康明斯 (CMI) 2007 Q4 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the fourth quarter 2007 Cummins Inc. earnings conference call. My name is Tewanda, and I will be your operator today. At this time all participants are in a listen-only mode. We will facilitate a Question and Answer Session towards the end of this conference. (OPERATOR INSTRUCTIONS)

I would now like to turn the presentation over to your host for today's call, Mr. Dean Cantrell, Director of Investor Relations. Please proceed, sir.

Thank you, Tewanda. Welcome, everyone, to our teleconference today to discuss Cummins' results for the fourth quarter of 2007. Participating with me today are Chairman, Tim Solso; our Chief Financial Officer, Jean Blackwell; and our President and Chief Operating Officer, Joe Loughrey. We will all be available for your questions at the end of the teleconference. This teleconference will include certain forward-looking information. Any forward-looking statements involve risks 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 statements. 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. Before we review our fourth quarter performance, Tim will summarize our accomplishments of 2007 and provide his outlook for 2008.

Good morning. This time last year, we predicted that our 2007 results would be strong but would not match Cummins' record-setting pace of 2006, primarily because of the projected 50% decline in the North American heavy duty truck market as a result of emission regulations changing January 1, 2007. Today I am pleased to report that instead of being just another good year, 2007 was a record setter and an outstanding year in many respects. Sales exceeded $13 billion, a 15% increase over 2006. Net earnings were $739 million compared to $715 million for the previous year. Earnings before interest and taxes were $1.2 billion or 9.4% of sales. This time last year, we had confidence in our technology and product performance, but knew the North American heavy duty truck market would be softer in an emissions change year. As a result, we did not forecast this level of overall company performance for 2007. However, as the year unfolded, both the strength of Power Generation market and our North American heavy duty engine share were better than anticipated. As a result, we increased our guidance and ended up at $3.70 per share which is approximately 45% higher than was expected at the beginning of the year. This fourth straight year of record sales and profits reinforces our value commitment to Cummins shareholders. As of the end of 2007 our investors enjoyed a five-year average annual total return of 58%. Other actions that reflect our commitment to growing shareholder value include a 67% increase in our dividend in the last eighteen months and ongoing stock repurchase plans. Over the last 25 months we have purchased almost $500 million in stock and in December we announced plans to buy back another $500 million. Our success in 2007 was driven by increased sales in all of our segments.

The Power Generation, Distribution, and Engine Business Segments once again delivered excellent results. They had record revenues, increased share in many of their markets, and offered innovative products and services that delighted Cummins customers around the world. The components segment also experienced a growing demand for its products which provide significant value to both Cummins and our customers. These critical technologies performed well, and the segment hit its revenue goals. These are the technologies that allowed us to produce a 2010 certified heavy duty pickup truck engine for Chrysler three years in advance as well as the non-SCR solution for heavy duty engines in 2010. Components' 2007 financial performance was better than in 2006, which shows progress. However, because of operational issues in two its four businesses, Components failed to hit profit targets this year. Otherwise, Cummins' performance would have been even better. To ensure this group's success in the future, we recently moved three of our best operations people into key roles in this segment. Their focus is on fixing operational issues and turning sales growth into increased profits, particularly in the emissions solutions and turbo technology businesses. We have a proven track record of dealing with operational challenges as illustrated by the turnarounds in heavy duty engine and Power Generation businesses in the 2002 and 2004 timeframes, so we remain very optimistic about our Components ability to achieve significant sales and profit gains.

Along with our financial success during 2007, we're proud of several major business and product accomplishments. We announced a large number of exciting new products that were launched or will be introduced during the next several years, including engines that meet U.S. 2010, Euro 4, Tier 4 and Tier 2 high horsepower emissions standards. We also started production of the new world class XPI Common Rail Fuel System and ClosEd Crankcase Ventilation System from our filtration division. As a result of our outstanding technology, Cummins heavy-duty monthly market share averaged above 40% for the last two-thirds of the year. In my 36 years at Cummins, I cannot remember this large a market share shift. We also enjoyed growing marketing leadership around the world including transit bus, Power Generation, marine, medium duty trucks, recreational vehicles, and other markets. Power Generation continued its trend of great results going from an EBIT loss of $19 million in 2003 to $334 million in EBIT in 2007. Distribution sales more than doubled in four years growing to $1.5 billion in 2007. Cummins earned a prestigious award for customer satisfaction from J.D. Power & Associates for heavy-duty engine performance, cost of ownership, and warranty. And finally for the second time in five years. Cummins received recognition as Diesel Progress Magazine's Newsmaker of the Year. We were recognized for the early launch of the 2010 ready Dodge Ram and its innovative NOx absorber, the announcement of the non-SCR solution for 2010 heavy-duty trucks and the unveiling of our Tier 4 off-highway strategy.

