康明斯 (CMI) 2006 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Cummins, Inc. second-quarter 2006 earnings release conference call. At this time, all participants have been placed on a listen-only mode, and we will open the floor for your questions and comments following the presentation.

It is now my pleasure to turn the floor over to your host, Dean Cantrell, Director of Investor Relations. Sir, the floor is yours.

Welcome, everyone, to our teleconference today to discuss Cummins' results for the second quarter of 2006. Each of you should have received a copy of our press release with a copy of the financial statements. If you have not received these copies, please let us know and we will fax them or email them to you at the end of the teleconference.

Participating with me today are our 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 certainly. 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 60 of our 2005 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 13% compared to the second quarter of last year. The increase was led by sales of Power Generation equipment, as the pace of construction in the Middle East remains strong. Revenues from engines, parts, service and filtration also saw year-over-year growth, and we continue to see strength in most geographic regions. We anticipate the growth trend continuing into the second half of 2006 for this segment.

Quarterly segment earnings of $36 million were a record, increasing 38% year over year. Earnings from joint ventures were the largest contributor to the increase, as we saw strong performance from our unconsolidated North American [distributor]. For the quarter, earnings for this segment were 10.7% of sales, above the targeted range of 8% to 10%.

Power Generation segment sales were a record for the quarter, up 21% over the same quarter of last year. The commercial generator business grew on strength in North America, the Middle East, India, and Latin America. Similar to the commercial generator business, the alternator business grew in all regions except China. Our consumer business grew against the headwind of continued softness in the North American RV market, which was offset by increased penetration into the towable segment of the RV market and gains in the residential standby and marine markets. Demand for our Power Generation equipment will remain strong through the rest of 2006.

Power Generation segment earnings were another record quarter for the segment, 60% higher than the second quarter of last year. Earnings were 9.4% of sales, above its targeted range of 7% to 9%. Absorption benefit from higher volume, priced further price realization and favorable mix all led to the improvement in profit.

Total sales for the Engine segment were a quarterly record, up 14% compared to the second quarter of last year. Within the segment, revenues from on-highway markets were up 15% and off-highway markets were up 13%, as nearly every end market saw year-over-year growth.

Earnings for the Engine segment were also a record, growing 22% from last year and reaching the top end of its targeted range at 10% of sales. The absorption benefit from higher volume across all of our end markets, along with some price realization, more than offset higher research and engineering spend for 2007 product launches and lower income from joint ventures in the Chinese truck market.

Global shipments for the heavy-duty truck market were up 14% and revenue was up 12%, compared to the same period last year, as we continued to benefit from a strong North American heavy-duty truck market. As we and others in the industry have been able to make incremental improvements in throughput, we have revised our 2006 outlook for the North American heavy-duty truck market, and now expect the Class A/Group 2 market to be 335,000 units, 8% higher than 2005.

Worldwide, shipments to our medium-duty truck and bus markets were down slightly this quarter, compared to last year. Market share gains in North America medium-duty truck were offset by an omission-related downturn in Brazil, with the introduction of Euro-3 engines at the beginning of this year. While medium-duty truck engine shipments were down, revenue was up, as the engine change in Brazil raised the average selling price per engine.

For the second half of 2006, we expect to maintain our market share leadership in Brazil and to continue gaining market share in North America. With increased availability of our [mid-range] engines at key OEMs in 2007, we expect our medium-duty truck business in North America to be up at least 60% next year, substantially higher than the growth we previously announced.

Global bus engine shipments grew 18%, compared to the same period last year. We saw further growth in North America, primarily through increased shipments to the school bus market. Outside of North America, the second quarter saw higher shipments to China as part of our recent successful bid at Beijing Public Transit, with the remaining buses to be shipped in Q3.

Global light-duty automotive and RV shipments were up 24%, due to strength in our shipments to the North and Latin America heavy-duty pickup truck market and our ability to grow in a soft North American RV market, through new product offerings and increased market penetration. We continue to see growth in both of these markets, with our North American light-duty automotive shipments expected to be up 9% and our RV shipments to be up 15% for the full year.

Shipments to the global construction equipment market were up 23% over the same period last year. Global construction remains robust, particularly in China, North America, India and the Middle East, as nonresidential construction spending drives higher demand. We are also benefiting from growth in our shipments to the light construction equipment market, as our A Series and B 3.3-liter engine offerings are gaining traction in the marketplace and outpacing the underlying growth of this market.

Engine shipments to the oil and gas equipment markets were 54% higher than the second quarter of last year, and are 62% higher year to date. Sustained oil and natural gas prices are driving investment in new equipment for the petroleum fields. Our shipments to this market should continue to grow as we penetrate more OEMs in this global market.

The Components segment had record revenue this quarter, increasing 10% compared to the second quarter of last year, with all of the business in this segment achieving year-over-year growth. Filtration benefited from strong aftermarket and OEM sales in North and Latin America. Turbochargers experienced increased sales to OEMs in North America, Europe and China. Fuel Systems revenue benefited from higher shipments to Scania and Cummins engine assembly plants, and the Emission Solutions revenue reflected the ramp-up for Euro-4 products to OEMs.

