康明斯 (CMI) 2004 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Cummins third quarter 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 comments, results for the third quarter 2004. Each of you should have received a copy of our press release with a 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, our Chief Financial Officer, Jean Blackwell, President of our engine business, Joe Loughrey and President of our power engine business, Tom Linebarger.

We will all be available for your questions at the end of the teleconference. This morning first Tim will start our conference call. Next, I will review the details of our income statement and business unit results. Then Jean will cover some miscellaneous items and our cash flow performance. And finally we'll have the question-and-answer period.

This teleconference will include certain forward looking information. Any forward-looking statement 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 10-K, and it applies to this teleconference.

During the course of this call, we will be discussing certain nonGAAP financial measures, and we refer you to our website for reconciliation of those measures to GAAP measures. I want to remind you that when we discuss earnings before interest in taxes or EBIT in our call today, that measure also excludes minority interest and preferred dividends.

Now I'll turn it over to Tim for some opening remarks.

Good morning. Cummins third quarter results were good. Record total company sales and record sales in the engine and power generation businesses, we are participating in the strong market recovery and capitalizing on additional opportunities as we gain market share, respond to global power crisis, and benefit from our geographic diversification.

Third quarter sales were 34% higher than the third quarter of 2003 driven by strong demand across all our businesses. Earnings before interest in taxes for the third quarter were $146 million or 6.7% of sales compared to $61 million or 3.7% of sales last year.

Our quarterly performance is within our targeted financial goals of 6 to 9% EBIT margins and our year-to-date EBIT margin is also within that range at 6.1% of sales. This reflects the benefits of both our strong volumes and the cost structure improvements we have made over the past few years. Net earnings for the quarter were $116 million, or $2.40 per share compared to net earnings of $24 million or 60 cent per share in the third quarter last year. As a result of our strong earnings performance, this year's third quarter results reflected a change in our effective tax rate for the year and other tax impacts which we will discuss in more detail later in the call. These tax items total $37 million or 74 cent per share in the third quarter.

In our automotive markets we experienced strong increases in North American heavy duty truck volumes, global medium duty truck volumes and shipments for the Dodge Ram pickup truck. The Cummins Turbo diesel engine for the Dodge Ram is still in great demand and on pace for a 15% or greater unit shipment increase over 2003. Remember, 2003 was also a record year for the Dodge Ram pickup truck.

In our industrial markets we saw increases in nearly all market segments, both domestic and international with the strongest increase in North American construction and global mining markets. In total, the EBIT margin for the engine business in the third quarter was 6.7% of sales within its targeted range of 5 to 8%.

In power generation, sales in the Middle East and China were strong and the commercial [INAUDIBLE] set market with very good alternator demand in those two areas as well as in India.

While we continue to closely monitor any signs of slowdown in China we believe this market will be strong until at least the end of 2005. In North America, the consumer business continues to do well with RB sales remaining the primary driver. Overall power generation sales were up 38% from the year ago quarter and earnings before interest and taxes increased by $17 million. Power generation has improved from a low point of $29 million loss in the first half of 2003 to a projected profit of at least $60 million in 2004.

Our filtration and other business continues to experience significant demand increases in North America. However, our Holset Turbocharger business has seen improvements in China following a slow down in 2003. We continue to see a mixed shift in the filtration business as both the market recovery and the increased sales from our long-term agreements have resulted in OEM sales growing much faster than our after market sales.

Higher commodity prices continue to pressure earnings and manufacturing inefficiencies have had a greater impact on this segment, particularly in our exhaust operations. The commodity prices and inefficiencies combined resulted in $14 million of additional cost compared to the third quarter last year. While the higher commodity prices are expected to continue, we believe the manufacturing inefficiencies are improving with lower cost expected going forward. Our international distributor business this quarter might be the best example of our globally diversified revenue base. In the third quarter, every company-owned distributor around the world experienced a net sales gain compared with a year ago, a phenomenon that has occurred for the first time since this business segment was formed in 2002.

Total unit business sales increased 24% while earnings before interest and taxes increased 33%. Our income from joint ventures continues to be a stable and diversified contributor to our overall profits. Year-to-date, 52% of the income has come from our two China joint ventures. 23% from our North American distributor joint ventures, 10% from those in India, and 8% from recreational marine joint ventures with MerCruiser.

While reports from China reflect the Chinese government's actions to cool its economy and enforce traffic regulations to prohibit commercial vehicles from overloading, the infrastructure expansion in Cummins advanced product line relative to its local competition has enabled our China joint ventures to continue to report increased earnings. It has been two years since the successful launch of our 2002 emissions compliant heavy duty engine. We now have 70,000 engines in the field with an accumulated 5.1 billion miles and are adding 17 million miles every day.

Our products continue to perform well for our customers, and we have gained significant market penetration as a result. Continued customer confidence in our products has resulted in a 5 1/2% increase in our heavy duty market share in 2004 reaching 27% share through the first eight months of the year. A significant contributor to the overall share gain has been our success with the top 100 fleets where we are achieving approximately 38% share in 2004 versus 27% share in 2003. Customers like Night Transportation, Wal-Mart, Swift, Penski Leasing, USF, Fed Ex, Hartland Express, USA trucking and Estes Express are operating significant volumes of ISX and ISM products and are reporting excellent results. We are confident that we have chosen the right technology to meet both current and future emissions standards while also providing the best performing in against for our customers' needs.

