康明斯 (CMI) 2005 Q4 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to your Cummins engine fourth quarter 2005 earnings release conference call. At this time all participants have been placed on a listen-only mode and the floor will be opened for your questions and comments following the presentation.

It is now my pleasure to turn the floor over to your host, Mr. Dean Cantrell. Sir, the floor is yours.

Thank you, Deena. Welcome everyone to our teleconference today to discuss Cummins results for the fourth 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, our President and Chief Operating Officer, Joe Loughrey, and President of our Power Generation business, Tom Linebarger. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty.

The Company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement.

A more complete disclosure about forward-looking statements begins on Page 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 to you our Web site 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 15% compared to the fourth quarter of last year, resulting in record segment sales for the quarter. Sales were strong across all product categories and service with Engine and Power Generation sales accounting for 70% of the growth.

Regionally, sales growth was strong, particularly in Europe in part due to a distributor acquisition during the second quarter, and in the Middle East as high oil prices are driving economic activity. We expect 2006 revenue to be up as most of the markets we serve continue to grow.

Our ability to leverage the higher sales into higher profitability was aided by a $4 million increase in JV income this quarter, leading to record quarterly earnings for the segment.

Earnings for the segment were 9.5% of sales, slightly better than the 9.3% from last year. Full-year segment earnings of 9% of sales are within its targeted range of 8 to 10% across the business cycle.

Power Generation segment sales were up 11% over the same quarter of last year with growth in commercial generator sales leading the way as all lines of business saw year-over-year growth. Strong sales in the U.S., and the Middle East more than offset the drop in sales from record 2004 levels in China.

Sales of commercial generators were up 11% over last year due to both volume growth and price realization. The increase in volume is due to higher demand in all regions driven by banking and data center projects in North America and non-residential construction in the Middle East as those economies benefit from revenue created by high oil prices.

The alternator line of business was up 13% driven by increased volumes in all regions except China and Southeast Asia, and increased price realization in Europe, Middle East, Africa and the Americas. We expect 2006 revenue to be up as demand for our product remains strong, particularly in the commercial markets for North America and the Middle East.

Fourth quarter Power Generation segment earnings were a record $49 million, or 8.5% of sales, more than double the earnings from the same period in 2004. Price realization was the primary driver of the year-over-year segment earnings growth.

We expect to continue to see the impact of this favorable price realization through the first half of 2006. For the full year earnings of 7.3% of sales are within the 7 to 9% targeted range across the business cycle.

Total sales for the Engine segment were up 22% compared to the fourth quarter of last year, setting a record for segment sales. We continue to see strength in nearly all of our end markets with revenues of on-highway markets up 21% and off-highway markets up 28%.

Segment earnings were 8.5% of sales compared to 6.6% of sales last year, resulting in a 56% increase in earnings. For all of 2005, earnings were 8.7% of sales for the segment within our targeted range of 7 to 10% across the business cycle.

Global shipments for the heavy-duty truck market were up 14% and revenue was up 19% compared to the same period last year. Revenue growth exceeded shipment growth due to higher mix of part sales.

Engine shipments in the U.S. and Canada were up 12%. We continue to forecast the overall North American heavy-duty truck market to grow slightly in 2006 to 315,000 units with growth being limited primarily because of industry and supply chain constraints.

Worldwide shipments to our medium-duty truck and bus markets increased 13% this quarter compared to last year. In North America, medium-duty trucks saw growth in share at key OEMs while international shipments grew as OEMs in Europe and Brazil achieved strong year-over-year demand.

We anticipate our medium-duty truck market share to hold steady going into 2006 with modest growth in the North American market ahead of the 2007 emission change.

Global bus engine shipments grew 50% compared to the same period last year. North America led the increase but we also experienced strong growth internationally, especially in China and Latin America.

Our market share in the North American transit bus market is now over 70%. We expect our North American bus shipments to continue to increase in 2006 as our engines enjoy a full year of availability in new accounts.

In the light-duty automotive and RV market, shipments to the LDA market increased 27% year-over-year, more than offsetting a 12% decline in North American RV shipments. We expect growth in both markets next year as new product offerings in the RV market will lead to growth in shipments, and shipments to the LDA market will post another strong year.

In our off-highway market, shipments to the construction equipment market increased by 30% as global construction remained robust, particularly in China and North America. Non-residential construction growth in both regions continues to drive higher demand, particularly in China, where the recovery in construction activity is creating an expectation of strong demand into 2006.

Engine shipments to the oil and gas markets were up 111%, driven by sustained oil and natural gas prices, which are driving activity in the oil and gas fields and investment in new equipment. We have also seen increased sales driven by sustained activity and investment in the oil and gas fields, and Cummins improved penetration at larger OEMs.

