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Cummins, Inc. (NYSE:CMI)

Q1 2009 Earnings Call

April 30, 2009 10:00 AM ET

Executives

Dean Cantrell - Director of Investor Relations

T. M. (Tim) Solso - Chairman and Chief Executive Officer

Tom Linebarger - President and Chief Operating Officer

Patrick (Pat) J. Ward - Vice President and Chief Financial Officer

Analysts

Henry Kirn - UBS

Adam Uhlman - Cleveland Research Co.

Ann P. Duignan - J.P. Morgan Securities, Inc.

Stephen E. Volkmann - Jefferies & Company

Andrew Casey - Wachovia Securities

Jamie Cook - Credit Suisse - North America

Eli Lustgarten - Longbow Research

Meredith Taylor - Barclays Capital

Kristine Kubacki - Avondale Partners

Operator

Welcome to the First Quarter 2009 Earnings Release for Cummins Inc. Conference Call. My name is Tanya and I will be your coordinator for today. At this point, all participants are in listen-only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator Instructions).

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

Dean Cantrell

Thank you, Tanya. Welcome everyone to our teleconference today to discuss Cummins' results for the first quarter of 2009.

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 2008 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 first quarter performance and updated guidance for 2009, I'd like Tim to say a few words.

T. M. (Tim) Solso

Good morning. As we expected, the first quarter was extremely challenging due to the ongoing global recession.

Demand for our products has fallen in nearly every market and geographic region around the world. Pat Ward will offer more details about the first quarter, but here are the high level facts.

Sales declined by 30%, more than $1 billion compared to the first quarter of 2008. Sales dropped in all four segments during the quarter. The Engine and Components segments were the hardest hit.

Earnings before interest and tax for the company was 3.9% of sales excluding a $66 million severance charge relating to actions taken throughout the quarter. We don't expect the global economy to bottom out until late this year at the earliest and we are not expecting any improvement in our markets in 2010.

We remain confident that the company is well positioned to take advantage of a number of long-term market trends and will resume its growth once the recession ends.

In the short term, however, we are assuming the worst from the economy and are continuing to aggressively manage costs and capacity across the company.

Our goals for this year have not changed. They are to align cost and capacity with the real demand for our products so that we maintain a solid profit through the downturn, manage the business in such a way that generates positive cash flow and continue to invest in critical technologies and products for 2010 and beyond.

We already have moved quickly to address each of these goals and Tom Linebarger will in more detail about some of our actions.

I want to emphasize, though, that our management team has the experience and the willingness to make the difficult decisions necessary to get us through this recession. As I said last quarter, managing cash through this downturn will be critical to our future growth. We had a cash outflow in the first quarter, mainly as a result of paying out variable compensation earned on record 2008 results, as expected. But I am confident that the actions we have taken and will continue to take will allow us to generate positive cash flow for the year.

I would like to remind everyone that we entered this recession in the best financial shape in the company's history. Our record results from 2004 to 2008 allowed us to lower our debt to capital to below 20%, build our liquidity and invest in several profitable growth opportunities.

In addition to our available cash, we also have $1.1 billion credit revolver, which we did not need to use in the first quarter despite the challenging conditions. We are taking necessary steps to ensure that Cummins emerges from this downturn as a stronger company, which will be well positioned to take advantage of the recovery when it begins.

Given our outlook on the economy and end markets, we have revised our guidance for 2009. Our guidance for this year is now for sales to decline slightly more than 30% from our record year in 2008 and for EBIT to be approximately 5% of sales excluding restructuring charges.

Now Tom will share some additional details on the actions we have taken and why we think the company is well positioned for the future.

Tom Linebarger

Thank you, Tim. We began taking aggressive actions to lower our costs in the first quarter of 2008 when it became clear the recession was going to lead to a significant decline in our volumes in most markets around the world.

As Tim said, we took additional actions in the first quarter of this year including further reducing our global workforce by approximately 4100 people. These reductions include 800 professional job cuts announced in February, approximately 2000 hourly workers in our manufacturing facilities around the world and 1300 contracted temporary workers.

Included in those actions was the closure of an exhaust manufacturing plant in Wautoma, Wisconsin. We also announced the consolidation of our two Turbocharger production operations in Charleston, South Carolina into a single facility.

When combined with reductions made in the fourth quarter of 2008, we have lowered our global workforce by about 7000 people, or 15% since October of 2008. Many of the job actions taken in the first quarter occurred in February and March, so we should begin to release the full cost benefit of those actions in the second quarter of this year.

We expect that the reductions taken in the professional workforce in the last two quarters will save the company approximately $80 million in 2009 and more than $100 million on an annualized basis.

Based on the latest information we have, I'm hopeful that we will not need to make additional global cuts in our workforce in 2009 as a result of the recession. We will, however, likely to continue to reduce or reorganize manufacturing capacity in response to volume declines for some products, and this may still have impacts on our people.

In addition to the employee reductions, we have worked hard to manage expenses to keep our costs aligned with the lower volumes we have experienced. Those efforts are reflected in our selling, administrative and research expense for the first quarter, which fell by $69 million compared to the same period in 2008 and was $116 million lower in the third quarter of 2008.

We have also scrutinized our capital spending, prioritizing our critical projects while reducing spending in other areas. For example, we will continue to fund time sensitive projects such as those related to our 2010 product launches, but we are pushing hard to define what is truly critical and what can be delayed.

