康明斯 (CMI) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to your Cummins Engine third quarter earnings release conference call. [OPERATOR INSTRUCTIONS] It is now my pleasure to turn the floor over to your host, Mr. Dean Cantrell. Sir, the floor is yours.

Thank you. Welcome, everyone, to our teleconference today to discuss Cummins results for the third quarter of 2005. 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 Chairman, Tim Solso; our Chief Financial Officer, Jean Blackwell; and our President and Chief Operating Officer, Joe Loughrey. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The Company's future results may be affected buy 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 59 of our 2004 Form 10-K 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 our website for the reconciliation of those measures to GAAP financial measures.

Now, some comments regarding each of our four operating segments beginning with the distribution segment. Sales for the distribution segment were up 18%, compared to third quarter last year. Sales remained very solid across product lines and geographies. Power Gen sales were exceptionally strong in the Middle East. Our recent distributor acquisition in Europe represented about 25% of the segment's year-over-year increase in engines and part sales. Earnings for the segment were 9.5% of sales, compared to 8% of sales last year. We were able to leverage the higher volumes straight to the bottom line. JV income from North American distributors was $2 million, better than the third quarter of last year.

Sales in the Power Generation segment were up, led by an increase in commercial markets. Economic activity in the U.S. and infrastructure development in the Middle East more than offset significantly lower sales in China. In the U.S., commercial Gen Set demand continues to outpace nonresidential construction and is expected to continue into 2006, with secular growth coming from the reconstructive efforts in the Gulf states following hurricanes Katrina and Rita. China will see a further 15% reduction of sales in 2006, as the power supply in demand gap narrows and the market shifts from prime power to stand-by power. An improving mix of market growth within the consumer business led to a sales increase of 4% compared to Q3 of last year. Growth in the marine and commercial mobile markets and further Gen Set penetration of the nonmotorized RV segment countered declining sales to the Class A motorized markets. These trends should continue into 2006 as a further 3% decline in RV sales will be offset by double-digit growth in all other consumer segments.

For the third quarter of 2005, Power Generation reported record segment earnings of $46 million or 9.1% of sales. This phenomenal incremental return on sales of 282% is attributed to greater price realization from pricing actions announced in the first half of 2005 as we worked through the order backlog. Total sales for the engine segment were up 18% compared to the third quarter of last year. We continue to see strength in nearly all of our end markets with revenues of on highway markets up 16%, and off highway markets up 22%. Segment earnings were 9.2% of sales, and are 59% higher than last year.

For the third consecutive quarter, incremental return on sales was greater than 21%, as we leveraged significantly higher volume and obtained greater price realization. Global shipments for the heavy-duty truck market were up 13% over the same period last year. Shipments in the U.S. and Canada were up 12% driven by growth in the North American heavy-duty truck market which we believe will be up 26% this year to 310,000 units, and up slightly to 315,000 units in 2006. Shipments to the rest of the world were up 20% this quarter, with higher sales to original equipment manufacturers primarily in Mexico.

Medium-duty truck engine shipments were up 19% in the U.S. and Canada, where we continued to benefit from increased market penetration at our key OEM. North America is now our second largest market for medium-duty truck engines, second only to Brazil, and our outlook is for continued growth in 2006 as we anticipate further increases in market share ahead of the 2007 EPA on highway emission regulation. Global bus engine shipment surged 88% higher year-over-year led primarily by further shipments to the Beijing Public Transit in China, new bus installations at two OEMs in Brazil, and increased market share in North America. Our share has climbed to 80% in North America, as we have successively won new customers as some competitive products in the transit bus market have exited this year.

In the light-duty, automotive, and RV market, engine shipments to DaimlerChrysler for the Dodge Ram pickup truck were 42,200 units up 10% from the third quarter last year as Chrysler launched its model year '06 truck with the new mega cab. With the introduction of the mega cab, Chrysler plans to make inroads into the crew cab market, which is currently 52% of the heavy-duty diesel pickup truck market. Our market penetration at Chrysler continues to increase with 86% of the model year '06 heavy-duty pickup trucks being sold with our diesel engine and our forecast is for even higher shipments to Chrysler in 2006. We believe part of the reason our share at Chrysler is increasing is that higher fuel prices motivate consumers to choose the more fuel-efficient diesel power option.

Moving to our off highway market, the mining equipment market continues to be strong reporting a year-over-year increase in unit shipments of 17%. Increased coal and steel production as well as higher commodity prices continue to support this market. Strong growth in Russia, South America, and Southeast Asia confirms our outlook for 2005 to finish 25% higher than 2004, and 2006 will be up slightly over 2005 levels. In the construction equipment market, nonresidential construction and federally-funded highway spending drove North American unit shipments up 17%. And a rebound from the government-imposed slowdown last year in the China construction market drove international shipments up 26% this quarter. We forecast continued strength in both of these markets for the rest of 2005, ahead of a flat 2006 market.

