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Executives

Dean A. Cantrell - Director of Investor Relations

Tim Solso - Chairman and Chief Executive Officer

Tom Linebarger - President and Chief Operating Officer

Pat Ward - Chief Financial Officer and Vice President

Analysts

Jamie Cook - Credit Suisse

Eli Lustgarten - Longbow Securities

Henry Kirn - UBS

Ann Duignan - J.P. Morgan

Joel Tiss - Buckingham Research

Andrew Casey - Wachovia Capital

David Raso - ISI Group

Cummins, Inc. (CMI) Q4 2008 Earnings Call February 3, 2009 10:00 AM ET

Operator

Good day, ladies and gentlemen and welcome to the Fourth Quarter 2008 Cummins Incorporated Earnings Conference Call. My name is Eric, I'll be your audio coordinator for today. Now at this time, all participants are in a listen-only mode. We will facilitate a question-and-answer towards the end of the conference. (Operator Instructions).

I would now like to turn your presentation over to Dean Cantrell, Director of Investor Relations. Please proceed.

Dean A. Cantrell

Thank you, Eric. Welcome, everyone to our teleconference today to discuss Cummins's results for the fourth quarter of 2008. Participating with me today are Chairman and Chief Executive Officer, Tim Solso; our President and Chief Operating Officer, Tom Linebarger; our Chief Financial Officer, Pat Ward; and our Vice Chairman, 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 statement involves risk and uncertainty. The company's future results maybe 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 our forward-looking statements begins on page three of our 2007 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 and guidance for 2009, Tim would like to frame the quarter and our recent actions in the context of the current economic environment.

Tim Solso

Good morning. I'll begin on a positive note by saying that 2008 was our fifth straight year of record sales. Overall revenues for the company were $14.3 billion compared to $13 billion for 2007, or nearly a 10% growth in sales for the year. Earnings before interest and taxes or EBIT was $1.3 billion or 9% of sales compared to $1.2 billion or 9.4% of sales for the previous year.

Unfortunately, and as you are all aware, most of our gains in 2008 were made in the first three quarters of the year. Pat Ward will offer more specifics about the fourth quarter in a few moments, but here are the high level facts. Sales declined by 6% year-over-year and 11% from the third quarter. EBIT was 5% of sales excluding the severance charge relating the actions we announce in December. This was below our target of 10%. Sales declined year-over-year in the Engine and Component segments, but all four segments saw our sales weaken during the fourth quarter.

We have moved quickly to respond to what has become the worst global recessions since World War 2. And we are prepared to take further significant action in 2009 if necessary. Our goal is to maintain a solid profit level through the downturn and to preserve our ability to grow profitably in the future. Still we expect 2009 to be extremely challenging, the recession almost certainly will last through the end of this year and we are assuming it could take until 2011 for the global economy to fully recover.

We remain confident that our company is well positioned to achieve its long-term growth targets once our global markets improve. But for the short-term, our focus will be on reducing cost to earn a respectable level of profit through the downturn, managing the business to ensure that we are generating positive cash flow, and continuing to invest in critical technologies and products for 2010 and beyond.

Tom Linebarger will provide further details on the actions we have taken to reduce cost. But I want to emphasize that we already have taken a number steps to cut discretionary spending, lower capital expenditures, and reduce our workforce to bring it inline with the expected demand for 2009. Our experienced management team has made the necessary tough decisions and we are committed to further action as needed. These actions and others such as aggressively moving to lower our working capital and suspending our stock repurchase program while maintaining a sustainable growing dividend will allow us to generate cash this year.

Cash will be critical to our future growth. We must be in a position to continue investing in key products and technologies such as those related to meeting new emission standards in the United States and the launch of four new engine platforms in the United States and China. I'd like to remind everyone that we entered this recession in the best financial condition in the company's history. Five years of record sales and profits have allowed us to lower our debt to below 20% of capital and to build a sizable cash reserve. We also have access to $1 billion in liquidity as we look to invest in our future.

So, while I do not think we have seen the worst of the current recession, I am also convinced that Cummins will emerge from this downturn, however long it lasts, an even stronger company. Our guidance for 2009 is that sales will be down approximately 20% from our record performance this past year and either will be 6.5% of sales. Now, Tom will provide you with additional details on some of the actions we took and why we think we are well positioned for the future.

Tom Linebarger

Thank you, Tim. As Tim said, when we began to see this rapid and steep decline in the fourth quarter, we started taking aggressive action to lower our costs; including the painful step of reducing our workforce around the world. Those actions have continued into 2009. We will continue to monitor demand for our products closely and adjust our capacity and the size of our workforce as necessary. With the actions we have announced so far, we will reduce our worldwide workforce by about 2800 people, or more than 6% by the end of March. Of the 2800 people, approximately 1500 will be salary professionals and the remainder will come from our hourly workforce.

In addition, we have cut approximately 2500 contract and temporary jobs, eliminated merit raises for professional workers, and cut officer's salaries by 10% in 2009. Based on what we know today, we believe the reductions made to our professional staff would be appropriate for the demand we expect in 2009. It is likely, however, that we will need to take further actions at individual manufacturing locations to react to changing demand. We'll continue to use our rings of defense approach to react to these changes.

In addition to the people actions, we have worked hard to lower our costs in other ways. For example; we have reduced our monthly travel expenses during the fourth quarter by half and cut a number of other discretionary expenses. Capital spending in the fourth quarter was approximately 48 million lower than our forecast in October. And our capital plan for 2009 calls for a 30% reduction in spending from 2008. We have closed three distributor branches in the United Kingdom and planned to close six more locations outside the U.S. in the first half of this year.