This market shows no signs of slowing down and we expect our business in this market to double in 2006.

Marine shipments increased 29% in the fourth quarter with strong demand in North America, Asia and Europe. Demand benefited from higher activity in oil field operations and towing applications, and at shipyards in the Gulf Coast region, Europe and Southeast Asia.

Revenues for the component segment increased 12% compared to the fourth quarter of 2004 with filtration, turbochargers and fuel systems each achieving strong double-digit growth in revenue.

Filtration benefited from strong aftermarket sales in North America and Latin America and higher OEM sales in Europe, Middle East and Africa. Fuel systems and turbocharger shipments increased along most major product lines especially to our heavy-duty engine plant and our European OEMs.

Turbochargers achieved significant growth in aftermarket as recent capacity expansion helped improve product availability.

The component segment should see broad revenue growth in 2006 with share gains in Europe as our OEM customers launch Euro 4 compliant products, and aftermarket growth following volume gains in OEM business over the last few years. Component segment earnings for the quarter were 4.5% of sales compared to 2.7% of sales in the fourth quarter of last year.

Gross margin improved from a beneficial mix of aftermarket to OEM sales and realized benefits of cost reduction work. Segment margins have improved but are still not in the targeted range of 7 to 9%.

To improve earnings, we are implementing aggressive profit improvement plans in this segment and we anticipate that these plans will begin to improve margins in the second half of 2006. We are also launching new products in three of the businesses in this segment in 2007, and while this requires significant investment in 2006, it will further strengthen margins for the segment in the future.

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 9.8% of sales surpassing the 7.3% of sales from the fourth quarter of last year. This marks the eighth consecutive quarter of higher year-over-year earnings as we continue to leverage higher sales growth and benefit from further cost reduction.

Net earnings for the quarter were $167 million, or $3.31 per share compared to net earnings of $119 million, or $2.41 per share in the fourth quarter last year, for a 40% increase in net earnings.

Fourth quarter results include tax benefits of $13 million, or $0.26 per share. Excluding this, and excluding a favorable tax adjustment in the fourth quarter of 2004 of $14 million, or $0.28 per share, net earnings this quarter increased 46% on a 17% increase in sales.

These strong results also include an increase in our effective tax rate for the year to 30% compared to our previous guidance of 29.5%.

Price realization, absorption benefit from higher volumes, improved plant efficiency and lower warranty costs all contributed to our highest gross margin since 1997. Overall we expect to see modest improvements in commodity costs in 2006.

We are now seeing costs stabilize for most major commodities with copper being the exception. We have taken steps at the end of 2005 to hedge a significant amount of our exposure to copper in 2006, thereby mitigating the risk caused by continued rising copper costs.

Price realization continues to benefit our gross margins. As we forecasted throughout the first half of 2005, with the pricing actions we implemented in our businesses at that time beginning of 2005, we more than offset the full-year incremental impact of commodity cost increases in 2005.

Looking ahead into 2006, we anticipate some targeted and selected pricing actions helping to sustain the gross margin levels achieved this year.

Total selling, admin and research and engineering, or SAR spending, in the fourth quarter was 13.9% of sales compared to 14.8% of sales last year, thus allowing us to continue to leverage SAR as it grows at a slower pace than revenue. On an absolute basis SAR was up $37 million as we incurred some increase in volume-variable spending in addition to higher salaries and wages across the Company, and increased spending in research and engineering, primarily in the Engine business, as we prepare for new product launches related to emissions regulation.

Our income from joint ventures and alliances in the fourth quarter was $12 million lower than the fourth quarter last year.

Distributor JV income grew primarily from growth in North American markets serviced by our distribution channel. However, this was offset by lower earnings from our joint venture with Dongfeng in China.

Excluding a favorable tax rate adjustment of $8 million in the fourth quarter of 2004, the earnings from our Dongfeng JV were $7 million lower as the truck market fell in the second half of 2005 in reaction to changes in the regulatory environment.

Even with an expected recovery in the China truck market during the second half of 2006, earnings from our Dongfeng joint venture are projected to be lower this year. They will offset expected growth in our other JVs keeping total JV income in 2006 in line with 2005 results.

Cummins' fourth quarter results include tax benefits of $13 million, or $0.26 a share, related to the favorable resolution of prior year matters of approximately $8.5 million, and additional benefits from repatriated dividends under the American Jobs Creation Act. Without benefits resulting from repatriated dividends and resolution of prior year matters, Cummins effective tax rate for 2005 was 30% for the year, slightly above our previous guidance of 29.5% due to increased earnings in higher tax jurisdictions.

For 2006, we expect our effective tax rate to be 31%, though this rate assumes Congressional action is taken to extend R&D credits early in 2006.