It's difficult to discuss Cummins' prospects for 2008 without acknowledging the prospect of a U.S. recession. I don't pretend to be an economist, but I do know our business. I have talked to our customers, our partners, and our people, and I am confident that despite the potential for economic road bumps in the near future, Cummins will do well in 2008 and beyond. In fact, I am predicting that 2008 will be our fifth straight year of record performance. The reasons are simple. First, Cummins is more diversified and better able to handle the cyclical nature of our businesses than at any time in our history. Even as some markets have softened, new ones have emerged such as oil and gas and light construction. Secondly, Cummins' advanced technology has opened new doors for our products and will drive our longer term growth. In particular, our technology will play an important role in markets related to more stringent emissions standards, better fuel economy, generating electricity, and the needs of developing countries such as China, India, Brazil, Russia, Vietnam, and Nigeria.

Third, we have already increased our capital investment in many parts of the world in anticipation of these growing markets. We consider new plants and facilities, particularly in China and India, as a primary requisite for being a significant participant in these markets. Along with the manufacturing and technical centers we built in recent years, we are planning 19 new plants and 42 capacity expansion plants or projects, many of which are under way. These include fuel system plants in Sweden and China, our light duty project with Foton in Beijing, and major expansions in India for both medium and high horsepower engines, power generation and turbochargers. 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. Most of these investments will drive profitable growth in the future as new engine platforms begin production in 2009 and 2010. Investments such as those in high horsepower engine capacity, fuel systems, turbochargers, and after treatment will pay more immediate returns.

In early January, I traveled throughout India and China to see our newest facilities and talk about our growing presence in those countries with Cummins employees, partners and OEM customers. In India, I visited new plants for our power generation, generator technologies, high horsepower and filtration businesses, all of which are experiencing solid growth in that region. In China, I met with our joint venture partners including Dongfeng, Shaanxi, and Foton, all of which will play a major role in our joint venture growth. I also visited plant expansions for turbo technologies and generator technologies along with two new filtration plants and our light duty diesel plant which is under construction. This trip reinforced my belief that we are well prepared to take advantage of the significant growth occurring in this part of the world. Our total capital investment for these two countries through 2009 including the investment from our joint venture partners is close to $600 million. Along with our willingness to invest capital in our quest for profitable growth, we are talking with potential new partners such as Vinamotors in Vietnam. The reason for the strategy is fairly obvious. Our access to these markets is made easier by our joint venture relationships which allow to us partner with established global companies such as Dongfeng in China, Tata in India and KAMAZ in Russia, with limited investment and volume commitments providing good returns.

The fourth reason for my optimism is the improvement in our ability to deliver bottom line performance. We have focused on margins and controlling costs, and as a result over the past seven years we have grown EBIT at four times the rate of sales.

Finally, our balance sheet is in good shape with less debt, good cash flow, and fully qualified pensions. This financial health gives us the flexibility to invest in people, products, facilities, and technologies. We need to capture profitable growth opportunities when they arise. These are exciting times for Cummins. We have outstanding products in technology, leadership, expanding markets, and growing share, a disciplined approach to investments and a strong balance sheet. Our people are extremely well prepared to take advantage of the profitable growth opportunities before us, and they will. Now I will turn the teleconference over to Jean, who will provide more details on 2007 and give our guidance and promising outlook for 2008.

Thank you, Tim. Let me start by giving you my perspective on our results. We delivered the year at $3.70 per share, another record year for net earnings. I am very proud we achieved what we said we would. Even with a significant downturn in the North American heavy-duty truck market in 2007 due to the emissions change, our net earnings as a percent of sales exceeded our performance in 2005, the last year before the prebuy. As a result, we surpassed our targeted return on equity and return on average net asset metrics for the fourth consecutive year. We reported record quarterly and annual sales in all of our segments. We saw year-over-year growth in nearly every end market and stronger international sales for the fourth time in the last five years. More importantly, three of our operating segments demonstrated year-over-year improvement in both quarterly and annual EBIT margins. Profitable growth. That's what's important. We expect earnings growth to accelerate again in 2008, faster than the top line as every segment improves operating performance. As Tim said, we are anticipating another record year in 2008. We are predicting strong sales growth and nearly 20% EBIT growth.

Before we discuss our 2008 outlook in greater detail, let me highlight our Q4 results for each segment. Power Generation and Distribution had a spectacular fourth quarter. Global Power Generation sales increased 28% with double-digit growth seen in every geographic region. Segment earnings rose 39% as significant price realization offset higher material costs. The distribution segment sales grew 21% versus the same quarter last year. Sales of engines and Power Generation products were sharply higher, especially in Europe, the Middle East, and Africa. Segment earnings improved 44%, benefiting from this broad market growth as well as record earnings from its joint ventures. We have said all along that the engine business would have lower margins year-over-year due to costs associated with the release of new products in North America to meet the 2007 EPA emissions regulations.

