康明斯 (CMI) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the second quarter 2010 Cummins Incorporated earnings conference call. My name is Yvette and I will be your Operator for today. At this time, all participants are in listen only mode. We will conduct a question and answer session towards the end of the conference. (Operator Instructions).

I would now like to turn the call over to Mr. Dean Cantrell, Director of Investor Relations. Please proceed, sir.

Thank you, Yvette. Welcome everyone to our teleconference today to discuss Cummins's results for the second quarter of 2010. Participating with me today are Chairman and Chief Executive Officer Tim Solso, our President and Chief Operating Officer Tom Linebarger, and our Chief Financial Officer Pat Ward. 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 three of our 2009 Form 10-K and it applies to the 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 and a copy of the financial statements and a copy of today's webcast presentation are available on our website at www.cummins.com under the heading of Investors and Media.

With those formalities out of the way, we'll begin our remarks with our President and Chief Operating Officer, Tom Linebarger.

Good morning. I will start today by sharing some thoughts on our performance in the second quarter. Pat will then provide greater detail on the quarter and our updated 2010 outlook, and Tim will talk about our longer term priorities. Second quarter was very strong in terms of our sales, and even more importantly our ability to convert those sales into profits. Sales of $3.2 billion were 32% higher than the same period in 2009. All four business segments reported significantly higher sales, led by our Engine and Components segments, which increased by 45% each. Earnings before interest and taxes increased significantly from second quarter of 2009 to $401 million or 12.5% of sales. That compares to 4.5% of sales during the same period in 2009 and 10.7% of sales during our strong first quarter this year. For the first time, all four business segments reported quarterly EBIT above 10% of sales.

Strong markets in China, India, and Brazil continue to drive large sales increases, as those economies have now fully recovered from the global recession and are growing robustly. Our sales growth in those countries was even better than we had anticipated for the second quarter, and we expect continued strong results from those markets in the second half of the year. As you know, our leadership in markets outside the US has played a large role in our success in recent years. Our geographic diversification has reduced the impact of economic cycles on our business as evidenced by our performance in the current economic downturn.

In addition, our growth rates have increased as a result of our strong position in the fastest growing markets in the world. In the first half of this year, 64% of our consolidated sales have come from outside the US, the highest percentage ever. During that period, sales in China have increased 99% from the same period last year, while sales in India are up 45% and sales in Brazil have risen 94%. And as you know, our consolidated sales picture understates the true impact of our international business because of our joint ventures in countries such as China and India. JV sales in China were up 105% compared to the same period last year and 64% in India. Our Dongfeng Cummins joint venture produced a record 63,000 engines in the second quarter and is expected to be a $1.3 billion business this year.

The second major driver of our strong financial performance in the second quarter and really throughout the downturn has been improved productivity across our manufacturing operations worldwide. As we have highlighted in previous earnings calls, we worked very hard in the early days of the recession to quickly align capacity with real demand for our products. At the same time, we took advantage of the slowdown in volumes in the first half of last year to implement significant improvements in many of our manufacturing plants and our supply chain. That work has resulted in improved efficiency and allowed us to leverage higher Engine and Components demand to increase gross margins in both business units. We have also benefited from increased efficiencies in our power generation and distribution businesses.

Here are just a few examples of improved productivity in our manufacturing plants. Productivity as measured in turbocharges produced per engine per day at our Huntersville, England plant in the second quarter was nearly double the rate in the same period last year. Using the same productivity measure, our turbocharger plants in Charleston, South Carolina; China; and India all increased productivity between 20% and 25% compared to the second quarter of 2009. Our mid range engine business produced approximately the same number of engines in the second quarter as during the third quarter of 2008 with 900 fewer people. Our high horsepower engine plant in Daventry, England has nearly tripled its daily output over the last five quarters, while we have doubled our output at our high horsepower plant in Pune, India. Critical to those gains has been our work to coordinate the shared supply base between these two plants.

Also, despite the increased production, managing expenses at Daventry have been reduced by 20% since the peak of the last cycle in 2008. At our heavy duty engine plant in Jamestown, New York, our direct labor cost per unit produced was flat compared to the fourth quarter of 2009, despite a 58% drop in volumes. Across our power generation business, generators set revenue per factory employee per day is up 28% from the same period in 2009. Pat will speak in detail about how each of these business segments performed during the quarter, but before I turn it over to him, I wanted to offer a few high level thoughts on our performance in each of the businesses.

The components segment has turned the corner and is now poised to consistently deliver the kind of results we have been telling you to expect from this business. Growth prospects are also very robust for this business unit. EBIT margin for the segment was at an all-time high during the second quarter. Our productivity improvement has taken hold more quickly than we expected, especially in the turbocharger infiltration businesses. We also are seeing volumes outside the US return faster than we had anticipated and are beginning to see the impact of increased component content on our engines. Our power generation segment, which is a later cycle business for us, seems to have bottomed out late in 2009 and has started to rebound. Compared to the same period last year, we experienced gains across all lines of business within the segment. In particular, demand for commercial products was much stronger in all four BRICK countries, as well as generator set assemblers in the UK who export to emerging markets.

Our engine business had an outstanding quarter, reporting its best quarterly EBIT percentage ever. What makes the results even more impressive is the fact that the North American heavy duty truck engine market remains soft in the second quarter, as we had projected. That weakness has been more than offset, however, by strong gains in many of our industrial markets, as well as in medium duty truck markets outside the US and for engine parts and kits. Sales to the construction and mining industries outside the US to medium duty truck markets in Brazil and our DCEC joint venture in China were significantly better than the same period last year. We also saw rebound in sales to Chrysler compared to last year, when Chrysler stopped truck production for several weeks during its reorganization.

