康明斯 (CMI) 2007 Q3 法說會逐字稿

Good day ladies and gentlemen, and welcome to the third quarter 2007 Cummins Incorporated earnings conference call. My name is Carissa, and I will be your coordinator for today. (OPERATORS INSTRUCTIONS) I would now like to turn your presentation over to your host for today's conference, Mr. Dean Cantrell Director of Investor Relations. Please proceed, sir.

Thank you, Carissa. Welcome, everyone, to our teleconference today to discuss Cummins' results for the third quarter of 2007. Participating with me today 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, Todd 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 61 of our 2006 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. Our press release with a copy of the financial statements and a copy of today's webcast presentation is available on our website at www.cummins.com under the heading of investors and media.

Now, some comments regarding each of our four operating segments beginning with the distribution segment. The distribution segment attained record revenue this quarter on solid organic growth. The segment also benefited from favorable currency, which added 6% and European acquisitions, which is added 2%. Sales were strong for engines in Europe and Asia, for Power Generation equipment in Europe and the Middle East, and for parts in Europe, the Middle East and the South Pacific. Joint venture income increased 73% on continued strength in the North American Power Generation market. Segment earnings equaled the record earnings established in the second of this year. Revenue for the distribution segment will be up 22% this year, excluding the reporting change.

Global nonresidential construction and economic expansion are expected to drive further distribution revenue growth, particularly in Europe and the Middle East in 2008. The Power Generation segment continued to benefit from strong global demand for our products. Segment earnings increased 46% as significant price realization offset higher material costs. Sales of commercial generator equipment and alternators benefited from three trends: Construction spending for data centers in North America, IT and manufacturing investment spending in India, and general infrastructure development in the Middle East, Europe, Latin America and Africa. Currency also added 8% to segment revenue, which is expected to increase 27% for the year, as demand for commercial generator equipment, including alternators, remain strong.

Engine segment revenues were a record this quarter with growth in both on-highway and industrial markets. Construction, mining, and marine led the growth in industrial revenue. With the -- within the on-highway markets, growth and medium-duty truck and bus and light-duty automotive and recreational vehicles offset the downturn in heavy-duty truck. Segment earnings were lower than the third quarter last year. As expected, gross margin was lower due to higher material costs and warranty accruals associated with the new 2007 engines. Joint venture income, however, increased 50%, primarily on the continued strength in the Chinese truck market ahead of the new emissions standards in 2008.

Engine segment revenue is expected to increase 7% for the year due to global industrial market demand, strong on-highway markets outside of the U.S., and market share gains, particularly in the North American on-highway market. Global heavy-duty truck shipments were down 27% as strength in international markets helped to offset some of the emission-driven downturn in North America. While the North American market is softer than we anticipated at the beginning of this year due to a weaker freight environment, we are forecasting this market to recover 25% next year. Our market share has grown significantly as a result of our product quality, performance and readiness. We expect to maintain our year-to-date market share, which is in the mid 30s, throughout the rest of 2007 and into 2008.

Our recent announcement regarding our 2010 technology path is further evidence that we will have a leading presence within this market beyond 2010. Shipments to the medium-duty truck market were up 23%, primarily due to robust truck markets in Brazil and Europe. In North America, shipments were essentially flat, as share gains with key OEMs neutralized a 25% decline in the overall market. Thus, market shipments were up 47% due to similar market share gains in the North American school bus market and strong growth in international transit bus markets in China and Eastern Europe. We anticipate these trends to continue and still expect our global medium-duty truck and bus shipments to be up approximately 25% this year.

For 2008, we are forecasting an additional 15% growth in our global medium-duty truck and bus shipments. We expect to benefit from full-year availability at both North American medium-duty truck and school bus OEMs. We are also forecasting the North American market to recover 19% of from the 2007 emission-driven downturn. Global light-duty automotive and RV shipments increased 32% this quarter, primarily due to higher shipments to the North American heavy-duty pickup truck market. RV shipments were slightly lower due to the strong pre-buy activity during the third quarter of 2006. For the full year, we expect our shipments to the global light-duty automotive and RV markets to soften 6%.

RV shipments are forecasted to be up 15 to 20% due to increased availability at key OEMs. However, shipments to the heavy-duty pickup truck market will be down 10% as our customer manages inventory levels at its dealers. We anticipate the combined shipments to these markets to be up slightly in 2008 with the heavy-duty pickup truck market flat and the RV market up nearly 5%. Revenue from our global industrial markets increased to 30% over last year, primarily due to growth and construction, mining and marine. In construction, global infrastructure development in international markets is fueling our growth. The other industrial markets of marine and mining continue to benefit from sustained high prices for petroleum and mineral commodities. We expect to achieve solid double-digit growth in the industrial market this is year.