Cash flow from operating activities was a record inflow of $375 million this quarter. Working capital was a net cash inflow of $38 million as is seasonally expected in Q4.

We managed accounts receivable and inventory balances down during the quarter and working capital as a percent of sales ended at 17.1%. While there has been improvement, our businesses are focused to continue improve our working capital performance.

Capital expenditures were $65 million for the fourth quarter and $186 million for the year. For 2006 we anticipate $250 million in capital expenditures still below our D&A shield.

Before I turn the call over to Tim, let me summarize where we have come over the last year and what we expect in the year to come.

We finished 2005, one of the best years ever, with a strong fourth quarter, one of our best quarters ever. Cummins achieved record revenue and record earnings for the quarter and year.

Nearly all of our markets are strong and growing. Our cost structure is leaner and improving, and our balance sheet is much stronger than just one year ago.

Earnings before interest and taxes as a percent of sales are at the highest level in the last 20 years. We are proud of our performance and look forward to continued success in the future.

We expect 2006 earnings to be greater than 2005, but the year-over-year growth will be at a slower pace due to a more moderate growth rate in sales, higher tax rates and lower JV income in China.

To summarize, here's the guidance we have given this morning for 2006.

Revenue growth of 5 to 7%, capital expenditures of $250 million, joint venture earnings will be in line with 2005, effective tax rate of 31%, assuming Congressional action is taken to extend R&D credits, and pension funding of 170 to $180 million.

With regard to earnings guidance we expect to make between 250 and 260 per share in the first quarter of 2006, and between 11.90 and 12.10 per share for all of 2006.

Now I'll turn it over to Tim.

Good morning.

By nearly all measures, 2005 was one of the best years in the Company's history. We achieved record revenue and record earnings for the fourth quarter and year.

Nearly all of our markets are strong and growing. Our cost structure is leaner and improving. Our improved efficiency has led to better gross margins and a greater percentage of our sales are going to the bottom line.

On top of all that, the average total return for our shareholders over the last three years has been approximately 50% a year, well in excess of the S&P 500 in our peer group.

Our financial highlights for the year included a 25% annual incremental return on sales, a 24% increase year-over-year in net cash provided by operating activities, an increase in return on average net assets from 19% in 2004 to 28% this year, a 26% return on equity in 2005 making this the second consecutive year we've exceeded our target of 18%. This outstanding performance supports what we have been telling the investment community that we are a new Cummins, a company that is less cyclical, that is committed to turning a greater share of our sales into profits, that is focused on responsible cash management.

Let me first talk about cyclicality.

Our investments in markets whose cycles differ from the North American heavy-duty truck market has been gaining traction since 1999, a peak year for the North American heavy-duty truck market. That effort to expand our sales mix across geographic markets and lessen the cyclical nature of our business has paid off.

Although we have had a 20% compounded annual growth rate in domestic sales since 2003, we had an even more impressive 32% growth in International sales propelling International sales for the first time in 2005 ahead of domestic sales. International sales were 55% of our total revenues in the fourth quarter of 2005.

In addition, we have expanded product sales from our less cyclical businesses, such as aftermarket parts and service, our components businesses and our distributor businesses. Today they represent about 40% of our total sales mix.

Since 1999, their revenue growth has surpassed our more cyclical markets by two and a half times.

While we will always be tested in a downturn, we believe that our focus on this more stable earnings base will allow to us remain much more profitable than before at the low end of the cycle. As we expand our sales mix and experience growth in our less cyclical businesses, we are also pursuing profitable growth through new markets, new products and cost leadership.

Because we operate in mature markets, we have turned our attention to emerging markets and we have created joint ventures that allow to us grow profitably while developing new products and new technology with lower risk and less investment.

Our newest, or expanded, partnerships include the following. A joint venture with the Shaanxi automotive group to produce the ISM engine for China's growing heavy-duty market.

Production will start in the fourth quarter of this year with projected volumes of 50,000 engines by 2010. The development of a new state-of-the-art 13-liter heavy-duty truck engine with Dongfeng Cummins Engine Company with production beginning in 2009.

A joint venture with KAMAZ, Inc., the largest vehicle manufacturer in Russia, to produce our B-Series engines with production starting in the middle of this year and projected volumes of 25,000 engines by 2010.

A long-term expansion the Cummins/Tata joint venture to expand production of the ISB engine in India by 45% to 100,000 engines in two years. And an extension of our long-term agreement with Volvo Trucks North America.

Even outside our joint venture partnerships we are introducing new products across all of our business. In November our emission solutions business opened a new facility in South Africa to supply exhaust after treatment systems to European heavy-duty truck markets.

These products will meet the Euro 4 and the Euro 5 emission standards in 2006. In August our fuel systems business announced a new joint venture with Scania to begin manufacturing the XPI common rail fuel system and to make that product available later this year.