In addition, as a result of weaker performance in the fourth quarter, our variable compensation expense for 2008 was approximately $44 million less than originally planned. As Tim said, we remain optimistic about the fundamental strength of our company and how market manages going forward. As a result, our basic strategy is not changing. Our long-term targets of 12% sales growth and 10% EBIT are still in place. We remain committed to investing in our key growth platforms in the downturn to ensure that we can meet our profitable growth targets through the cycle. For example; work is progressing on our four critical engine platforms and the related components to go with those despite the significant reduction in capital spending plan for the year.

In addition, Cummins Technology leadership continues to position our company well for future growth. Market share gains for our Engines, Components and Power Generation equipment around the world are the clearest sign that our customers recognize the value that our technology brings to their products. New fuel efficiency standards offer Cummins another opportunity to leverage our technology leadership for business advantage. For example; our 2010 on highway engine will offer industry leading fuel economy, while our investment in new light duty diesel engine platforms in the U.S. and China would open new markets for clean diesel engines for the company.

Our immediate challenge is to get through this global recession by producing a reasonable level of profit and generating sufficient cash to allow us to invest in the future. The actions we have taken so far, our plans for 2009, and our current financial strength position comes to emerge from this significant downturn, stronger than when we entered it and in terrific shape to resume the growth we have seen in recent years. Now Pat will provide more specifics about the quarter.

Pat Ward

Thank you, Tom. As we warned in December, global market conditions deteriorated rapidly in the fourth quarter, especially in the truck and construction businesses.

Fourth quarter sales for our company was $3.3 billion or 6% below the same period of 2007 and 11% lower than the fourth quarter of 2008. Despite the fourth quarter slow down, full year sales increased 10% which was slightly back of our guidance. Although we move quickly to adjust the company's fixed cost structure, we were unable to offset the impact of the volume decline in the quarter.

Along with lower joint venture income, negative impact from currency movements and other one time charges, EBIT margins drop to 5% in the quarter and finished at 9.3% for the year. Both numbers excludes the $37 million restructuring charge related to workforce reduction actions initiated in the fourth quarter.

Due to more favorable geographic mix of profits, our full year effective tax rate of 31% was more than our prior expectation of 32%. The full year adjustment along with the recognition of the research tax credit lowered the fourth quarter effective tax rate to 12%. Including the $37 million restructuring charge, which comes to $0.13 per share, net income was $89 million or $0.45 per share for the fourth quarter. To give you a clearer picture of what has happened during the quarter let me provide details for each of our operating segments.

Our Distribution segment had another solid quarter. Revenues were up 19% and there was strength in all our regions as a result of sales in industrial high horsepower engines and Power Generation equipment. While our EBIT margin was negatively impacted by currency translation, they remained above their 11% target.

In Power Generation, sales increased by 6% versus a year ago. Demand for commercial generates as an alternate primarily in China and Western Europe more than offset the decline in the U.S. consumer markets. Price realization remained ahead of increasing commodity costs. However, the impact of a less favorable mix of products sold and unfavorable currency movements pressured the EBIT margin downwards to 8.5% of sales in the quarter.

We experienced a significant reduction in demand in the engine segment. The revenues dropped 10% versus the same quarter a year ago. Sales in all on-highway applications declined particularly in the pick-up truck and RV markets in North America and global medium duty truck markets. Sales to industrial applications were also down with the slump in construction markets offsetting stronger demand in agricultural and marine markets.

Engine segment EBIT dropped to 1.3% of sales for the quarter as a result of the rapid decline in volume, higher material costs, unfavorable currency movements, and the drop in income from our joint ventures. The segment results were also impacted in the fourth quarter by a net charge $38 million related to unwanted (ph) liability, associated with the increasing cost of repairs to engine sold in prior periods.

Hardest hit in the fourth quarter was the Component segment; revenues dropped 13% and EBIT declined by $45 million finishing just above breakeven. As we previously warned, the demand decline from the truck and construction equipment OEMs in North America, Europe, China, and India accelerated as the quarter progressed. In addition, the gain associated with the sale of our business in the fourth quarter of 2007 contributed to the lower EBIT year-over-year. The challenging market conditions we experienced in the fourth quarter will not improve in 2009, and we anticipate further deterioration in most of our end markets.

For the Engine segment, we project 2009 revenues will fall close to 20% and EBIT will be around 4% of sales. Nearly every on-highway market will be smaller in 2009 as freight tonnage and credit availability will harbor on the purchasing decisions of end users. We project that North American heavy duty truck markets at 137,000 trucks, down almost 20% from 2008. But we forecast those shipments to drop less than the market due to share gains.

Within the medium-duty truck market we expect the shipments to decline around 30% from softness in North America and sharp declines in Brazil and Europe. Demand for Dodge Ram pick-up trucks stabilized in the last few quarters, and we anticipate engine shipments to Chrysler will remain flat, while the recreational vehicle market will continue to deteriorate in 2009.

Revenue from global industrial engine markets is expected to decline nearly 30%. In spite of infrastructure stimulus spending programs around the world, we believe demand from new construction equipment will be reduced by about 40% over 2008. Demand for mining, marine and agriculture is also forecasted to drop significantly in 2009.