Our 2010 engine launch in North America has been very successful. We now have 14,000 new medium and heavy duty engines in the field and they are performing extremely well and delivering the type of fuel economy improvements that we expected. Based on 60,000 hours of testing at our technical center and more than 5 million miles of customer field tests, we're confident that our 2010 15-liter ISX engine operating with an STR system is providing 5% to 6% better fuel economy over our EPA 2007 engine. Also, we estimate that our new engine is 5% to 8% better than the 2010 EGR only engine, even including the use of diesel emissions fluid in the STR system.

As I said, the new engines are performing well and we are seeing orders start to pick up. For example, we already have more than 30 fleets who will each take delivery of at least 20 ISX 15 engines in the third quarter. We've also heard from customers that are pleased with their new Cummins engine. One such customer is Frost Trucking, located near Chattanooga. Frost regularly runs Cummins powered Peterbilt trucks to and from the West Coast, averaging 5,000 miles a week. The owner told us recently he had already has two Cummins ISX engines with more than 65,000 miles on them, and [is] extremely happy with the overall performance and fuel economy of the new engine. In particular, Frost drivers have been very pleased with the improved acceleration and quieter ride as a result of using the new ISX 15.

The distribution business continues to perform extremely well, as it has throughout the downturn. Sales rose significantly from the same period last year and the business produced EBIT margins in line with our expectations. We are pleased with how our performances continued to improve despite the fact that some of our key product and geographic markets have yet to fully recover from their session. As a result, we are increasing our guidance for 2010 to reflect that performance and our expectations for the rest of the year. We now expect to earn 12% EBIT on sales of $13 billion for 2010. I will now turn it over to Pat, who will give you some additional details about the second quarter.

Thank you, Tom and good morning, everyone. Second quarter revenues of $3.2 billion were up 32% in the same quarter last year, with revenues in our international markets increasing by 51%, led by stronger demand in China, India, and Brazil, while sales in the United States were up by 8%. Compared to the prior quarter, revenues were up 29% with similar growth across all major regions. The emerging markets continue the trend of sequential growth, while European and North American markets started to recover. Earnings performance [less the] taxes were 12.5% of sales in the quarter, significantly better than a year ago as well as last quarter's performance. In fact, this is the best EBIT percentage we have recorded over the last 25 years. The main reasons for the strong EBIT margin performance were the productivity improvements in our manufacturing class as just mentioned by Tom, increased demand for products across all four segments, more material costs compared to last year, and pricing increases in certain markets, record joint venture income particularly from engine joint ventures in China and India, and lower warranty costs. Earnings per share were $1.25 in the quarter.

Now let me turn to each business and give you some details of the performance in the second quarter as well as an updated 2010 revenue and profitability outlook for each of them. Starting with the engine segment, revenues of $1.9 billion were up 45% from last year. Revenues to the on highway markets grew 35% due to stronger demand in the round pick up and medium duty truck segments, while shipments from North American heavy duty truck engines 58% below previous year levels. Revenues to off highway industrial markets grew 49% year-over-year, led by stronger demand in construction and in mining. Compared to the prior quarter, revenues increased 33%. Sales to on highway markets were up 43%, with medium duty truck and bus revenues up 62%, light duty automotive and recreational vehicle revenues up 43%, and heavy duty truck sales up 35%. Industrial revenues were up 14%, mainly due to strength in the construction, [mining], and oil and gas markets.

Segment EBIT margin of 10.4% of sales this quarter increased significantly from the near breakeven level of a year ago. The improvement in EBIT margins were driven by the productivity improvements in our manufacturing plants and the benefit from increased volumes, stronger joint venture income, more material costs, benefits from pricing actions, and lower warranty costs. EBIT margins also increased from a relatively strong prior quarter, mainly by leveraging our operating costs on higher sales. For the full year, we now expect engine segment revenues to grow 25%. For heavy duty trucks, we continue to forecast NAFTA truck production to grow 30% in 2010. However, Cummins revenues are expected to decline 11%, as the recovery in aftermarket and international markets were only partially offset a decline in engine shipments due to the EPA [transition]. Revenues from the medium duty truck and bus markets will be 12% higher this year. Strong demand in Brazil, the recovery of OEM truck production in Europe, and market share increases in North America more than offset the drop in engine demand in North America due to the EPA transition. Light duty automotive and recreational vehicle revenues are projected to grow 42%, due to the [RAM] pick up truck recovery in North America and strong demand for Ford pick up trucks in Brazil. We are now forecasting industrial revenues to increase 55% this year, with stronger demand from the mainland construction and oil and gas markets.

As I mentioned in our previous call, our engine joint ventures are expected to perform at record levels of production this year. Our Dongfeng Cummins joint venture in China and our Tata Cummins joint venture in India were both running at record levels in the second quarter. We now project full year engine segment EBIT margins of 10% of sales which implies profitability in the second half of the year will remain strong. The leverage from higher sales volumes in the second half will offset some of the challenges that we cited last quarter, such as a production ramp up of new EPA 2010 engines, which initially will carry high warranty rates, from higher research and development investment and the reinstatement of merit increases, from rising commodity costs early in the quarter that are now beginning to flow through our spending with suppliers, and from the slowing of demand in China as a result of government efforts to control economic growth -- although the amount of the slowdown is less severe than what we thought three months ago.