As a result, our capital spending in the first quarter was $64 million, nearly 30% less than what we spent in the same period a year ago and 70% less than our spending in the fourth quarter of last year. Pat will talk in more detail about working capital in his remarks. But I wanted to say a few words about the importance that we're placing on lowering working capital and in particular on reducing our inventory as part of our strategy to generate cash during the downturn.

We believe that reducing inventory without sacrificing sales or delivery performance is our single largest opportunity to lower working capital and improve cash flow for Cummins this year. Over the next three quarters, we expect to reduce our inventory by over $200 million and we have people at all levels across the company working on this issue.

We have established a corporate supply chain team made up of people from all parts of the company to identify opportunities to improve supply chain efficiency, eliminate waste and reduce inventory. We expect to begin seeing the results of this work in the second quarter and this effort will remain a priority for Cummins throughout 2009.

I would like to close my remarks by echoing what Tim has already said about our long-term prospects.

The company is fundamentally strong and there will be a number of significant macro trends working in our favor once the recovery begins. For example, our technological leadership positions us very well for future growth as emission standards become more stringent around the world and the demand for cleaner, more fuel efficient vehicles increases.

The expected global shortage of electricity, especially in developing regions such as the Middle East, India, Latin America and Africa will benefit our Power Generation business, which is poised to capture many of these opportunities. Increased infrastructure spending, especially in the large developing markets such as China and India will increase demand for all of our products.

Even in the shorter term, economic stimulus efforts in these countries may provide some business opportunities for Cummins later in the year.

As the first quarter clearly showed, 2009 is going to be a challenging year. But I am confident that our current financial strength along with our plans to manage through the global recession will position Cummins to emerge an even stronger company.

Now I will turn it over to Pat who will provide more details about the first quarter.

Patrick (Pat) J. Ward

Thank you, Tom. As mentioned earlier, we saw further deterioration in global market conditions this quarter which affected all of our businesses. Although currency negatively impacted our sales by 5%, the majority of the drop was from lower volumes across all four segments, but particularly in Engines and Components.

Sales were down 30%, a drop of over $1 billion compared to the first quarter in 2008, which contributed to a decrease of $262 million in gross margins.

Joint venture income was down $34 million as expected, nearly impacting the Engine segment.

Spending reductions in selling, administration and research and development resulted in a $69 million decrease in expenses from a year ago.

EBIT margins excluding the restructuring charge dropped from 9% last year to just under 4% in the first quarter. We recorded a $66 million restructuring charge in the quarter, of which $60 million was related to severance costs.

Net income was $7 million or $0.04 per share. Excluding the restructuring charge, net income was $51 million or $0.26 per share.

Let me provide details for each of our segments starting with Distribution.

Revenues for this segment were down 7% year-over-year. Currency had the greatest negative impact on sales for this segment, contracting 11% as a result of the stronger U.S. dollar. Excluding unfavorable currency effects and benefit from acquisitions last year, organic revenue was down only 3%. Aftermarket sales and services were relatively stable while industrial engine and power generations sales began to turn negative.

The combination of increased pricing, higher joint venture earnings and the absence of acquisition expenses in the prior year led to the improvement in EBIT margin to 14% of sales.

In Power Generation, sales declined 17% versus a year ago with nearly a third of the decline due to unfavorable currency movements. Demand for commercial products and alternators was lower in the U.S., India, Western Europe and Russia.

EBIT margins improved to 10.5% of sales and were positively impacted by increased pricing and lower selling, admin and research and development costs.

The Engine segment experienced a decline of 32% in sales from a year ago as all end markets were negatively affected by the global recession. As a result of the significant volume deterioration in gross margins and in our engine joint ventures, the Engine segment EBIT margin dropped to a negative 1.1% of sales for the quarter.

And finally, revenues from our Components segment declined by 35% from a year ago. All four businesses were down significantly. Volume was a primary contributor for the EBIT margin decline to 0.2% of sales.

Looking ahead for the remainder of the year and as Tim mentioned earlier, we are now forecasting a revenue decline of slightly over 30% this year and an EBIT margin of 5% of sales excluding this quarter's restructuring charge.

Here is how we see each segment for 2009. For the Engine segment, we project revenues to fall more than 30%, but are still forecasting the segment to generate a positive EBIT margin of 1% to 1.5% of sales. We expect margins to improve sequentially in the second half of the year as production volumes stabilize, joint venture income improves and we fully realize the benefit of the restructuring actions we have taken as well as lower material costs.

We have highlighted the revenue outlook for the major end markets on slide 16. We now project North American Class 8 heavy-duty truck production at 113,000 units and our market share to hold at 45%. Within the medium-duty trucks and bus markets, we expect our truck shipments to decline 20% in North America with even sharper declines of 30% in Brazil and 60% in Europe.

Globally, our shipments to bus markets will decrease. However, stimulus spending in the U.S. and in India will benefit transit bus markets as both governments have announced specific plans to renew or expand bus fleets.

Shipments for Dodge Ram pickup trucks will be down nearly 10% while shipments to the recreational vehicle market will deteriorate close to 40%.

Revenues to the industrial engine market are expected to decline nearly 40% as OEMs continue to reduce excess inventory in the channel. We experienced significant cancellations during the first quarter and now expect our engine shipments to global mining and construction markets do be down 50% and 60% respectively.

Our Components segment revenues will fall more than 30%, primarily due to the same weakness in truck and construction markets in North America, Europe, China and India. We are forecasting the segment to deliver EBIT margins in the range of 1% to 2 % of sales with sequential improvement in the second half of the year as end market demand stabilizes and we realize the cost benefit of the restructuring actions.