We are on track to have 2007 EPA compliant engines available for field-tests in the middle of next year. We are leading our competitors in off highway engine development as well, as we recently introduced two Tier2 engines at Minexpo in Las Vegas, the first to accept EPA certification in their horsepower ranges for use in large mine hall trucks and excavators. As good as the quarter's results were, they could have even been better. Because of the rapid increase in volumes across businesses, we've experienced higher operating cost in the form of supply chain constraints and inefficiencies at some of our plants, including premium freight and overtime. In addition, commodity prices have continued to increase material costs for our businesses. Combined these costs negatively impacted our results by an estimated $40 million pre-tax compared to the third quarter last year.

We have specific plans to address certain of these inefficiencies which are isolated in a few plants and believe we will see improvement in the fourth quarter. Commodity prices and the impact of supply constraints are likely to continue but we are working to lessen their affects on our results. With the strong market outlook continuing, our expectation of lower efficiencies going forward and the tax changes I mentioned, we are increasing our guidance for the full year to $7.10 to $7.20 per share. We expect earnings for the fourth quarter of between $2.15 and $2.25 per share. Tax items contribute approximately 30 cent per share to our improved expectations for the fourth quarter.

I can't remember another time in my 33 year career with Cummins where all of our markets were so strong and we are as well positioned to translate that market recovery into earnings and value for our shareholders. We are achieving our stated financial goals, including cash generation, demonstrating discipline in our capital spending, cost reduction efforts and growth initiatives and giving our customers quality products as well as confidence in our technology plan to meet their needs in the future. We did what we said we were going to do and we intend to keep doing it.

Now I turn it back to Karen to review the details of our third quarter results.

Thank you, Tim.

In the third quarter of 2004, Cummins recorded sales of $2 billion 194 million, 34% higher than sales of $1 billion 634 million in the third quarter of 2003. Our revenue continues to benefit from a broad market recovery with increased volumes across all our businesses with particular strengths seen in the North American heavy duty truck market and international power generation market.

Earnings before interest in taxes for the quarter were $146 million or 6.7% of sales compared with 61 million dollars or 3.7% of sales in the third quarter of 2003. Net earnings for $116 million or $2.40 per diluted share on 49.8 million average shares for EPS purposes. This compares with net earnings of $24 million or 60 cent per share in the third quarter last 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 third quarter were $1 billion 438 million, a 53% increase from sales of $942 million a year ago. As we discussed in previous quarters, our change to market-based transfer pricing results in increased sales in the engine and the filtration and other businesses with a corresponding offset in elimination alone with somewhat lower EBIT margins for those businesses. For the engine business, the segment reporting change added $140 million in sales in the third quarter. Excluding the change in engine business sales increased 38% compared to the third quarter of last year.

Revenues in automotive markets were 41% higher than Q3 last year with increased demand in all segments driven by the broad market recovery. Overall revenue from industrial markets was up 28% year-over-year with increases in all segments. Earnings before interest and taxes for the quarter were $96 million or 6.7% of sales versus $36 million or 3.8% of sales in the third quarter last year. Excluding the segment reporting change, EBIT margins for the engine business were 7.4% of sales. In addition, the engine business incurred a one-time charge of $9 million in the third quarter related to inventory evaluation.

The increase in profitability during the quarter was primarily driven by the significantly higher volume, the associated leverage, and the business' cost structure improvement.

Revenues for the heavy duty segment as a whole were up 68% in the third quarter from a year ago while global unit shipments were up 97%. The variance between the revenue and volume increase was due to the mix of engine versus part sales. Part sales increased 28% compared to third quarter 2003, but were a lower percentage of overall revenue in this year's third quarter.

Unit shipments in North America were up 119% 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 longterm agreements with our OEM partners and have seen increased penetration under these agreements.

Unit shipments to the rest of the world were up 15% with higher sales to OEM's in Mexico, Australia, and Asia, more than offsetting sales in Europe.

In the worldwide medium duty truck and bus market, total revenues increased 39% for the third quarter year-over-year. Medium duty truck engine shipments were up 74% in the U.S. and Canada, with significantly higher volumes with several key OEM customers. International shipments were up 47% with higher OEM sales in Brazil, Mexico, and Europe. Global bus engine shipments rebounded in the quarter increasing 35% year-over-year compared with last quarter's 19% year -over-year decline. Shipments were up 45% in North America due to improved demand in our engine availability and additional OEM vehicles and up 31% internationally with the strong increase in East Asia.

In the light-duty automotive and RV segment, revenue was up 13% this quarter compared to a year ago. Engine shipments to DaimlerChrysler for the Dodge Ram pickup truck were 38,200 units, up 11% from the third quarter last year and 20% year-to-date for the first three-quarters -- over the first three-quarters in 2003. Unit shipments for RV engines in the third quarter experienced a 36% decline, due primarily to unusually high sales in last year's third quarter in advance of new product introduction. Overall, demand for RVs continues to hold up pretty well compared to last year's record levels. Year-to-date, RV shipments are down 8% while sales have increased 2% versus the same period in 2003.

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 12% compared to the third quarter of last year. Unit shipments in North America were up 36%, and shipments to international markets were up 13% compared to the third quarter of 2003 with demand improvement in most regions except China.

Sales for the agriculture equipment market were 69% higher than the third quarter last year. Unit shipments in North America up 73% drove the increase while international shipments were up more modestly at 11% with sales increases in Brazil more than offsetting sales declines in Europe.

Revenue in the mining segment continues to be strong, up 41% compared to last year with shipments up 89% in North America and 46% internationally, with increases in Russia, Europe, and the Middle East. The demand continues to be fueled by increased commodity prices.