Looking forward to 2008, the expansion of certain mid range and high horsepower manufacturing capacity will power additional growth in our industrial markets. We have been inclemently increasing manufacturing capacity for engines larger than 30 liters since the end of 2006. By mid 2008, this investment will have achieved a 30% increase in capacity. Component segment revenue grew 31% from the same period last year with growth in all four businesses. Emissions solutions, and turbo technologies saw significant growth from the sale of new products to help customers meet the on-highway emission standards in the U.S. and Europe.

Filtration revenue grew in the emerging markets of Eastern Europe and the Middle East, and currency contributed another 8% to the year-over-year growth. Segment revenue is expected to grow 25% for the full year. Earnings for the segment increased to nearly 80% from the same period last year on favorable overhead absorption from higher volumes and our ability to leverage operating expenses to the bottom line. These benefits were partially offset by lower gross margin due to increases in metal markets and higher costs related to new product introductions. Now, I'll turn it over to Jean to comment on our consolidated income statement, cash flow and guidance.

Good morning. Net earnings for the company were up 8% over the same period last year. Strong sales up 20% year-over-year and higher joint venture earnings contributed to the increase in net earnings. Gross margin as a percent of sales was lower this quarter, mostly related to the engine and component segments. In the engine business price increases for new products were offset by higher new product costs, increased warranty accruals, decreased heavy-duty engine volumes and a higher mix of new products relative to earlier in the year.

The increased warranty accruals are typical with new product introductions, and while our products are performing well, we will continue to accrue at higher rates until we gain more experience with the new products. Additionally, the lower heavy-duty volumes this year have reduced our ability to leverage our cost structure as well as we did in 2006. Still the heavy-duty engine business remains profitable at the lower volume levels, a demonstration of our restructuring earlier this decade. In the component segments, two of the four businesses, emissions solutions and turbo technologies, are experiencing low margins primarily due to the costs associated with meeting extremely strong demand. The emissions solutions business, which more than tripled in sales last year, is still in its infancy. And as a result of turning out several new products on an aggressive production ramp-up schedule, we have incurred higher product costs and warranty accruals.

A similar situation exists in our turbo technology business where sales have grown nearly 50%, and we have released multiple new products in the past year, serving many new markets and customers. In both of these businesses, demand for new emissions compliant products at our new and revamped plants has grown far faster than our expectations. We have chosen to support our customers at the expense of our margins in the short-term by incurring higher costs for air freight, overtime and additional staffing. We believe this commitment to our customers will pay off in the long-term, but for now, we are experiencing significant top-line growth while not taking as much of it to the bottom line as we would like. So, we anticipated the lower gross margin in the engine segment, and we made a conscious decision to meet customer demand in the component segment.

Margins in both segments are expected to improve significantly over the next several quarters starting in Q4 as we gain manufacturing experience with our new products. Total selling, admin and research engineering spent in the third quarter was 12.5% of sales, down from 13.2% in the third quarter last year. Expenses were higher in dollars as we built infrastructure, including hiring people to invest the for our profitable growth opportunities, such as light-duty diesel products, opportunities in India and China and preparation of new products to meet the ever changing emissions regulations around the globe.

Income from joint ventures increased $21 million, or 57%, compared to the third quarter of last year. Sales of Power Generation equipment continues to be the biggest driver of year-over-year growth in North American distributor joint ventures. In the engine segment, joint venture income increased due to a strong truck market in China as a pre buy drives demand ahead of a new emissions mandate in 2008. As a result, we are raising our joint venture outlook for 2007 to reflect a 40% increase over 2006. Cash flow from operating activities was an inflow of $367 million this quarter compared to a cash inflow of $258 million during the same period last year. The improvement is primarily attributable to better working capital management.

Year-to-date, we have spent $182 million on capital expenditures to grow our business and increase capacity. We expect to spend $320 million to $340 million for the full year as we pursue the profitable growth opportunities ahead. Regarding our strategy to return value to our shareholders, this quarter we repurchased $174 million of our common stock, or 1.5 million shares. We have the ability to purchase an additional 1 million shares under our current authorization and anticipate that our share repurchase program will continue as we believe our stock is a good investment. Before moving on to talk about our guidance, I would like to spend a moment reviewing the new targets we communicated at our recent analyst day, which many of you attended.

Slide 13 of the presentation that accompanies my remarks shows the new targets for new revenue growth and EBIT margins for each of our four operating segments. The first thing to note is that our revenue growth is much higher than our previous growth targets. Our EBIT targets reflect our confidence that our strong performance over the last cycle will continue even with more aggressive growth targets and, in some cases, the EBIT targets go even higher. As we continue to operate at high levels of operateability and generate positive operating cash flow, we will use the cash to fund profitable growth initiatives in each of our businesses around the globe. These targets are a reflection of the fact that we are well positioned to take advantage of a number of macro growth trends in the coming years and of our commitment to make the investment necessary to pursue many of the profitable growth opportunities we have identified.