For Power Generation, we project sales to decline by more than 25% in 2009 with segment EBIT in the range of 9% to 9.5% of sales. Inventory corrections in the channel will continue to affect sales through the summer, but we expect demand to stabilize in the second half of the year.

We are projecting some level of pricing pressure to our margins going forward due to the inventory in the channel which is implied in our margin guidance.

For our global commercial genset business, China demand is expected to fair better than the rest of the world and soften only slightly from 2008 levels as stimulus package spending continues to drive demand in the country.

Western Europe and Russia are expected to experience the steepest declines as the recession and credit availability are limiting investments in these regions. We anticipate additional deterioration to the already depressed consumer market for gensets as recreational vehicle and recreational marine markets continue to drop in North America in 2009.

In Distribution, sales are expected to drop between 15% and 20% with half of the decrease coming from the impact of a stronger U.S. dollar. About half of the segment's sales are exposed to industrial engines and power generation where expect a decline in demand. We also anticipate that aftermarket sales and severance revenues will be slightly lower, similar to past downturn cycles.

Segment profitability as a percent of sales will improve slightly from 2008 levels to between 11% and 12% sales. The benefit of increased pricing, the restructuring actions and lower spending levels are expected to mitigate the decline in revenue.

And finally, cash management remains a top priority for the company this year. Despite the challenging economic environment, we remain well positioned with a strong balance sheet, relatively low debt and access to a significant level of liquidity. We were pleased to manage through the first quarter without having to use any of the $1.1 billion revolving credit facility that we put in place last summer.

Although inventory levels continue to decline in the first quarter, we expect to see more significant reductions as move through the second quarter. In addition, we continue to review our capital investment needs for this year and are reducing our guidance to the range of $300 million to $350 million. We are committed to generating positive cash flow in 2009 so that we can continue to invest in future growth opportunities.

We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). And your first question will come from the line of Henry Kirn with UBS. Please proceed.

Henry Kirn - UBS

Hey, good morning guys.

Tom Linebarger

Good morning, Henry.

Patrick Ward

Good morning.

Henry Kirn - UBS

A question about end market price discipline. You mentioned pricing pressure in Power Gen. Could you talk about it more generally across your businesses?

Tom Linebarger

I think, as we've talked about before, in many of our segments pricing is relatively stable as a result of the agreements that we have with OEMs over significant periods of time. And where we see more short-term pricing pressure is in those markets where we sell directly to the end users such as Power Gen. And again, I will just reiterate that we have been increasing prices over several years now in those markets. And so what we're anticipating is that's going to be more difficult and we may see some... even some retraction in the second half of the year. But we are still at this point experiencing some of the increases we put in last year. So it's kind of an anticipation point as opposed to what we've experienced so far. Is that close enough, Henry? Do you want more?

Henry Kirn - UBS

Yes, is there anyway you could talk about sort of maybe geographic expectations for pricing?

Tom Linebarger

I don't think I have a geographic view of it. I mean our anticipation in Power Gen markets is that we'll see pressure in various parts of the world. I don't think it's a geographically-driven issue. I think where we have seen probably the most pricing pressure in Power Gen has been in China and India where it's been much more competitive than let's say in Western Europe at this point on pricing. But it's not predictable I think going forward where the most pricing pressure is going to be.

Henry Kirn - UBS

That's fair. And could you talk a little about the 2010 engine feedback? How many do you have in testing, the customer response? And have you gotten any sort of early order indications that fleets are going with your engine?

Tom Linebarger

Dean, do you want to add... I can add some if you...

Dean Cantrell

Our view is we have, rather than talk about details of our program which I think would not be smart on our part, we've got very positive response. We have a lot out already. We anticipate very strong portfolio performance and so do our OEMs. So what I'd say is we are on track and feeling really good about where we in a 2010 launch. I just don't want be more specific from a competitive point of view.

Henry Kirn - UBS

Okay, thanks a lot.

Operator

And your next question will come from the line of Adam Uhlman with Cleveland Research. Please proceed.

Adam Uhlman - Cleveland Research Co.

Hi, good morning guys.

Tom Linebarger

Good morning Adam.

Adam Uhlman - Cleveland Research Co.

I have a question regarding the earnings guidance for the year. Could you talk about the expected seasonality of earnings, noting that you are not giving quarterly earnings guidance here. But there seems to be a lot of moving parts here with restructuring accelerating in the back half of the year. But presumably, many of your customers are going to be having extended shutdown days. So could you talk about just generally how you would expect earnings to unfold as the year progresses?

Patrick Ward

Yeah, Adam, this is Pat. You're right, I'm not going to give you quarterly guidance. But what I would say we do expect the second half of the year to be stronger than the first half of the year. And let me give you a bridge from 2008 to 2009; it might help illustrate why you're thinking that's the case. When we look at the volume impact year-over-year, we translate that to EBIT margins, we think the volume drop of over $4 billion is going to cost us about 9 percentage points in EBIT margin. And we also as we said on the comments earlier, expect joint venture income to be less in 2009 and 2008, and that's going to cost us about another seven-tenths of a point in EBIT margins.

Offsetting those two between price and cost reductions and material cost improvements, we expect to get 6% of that margin drop back. So you net the 9 for volume and net the almost 1% for joint ventures and take the 6% back, that's how you get to a 4% drop year-over-year what you're looking at.

Pricing has been strong in the first quarter and, as Tom just commented, we are anticipating some pressures as we can see in the rest of the year in pricing. We will see joint venture income improve sequentially as we go through the year. And we do expect to see material costs improve sequentially as we go through the next four quarters too.