We anticipate that in 2006, approximately 55% of our capital expenditures will be targeted at new product introduction and capacity expansion for future growth.

In addition to developing emerging markets and new products, our pursuit of cost leadership will help us maintain profitable growth. Our cost structure, which is lower today than it was five years ago, continues to improve because of our pervasive use of Six Sigma, increased global sourcing and improvement in both plant and technical productivity.

Six Sigma is being used now in every function of the Company, in every business in every part of the world to streamline administrative processes, cut overhead, reduce variation and improve quality in the way we design and make products.

As part of our global sourcing initiative we've established purchasing offices in the Czech Republic, India, China and Brazil to leverage locally developed suppliers. We continue to increase our use of analytical methods and more sophisticated statistical tools to enable us to be more innovative in developing products that meet customer expectations for quality and performance when they are introduced.

Finally, we are focused on responsible cash management. During 2005 we reduced debt, invested in future growth of our businesses and returned value to our shareholders.

Not only did we pay $294 million toward our debt obligations, we also contributed $151 million to our pension plans around the world, well above the minimum required for our U.S. and U.K. pensions.

We managed our business investments carefully. We provided working capital to spur growth in our domestic and international markets. We also expanded facilities primarily outside of the United States.

Only a few of our joint venture initiatives required additional cash. For example, we were able to use positive cash flow from the Dongfeng joint venture to fund that business' next round of capacity expansion from 160,000 engines to 200,000 engines a year beginning in 2008.

As Cummins' cash grew, we repurchased company stock buying about $38 million worth in the fourth quarter to enhance shareholder returns. As you can see, we are a much different company than we were five years ago thanks to our commitment to reducing cyclicality, profitable growth and responsible cash management.

2006 holds significant promise. Our business outlook remains positive and we are expecting our operating segments to improve upon their record performances.

We are also anticipating and our prepared for the 2007 emission changes from the EPA. Given the breadth and depth of our technological expertise, we consider the challenge of tightened emission standards as a competitive advantage for Cummins and we are committed to remaining a technical leader in our industry.

We believe our outstanding products will enable to us gain share in engines, generator sets and components. In the emerging markets of China, India and Russia, our existing relationships and joint ventures will provide us with additional business opportunities.

Our growth initiatives will rely on our superior technology, leading brand names and market presence to provide us with a competitive advantage. Our initiative to assume greater ownership of our distribution channel, both domestically and abroad, will enable us to focus on parts sales and service and to further leverage the value of the Cummins brand in emerging markets.

As we head into 2006, our efforts, as always, will be based on our strategic principles, having our businesses work closely together to leverage their complimentary capabilities and capture synergies, maximizing the return on our investment to improve shareholder returns, aggressively pursuing cost leadership through Six Sigma, material cost reduction, global sourcing and technical productivity, growing in related markets that are less cyclical and have less competitive rivalry and more attractive returns, and creating the right environment by reinforcing a performance ethic in everyone who works at Cummins.

Thank you. We will now take your questions.

Thank you. The floor is now open for questions. [OPERATOR INSTRUCTIONS] Please hold while I poll for questions. Thank you. Our first question is coming from Gary McManus. Sir, please state your affiliation and pose your question.

JP Morgan. Good morning, everybody.

Hey, looking at Engine performance in the fourth quarter versus the third quarter, if I look you had about 166 million of incremental revenues but even excluding the joint venture income, you know, you only had about a $7 million in consolidated profits, which is a pretty low incremental margin.

So can you talk on the fourth quarter engine margin relative to the third? Was there anything unusual that held margins down there that are non-recurring?

No, nothing significantly unusual though we've been gradually increasing investment in a broad sense, not just R&E in our product line, getting ready for the '07 introductions, and that's had a little bit of an effect in several lines in the fourth quarter. But, no, there's no fundamental shift in the underlying profitability of the business and we view the business as being very strong going through next year.

Okay.

Just on the '06 guidance, you know, rough numbers you're looking at $12 this year including 2.55 at the midpoint in the first quarter. If I look at that time first quarter growth year-over-year in earnings per share it's about 30%. But if I look at the growth in earnings per share beyond the first quarter it's only 4%.

Jean talked about the tax rate differential and so forth but, you know, moderating sales growth, but I would think with the kind of cash you're generating so forth that would suggest maybe flat or down margins in the remaining three quarters of '06. So can you talk a little bit further on why you're seeing that?

I think your conclusion is wrong. We don't see down margins in the rest of 2006.

I think what we're basically saying is primarily because the supply chain constraints you'll see growth being more modest this year but continuing to maintain our margins and then we are hit a bit by higher taxes throughout '06.

Okay. Just one real quick follow-up.