In the component segment, revenues increased 45% from the prior year and 16% from the prior quarter. Both year-over-year and quarter-over-quarter improvement in revenues were driven by strong orders from truck OEMs in China and India, global aftermarket demand improvement, production recovery from European truck OEMs, and higher technology content on our EPA 2010 engines. EBIT margins of 10.3% of sales this quarter was a record for the segment and a significant improvement from the prior year as a result of operational improvements and volume leverage from higher sales. Profitability also improved from the strong first quarter's performance due to the higher sales volume.

For the full year, we are now forecasting revenues for the component segment to increase 30% over 2009 levels. EBIT margins in the second half of the year will continue to improve and full year EBIT margins are now expected to be 10% of sales. Revenues for the power generation segment were up 16% from last year as a result of stronger demand in Latin America, China, and India, compared to the first quarter revenues were up 37%, which was in most regions. Although we are beginning to see increasing orders in North America, second quarter sales for North America, were down from the prior year and up almost slightly from the prior quarter. EBIT margins of 10.7% of sales improved both from the prior year and from the prior quarter. Year-over-year profitability was positively impacted by higher sales in productivity improvements, while improvement compared to last quarter was driven by sales growth and strong operating leverage. The outlook for the full year has also improved. We are seeing better order activity in all regions, driven by data centers in North America and Western Europe and strong economic activity in Latin America and Asia, as well as some recovery in the Middle East and Russia. We now expect power generation revenues to grow 20% in 2010 and deliver full year EBIT margins of 10% of sales.

And finally, the distribution segment delivered another excellent quarter. Sales are up 24% from the prior year with the consolidation of western Canada distributor accounting for 13% of that growth. Compared to the prior quarter, revenues are up 21%. Most regions are up sequentially due to seasonality and recovery in demand for industrial engines in Europe and power generation in both Europe and the Middle East. EBIT margins were 12% of sales and were in line with prior year results. Profitability was also in line with the previous quarter of the one-time gain from the consolidation of the western Canada distributor is excluded from the first quarter results. For the full year, we continue to forecast revenues to be up 25%, with about half of that growth coming from the recent distributor consolidation. EBIT margins are now projected at 12.5% of sales.

As a result of the improved outlook for all four operating segments, we now expect the Company to deliver $13 billion in revenue, up 20% from last year, and EBIT margins of 12% of sales in 2010, compared to previous guidance of $12 billion in revenue and 10% EBIT margins. While first half profitability levels have been very good, we expect profitability to improve further in the second half of the year. The leverage from higher sales volumes in the second half will offset some of the headwinds we expect to face over the next six months, including the higher warranty rates as we ramp up production of new EPA 2010 engines, from higher Research and Development investment and rein statement of merit increases, some slowing of demand in China, and from rising commodity costs in the quarter that are now coming through from our suppliers.

Now before I turn it over to Tim, let me say a few words about balance sheet and cash flow, and also reinforce what we said last quarter. Our cash position remains strong. In the first half of the year, we have reinvested $130 million back into the business in the form of working capital, particularly inventory, as we respond to increasing demand for our products. We invested over $100 million in capital expenditure projects and software investments. We contributed over $150 million into our pension funds and we have repurchased $162 million of Cummins shares.

For the remainder of the year, we expect further investment in working capital to support growth. Our capital investment fund remains at $400 million for the year, which means that spending will accelerate in the second half to support capacity expansion and new product introductions, and we will continue to return value to our shareholders through our stock repurchase program and sustainable growth in our dividend, as evidenced by the recent announcement to increase the dividend by 50%. Finally, we just completed the renegotiation of our revolving credit facility, which was due to expire next year. The new $1.2 billion facility extends through July 2014 and along with internal cash from operations gives us adequate liquidity to make the future growth needs of the Company.

Now, before we would address your questions, let me turn it over to Tim.

Good morning. I want to start by adding just a few thoughts on our outstanding second quarter results. Our performance is the latest indication that our work to manage the business conservatively during the recession while continuing to invest in critical technologies has paid off. Our EBIT margin has improved from 2.8% in the fourth quarter of 2008 to 12.5% in the most recent quarter on similar level of sales. Our second quarter EBIT percentage was the best in more than 25 years. As you heard Tom discuss, our manufacturing plants around the world are working more efficiently than ever. I would add that Tom, Pat, and I have visited manufacturing operations around the world over the past several months, and we can say they are all performing better now from a productivity standpoint than they did at the peak of the last economic cycle. As a result, we are earning very strong margins as our volumes start to return. We expect even better results as our US and European markets continue to recover. In March, we shared our long term growth projections, which calls for Cummins to be a $20 billion Company that will earn 12% EBIT in 2014. Based on our current performance and our plans for the future, I have every reason to believe we will deliver on that commitment, perhaps even earlier than expected.

As we look beyond 2010 we see significant growth opportunities across our businesses and we are already starting to plan to take advantage of those opportunities. For example, we are investing heavily in our high horsepower engine business. We announced this month that we are investing $100 million in capital and another $200 million in R&D in our high horsepower plant in Seymour, Indiana over the next five years. This will allow us to expand into even larger displacement engines to take advantage of long term opportunities and markets such as oil and gas, mining, and commercial marine, while helping customers in these markets meet future emissions standards. We have started production for our second light duty diesel engine in China at our Foton joint venture. Our forecasts call for the Foton joint venture to generate more than $1 billion in revenue in 2014 making it the same size as our Dongfeng Cummins JV today. As emission standards tighten around the world, the demand for Cummins engine components will increase, both on our engines and on those engines produced by our customers and competitors. That type of growth can already be seen in our 2010 guidance for the components segment, which is expected to grow faster than any other part of the Company. We expect that to continue into the future as well.