Adam Uhlman - Cleveland Research Co.

Okay, got it. And then just a follow up on that. The guidance for the Power Generation business is coming quite a bit on the top line, but it seems like the detrimental margin that's assumed is a bit lower than what we were talking about 90 days ago. So there was a comment that pricing was going to be coming under pressure in the Power Gen business. Could you bridge what's unfolding within the Power Gen business that might be offsetting that pricing pressure?

Patrick Ward

Yes, absolutely. We're definitely seeing material cost improvement as we go through the year that's going to help Power Gen business. And I think that segment has done a pretty good job to date and will continue to do a good job in reducing its selling, admin and research and development costs. So I think that will help offset some of the pricing pressure that we are anticipating for the second half of the year.

Tom Linebarger

If I can just add two things, in the Power Gen, this is back to our pricing point, we are seeing... we're anticipating some price decreases, but we are benefiting from some pricing increases we put in coming into this year. And the one material cost negative for us is copper where although copper prices are decreasing, we have a hedge program in our alternator business which has benefited us over many years now. It now is acting against us in terms of benefiting fully from the decrease in copper we're still going to paying prices from previous years.

So I think all-in-all, while the pricing is anticipated to be worse, as a general matter, pricing over the course of the year is not much worse. And material costs will have some benefit, but not as much as we anticipate. Most of the benefit we're seeing in costs is because of actions we're taking within the business to reduce costs in the current demand environment.

Adam Uhlman - Cleveland Research Co.

Okay, got it. Thanks very much.

Operator

And your next question will come from the line of Ann Duignan with J.P. Morgan. Please proceed.

Ann Duignan - J.P. Morgan Securities, Inc.

Hi, good morning, it's Ann Duignan, how are you guys?

Tom Linebarger

Good morning Ann.

Ann Duignan - J.P. Morgan Securities, Inc.

Tim, I think reviewing your opening remarks, you mentioned that you are not anticipating any economic recovery until late 2009. And I think you said no improvement in your end markets in 2010. Could you just dig into that a little bit more? And is that a blanket statement that you don't expect any of your end markets to recover next year or you think on balance, some of the early cycle businesses might but the later cycle businesses may continue to deteriorate? If you could just give us a little bit more color in terms of what your thinking is, I'd appreciate it.

T. M. Solso

Yes, I said that we wouldn't see the bottom, at the earliest would be at the end of this year and it might be in 2010. I think our markets and our business is in a very, very uncertain time right now. And we want to assume and be very conservative about our forecasts in order that we run the business and manage both costs and manufacturing capacity to what we think is the real demand. And I think we've done a reasonable job and we've done it faster than we've ever done before.

If in fact some of the markets return in the latter half of 2010, then we're just going to benefit from that. But both internally and externally, we're taking a point of view that this recession is going to last for a couple of years, actually nine quarters, and we want to manage our business that way. But I don't think we know anything move about the economy and whether it's our end markets or geography than anybody else does. We just need to make sure we're running our business in a very effective way.

Ann Duignan - J.P. Morgan Securities, Inc.

Just you are setting a tone for the organization internally not to plan on a recovery and right size your businesses for today's level of activity?

T. M. Solso

Exactly. And in particular, there is a big emphasis on managing cash. And our inventories are not where they need to be, so that's going to be an area of emphasis for the rest of this year. And I think as Tom said, we expect to generate a couple of $100 million from inventory and we expect to be cash positive. And I think we've got our cost structure right for today and we're going to see some benefit because of the restructuring that we've done. If in fact we have an impact in other parts of the organization, we see more deterioration; we're prepared to take further action.

Tom Linebarger

And we are though, the tone setting that Tim talked about helps us organize our prioritization activities and that sort of thing. But we are at the lower level positioning ourselves to be able to capture early recovery kind of markets. If for example if we do see China coming back a little faster and India coming back a little faster, we're focused on those markets to make sure we're seeing if there is stimulus package stuff we can get or whatever and making sure we have resources ready to go in those areas. So we are keeping our mind on places that might recover more quickly and those places where there might be longer cycle recoveries or late cycle businesses, we're trying to be even more conservative about how we are planning capacity. So we're taking the tone Tim is setting and differentiating a little bit down when it gets down to what markets we might be able to benefit earlier and later. But I think the tone setting helps us not loose track of what we need to be prepared for.

T. M. Solso

This is my fifth recession in a leadership position. And the most common mistake we've made in the past is we've waited too long to react. And when we reacted, we were too optimistic about what we thought the demand was going to be. So we're trying to avoid that common mistake that we've made and other businesses have made and be as realistic as we possibly can and right size the organization.

Ann Duignan - J.P. Morgan Securities, Inc.

Yes, that's helpful, and I sympathize that you're on your fifth recession; it can't be easy. Just a quick follow up on the inventories. Could just describe what specific challenges you faced, because I mean I know your fifth downturn. I mean you have been though this before, pulling inventories out quickly is always a challenge. What lessons have you learned this time and is there anything unique about your supply chain that just causes the lag in the ability to get those inventories down?

Tom Linebarger

Let me comment; I don't have five recessions behind me yet, but I feel like I do because Tim reminds me frequently. But in inventory, we do have some challenges in our supply chain. It's a long one because we do have... we do go from Components all the way out to Distribution. So trying to make sure that we're keeping track of what the end markets are all the way back to our Components group is challenging from an inventory point of view. And as you would guess, as the market has fallen, particularly some of the late cycle markets and therefore, we've seen some cancellations, we see inventories run up just in some areas just as we make improvements in bringing the inventory down in other parts of the company.