Given reasonable economic conditions over the next business cycle, we feel we are well positioned to achieve the targets we have established. Today, we are reaffirming our 2007 earnings per share guidance at a range of $7.15 to $7.65. Revenue for the year should grow 13%. EBIT will be between 9 and 10% of sales with an effective income tax rate of 33%. We remain excited about the opportunities we see in front of us and look forward to great performance for the rest of the year. Now, I'll turn it over to Tim.

Good morning. The third quarter was a good one for Cummins, continuing the record performance that you've seen all year. These results continue to demonstrate that profitable growth is a top priority at Cummins. Three of our four operating units generated record revenue growth this quarter despite the traditional slowdown that occurs this time of year with many of the large OEMs. We have two companies in our components group operating well. As Jean said, we know we have work to do in turbochargers and emission solutions, and we will. We look forward to 2008, and we believe will see more record growth. In fact, we are confident, given normal economic conditions, that 2008 will be better than 2007.

Uncertainty in the U.S. economy related to housing appears daily in the headlines. However, Cummins remains much less affected by U.S. residential construction as a result of our diversified revenue base. Many of our markets outside of the U.S. remain healthy and are projected to grow faster than U.S. next year. Our order boards for high horsepower engines and Power Generation markets within the U.S. stretch well into next year, in fact, a year out. We also expect 2008 American truck market to recover from its post-emission lows as Dean said, 25%. My optimism about our growth prospects for 2008 extends beyond the U.S. economic outlook.

Those of you attended our investor conference last month in Jamestown, New York, will recall that profitable growth was the focus of the senior management presentations. The new growth targets we announced for each business should result in Cummins generating at least $20 billion in revenue by 2011 and a 10% EBIT margin. These targets are very achievable for the reasons that we've been telling you for some time. Cummins is well positioned to take advantage of the long-term growth trends. We are focused on disciplined investment and profitable growth, and our technology leadership creates a sustainable competitive advantage.

There are three long-term growth trends contributing to an anticipated 12% growth rate over the next five years. The first is market demand for energy and fuel efficiency. The second is the global adoption of tougher emission standards, and the third is the economic growth in several emerging markets. All of these trends play to the strengths of Cummins and will fuel our growth. Let me give you just a few examples. In the areas of energy consumption and fuel efficiency, consumers are demanding faster and more powerful computers, phones and electrical appliances. This technology trend, both here and in emerging markets, is increasing consumer's dependence on electric power. This demand is also creating higher incentives to invest in stand-by applications and sophisticated protection systems. In addition, overloaded transmission lines and the lack of suitable investments in recent years in the electric grid have created concerns about its reliability. That concern has generated increased interest in investment in distributed generation.

The South American energy crisis this winter provides a good example of this opportunity for Cummins. While steady economic growth has increased energy demand in South America, governments there have failed to invest enough in natural gas exploration and new power plants to keep pace with demand. As a result our Power Generation business has experienced growing demand in Argentina, Chile and Brazil. Our power generation markets in Latin America are up nearly 80% this quarter and 37% year-to-date. In the trend associated with tougher emission standards, we have seen growth in our businesses in China, Australia and Mexico. Each of these countries is adopting tougher emissions standards next year, and these changes are fueling growth in their truck markets.

In China, for example, truck markets have experienced nearly 30% growth this year. The market there is focused on cost control, technology and product innovation which will benefit the longer term development of the Chinese truck industry and plays to Cummins' strengths. As a result, our sales volume through the Dongfeng Cummins and Shangchy Cummins joint ventures have grown faster than the market at nearly 55% this year. The truck markets in Mexico and us a have also experienced growth this year, as I said, ahead of the emissions standard change. Our shipments to Mexico and us a this year have increased 15 and 79% respectively. Everyone is familiar with the brick countries and our historic presence in these emerging markets overshadowed by China and India. The commonwealth of independent states' economy is expected to grow between 6 and 7% during the next five years. Our revenue in Russia has grown 46% this year. We reached an important milestone this year in the development of our joint venture with [Kamas].

Together with our partner, we invested $20 million to build a manufacturing capability that will support our continued expansion in the CIS market. As we examine the trend of growth in emerging markets, Cummins is gaining a foothold in the next generation of growth areas. For example, last month we announced plans to develop a new joint venture relationship with Vinamotor to produce on-highway diesel engines in Vietnam. As you may be aware, Vietnam was identified as Goldman Sachs as one of the next 11 economies with promising investment out looks and future growth. This opportunity will broaden our existing presence in other high-growth countries on this list, such as Mexico, Korea, Nigeria and Turkey.