In our Component segment; we expect sales to decline about 25%, primarily due to weakness in truck and construction markets in North America, Europe, China and India. Because of the impact of the lower volumes, we are forecasting the segment to deliver EBIT margins in the range of 2.5 to 3% of sales.

For Power Generation; we project sales to decline by 10% in 2009 with EBIT in the range of 9.5 to 10% of sales. In our global commercial Genset business, we are experiencing a slow down in order intakes. However, the very high-end markets of plain power served by our project in alternative businesses have not yet seen an increase in backlog cancellations. In the consumer market we anticipate further deterioration this year from an already weak position in 2008.

In distribution, sales are expected to drop 10% and the segment profitability as a percent of sales is forecasted to remain flat with 2008 levels at 11%. About half of the segment sales are exposed to industrial engines and power generation, and we expect a decline in demand. However, we anticipate that aftermarket sales and service revenues will be flat to slightly down similar to past downturn cycles.

Overall, for the company as Tim mentioned before, we expect sales to drop approximately 20% compared to 2008, and the EBIT margin to be 6.5% of revenues. The first quarter is anticipated to be our lowest quarter of the year. The 2009 guidance excludes restructuring charges related to additional workforce reductions and plant closing activities announced in January, which will be included in our first quarter results.

We so project to generate positive cash flow in 2009. We are planning capital investment of about 3% of sales; a significantly reduction from last year. We will continue to invest in key projects related to emission compliance, fuel economy, and new platforms, which are critical for our future profitable growth.

In addition we are taking a hard look at adjusting our working capital and have improvement plans in place that will benefit our cash flow in 2009. In light of the current economic conditions we have also suspended our stock repurchase program, but remain committed to maintaining our current dividend. We have worked hard to build a strong balance sheet and keep their levels low and that remains our goal in 2009.

We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). First question comes from the line of Jamie Cook with Credit Suisse. Please proceed.

Jamie Cook - Credit Suisse

Hi. Good morning.

Tim Solso

Good morning Jamie.

Jamie Cook - Credit Suisse

My first question relates to your guidance within the Power Gen segment with sales declined, I think, of about 10%. I am just wondering what's your visibility at this point, how far into 2009 do you have visibility? You also mentioned you weren't cancellations yet on the higher end wondering what your expectations are and sort of what you're seeing geographically? Because that to me along with the margin assumptions based on what I am hearing on the Power Gen seems a little optimistic. So, I am just wondering how you're thinking about that guidance for 2009 within Power Gen?

Tom Linebarger

Hi Jamie, this is Tom. In Power Gen, we have some orders that stretch out still a long way. As you know the order board was very long for a period of time. And it has come in, our newly times are much shorter than the old ones. But there are still orders out quite away. So as we have some visibility out for some orders through the year, but as you guess the books unfold like they were for the whole year. So it's more...

Jamie Cook - Credit Suisse

Is it through Q2 or is it...

Tom Linebarger

Right. It's more like 90 to 180 days now. And that's a broad statement across larger Gensets. It depends by as you said by region and size and all that kind of things, but as a broad matter, it's more like a quarter or two as opposed to a full year.

Jamie Cook - Credit Suisse

So I am assuming that -- would that imply that the first half of the year, maybe you are hoping for modest growth or backlog growth with more dramatic declines in the back half to get your downturn for the year? Is that the way I should be thinking about it, given what you're seeing now... given your visibility?

Tom Linebarger

I think we're seeing the year pretty flat across the area. It is a broad statement. I mean it doesn't mean there is not variation there, just up and down depending on place. But as a broad statement we are seeing at it as generally flat through the year. Although you might think it might get weaker in the second half in fact because the first quarter is normally a slower quarter for us there is some seasonality. It's kind of playing itself through to be roughly flat through the year. There is some negative currency movement year-over-year that is also affecting revenues up as a general matter, even quarters will be closer than what you said.

Jamie Cook - Credit Suisse

Okay. And then can you comment specifically, I mean part of the strength that you are seeing was sort of in the emerging market, what are you seeing within Power Gen or what's your assumptions for 2009 for within the emerging markets within Power Gen?

Tom Linebarger

Yeah, emerging markets are still a significant part of our business. Where as you I think are suggesting, the emerging markets are not as strong as they were a year ago. The economic growth rates in both China and India for example are down. But still markets are reasonable. Both markets for power generation we saw some pickup in China actually in the fourth quarter power generation. So as a general matter both regions will remain strong in the fourth -- I mean in 2009 but not as strong as they have been in previous years.

Jamie Cook - Credit Suisse

So you are not assuming any material cancellations in your forecast?

Tom Linebarger

No. But there will be order board shifting. We do expect order boards shifting that's kind of how we are seeing but not major cancellations, no.

Dean Cantrell

Jamie this is Dean. Just to clarity on the comments that were made in the scripted remarks about not seeing cancellations at the very high end. Keep in mind that some of the markets in which our alternative business through that it serves was some very large alternators that go into independent power producers that's where we are specifically not seeing the cancellations yet. I think with a lot of the product that we supply through our commercial line of business we have been seeing some cancellations there. As Tom indicated it is not as full, the lead times have come in, and it is not like it was 90 days ago when we talked you. The comments were more specific to the very high end alternators that actually don't even often time marry up with some of our own engines.