So I think our biggest challenge in the short run has been as sales have fallen so rapidly and we have been unable to get the order rates and inventory ramp down as fast as the sales have fallen. We will get that managed and we've done a lot of work in the last three or four months to figure out where we're on that. But that's why we're disappointed a little bit with where we're in inventory today is the sales drop has happened quickly enough that we haven't got our inventory back to where we want.

And that's another reason why we've put this cross business effort in so we could find out where all the pockets were and make sure we were cleaning all the order boards and knew where we stood and then could start working inventory down from there.

Patrick Ward

The one thing I would add and if you go back and look at our inventory levels at the end of the third quarter, we were just under $2 billion. And today at the end of the first quarter, we're somewhere around 1.75. So luck (ph) has been going on and some of that reduction is due to currency movements. But inventory has been coming out primarily in the early cycle businesses in Components and the Engine business. What we expect to see going forward is more improvement in those businesses but also in the later cycle, high horsepower engine, Power Generation and Distribution businesses to see improvement there. But you're absolutely right, there's more work we have to do to get inventory where it needs to be.

Ann Duignan - J.P. Morgan Securities, Inc.

Okay. So my takeaway is that it's a lot about your mix of businesses, the early cycle versus late. And I'll leave it at that just because I have taken enough time and I'll get back in queue. Thank you so much for the color.

Operator

And your next question will come from the line of Steve Volkmann with Jefferies & Company. Please proceed.

Stephen Volkmann - Jefferies & Company

Hi, good morning.

Tom Linebarger

Good morning, Steve.

Stephen Volkmann - Jefferies & Company

It sounds like if you're really focused on inventories that the second quarter could be sort of significantly weaker than the first. Are we willing to make any comments in that regard?

Patrick Ward

No, I'm not going to tell you what the second quarter is going to look like. I wouldn't expect it to be much different from the first quarter. As I said earlier, the second half of the year is when we expect to see more improvement in our margins and in our EBIT margins at the bottom line. We are anticipating I think from the remarks we've just said that Power Generation and some elements of the high-horsepower markets will come under more pressure in the second quarter than what we've seen in the first. But I'm going to avoid trying to give you too much guidance on exactly what the second quarter is going to look like.

Tom Linebarger

And you definitely don't want to read into our comments about inventory sales forecasts. What we're saying is we have... we're given you an annual look. And what we're really responding to in our inventory goals is trying to respond to the fact that we expect sales to be down now significantly year-over-year. And we want to get working capital levels commensurate with where our production and sales levels are. That's what we're really taking about as opposed to a quarter-to-quarter look.

Stephen Volkmann - Jefferies & Company

Okay, great, thanks Tom. And just to follow up on the cash flow, assuming you hit your inventory targets, what do we think about sort of net working capital? I assume you'll have to give a bunch of that back on payables and how should we think about net working capital?

Patrick Ward

Net working capital will come down. We will see a cash inflow this year. You are quite correct, payables will be an outflow, receivables will be an inflow and those two, I would expect, to somewhat offset. So most of the improvement that we expect to generate will come through the inventory work that we are doing.

Stephen Volkmann - Jefferies & Company

Okay. Great. And just a final color question I guess. A number of industrial companies have sort of made comments this quarter that business kind of fell off a cliff around year end and was extremely difficult thereafter, but really hasn't deteriorated much since then. Is there any color you can give us with respect to kind of how the monthly progression of the quarter went that might be worth calling out?

Tom Linebarger

Yes, I would say that we would even say business fell off a pretty deep cliff in the fourth quarter.

T. M. Solso

In the second week of October.

Tom Linebarger

Yes, just to give the date. So I wouldn't have said first... January was not that significant in terms of... it really started in the fourth quarter. But we do have this early cycle, late cycle situation where Power Generation business and the distribution, the whole goods sales of those components in our Distribution business did hold up longer. And frankly when we started the year, we expected it hold up a little longer than it did. And so what we saw, we saw that business deteriorate more quickly as we started going through this quarter than we had anticipated. So I think that's the major... if you want to think about what shifted during the quarter, everything got a little worse, definitely. You heard from Pat in terms of that. Everything in terms of outlook got a little worse looking across the year. And Power Gen, the Power Gen business fell off more quickly as a late cycle business than we had anticipated when we entered the year.

Stephen Volkmann - Jefferies & Company

Okay. Tom, roughly, what do you think of in terms of early cycle, late cycle mix for Cummins?

Tom Linebarger

Late cycle really is... I mean the Power Gen business, some of the high-horsepower engine businesses like mining and oil and gas fell a little bit later and then the distribution... part of the distribution businesses. But I don't really have a percentage of those. We can kind of... look for, you can later, but I don't have a number that I could give you off the top of my hand.

Stephen Volkmann - Jefferies & Company

Okay, great. Thanks guys.

Operator

And your next question will come from the line of Andrew Casey with Wachovia Securities. Please proceed.

Andrew Casey - Wachovia Securities

Good morning everybody.

Tom Linebarger

Good morning Andy.

Patrick Ward

Good morning.

Andrew Casey - Wachovia Securities

Question on the restructuring benefits. The $100 million that you're talking about projecting for 2010, and appreciating that you really don't want to recognize any sort of positive things that you may or may be not be seeing. But in the $100 million, if you do see some sort of recovery in the early cycle markets, mainly on the on-highway piece, do you expect to maintain that $100 million or would you give some of that back as variable costs go up?