Even as Cummins is taking advantage of the long-term growth trends I just discussed, we are approaching these investments in capacity in new products with discipline. Over the next five years, our consolidated entities will spend $2.5 billion in capital expenditures. Together with our partners, we will spend another $1 billion in capital expenditures in our joint ventures. That's $3.5 billion on building capacity and new products that will meet the demands in the future emission requirements around the world. That's three to four times what we've been spending over the last few years. A significant portion of the capital spending within the joint ventures, nearly $440 million, will be in China.

Our joint ventures with Dongfeng and Shangchy Truck represent $120 million for new assembly capacity for the ISM and mid-range engines and the new 13-liter heavy-duty engine platform for the Chinese truck market. During the quarter, we received approval from both the national development and reform commission and the ministry of commerce to begin our joint venture with Foton. As previously announced, this joint venture will spend over $260 million to begin production of two new engine platforms for the light commercial market in 2009. Other noteworthy joint venture investments include our previously announced engine capacity expansion at Tata Cummins and Komatsu Cummins and Cummins Kamaz as well as the fuel system capacity expansion at Cummins Scania. We have discussed our ability to take advantage of the new growth trends with disciplined investment approach.

Our third path to profitable growth is our technology leadership, which creates a long-term competitive advantage for Cummins. This technology leadership became more evident with the recent announcement that our 2010 heavy-duty engines will not require the use of Knox after-treatment systems. We have chosen the right technology for 2010 to meet our customer's varying needs for mid-range and heavy-duty engines and, as a result, will be providing them with a competitive advantage in their markets. Heavy-duty truck customers demand reliability, operating efficiency and low cost of ownership. Our incylinder approach which relies on the innovative XPI fuel system and the Next Generation EGR offers customers lower operating cost without the use of a Knox catalyst. Fuel economy for the newest heavy-duty engine is expected to be comparable to that of 2007 engines. At the same time, it will provide our customers with performance and power comparable to today's products.

Response to our 2010 product announcement has been very positive. Chris Brady, President of Commercial Motorcycle Consulting, was quoted that if Cummins can meet 2010 EPA emissions standards using improved 2007 technologies, then they have a competitive advantage in the marketplace. Steve Sturgis, Executive Director of Heavy-Duty Trucking, reports in the October issue that Cummins likely will endure itself to fleet owners reluctant to put the additional SER tank, dosing pump, and catalytic chamber on the trucks post-2010.

Let me close my comments today by once again expressing our excitement about Cummins' new targets and our confidence that we can meet, and in some cases, beat these goals. By 2011, we will be a $20 billion company earning 10% profit before interest and tax. We will invest at least $3.5 billion in the next 5 years for capacity expansion and new product introduction to meet the trends I've talked about earlier. At the same time, we will have enough cash to create more shareholder value through increased dividends and share repurchases. We believe 2007 to be a record year for Cummins, but the future will be even better. We'll now take your questions.

(OPERATORS INSTRUCTIONS) And your first question will come from the line of Andrew Casey of Wachovia Capital Markets. Please proceed.

Good morning, everybody.

Good morning, Andy.

A few questions; the first two on the quarter. The warranty accrual increase, the 3.4% of sales in Q3 versus something over 2 in Q2, should we expect a 3.4 level to continue, and can you review why that occurred again, the sequential increase?

It should go back to 3, 3.0 is what you should plan for the year, and, one, we have new engines out with less experience, so we automatically have a higher accrual level; and, two, the mix is that in this quarter we had more '07 engines going out than we did in the first half, and then there was a $14 million adjustment with our accruals for a special occasion or special incident.

So 14 kind of non-recurring, Tim?

Yes.

Was there any offset in gain against that?

No.

Okay. Now, on the quarter itself, if I reconcile very strong free cash flow versus net income, the cash flow appeared to be about double net income, and if I of combine that with both your comment on strong working capital performance and then look at the engine's lower incremental performance year-over-year, did you sequentially underproduce the sequential demand variations in engines?

I'm not sure I follow your question. Sorry.

The incremental year-over-year engine margin declined sequentially in Q3 versus Q2. In Q3, it was a negative 9%. In Q2, it was negative 2. And then, if I look at your cash flow statement, it implies a pretty big Q3 free cash flow performance. So I'm trying to reconcile why the incremental went down and the cash flow went up.

I don't think we underproduced on engines, Andy. If you look at in our press release in terms of the number of unit produced, we are maybe down just below 2000 units versus Q2. It's kind of a mix between whether it's mid-range, heavy-duty or high horsepower engines.