Sales in the power generation business for the third quarter were $502 million, up 38% from third quarter of 2003. The power generation segment continues to benefit from its worldwide market presence and is capitalizing on the power shortages in China where our Genset business continues to be at record levels with customers placing orders for delivery in the first half of 2005. Volumes were strong in the Middle East and Europe for both Genset and G drive engines with order activity increasing for high horsepower engine being placed in anticipation of Iraq-related activities. Sales of alternators were also strong in the Middle East, India, and China.

During the third quarter, we consolidated the results of two Newage operations, our ABK subsidiary and our SEG joint venture resulting in a sales increase of $51 million. The consolidation included five months of results for these two entities in this quarter. Combined, these operations are currently performing at break-even levels, so there was no corresponding profit increase.

The U.S. commercial market showed good improvement, even though nonresidential construction spending may be up only in the mid single digits for 2004, with forecasts in the high single digits for 2005. Consumer power generation sales were up 17%, led by continued strong sales to the RV market due to high demand and increased penetration.

In the third quarter of 2004, power generation reported earnings before interest in taxes of $17 million or 3.4% of sales compared to break-even results a year ago. The profit improvement compared to last year resulted primarily from the benefits of the higher volume, cost reduction actions, and some pricing improvement. Revenues for the filtration and other segments were $369 million for the quarter, a 45% increase compared to the third quarter of 2003. Excluding the segment reporting change, sales increased $61 million or 24%. In filtration, North American sales continued to contribute heavily to the revenue increase while some improvement was seen in Europe, the Middle East, and Asia Pacific. Holset Turbocharger sales continued to be strong in North America and also saw increases in China. This segment's earnings before interest and taxes for the quarter were $21 million versus $16 million in the third quarter last year. The higher volume contributed $26 million in additional profit but was partially offset by continued cost precious in several areas.

Manufacturing inefficiencies resulting from the significant increase in volume added $9 million of cost compared to last year's third quarter. Steel and other commodity price increases contributed $5 million of the variance. Currency added $4 million and higher R& E spending added $3 million. As Tim mentioned, we expect some of those costs to decrease beginning in the fourth quarter as we have taken steps to address the operating inefficiencies.

Sales for the international distributor business were $215 million in the third quarter an increase of 24% compared to third quarter last year. Sales were very solid across product lines and geoographies with roughly half of the increase from parts and service sales. Engine and Power Gen sales were both up, particularly in Asia and currency accounted for $8 million of the increase. Earnings before interest and taxes for the segment were $12 million or 5.6% of sales this quarter compared to earnings of $9 million or 5.2% of sales last year.

Returning to the corporate level I'll review our total sales by region. In the third quarter our sales mix was 52% U.S. and 48% international compared to 53% U.S. and 47% international in the third quarter last year. For the third quarter compared to a year ago, sales in the U.S. increased 30% while international sales in total increased 40%. The higher U.S. sales were attributable to increased market demand for heavy duty and medium duty trucks, power generation equipment and filtration products.

International sales increased in nearly all regions. Sales to China continued to be strong with a 56% increase over last year led primarily by strength in the power generation and international distributor businesses. Sales to Asia in total were up 41% with increases across all markets. Canadian sales reflected a dramatic increase of 131% due to the recovery and heavy duty truck engine volume. European sales were up 49% with significant increases in the engine, international distributor and filtration business. Sales to Latin America were up 27% compared to last year, primarily due to higher sales in the engine business.

Next I'll review corporate gross margin. The gross margin percentage for the quarter was 19.8% up from 17.9% in the third quarter last year. The absorption benefit of the higher North American automotive shipment and increased volume across our businesses was the primary driver for the improved margin, partially offsetting the benefit from the higher volumes were several negative factors including manufacturing inefficiencies totally $23 million resulting from the significant volume increases, including premium freight and overtime. The impact of commodity prices netted price recovery of $17 million and a one-time adjustment of intercompany profit elimination of $9 million where we refined our process to calculate this inventory evaluation. The total of these items was $49 million or 2.2% of sales.

While we expect the impact of commodity prices will remain in the near term, we expect to reduce the amount of operating inefficiencies in future periods as our volumes stabilize. Product coverage costs was 3% of sales or $66 million in the third quarter compared with 3.3% of sales or $54 million a year ago. Product coverage costs as a percentage of sales have continued to decrease reflecting the improved performance of our product.

The absolute dollar increase was in the engine business driven by the higher volume and a greater percentage of heavy duty engines which typically have a higher per engine warranty cost. Total selling, admin, and research and engineering or SAR spending in the third quarter increased from a year ago but declined as a percentage of sales. SAR spending for the quarter was $320 million or 14.6% of sales compared to spending of $259 million or 15.9% of sales last year.

Research and engineering expenses were 2.7% of sales, and we continue to tightly manage this spending while providing the necessary funds for all major technology development. Approximately $20 million of the year-over-year SAR increase was from the consolidation of additional entities, $18 million was increased variable compensation accrual, $8 million was the currency impact and $3 million was higher pension expense. In addition we have increased spending to fund our growth and improvement initiatives as well as some volume variable spending.

Our income from joint ventures and alliances in the third quarter was $26 million compared with $20 million in the third quarter last year. The increase in income was broad-based across all joint ventures but the largest contributors to the quarter's earnings were $13 million from the China joint ventures and $7 million from the North American distributor joint venture. We now expect 2004 joint venture income to reflect a 35 to 45% increase over the 2003 level of $70 million.