Compared to the third quarter, the segment EBIT dipped to 5.6% of sales for three reasons. First, higher costs to get facilities ready for future new products, some of which will continue into 2008. Second, lower overhead recovery from significantly lower heavy duty and pickup volumes and, third, higher research and development expense for future emission regulations and new products. However, I feel really good about the potential for margin improvement in the engine business this year. We are seeing positive incremental margins from the new '07 products and expect further improvement as volumes pick up. Our EPA '07 products continue to perform well in the market, so we should also begin to see warranty accrual rates trend downward later in the year. The components segment posted a 6% EBIT margin in the fourth quarter, better than last year and last quarter, though less than the margins we had targeted. Clearly we're not satisfied with these results. Let me remind you that our segment EBIT target is 7% moving to 9% longer term.

Let me walk you through each of the four businesses in the components segment. During the second half of 2007, filtration demonstrated operating margins above the long-term 9% segment target. Start up costs on the XPI joint venture lowered the margins in the fuel systems business somewhat in Q4, but overall for the year they are on track with our expectations. On the whole, both are performing well with no surprises.

Leadership changes were made early in 2007 with the appointment of Jim Lyons to head Turbo Technologies. Jim brings a wealth of manufacturing experience to this business. As a result of his focus on delivery and improvement in manufacturing processes, this business showed improvement every quarter in 2007. Operating margins will remain below the segment target in 2008, but are expected to improve year-over-year.

As you are aware, emissions solutions did not make the progress we had hoped. This business added only $12 million incremental EBIT on a $300 million additional revenue in 2007. They have high quality products that are delighting customers and are in very high demand as evidenced by the 200% growth in sales. Our focus remains on fixing the operational issues in this business. We recently announced a new leader for this business, Srikanth Padmanabhan. He has an excellent track record driving manufacturing improvements in our generator technologies business. As we had forecasted for the fourth quarter, emissions solutions did eliminate the expedited premium air freight in its South African facility. However, the business experienced higher than expected material costs and lower overhead recovery. Emissions solutions operating margins will remain below the segment target in 2008, but we look forward to significant year-over-year improvement and its results.

Finally, we have asked Rich Freeland to head our components group. Rich has significant operations experience. He led the distribution business for the last 2.5 years and formerly led the fuel systems business and many of our manufacturing plants in the engine business. Our actions to improve operating margins and components are only part of the reason for our optimism in 2008. We see profitable growth in all of the segments. Our 2008 guidance reflects earnings growth growing faster than revenue.

Let me turn to our view of company performance in 2008. We have assumed relatively slow growth in the U.S. economy but still anticipate Cummins revenue will grow 12% in 2008. Slide 16 illustrates that more than half of the growth will come from market growth and share penetration. Let me first discuss the U.S. truck market. We expect to see double-digit growth from the supply of engines to the U.S. truck markets. We are forecasting the NAFTA Class 8 Group 2 truck build at 205,000 units, 16% higher than 2007. However, we believe our heavy-duty engine production will grow 35 to 40% as we enjoy a full year of our 2007 market share gains. We also expect our shipments to the global medium duty truck and bus markets to grow 25 to 30%. We are forecasting the markets outside of the U.S. to grow while the medium duty truck market here will remain soft. The recovery in engine volumes and Cummins' higher share in the on highway engine markets will also strengthen component segments by 20 to 25%.

The global industrial engine and power generation markets are expected to continue to grow, especially markets served by high horsepower engines where we have been adding capacity. Demand remains driven by global nonresidential construction activity and investment in the extraction and transportation of natural resources. We forecast nearly 12 to 16% growth in both the power generation segment and the industrial engine markets that serve the construction, mining and commercial marine markets. The heavy-duty pickup truck market is one of the few markets where we're seeing the impact of economic uncertainty. Although we continue to enjoy high diesel market share and have broadened our offering into chassis cab, demand for heavy duty pickup trucks are expected to soften 10 to 15% due to the U.S. economy. All of this revenue growth translates into nearly 20% growth in EBIT in 2008.

Slide 17 illustrates that while we continue to invest in profitable growth around the world, we will continue to leverage our operating expenses to increase earnings. We have also implemented some price increases in 2008 and have set aggressive cost reduction targets for Six Sigma and low cost country sourcing. We expect these initiatives in 2008 to enable us to yield 10% EBIT margin. Let me remind that you our first quarter is seasonally our lowest quarter. This year will be no different, especially with the recent heavy snowfall across China that has idled all of our Chinese facilities prior to their New Year holiday.