Jamie Cook - Credit Suisse

Okay, and then my last question also, on the engine side of the business, I sort of agree with you but I don't find your top line for cash too unreasonable on the engine side given some of the declines we have seen so far but it sort of implies to get to your operating margins, the 20% decremented margins for 2009 which again to me seems, can you just walk me through your assumptions I would have thought on the -- side, the decrementals would have been a lot worse than 20%?

Pat Ward

This is Pat, let me take that question and let me take it in two ways. Let me talk about the company across the wall and then answer your question on the engine business.

Jamie Cook - Credit Suisse

Sure.

Pat Ward

The -- for the company were going to go from 9.3% of sales 2008 to 6.5% in 2009 but the volume drop of 20% on the top line will cost us about 5% drop in EBIT. We expect probably close to another 1% drop from the combination of joint venture income and still some higher material cost year-over-year and not to the same extent we see in 2008 but it still will be higher. Offsetting that we expect to see benefits from pricing and from our cost reduction actions that we were taking in the fourth quarter and was taking through the first quarter and the combination of those two should bring back 3% of EBIT. So that's how you kind of get higher level from 9% EBIT going to 6.5. And if you think of the Engine business to your specific question, the cost reduction actions in particular, I think, will play a significant role in helping the Engine business, minimize the detrimental margins is going to see in 2009.

Jamie Cook - Credit Suisse

Already I have a couple of more questions but I'll get back in queue. Thanks.

Operator

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

Eli Lustgarten - Longbow Securities

Good morning.

Tim Solso

Good morning Eli.

Eli Lustgarten - Longbow Securities

Hi, just a clarification, the 20% decline in revenue is that including currency and what are the currency assumptions or is that excluding currency?

Pat Ward

That includes currency. So, the 20% is the number, the currency element of the 20% is a about 5%.

Eli Lustgarten - Longbow Securities

5%. So your volume is down 15 towards the currency effect is what you are saying?

Pat Ward

Yes.

Eli Lustgarten - Longbow Securities

And warranty expense you guys hit with 38 million in the quarter. Do you have any idea what the warranty assumption is for 2009, is there any change in that assumption with your overall percentage?

Pat Ward

Yes. Warranty expense in 2008 including campaigns and change in estimates is 3.5% of sales. That was higher in the fourth quarter. The fourth quarter was 3.8%. Again we don't get specific guidance on warranty for '09, but you shouldn't expect it to be much different from the full year number for 2008.

Eli Lustgarten - Longbow Securities

Either percentage or the full year number as an absolute total for this quarter?

Pat Ward

As a percentage.

Eli Lustgarten - Longbow Securities

As a percentage. And if I hear correctly Tom said on the Power Generation you expect some business, you're bidding on some business sustaining throughout for the rest of the year to keep you at board relatively flat is 180 day window. So for the first half you have got some visibility that you expect in continuation of kind what levels of demand, is that the assumption?

Tom Linebarger

Yes.

Eli Lustgarten - Longbow Securities

Going on. And if you talked about the Engine business, I mean you gave us down 20% in North America in trucks and down 30% in the global market. Is there a bit of way a market share is in truck at this point, what do you expect to hold it, what is your forecast for international heavy truck typically in Europe. And you started indicating what's going on in Ag and construction, can you give us some sense or color what's going on those markets?

Tom Linebarger

I missed the first part of your question?

Tim Solso

Market share and trust down, we finished the year Eli, on the awards data came out just shy of 45% for the full year. So that's up from the 2007 levels that we are in kind of the upper 30s. And our expectations as we go out into 2008 or 2009 is that we would be in the 48% market share for the full year in 2009. So we'll obviously we'll run in the first six months of 2008 more like 43%. So there is about a 5% swing there in the first half of '09 before we would anniversary.

Tom Linebarger

You know the medium-duty I think we are at 33%. If you break it down we are assuming drop in North America between 5% and 15%, Brazil will be down 30%, and Europe will be down 40%. So that's where the total number adds up. And then the construction market, basically we see that down literally all over the world. We have been asked about the stimulus packages not only here in United States, but there's been two in India already in a 600 billion in China. And they will obviously help us in terms of infrastructure investments, transportation and so forth. But we think it's going to take some time so we'll probably see that more at the end of the year or in 2010. So we still see that construction and the Ag markets being down from where they have been.

Eli Lustgarten - Longbow Securities

Let me just one question. You talk about your 2010 engine fuel economy, how much better I mean that will charge out (ph) today with a big deal trying to make through their EVI is complicated in getting their economy. Then the SCR that everybody is going to, can you talk about what is going on in technology for 2010?

Tom Linebarger

Eli, I can comment on that. We do expect our 2010 engine to have a fuel economy improvement over our 2007 engine and we do expect it to have fuel economy advantages over the competition. And so in both cases, we are well advanced in those programs. As you know we made a significant switch to SCR in the middle of the year on heavy-duty, mid-range we are continuing the same strategy. We are well progressed with those programs, we are active in testing and we are seeing the results in fact slightly better than the results we have projected from our analysis in terms of fuel economy. So we still think we are going to offer customers an advantage over our '07 and over competition in 2010.

Eli Lustgarten - Longbow Securities

And you have 5% to 10% in fuel economy, that is what the number seem to be at this point.

Tom Linebarger

5 to 10% over what?

Eli Lustgarten - Longbow Securities

Over '07 engines?

Tom Linebarger

Eli, that's at the high-end. But...

Eli Lustgarten - Longbow Securities

The 5% is the number we are quoting (inaudible).

Tom Linebarger

Yeah, that's reasonable, yeah.