You said 5 to 7% revenue growth in '06. What would the first quarter revenue growth assumption be?

We don't really give revenue growth by quarter.

Okay. But presumably stronger. Is that fair?

Well, actually, revenue in our first quarter, that's typically a low seasonal quarter for us.

I'm talking year-over-year.

Oh, year-over-year?

Not necessarily?

It will be a slight uptick.

Okay. And tax rate in the first quarter, is it 31 as well?

Yes.

Okay. Thank you.

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

Bear Stearns. Maybe a follow-up on Class 8.

I guess when I look at the awards data for Class 8 engine shipments it shows Cummins losing about 200 basis points of share in October and November year-over-year. But then when I look at the fourth quarter heavy truck engine shipments at Cummins you're up about 12% versus the industry up only about 5% so that implies that you're gaining share.

How do I reconcile those two? Are the OEMs starting to build some inventories very gradually of engines?

Well, it's difficult to reconcile precisely but there's a lot going on. Last year some OEMs built inventory for some people's engines in the industry, and towards the end of last year began to consume some of those engines at a fairly rapid rate where they had built inventory.

I think as we go into this year, and as we go through it, I think while it isn't entirely clear to us as to how much we'll see, we do expect to see OEMs building inventory during the course of this year in order to smooth the transition in the beginning of '07. How much they build of each supplier's engines remains to be seen.

We believe, we know we're going to be in more vehicles in '07 than we are in now, and we believe as we get through the latter part of '06 and the first part of '07, we'll come out of that period, in fact, growing share at a number of the truck OEMs based on what we know today. But frankly, at the end of this year and the beginning of next we're going to see a little bit of confusion in the numbers based somewhat on choices the OEMs make about how many engines they stockpile and from whom.

And we may see more stockpiling with those suppliers who may lose share in heavy and medium-duty truck as we come out of the first half of '07.

Okay.

I guess just so I can understand it. I mean, to the extent that maybe there was a little bit of modest inventory build of engines at the OEM level in the fourth quarter, do you think that build levels off here? Does it increase, or like your competitor, do you think it reverses out at some point, the build that happened in fourth quarter does that reverse out at any point in '06?

It's a question you're going to have to ask the OEMs. I mean, they share only so much detail with us in that regard. All I can say is, we are extremely confident that as we get through the back -- this year and the beginning of '07 that you will see our share both in heavy and medium-duty truck grow.

Maybe I could switch gears for a second and focus on the LDA segment. What's driving the strength there?

Because I guess when I look at the Dodge Ram shipments that Daimler puts out every month, I certainly wasn't seeing anything like 27% year-over-year growth. So has the dieselization rate increased, and if so where is that today or are you on additional platforms now at Daimler?

Dieselization rate has been going up gradually for some time now so that's the case. Also in that category, it isn't just the Chrysler volume, it's also volume we have with customers in Brazil that's been very strong for us and growing as well as the RV segment, which has been down this year over last.

So both our share of business in the truck at Chrysler is growing as well as our share of business in Brazil.

Okay. And I guess one other quick follow-up, and I'll hand it off.

On the R&D spend, or I guess the engineering and research spend leveled off sequentially at about $71million. I mean is that a fair quarterly number going forward or do you expect that to continue to rise as you start to tool-up for the transition into '07?

Simple answer to the question is we expect it to rise somewhat as we go through next year, and frankly, it's more beginning to kick off our programs this year for 2010 than it is for 2007.

Okay. Thanks for the time.

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

Hi, I'm with Lehman Brothers. How ya doing, guys?

Good morning.

Can you talk a little bit about capacity constraints? Maybe try to get a little specific on us and talk about what you guys are thinking about doing in the nearer term and maybe any impacts that it may have on the mix.

I would say the capacity constraint is different for different businesses, but essentially we are operating at capacity in most of our business right now and we can break some incremental bottlenecks and we can work with the supply base so we can get some modest increases. In the high horsepower, for example, this would be for the big gen sets and mining trucks and marine applications, we probably raised our capacity by 100% in the last year and still have some ways to go there.

I think we're at capacity with our heavy-duty business. We have some capacity available in our medium-duty business.

Wholesale is pretty much at capacity. So we're operating pretty much close to capacity and can get some increases.

Are there any comments you can give us on mix? Are there any impacts in 2006?

I think mix will be much like it was in 2005. It's a pretty broad question.

I think from a capacity, this is Tom Linebarger from Power Gen, I think across the engine markets and the gen set markets the mix is not likely to be impacted by capacity, but, you know, mix changes from different market regions. In all of our businesses in all of our markets we've been taking up capacity really for the last 18 or 24 months incrementally, as Tim said, to minimize capital investment and maximize the benefit pretty successfully.