Interest expense for the quarter was $28 million compared to $25 million of reported interest expense in the third quarter last year. Increases of $2 million attributable to the consolidation of additional entities and $2 million from capitalized leases more than offset reductions due to lower borrowing.

Minority interest in the third quarter was $2 million higher than last year due to higher earnings at our less than wholly owned consolidated operation primarily in India and China.

Thank you. Now I'll turn it over to Jean.

Good morning.

There are several miscellaneous items I will cover this morning, then I'll provide comments about our cash flow. First regarding taxes, as Tim mentioned earlier in the call, this quarter's earnings reflected a tax adjustment as will next quarter's earnings to a lesser extent. Let me explain each quarter's changes and then quantify the impact on the revised full year 2004 guidance.

Cummins determined in the third quarter that our improved profitability would allow us to realize more benefit from foreign tax credits and state net operating losses than we had previously recorded. This resulted in a reduction in income tax expense of $37 million or 74 cent per share for the quarter. With these adjustments, we are now estimating that our effective tax rate for 2004 will be 21% instead of the previously communicated 28%. In addition for the fourth quarter, the working families' tax relief act signed in early October provided an 18-month extension of the research credit that expired June 30, 2004.

In accordance with tax accounting rules, the company's estimated $5 million of federal research credit covering the second half of 2004 will be recorded in its entirety in our fourth quarter results. In addition we'll be using our revised effective tax rate of 21% to record our fourth quarter tax provision. We have not reached a conclusion as to the tax impact of any other pending tax legislation. Our new guidance for 2004, $7.10 to $7.20 per share therefore reflects approximately $1.04 cent per share from these combined tax adjustments.

Now I'd like to provide a brief update on our progress towards Sarbanes Oxley 404 certification. Cummins has been actively engaged throughout the year in achieving quality internal financial reporting and disclosure controls in order to fully comply with Sarbanes Oxley 404 requirements. Auditors are required to test internal controls as close to year end as possible so their testing of controls is not yet complete. I can tell you, however, that no material weaknesses have been reported to the audit committee and we have adequate resources to complete the process. Nothing has come to management's attention that we believe would prevent the issuance of an unqualified opinion from the auditor and a full certification by management.

We have devoted substantial time and resources to this project because we believe this is an important improvement tool to enhance transparency in reporting to investors. Now a few comments on the Medicare act an its affect on Cummins.

A number of other companies have reported benefits resulting from the Medicare act. Our financial results and guidance do not reflect any such benefit. A portion of our retiree healthcare liability for which we will likely receive a subsidiary under the act is not significant. Cummins benefits plans have caps or limits on the company's obligations, covering the majority of plan participants and the retiree claims are reaching or exceeding those caps. While we would expect participation in our benefit plans will decrease as some plan participants elect the Medicare plan over ours, we do not believe the reduction in our liability will be significant. We will reflect the anticipated impact of this act at the remeasurement date of the liability which is November 30th, 2004.

Next commodity prices continue to impact our businesses so let me provide an update. Due to the increase in certain commodity prices, primarily steel, and our inability to continue to push back on our suppliers, we are continuing to see increases related to commodity. We now believe the pre-tax earnings impact to Cummins overall in 2004 will be around $58 million or $46 million net of tax. This impact is much more heavily weighted toward the second half of 2004 as we were successful in delaying many price increases earlier in the year.

At this time we do not see signs of decreases in commodity prices and we believe it is likely that costs for 2005 will be higher, although the magnitude of increase will be less than in 2004. These increases, while fairly significant, are already built into our guidance for this year.

Finally, a few comments on cash flow we're continuing to generate solid cash flow with the cash in-flow from operating and investing activities of $71 million for the quarter and $245 million year-to-date. Changes in working capital represented a net cash outflow of $79 million for the quarter driven by the increase in volume. Working capital, including receivables, inventory and payables as a percent of sales improved from the prior quarter. Accounts receivable increased $11 million during the period with day sales outstanding decreasing to 49 days. Inventory increased $64 million during the period, and our inventory turns decreased slightly to 7.6 turns. Accounts payable decreased $4 million in the quarter. Capital expenditures accelerated with spending of $41 million for the quarter and $78 million year-to-date period. We are still projecting our capital spending for the year to be in the $135 to $145 million range.

Investments in and advances to joint ventures and alliances were an in flow of $2 million for the quarter and $19 million outflow year-to-date. We expect only modest additional investment during the remainder of the year. We have substantial liquidity and currently have no borrowings outstanding under our current credit facilities which have a combined availability of over $500 million. In addition at the end of the quarter we had short-term investments in the U.S. and U.K. of $359 million. We will use these funds to retire our March 2005 maturity of $225 million and intend to further reduce our debt with ongoing cash flow generation. With our strong cash performance and continued focus on debt reduction, we expect to achieve investment grade metrix, credit metrix by early 2005. Thank you and we'll now take your questions.

Thank you. Ladies and gentlemen, the floor is now open for questions. If you have any questions or comments, please press the numbers one, followed by four on your touchtone phone at this time. Pressing one for a second time will remove you from the cue should your question be answered. We do ask you to pick up your handset for optimum sound quality. Please hold while we poll for questions. Thank you. Your first question is coming from David Raso at Smith Barney CitiGroup.

Hi, good morning.

Good morning.

The questions I have, trying to get a feel for the operating leverage in '05. I appreciate the comments on the raw materials, the costs in '05 won't be up as much inclemently as '04.