We also are increasing capacity for current products to meet growing demand in key international markets. For example, by the end of this year, we will have expanded capacity at our Tata Cummins engine JV in India by 50% and have plans to expand future in 2011. We are strengthening our presence in newly emerging global markets such as Africa, the Middle East, and Southeast Asia, much as we did in the 1960s and 1970s in China, India, and Brazil. Africa in particular holds significant potential as the next large emerging market for Cummins. We already have manufacturing presence in South Africa and we are strengthening our distribution network across the continent. Our leadership team has spent considerable time in Africa over the past year learning about the different markets for our products.

These opportunities and others are consistent with the four key long term trends that we expect to drive much growth over the next several years. I won't go into detail on each one again, but as a reminder, they are one, the price and availability of energy, especially as it pertains to the power needs of newly emerging markets such as the Middle East and Africa; the second is more stringent emission standards around the world, which Cummins is uniquely positioned to meet and which provides us with competitive advantage; the third trend is increasing infrastructure spending around the world; and the fourth trend is the globalization of our business and continued growth in large international markets such as China, India, and Brazil, where we already hold leadership positions.

I also want to say just a few words to reinforce Tom's comments on our 2010 engine launch. Just as we did in 2002 and 2007, we have met the new EPA emission requirements with products that have met our customer expectations. Our 2010 SCR engines are meeting fuel economy requirements and are performing to high standards on our customers' demand. We are already working toward the next big challenge in emissions, which is the regulation of carbon emissions expected midway through this decade.

This translates into the need for fuel efficiency improvements of between 15% and 30% from today's standards. We expect SCR to be a part of the recipe that helps us achieve this type of improvement, but we're also exploring new technologies such as waste heat recovery systems that have considerable potential. In fact, Cummins and PACCAR are teaching up on the Super Truck project to explore ways to improve fuel economy in heavy duty trucks, which received a large Department of Energy grant this year. This is just one way we are committed to working with our customers, who will always have the final say over which products best meet their needs. We work with some of the best companies in the world, and we recognize that to be successful, we need to care about our customer success more than anyone else in the industry. Increasingly, we are using tools such as Six Sigma to help us better understand our customers' business so that we can fully leverage our skills to their benefit.

Finally, I want to recognize the work of our people throughout the recession. Our employees around the world have done a terrific job staying focused on the job at hand, often succeeding under very challenging circumstances. Keeping the Company strong over the past two years has required a lot of hard work and discipline from employees around the world. As our business continues to improve, we now are facing the challenge of taking that work ethic and discipline and applying it to the significant growth opportunities ahead of us. I am confident that we have the right people and leadership in place to take maximum advantage of these growth opportunities that will lead to a period of continued and sustained long term growth. Thank you, and we will now take your questions.

Thank you, Tim. Out of consideration to others on the call, I'd ask you limit yourself to one question and a related follow-up. If you have additional questions, you're free to rejoin the queue. Yvette, we are now ready for our first question.

(Operator Instructions). Your first question comes from the line of Jerry Revich with Goldman Sachs. Please proceed, sir.

Good morning.

Good morning, Jerry.

Excellent performance out of the component supply chain. How comfortable are you with your suppliers' ability to continually meaningfully ramp up production further as interim to your four, China [Euro four] and US truck production ramp up in 2011, perhaps you can discuss any of their capacity expansion plans as you did yours? Thank you.

As you'd guess, the supply chain ramp up, Jerry, is a big focus for the Company. We switched from trying to reduce the size of our plants and supply chain to really having to ramp it up. So certainly, really since the last quarter of 2009, we've been in the process and we got I think we were more ahead of it than we've been in previous recessions preparing our supply base. So for the large number of suppliers, we're feeling pretty good about where they are in terms of the ramp up, and certainly in the component segment that's true. We are facing some constraints that have driven some temporary lengthening lead times, but we expect those to be resolved relatively shortly, and really they are mostly around foundries and forges. Some of the foundries and forges are a little bit slower to ramp up. We've worked extensively with them to help them make sure they can get capacity in place, and most are doing a really good job on that and some are a little behind. But as a general matter, I'd say we feel pretty good about where we are in terms of ramping up the supply chain and seeing our way clear to working that through 2011. I think it won't be too long from now before the worst part of the ramp up is behind us. The first part of turning the gas on is harder than making the next incremental steps.

This is Tim, and I would just add to Tom's comments is that we've identified the most critical suppliers in this area and have early on assigned teams to help them, whether it be improved bottlenecks, help with financing, help with guaranteeing certain support levels and volumes, and guaranteeing an effort to really help them improve. So as one gets off the list, then another one gets on the list, and I think we're much more organized and much more disciplined in this ramp up than I've seen in prior times.

Thank you very much, and can you please provide an update on Foton Cummins and Xi'an Cummins engine production rates and contribution in the quarter and what your guidance assumes for the back half of the year? Thank you.

Yes, this is Pat. Let me take that one. In the first half of the year, I think we produced 5,000 engines from the Foton joint venture, and we're now in production with both the 3.8-liter and 2.8-liter. And the second half of the year calls for a fairly significant ramp up from that level and I think we'll probably end the up year somewhere around 20,000 engines coming out of Foton.

Thanks, and Xi'an Cummins? Can you comment there?

Yes, it's picking up and I think we're seeing more volumes coming through that joint venture this year than we have ever before. I don't have the exact numbers in front of me, but this will be their best year in terms of volume shipments.