Components segment earnings increased 62% from the second quarter of last year, and were 6% of sales for the quarter. Year to date, earnings for this segment are running 5.8% of sales. While we still have further to go, the performance over the last two quarters gives us confidence that we are on the right path to improving the profitability of this segment. We are expecting continued profit improvement through the rest of 2006 and into 2007 that will help this segment reach the lower end of its target range of 7% to 9% across the business cycle toward the end of 2007.

Now, I'll turn it over to Jean to comment on our consolidated income statement, cash flow and revised guidance.

Good morning. Our earnings before interest and taxes were 11.4% of sales, above our targeted range of 7% to 10% and significantly better than second quarter of 2005, which was 9.4% of sales.

Net earnings for the quarter were $220 million or $4.38 per share, compared to net earnings of $141 million or $2.83 per share in the second quarter of last year, for a 56% increase in net earnings on a 14% increase in sales.

Gross margin improved from 22.1% of sales in the second quarter of last year to 23.6% this quarter, the highest level we have seen since 1996. In addition to the absorption benefit of higher volume, we have lowered our manufacturing cost structure considerably in the past few years, through cost reduction initiatives such as global sourcing, lean manufacturing and Six Sigma. We continue to closely monitor commodity costs, and remain confident in our ability to manage them through our hedging programs and cost reduction initiatives.

Total selling, admin and research and engineering or SAR spending in the second quarter was 14.1% of sales, compared to 14.5% of sales last year, with a year-over-year increase of $40 million. We have been increasing our SAR spending to fund our growth initiatives, and some of the increase in spending is volume-variable. However, we have still been able to leverage our SAR by growing it at a slower rate than our sales growth.

Income from joint ventures and alliances in the quarter were slightly lower than the second quarter of last year and in line with our expectations. The growth in the number and profitability of our North American distributor joint ventures offset nearly the entire lower earnings from our Chinese joint venture, due to the decline in shipments to the Chinese truck market that began almost a year ago. We still expect JV income in 2006 to be in line with 2005, as we anticipate continued strength in our distributor JVs and higher shipments to the Chinese truck market in the second half of 2006 than we saw in the second half of 2005.

During the second quarter of 2006, tax uncertainties relating to prior years were resolved with US and UK tax authorities, resulting in a $28 million or $0.55 per share credit to the second quarter income tax provisions. After this adjustment and a $12 million first-quarter charge for an Indiana tax legislation change, our effective tax rate for 2006 is estimated to be 32%. If Congress retroactively extends the federal research tax credit that expired last year, our effective tax rate will drop to 31% for the full year of 2006.

Cash flow from operating activities was an inflow of $337 million this quarter, 55% higher than the strong cash inflow of $217 million in the second quarter of last year. Year to date, cash flow from operating activities is $200 million higher than this time last year, and we're on pace for record operating cash flows this year.

Our working capital for the quarter improved from 17.7% of sales last year to 17.5% of sales this quarter, but still remains above our targeted range. This is an area of renewed focus for us, particularly in the area of controlling inventory levels as we increase global sales, so we have a number of Six Sigma and other projects focused on working capital improvement.

Finally, I would like to take a moment to summarize and update our guidance for 2006. We are increasing our revenue growth to a range of 11% to 13%, maintaining our capital expenditures at $250 million, still expect joint venture earnings to be in line with 2005, reaffirming our effective tax rate to 32% and raising our global pension funding to a range of $230 million to $240 million. With regard to earnings guidance, we expect to make between $3.35 and $3.45 per share in the third quarter of 2006 and between $14.00 and $14.20 per share for all of 2006.

Now, I'll turn it over to Tim.

Good morning. As you just heard, this has been another outstanding quarter for Cummins, and a great first half of the year. For the quarter, we had record financial performance in sales, earnings before interest and taxes and profit after taxes, along with record sales and profits in nearly all of our segments. That is just the beginning of the good news.

In June, we completed the $100 million share repurchase we began last fall. In July, we announced an increase in our orderly cash dividend by 20% and an additional authorization to repurchase 2 million shares. These two initiatives demonstrate our ongoing commitment to return value to our shareholders.

As a result of our stronger balance sheet and cash flows, both Moody's and Fitch upgraded Cummins' debt rating in May. That put us at investment-grade ratings across the board.

From a customer product standpoint, our activities were also outstanding. Yesterday, we announced our agreement with a major automotive manufacturer to develop and produce a high-performance, light-duty diesel engine for use in a variety of applications and markets. This is a major profitable growth opportunity for Cummins. Currently, there are no diesel-powered engines in the US light-duty automotive market segment, which includes standard pickup trucks and large SUVs. This market has an annual sales of about 9 million units. There are also significant opportunities for this engine in marine, bus and RV markets to displace gasoline engines and some larger diesel engines that are less fuel-efficient.

In addition, we are extremely pleased to reach the following agreements -- to begin exclusively supplying PACCAR with engines for Peterbilt and Kenworth's North American conventional medium-duty commercial vehicles in 2007; to become the standard engine offering in Ford's F-650 and F-750 medium-duty trucks for the 2008 model year with her Cummins ISB engine; and to supply the Cummins QSK60 engine as the exclusive power in TEREX unit rig trucks for the largest single order in the history of China's mining industry.