For a moment, let's talk about segment targets on slide 18. Power Generation will continue to operate above its target margins. Engines will improve upon 2007 even as it invests heavily in people, products, facilities and technology in 2008. The initial costs associated with distributor acquisitions and consolidations are expected to dilute the distribution EBIT margin slightly in 2008. Components will continue to improve from 5.2% in 2007 and should achieve an EBIT margin between 6 and 7% in 2008. The acceleration on our earnings and improvements in working capital management will generate strong operating cash flow to fund our growth and shareholder return initiatives. Our efforts to do a better job of controlling inventory and receivables growth should result in an improvement in working capital in 2008, getting us back within our target range of 16.5 to 17.5. Capital expenditures are expected to run $550 million to $600 million or nearly 4% of sales in 2008. We will partially offset the increased capital spending with lower pension funding since we achieved our global funding goal in 2007.

In summary, the drivers of the longer term 12% earnings growth story we outlined in September at our analyst day continue to fuel our growth. We know how to improve the operational performance and components, and we will be successful. 2008 will be another record year for earnings growth. We will now take your questions.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Mr. Peter Nesvold with Bear Stearns. Please proceed.

Hi, guys.

Good morning.

Hi.

I guess as I go through the segment guidance, Power Gen jumps out a little bit at me here. You're coming off two straight years of plus 20% type growth, so you are -- the guidance seems to discount meaningful deceleration in the growth from kind of plus 20 to 10 to 15, and the margins are slightly above 10%. You did about 11%, I believe, in '07, so there is actually margin contraction discounted into the guidance, and I guess that I would just hope to get a little more color. What's driving those two assumptions in the outlook for '08?

I think that that's our view. The 29% from last year was an exceptional year. Right now on the high horsepower, the larger generator sets, we have -- we're restricted by capacity, particularly from the high horsepower engines, but also the larger alternators. The RV business we think will be soft during the year, flat to soft, so we're just being conservative with that. Power Generation had a great year last year, and they're going to have a good year in 2008.

When I look at it, frankly it seems awfully conservative in the context of what we've seen the last couple of years. Is there anything in pricing you're seeing? Mix? Or are both of those items turning flat from what you saw in '07 or up or what?

Our pricing, again, it depends on the region and so forth, but is in the 4 to 5% range, and we're assuming that material costs will go up in the same range, so there will not be margin expansion as there has been in the last couple of years.

Okay. Okay. That's fair. Other thought, initially when I saw the outlook, a little confusing that CapEx was going up but you're seeing margin expansion. And I think you outlined it well in slide 17 with how much you're investing into the growth. Margins -- again, that's Slide 17. How quickly do you get a payback from something like that -- so if we looked out into 2010 or so, when does that start to give you a bit of a slingshot on margins?

Well, I think the expansion of our heavy-duty engine which we're increasing in the 15%, and we've increased the capacity of the high horsepower by 15%, and we'll do another 15% by the end of the year allows us to get more volume which gives us some benefits with the margins.

Peter, I was just going -- this is Joe. I was just going to say that the investments we're making in the high horsepower side of our business we should see pay off in '09. We're already seeing day-to-day increases as the numbers go up. Just given some of the jumps as we go through the second half of this year, we'll see benefit pay off beginning in more substantially in '09. And then while 2010, who knows at this point, but obviously maybe a down market given emissions changes, we are investing on the presumption in several of our markets that have -- with certain OEMs we will continue to gain share. We'll be able to pay back on that investment very quickly as we begin moving through 2010 and beyond on that side of the coin. That will also be a plus. That's not just an engine comment by the way, that's also a components comment.

One last question and I'll jump back into the queue. What's discounted into the outlook as far as joint venture income growth? I think this is the first time you haven't broken that out separately.

I think we said 5 to 10% growth in joint venture income. Part of that is this is also a heavy year for investment in some of our joint ventures, so that's the range we're seeing.

Excellent.

Peter, that's broken out on slide 15.

Okay. I missed that. Thank you. I will jump back into queue.

Your next question comes from the line of Mr. Andy Casey with Wachovia Securities. Please proceed.

Thanks. Good morning, everybody.

Good morning, Andy.

Before I do some nitpicking on the quarter and outlook, can you talk about what Q4's total year to year percentage decline in U.S. and Canadian Dodge Ram and RV, heavy-duty and medium-duty truck for the industry was in the quarter on a combined basis, and then have you ever seen that sort of decline rate in any prior quarter that you can remember?

The pickup truck business was down 13%. It was particularly down in the fourth quarter where we had some shutdown days at the CME plant where that engine is produced. We -- our volumes were somewhere around 160,000 in 2006. Last year they were 140,000, and this year we're predicting somewhere around 125,000, so that business is pretty soft. What I would add back to that is the dieselization rate of the pickup truck is over 80% where its competitors averaged somewhere between 55 and 70%, and they basically have one third of the market, so they've gained market share in the heavy-duty market maybe a third relative to their overall pickup truck share around 23%. The product is performing well. There's no issues there. It is just that with the state of the talk on recession and so forth, that market is going to be down. So this year or '07 was the first down year that I can remember other than the modeling changes that we had in the 2000 timeframe and then next year we'll be down, so we would have two consecutive down years.