Thank you very much.

Your next question comes from the line of Henry Kirn with UBS. Please proceed, sir

Hi, good morning guys, and congratulations.

Thanks, Henry.

What do you expect for the cadence for North American truck engine shipments in the second half of the year? When do things get revved up and start to hum along at a better pace?

Jerry, this is Dean. We still feel our production of EPA 2010 is probably balanced much more heavily towards the second half of the year. I think the split first half to second half is looking like a 25% in the first half and 75% of what we do in the second half of the year. We are starting to hear some signs from some of the OEMs that they might be taking their build rates up towards the end of the third quarter, and so it is feeling much more heavily towards the back end of the year.

So more fourth quarter weighted there?

Yes.

And could you talk about, I guess, the fuel economy delta between your engine and the 13-liter SCR competition?

Which competition specifically are you talking about?

Well, any of them you're willing to address. Any of the 13-liter SCR competition as opposed to the EGR guys.

Well, again, it's early on in terms of the launch. I mentioned in my remarks that our engine has had a very successful launch. We've met our expectations with regard to fuel economy improvement, which is no small feat. We worked on those engines for four or five years. We worked on the SCR technology for a decade. We were able to get them launched at the fuel economy deltas we were hoping for, so we feel really really good about that. This is always the period during the launch where the fuel economy stuff is up in the air because essentially, people don't have roots that they are able to run and compare on. They have new tires, they have all of these other confounding factors. We're of course all over it trying to figure out where we stand, trying to get as much data as we can. Our own view is that our 15-liter is going to compare on fuel economy very well to 13-liters. Some cases we expect to be better than a 13-liter, and other cases maybe we'll be even. But we expect to compare quite favorably at 13.

And I think the other point to make there is 15-liter offers other advantages besides just fuel. It also offers power and torque, which people like for specific applications, and over the last decade, the number of customers that buy 15 versus 13 or smaller has grown. And the part of that is because the other performance factors -- durability, reliability, resale, torque, and power that the 15 offers. So our view is we'll be competitive with 13 and sometimes better, but we'll offer all those other advantages as well. So -- but I guess the end answer to your question will be some time before we'll know exactly how we're doing against each engine but we'll be checking and we're making sure that customers are able to compare fairly because we think we'll do pretty well in those comparisons.

Okay, thanks a lot.

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

Hi, good morning, it's Chase Becker in for Jamie. Nice quarter. Just had a question with respect to your implied incrementals for the second half of the year. I believe this quarter you're in the high 30% range in the back half. It's more mid 20s is what you're implying, and I know you mentioned headwinds on the engine side, but wonder if you can flush that out a little bit more, please?

Yes, sure. I think our incrementals are actually quite good in the second half of the year, whether you compare them to the first half of this year or compare them to the second half of last year. Clearly, the comparables are easier when you go back to the first half of 2009 and compare that to the first half of 2010. But if you look at the second half of 2010 to the first half, just based on the guidance we gave you, our incremental gross margin is going to be very close to that 25% number I've talked about on a number of these calls before, which is our target going forward. And when you compare it to the second half of 2009, Chase, I think our incremental gross margin is higher than that -- it's actually closer to 30%. So I'm not seeing much slippage at all when you compare really good quarters against good quarters. And keep in mind, in the fourth quarter of 2009, we delivered over 11% EBIT. It was a really strong quarter for us, so no slippage there at all.

Okay, great, and then on the material cost side, how much benefit did you get in the quarter? And then I think you mentioned you expect some rising material costs in the back half of the year. Was wondering what you're embedding in your assumptions there?

Yes, in the quarter on the material cost when you compare it to a year ago, it was probably a 1% improvement on the bottom line. For the full year, we're looking at material costs being 0.6 points better than what they were in 2009, which is consistent with the previous guidance we had given on that topic in the last couple of calls. We do expect increases coming through from metal markets. We started to see some of that as a second quarter progressed, and that was why I made those remarks given the outlook for the next six months. But year-over-year, we expect to offset that by improvements in low cost country sourcing, value engineering, et cetera. So year-over-year we do expect it to be favorable by 0.6 percentage points.

Okay, great. Thank you very much.

Your next question comes from the line of Ann Duignan with JPMorgan. Please proceed, madam.

Hi, good morning, guys.

Good morning, Ann.

Good morning. Could you walk us through maybe by segment the net impact of FX on revenues and EBIT?

Yes, let me take that one, Ann. Because everyone else has been quiet here. It really wasn't that significant overall for the Company or for any one segment when you look at quarter-over-quarter or year-over-year. The one segment that tends to be most impacted by this is distribution just because they are far more exposed to some of the problems. But year-over-year, Q2 to Q2, it's a higher level -- it had a $65 million favorable impact on sales of just under 3% of our Tier 1 on sales. And the bottom line, it was about a $25 million benefit, and that includes remeasurement improvement from last year when we took a hit in the second quarter of last year. And then the currencies that we pay most attention to are the pound, the Euro, the Sterling dollar, the Brazilian real, and the Indian Rupee. And when you compare the second quarter this year to the second quarter of last year, the Aussie dollar is up 20%, the real in Brazil is up 20%, the Rupee is up 8%. And really, although there's been a lot of focus recently on the Euro and on the Pound, year-over-year when you look at the average for the second quarter of last year to the second quarter this year, they haven't moved an awful lot. When you compare second quarter to the first quarter, our sales were negatively impacted by about $20 million due to currency movements, and that's really the pound and the Euro. The pound is down 6% from what the average rate was in the first quarter and the Euro is down about 7%. The impact on the bottom line was negligible, just given the mix of business we do around the world.