And just last week, Cummins Turbo Technologies, formally known as Holset, officially opened its newest manufacturing plant in Charleston, South Carolina. This new plant will produce 200,000 turbochargers a year, and will provide capacity to serve the growing demand for our product, which is seen by the market as best-in-class. We expect this good news to continue.

Last quarter, in talking about New Cummins, we shared with you how Cummins' profitable growth opportunities can mitigate a decline in earnings from the North American heavy-duty truck market in 2007. We also talked about how significant improvement in our cost structure and how the breadth and depth of our technology give Cummins a major competitive advantage well into the future.

This quarter, I want to emphasize our management strategy on cash flow, which is on pace to set a record this year. Our cash flow management strategy focuses on three components -- building a strong balance sheet, investing in profitable growth opportunities and continuing to deliver growing returns to our shareholders.

Strengthening our balance sheet is particularly important, because it allows us to take advantage of profitable growth opportunities and make timely investments in businesses that can help reduce our cyclicality. Over the past four years, our primary balance sheet effort has been to reduce debt and return to investment-grade ratings, which we have now accomplished. After we redeem our high-yield debt security in December, Cummins will have reduced its debt by nearly $900 million over a two-year period. We have also reduced our underfunded pension liability, and our focused on our other post-employment benefits through design changes and future increases in contribution levels, as our cash position warrants.

Our stronger balance sheet has also allowed us to invest in more profitable growth opportunities, such as the on-highway markets in China and India through our joint venture OEM partner, Shaanxi, Dongfeng and [Photon] and Tata Motors; turbocharger and after-treatment capacity to meet the growing demand of key OEMs in North America, Europe, India and China; engine and after-treatment technology for new emission requirements; and the next-generation common rail fuel systems for medium and heavy diesel engines with our joint venture OEM partner, Scania.

Some of these growth initiatives have required an increase in capital expenditures. Where the new Cummins differs from the old is that our businesses today are tightly managing their capital expenditures by focusing on generating asset returns above performance targets and leveraging our partnerships to share in the financial investment.

The final aspect of managing our cash wisely is to grow shareholder returns. We have created a positive shareholder value by strengthening the balance sheet and investing in profitable growth opportunities. As a result of our efforts, the Company's stock has outperformed the Standard & Poor's 500 index for the previous one, three and five-year time periods.

We have also worked with our Board of Directors to create policies of returning greater cash to our shareholders in the form of dividends and share repurchases when our growth in cash position warrants. We look forward to continuing our strong performance in the area of growing shareholder returns.

As I said earlier, we had a really great quarter, exceeding the high end of our targeted EBIT range. Demand continues to be strong in many of our end markets around the globe. In some areas, we are growing faster than the end market, due to share penetration. More important, we believe we can sustain our EBIT performance above the top end of our targeted range of 10% of sales in the second half of this year, even as we ramp up production at some of our new and expanded plants; introduce new products for 2007; customize our existing products to newly-won business for 2007; and begin development work on new engine platforms in North America and China, all of which are important to generating near and longer-term profitable growth.

Our field test program and manufacturing readiness are building confidence with customers that we are ready for 2007. We firmly believe we will continue to demonstrate in 2007 that this is indeed a new Cummins, stronger, growing and profitable, with great products and a renewed commitment to the success of our customers.

Thank you, and we will now take your questions.

(OPERATOR INSTRUCTIONS). Gary McManus.

JPMorgan. Good morning, Tim. Great quarter. I'm looking at the segment profit or EBIT information, and there is a category there called eliminations which was a positive $9 million. In the first quarter, it was minus $40 million. So can you talk about -- or Jean or whoever -- talk about what is going on there? It's kind of hard to model. Why was it so bad, minus $40 million in the first quarter, and what happened to cause it to be plus $9 million in the second quarter?

As I mentioned, in the first quarter, we had a lot more intercompany activity going on within the four walls of the Company that built profit on our balance sheet and inventory that, during the second quarter, we released that inventory without building it up as much as we did between Q4 and Q1. As a result, we saw that profit relief, and that's why you see the positive number there in the elimination column in the second quarter.

I'm sorry -- so, I'm trying to get a sense on this. So you had inventory you built in the first quarter with released in the second quarter?

What it has to do is with how much of it is intercompany, how much we're selling from one business to another one of our businesses, and we have to eliminate the profit levels between the [businesses]. We have less of that in the second quarter.

What kind of guidance, in a normal basis, would you have for that number? It has typically been a negative, about $10 million to $15 million a quarter. Under a normal environment, what would that number be?

I think you have seen a seasonal pattern with that number where, as you said, it has been negative in some quarters, and then usually in the fourth quarter, it reverses. The number has been growing, if you look at it from a trend perspective, given that our gross margin has been growing. So I would just continue to look at the seasonal patterns that you have seen in the last few quarters of how to model that going forward.

Okay. Still unclear, but I'll move on. Tim, way back when -- it must be more than a year ago -- when you were addressing the concerns about the downturn in 2007 North American heavy truck market, you said that you would expect the 2007 EBIT margin to be comparable to 2004. If I look at how strong your earnings are going to be this year, $14 plus, and make certain assumptions, an 2007 EBIT margin at 2004 would give you around maybe $9 in earnings. So that's a fairly big drop-off, considering, as you say, the heavy truck market is only 15% of total sales or so.