When I'm trying to figure is outside of truck, which I'd like to have a follow up question about some of the supply constraints, if I try to do a real apples to apples comparison for incremental margins for your engine division versus Power Gen, stripping out a few [INAUDIBLE], Power Gen year-to-date is putting up better incremental margins than engine.

It suggests to me that the Dodge Ram must still be providing a large percent of the profit for the engine division, thus the Delta is not as big as maybe you'd think. I know you don't usually give that much color on the breakout, but can you help me a little bit with the engine profitability? Now that the truck business is doing a lot better than a couple of years ago what is the mix of the engine profitability between those line items?

David, as you commented, we don't really give specifics on the individual pieces of the engine business, but on an absolute basis, I would agree that maybe the Dodge Ram would have some better profitability, but the absorption benefits on the truck side make that a very different story. You might not see as much as of that to the bottom line right now because of some of the operating inefficiencies that we discussed. But that's about the best color I can give you on that.

Well, that was kind of the genesis of the question, I was trying to back in if I could pull out Dodge Ram --

David, we're not going to give that information out.

Okay. I appreciate that.

Then on the supply constraints, can you help us a little bit with where you're seeing it the most? You also said there was some plant in particular with some inefficiencies lie. Can you flesh that out a little bit further?

The supply basis, there isn't any one particular component. If you look at the engine business, it can be blocks or heads or specific [INAUDIBLE] like cranks and rods. In the power generation business, it is engines, alternators, electronics. In filtration it can be steel stampings and that type of thing. And even before the constraints were there, we've had our supplier quality insurance people in almost all of these plants where there has been constraints and several of our Six Sigma black belts involved with it continually breaking the bottlenecks.

But at the current demand levels, which I said in my earlier remarks, this is going to -- managing the supply base is clearly one of our challenges. And what we need to do is do away with some of the premium freight but we'll continue to do that if we have to take care of customer needs in trying to manage the overtime.

At the supply level, what is the thought among your suppliers working with them on increasing their capacity? There's no general answer to that. I think each one of them, you know, is incrementally improving their capacity right now. I'll follow up. Thank you very much.

Thank you. Your next question is coming from Andrew Casey at Prudential Equity Group.

Good morning.

Good morning, Andy.

Question on the cash flow just for clarification. The $115 million pension contribution, was that all in the quarter or was there some in prior quarters?

That would have been the year-to-date funding, Andy. In the quarter I think it was $64 million.

Okay. Thanks.

And then on power generation, given that you're seeing some improvement in the commercial GEN set business in North America and continued strength internationally, plus at the beginning of the year you talked about some cost reduction, when are we going to see the cost reduction come through and help that incremental margin, if you back out the extra revenues it was about 20%, which was consistent with 2Q?

Hi, Andy. It's Tom Linebarger. I think we will basically continue to see incremental cost reduction quarter-over-quarter. There's not a date at which it will all come in. You are right, from an incremental margin point of view, we're seeing numbers like 15 or 20% depending on the market, as opposed to much larger. The characteristics of the power generation business are we have lower incremental margins, because it's a lower fixed cost business than, say, the engine business is.

Nonetheless, we expect to see better incremental margins as we progress through the quarter. And in fact we expect to see better incremental margins at the fourth quarter. I think if you go back to the what was referred to as the 100 day plan, we're running about $8 million a quarter now on lower costs, plus Tom has been involved and his people have been involved in redesigning a major portion of the commercial Gen Set lines and some of that is coming to market with several more coming to market in the fourth quarter. S owe think we'll see some increased penetration as well as better margins on those redesigned sets.

Okay. Last question as it relates to truck.

Given that you have the long-term agreements and you're running into presumably some material cost issues within the truck engines business, do you have any latitude for, you know, some price realization underneath the long-term agreements given the environment you're working with?

The simple answer to the question on the long-term agreements is actually no, Andy. We pretty much agreed to pricing in the long-term, heavy truck agreements over a period of time, and we're sticking with those agreements.

However, I think what we are seeing is in terms of fundamental costs on the engines themselves, we're making more progress than our plan at both -- at cost reduction, Both within our plants and, in fact, on material cost reduction other than the commodities where we're struggling right now. But so we're gaining on the cost side, despite an inability in the heavy truck long-term agreements to price beyond the prices we've agreed to over the next couple years.

Okay. Thank you very much.

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

Good morning, everyone.

Hi, Gary.

Talking about the $40 million pre-tax of these -- I'll just call it generically cost inefficiencies you had in the third quarter, what was the number in the second -- first and second quarters roughly and what would you expect in the fourth quarter. You say you're going to make some improvements.

Okay, Gary. Let me try to help you.

In the second quarter, we would have been something close to maybe a $27 million number. '04 second quarter compared to '03, and not a very big impact in that in Q1 we were able to push back on most of the commodity price increases at the beginning of the year, and that was before we had really seen the huge ramp up in demand that we've seen in most of the businesses, so our inefficiencies were not as significant either.

And again, what would you expect in the fourth quarter?

Sorry. We think that it will combined likely be close to the same, yet we'll see improvements on the inefficiency side and some slightly higher pricing on the commodity side.

When you say the same as the third quarter?

Yes.

Okay. Now, I mean Jean when she was talking about -- I heard a $58 million pre-tax impact. If I add these numbers up, it equals more than $58 million. So can you explain the difference? You obviously using different definitions here.

No. The 58 Jean was talking to was a pre-tax number for commodity pricing alone, not including the inefficiencies.