The commercial marine market saw strength in North America from the offshore oil field and towing industry. Higher fuel prices, not only added to demand for oil exploration in the Gulf, but our fuel economy leadership provides a competitive advantage in customer repower opportunities. Commercial marine will continue to be a strong market with a forecasted 39% increase in 2005, and a 29% increase in 2006. Revenues for the component segment increased 8% compared to the third quarter of 2004, with each of the four businesses in this segment reporting year-over-year quarterly growth in revenue. In filtration, all geographic regions experienced increased revenue over the third quarter of last year. Aftermarket sales in North and Latin America were the prime contributors to the revenue gain.

Turbocharger sales benefited from a strong aftermarket as well, capitalizing on improved availability of product. This segment's earnings for the quarter were 4.4% of sales, down from the third quarter of last year, while higher volumes and the beneficial mix of aftermarket to OE sales helped the gross margin, this segment in particular has not yet seen gains against the cost headwinds that we have seen in other segments. One of the steps we're taking to improve operational efficiency is to implement a new warehouse management system for our filtration business which will be shared with our power care distribution centers and create a strong opportunity for synergies between the businesses. The expected operational efficiency gains along with continued improvement in pricing realization and commodity costs will strengthen margins in this segment in 2006. Now, I'll turn it over to Jean to comment on our consolidated income statement, cash flow, and performance targets.

Good morning. Our earnings before interest and taxes were 66% greater than the third quarter of last year, on a 12% increase in sales, resulting in a 35% incremental return on sales. Our ability to convert sales growth and higher year-over-year earnings for the seventh consecutive quarter demonstrates further that our focus on cost reduction and execution of our strategy is working. Net earnings for the quarter were $145 million or $2.90 per diluted share, compared to net earnings of $116 million or $2.40 per share in the third quarter last year. For a 25% increase in net earnings.

Excluding favorable one-time tax adjustments a year ago of $37 million, or $0.74 per share, net earnings this quarter increased 84% on a 12% increase in sales. The gross margin percentage for the quarter was 22.7%, and is 21.9% year-to-date. Approaching levels we have not seen since 1997. In addition to the absorption benefit from higher volumes, we are starting to see the full effect of pricing actions taken earlier this year. We continue to make progress in overcoming manufacturing inefficiencies resulting from the higher volumes. Additionally, coverage costs as a percentage of sales have improved as our products continue to perform well.

Recent disruptions in the industry supply chain created by events in the Gulf Coast states and subsequent increases in fuel costs have delayed widespread commodity cost relief that many had forecast for the second half of 2005. Overall, steel costs have fallen slightly from Q2 but increased costs of copper and petroleum-based materials have offset some of the reductions in steel. We expect commodity costs to trend slightly higher in Q4 before improving in 2006. Nevertheless, even with the slower recovery of commodity costs we remain confident that the pricing actions we have taken in all businesses at the beginning of this year will more than offset our current estimate of the full-year incremental impact of commodity price increases in 2005. In addition, we continually review our pricing strategy and anticipate further benefit from pricing in 2006. Our year-over-year impact of manufacturing inefficiencies and commodity cost increases net of pricing action has improved from an unfavorable $30 million in Q1 to a favorable $23 million in Q3. While we are pleased with our results, we realize there is still room for improvement and we'll continue our process improvement initiatives to remain the low-cost producer in our industry.

Total selling, admin, and research and engineering, or SAR spending in the third quarter was slightly better as a percentage of sales. SAR spending for the quarter was 14.5% of sales, compared to 14.6% of sales last year. Within SAR, the year-over-year increase included approximately $15 million from higher salaries and wages across the Company, $11 million in research and engineering, primarily in the engine business as we prepare for new product launches related to emissions regulations, $3 million from the acquisition of a new European distributor in Q2, and $2 million from currency. In addition, we had increased spending to fund our growth and improvement initiative as well as some volume variable spending. Our income from joint ventures and alliances in the third quarter was $28 million, compared with $26 million in the third quarter last year. Higher earnings from Dongfeng North American Distributors, and Cummins MerCruiser, offset lower income from our Dongfeng joint venture do to short term disruptions in the Chinese on highway markets.

Now on to taxes. We now expect our annual effective income tax rate for 2005 to be 29.5%. Which is less than our previous forecast of 30%. As a result of this change, the third quarter income tax provision was 28.4% of profits before taxes. Cash flow from operating activities was a near-record inflow of $230 million this quarter, and when combined with investing activities exceeded our preview record from Q4 of last year. Working capital was a net cash outflow of $81 million. Accounts receivable trended with sales, keeping days sales outstanding flat. However, inventory turns were weaker in Q3. The increase in inventory was primarily attributable to isolated operational issues at some of our Power Gen facilities, and increased level of engine inventory as we prepare for higher Chrysler volumes in Q4. Inventory remains an area of focus and we have action plans in place to address these issues and expect turns to begin to improve in Q4.

Capital expenditures were $43 million for the third quarter and $121 million year-to-date. Although capital spending is typically higher in the fourth quarter, we expect capital expenditures in 2005 to be somewhat less than our previously announced range of 220 to $240 million.