So can you comment a little bit on what you think -- are you still thinking EBIT margins in 2007 are at that 2004 level? I think it could be substantially higher.

Well, I made the statement about the 6.4% -- it was more than a year ago, and we were very confident about that number. What we were trying to do was create some confidence among yourselves that we were going to have a good 2007, and it wasn't a repeat of some of the cycles we've had earlier, when we have had emission changes.

I think we have done substantially better than we thought we would do back when I made that statement. I'm reluctant today to say anything about 2007. I think we will make our guidance at our teleconference in January, after the fourth quarter, and we will probably make some kind of a general guidance in the October/November timeframe. But I think we have had a very, very good first half, and I think we will have a good second half. That should raise the bar.

One real quick question. I think, Dean, in your prepared remarks, you said the medium truck he expected to be up 70% in 2007 with the new business. Can you just give me what's the revenue delta for that, round numbers?

It was 60%, not 70%.

I'm sorry, 60%. But how much revenue growth are we talking about, just round numbers?

How about we follow up after the call on that one? The quick answer is you kind of have to dissect it down, since we combined bus and medium-duty truck there. So we can talk about that one off-line.

David Raso.

Citigroup. Not to beat a dead horse on the eliminations, but just trying to understand it better, because the amount of intersegment sales during the quarter was as much as the first quarter, and the inventory this quarter actually grew faster than the sales. So, when you say released the inventory, was this then released to the divisions or released externally? Also, why, if the intersegment sales were the same quarter to quarter, such a dramatic swing in that eliminations profit line?

As Jean had indicated, this is the activity, the profits on the intercompany sales activity between the segments. So we make a reserve for the profit that's captured on those intercompany activities. As we look in Q2, we did -- the evaluation of the reserves was that we needed less of that reserve for the intercompany activity, and it was released and added to the profit that you see this quarter.

Is a way to think of it, if you combine the two numbers, cut it in half, kind of average the two quarters, it's not dramatically different year over year? And so going forward, should we expect a more normal (multiple speakers)?

Theoretically that is correct. Just so you understand it, we make a turbocharger, we sell it to the engine division, we take that and we sell it to Power Generation, and that is where the profit in inventory gross. When those products are sold, it is relieved, and this was -- we had a bigger buildup in the first quarter than we normally do, and we had a good shipment in the second quarter. So that is what you're seeing. But it should balance out over the long-term.

And regarding the rest of your guidance, the third-quarter midpoint and below the second quarter, we have seen typically from the Company third quarter is a little bit higher. Is there anything to do with selling days or anything I should be thinking about that would suggest now over the last three quarters you have obviously beaten numbers pretty handily. So I'm not sure what to make of the guidance. But in general, just the idea of it down from this quarter, anything to read into that at all?

Well, let me comment on it because I anticipated you guys ask us about our guidance every quarter. First of all, I think you have to recognize that this second quarter is by far the best quarter in the history of the Company. So we are operating at well above targeted levels in almost all of our businesses. And if you look at the second half of this year, we are at capacity in most of our businesses. We might be able to incrementally improve it, but we are operating again and will remain operating above our targeted levels in almost all of our businesses. In the components area, they are approaching it, so we are at a very high-level. And I think we have got to be prudent as we forecast or give guidance for the second half of the year.

The second thing is the third quarter historically, although there has been some change in this pattern, but historically it has been our lowest quarter of the four quarters in the year. There are six less production days in the second half of the year versus the first half. And we're also -- you know we are opening plants, we are expanding capacity, we're producing new products, so we have to reserve more for our warranties. There is more engineering expense as we're going right now. So I think our guidance is prudent. And what I would read into it is that it is lower is that we are having a fantastic year.

The other thing I would add to that is we have also -- we have announced a number of programs and partnerships that we are going to be able to fund from that or in that existing guidance and still maintain above our targeted range. So we feel pretty good about the fact that we're funding all of our growth initiatives but still performing above our targeted range for the rest of the year.

And two just real quick questions. The balance sheet, the debt reduction was pretty significant. And excuse my ignorance, I am just not really seeing the cash flow statement apply to such debt reduction. How I misreading it?

Remember during the second quarter we announced that we would redeem early our quarterly preferred securities, which were treated as debt on our balance sheet. It had a conversion feature, and nearly 100% of the holders of that security chose to convert into common stock. So that is why debt decreased and did not show a cash flow on our cash flow statement.

Okay and lastly, the announcement yesterday, the initial thoughts for that plant, what are we thinking initially on volume in that plant? Obviously you can ramp it up and down based on diesel penetration looking out over the years, but just what is the initial thought on what's volume for that engine series?

The base case that we have put together for this was 175,000 units, reaching maturity within a relatively short period of time given the arrangement we have with our partner who is not our only customer.

Okay, very helpful. Thank you very much.

Peter Nesvold.

Bear Stearns. I guess a question on the guidance. You had a tax charge in 1Q and then a tax credit in 2Q. If you take the midline midpoint of your annual guidance and take the midpoint of 3Q, what exactly is 4Q implying? Because my initial read is it implies in line with a consensus for Q4, but I just want to understand it better.