Okay. I'll run through that with you off line, Dean.

Yes. But one contributing factor -- I'm not sure it's -- I don't know what the arithmetic is, Andy, but our heavy-duty North American engine shipments were up a little and, particularly 2 -- quarter two and quarter three, and our accrual rates associated with those would also be up, and since those are accrual rates and not costs, from a cash point of view in effect, we have a little bit of a plus as we work our way through the year -- worked our way through the year so far.

Okay. I get it.

I don't think that will answer the whole question, but it's clearly a contributing factor, in terms of North American heavy-duty shipments from Q1 to Q2 and Q2 to Q3.

Okay. So, just basically to clarify, if I add the 14 million one-time item back, you're looking at bottom-line performance probably somewhere 195 or slightly above on a per-share basis, and then the 14 million also impacted the engine's incremental performance? Is that what you're saying, Joe?

Yes.

Okay. Now, the last one -- and if you commented on this I apologize, but it's kind of a recurring question. The component margins, are you still targeting ing 7% in the fourth quarter? Yes. That's the simple answer.

I think -- Let me just make a couple of comments about that sort of from my perspective. Obviously, as you sort of already heard in the remarks, Q3 '07 was much better than Q3 '06. On the other hand, while we said -- I don't know whether it was your question the last time, Andy, or not. In the teleconference, we clearly said we did not expect EBIT as a percent of sales in Q3 to be as strong as Q2. We still expected to hit our 7% number in Q4. I think, if you look at how things turned out versus what we expected, basically we expected that we would lose about 1 point on EBIT in Q3 versus Q4 -- versus Q2. All right. The rest of it was unexpected.

The part we expected were seasonal reduction in volume, mostly Europe-related. A lot of shut-downs related in Europe. All right. So, we expected we were going to lose sales and EBIT based on that. We also, in Q2, had a higher -- we had a high engineering expense recovery from our customers that took place in Q2 that was not going to repeat itself in Q3. And so those two things, for the most part, in terms of what happened the seasonally adjusted volumes particularly as it relates to Europe and the engineering recovery, were what we expected and roughly equal to the 1 point on EBIT. Our inefficiencies were higher than expected, particularly in the early part of the quarter.

As we came through from July through to September, we improved significantly on the efficiency score, and if you kind of look at where we are now as we came out of the quarter, our palmetto plant in Charleston, that's been a really -- turbochargers, yes, been a really good ramp-up and so we feel good about where that is right now. Our -- while not true totally in July as we worked our way through the quarter, air freight costs coming out of South Africa have reduced significantly, and the Jamestown ramp-up, which we just began producing off of on for -- for diesel particulate filters to add to our capability at Mineral Point started late in the quarter. It's gone well. And the collaboration between Mineral Point and Jamestown right now is very good. So we ended the quarter a lot better than we started the quarter. So, if you kind of look, I think to -- so those -- the inefficiencies are what contributed beyond the point that we expected, in terms of the introductions, and those were almost all loaded in the first half of the quarter. Q4, we expect volume to be up a little.

We expect we're going to have the best quarter we've had all year from a plan efficiency, from an air freight -- premium air freight cost, continue to see improvements, particularly in the plants that I already mentioned. I think the things we're going to have to watch most carefully is, within the components group, we're doing a lot of plant rearrangements and realignments, and we're making some shifts there the UK. We're -- we've gotten out of some products like our so-called serve products. We've -- and we continue to look at products we're making in components that either are not competitive or not strategic. And we're in a variety of conversations sort of internally working our way through each of those. So there could be maybe some small surprises in and around that, depending upon how the quarter plays out. But, right now, our expectation is we're still going to - we're still going to come in at the low end of the range from a profit-target point of view. And then in Q3, what you can assume from everything I just said, is that we're about a half a point EBIT lower than we expected to be.

Okay. Thank you for the color.

Your next question comes from the line of Jamie Cook of Credit Suisse. Please proceed.

Good morning, guys.

Good morning, Jamie.

Just my first question. I appreciate the color on the components margins because that's been an area that's been a little, I guess, below expectations but I guess, Tim, if you look at you end the year at sort of a 7% margin, what in most of the inefficiencies you think are behind you, without giving guidance for 2008, is Q4 sort of the run rate we should look at for the next 12 months, or what are some of the things that could impact 2008 as well that we need to be aware of?