Eli Lustgarten - Longbow Securities

All right, thanks. I'll get back in queue.

Operator

And your next question comes from the line of Henry Kirn with UBS. Please proceed.

Henry Kirn - UBS

Good morning, guys.

Tim Solso

Good morning, Henry.

Henry Kirn - UBS

Could you talk a little about the age of the U.S. class fleet, and if the bill is down 20% in '09, when could this spur a replacement?

Tim Solso

Well, I think clearly Henry, we are now with the expectations that we have for 2009. We are looking at three years now that are below replacement demand. I don't have the numbers in front of me in terms of what the specific age of the fleet is. We clearly look to the pundits (ph) out there in the world that provide the research on what the age of the fleet is. But clearly, it is starting to say that there is essentially or virtually no pre-buy in 2009, and it's continuing to add the expectation that customers will come back into the market in 2010 and beyond to obviously try to address the ageing fleet and does start to build expectations for much sizable markets in 2010 and beyond?

Tom Linebarger

I just ... there is more uncertainty right now in all over the markets, but in particularly the truck markets. And, I think the way we're thinking about our business is that we're going to assume that this recession is deeper and longer than anything we've seen. And that we've already taken capacity down and we are going to manage costs and manufacturing capacity to demand. And, bet less on the fact that there is going to be a recovery at the end of this or in 2010. And we'll be prepared when the recovery is there to go ahead and meet the demand. But that's kind of what the management philosophy is now. And, I personally don't think anyone really knows for sure exactly when we're going to see a recovery or what that recovery is going to look like.

Henry Kirn - UBS

Okay. That makes sense. And could you talk a little about where your inventory stands or where inventories in the channel stand? How much you may have to under produce demand in the first half of the year to right size the global inventory channels?

Tom Linebarger

We don't have a lot of channel inventory issues to deal with anywhere really. As we've some... we kind of managed channel inventories on an ongoing basis. And so, we don't... we are not really planning any adjustments anywhere in the world. The place that the inventory that our distributors hold is mostly parts related to service parts and some generator sets. And in both cases, we're feeling like our inventory levels are reasonable.

Tim Solso

And the Chrysler dealer inventories have come down and we don't think there is going to be a need for another adjustment there. They were quite high six to eight months ago. But they've brought them down to I think about two or three months right now.

Tom Linebarger

And they definitely under produced in the fourth quarter relative to demand for that reason. Yeah.

Tim Solso

That's why we say we think our Chrysler volumes well down from 2007 and 2008 will remain flat for this year.

Tom Linebarger

Our truck customers also have been adjusting inventories down for sure. And they did a lot of that in the fourth quarter. I am not sure how much more that each of them are... each case is going be different, but they are definitely reducing inventories in the truck business too.

Henry Kirn - UBS

Okay. Thanks a lot.

Operator

Your next question comes from line of Ann Duignan with J.P. Morgan. Please proceed.

Ann Duignan - J.P. Morgan

Hi, it's Ann Duignan. Good morning, everybody.

Tim Solso

Good morning.

Tom Linebarger

Good morning.

Ann Duignan - J.P. Morgan

Okay. Can you just talk about your relationship with Navistar in 2010, and whether you would be supplying them any for 15 liter engines? And then, can you talk about Navistar today international represents somewhere between 35 to 40% of your heavy duty engine volumes. What do you expect to do in terms of restructuring or rightsizing the business if indeed Navistar disappears as a customer?

Tom Linebarger

Ann, this is Tom. Post 2010, our expectation is that we will still supply engines to Navistar not for U.S. truck use, not for 2010 admissions, but outside the U.S. In side the U.S., we don't expect to sell them 2010 engines at this stage. We'd love to change their mind but right now that's not the plan. And, with regard to adjusting, our view is that we that already in our expectations and are already building our capital plans and workforce planning around that. We don't think it's going to require any further adjustment and things we are already doing. And we think we are highly confident our heavy-duty business can be successful and profitable despite losing Navistar as a customer, we sure would like to win them back though, and we are working on it.

Ann Duignan - J.P. Morgan

Can you help me try and quantify the impact on revenues and potentially earnings for Navistar and Cummins in 2010, would it be loss of about 25,000 engines which is about 30% to 35% of our heavy-duty high end engine business is that correct?

Tom Linebarger

Yes 38%, I think your numbers are roughly right. I think probably you can do your own calculations there. The thing to watch out for is the calculations you are doing of course on the year before as opposed to current year. So I think we're -- our expectation is it depends a whole bunch on what year you are talking about, how much it will -- the actual volume we have. I think you have the numbers broadly right for last year. Our view is that we will be moving up in shared pack as we have been as steadily, moving up in share pack and after '09 we will essentially represent all their business. In freightliner all their outside purchase anyway and then freightliner will begin to move up a freightliner both of which we hope to largely offset losses at Navistar.

Ann Duignan - J.P. Morgan

So, the 25,000 units is going to be hard to offset that entire volume?

Tom Linebarger

Yeah, we're going to try to do that.

Ann Duignan - J.P. Morgan

Okay.

Tom Linebarger

Are there more questions.

Ann Duignan - J.P. Morgan

Well I'm just thinking that 25,000 units incrementally PACCAR and Freightliner probably not well and may be possible if the market is up significantly.