At our investor conference in New York City on September 26, we announced new targets for our financial performance. I would like to briefly review these targets and see how we are measuring up. Our revenue growth for the third quarter was 12.4%, exceeding our 8 to 10% target. Our third quarter EBIT margin was 9.7 -- of 9.7% at the top end of our 7 to 10% range. For the third quarter, ROE was 24%, exceeding our target of 18%. With this strong earnings performance, we are generating significant cash flow and we are committed to using this cash to pay down debt, make prudent investments in the business, and return value to our shareholders. Our recently announced intention to pay our high-yield note when it becomes callable in December 2006 will further strengthen our balance sheet and reduce our debt to capital to the low end of our targeted range of 30 to 40%.

We are confident about our cash flow generation and announced a new share repurchase program last month. During the quarter, we have obtained investment grade ratings at S&P and an upgrade at Moody's with a positive outlook from both agencies. We are focused on continuing to deliver strong financial performance and on going the less cyclical portions of our business. This coupled with an improved balance sheet will position us to perform well over the next business cycle. With our strong performance year-to-date, we are raising our earnings guidance for the full year from a range of $10.10, to $10.30 per share, to a range of $10.70 to $10.80 per share. Now I'll turn it over to Tim.

Good morning. I'm pleased with our results for the third quarter as we continue to generate several new records for profitable growth, including the highest gross margin as a percent of sales in eight years, a record earnings before interest and taxes, higher year-over-year earnings for the seventh consecutive quarter, an incremental return on sales of 35%, well in excess of our overall target of 20%, record cash flow from operations and investing activities, record revenues for the engine business, record engine shipments to Chrysler for the Dodge Ram pickup trucks, and record earnings for both Power Generation and the distribution businesses.

In light of these record results this quarter, let me take a step back to the investor conference we held a month ago in New York City, and share with you our view of the new Cummins. Given the Company's transformation over the past five years, we think we are trading at historically low earnings multiples relative to our peers. Even as we have hit or exceeded our long-standing financial targets for the past two years, we have not seen this translate into higher forward earnings multiples relative to our peers. Our 2005 and 2006 performance will exceed historical peak earnings, and in spite of forecasted softness in the North American heavy-duty truck market in 2007, we expect our earnings before interest and taxes, as a percent of sales, will be equal to or better than what it was in 2004. The sustained profitability, the improved cash flow, and new significant growth opportunities in existing and emerging markets explain why we are very bullish about our stock.

Based upon a recent investor survey, I will highlight three ways in which we are demonstrating that this is a new Cummins, a different company from historical perceptions. First, we have reduced the impact of cyclicality on our financial results. However, this survey indicates the financial community still perceives Cummins as a North American truck stock, even though North American heavy-duty truck OEM engine revenue has gone from 19% of our total revenue in 1999, to 14% today. The truck business is a very important and earns more than it costs of capital. Following the restructuring to a new business model, it is still a very good business. However, it does not drive the Company as it did 5 or 10 years ago by design as part of our strategy to grow in related markets that are less cyclical, less capital intensive, with less competitive rivalry, the Power Generation and distribution businesses have grown both in terms of revenue and earnings. We have also expanded the geographic diversification of our sales as evidenced over the past five years by compounded annual growth rate of 35% in China, and 14% in India. Our growth in both countries is much greater than their GDP growth. While some markets in our businesses are cyclical, we have created, through diversification, including distribution, aftermarket parts and service, Chrysler volumes, and our joint venture incomes, a significantly more stable earnings base than what we had five years ago.

Second, we are profitably growing earnings. I have never seen a time in my career at Cummins when we have had so many profitable growth opportunities in front of us. The quality of current products across the business is enabling us to gain share in engines, in generator sets, as well as in components, such as turbochargers, fuel systems, and exhaust aftertreatment. New products are being introduced across all of our businesses that build upon the success of our current products, and expand our current product offering. And we are aggressively pursuing increased participation in aftermarket sales and new business opportunities in China and India.

In addition, through initiatives such as Six Sigma, global sourcing, technical productivity, and lean manufacturing, we have successfully lowered our cost structure and demonstrated superior product quality through lower product coverage costs. We have also responded far better to the cost headwinds of the past 12 months than we would have five years ago. That is why we are confident that our '07 earnings before interest and taxes, as a percent of sales, will be at or better than our '04 earnings before interest and taxes as a percent of sales, even with the downturn in North American heavy-duty truck volumes as many are predicting.

Finally, we are focused on responsible cash management. Our priorities continue to be to reduce debt, to invest in future growth of our businesses, and return value to our shareholders. Successfully forming partnerships to enter new markets, to develop new product, to minimize the capital investment, and to reduce costs with scale has been crucial to our global profitable growth. The two recent joint venture announcements in China are an excellent example of how we are using our capital wisely to invest in projects to grow earnings. Using cash to reduce our debt and to fund our pension obligations, has also lessened the risk to claims on our future cash flows as viewed by the rating agencies and our shareholders. The announcement to call our high yield debt in 2006 will further strengthen our balance sheet and we accretive to earnings in 2007. As earnings and cash flow continue to become less cyclical, we can return greater value to shareholders through dividends and the new share repurchase program.