So I think we'll just continue to do that, not making a big bet here or there but making incremental bets to increase capacity. So we're not really seeing one shoot ahead of the other from a demand versus capacity point of view.

Okay. Great. And just a quick follow-up.

Can you give us a sense of your free cash flow expectations in 2006? Thank you.

I mean, we don't give specific guidance on free cash flow. The guidance that we gave in the scripted remarks we tried to give you select line items.

We continue to talk about working capital as a percent of sales, a target of being 15.5 to 16.5% of sales. I think we gave you the pension funding assumptions and Cap Ex. I think overall we'll see positive cash generation in 2006 but those are the specific line items that we'll give guidance on.

We will have robust cash flow this year.

All right. Thank you.

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

Hi. Good morning. Credit Suisse.

My first question relates, could you just give a little more color on, you talked about your guidance within the component segment and you said that we should expect an increase in profitability in the second half of the year. I guess one, I guess how much of an increase? I mean should we, do you think by then you can hit your target of 7 to 9% margins?

And I guess can you also talk about the level of investment we should expect in '06 within components versus last year?

Okay. This is Joe again. Let me try.

We expect that based on a number of activities we've already been engaged in and will be engaged tin first half of this year that we'll see performance from an EBIT as a percent of sales point of view, the components group, to begin to increase in the third quarter of 2006. The group will not reach its 7 to 9% target by the end of '06.

We do believe that the group will reach, get in the range of its target somewhere towards the end of '07 or the first quarter of '08. And for the '08 year move well within the range of the target.

Most of the activity '06 is really focused on operational improvement. We're doing some restructuring in the exhaust business.

We're making significant improvements in productivity in Holset, a major uptick of Six Sigma in a couple of the components companies which have been a little further behind the rest of the Company. So the big focus in '06 is operational improvement and restructuring, particularly in the exhaust business.

In '07, we'll be introducing several new products, the fleet car group will be introducing our CCV product and our Holset group will be introducing both new turbochargers and implementing share gains that they've gotten in contracts that start in '07. And our emission solutions business really begins to take off in '07 given that's when we begin using after-treatment in a big way and they've already won significant contracts with customers in that regard.

And we will also begin to see in '07 increases in the slow ramp-up of our new fuel system, XPI fuel system, not only in our C&L engines but beginning on Scania engines.

And then I think in '08 we're expecting it will all come together. A combination of the operating improvements, the quality of the new products and the increases in share with a number of customers as a result of those new products. So we've got a very steady step by step approach looking out through '06 and '07 to get us within our target range in '08.

Great.

And then next, could you just comment on the number of engines that you have out there for '07, if there's been a change since the previous quarter? And sort of what your expectations are for the number of new engines out there for, you know, in '06 and just any feedback on performance?

Yeah. We haven't been commenting, frankly, on number of engines. We've had, as we've said in prior teleconferences, we've been testing our '07 recipe for years through hot and cold weather.

The OEM collaborative work in '07 which we began in late '01-'02 time frame has been going very well with every OEM. All the engines we do have in our field test essentially were assembled down our assembly lines and assembled down OEM assembly lines, which is a real change from prior field testing, which means we get a chance to test the whole production process early.

We do have about 38 end users who are testing on highway engines in North America right now. We're very pleased with the tests so far. Particularly this winter, passive regeneration is working better than we expected it would in our after-treatment system despite the cold temperatures and weather.

The process so far is verifying the quality of the significant up-front analytical work we did this time, much more than we have ever done in the past, and it's contributed significantly to improving technical productivity.

Right now we still see ourselves in shot of our target, which is to introduce engines that are comparable from a fuel economy point of view in '07 to where they're running today. And we'll be adding, as we go, over the next several months, another 25 more end users to the field test. So frankly, so far so good.

When we have also the distinct advantage that for most of the engines we're introducing in '07, the engine is changing very, very little. So you could argue we have millions and millions and millions of miles of field tests on our engines for that point of view and our real focus, both in lab and in the field tests, is making sure that the integration, the after-treatment devices work well and the integration of the after-treatment system does what we expect it to do and so far so good.

Great. Thank you very much.

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

Credit Suisse First Boston. Good morning.

Joe, when you guys were in New York, Tim said there were 37 engines in tests. Is 38 end users more than 37 engines? In other words, is it just literally one engine per -- no end user gets two? Is that the same number or?

No, no. It's a different number, John. Some end users have just one, but several have many more than one or two, and when we were talking back then we were also talking a little about engines we were running ourselves. So understand we're running engines ourselves, we're running engines in collaboration with OEMs, and we're also doing field tests with end users.

Okay. So where are you on schedule? Not for the performance, but on schedule for the rollout and the ramp-up of the testing plan that you had?

Yes.

