in terms of generator sets, engines and components as well as distribution, which I think puts us in an advantage over our competitors, so, as that region strengthens, we're able to take a pretty strong share of the business. That's really helping our results in the quarter.

Great, thank you.

Thank you. Your next question is coming from Charlie [INAUDIBLE] Company.

[INAUDIBLE] A couple of questions, you're starting to pump some terrific free cash flow, can you give us priorities of what you're going do with that, I think Jean reference the 225 million of notes for '05, but can you give us a sense of ranking what you're going to do with the cash?

Well, I think we've been fairly consistently focused on debt reduction and will continue to stay focused on debt reduction for quite some time, getting back to investment grade. Further out we're not focusing on acquisitions and we are really focusing on improving our balance sheet right now.

Okay. And the second and last question, people that I talk to about Cummins and the outlook, you know, you're doing so well, having such a good time, working so hard, but the concern that keeps getting tossed up is about the possibility or probability of prebuy against the January '07 emissions hurdles coming up. I know that's some time away but maybe it isn't. I wonder if Joe or Tim could -- could comment about that. Is this a case where '05 is better than '04 and '06 better than '05 and then the pencil drops off the tabletop, or what are your views on that, please?

Well, we're certainly hoping for a better '05 than '04 and a better '06 than '05, in general. Nothing do with potential prebuy and believe we have some prospects for that. On the prebuy situation, Charlie, while it is a little early to predict exactly what's going to happen because of our experience the last time, we're deep in both with our OEMs and in conversations with the industry and government for that matter. What are the kinds of things we can do to mitigate the possibility or impact of a prebuy? So, we think when it becomes known what our product--more clearly know what our product strategy is for '07 and the fact we plan -- we already have engines out running on the road in trucks and plan to put engines in the hands of customers as field test units in midish 2005 and to spread them around enough so that people talk about the experience. We think we can, through programs like that, do some things to actually mitigate the concerns people might have as a result of the emissions change. That obviously remains to be seen but we're -- we're heavily involved in trying to do things that will lessen the concerns of end user buyers and to thereby mitigate impact of prebuy might have in '06.

Uh-huh. Okay, thank you.

Thank you.

Thank you. Your next question is a follow-up question from David [INAUDIBLE].

Yes, hi, just a question for Tom. Tom, on Power Gen, the North American market is still kind of holding it back a little bit. Can you give us a feel on the pricing that you're seeing and the mix in North America and then also internationally?

Yeah, North America actually is stronger year-over-year as you know, there is significant growth year-over-year, but you are right to say that relative to some of the other markets it's still not growing -- has not grown that much and part of that is reflected as Karen said, in the non-residental capital spending levels, which are still not that strong. Our mix in pricing experiences as follows. I mean the mix still remains more at the -- the lower end of the market, you know, smaller kilowatt range as it has for some time. Although we are seeing more interest in the -- the upper end now and that's been really true for the last six months or nine months. Additionally, pricing remains competitive. It's not -- we have not seen return at all to the peak level pricing, so, my view is we still have prospects for growth in the North American market in terms of volume as well as improvement in pricing. Our approach to the market remains the same, which is we're driving for a cost position that allows to us make good returns at pricing levels that extinct today. But I think we have more opportunity, more upside, if the North American market returns to its historical peaks and strengths, you know, there is no reason to think it won't.

Is the mix internationally, also -- when we say small, are you talking sub-250?

Sub-500, really. Internationally, the mix is much stronger at the high end. Much of the demand for example in China and the Middle East is really distributed on a generation kind of demand so they're looking for larger generator sets that are going to run quite a bit during the day. So there the mix is at more of the high horsepower end.

Thank you.

I think we're out of time. Thank you very much for joining our call today. If you have any questions, please give me a call.

Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time. Have a wonderful day and thank you for your participation.