Before I turn the call over to question and answers, let me say a few things about our markets in China, having just returned from there. In spite of the short term disruptions from policy changes and oil prices, the secular drivers of growth remain very positive as China continues to aggressively expand its infrastructure network, particularly in the development of its interstate highway, as I've discussed before. One of the markets to benefit from this infrastructure development is construction equipment. We are seeing renewed demand from construction OEMs as previously high equipment inventories in China have been consumed. Our market position remains strong, and we are well-positioned for growth as this market recovers.

Cummins powers the largest number of imported hydraulic excavators because of our strong OEM relationships outside China, and excellent distribution and service infrastructure within China. The introduction of the Cummins A series, and 3.3-liter B series engines, is also helping us to gain share in the domestic forklift and mini excavator segments. We are aggressively pursuing a number of initiatives in China to increase our market share in other attractive end user markets, such as Power Generation, and heavy-duty trucks. A drop in Power Generation market was inevitable after the record year in 2004, in which the market more than doubled. As the supply and demand gap for electrical power closes over the next few years, the Power Generation business is concentrating on a large growth opportunity and less volatile standby markets. By increasing the local Gen Set assembly capacity in Beijing and by expanding the Gen Set distribution network coverage, we will strengthen our competitive position in the cost sensitive standby power market.

As recently announced, we are expanding our joint venture relationships in the heavy-duty truck market to strengthen our leadership position in this rapidly growing market. A recent report by China Auto Daily forecasted that the heavy-duty truck demand will reach 650,000 units in the year 2010, twice as large as the North American heavy-duty truck market is today. Our newest joint venture with China's Shaanxi Automotive Group to produce our ISN 11-liter engine and our expanded with Dongfeng Motor Company to design and manufacture a new 13-liter engine, position -- positions Cummins with the broadest and most complete engine offering in this important China market. The end user markets to which we sell in China are expected to grow at 8 to 10% compounded annually, through 2010. Slightly higher than the 7 to 9% forecasted GDP growth during this period. However, we think the initiatives discussed above and our initiatives yet to be announced will allow us to grow faster than our end user markets. Furthermore, we still expect in 2006 for our businesses to grow faster than the forecasted growth in end user markets to which we sell.

Let me close by reinforcing that we continue to demonstrate profitable growth. Now and for the future. We are clearly benefiting from strong demand across a number of our more cyclical markets, and are growing share profitably with disciplined pricing. We are seeing margin expansion from our cost reduction initiatives, our focus on execution and greater price realization from actions we initiated in late 2004, and at the beginning of 2005.

And finally, we are announcing profitable new business opportunities in existing and emerging markets thanks in part to our superior product performance. As a result, we will deliver another record year in 2005, and believe that 2006 will be even better. This is a new Cummins, a very different Cummins from the past. The record for profitable growth demonstrates the changes we've made over the past five years. Since many of you have not visited our facilities, I encourage you to work with Dean Cantrell in Investor Relations to visit and learn more about the new Cummins. Thanks, and we'll now take your questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Andrew Casey. Sir, please state your affiliation then pose your question.

Prudential Equity Group, good morning.

Good morning, Andy.

Two clarifications before a question. On the quarter, could you, and if you did, I missed it, could you quantify the coverage cost, and then Jean could you repeat the tax rate because I got disconnected for a minute?

On the tax rate for the full year, it's going to be at 29.5%. For the quarter, it was 28.4%.

And coverage costs were consistent with Q2 in terms of a percent of sales, at 2.7%.

Okay. Thanks. And then on the quarter, could you help me understand what the unit volume change was year-over-year in Power Generation just so I can see the magnitude of the pricing benefit that you saw? And then have you seen any pickup in that segment in terms of order in-take to prepare for the Gulf Coast reconstruction, and if not, when would you expect that to happen? Thanks.

While Dean looks up the specific, the first part of your question, I would say that in general, the Power Generation order board remains strong. It's strong in most markets with the exception of China, where it's still somewhat depressed from the record 2004. We have seen some uptick in business in the Gulf area as well as Florida, but that's kind of in the 5% range. I wouldn't say that that's going to have a major impact on the volumes. But the business remains fairly strong.

There were fairly high inventory levels in the RV dealers, and a lot of that inventory is gone for temporary housing for the people that have been displaced from these hurricanes, so our expectation is that the RV market will be stronger than what we were seeing before the storm. So that's one of the issues. And then also, the oil and gas, getting back to exploration, we're seeing a lot of increase both in commercial marine, as well in the oil and gas to get the energy sources going. The -- your first part of your question is 600 units in G drive and generator sets over the quarter.

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

Credit Suisse First Boston. A couple of different questions. What was, on a full-year -- on an overall company basis, what was the impact of currency in the third quarter?

In the third quarter--.

In the quarter just reported.

In the third quarter, or do you want the full-year?

No, the third quarter, was currency a positive, a negative, all in taking all of the pieces in?