Yes, and I guess that's what I wanted to get clarification on. So [global], you have to do a basket of currency, not just Euro? I was just going to ask for my follow-up question, I wanted to take a step back and talk about the fuel efficiency again of the 15-liter engine. I mean, I'd like you to at least talk us through your reaction to Navistar's recent press release where they are claiming that their engine is 1% to 2.5% or their engine with their Pro Star is 1% to 2.5% more fuel efficient than a 15-liter Cummins in a Kenworth truck. Can you talk about -- where are they coming from if you're saying no, our 15-liter is going to be as fuel efficient as anybody else's, and also the comments you made about your 15-liter versus a 15-liter 2010 EGR? Can you just help us clarify where you think the apples and oranges are in Navistar's press release versus what you're saying?

I don't have a good answer about all of the differences and facts between theirs and ours. Here is what I guess I'd like to say about that, because there's a lot of stuff out now of course about their press release and some of the other comments they are making about SCR technology, and if you wouldn't mind, I want to say a few things about that. None of them will surprise you. We've been talking about this for a while, but we've been working on SCR technology for about a decade and EGR technology for another five years before that. We use both technologies extensively. We have been for some time. We've produced a lot of SCR engines and components in Europe even prior to the 2010 launch, and now of course we have quite a few in the field now operating and they are working really well. The SCR technology is not only good, but getting better as the improvements in technology we've seen for the zeolites, the catalyst themselves, and then of course the robustness of the system. So my own view is SCR technology is here to stay and will be in place for some time, because it's going to help on the carbon requirements because of its improvements in fuel efficiency. So our view is that SCR's doing everything we expected and that's terrific and that doesn't surprise us. We spent thousands of hours of development and tens of millions of dollars making sure we had it right, and we feel good about that.

I guess the second point I'd say is our products are doing really well. They've met the standards that we expected with regard to fuel economy, and what's more is in our typical launch, we'll continue to make improvements on the engines we've already launched from here. So we're already looking at ways to improve calibrations and other things to drive better than the 5% to 6% we've already seen, and we'll continue to work on that. I'm confident we'll even improve that further. So all that stuff came out the way we expected. We will definitely be encouraging our customers and helping our customers run head-to-head tests, and we're doing our own tests to make sure that we're -- relative to others, we're as good as we think we are, and we think we're going to be in a good position on those and our customers will of course be the end judge of that, not press releases we put out or anybody else puts out. And so far, again our feedback has been really good on that. We haven't had any opportunity to run head-to-head tests with Navistar engines. We just haven't been able to get one and put them together and do one. But over time, we'll compare with all competitors and we'll be able to talk to you about that data. Just now we don't have those comparison, and again, I feel very good about the position we're in and I guess that's the way we're talking to our customers about it.

I think a lot of those comments and press releases frankly are just kind of a distraction from what really matters, which is making sure we're meeting the emissions requirements, which we definitely are, and that we're meeting customer requirements on improving fuel economy, which we are. So I guess my general answer is tit for tat with their press release is not our action. Our action is trying to help our customers succeed by selling better products.

And this is Tim and I'd like to add just a couple of things is that -- there's some experience associated with this is that when there is a divergence in technology and two companies or two groups of companies go certain ways, and you're at the introduction phase, there can be aggressive claims. And the marketplace, including the analyst community, loves to see these kinds of disputes and fights. I can go back to the last one was the Caterpillar ACERT engine versus the EGR, and there was at least two or three years of debate and claims and studies and so forth. And I think where Cummins's position is that we want to stay away from some of the behavior in the marketplace that isn't necessarily constructive.

And I think what Tom is talking about and what I agree with is that you'll see over a period of time which technology prevails. And the fact that we've had as much experience we've had both in Europe and here, we're very very confident we're on the right path. And I think over six months, over a year, over 1.5 years, the marketplace will determine which technology will prevail. And as -- I agree with Tom, I think I like where we are and I like where the position is that we have with certain customers and we're getting a lot of confirmation from the marketplace that we're on the right track. But we're going to try and keep this at a civilized level.

I appreciate the response. I'll get back in line. Thanks guys.

Your next question comes from the line of David Raso with ISI Group. Please proceed, sir.

Good morning. My question relates essentially to engine margins, trying to peek into 2011 a little bit by some of the implications on the second half of 2010 and the guidance. The engine business as you know grew about 19% in the first half of the year. You have it accelerating to 30% growth in the second half. But the margins you essentially have flat sequentially, and of course even incrementally year-over-year you go from a [67%] incremental the first half down to only 18%, and for a lot of reasons obviously you cited. Trying to think through those moving pieces. If you add back certain level of warranty incentive comp, commodity costs, R&D, you can get back to where maybe you're implying something like 32% core incrementals on engines. I guess first before the question on 2011, the incremental warranty costs for the heavy and medium duty engines in the back half -- is a 3% incremental warranty expense too severe? Is that how you're thinking of it roughly?

I think, David the way you should think of warranty in the second half of the year is going to be just under 4% of sales. So we were 2.4% across the Company in the first half of the year, and we were 1.5% in the first quarter. That increased to 3% in the second quarter, and I'm thinking the second half of the year is going to be just under 4%. So it is going to increase as more of our EPA 2010 engines come out, and again keep in mind the comments I made initially. In the first number of quarters and in particular after we launch the engine, we will have clearer higher rates. We started the year off indicating it's going to be close to 4% this year, and now I think we'll be much closer to 3% given the performance of our engines and products out there in the field already, but there's no question. Rates are going to increase in the second half of the year, and probably stay high through most of 2011.