Patrick Ward

My goal, Andy, would be maintain it all. So I don't anticipate giving any of that back.

Andrew Casey - Wachovia Securities

Okay. And then Pat, if you could comment, there was a lot of discussion on working capital and cash flow and all that, which I understand you're managing to that. Are you close in any of your covenants at all?

Patrick Ward

We have got bags of them, ample room with regards to all our covenants that we were obliged to comply with, plenty of them.

Andrew Casey - Wachovia Securities

Okay. Thanks a lot.

Patrick Ward

Thank you.

Operator

And your next question will come from the line of Jamie Cook with Credit Suisse. Please proceed.

Jamie Cook - Credit Suisse - North America

Good morning.

Tom Linebarger

Good morning Jamie.

Jamie Cook - Credit Suisse - North America

I guess my first question, just to follow up on Steve's question. Tom, a lot of companies, also, Tom, you gave good color on the quarter. But as you look to I guess after the quarter, as we look to April, did you guys see any signs of stabilization after Q1? And then my two other quick questions on the distributor side. I'm surprised that we're maintaining margins comparable to last year. So how you sort of think about that? And then Tim, you're thinking about a 5% margin or so at the trough. How is that relative to I guess your expectation? Is that a better job than you thought you would do? Is it about in line or are you disappointed with that?

Tom Linebarger

Okay. Let me start with one, make sure (ph). I appreciate you're saying you told me so about Power Gen by the way, Jamie.

Jamie Cook - Credit Suisse - North America

Every once in a while I get some.

Tom Linebarger

April... I write a monthly note to all of our employees talking about where we are and trying to help everyone in the company understand our situation and what's going well and what's not going well. And needless to say, there is not too much in the 'what's going well' column of late. But I get a lot of questions about that and I reviewed all the economic data and sales data that we're seeing. And my view is that April, it's really hard to say. There are a few things that make you, if you really want to be optimistic, you can look at them and stare close and say hey, things are stabilizing, it's fine. There is a few other things you can say which say they are not. And I kind of fall back to Tim's point: it's just really difficult to tell. And I think our goal is to say we think we have a reasonably... reasonable view for the year and for 2010. It's sensible and we're going to continue to do it and we're going to be ready to react to whether it stabilizes or it doesn't. I am sorry to be... I don't mean to dismiss the question. I just have... -- all the stuff I looked at says you could...

Jamie Cook - Credit Suisse - North America

We then conclude...

Tom Linebarger

Conclude either way, yes.

Jamie Cook - Credit Suisse - North America

Okay, that's fine.

Tom Linebarger

And then remind me, your second question was again...

Jamie Cook - Credit Suisse - North America

The second question, margin on the Distribution side?

Tom Linebarger

Yes, the DBU margins have done quite well. We're really pleased with it. And we were frankly a little positively surprised by it as well. Two or three things working in our favor. One is that we have been over the last several years expanding territories while at the same time reducing costs by aligning our businesses better in the Distribution, finding synergies, expanding our business in each of our regions, improving distribution. So we have some positive trends coming into the year about things that we're doing better in the Distribution business which are offsetting some negative things like falls in sales particularly and things like Power Gen and Engines.

The other issue is we have some mix benefits here as whole good sales go down and parts sales go down less, you have a margin mix benefit in the Distribution business. It's still... from a dollar margin point view, it's down, but a percentage, it's up. So those were a couple of things working in the Distribution business that are making the numbers a little better.

T. M. Solso

And the question about how I feel about the 5%, I'd just begin with I'm never satisfied. And I think...

Tom Linebarger

He is not, really.

T. M. Solso

I think we need to do better. If you look at our performance from a historical standpoint, first of all, the drop in sales is the steepest and the fastest I've ever seen. So we clearly didn't expect it to be as significant as it is. But if you look at any point in time in our history prior to this, we would be losing money and losing a lot of cash or using a lot of cash right now. So from a historical perspective, we've had a very, very solid quarter, and that's because we assumed the worst and we acted very quickly.

Going forward, I would hope that we can do better. But I wouldn't forecast that because I think we have to demonstrate what we can do quarter by quarter. Long term, I'm still very comfortable with our guidance on profits. And I do feel that we haven't sacrificed... the biggest concern I've had is to sacrifice on our products in introduction, and we've have continued to invest in that. We've gained market share and the products that we've got out on test right now are doing very well. So I still am very bullish on our future. But we need to do the very best we can. I think we had a solid quarter and I hope that we can do better in the next few quarters.

Jamie Cook - Credit Suisse - North America

Well if it helps, I'm pleased. Congratulations. Thank you.

T. M. Solso

Thank you, Jamie. I don't think I've ever heard you say that.

Operator

And your next question will come from the line of Eli Lustgarten with Longbow Securities. Please proceed.

Eli Lustgarten - Longbow Research

Good morning everyone.

Tom Linebarger

Hey Eli.

Eli Lustgarten - Longbow Research

Can we talk a little bit more about Power Generation as we go through the year with margins going down. And the odds are one, is Power Generation decline likely to continue through 2010, or are you expecting 2010 to be lower than 2009? And then do you have any sense for what you think truck margins may look like in Power Gen as you go through this downturn?