Operationally I think it implies that we will see a fourth quarter as strong or nearly as strong as what we saw here in the second quarter.

Okay. So just -- all right. So it would be like 362 -- all right. What I'm doing is I'm taking the midpoint, 410 minus 2Q at 438 including the tax credit minus first quarter 278, minus the midpoint of 3Q of 340, and that gives me about 362 for fourth quarter. Is that the appropriate way to be looking at this?

I mean -- I follow your math and your backing into what that leaves for the fourth quarter. I don't disagree with your math.

Okay and that is helpful. On the number of operating days, because it did seem like there was an extra operating week in the second quarter. That seemed to benefit earnings more so than we were expecting. But it sounds like that comes out in the second half. Which quarter does that comes out in?

I think there is one day in Q3 and five days in Q4.

Okay. Great. Let's see, on the release on July 11 it said you had 52 million shares outstanding. At least the average diluted share count in the quarter was 50.8. Should we assume that that is 52 now at the end of the quarter?

That is a point in time. It is not the average that you would use for EPS calculation.

Right. So 52 was at the point in time at the end of the quarter. The average diluted share count for the full quarter was 50.8. I guess what I'm trying to understand is what was the quarter ending fully diluted share count that I should use going forward?

Well, I mean we reported the 50.8 here for the second quarter. We are not going to give guidance on what our share repurchases activity will be in the second half that would affect that number. So I think you'll have -- (technical difficulty)

End of the quarter.

(multiple speakers). We will have to get back with that.

The July 11 release said it was 52, and I'm just trying to understand if that is the number. On the eliminations and I guess I will beat a dead horse a little bit here, I completely understand production is ramping up, all the segments are producing inventory and is taken into inventory at other segments. Second quarter has reversed out. Doesn't that imply a slowdown? I mean if that were to happen externally where an external buyer was working down inventories, that is how I would interpret that. So is that interpretation right or where am I wrong there?

Your interpretation is wrong.

Okay. So why would you ramp up the inventories at the end of first quarter and then work them down in second quarter because historically you have never done that?

It is a mix issue.

It is a mix issue (indiscernible). Again, the only thing that happens if we sell more product that intercompany that is driven by intercompany. So, for example, if gensets if we have more profit inventory tied up in gensets because the engine was (indiscernible) and then we sell more gensets with our engine, that reduces the [DII] roughly in inventory. But if we sold a different kind of product that did not have that, it would not have that effect.

So my only point is mix of what you sell also affects whether or not you are releasing DII. So that is not only ramping up and ramping down.

This is not a pattern that is really a typical process or business through the year.

Yes, but this is in the elimination plan. It has never looked like that before. I guess one last question and I will get back in queue. I guess I will elaborate on the business strategy with PACCAR and letting them go with a private-label engine. Because when I look at that, it would seem like you are giving up the first take at the aftermarket. And when I look at EMD on the railroad side, they did that several years ago, and it really ultimately came back to haunt them. So what is the business strategy with letting PACCAR private-label the engine, and don't you give up the aftermarket doing that?

Well, we're still in conversations between PACCAR with its dealers and Cummins with its distributors, so I'm not going to say a lot. But the underlying strategy is like we have done in Europe, is to win more of PACCAR's engine business, and between us appropriately share both the opportunities and profit, as well as the opportunities to serve our customers. But we have had a very successful relationship with PACCAR/Leyland in Europe where we have private branded the engines for several years and have 100% of their business. And it is a business where we have been able to make money both in the way that we -- in selling the engines and collaborating between our distributors and the PACCAR dealers and supporting customers who buy their trucks with our engines branded PACCAR in them.

We will be working very closely with PACCAR in the U.S. both factory to factory, dealer to distributor in supporting their trucks with our engines in them. We feel very comfortable with the business model from a profitable growth point of view that we have created with PACCAR here.

In places where you have done that in Europe, what is your -- is there a difference between your penetration rate in the aftermarket in Europe versus what you get in North America?

Yes, but it is not for these reasons. Our distribution system in Europe is totally set up, totally different than what we do and how we do it in Europe versus the U.S. It is not a great comparison to make from a market to market point of view.

From a relationship point of view, with PACCAR in terms of what we're doing, as I said, we work it out, it is a good business. We think PACCAR is very happy with it and so are we, and we have taken the lessons learned from that business in Europe and creating the medium-duty exclusivity partnership with them in the U.S. They are excited about it, we are excited about it. It is going to be good for both companies.

And I would argue it is not a flawed strategy. We earned 100% of their medium-duty truck business, and I agree with Joe, we've never had a better relationship with PACCAR, and we are working through a lot of the important opportunities that we have. So we're delighted with our strategy.

It is a best truckmaker in the world. There is no question. Thanks and I will get back in queue.

Jamie Cook.

Credit Suisse. My first question just to build a little bit on Peter's question with the PACCAR strategy, one of the comments PACCAR made on their conference call was before -- was now -- you know, the truck guy can go to a Cummins or a PACCAR dealer whereas before they were not able to. So it sounds like you are giving something away.