Okay. Now, again, you're saying the fourth quarter is not going to be much improvement from the third, but I thought in Tim's comments or in the press release you're saying you believe it's going to have a less impact.

Let me help clarify that Tim was talking to the inefficiencies that we think we can improve, and we expect to do so. We expect higher commodity pricing in Q4, lower inefficiency cost for a net about $40 million year-over-year cost increase in Q4.

Okay. When you were talking about the third quarter, you said there was $23 million of inefficiencies and $17 million of raw material price increases, net of pricing. That equals $40 million, that is the same $40 million we're talk about?

That is exactly the same 40 and the make up of that changes in Q4 but the number is about the same.

I know it's early, but can you give us some sort of guidance on an '05 tax rate? Is it going to be closer to 20%, 21% you're talking about this year or go back to a more normal 35% tax rate?

Neither.

Neither?

28%.

28% would be your best guess rate.

That's correct. We're going to see some phase out, we're going to get some of the impact of phase out of the export benefit in next year and that's why it will actually be going up.

Okay.

Plus we've taken benefits from this year related to our improved performance.

There's a lot of talk in the heavy truck industry about engines being on allocation. Can you talk a little bit about that? Did you have demand in the third quarter that you couldn't satisfy because you're constrained? I hear some OEMs are having difficult raising production because they can't get enough engines, talk may be competitively, are there other engine manufacturers that are having more of a problem than you are. Just give me some color on that.

This is Joe. First of all, I think just state the obvious. Market is clearly up significantly more than we thought, number one. And number two, we've gained about 5 1/2 points a share year-to-date.

Put those two things together, the customer requirements demand point of view, are greater than the higher range that we anticipated and we're building capacity for. So we're in what we would refer to in our OEMs as short-term managed demand situation. And let me just say a little bit about when we're doing about it and make a comment about the rest of the industry. We put together a two-phase plan to try to increase capacity from where we we were on ISX engines in August by about 33%. Okay? Phase one was to increase capacity by about 20% by January of '05. Where we are right now versus that is about -- we have increased capacity since August by 15%, with the rest of it coming between now and January.

We are then separately and now evaluating in phase two the rate and pace at which we move on the rest. We're pretty confident -- very confident, actually, as you look to 2005, presuming the market turns out to be somewhere between 275 and 290, right, which is a rough range, a variety of estimates, that given the capacity, where we'll be on capacity in January, we can satisfy customer demand, assuming modest increases in market share. So we can handle more share than we have right now and still meet requirements at a market size in the 275, 290 kind of range and are evaluating, then, the additional capacity how much of that are we going to actually commit to go forward with.

Most of the issues, as you know, from comments you've heard earlier and separate from this meeting, are around component supplied by our suppliers. So we've been going through line by line, through put analysis with every supplier, sorting out where we can get basic operating improvements. We have people on site doing Six Sigma projects, and we're targeting capital investment where appropriate and where we can't do anything else to keep also capital investment down in the whole process. So right now, we're making good progress against our capacity improvement plan. We expect to be based on current estimates market size next year by the January timeframe to be in good shape to meet customer demand, even assuming higher share levels than where we are right now. And we're evaluating whether or not we shall take it further.

Probably the risk of saying something more than I should, I think as I've said in the past, we do not intend to spend a lot of capital dollars to invest for a short-term burp in demand. So we are evaluating what might happen in the market beyond 300,000 and sorting out where do we want to position ourselves there. Yeah, in terms of other folks, I think maybe two comments. I think we're confident that the way we're dealing with our OEMs is fair. I mean, as I said, we're managing demand right now while we're building capacity. We're confident that the way we're dealing across OEMs is fair. I can't comment on how others are dealing with OEMs given rumors and statements that have been made. I do now that where I think we are a step ahead of the other guys who are struggling with the same issue is well before we got into this capacity situation, we've been developing suppliers in India and China who have been suppliers for us for a while, to our JV plants there, to supply parts for heavy and medium duty truck market applications in the U.S.

That program is going well. We have already begun to introduce parts into the system to give us more capacity, high quality parts to give us more capacity, as we go forward, and it's part of our program. And so we think that in terms of knowing who we're talking to and who else isn't talking to them, that we're building capacity with suppliers on whom we have relied and know well for additional components as we look in the years ahead. I think right now I would say we're in a better position than the other guys on that score.

Thanks for the great detail there, Joe. Thanks a lot.

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

Good morning. Just one clarification on the engine, the 275 to 290 for the market, Joe, could you just remind us what that versus, just so I make sure of what kind of an increase you're building in, because everybody uses a slightly different base.

I think if you look at it, if you go '03 market was 165, this year '04, it will be about 245. And we're seeing in in the range of 275, maybe as high as 290.

And you mentioned that you don't want to spend a lot of capital. That's fine. Can anybody make a comment as to when we're building our models for '05, what kind of a cash flow CapEx number, should we stay in the same 135, 145? Does it go up?

I think you'll see some incremental capital next year, not a huge amount. I would probably say --

150 to 200.

Okay. Could somebody explain to me exactly what the $9 million was that kind of came in and out of being nonrecurring? I think it was in Karen's $49 million, it was not in Tim's $40 million.

Right. John that's the $9 million we talked about related to the inventory evaluation.

Could you explain what that means?

Okay. We sell a lot between our businesses, a lot of product between our businesses. And if we have not sold that product and are holding it in inventory at the end of the period, we have to eliminate any intercompany profit that is reflected in that, because our businesses sell at different terms between them, between each other. And through some of our improvement processes, we just refined our process to do that and it resulted in taking a $9 million third quarter adjustment for that.