Tom Linebarger

Eli, first, with regard to 2010 versus 2009, I'd say we really just don't know. What we're saying now is that as Power Gen as a later cycle area is likely to have a longer negative as well. What we don't know is whether 2010 is going to be better than 2009 or worse. It's just too far out to say. And there is... you may remember from previous years, there is some significant variables in Power Generation that are very difficult to forecast. For example, energy crisis in one area or the other caused very large spikes in orders for us. Development in some of... earlier stage development in some of the economies like China and India could have significant positive impacts.

So it's really difficult to say. I am not dodging that. We're wondering ourselves. But right now what we're assuming is that 2010 is going to be another tough year for Power Generation in terms of volume. So that's kind of how we're thinking about it.

With regard to trough margins, I don't have a number to give you because of course it depends on the size of the trough. But our view is that we have significantly changed the structure of that business. You'll remember in the last downturn, we were loosing money in that business. We were having very difficult time making very much money even at the gross margin level. And what... we've significantly changed that. We can see now in quite a low quarter that they're still making good margins. And the way we've done that is we lowered the cost of all our products to be much more competitive. We diversified our businesses across a whole bunch of markets so we are not dependent on one or two markets. And we've improved our market share and market position so that we can maintain prices in markets across the world.

All those three things I think are sitting in our favor with regard to maintaining good margins as we go through the cycle. But I just don't have a number to give you to say this is the bottom. But suffice it to say that my expectation of the Power Generation business is they will maintain strong margins in their target range throughout the entire cycle. That's what I'm trying to get them to do.

Eli Lustgarten - Longbow Research

And have you seen any change in Power Generation business from the China stimulus program and the movement that's gone on there? We hear a lot of company's talking about and you have a big exposure to China.

Tom Linebarger

Yeah. There is...

Eli Lustgarten - Longbow Research

Have you seen any benefits yet or any flow through from those programs?

Tom Linebarger

What I would say is we have participated now in a number of bids and projects. So now we are seeing projects. What I can't tell you is there is any sales booked yet from significant projects related to stimulus. But there are definitely a number of projects being bid. I talked to Tony recently and he said we're at least in three significant bids, not all in China, but across the world and a couple in China that are... that could be real business for Cummins. So we'll see how those play out. But we are now seeing projects. Whether or not they'll result in significant business remains to be seen.

Eli Lustgarten - Longbow Research

One final question. I guess we've been through the last couple of years talking about the components sector and achieving I guess 7% operating profitability. Now the world is going to (ph) change dramatically and just to stay above breakeven is sort of a... probably quite a tribute to a lot of the changes there. But have you any thought process of how you look at Components over the next couple of years? Is it true you've got to wait for volume to come back or can we see some real improvement in profitability from sort of a breakeven, just a slightly breakeven level as just to 2010 markets develop, even if it's not huge volumes changes?

Patrick Ward

Eli, this is Pat. Yes, we expect Components profitability to improve as we go through this year without any significant volume recovery. I think you'll recall in the second and third quarter last year, these volumes were much stronger. Components were heavy and beating that 7% number you just quoted. Our target for Components is 9% and we're not backing off that. Clearly, we're not going to be anywhere near that just now. But you should expect to see their business improve as we go through the second half of this year.

Eli Lustgarten - Longbow Research

And with volume... if volume doesn't change a whole lot industry wide as you are sort of indicating in 2010, can that improvement continue in the component sector just on the basis of your change in mix of your new emissions engines?

Patrick Ward

That's my expectation.

Tom Linebarger

Yes, Eli, I would point you back to what we talked about at the Analyst Day back in November in Charleston and the number of initiatives that we have visibility to in terms of content increase for every engines sale that's going to benefit the Components segment and some of the commercial pricing discussions that we're having about 2010 product that we both believe are going to help improve the margin situations as we go into 2010.

Eli Lustgarten - Longbow Research

All right. Thank you.

Operator

And your next question will come from the line of Meredith Taylor with Barclays Capital. Please proceed.

Meredith Taylor - Barclays Capital

Hi, good morning. I am hoping you can help us think through mix a little bit, particularly in some of these later cycle businesses. Industrial engines, where it seems you're still looking for quite a dramatic falloff in mining as well as Power Gen. As we think about the adjustments to EBIT targets for both of those businesses, how should we think about the role that mix is playing there over the balance of the year and then perhaps ahead to 2010?

Tom Linebarger

On the Power Gen side, I've talked about mix before and it's not a significant determinant of margin. At one time as I was talking with Eli, back in 2003, we were very reliant on a few business units or business segments, I'd say, markets to generate most of our profit. And when those went down, we went down under zero. But in today's Power Gen business, we have strong profitability across each of the segment. So I don't expect a significant deterioration in margin based on mix in any of the segments that you mentioned. There are definitely volume impacts from those segments, but I don't expect a margin deterioration.

With regard to the Engine business, there are, I would say, the same thing generally speaking, although there clearly are mix differences by end market and customer. Overall speaking, though, the bug impact on Engine business margins today is volume. I mean there are mix impacts that are hurting us today, but the biggest impact is volume. Pat, would you add anything with regard to what you commented on?

Patrick Ward

No, I think you summarized it perfectly. I don't think mix is something that we see improving or deteriorating our margins as we look forward; it's all (ph) volume storages now.

Meredith Taylor - Barclays Capital

Okay, that's helpful, thanks. And then in terms of heavy-duty engines, I mean it doesn't really seem like you're your looking for much in the way of improvement over the balance of the year in terms of some pre buy activity, could you talk about what your expectations are though for business from Navistar as they are seeking to fill some of their 2010, 15 liter engine requirements from you in the back half of the year of what's been built into your model?