I guess the spirit of the question, Tim, is a large chunk of the investor base is concerned about the North American market in the next couple quarters or so. And what I would say is in the quarter you had heavy truck on an industry basis down 51%, medium truck down 30, sounds like the heavy pickup truck was down somewhere in excess of 40%. You still posted the 9% margins and 7% earnings growth. Would Q4 be the worst year-over-year decline in those three combined markets that you've seen?

Certainly in the pickup truck business -- help me on the heavy-duty.

Andy, this is Joe. In general -- I think in general at this point in time based on the way we see '08 and each of the respective markets you've kind of asked about, the answer to your question is yes. One little detail to add, part of our issue from third quarter to fourth quarter in Chrysler is that volume was cut more than half from well over 40,000 to just slightly over 20,000 units from quarter to quarter, so that was -- that's part of your observation about the size of the drop. So the other thing to keep in mind as you're looking forward through '08 is while we'll be moving a little counter trendy, if that's a phrase that makes any sense, in particularly heavy-duty, medium duty, medium duty RV, medium duty bus, even medium duty Europe for that matter, where our share will continue to grow, regardless of what happens to the actual market size. And if you look at how we started the year and what was going on in each of those markets, and how things have played through during the course of the year, in our mature markets with lower GDPs as a percent of sales, we're actually going to see a reasonable amount of share growth that will help us offset in some cases completely and other cases close to what's actually going on in each of those respective markets.

Let me add a couple of just to your point about people are concerned about certain markets, but overall we've assumed slow growth in the U.S. and western Europe, but the emerging markets that we're in are growing anywhere from 6 to 10%. And the businesses we're in in those markets are growing faster than that because they're investing in infrastructure, roads, power generation, and so forth. So our businesses in China and India are just remarkable. I spent eighteen days this month in detailed visits in both of those countries, and I am very, very confident that with the capacity constraints we have that we're going to be able to meet our growth targets there. And also now China seeing some power shortages, and Brazil is anticipating power shortages in late '08 and 2009, so those are going to be good Power Generation markets on top of the Middle East and some of the other businesses that we have. And then also these emission regulations are starting to be implemented in different countries, and again as Joe was saying, I think that's one of the reasons we're starting to get some share gains. So, yes, not all markets are as terrific perhaps as they have been the last couple of years, but we're still anticipating the kind of growth that Jean was talking about.

Sure. Before I move onto the nitpick stuff, to further the point, the U.S. and Canadian on-highway markets, you're outside of the Dodge Ram basically projecting growth for various reasons above market, so it appears as if your North American on-highway business is kind of coming out of an '07 trough. Is that about right?

Yes, that's right, but it will be stronger in the second half than it is in the first half. Essentially we said the heavy-duty market would go up 15%, and we would go up 30%, and in the medium-duty, when you consider the international, we think the market in the U.S. will be flat to down to 5%, but our production will be up 25 to 30%.

Okay. Thanks for that. On the nitpick stuff on the quarter, the 3.4% warranty expense, we talked about that same level as a percent of sales in the third quarter, and I kind of thought that would revert to 3%. Where are we in our outlook for '08?

What I think we said in the last teleconference, Andy, this is Joe, is that we expected year to end up on average about 3%.

Okay.

So a couple of comments relative to the number is -- right now we're I guess even from the last quarter increasingly pleased about what's happening with the reliability of our product. It is still a little early days for us to confirm where we're hoping to be. But we're expecting as is our plan, as we go through the course of the year, and get more data, that reliability will continue to improve and have some positive impact on product coverage costs as a percent of sales presuming we don't get any big surprises in mix in our business given the nature of next year. So we're going to start the year pretty close to where we ended the year from the point of view of product coverage costs as a percent of sales, largely because we've locked into product coverage rates that we aren't changing at all or much until we get enough experience over several quarters to feel good about where we are. But I want to kind of emphasize here right now things are going well, and subject to any issues as we get more and more higher mileage that we haven't seen, we're expecting we'll end that by the end of the year we'll be doing -- we'll be able to talk about significant improvements and the reliability of our product and how it will be reflected in product coverage costs.

Okay. Thanks. Two quick ones and a longer term. The '07 base that you're looking at for the 205,000 '08 heavy truck forecast, what is that?

[176].

Okay. And then on the light-duty diesel engines to the heavy pickup market, have you shipped any of those in '08 so far?

The light duty diesel below 8,500 pounds?

No, heavy-duty. CMEP shipping.

Have we been shipping engines? Yes.

Okay.