And then I guess may -- or to ask the question a little differently, you said because of this PACCAR agreement, obviously your volumes in '07 for medium-duty truck are going to be up substantially. What does that do to margins?

Well, two things. One, we have been working with PACCAR for some time on the heavy-duty side of our business, as well as in Europe, and we have created a model with how we work with them on servicing the trucks and the engines between our dealers and distributors. We're not prepared to say a whole lot more about how that is going to work in the medium-duty deal because we're just in the process of PACCAR meeting with their dealers and us meeting with our distributors and taking them through it. It is a profitable model believe me and profitable for PACCAR, profitable for Cummins, and we both work very closely with one another in figuring out how we ensure that it is profitable for both parties. So I want to emphasize that in terms of the approach that we are taking here.

Okay. And then, Tim, just a question -- I understand why you are reluctant to give guidance for 2007 this early. But given your performance and you alluded to the fact that you can probably do better than the operating margin in 2004, but if you don't want to comment about the Company specifically, given the fact that you are so close to the customer and you have been in the industry for awhile, how do you view the industry for 2007 versus previous cycles? Do you see the 40% decline that most people project, or do you view that differently?

No, I think that is what we're seeing. The numbers that the industry is talking about, 30 to 40%, I wouldn't disagree with. Clearly the decline is going to be for component suppliers like ourselves is going to be more severe in the January/February/March timeframe. I think the conditions are very different right now than what they were going into '02 both in terms of knowing the technology, knowing the operating costs and the fact that the industry has been at capacity now for a couple of years. So the opportunity for a big prebuy has been less, and also the used truck market is very robust right now, which was not the case back in '02.

What I would say is that, and this is a known event, this is like the point I tried to make in earlier conversation, and we have had plenty of time to prepare for it. We have manufacturing plans in place that will allow for a significant downturn in the first quarter, and the other sides of our business are clearly more robust. We have the distribution business now that we did not have before. Our China and India businesses are much stronger than what they were before, and in some cases we were not in the deals.

The Power Generation business is in full recovery, and they expect to grow their business next year. You can see that we have gained penetration. So we've gained penetration at PACCAR. We've gained penetration at Freightliner medium-duty truck. We've gained penetration with Ford. We've gained penetration at Blue Bird. We are gaining penetration at TEREX and other off-highway or industrial. Right now we think that both the growth in some of those markets, the growth in geography and the fact that we are increasing penetration is going to really mitigate the historical impact that you get with an emissions change.

Yes, and I would like to just add one thing to that because it is a comment we have made before. And that is that we believe based on feedback from OEMs on one hand and end users on the other that we have done the best job of working with the OEMs on getting our '07 product both heavy and medium-duty integrated well in the trucks.

And second, that our field test relative to the other guys has gone a lot better. And so we are as we get closer and closer to the end of the year, we are increasingly confident that OEM trucks with our engines in them are going to perform better from an end-user point of view than the other guys. And that is -- that is part of the reason why we're gaining share already in medium-duty. Because people see that and understand that. And I think as we come out of '07, while we have been very clear on share gains in medium-duty in '07, we have not been so clear on heavy-duty other than to say I'm personally very confident as we come out of '07 you are going to see gains in our heavy-duty share as well.

Thank you very much.

Joel Tiss.

I'm still at Lehman Brothers. Can you give us a little bit of a sense of where the 60% growth comes from in the medium-duty? We obviously know about the PACCAR piece, but can you build it up just a little bit for us?

And also maybe this will help answer some of the other questions that you have gotten, can you talk a little bit about that 60%, the profitability on that relative -- just relative to where the margins are today?

In terms of the numbers or the volumes in OEMs, we have already talked about PACCAR and winning their 6 and 8-liter business in their medium-duty commercial trucks in North America.

The second piece, which I think I talked a little bit about in the Caterpillar conference actually, but Cummins has been chosen as the nonproprietary partner for medium-duty truck and specialty -- medium-duty specialty vehicles by Freightliner. We will be the only non-Chrysler group engine offered in Freightliner family of vehicles, not just Freightliner branded vehicles, in North America as soon as we work through whatever stockpiling takes place and its impact in the beginning of '07. So we see our share as growing significantly at Freightliner, both in the -- as I say at all Freightliner branded vehicles -- truck, bus and specialty vehicles. And that will be a significant contributor to what we're doing and how we are doing.

And then as mentioned in the remarks that we made earlier in the teleconference, we have also been named as the standard engine in the Ford medium-duty trucks, and that will be our ISB. Our ISB is the fuel economy leader in the industry and will remain so as we move into next year in medium-duty trucks. So we think we have a terrific platform upon which to build. So most of the gain is again going to be around exclusivity in PACCAR, nonproprietary exclusive at Freightliner, new standard to standard engine in the medium-duty truck, and those are really the primary influences on growth in units, more than a doubling really of units next year.

Also, our business with VW and Ford in South America remains very solid, as well as with Leyland and with PACCAR in Europe. So with those volumes, we think we will see some recovery in the Brazilian market, so we will see some growth there as well.

Again, I remind you that we earned back the Blue Bird schoolbus business, and we are also picking up some share in the industrial accounts.

And then how about the margin, the profitability part of that question?