Conceptually this is something built up not by mistake but just kind of it doesn't reflect any one recent period, it's a cumulative thing over a number of years?

It's a change in how we estimate it, and it should not be recurring.

John, it's based upon margins within our business, which change over time and hold rates of inventory. And so we think that we've got it refined at this point and shouldn't see any more on that.

And over on the power generation side, the two subsidiaries that you brought in, I think you said $51 million in sales at essentially break even, should we -- is that a year-to-date number or was that for the quarter?

That was for the quarter. Both of those businesses are in segments of the power generation market that are not doing well as the total market. So, yeah, we actually -- when we consolidated, because they are newly consolidated, we actually consolidated five months of results in a three-month period. It was unusual. That's just because we only recently consolidated them 46. That's one odd thing about it.

But nonetheless, the basic operating conditions of those businesses is they are in the larger project part of the power generation business, which is not as strong as the commercial generator set and consumer businesses are, and has not recovered quite as much. Still under the turboin market and wind power market which is not as strong. They are breaking even, we are making improvements there and we expect continued improvement but they are not as strong as the rest of the segments of the businesses.

If we were making an example for the fourth quarter we should at $30 million of sales in no profit -- it understates the incremental but probably by $50 million -- five months for $50 million, probably only $30 million in the further quarter to essentially break even?

Yes.

Then, if I can come back, make sure I understand these numbers, Karen, with you were talking about, where we've got 107 million, which is adding up the 27, the 40 and the 40. 58 million of that is the unrecovered material cost, and that leaves $49 million for the inefficiencies.

That's about right.

Is that $58 million after I'll make up a number $70 million of material cost increases that you got back, whatever it was, $12 million of price increase or is that $58 million just the absolute level against what you probably got some price increases?

That's net of price recovery. We had probably close to maybe a $25 million price recovery netted in that. So we'd start out with about an 84 or so million dollar number, three or four down to the 58 net of recovery.

Do you think the hundred -- if we look at the 107, you get a full quarter where you got nothing in the first quarter. You get the material prices staying, but you get the inefficiencies going down. Does the 107 get cut in half next year? I assume it's going to be a negative, less than a negative, right? Should we assume it's 50 to 75 million? Do you want to take a crack at the 107?

No, not at this point, John. We'll be giving a look in our fourth quarter call about next year. But because some of this has continued to move on us and everyone else, we really need to be able to get a little closer to it to give you a good number.

I think it's fair to say on the fuel prices in particular, we're building in at least for the next year, and perhaps longer, some continued price increases, not at the same rate that we've seen in the second half of this year, but just in terms of how we run our business, we're going to assume there's a continued tight supply with steel.

With the exception, Tim, of the long-term agreements, which I'm a little surprised at, why are you not giving these -- why are you not raising prices more aggressively? Because some of your competition is. And the other side of it, maybe as a subset of that, Joe could talk to the issue of the truck manufacturers don't seem to have any [INAUDIBLE] we just heard that Peterbilt's prices are up 3 to 5 % in a call monitored distributors just half an hour ago. They are happily raising prices and you guys are just eating the price increases?

I'm not sure I would use those same terms that you did. We're getting in terms of surcharges on the steel, we're getting them wherever we possibly can.

Not in the long-term agreements is what Joe implied.

He said we're not doing it in the long-term agreements because they prevent us from [INAUDIBLE] it.

In some cases, John, we're getting some credit for cost reduction programs against steel price increases, okay, that's not reflected in prices.

On the other hand, I'm not aware -- and maybe you are -- but I'm not aware that any of our competition who also has a long-term agreement is getting price increases from our similar customers. And so I'm not quite sure what you're referring to there.

No I was talking more there about as much the other -- just the other whatever X percent of Cummins business is not covered by the long-term agreements, in other words, all of the other businesses in engine and everything else, I would think you could be more aggressive on pricing with costs going up as they are.

John, this is Tom. We in Power Gen markets we are putting in price increases really around the world. It's a question of rate and pace and where the market will bear. We're increasing prices everywhere. Wherever we can get and as much as we can get everywhere we can get it. We are definitely doing that. And of course the markets are reacting well in some cases because there is some pressure on cost and some not as well. Generally we are pushing prices up everywhere.

The other comment I wanted to make about the general topic of inefficiencies and that sort of thing, all of our businesses, Power Gen for certain is looking at this to say we are -- this is just a small decrease in our incremental margin. What we're really trying to do is drive sales up and costs down so that we increase our margin to the business. This is a little head wind on that incremental margin that we've been gaining. So our view still is that our job is to drive costs down and sales and prices up to drive incremental margin in the business. This is just one thing going the other way.

As Tim talked about in the beginning, there's a lot of things that are going our way like better cost structure that's improving every quarter and better pricing in a number of our markets and very, very strong sales. So we think that's going to continue.

If I could just follow up on that and go back to something, point you made, Tim, you've been around 33 years as you said in the business. So you harken back to the days when price increases in this industry overall, not just heavy trucks but everywhere, were the norm. That's what life was all about. Given the kinds of increases we're looking at, are you all as a corporation treating these cost increases as an anomaly, they will go away, we'll get back to no price increases, are you saying the world is changing, this is what we have, we'll have to be more aggressive overall. What's your state of mind in that regard.