Okay. One nitty question from the beginning.

The International Distribution had a $4.1 million I think, was it $4.1 million kick from a JV in an equity overseas?

That $4 million is additional revenue or dividends from our domestic distributors. You remember, we've taken it down to from 30 to below 20 and have taken an equity position in many of the distributors, and that $4 million refers to more equity position by the Company.

Just to clarify, it's $4 million in increased earnings by our joint ventures that are in distribution and that includes at least one international distributor also.

Well let me just ask you, is that a, is there seasonality to that coming in the fourth quarter or is that now a sustainable rate? I'm just trying to understand what that meant.

It's sustainable.

Our distributor JVs have been growing steadily over the last several quarters.

Who was the one Euro distributor that you picked up?

It's the Benelux countries.

Wow. Okay.

The stock option, 123, I'm sure you've said it in the past, I just couldn't find it in my notes. Could you remind us what that impact would be?

Yeah, it's not material to us. We have been expensing stock options for some time now and most of our performance plans are through stock grants and not through options.

So that will not be a number that you'll even bother about talking about.

Correct.

Okay. Great.

And then with regard to China, again, listening through what you were saying, are you assuming essentially that the benefit to Cummins from China in 2006 is essentially even with 2005, or was it just that the weakness in the heavy truck market might be offset by higher construction, or could you kind of -- China '06 versus '05 in your mind.

What we said was that we anticipate that China will, particularly in the truck side, will remain down during the first half of '05 and begin to, or '06, sorry.

'06, right.

And begin to recover in the second half of '06, and that will sort of be offset by gains in our other joint ventures, so that joint ventures would remain essential flat year-over-year.

Just to remind you, too, China consolidated and unconsolidated is about a billion dollar in sales. And as we said, I think that will probably continue this year. That's with [inaudible] off the record 2004 Power Generation which was up 40%, but it's still very, very robust markets for us in both the new joint ventures and the increase in capacity, not only in engines but also components. Our target is to get that to be to a $3 billion market by 2010.

Of that 3 billion, Tim, what part would be consolidated and what part would come in through a joint venture just so we could put it into a model that at least conceptually in that how big is as a percent of parent Cummins.

I'll let somebody look up that number. The biggest joint venture we have by far is with Dongfeng and that's unconsolidated. That was probably, what, $450 million this year out of the billion to give you some idea. So most of it is unconsolidated.

And that would probably be at least a billion of the 3 billion would be Dongfeng by 2010.

I don't if I've got that break down.

It's not an imperative number right now. [It'd] be, I think, a really helpful number to help you guys, help us give you guys credit for where China is, because to put it into whether or not you consolidated at the sales line doesn't make any difference because its it's at the income line that we care about but at least people tend to look at things on a first blush on a sales basis.

That's a point well taken, John.

In the future what we'll try and do is clarify better for you guys what our businesses in China are doing, because it is a significant opportunity. It's a significant business.

It's a much bigger opportunity and it also makes the point of less dependence on the North American truck market.

Okay. Then, Tim, let's talk about the 500-pound elephant that nobody wants to discuss which is 2007.

We look at a truck market and who knows what's going to happen in 2007, there is a consensus that really, it's kind of the ACT consensus of a worst case of a 35% decline in build in '07. Who knows if that's going to be the case or not, but at least it's a starting point.

One of your competitors who makes transmissions, not engines, has said, okay, if you assume that we still think that we as a company can do X, Y or Z, because of, well, in the case of Cummins, it would be all of the things that you talk about, all of the non-cyclical, contra cyclical, and so on. And so at what point could you feel comfortable talking about what you think the earnings, I mean, where the $12 numbers midpoint for 2006 if there were a 35% decline in '07 truck engines?

In other words, not that that's going to be the case or not, but that's what ACT has kind of thrown out at one point as a worst case environment. Not judging whether that's right or wrong, but if that, in fact, occurred, could you talk about what would you think Cummins should be able to do?

I mean, seems to me that's really what's impacting your stock price right now, not that people don't believe that you can't earn $12 next year but it looks like they think you're going to earn 2 or $3 the following year, which I think is ludicrous, but I was wondering if you'd want to put any numbers around it?

What we have said is that 2007's earnings before interest and taxes as a percent of sales would be no worse than what we did in 2004 which was 6.4%. And I think, you know, in our financial modeling we've assumed a market of 315,000 heavy-duty this year and we've looked at dropping to 190,000 to 220,000, which is in that 30 to 40% range.

But when you look at our other businesses, we're forecasting medium-duty truck, for example, to be up 35% because we have more availability. We're looking at India and China to be up 15 and 30% respectively. We're looking at a significant increase in our Chrysler business, so we can see, and because of long-term contracts that we will have significant growth in other areas which we think will offset the decline.