We usually don't disclose the margin or profitability of any one of those individual markets.

Okay. And --

But I will just say we are satisfied with the agreement, very much satisfied with the agreements we have reached with our partners. So --

All right. And in the Power Gen business, can you just give us a little bit of a sense of the price talk that is going on in 2007? We get some very mixed messages from different suppliers about supply/demand is coming into balance. No, it is not. And can you just give us a little bit of a sense of, you know, like what the customers are saying and what the pricing talk is for 2007, just generally?

Right now the price talk is all relatively positive. I mean I have heard various things about things coming into balance and all that. There's no evidence of that that things are coming into balance, and most of us that are significant producers in the industry are out of capacity, as Tim said, and not just because of the Power Gen market. That is not the issue. The issue is that many many of the markets are up, which is, therefore, driving strong engine demand across the board.

So everything I hear about price talk is up. There is also, though, a fair bit of discussion about emissions changes in the U.S. and what that does to price. Because you're actually adding quite a bit of emissions equipment onto Power Generation equipment now and then just in 2006 and 2007, which can have a dramatic increase of costs and price. So it is a little bit mixed.

So I guess my advice would be, if you are trying to kind of figure out what is going on with the price, make sure you understand what you are asking about is what product changed versus what is the actual price change. But again, my estimation is prices will increase again in 2007. I don't have -- we are not there in 2007 yet, but what I can tell you is that we will be pushing it.

Okay, that is helpful. Thank you very much.

Eli Lustgarten.

Longbow Securities. I have been called a lot of things. We have a couple of cleanup questions. I think you talked about the tax rate being 32% in '06. Do you have any guidance would it change much in '07?

I mean we continue to see the phaseout of the export credits as part of our tax strategy, so we would expect it to be higher, and we will give more clear guidance on the tax rate for 2007 at a later time.

I assume it will be up a percent or something like that if reasonable based on whatever turns out. Is that fair?

We will give more clear guidance at a later time.

The second question with the conversion of the convertible and the cash flow, can you just -- does interest charges go down for the rest of the year into next year?

Yes. We were paying 7% coupon on 300 million principal on that security, and so you should expect interest expense for the back half of this year to be less as a result of the conversion of that security.

There is a slight offset on that because we will be paying dividends on those shares now. But still you should see a pretty decent interest expense decline over the rest of the year.

So you are down 3 or 4 million a quarter and whatever and something like that goes into next year, correct? Something of that magnitude?

Yes, I mean it is $11 million pretax over the back half of the year.

That's why I have your numbers. Is the purpose of the 2 million share repurchase to stop share creep, or do you actually want to reduced the shares outstanding?

We want to reduce the shares outstanding and see this as a good way of returning value to the shareholders. Again, there have been comments about the size of it. What we're saying is that we did the $100 million one. We said we were going to do it and we did it, and we think 2 million share buyback is the right amount, and we are confident that we will complete that, and when we complete that, we will look at further share repurchases.

One of the things you are making contribution to pension plans to, has there been benefit in the second quarter, and do we expect better the rest of the year and next year for pension and health, lower pension and health care costs? We have been seeing that a lot in a lot of companies. I was just wondering, was there any impact on Cummins?

On pension I'm not really sure I can speak to that one, but on health care what we have seen is a trend. We have had substantially improved trends for most businesses in our health care costs. In terms of actual reductions, I'm not sure I would see that the second half of the year versus first half.

Is it quantifiable? How much -- we have seen a lot of companies have nickels and dimes of earnings come from quarters from pension and lower pension and lower health care cost. Is that true here too, or is that quantifiable at all?

No, I don't --

I don't think so. We are not going to improve our earnings substantially because of lower pension costs or lower health care costs. We have managed our health card plus where we have -- our increased rate has ranged anywhere from 0 to 5% over the last three or four years, which we think is less than half of what the national is going up. And as far as the pensions are concerned, our goal was to get them 90% funded by the end of next year, and so we are investing our cash to do that. In the guidance you have seen that has gone up from 170 to 180 million to I think we said 220, 230 to 240. And that allows us to get to the 90% funded level faster than what we were saying before.

This is Dean. If you look at the expense for the other postemployment benefits, the trend on that has been favorable. We have made some designs plan changes that have helped to reduce that expense year-over-year.

Okay. Thank you. Everybody worries about the elimination stuff. Should we expect any other positive elimination number in the rest of the year, or will it be a big surprise, a big swing in the second quarter?

I think as I said earlier the typical seasonal pattern is that in the fourth quarter we usually -- as we reduced inventories, we usually see a reversal of that profit, and it flows out of the Company and shows as a positive number in the elimination column usually in the fourth quarter. That has been a seasonal trend that has repeated multiple years now.

And despite it happening in the second quarter, we should expect it again in the fourth quarter?

Given our typical behavior at year-end on how inventory balances move, I think we would see that seasonal pattern repeat.

One final question. Can you talk a little bit about Power Gen outlook, not only this year but going into next year? With the alternators and a lot of products generators doing very very well, is that sustainable into next year, or do we get a big volume slowdown in profitability going back down to more normal levels in '07?