This is Joe. We would expect that the year as a whole will be better than the low end of our target in '08 versus just the fourth quarter being at the low end of our target in '07. Okay. We would not necessarily expect that every single quarter will be above the 7%. I think the big question mark, as we go through the year, will remain what I of ended my last set of remarks before, is the rate and pace at which we discontinue products that aren't profitable and we realign plants to get oriented toward improving profitability as well as capability to deliver. Those things will have some influence as we go through the course of the year because we won't be completely done at the end of this year. We'll have influence as we go through the course of next year in terms of how each quarter will turn out. But we expect that we'll be within our range, in profit range, for the whole year next year as opposed to just the fourth quarter this year.

But it's fair to say Q4 and beyond, that the noise that we're seeing should continue to diminish at an increasing rate?

Yes.

Yes. We'll still have some.

Okay. And then I just -- just back to Andy's question on the engine side. You talked about, I think, your warranty accrual about 3% for the year. Is that where you guys had originally thought -- I mean, was that where you guys originally thought when you gave your forecast given the new engines, or is that above where we thought it would be for the year?

I think I -- I think we're on track with our warranty accruals on the new products. The product is performing very well in the marketplace, particularly against our competition. We've gone up in market share, as you well know, and it's just -- it's been our policy for as long as I can remember is that we reserve conservatively when we bring out new products until we get enough experience, and then we make whatever adjustments we need to do. So, I think you should view it as that we're right on track with our 2007 products. That's not just heavy-duty, it's across the board, all of our 2007 products.

And then last -- if you guys -- and I'm sorry because I was running back from the Navistar analyst meeting, but I thought you said for '08 for heavy-duty truck, you thought we would be up for 25% versus 2007. Can you just give a little more color and at what point do we need to see the pickup in 2008 for you to get comfortable with that?

Well, we're now going into the area of speculation. We're -- let me just say that we're a little more optimistic about the truck market -- heavy-duty truck market in North America than some of the other conference calls that have been going on. Clearly, we think the back end of next year will be stronger than the front end. Both Joe and I have spent, you know, a lot of time with fleets this week in talking to people, and I think we would say the earliest would be the buying coming back in the second quarter of next year. So it's going to be soft in the fourth quarter. It'll probably soft in the first quarter, and then we think we'll get a recovery.

But are you more optimistic because of market share or because of what you're hearing -- is it market share or industry related? Because I'm not hearing anyone in the industry that's optimistic. Market share might be one thing, but --

No. I understand what you're hearing; but if you go out and talk individually to the truck fleets and what their buying patterns are, they're going to be buying next year, and I think the market is much lower this year -- not much lower, but somewhat lower than what we anticipated. So you're get kind some kind of a rebound there. And what we are assuming is that we'll maintain our 35 or 36% market share for next year. There may be some upside on that, but that wouldn't be included in the 25% target that we're talking about.

All right. Thank you. I'll get back in queue.

Your next question comes from the line of Joel (inaudible) from Lehman. Please proceed.

Good morning. How's it going?

Good.

I have a little bit of the opposite question of Andy. I calculated your free cash flow dropped 136 million the year-to-date from 414 million down to 278, and I wondered, gluing two questions together, why inventories are up 27% and the free cash flow is down, and more wondering also, is that just sort of seasonal? Can you make up for that in the fourth quarter?

Well, just generally, on the inventories is that if you look at our capacity right now, we're at capacity in a lot of the markets that we're in right now, and we've really stretched our supply base, so in some of the businesses we have given relief on inventories and said let's have the parts there so we can go ahead and build product and ship it. So, there's some anticipation of having a really tight supply base. There are other businesses that need to work on their inventories. We've also expanded in our distribution business and international markets so you've got more parts on the water and longer logistics there, and that's part of the issue that's going on here. I think we've made some progress or we're in the process of making some progress on inventories, but we still have some opportunities there.

And when Tim was talking about increased inventory in some of our businesses, where you can really see that is in some of the components businesses as they ramp things up, their inventory has gone up fairly, fairly dramatically.

Okay. And maybe -- not trying to get you to speculate, but maybe you can just nod or whatever as I speculate. Can you talk a little bit or help us understand -- we get the strong feeling that the technology is in place for 2009 and that ought to logically lead to less of a pre-buy. Can you just talk about what you're hearing from your customers about where their fleets are and if you still think that there will be a big surge in 2009? Thank you.

The Frank answer is on one end it's really too early to tell. On the other hand, response to our announcement on what it is we're doing relative to 2010 has been extremely positive. So -- and for a number of fleets, unexpected. So, a lot of them are now kind of relooking at what it is their buying plans -- how their buying plans over the next several years might be affected.

I'd like the add, though, that it's -- one of the things that's clear to me from a number of the conversations that I've had with end users, that an increasing number of end users are beginning to decide that they should haven't such big swings in buys driven by emissions changes and, in fact, the people who have kind of continued to buy despite the change, almost to an end user, are very comfortable with their decision to do that and plan to continue. Some did it in '02, an increasing number do it in '07, and I think what we can expect to see is an increasing number that will do it in 2010 who will be -- and I think our announcement about what we're going to do product-wise in 2010 will even encourage more movement in that direction. However, bottom line, it's still a little too early to tell what really to expect, then.