But for the engine division itself sequentially, it sounds like maybe 150 to 200 bips sequentially? Because you were already raising it a bit in the second quarter. Is that a fair assessment roughly?

Well, I don't have those numbers and I don't think I gave guidance, but I said where warranty costs are.

And the incentive comp, about 100 bip hit would be fair sequentially and commodity cost about 50 bips? I'm trying to get this base down so I can think about 2011.

The first part variable comp?

Incentive comp. The merit pay.

The merit pay is going to be about 0.3% increase as we go into the second half of the year, and commodity costs are going to be about 0.6% increase as we go into the second half of the year.

Okay, and that means the incrementals in the back half of the year for engines, even [those back] -- it's still relatively not low, but say [25 to 30]. And the question on 2011 is I'm just trying to think through -- heavy duty is a bigger piece of the pie you'd think in 2011 than it was in 2010, right? North America heavy? Just trying to think through the implications on mix. If we're looking at 10% guidance for engine margin this year, trying to think through that mix, and trying to think through all you've done obviously since the days of having two heavy duty engine plants to now up to one in upstate New York, how should we think about your thoughts about the engine margins for 2011 with that said?

So David, I think one way to address this is -- you might want to for some of the more detailed questions you might want to talk to Dean after. But here is what I'd say, that for 2011 we're going to do our normal thing. We're going to finish the year and come out with guidance. But we've given our long term view. I think about each of the segments including the engine, you can see where we are today. You can expect us to try to make steady headway towards what our long term objectives are for 2014 and 2015 from here, and we're ahead of the game in nearly every segment towards where we're headed. So I think as you get to talk about 2011 now, there's more variables than we can really address, so what I'd say is we're going to continue to make steady progress. We'll have mix issues, we'll have growth in different regions, all of those will affect the mix. So my suggestion is in terms of modeling purposes, I'd talk to Dean and see if you can get the incrementals and then unfortunately you'll have to wait for us to get through 2010 before we can give you 2011 views.

And then quickly on the back half guidance. You raised the sales guidance a lot on power gen and the industrial engine revenue growth accelerates from 36% in the first half to 74% in the second half. I was just trying to think through -- those division sales in the US and Europe, how much is the interim tier 4 potential pre-buy? I'm not sure what your reaction is to customers' view of it, but how are you thinking about the implications on interim tier 4 in those divisions and how that dovetailed into your back half guidance?

Yes, tier 4 interim is not having a big effect in 2010 numbers. It's not that there's nobody, but it's negligible. It's not as significant issue. What's going on in power gen is that sales in the BRICK countries as I've mentioned are ramping up more quickly than we expected, in line with general economic recovery in those areas, especially in large units. We've seen a lot of large unit demand in those regions. In addition, there's a bunch of other -- we're selling components in the gen set business to other assemblers who are shipping we think mostly into those regions. Both those are happening. The second factor that's affecting the second half is that we're seeing order rates pick up for the US. So they aren't -- shipment rates haven't picked up so much but order rates have, mostly for shipment in the second half, which is a good sign. That's the first we're seeing of that really, the US may be starting to come back to some reasonable level, not to its peak but back to some level that's a good deal.

On the industrial side, really throughout this year we've been pleasantly surprised by the strength of the industrial markets. We talked about mining already, construction, and again mostly in the construction markets and those markets that we've been talking about -- Brazil, India, China, just really taking off for construction equipment. So all that is really what's driving that tier 4 interim which is a driver for our technology for increased content for components. The pre buy concept there is not really a big driver for volumes this year, and we don't think pre-buy is going to be a big factor in that markets, and those are the markets that are tier 4 interim.

That's great s-- o you're looking at the very core pickup, nothing related to the interim tier 4? Okay, great. Thank you very much. I appreciate the time.

Your next question comes from the line of Tim Denoyer with Wolfe Trahan. Please proceed, sir.

Good morning. Thanks for taking my call.

Good morning.

Can you talk about the component strength in terms of the margins? How much of that is coming from after market relative to OEMs? Do you have a great sense of that in the second quarter and your expectations in the second half?

I think the improvement in component margins in the second quarter are really driven by the volumes both in aftermarket and with first fit OEMs in China, India, and Europe as we talked about in our earlier remarks. And I would expect that to continue in the second half. And along with that productivity improvements Tom is mentioning have driven considerable better results in that segment, so I would expect that to continue. I don't think there's been any significant difference between the margins or the improvement in margins we're seeing through aftermarket versus OEM.

Okay, thanks and then just one follow-up on the earlier discussion of SCR versus EGR. Can you address the workshop the Carbon EPA recently held? If they did revise standards to require SCR system toss warn drivers when DEF is low, derate the engine when it's almost out, and prevent using other liquids like they were talking about water instead of DEF, are your SCR systems already set up to prevent that kind of thing or would there be any material changes?

Our engines are indeed set up to do that. There are requirements for that called inducements now where you -- our engine already first has a reduction in power, a significant reduction in power, 25% and then has a five mile an hour limit [then] after a period after the derate. So there's already significant inducements to A) use DEF and secondly to have it at the right concentration. So those limits exist, our engines are ready for it, and so we don't see any significant negative impact of the workshop or any of the outcomes of the workshop.