Sorry. I misunderstood.

Remember, Andy, I think in their announcement back in December our customer talked about its Mexico facility being down just half the time as some of their U.S. facilities, and it is the Mexico facility that we ship to.

I appreciate it. I just wanted to confirm something. Then on the longer term, the 2010 discussion, can you talk about what customer response you've had for that so far and then I will let it off. Thanks.

Customer response in terms of our 2010 announcement?

Yes.

Terrific. Both at the OEM level, heavy and frankly medium, and as well as the end-user level, a lot of good questions, and a lot of great discussions, but for the most part just wanted to remind you -- our significant OEMs, that was not a new announcement for them because they've been working with us for some time on what the right choices were up to the announcement date. But the reaction very positive to our 2010 technology announcement.

When I have been at it with some of the -- this is Tim again -- out with the fleets and both Joe and I visited ATA at different times, and the non-SCR solution was the buzz because basically people were expected to have to use SCR and have all of the added issues around using urea and so forth. And the fact that they're not going to have extra tanks and worry about whether the infrastructure is developed is very popular, and people are excited about it, so I think the response was even better than what we anticipated.

Thank you very much.

Your next question comes from the line of Mr. Steven Volkmann with JPMorgan Securities. Please proceed.

Good morning.

Good morning, Steve.

Just a little drilldown if we could on the engine business. I guess the margin there was a little bit lower than what I was expecting, and maybe that was just me, but you talked about higher costs for new product development and higher R&D. Both of those things I guess I was a little surprised that you cited the '07 change in the release because I wouldn't expect anything for '07 to kick up in the fourth quarter. So maybe I just read that wrong. And second, it seems like those things are likely to continue going forward as we come through the next couple of years of development on the new stuff, so maybe we can just drill into that for a minute?

This is Joe. I can make a couple of comments and see if they're helpful at all. If you look at where we were at the end of '06, fourth quarter versus where we are -- we were at the end of '07, it is kind of one-way of looking at it. The prime differences that drove the margin reduction were significantly lower number of automotive units, some mix -- meaning the mix percent shifted to a higher content of lower margin engines than higher margin engines. Their product coverage costs, which we've already talked about is higher and directly related to the '07 engines. All right? And versus the '06 quarter, and we had some absorption issues at least relative to the fourth quarter of '06, particularly related to the drop in the Chrysler volume from where we were. Those were some of the contributing factors. As we look through the course of next year, through '08, a few things -- we're expecting overall volume will be a little better as we move into the first quarter of next year. We are going to get a few pricing pops, not many, but both on the parts and the engine side, but that will benefit us. And we will -- as we go through the course of the year, then, continue to make progress on cost reduction that will contribute to margin improvement through the course of the year as we kind of smooth out flows, get things working even better than they are right now with our supply base in that regard, and continue to refine and improve our process given the changes we made for '07. I think in the engine business we're expecting a relatively significant improvement in gross margin from Q4 '07 to Q1 '08, and then continuous improvement as we go through the course of the year.

And this is Jean. If part of your question is will some of the investments in growth continue, yes, that is something which is a comment as to why the engine business margins might be slightly below the targeted range, so the investments in growth will continue. But as Joe said, what the -- what will improve is both absorption and impact of some of our cost reduction activities as well as the pricing issues. So that's why we expect to see improved margins Q4 to Q1 and then beyond.

And one thing to maybe add just there in the engine business -- when we talk about investment in new products as we're working our way towards the 2010 introduction and working our way to the LDD introduction, we're spending money on new products in terms of up-fitting and getting plants ready beyond what you would see in an R&E line, all right? And we had a little extra pop relative to the rest of the year in the fourth quarter, but that spending will continue. We'll continue to do that spending as we work our way through the course of the year, but again expect margins in the engine business to continue to improve.

Essentially for long-term planning you should assume that our R&D expense will be 3% of sales. We're budging $440 million for 2008.

Great. That's very helpful. Just one quick follow-up. Lots of spending going up in various different places for investment. I am just wondering how that leaves us with respect to share repurchase going forward and where that kind of fits on your priority list?

As you know, over the last couple of years, we've repurchased about $500 million worth of stock and recently announced another $500 million. What we've said, and will continue to say, is that you should always anticipate we would at least cover compensation programs, but we will continue to be in share repurchase mode over the next few years.

By the way, we will continue share repurchases on an ongoing basis on a regular basis. We may vary the amounts, but that's the way we've done it the last two years.

But sounds like no change in philosophy there?

Correct.

Great. Thanks.

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

Good morning.

Good morning, Jamie.

I guess I was sort of shocked by the engine margins. I am sort of with Steve on that. One of the things you mentioned was higher costs related to getting facilities ready that hurt the margins in the engine business. Did you guys quantify that and if not, could you tell us how big that was in the quarter?