In SAR, the impact was 2 million, actually we're going to look up real quick on the other and we'll get back to you.

Okay. While you're looking that up, could we talk to the component business? Because that is -- that continues to be fairly disappointing in terms of margin, and on the one hand, it actually stands out pretty significantly, because, Tim, as you said, everything else seems to be going really phenomenally well, and that one business continues to stick out. And at what point do you say, okay, it's not just steel prices, maybe I've got a fundamental problem, maybe I've got to do something more than just simply say, gee, hope it will get better next quarter?

Do you have the answer on currency?

Yes, on currency, John, it was down 3 million year-over-year.

In other words, it was a $3 million negative year-over-year?

Correct.

Okay, thank you.

Go ahead, Joe, on the components.

On components John, it would be wrong of you to draw the general conclusion you drew from the components group as a whole. A couple things, and we said a little bit of this in the investor conference, but a couple things to understand. From a business point of view, there's no question, we are making significant investments particularly in emission solutions, turbocharging, and fuel systems, because both investments in engineering expense, and some capital capacity expansion, because we have -- are coming out with new products and have won, already signed contracts, significant business in those areas, most of which begins in end of 2006, early 2007. So that's having an impact on earnings. And part of the reason is, is we have, in fact, won more business than we anticipated winning. So that's an impact on the -- on three of the businesses in the group.

In terms of underperformance, it is most focused on our exhaust products. And that is where earnings are disappointing and having an impact on the group overall. We have been and are very focused on making the necessary improvements there through a combination of aggressive, meaning pushing up pricing, reducing cost, and moving production to more lower-cost locations. The pricing has already started, the move to lower-cost locations is already started, and we are very confident, as we work our way into and through next year, you'll see the results of the group improve overall as it relates to improvement on exhaust products. But keep in mind, next year we will continue to invest in the new products we're coming out with in emission solutions, fuel systems and turbochargers, as well as the capacity necessary to meet what will be a very large increase in demand for us in 2007.

Can you give us some order of magnitude of the level of investment? In other words, the costs that you're absorbing? You have 21 million in operating profit, are you absorbing on a year-over-year basis, 3, 4, 5 million in higher investment? You're saying that's one of the major things that's going on. Could you quantify that?

For the full year?

Or the quarter, whichever you prefer. In other words, help us understand how much that is. Is that 5 million on a full-year basis, 10 million?

The engineering costs on the emission solutions is up $11 million this year over last year.

That's all in that segment?

Yes.

No, the engine business. That was in engine business.

Yes, that's what -- sorry, John, it's -- in terms of at least versus last year, John, research and engineering for the group is up $3 million.

For the year?

No, for the quarter.

For the quarter. In the component group?

I'm talking components group, engineering expense for the quarter is up 3 million over last year.

Okay. That's helpful. And then on the -- I think I misheard, but if we look at the Power Gen, which is an incredibly strong performance in terms of earnings, we're looking at essentially flat sales and we're looking at earnings going from, what, from 17 million to 46 million, okay? And then what you said was really that that was pricing. I can't believe it's $29 million of higher pricing that falls through. Is it -- is that what is going on?

70% of it was pricing, the rest was taking care of costs and more efficient manufacturing.

Wow, okay. That is a very impressive. And then finally, the '07 engines that you have out there, how are they performing in terms -- I know it's still early, but you have not -- have you been able to put more out there from what you had when we talked in September? And how is the fuel efficiency doing on them?

The simple answers, there are more out there than when we talked at the conference, the answer's yes. A couple things, John, one, again, just to make the point, our engines, heavy-duty engines aren't changing very much. We're making some improvements, primarily around reliability and cost reduction in the engines, so in effect, we've been running a massive field test on those engines for some years. Second point is we have close to just under 30 end users now running heavy-duty engines. We continue and will continue to get heavy-duty engines to end users. We also are well into our medium-duty engine field test.

The field test, the purpose of it is to find issues. So we have found a few issues, but it is really going very well. Both from a performance point of view, and from a reliability point of view, and most, it's too early to tell really on your fuel economy question, but most of the short-term evidence we have right now is consistent with what we have been saying, and that we do not expect to lose fuel economy in -- with our '07 products versus where we are today. It is, as I say, it's a little too early to tell, because we've only got so much evidence, but so far the evidence is supportive of the claim we've made in that regard.

Excellent, thanks very much.

Thank you. Our next question is coming from Elliot Lustgarten. Please state your affiliation and pose your question.

It's Longbow Research, you were close, right? Good morning.

Good morning.

A couple of quick questions, one, you talk about the tax rate is going to be 29.5% this year. Can you talk about the tax rate for 2006 and 2007?

Yes, this is Jean. Let's see, 2006 is currently about 31%, a little bit higher.

And 2007, does it go say about the same or is there any--?

It might be slightly higher but not much.

Second, when you go through the press release, and I apologize, because I'm at another meeting so I'm doing it very quickly, what I noticed, is that the heavy-duty engine shipments declined in the third quarter versus the second quarter. Can you talk about what's causing the actual shipments to go down and sort of what it's apprised? And then put in context the fact that you really have the heavy-duty market in North America flat, essentially flat in '06 versus '05, is that a reaction to the low freight movement and the higher prices, or is that what you're hearing? Because that's quite a bit lower than even most people expect.