One of the issues though that we have with the tone of the questions is that it assumes that the marketplace is looking for ways to avoid regulations and so forth. And our experience has been that the vast majority of the trucking industry when they understand what the regulations are and what's required, they do everything they can to follow what's the right way. So I think there's some flaws in even having that kind of discussion. That's kind of the distraction that Tom's referred to.

Thanks very much.

There's no question though that the rules to govern technologies and emissions requirements by the EPA are developed over many years. Our Company and others in our industry contributed to developing those rules for some time. And first they have to stand for at least three years and there's a comment period before that, and even before that all the measurement technologies out there. So again, really interesting point is that 2010 emission standards are a huge win for the environment. These are a massive reduction in air pollutants that's achieved in 2010, and it turns out now with darn good products -- products that work, that have good fuel economy, and it's a great win for the industry and the environment and took a lot of work. And what I'd say is that these are kind of tweaks that people are talking about, but in fact the rules were set for many years. So they are after the fact debates about the rules, and we're fine if there's some adjustment to them. I think our engines are ready to do it. But it is looking backwards at a process that took remember five plus years to develop and is a huge achievement by the industry.

So again we're just feeling really good about where we are. We think the rules are sound and measurable and in a good place. And so we'll react and obviously participate in any process that's there. But we're already feeling pretty good about where the engines are.

Great. Thanks very much.

Your next question comes from the line of Eli Lustgarten with Longbow Securities. Please proceed, sir.

Good morning. Never cease to impress me with these numbers. Can we talk a little bit about what's going on outside the United States? [65%] of the quarter and you've already told us that China was going to be a little bit slower, but not as slow as you thought, and we knew that. But you're getting phenomenal results in Europe and terrific results in Brazil. Can you talk about what you're seeing second half? Everybody is paranoid that Europe is going to suffer maybe not this year but early next year. Brazil does have elections coming later this year that can impact next year. Can you give me some idea of sustainability of this phenomenal demand that we're looking at, particularly big market share gains in Europe.

Let me start, but I'll talk through two or three of those regions and Tom can jump in. Let me start with China, since there is some concern out there I think as just how severe the slowdown is going to be. It's certainly not shaping up and anything like we thought three months ago. Three months ago you'll recall I gave guidance at total revenues in China were going to be in the range of $2.6 billion to $2.7 billion for the Company, and now we're revising up to north of $3 billion. So not only are the markets improving in China, but we're getting market share pretty much in every segment that we participate in there. And although the growth rate is going to come down from 10% to 11%, it's going to bottom out at 8% to 9%, which is still pretty attractive to us and I don't see any slowdown in our performance and our growth in China as we look forward over the next two or three years.

Same story in India. Business is growing very nicely, I think we'll be close to $1.9 billion total revenues this year when you include the joint venture, which is up about 45% to 48% from a year ago. And all the macroeconomic factors, the government actions in infrastructure investments continue to make India a very attractive growth market for us, and I think our market is also in very good condition there.

I was in Europe with Dean five or six weeks ago, a time where there was probably most concerned about the Euro. Back then, the Euro was down about $1.20 to $1.22, and everyone was getting a little bit nervous about it. The Euro was back up to close to $1.30 now, which is actually better than the 10 year average and we've done pretty well over the last 10 years. My sense of the European markets, we're definitely starting to see them come back. We express some of that with the remarks in the truck market in particular supporting the engine segment, our component segment coming back strongly. We're seeing an increased demand in Power Gen, and our distribution business has seen an uptick in demand for industrial engines too.

I don't have as skeptical an outlook for Europe as some of the experts do, so obviously you're far more expert in this than I am. But when I talk to people over there, I think Europe is going to be okay. It's not in much difficulty as I think some people were speculating a number of months ago. You're not going to see significant growth rates in Europe, but I do expect to see somewhere between 1% to 2% over the next couple years as we go forward.

And with regards to Brazil, you did mention the elections in the latter part of the year. We've seen some of the incentives extended through the end of the year through the elections. That's helped to really propel the Brazilian market forward. As we look into next year, I think we still see the potential of a pre-buy taking place in the truck markets in Brazil as they move to a Euro 5 emission standard at the beginning of 2012, so we still see that on the horizon. Obviously there's just -- the growth with the economy, a lot of infrastructure development that's helping to fuel some of the construction, the commodity markets in Brazil and obviously other countries in South America is helping propel our engines for the mining markets as well. So we see potential still for continued growth in South America more broadly even in 2011.

One quick follow-up with the great margins you've got now and you're almost approaching 2014. Is the goal over the next couple years is basically sustain profitability, or is there any thought to the point that maybe your targets for 2014 are a little bit conservative at this point?

I knew the question was coming.

Well, somebody had to do it.

Just glad it's from you. So the answer is we're definitely, there's just no question we're ahead of where we thought we would be now. What we need to do is we need to finish this year out, see where it comes, and we need to come back and talk to the investment community about what we're saying about our longer term targets. Right now we're leaving them the same. There's significant improvement over our past. They represent terrific value growth to the shareholders in terms of profitable growth, but we need to look at them and say once we finish this year, are they right?

Do we need to adjust them? It's a good question. I just think we want to make sure we get through the year, have a chance to sit and reflect, and we will definitely do so -- because as you know, we're not a group that just wants to sit and maintain. We definitely want to figure out how to drive more profitable growth, so we'll be thinking about that and come back to you. It's a good question. I don't mean to deflect it. It's just now is not the time to answer it, though we are definitely ahead of where we thought we would be now.

Thank you very much.

Thank you everyone. That concludes today's earnings call and we will be available for your questions offline at offices for the rest of the day, so thank you everyone for joining us.

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