The more normal level -- I might take issue with that. Of course, I'm just trying to demonstrate to my boss that this is my normal level. But the answer is our outlook for next year is pretty good today. I mean there's a lot of water to go under the bridge still about how the economies are going to shape up and everything. But based on what we see, we see a good outlook next year. Orderbook is strong. There's enough backlog in the industry now that there's already a fair strong orderbook in Q1 and even some into Q2 already particularly on bigger jobs. There is a fair bit of activity in the market now on data centers, and that activity is busy enough that the engineering firms and other firms are kind of sold out. So right now it looks good. We will see what happens, but we're pretty optimistic about how '07 looks even relative to '06.

And is the mix favorable enough to keep the profitability above the -- I think you used 7 to 9% normal range in the comments. Would it be above that? Can we maintain above that?

Let's put it this way, our target is to remain at the top end of our range when markets are as strong as they are now. So that is what we're still trying to do. That is how we set the range. We said we should be at the top end of the range when markets are good, and that is what our intent is. There's a lot of stuff to deal with with regard to the exact number, in as Dean said, we will definitely give you guidance on that as we get to the end of the year. But we are expecting if it is as good a year as we expect, that we will be operating near the top.

[Casey Andrew].

Wachovia Securities.

Good morning, Andy. Did you change your name?

I guess. I'm changing a lot of things. A couple of clarifications on the first question. On the income statement, what was the product coverage cost in terms of percent of sales? And then on the balance sheet, pension liability decreased, and was that all due to cash funding, or was that part of the redesign that you referred to?

Give us a second here.

Product coverage as a percent of sales in the second quarter was 2.9%.

Okay.

What was the second question, again?

On the pension liability decrease 2Q versus 1Q, was that all due to cash funding?

You know, that one actually we're going to have to get back to you on. Okay?

And then for I guess, Joe, on the previous answer to the light vehicle volume question -- and congratulations on that contract, by the way -- your 175,000 volume, was that the mature volume base case, or was that base case for year one?

No, that is mature volume base case but within a few years. In other words, maturity will get reached within our base case within three years.

Okay. Thank you very much.

Peter Nesvold.

Just a quick question on engine volumes as '07 progresses. Are there any scenarios under which you might build inventory ahead of the OEMs ramping up production of '07 trucks with '07 engines?

No.

Good to hear. On the auto OEM contract, would that be branded a Cummins engine?

The simple answer is yes. Again, we have more than one customer.

More than one customer?

Right. As we said in the announcement, we secured a large partner, but we have more than one customer for the engine business as we go into the future.

And again, remember in the press release, we talked about it, this engine family serving more than one market. This is more than just automotive markets that will be served. We talked about bus, RV, Marine, so there are other opportunities there, and that will lead us to other customers as well.

I think you mentioned just going into a regular sized pickup, not a full-size. Is there -- am I able to conclude that it is not a big three customer because it would seem a little competitive to offer to a Ford or to a GM if you're making a Cummins engine for the full-sized Dodge Ram?

Nice try. (multiple speakers). You will have to conclude whatever you want to conclude.

You have got to give me credit for asking. All right. Here is an easier one. Now that your investment grade, my sense is you passed on a lot of acquisition opportunities in this cycle. You have been very disciplined in the balance sheet. It is very clear you've wanted to get back to investment grade. Now that you are there, you have started to do some more buybacks, you have started to do more dividends. Do you expect to maybe start looking at acquisitions again?

No.

Why is that?

We don't need to. We have enough organic growth to grow substantially and meet the targets that we have got. Right now if you look at the acquisition market, the prices are too high, and we're not going to spend money on a business that we cannot earn a good return on. There may be an opportunity that comes up that is very related to one of our businesses, and we take a look at it. But an acquisition strategy or a main part of our strategy is not something that we're going to do.

That seems prudent. And then final question. When do you expect R&D to start ramping up meaningfully ahead of 2010 in North America in 2009 in Europe? I'm sure you're spending some already, but would you expect it to kind of settle down a little bit in '07 before it ramps up again, or how should I think about it for the next three years?

First of all, you should not just think about it as a 2010 issue. In terms of our R&E expense, it is aimed at 2010. It is aimed at Tier IV off-highway opportunities. It is aimed at different geographic markets in the U.S. versus Europe versus India and China, and we have already started in essence the ramp-up process -- the spending I should say, not ramp-up but the spending on some of the new opportunities we have already talked to you about. Both the announcement we made yesterday -- I mean we are well into the work necessary to realize that and as well as what we told you a little bit earlier this year about the feasibility study that we got approved in China for two new engines with a new partner that we are also well into the process of the design and development process.

So our goal is to continue to get more and more productive in the way we do our technical work. That is a strategy that has worked very well for us the last few years -- to significantly increase the productivity of every dollar we spend so that, in fact, we can do more with roughly the same number of dollars. So we have been saying we think we're going to run somewhere above or below the sort of 3% sales level on the R&E line, and it will move a little year-to-year, partly depending on sales and partly depending on where we are. But that is kind of where we are going to be.

Perfect. Thanks again for the time.

Thank you. That is all the time we have for questions today. I appreciate all of you joining us today for our second-quarter earnings release, and we will talk to you again next quarter. Thank you.

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