Mostly the third quarter impact your seeing is mostly related to number of days in the quarter from a production point of view than anything else. Our actually daily rate has continued to increase.

Okay.

The second is the heavy-duty truck number that market number for '06 is not any different than what we've been saying for some time. It's slightly up over our estimate for '05, but our view is that the market is somewhat limited in its ability to go much higher based on a variety of capacity issues, not just in powertrain, but also in other components. So our estimate for '06 is really based on what we think the industry is capable of doing as it relates to what we know about orders in the system.

Now, that's not an NAFTA number, that's just a U.S. and Canada number or is that?

It's a NAFTA number. But it does not include medium-duty engines. If you're trying to compare to external sources of information on market size.

Okay. And then can we go back to the problem group, or the components group that we talked about? You said it was 11 million of high investments this year, can you do -- three questions on that, one, can you give us the magnitude of the investment for next year, does it go up -- or how much does it go up over this year? Two, could you quantify the magnitude of the new contract wins that we look forward to in '07, without being specific, I mean, can we get some magnitude? And then three, 11 million is less than 1%, and the 3 million in the quarter is less than 1% impact. So when you do 4 or 5%, it's still less than half of where that group profitability should be. So there's got to be -- is your problem in the exhaust really costing you 4, 5% in margins? Is it losing money? I mean can you give us some context, because that profitability should be double digit, too, or pretty close to double digit.

Yes, I don't know what your reference point is exactly here, so it's a little tough to answer, but I'll try on a couple of points. This is Joe, by the way.

Okay.

First on -- we're not going to share information been what's going to happen in '07 specifically, because in many cases, the contracts we have won have not been announced by the OEMs themselves. So they'll take the lead on that.

But is the magnitude up? Clearly a double-digit gain over--.

It's a, if anything, you're low, it's a huge increase and we'll be talking about it more as we go through next year and OEMs become clearer about their intentions in terms of either taking on our new products, emission solutions, or increasing share of our turbocharger business, and that will become clear as we go through next year. But your 20% number or whatever is a low number. The -- so that's first point.

Second point is I can't, again, can't tell exactly what you're referencing to, but -- exhaust business, our filtration side of our business continues to perform, has performed, and continues to perform well. It is within the range of historical performance and what we would expect there. Exhaust business is significant -- exhaust products are significantly off track, and there's a whole lot of reasons for it. One of which is it's been harder hit by steel pricing, and we have probably not done an effective job, as we could have done in understanding the relationship between the markets we're trying to serve and the products we're producing.

The solution to the issue is being aggressive and appropriately aggressive on pricing, which we are -- has already started happening and taking -- some taking effect this quarter, and to address the significant cost issues in part by making sure we're doing these components in the lowest-cost plants. So a number of pieces of this business has already been moved to places like China and Brazil and India, and we will see improved performance from a cost point of view as we work our way through next year. So I think I'm going to leave it at that for now.

Let me just follow it up with one, are the investments, 11 million that you're investing in that sector this year, going up a lot next year? What's the incremental change next year versus this year?

The $11 million was a misstatement, it was $3 million in the exhaust system for the quarter, so you can -- and that kind of investment will continue next year. I want to take issue with both the question that John McGinty asked and your quote to say that this is a problem area. I want to put it in a context, we just had the best quarter in the history of the Company. If you look at the components, a host of turbochargers has the best technology in the marketplace, has signed long-term agreements, they're investing in the application of those products with several OEMs internationally. They're increasing their capacity.

The same is true with Fleetguard filters. Emission solutions is a business that didn't exist three years ago, it will be a $500 million business by the time we get to the 2007, and we're also signing new agreements in the fuel systems. This is a spectacular area for Cummins. Yes, we've had some manufacturing deficiencies, some logistics deficiencies, but it's a very good business. We're not just letting it sit there and hoping for the best. We've invested a lot of time, we've got great leadership there, and it's a business that I think you can look forward to seeing giving very good results.

That's what we're driving at. And let me ask one last question, what do you think that components group normalized margins should look like as opposed to where they are? Let's say you solve the problem, you get there. What kind of profitability can we expect to that, can that meet that 7 to 9% goals for the corporation?

It will have the same kinds of margins that the rest of the businesses have.

Okay. Thank you very much.

Thank you. Our next question is coming from H. Peter Nesvold. Sir, please state your affiliation, and then pose your question.

Thanks, it's Peter Nesvold from Bear, you can drop the H. I hate to be so formal here. I guess, I was going to ask about the component business, but I think that Eli's point, I mean, $3 million, you add that back, it was 60 basis points of margin, and in the business would have still been down on a margin basis year-over-year. I know it's been reclassified since the '90s, but in '99 before you bought Nelson, this was a 16% EBIT margin business. I guess that's what we're struggling with. And I guess you're probably getting it from multiple people. Can you talk a little bit about China and what the short-term disruptions that you're seeing there? Because we heard similar comments out of Volvo on their call.