I think the big question mark in our mind right now is we know that it's going to hit the first quarter of 2007 and probably the first half of 2007. But I think we're in much, it's just a much different company than what we were when we had 2002, and I personally think that it is unlikely that we would see the kind of peek to bottom like we saw in [inaudible].

No, Tim, I don't disagree, I think that's good. I actually would think you might do better by being a little bit more explicit in your statements, but obviously that's the right direction.

Hey, John, this is Joe.

One thing on heavy-duty that we don't completely understand yet but are watching carefully is related to a comment I made earlier, is while, you know, our range has been 30 to 40% drop in the number of heavy-duty trucks made in '07, it's dangerous to equate that number to number of engines. Because as I said earlier, we know there's going to be some stockpiling of some engines to enable OEMs to make a transition into '07.

Our guess is, but this is a guess right now, that that stockpiling will be higher on those engines that the OEMs intend to discontinue in the new trucks in '07. And so there is some chance, two points, one, engine shipments will be down in the beginning of the year, lower than truck shipments because of stockpiling.

Two, we may be disproportionately hurt because we believe we'll be the share gainer in the second half of '07. And so, therefore, more of the other guys' engines might be stockpiled and used in the first half.

Nonetheless, with all in that mind and even though we don't completely understand it, based on all the scenarios we've run, we still believe we can achieve an EBIT as a percent of sales better than what we did in 2004. So this is an area we're going to be watching very carefully as we go through the course of this year.

Great. Thank you very much.

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

Prudential Equity Group. Good morning. Two clarifications and then I'd like to kind of get back to John's question.

On the clarifications, what was the warranty expense as a percent of sales or -- and then -- I guess that's it for the clarifications.

2.9%.

2.9. Thanks. Now, if we look at 2006, if I can get back to your comment about medium truck availability --

That's 2.5, not 2.9.

2.5. Thank you.

On '06, the medium truck availability, does that imply that your capacity right now allows that 30% increase or are you investing in capacity? Could you help me understand that? Thank you.

Yeah, Andy, we're, particularly where we see the big gains, our big capacity issue is four valve heads, and we have significant programs in Brazil and China that are well underway to produce the heads we'll need to be able to deal with the increased opportunity come '07.

Thanks.

And then lastly on the offsets, when you allude to, well, explicitly state that you expect your engines to be in more vehicles than basically what they are now, should we look at the market share gains more as penetration gains of existing customers, or are you actually regaining in customers that you may not have supplied over the last couple of years?

Flavor will be gaining share at existing customers. It will be a little of both but more gaining share at existing customers.

Okay. Thanks a lot.

Thank you. Our next question is a follow-up from Peter Nesvold. Sir, please restate your affiliation then pose your question.

Bear Stearns.

I think you talked about this a little bit on the last call but I think and along the line of John's questions, I'm trying to understand exactly what's discounted into the '07 EBIT target, if we can call it that of being at least as high as it was in '04. You mentioned 35% growth in medium truck, 15 and 30% growth in India and China respectively.

Are there a couple of other line items you can help us out with just so we can try to get a better sense for how you're looking at it versus how we're looking at it?

You have a lot of the industrial engine markets that range from 0 to 30%, so the oil and gas is well up, mining is up, Power Generation is up slightly in addition to what I talked about. Fleet guard is up, Holset is up. Emissions solutions kicks in '07 big-time like Joe was talking about.

So you can see a lot of these other businesses, and I mean, you know, our ability to predict exactly what's going to happen in '07, we're just giving you a feel for it. So we wouldn't be making the statement we are about the earnings before interest and taxes if we didn't have some confidence that some of these other businesses are increasing in sales and revenue. And then we're still staying focused on the cost reductions that we have.

In the medium truck one, and I don't want to try to take them one by one, it's just that's the one that jumped out at me the most, 35% growth, I mean, you did a little bit better than that in '04, but granted, that was really early in the cycle and prior to that you haven't done 35% growth since 1993 in a year.

So is there something that's changing in'07 in medium truck? Is that your view on where the macro economy is going? Are you on some new platforms on in '07? Can you just give me a little more color on that because that one really jumped out at me.

No, I think that's -- the 35% represents less what's going on with the market and more what's going on with our portion of the market. All right? And so our field test on '07 product relative -- is going very well.

And we know as a result of the work we've done with a number of our OEM customers that we will see, have seen and will see significant increases in share for medium-duty engine applications. And I think we'll let the OEMs at the right time tell their story, but it's primarily focused on, as I said, on us increasing share at a number of OEMs.

Okay. Thanks again.

Okay. I think that's all the time we have for questions today. Appreciate your participation in our fourth quarter earnings call, and again, if you have questions throughout the day, feel free to contact us at the office. 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.