I think the piece of data that's missing still is what the OEM's choose to announce, in terms of their pricing or 2010 product relative to the 2009 product. I think, Joel, as that information starts to be announced by our customers, there will be better indications on which way the demand will move between those two years.

But clearly, by not having Knox after treatment and building on our 2000 technology gives us a better chance, I think, than we've ever had before of mitigating the swing on a pre-buy. So, we're in a good position in that sense.

Okay. Thank you very much. Very helpful.

Your next question comes from the line of Peter Nesvold of Bear Stearns. Please proceed.

Good morning, guys.

Morning, Peter.

I have three questions. Forgive me if the first one doesn't sound like a fair question, but I remember at the analyst day, very specifically Rick Mills said that in fourth quarter, the components margins would come in below the targeted range, and we talked about some of the reasons why that is, and it sounds like the margin is going up, but maybe not to the trajectory that I expected. We didn't hear any of those comments about the engine business, and warranties would seem to be something that you have pretty good visibility into, so I guess I'm surprised and just more perspective, why take up the targets in the second week of September when the quarter is almost complete, provided that you actually had visibility without giving people a heads-up that this is the dynamic that we should expect?

Well, first of all, Rick Mills at the conference said that we would be at the 7% level. We explicitly did that. So I think you heard him wrong or you're misinformed.

Well, I think you may have stated it wrong. You said Rick Mills commented on Q4 being below the targeted levels. Rick commented on Q3.

Okay.

Being below the targeted levels. However, the expectation that in Q4 we would be at least at the bottom end of our target range. That's just to kind of square that away. That's what Rick said, Q3 versus Q4.

Okay. Taking that at that face value still why not a similar heads-up on the engine side?

Well we do the warranty calculation in the second month of the quarter, and so that would have been after the September thing, and our mix had changed. We had more '07 projects, and if you look at it, we're -- we're not concerned about it our warranty accruals. Okay. I can just say that as I said before, we're right on track with our products, and we made those warranty adjustments and in the grand scheme of things, they're not material.

And I think if you think about the targets we gave, those were long-term targets that we put out there, but as you may remember, we reaffirmed our guidance then. We didn't change our guidance. So those were intended more as we look out over the next several years, not changing any prospective on how we saw 2007.

Sure. And I respect that, because, I mean, you're still tracking, it looks like, in line with your guidance from earlier in the year. It's just the old saying "the only thing the market hates more than a miss is something that's unexpected" or to that event. Let me, and another, I guess, element on this. One reason I why I like this story a lot, and I still like it, is the strong cadence of product introductions over the next several years as a result of these conditions and regulations and you're built up out of capacity. So as you're introducing new products in new geographic regions, why won't the warranty reserve be sort of a recurring/non-recurring item?

Well, it depends on what the volume is, what the products are and that type of thing. But, I think that the 3% of sales at least in the next year or so is a good number, at least to build in your models. I think we ought to step back here for a minute and say, "You know, Cummins is going to have the best year in its history in 2007 with a down market in North American heavy-duty and emissions change," and we should not lose sight of that, and what we're talking about in the future is even better results. And while, yes, there may be an issue with one or two of the components plants, there may be a quarter where we increase the warranty accruals and that type of thing. Overall, Cummins is performing extremely well this year.

Peter, I think maybe just to add that you're going to have sort so if a dual effect to your point. On one hand, we're going to be continuing to introduce new products, but in a variety of markets over time. Those things, based on the way we do what we do, we will assign a higher warranty accrual to those new products than their predecessors. All right? And on the other hand, those accruals, as anticipated as the product moves along, will come down. And the question is is will they come down faster or slower than what we anticipate? And they will come down, though, and so we're going to see a positive effect on engines introduced the previous two years and a negative effect on warranty on new engines we may be introducing during the current year and at least as we look at it the next several years, it comes out in the wash pretty well. Now, what we're hoping for is that our products do so well that, in fact, warranty rates overall costs actually come down. And it's the costs of the current engines that helps us understand what we should accrue for new engines, and as current engines get better, then potentially the increase in accrual rates may even go down if we're able to achieve that as we look to the future.

And the other thing, just to sort of keep in mind, many of the new products that we're talking about, to meet emissions changes in other parts of the world, we will be taking our learning from the new products that we've introduced this year so that perhaps the accrual may not need to be as high as we bring out those products. So, to Joe's point, it's sort of an involving, some things up, some things down, but I think to Tim's point, 3 percent range is what you ought to be anticipating over the course of the next several years.