I think that the specifics is that several months ago, the overloading or the weight restrictions was being enforced pretty strictly, which said that the market was moving from smaller trucks to larger trucks and larger engines, and that was a trend that benefited our C engine in our joint venture. There has been less compliance with those weight restrictions, and so the market has really moved back towards the trucks that would have the B engine. So you're seeing some fluctuation short term in the truck market. However, again, I just got back from China, I think the numbers are like 85,000 kilometers of interstate highway by 2010, the truck market is over 600,000, so not only our C engine, but also the 11-liter and then the 13-liter play right into where the trucks are going. Because more goods will be transported by truck, the trucks can go faster, and they can carry bigger loads requiring bigger engines. So, yes, there's some short-term fluctuation based on government policy, but the demographics of China and the direction that they're going is going to play really strongly into where we are.

I definitely agree the secular trends there are pretty incredible. How long do you think the volatility is near term? I mean, shouldn't we be thinking only a modest sequential uptick in fourth quarter or should we expect a bounce in fourth quarter like we did last year?

I think -- we've talked a lot about that, and the honest answer is I don't really know. I think what we're doing is as we put our plans together, is that we think it will continue for the first half of next year and then get better. But if you ask for a lot of hard data behind that, I don't think we could give it to you.

And Peter, a lot of the bounce that you saw in Q4 last year with Dongfeng was due to a one-time tax adjustment. So obviously that's not going to be repeatable.

Okay. Just a quick question on inventories. I apologize if you addressed this earlier. It looked like there was a fair amount of absorption onto the balance sheet. We've seen it at other companies this quarter. Can you just talk to that and give us a little more color about that?

Yes, the inventory issues were some isolated plants for the Power Generation, where they did not have all the components that they could ship the entire generator set or upgraded G drive engines. So -- and that was at the end of the month. That would be one of the elements. And then the Chrysler volumes for the fourth quarter are going up substantially, so we started bringing in material early in order to meet that demand in the fourth quarter. And I would expect that the inventories would go down from the third quarter into the -- in the fourth quarter. We have, a lot of focus on that right now.

Okay, great. Thanks for the time.

Thank you, our next question is coming from Joel Tiss. Sir, please state your affiliation and then pose your question.

I'm with Lehman Brothers. How are you doing guys?

Good.

In medium-duty, we've heard some differing views or whatever on what happened in the third quarter. I'm just wondering from an industry standpoint, can you give us a little sense of what the volumes look like in the industry? And then, I understand you guys were strong, can you talk a little bit or give us at least the sense of who may be losing some share there? Thank you.

Numbers are down slightly overall, in the medium-duty truck market from a market point of view in North America, and so you've seen some adjustments being made by some of the truck manufacturers. As we said in the September investor conference, we are and expect to continue to grow share in medium-duty markets, on highway markets like, for instance, truck and bus in North America, as we work our way through next year and into '07. That's primarily driven by the fact that our product is running well, and our solution for '07 is perceived to be simpler, and more straightforward for -- from an OEM installation point of view.

So as we announced -- as was announced on the day of our teleconference, Bluebird has made a decision to switch from Cat to Cummins, we'll begin to see that happen in the first quarter of '06, and I think as we go through the next 12 to 15 months, either it will become increasingly evident, or OEMs themselves will make announcements about decisions they've reached on what roll our product line, increased role our product line will play in their business as we make our way through to '07. As we said, we expect, last year, at least in the way we added up, we were looking at shares of about 10% in the medium-duty truck market. We expect to be no less than around the 22 to 25% range as we work our way into '07.

Why don't you comment on Brazil and Europe too for mid range.

Just a quick follow-up, on the Chinese Power Gen business, does that drop help the overall division's margins or hurt them?

Just about mix, is China more profitable than the segment or less?

China, it's no different than the rest. I mean, our business in China is very profitable.

Okay. Thank you.

Thank you. Our next question is coming from Jason Feldman. Sir, please state your affiliation then pose your question.

Is my line live?

Yes.

Okay, it's David Bleustein. Coming back to the component segment, maybe it would help if just for this quarter, maybe just for this calendar year, you gave us some sense for what the margins were by business unit. I mean, maybe even just ranges like Fleetguard between 10 and 15, just some semblance so we can see how Holset is comparing to Honeywell's business and so on and so forth.

We're not going to do that.

All right. Can't blame me for trying. Thanks.

Thank you. Our next question is a follow-up from John McGinty.

Yes, just on that point, Tim, as you could see, you may think it's a great business, but if you're not going to give us that kind of information so we can see it, too, you can understand why people are somewhat curious about it, since the margins have continued to go down as the revenues have gone up and the earnings have stayed flat, so in any event. You talk a lot about '06 on a number of these different businesses, there were, I think were only a couple that when Dean was giving the commentary that he didn't at least touch on some expectation for '06 one way or the other. Are you guys ready to kind of pull it all together and talk about '06 at least in terms of overall revenues and directionally in terms of earnings or anything? Can you take it any further than just the pieces that Dean gave as he kind of touched on the different pieces?