I think the only thing we haven't talked about physical Fleetguard and Holset, they are raising prices in today's environment. I think as stated in our corporate strategy is our long-term future depends on being the low cost producer. And that's not a new thought for us. We've talked in these conference calls about many of our cost reduction efforts. And I think that we will continue to aggressively pursue that. It's in the form of Six Sigma, it's in the form of R&D, increased productivity, its global sourcing for both material and services and so forth. And I think that's what I would advise those that are investing in us is onto measure us against the progress on that. And then if we can price aggressively or strategically, then we will go ahead and do it. But I don't want to see our future dependent on, you know, pricing going forward. It really depends on the execution of where we are, and that's where we're committed.

Fair enough. Thank you very much.

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

Good afternoon. We're going back to the capacity question, talking about the 275 to 290 number. You guys alluded to the fact that includes some kind of modest marketshare gain. What kind of, you know, number are we thinking about there? Are you guys saying that you want to bring capacity up to supply 30% of the market? Where do you guys fit in with that?

Brian, I think you may have misunderstood, he's saying we're looking at production and capacity so we actually could take advantage of additional share opportunity, but we have not counted on it or put that into our numbers. So those are two different things.

I mean, we're very pleased with the share improvement we've seen this year, but, you know, Joe would be the first to tell you that's not our main focus is growing market share. So we really don't build increments to that into our plans.

I think we've got to be real clear again as we have been in these past teleconferences. Our strategy in heavy duty truck is to earn a return that we can reinvest capital at 20% market share. That's how we built our business model. We're focused on making a profit in that business. And then when we have products that take care of the customers like we have right now and get the 5 1/2 point share increase and maybe get more, that's an incremental profit for that business. But again, we had to focus on the fixed cost, reducing our break even. Again, we talked about that several years ago in terms of what our strategy was. So we met the '02, will meet the '07 emission regulations, we've got global manufacturing around that and we've got increased productivity in our manufacturing. At Jamestown we moved all our production over there. We said we would save somewhere around $20 million a year, and we're ahead on that cost reduction.

Right. I understand it's not built into the plan, I'm just trying to get an idea if you guys think of -- you're just looking at it as an opportunity, it's not in that those percentage increase numbers, what do you think of as a reasonable, potential -- how do you quantify roughly what you think that opportunity would be.

We don't quantify it.

One follow-up on the engine, too. The Dodge Ram has been, you know, unqualified success, I think, throughout even probably with what you guys were expecting. Any new information with regard to potential of, you know, going to a lower GVW with some of your other engines?

From a customer point of view, no. That's something customers will talk to everyone about if and when the time comes. But we have made comments at least over the last quarter about the progress we're making on the engine design and development and the fact that engines -- the engines V6, V-8 engines we've been developing for below 8500 pound applications, we've demonstrated over and over again that we can meet the Tier2 bin 5 gasoline engine standard in '07. And we've gotten increasingly confident about the durability of the after-treatment devices and reliability of after-treatment devices that will be used on those engines. And have demonstrated that they can continue to perform well after deterioration. So we continue to make progress on the engine relative to the emission standards. We continue to share that with the customer's -- potential customers with whom we are working. But other than that, no more to share.

Thank you.

We have time for one more question.

Thank you. Your next question is coming from Chip Miller at Bear Stearns & Company.

It's actually Peter Nesvold with Bear Stearns. Glad we just made it there.

Good morning.

Question about seasonal -- when I look historically, Cummins earnings have come down a third quarter, I guess into plant shutdowns. Then you've usually had a pretty big fourth quarter. If I exclude the tax benefits and and the timing of an upturn in bills this year, why didn't you see that pullback in third quarter and why don't you expect fourth quarter to be more than the 6 or 7% type upside from third quarter sequentially.

Peter, I don't think you're seeing what we would consider to be a normal year this year. When you look at the rate of improvements and a lot of our markets particularly in North America and automotive markets, we didn't see a pullback in Q3 because was demand is very, very strong. So I don't think you can apply kind of like past, normal seasonal patterns to that.

So when we talk about being, you know, capacity constrained in certain places and the supply chain being very tight, that means the industry is pretty close to peak in a lot of areas. We can't go up in Q4 way above where we were in Q3 but hope to have some improvement.

I would just comment building on what Tom said a little while ago. I'd like to remind people we are operating at record levels right now. Okay. And these are the kinds of results we predicted as we were we were going through the recession and restructuring our various businesses. I think we need to keep that in perspective. In going forward we're still focused on the cost reduction and managing our cash to pay down our debt. And I think we're looking at a very strong series of markets now and we expect these to continue in 2005.

Peter, the one place we did see our normal pattern was in Europe. We thought we did see some shutdowns in Europe, slightly lower sales in Europe, it doesn't affect the numbers relative to small percent compared to all the other strong markets Karen talked about.

If I can ask one quick follow-up, then. If you're sort of firing on all cylinders right new from a demand perspective and from a capacity perspective, third and fourth quarter both looking terrific, is this suggesting that this type of run rate operating performance that you've seen in the second half of this year is starting to feel like peak? It would seem to be awfully early to be the case. Is this sort of the peak earnings power, this type of run rate production.

No, I think we have significant opportunity going forward.

Just from operating leverage, continued operating leverage?

I think we're gaining market share, we've got broad product lines. We have long-term agreements with many of our businesses that are starting to mature. We've already talked about our cost reduction. I think, you know, as far as the markets are concerned, I don't think they have peaked either. I think we're going to have the strong markets to go out and a lot of improvement in our performance. You should continue to expect us to do better going forward. That's all the time we have right now. Thank you very much.

Thank you.

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