Okay. Then last quick one if I may. Tim or Joe, I've gotten this question many times from people. On the 2010 engine, is the 2010 engine no additional after treatment, is that going to be certified and compliant without the use of emissions credits beyond let's say a brief transition period?

It will be certified and compliant, period, for the whole period. So I don't know exactly what you may be trying to get at that, but we're going to be using, as we said, the full flexibility allowed under the law. The approach we're taking has been fully reviewed with EPA and CARB, and all of our engines, every single one of them are going to be certified and compliant.

But if I'm reading between the lines here, within the boundaries afforded by the law, which would mean potentially using emissions credits --

Peter, we've been using emissions credits for this whole decade. I mean, emissions credits is not new for us.

Well, let me put it a different way. The speculation I hear from some of my industry contacts is that Cummins will have to capitulate in 2012 after the emissions credits run out and start using SDR like everything else. So that may be perhaps a more direct way of asking the question.

Okay. That's not what we're saying. What we're saying is we will have a product that is certified and compliant through the period, and that as we look at the next set of introductions until we will be on the heavy-duty side using product that does not use Knox after treatment.

Terrific. Okay. Thank you.

Your next question comes from the line of Jonathan [Stinmetz] of Morgan Stanley. Please proceed.

Thanks. Good morning. Good morning, Jonathan. A couple others here on the warranty. Not to sort of beat a dead horse, but just to get some clarity. The 14 million that you talked about which sounded like a reversal from a prior accrual, what exactly was the underlying experience that caused that to happen?

Underlying experience? Could you be a little more specific?

Yes. You took -- I understand accruing more, in terms of the '07 engines, but it sounds like you had to make a reversal to a prior accrual or increase from a prior period estimate. So what was it that you saw that sort of caused you to do that?

Let me back up a little bit. Tim sort of already alluded to this. Every single quarter we sit down and look at all of the real live experience we have had, and we make decisions about any adjustments that may be related to our total accrual pot that are appropriate to make in that quarter. If you go back to the first quarter, we had some positive adjustments that influenced where we were on our experience. If you look at this quarter, we had some negative. You should not assume, however, that they're all '07 related. In other words -- or on-highway related. Okay. You seem to be thinking that's tissue here. The special adjustments we did this quarter are not all on-highway related and not all '07 product related.

And they're not tied to one engine, and they're not -- I mean, it's not one event or anything like that. It's just a broad adjustment to the overall warranty accrual.

Okay. And it looks like, I guess, the expense is about 114 million, I think, if I'm doing the math right. What was the cash out the door in the quarter related to warranty?

We're scrambling here.

Yes. We'll have to look here. Sorry.

Okay. I'll jump back in the queue, and let you guys dig up the number. Thank you.

Your next question comes from the line of David [Bluestein] of UBS. Please proceed.

Terrific. The question that somebody asked earlier about the credits -- let me just rephrase that. Do you think the production of smaller engines in your product line compared to some of your -- compared to somebody like Caterpillar, provides you with a long-term sustainable advantage?

Well, I mean, we've always felt that having a broader product line to offer to a wide range of markets is a plus for us in a whole lot of ways. And I don't think -- we don't feel any different about that now. In fact, we continue to try to broaden our product line so we can participate more aggressively in a number of in-use markets, and that will continue.

Okay. What I was driving at -- maybe you just don't want too to ask, which I understand, but does your production of a high volume smaller engines provide credits that aid in meeting the emissions regulations on some of the big board product line?

The literal answer to your question is no. You're talking credits.

Okay. What am I missing?

I'm just saying, what we're trying to do and have been doing is to understand fully what's allowed under the 2007, 2010 REGS and take full advantage of all the flexibility that REGS offer and in part of our line we're already at 2010 and in part of our line we're working to 2010. The REGS offer some advantages and we're taking full advantage of those across our product line. Having a broad range, yes, that and a variety of ways helps us versus the other guys. But some of the other guys have a pretty broad range, too.

And use the credits as well.

Yes. Use of credits is not a new thing. And we've been using them for a long time both on-highway and off-highway, as have our competitors.

Terrific. Thank you.

Back to Jonathan's question about the warranty accrual, this is Dean Cantrell, the payments for a 9-month period are 229 million out flow. That compares to the prior nine months of 2006 at 215 million out flow. So you can see it's not a significant increase given the volume that we've seen in our numbers. He has the cash, I believe.

Yes.

And there are no further questions at this time. I'd like to turn the call back over to Mr. Solso for closing remarks.

I think that's all that we have for today. If you have any additional questions, I will be in my office today. Feel free to give me a call and thank you for participating in our third quarter call.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.