Well, this is Jean. We're right now in the middle of our planning process, so I think it would be premature at this point to give -- as we've said, we expect '06 to be better than '05, and at least directionally, Dean's given you some of our thoughts by market. So I don't think we're at the point right now where we're ready to give guidance for '06.

Okay. And then -- that's fine. Just that he had given so many different pieces, I assumed that that must have come out of some grander or larger document that had something behind it. With regard to '07, Tim, you said a couple of times, I just wanted to make sure that I understood it, what you were -- well, what are you saying about '07? Just that the EBIT margin '07 will be equal to or better than the EBIT margin in '04 even if the market -- well, is down or were you -- even if it's down, how far were you saying? Anything about how far the truck market was down or just maybe let me just ask you to repeat what you were saying specifically about '07?

What I'm trying to address goes back to the - my statements where I think our PE ratio reflects a heavy-duty truck stock as opposed to our perception of what our company is. What I'm trying to do is say with a 30 to 40% drop in a prebuy, no-buy situation in '07, which is what the industry is now talking about, is that our EBIT, as a percent of sales in 2007, will be no worse, okay, than what it was as a percent of sales in '04. And I remind you that '04, was a record year. I might back that up a little bit. I know that you want to see what our sales revenues will be in '06, and yes, we're pulling our plans together right now so some of our comments are based on a preliminary plan, and I don't want to put something out there until we've really signed off on it in the Company. But just roughly, the following markets, okay, we would see right now as being up in '06 and '07, both years, medium-duty truck, RV Class A, Worldwide Bus, Dodge Ram, recreational marine, construction, light construction, commercial marine, mining, oil and gas, and the components businesses, plus China and India.

So if you look at that kind of increase, we think that will compensate for the 30 to 40% downturn that we might get in the North American truck. And that's the basis by what we are saying is that one we've got a better cost structure than we had before, and we really have a different mix in the businesses, and many of the businesses that are not related to truck, we think, will be up not only next year but also in '07. And so it's not just, -- it's not just rhetoric, we've got some data behind that. And as we become more certain with that data in hard plans, then we'll communicate it the best way we can.

I think that's more than fair. But just if I could, two clarifications, you ran through that list of markets that you think would be up in '06 and '07 with the North America, with the possibility of the North American truck market being down 30 to 40% as some say. Two questions, one, as you ran through that, was Power Gen in that market, or -- because you talked about different pieces, but I -- and you talked about the components, you talked about most of the engine markets.

Yes, Power Gen I skipped over. Basically on the commercial side of the power market, we think that will be up in '06 somewhere between 5 and 10%, and our preliminary look at '07 is up another 5%.

Okay. What else is in that, I mean, when you define Power Gen, commercial is a piece of it. What are the other pieces?

Commercial is about half. The consumer business will be flat next year, we think it will be up in '07. Rental's up both years, power electronics is up both years, energy solutions is up both years, and alternators was up slightly next year and flat in '07.

So basically everything would be -- the Power Gen would be up in--?

Well, certainly more upside potential across the business.

Fine. Then final question is, are you all -- I mean, the 30 to 40% decline is kind of what people are throwing out, although interestingly enough, everything throws it out a what people are saying, no one is actually saying down 30 to 40%.

That's because nobody knows, John.

I understand that. But I mean, are you guys -- you have to plan your business one way, but as you look at the market, I mean, the reason it's supposed to be down 30 to 40% is that your engine and the other guy's engines aren't supposed to be as good, they're not supposed to be out there, and yet everything you have said in the past about your engine, has been that this engine will have the same fuel efficiency, as I think Joe said it's the same engine you've been running with some more stuff hung on it, are you expecting a 30 to 40% decline in '07 -- I'm not talking about budgeting for it. I'm just asking what do you think. Are you expecting a 30 to 40% decline in '07?

Frankly, as Tim sort of said, John, we don't really know. We're hoping it won't be the case. But to do prudent financial planning, that's the way we're planning. We do think, as we work our way through next year, there is some prospect as end users and OEMs get a clearer view of our product versus the alternatives, that it might have some impact on buying decisions that end users would make that would cause the market not to drop as much, but more fundamentally for us, it may mean as we're working our way through '07 and whatever stuff goes -- happens in the first quarter in terms of how people plan for it, I think as we go through the year, we'll also see share gains in heavy-duty truck from Cummins as well. So we're prudently planning around the 35 to 40% range.

Tim's comment about EBIT as a percent of sales is -- assumes that things would be cut as much as that, but obviously, we're doing everything we can right now to demonstrate that our product and the way it performs, its reliability, its cost, and fuel economy will make it a very attractive product for people to put in their truck installations and attractive product for end users to run. So hopefully as we work our way through next year, we can get clearer and clearer as to what we really think will happen in the market generally.

Fair enough, thanks very much.

Okay. I think that's all of our time. If you have additional questions, Troy and I will be in the office and we will be more than willing to take your questions today. Thank you for calling in.

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.