Relative to the fourth quarter of '06?

You said higher costs related to getting facilities ready -- that hurt your fourth quarter margins. How big was that in this fourth quarter?

Maybe in and around altogether around 70 basis points.

Okay. All righty. And then I guess just my next question, on the Components side we're sort of disappointing on the margins again. Outside of the management changes, how comfortable do you feel that we can sort of at some point get to the longer term goal I think of 79%? And how should we think about margins as we progress throughout the quarters?

Good question. I think first Jean laid out a pretty good summary in her remarks about where we are, and just as a reminder, got four businesses, one above the target range of 7 to 9, the other running just below the lower end of it, but on average the last couple of years about at the lower end of that target. And two other that is aren't doing as well, though one has had an improvement plan all year, has done better quarter to quarter, and we're very confident it is going to continue to make progress towards the 7% number. The fourth one, which is the emissions solutions business, is the one where we've had our issues where we still have had our issues through last year. On the plus side, their go to market strategy we developed many years ago has worked extremely well, and the product that was designed is also working extremely well, and we're very pleased with that side. The other side of the coin, the business grew by a factor of 3 times in terms of sales from '06 to '07. More volume came at us than we anticipated, so that was a failing on our part, and though exciting. And therefore rampup costs were more significant than we anticipated, and we didn't do as well in some of our plants as we thought -- as we wanted to do in terms of the ramp-up process. Premium freight, overtime, flow mess-ups, all kinds of issues that this didn't go well throughout the year and we were disappointed with how the year ended.

However, as Jean pointed out in her remarks, and I know Tim has said before, the problems we have in that business are ones we know how to fix. It is not a market positioning issue or go to strategy issue. It is not a design or technical issue in terms of the how well the product works versus other choices. It is operational issues in terms of getting each and every one of our plants working as well as it needs to work in order to hit our cost and profit targets. Like we did at the beginning of the year, putting a significant operations person in charge of our Turbo business and we've seen the changes through the course of the year in terms of the improvements that have been made, first on delivery and quality and now gradually on margin improvement. We've made some shifts in on the emissions solutions side of things to put someone in charge -- he has got a great track record of running a business within Cummins that's even bigger than emissions solutions with a lot of operations experience. So while we're behind where we wanted to be from a timing point of view, we have no doubt whatsoever we will get to the 7% target range, and work our way from that up towards the 9% range.

And then I guess my last question is just sort of for Tim. Tim, philosophically, a philosophical question for Tim, you mentioned -- you made a good point in your prepared comments when you said you guys originally gave guidance for '07 and came in 45% better than as we sit here today. I guess as you look at your guidance for 2008, you have companies that put out guidance, everyone always assumes they're too conservative, so the Street goes above that. How should we think about your guidance this year? Do you think you're taking -- should we still view this guidance as sort of a conservative approach or view this as this is really the best you think you can do? I am trying it get a feel for how I should look at it.

Let me put it this way. We wouldn't put it out there if we weren't confident. I think the issues quite frankly in the third quarter and this quarter is the consensus was higher than what we would have suggested, and I think there has been some issues around that. So the guidance we're trying to do is be more transparent than what we had been in the past in giving information. But you should take the guidance as what it is, that we have a confidence that it is, it should not be considered aggressive nor should it be considered conservative.

And I think just one quick point. There were some things that happened in 2007 that I am not sure anybody could have anticipated. The markets changed a lot more particularly in Power Generation than we thought, plus some of the share shift that Tim talked about, I think everyone would have thought they were nuts if we would have projected that level of share shift in 2007. So I think to Tim's point, we're trying to give you our best thinking right now, so I think it is a pretty balanced approach in terms of our guidance.

Thank you. I will get back in queue.

Your next question comes from the line of Mr. Joel Tiss with Lehman Brothers. Please proceed.

Wow, Mr. Joel Tiss. I have been upgraded. How are you doing, guys?

Good morning.

One or two bigger pictures and just like Andy, one nit picky one for Jean. Can you -- it is a little unclear to me. Are you baking in a recession in the U.S. into your estimates or are you just sort of floating around in the back of your mind and not sure which way it is going to go and you're conscious of it or whatever?

We're not baking a recession. We have certainly lowered our economic forecasts from where they were say six months ago, but I would say slow growth. We're somewhere between our assumptions are somewhere around between 1 and 2%. And it is more important in our businesses to look at the specific markets rather than the general conditions. Clearly the recession or slower economy as well as the housing market hurts the pickup truck business, but you can see what we baked in there. And again the medium-duty truck business is probably going to be down 5%, which again would reflect our view of the economies, but both our international markets and our share gain compensate for that, and overseas we're not -- we're again in the emerging markets we're anywhere from 6 to 10%. And quite frankly those markets have been going faster than that, and clearly the businesses that we're in around infrastructure are growing even faster than that. I don't view 2008 as a recessionary year, but the certain economies, the U.S. and Europe in particular will be very slow.