Tim Solso

I think what you can take away from this is what Tom has said is that we've anticipated this for a long time. We have flexible capacity so we can adjust our fixed cost. And we think our heavy-duty engine business for North American trucks in 2010 and beyond would be as profitable as it has been in the past I mean at the top end. So we are not planning on some large drop in profits as a result of that. We have a very profitable business, we have great relationships with our customers, we have got a super product that's coming out, and we have a good relationship with Navistar. So I think your question implies if there is a doom and gloom out there and we would not agree with that.

Ann Duignan - J.P. Morgan

Okay, sounds fair, I appreciate the response. Can I just circle back a little bit to your comments on the decline in the agriculture and mining and marine end markets? Can you just give a little bit more color on what you are seeing in those three sectors?

Tim Solso

From a mining perspective, obviously at the end of 2008 when some of the large mine sites started announcing some of their capital expenditure reductions, we did start to see that filter through then on the OEM order boards. We did start to see some cancellations, some of the large high horsepower engines upon our factories. I think it is clearly an expectation that it's going to be down this year. We're I think expecting it could be down as much as 30 to 40% for our mining business. There are obviously some spots where we're continuing to deliver to orders in the backlog. But that is an area that it's going to be down this year.

From an agriculture perspective, as you know, where we participate most in the Ag segment is really in the 4-wheel drive tractors and the larger combines, so mostly with larger displacement engines, mid-range and heavy duty engines to go into those markets primarily in the Brazil kind of Eastern Europe and North American markets. And we are seeing some changes in the demand in those markets at this time. So we are expecting that to be a softer market in 2009.

And the marine I believe was your third market which you're asking specifically on. Let me address it in both the recreational marines as well as in the commercial marine, two different stories going on there. Recreational marine which is part of our joint venture with Brunswick Cummins MerCruiser clearly has had a very difficult 2008 and we are not expecting any recovery in the recreational marine market. So recreational marine being pleasure yachts that use 15 liter engines or smaller. 2009 will be an additional difficult year for that market.

The commercial marine market has got some pockets right now that are feeling the pinch from availability of credit. Where some shipyards are running out of credit availability to continue with the production of commercial marine vessels and so we are seeing some of those areas in the Asia Pacific Rim that are dealing with that. There are other areas where we are continuing to see good backlogs that are continuing... the customers are continuing or committed to building out some of those vessels, primarily those that have been supporting a lot of the oil and gas industry. So it's kind of a mix bag right now in the commercial marine market. But overall we are expecting that it will be down in 2009 as well.

Tom Linebarger

If you look at the consumer markets that we have, the recreational marine, RVs both the primary engine as well as the Gensets any of that, a lot of that's right now at 40 year lows and that's build into our forecast. And we are not counting on any recovery in 2009. Those markets are absolutely dead.

Ann Duignan - J.P. Morgan

Okay that's great color; I really do appreciate it. Thanks I'll get back in queue.

Operator

Your next question comes from line of Joel Tiss with Buckingham Research, Please proceed.

Joel Tiss - Buckingham Research

Hey guys, how's it going?

Tim Solso

Okay.

Joel Tiss - Buckingham Research

That's good, Can you just zero in on one thing that has sort of been danced around, PACCAR's delaying their engine plans I guess in 2010, but can you talk a little bit about your expectations from market share with them in 2010 over '09? Do you think it's going to go up or down?

Tom Linebarger

Yeah, I think it'll go up in 2010.

Joel Tiss - Buckingham Research

And then may be decline after that, when they get fully ramped up?

Tom Linebarger

Yes.

Joel Tiss - Buckingham Research

Okay.

Tom Linebarger

If you are adding together the two platforms, that's what you are trying to do, figure out market share by in total. We expect overtime that we will be their sole 15 leader supplier, once they clear out backlog of core (ph) engines that they bought. And they will eventually introduce their own engine and those will be the two engines that they'll use.

Joel Tiss - Buckingham Research

Okay.

Tom Linebarger

What the market share of each of them is kind of depends on how they position the trucks and what customers are trying to get out of them.

Joel Tiss - Buckingham Research

Can you help us also on clarification around first half, second half, do you expect the first quarter for the overall company to still be profitable?

Pat Ward

Yes, the first quarter we do anticipate and we expect that to be profitable. If you are looking for guidance, we are not going to give you quarterly guidance for the full year. But certainly we would expect the second half to be better, than the first half.

Joel Tiss - Buckingham Research

Okay. And then last can you just help with free cash flow, maybe you are not going to give guidance on free cash flow, but can you just give relative to 2008 where you expect it to be?

Pat Ward

Yes, I think in 2008 we had our net overflow 2009 as you heard from the scripted remarks we are targeting positive inflow of cash. And I think two areas relative to 2008 that a different capital expenditure we are taking them from around $540 million to somewhere between 316 to $400 million. So there is a significant improvement there. And in 2009 we are targeting our businesses to reduce our working capital. And specifically an inventory and generate cash from working capital in '09, and '08 that was overflow.

Tom Linebarger

Also on the stock buyback I think we spend somewhere around $128 million in 2008 and as we said we have temporarily suspended the stock buyback and that's just a conservative way of looking that we want to make sure that we are conservative in managing our cash and once we see the market stabilizing and that we will be still committed to the buyback that we're going to be conservative at this point in time.

Joel Tiss - Buckingham Research

That makes sense. And then, with all those moves, do you think the free cash flow could end up being higher than your earnings.

Pat Ward

I am not going to give guidance, not just now.

Joel Tiss - Buckingham Research

Okay. All right.