Tom Linebarger

Well I won't comment on specific orders from customers, but I will say this that as you know, the heavy-duty market... our view of the market has fallen significantly since late last year even from very low level to a extra very low level. But we will still have customers trying to plan for the transition to 2010 and each of them has a number of truck models and a number and a number of challenges regard to how they plan to engineer those engines into their new models. And each has a different plan and it's frankly a plan by truck model. And so we're supporting our... each of customers in that way and they have been modifying those plans over the course of the year as their own volume drops and that continues. So, it's actually quite a volatile those situation in how they decide plan for, but they all have plans and we're responding to all those plans to make sure that they are... they can run their transitions through 2010 and that includes Navistar, we're talking actively with them about how they plan their transition. But as of now, I think it's... I wouldn't want to comment specific levels for them.

T. M. Solso

I would see that we're also not planning on any pre-buy whatsoever. There is no indication now that there will be, if there is some pre-buy later on in the year, then we will benefit greatly from that. But again, we're going to take the most conservative point of view we can in terms of how we're doing our cost structure in the business today.

Meredith Taylor - Barclays Capital

Okay, that's helpful. Thanks. Great execution in a tough environment.

Operator

And your next question will come from the line of Kristine Kubacki with Avondale Partners. Please proceed.

Kristine Kubacki - Avondale Partners

Good morning.

Tom Linebarger

Good morning, Kristine.

Kristine Kubacki - Avondale Partners

Just a follow-up question on the on highway business. Can you give us some color perhaps with those plans on what the inventories are looking like at the... with the engines at the truck OEMs and if that's going to forestall your business further?

Tom Linebarger

Unfortunately, that's a difficult one to comment on too. I think it's much better to ask them about their inventory levels than us for obvious reason. But, what I would say is that throughout the industry, there's no question at sales have fallen off quickly. And everyone is trying to figure out how to deal with previous... their production levels have comedown, there's more inventory throughout the chain and everyone is adjusting their production levels down. You've seen announcements of our people in terms of production levels and that's all of them adjusting to lower demand and inventory levels throughout their supply chain so that is definitely a big issue in the industry and that's another reason why as Tim said we just have demands really conservatively because everyone is dealing with that and we're back in the channel of waves in terms of how we respond.

But we're actively talking with every OEM about their order rates, why they are ordering those? What they are doing with inventory? What they do on transition?

We talk everyday with them to make sure we understand what they need and why? So I think for current, but it's definitely an issue throughout the supply chain, not just engines on overhang.

T. M. Solso

But generally speaking, I would say that the truck OEMs have been more responsible in this recession than perhaps in historical times, particularly in a year prior to when emissions change. And I think they have in the past sometimes built inventory in anticipation and they haven't done at this time. So I don't think that there is as much inventory in this recession as we've seen in previous ones.

Kristine Kubacki - Avondale Partners

Okay, that's helpful. And then my last question would be with the automotive group making news even this morning of potential bankruptcy. Are there are any issues within the supply chain that you do or you are already working on or are there are any issues that we should think about as that progresses?

T. M. Solso

I am surprised it took almost a full hour before we got that question. We've been working with Chrysler for sometime. I've had personal conversations with Bob Nardelli exactly where we are. The pickup truck business is a very important one to us. Chrysler is an important customer. We'll continue to work with them. I don't think that Chapter 11 restructuring is necessary a bad thing and we've dealt with customers in this kind of situation before. And we have done several things to protect our business and mitigate the risk. And Tom got into it this morning to make sure we would have the most up to date details. So I am going to turn it over to Tom and let him give you some specific facts.

Tom Linebarger

So I'll talk first about our relationship with Chrysler and then I'll talk about the supply chain, which I think was maybe your specific question. But with Chrysler, we've been now preparing for this potential eventuality for a long time and that's really on the customer and supplier side. And we have done work to protect our exposure with Chrysler. We've so we participated in this U.S. Treasury supplier support program which allowed us to insure our receivables after March 19th. So we've got our receivable... it cost us a 3% discount, but we were able to get all of our receivables after March 19th into that program, which leaves us with less than $8 million in receivables prior to the March 19th program, which we are happy that we're able to do that.

In addition, on the supply side, there are a number of suppliers that supply us that also supply the auto industry. And we've for last six months had a special program where we evaluate all suppliers for financial stability. We've always done that on annual basis but know we're doing it on a monthly basis where we look to financial stability. And those that are falling to a set of criteria which most of the automotive suppliers do, then we do extra work on those and we have a report that we put out each week on status. And so we have a bunch of those we are working with to make sure that we have continuity of supply. And if for some reason we don't think we'll be able to... that we have made other arrangements to get continued supply with another supplier or some other arrangement with that supplier. So we've been actively working that for months.

So I don't really see anything new happening as a result of things today with those suppliers because the ones that have been potentially exposed we have been tracking now for several months. I'm worried about it. I think supply base is a big concern out of a general downturn. But I don't think Chrysler going into bankruptcy actually changes very much of that. I think it's mostly a result of the fact that volumes are just so much lower in the automotive that's caused the problem. So we're very close to it. It's a big issue for the company and we're taking action all the time on the supply base.

Kristine Kubacki - Avondale Partners

Appreciate the color. Thank you very much.

Dean Cantrell

Okay, I think that's all the time that we have for questions today. Appreciate everyone tuning into our Q1 earnings call and then I will be available throughout the day for questions. Thank you.

Operator

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

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Source: Cummins Q1 2009 Earnings Call Transcript
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