Okay. And just another sort of philosophical. Pat Carr tried to float the idea maybe there is not going to be a prebuy, or if there is it is going to be muted. Can you give us a couple little talking points to think about for 2009?

This is Joe. It is a good question, and it is one clearly the industry is looking hard at because once again the volume of inventoried engines so to speak going from '06 into '07 was relatively high. I think part of the reason, not just Pat Carr but others are looking hard at this question is in part related to the announcement we made about our product -- is that where will we be from a reliability and a fuel economy point of view given in particular no SCR, and what does that say about end-user willingness to buy in 2010 versus building banks, so to speak, or buying more trucks in 2009. I frankly don't think anyone really knows the answer to the question, but the differences -- the things that will be evaluated is at least from a Cummins engine point of view two really good introductions over the last couple of changes from a reliability and a fuel economy point of view, and giving the market a sense that they don't have to expect huge change in 2010. So therefore they should be confident that what they experienced in the last two will be at least repeated. That will be something both end-users from a buying point of view and OEMs will be talking about and working through. So there is some prospect we won't see as much of a prebuy, but it is too early to tell.

Okay.

I think some of the fleets that did prebuy in the last half of '06 in anticipation of '07 has had a lot of trucks parked, and then -- which is not earning any obviously any revenue on that, so those that have been burned I think may have a different philosophy in the '09 timeframe, just looking at numbers, we say the market's 205,000 in '08, ACT is saying 184,000 going to 282,000 in '09. You can see that I think the build up will start in the second half of this year and in '09 should be a very strong year.

Okay. Thank you. Then as promised, just a couple pain in the necks for Jean. I wonder if you could either give us the aggregate cost cutting target, for the whole company, if you want to fuzz it up or if you could give it by segment, it would be great. And then can you talk a little bit about why the tax rate is rising and also the free cash flow was down over $150 million year-over-year, and I just wondered if you could give us a little color around that. Thank you.

Okay. Let me deal with your second two questions first as I think about your first question. On the tax rate, as I guess it is a good news/bad news story. As we become more profitable, we move much higher to the highest tax rate. The one thing you should assume in there is the research credit lapsed, and so if in fact that gets reuped, that would impact it by about 1%. So it is basically as we become more profitable, it has moved up. In terms of cash flow, the biggest reason for that is CapEx. It is the investments in growth, which have been much more significant this year than in prior years. In terms of a number around cost reduction targets by segment, I don't really have that. We've got the chart in our materials that you can look at for directional approach as a company.

The way we specifically -- the reason we don't necessarily look at it as a company basis, but if you take, for example, our Six Sigma efforts, then everybody has a specific target to reduce costs that way. Although we're doing a lot more with customers with Six Sigma now than what we were the last couple of years. And if you look at low cost country sourcing, there are specific targets around there, and there is also targets in specific plants for lean manufacturing improvement. So again, go ahead and say it, Dean.

On chart 17, when you're looking at the cost reduction, that's where Tim is talking about the Six Sigma initiatives as well as the low cost country sourcing activities, and as you can see it is about 1 full percentage point of improvement there.

That's helpful. Thank you.

Your next question comes from the line of Mr. Charlie Rentschler with Wall Street Access. Please proceed, sir.

Good morning, everybody. I had a question about North American heavy-duty. On the basis that Caterpillar seems to be nearing an announcement about its intentions on highway heavy-duty, if they decide to get out of this business, how well fixed are you with capacity to benefit from this? I realize you're expanding Jamestown, but can you give us some details about that, please?

I don't think we're going to enter into speculation, Charlie, about what Caterpillar is doing. I can just tell you that Jamestown plant is increasing capacity 15% during the year here, and then they have what we call burst capacity on top of that. So we think we can meet the demands of the marketplace given our share assumptions and the size of the market for what we're looking at as '08 and '09.

Okay. And just a follow-up on the non-SCR heavy-duty engine for 2010, presumably you're testing those, you have got them I would assume on the road testing them. But are you pleased with the what you're seeing, especially in terms of fuel consumption and what have you?

Yes and yes, Charlie, yes, we've had a number of trucks on the road and in customer equipment as well, and we're pleased with what we're seeing from both a reliability and a fuel economy point of view. And just want to add we're building directly off of where we are. And so this is an evolution for us, not a right angle turn for us. And there is going to be a lot of familiar-looking stuff, though some changes, for OEMs and end-users in 2010.

Okay.

Our expectation on fuel economy -- it will be similar to what the '07 engine is.

Very good. Thank you.

Thank you.

Okay. I think that's all the time we have for questions today. I appreciate your participation in our fourth quarter call. Feel free to follow back up with me with additional questions. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.