Tom Linebarger

Joel, we focused on really what we believe to be the key pieces of the free cash flow that you're trying to calculate. And I think on slide 15 of the presentation, as Pat indicated capital expenditures is one of those larger numbers. The global pension funding number is around there as well and as you can see much like we talked about at the Analyst Day back in November, are kind of going to be up in about the $30 million range from what they were in 2008. So, not as large an impact as maybe what you're expecting at other companies.

Joel Tiss - Buckingham Research

Okay. All right. That's helpful. Thank you.

Operator

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

Andrew Casey - Wachovia Capital

Good morning, everyone.

Tim Solso

Hey, Andy. Good morning.

Andrew Casey - Wachovia Capital

I guess, Dean just a follow-up on that pension structure, just went through the sequential 494 million decline in shareholders equity from Q3, is that both currency and pension, or mostly pension?

Dean Cantrell

The pension was about 433 of that?

Andrew Casey - Wachovia Capital

Okay. Now, does that trans -- and maybe you just answered this with Joel, but, does that translate into a headwind for the P&L in '09?

Pat Ward

From the P&L in '09, we expect the pension expense to be marginally higher than '08. And we are looking just now, somewhere in the 10 to $15 million range of an increase in the P&L. From the cash perspective as you can see from the presentation, we're projecting it to be around $30 million higher from the cash contribution perspective.

Andrew Casey - Wachovia Capital

Okay. Thanks, Pat.

Pat Ward

So no, not a headwind.

Andrew Casey - Wachovia Capital

Okay, thanks. And, in '09 with the positive cash flow, are you looking to reduce debt or you're just keeping that for dry powder.

Pat Ward

We have no intention of reducing of debts in 2009.

Andrew Casey - Wachovia Capital

Okay.

Tim Solso

Dry powder is a good explanation of it.

Andrew Casey - Wachovia Capital

Sometimes I get lucky with it Tim. The pricing benefit that you talked about when you were going through the margin, puts and takes, is that mainly in the high horse power engine business components and distribution?

Pat Ward

Yeah, I think we can see pricing opportunity across most of our segments. Certainly, in higher horsepower element, high horsepower segment, there is an element there, but it should help the engine business with its margins. Pretty much across the board we see some opportunity for pricing; not to the same extent as I think that we generated in 2008.

Andrew Casey - Wachovia Capital

Okay. So, within that Pat, it doesn't sound like you're expecting any discounting, is that an accurate assessment?

Pat Ward

Yes.

Andrew Casey - Wachovia Capital

Okay. And the reason I asked Tim, some of your competitors seem to have better availability on the high horsepower engine applications than even the two quarter discussion that Tom had in the prime power piece of Power Gen?

Tom Linebarger

Yeah. Andy, we're careful about our availability here, because we... what we are coming off of is a long, where we had long lead times and very few open slots. And now, as one of the earlier callers asked, are the cancellations -- people are dropping there -- they are shifting on the order board. They are postponing projects or they are doing whatever, which is opening slots in order board. So, you might be able to drop in a week if somebody doesn't want one delays, you might be able to drop in a week. So, what I gave was average kind of order lead times. But in fact, today, given how much shift in there is, you might be able to get one or two high horsepower Gensets really quickly or engines.

So, it is going to... and it's going to keep producing. I mean, at some point we'll use a 90 or 120 day lead time, because that's just a practical supply chain operating lead time. But, that doesn't mean that if you just wanted to get one, you might not be able to get one early or distributor might have one on their lot that they'll sell you. So, I think your real point there was will that eventually lead to discounting like it did sometime ago. And our intention is not. And I think the industry got some tough lessons in the last downturn about discounting. So, I think there is some good learned behavior. And the last thing that's different as you remember, in the last downturn, there was a whole bunch of telecoms that had bought a lot of equipment and basically put it back on the market as used equipment, which we don't see this time.

So all those things... we hope moderate pricing behavior in the market but our own behavior is going to be not to pursue discounting as a strategy. And right now we just don't see a need to do it.

Andrew Casey - Wachovia Capital

Okay. I am sure we'll all watch that. And lastly, just want to clarify something I saw in the trade press. On the light duty automotive some reports are suggesting a delay in the Dodge Ram 1500 diesel application to 2011. Is that consistent with what you've been told by the customer?

Tom Linebarger

Yes.

Andrew Casey - Wachovia Capital

Okay. Thank you very much.

Operator

The next question comes from the line of David Raso with ISI group. Please proceed.

David Raso - ISI Group

Yes. Two questions, one on '09 and one with a bigger picture. For the JV income down 20% the guidance for '09, I know roughly 40 to 50% of that income is China and India JVs, can you give us a little breakdown between what you see in those JVs versus the distribution business for '09 and within the JV line items?

Tim Solso

Yes, I would kind of maybe get you thinking about the JV income in terms of two major buckets being the engine business and distribution. And yes, the guidance that we gave in terms of JV income being down, the majority of it is going to be in the Engine business. I think you will see some slight deterioration just as you would expect during this recessionary period in the distribution segment but in more or like the single digit, probably in their distributors' market.

In the Engine business I think that's where you are going to see most of the drop in the JV income. And obviously these are some of the things that we've talked about in prior calls in terms of Dongfeng joint venture and the challenges with the truck market there, they are seeing in China where we make the volumes within the joint venture dropping 25 to 30% there and obviously affecting the level of income that that joint venture contributes. We are going to see the start up of the joint venture in Beijing with Photon where we are introducing two new light-duty diesel engines. We will obviously be incurring additional start-up expenses until those engines actually go into production here this summer. So that will be an additional negative to joint venture income. And then there is obviously the Indian truck market and our joint venture with Tata Motors there. Again expect it to be a difficult year for the truck sector in India. And we would expect to see a decline in volume in that joint venture as well. And between those three I think I parade majority of the decline that you would see in the engine business joint venture income.

David Raso - ISI Group

Okay. Thank you. And the big picture question. Obviously everybody can have their own thoughts about the progression the truck cycle in next couple of years. Obviously the company faces a lot of questions around, the market share and heavy truck going forward and so forth. I mean you are facing for a long time of course, it's not a new issue. But, clearly more of your competitors have their own -- your customers have their own engine. So, it's a legitimate concern? I mean, to keep your earnings power it is going to be can this component division really become a rigid profit contributor and I know the market obviously didn't work out the way you would have thought for '09 and even for that matter the end of '08. But 2.5% to 3% margin in '09, can you take us through a little more detail now that we have kind of seen how difficult '09 should on the revenue. Can you give some guidance on where you think these margins could be, even if I did give you component growth of double-digit in '10 and '11? I mean what are we missing here that we should think these margins can go to 5, 6, 7% anytime soon, let alone if this 9% EBIT margin target you have. That's going to be critical to the structural earnings power the company will make really next 3 to 5 years.

Tom Linebarger

David, just one backup point and then I'll get into your details of the question, but we definitely believe that the engine business plus the components business together is our strategy by which we think we can help our customers succeed. So we don't think it's an either question. Our view is that, really all of our customers make engines and they have for sometime. The question is which ones they make and our view is us being able to provide the engines that they need plus the components and sub-system technologies they need on their engines will be -- had been and will be a successful long term strategy.

When it comes to margins on components, our view is that we definitely can see our way as revenues return to earning in the 7% to 9% range that we talked about. And we have been active in working on and restructuring the parts of the business that have been lower margin in the good years, in 2008. And we're making good progress on that and you saw some of that progress during Q2 and Q3. And I think the work that we're doing to restructuring the business will position them well for when growth returns. So we remain highly confident that we will hit our 9% EBIT target as growth returns and will move to 7 pretty quickly as business returns to normal levels. So for us that, we're confident that we can do it, it's not a difficult bridge to do. Right this is rough year for them and just as we were positioning ourselves for growth, volume dropped a lot and that really had a hard -- took a hard lat at margins on those component businesses but we expect as growth returns we will return with good margins.

David Raso - ISI Group

Well I guess I ask the different way, if you didn't... I understand why for the growth opportunities, if you hadn't added the incremental cost to the business thinking '09 was going to be a better year than it is going to end up being, how would you have thought of the '09 margins and I am just trying to think did you feel you are on your way to getting 5, 6, 7% in '09, if you just let the business run but understandably you are burdened with cost, and hope for eventual growth opportunity in '09, '10, '11. I am just trying to think through...?

Tom Linebarger

That hypothetical is hard for me to do but I can answer the other one which is, what was our '09 plan before the volumes dropped off, and yes we plan to be up in our 7% to 9% range.

Pat Ward

The other thing David is, you go back and look at the first three quarters of 2008. The components business across that period delivered about 7% of sales. So yes we absolutely believe it can have those type of target margins when the volumes do it all.

David Raso - ISI Group

Okay. I appreciate it. Thank you.

Tim Solso

Okay I think let's stop here on the questions. And I think we've got some closing remarks that we'd like to make.

Tim Solso

Yes. I would like to make a few comments just to give you a perspective on how we see the world and why we're doing what we are doing. This is the fifth recession that I have seen in my career and four of them, I was very senior, one running the Engine business, one as President, the one earlier in this decade as Chairman, and now this one. And this is very different than what we've seen and it's going to be deeper and longer and it's going to be more global. And so that's kind of our view of the world. And we are going to manage our business with that assumption and if we are wrong then we'll benefit sooner than what we are anticipating.

The second thing is that the company is in very good shape right now in a sense of a very strong balance sheet. We've got great products that are coming out, our capacity is in place and so forth. So we are strong and I truly believe that no matter what happens in this recession that we're going to be able to manage it very successfully.

Our strategy is simply that we are going to manage cost and manufacturing capacity to meet the demand and the volumes. And so when Tom talks about we're through a couple of people reductions we'll now look at demand on an ongoing basis at various plants. And we have the flexibility to make adjustments fairly quickly at those plants.

The second thing on strategy is that we are going to manage for cash. We did this earlier in the decade, we've already reduced capital but not to a silly position. We're still investing in the future. Our discretionary spending is in control. We have work to do on our working capital, but as Pat said, we have plans in place. We've temporarily suspended the stock buyback. But we're going to maintain the dividend. And finally, in all of that, even in this time as Tom has said, we're going to invest with a very focused approach for growth in this future. We look at pay back periods, but it's not like we're going to stop planning. So, that's where we think we can come out of this. We think this is a really solid approach. It's one that we will continue to report to you on. But, I think the company is in good shape, we're going to manage this and we'll come out of it in even better shape.

Dean Cantrell

Okay. Thank you everyone for joining us today on the teleconference. And, I will be available in the office for additional questions after the call. Thank you.

Operator

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect. And have a good day.

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Source: Cummins Q4 2008 Earnings Call Transcript
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