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Executives

Dean Cantrell – Director of Investor Relations

Tim Solso – Chairman and Chief Executive Officer

Tom Linebarger – President and Chief Operating Officer

Pat Ward – Chief Financial Officer

Analysts

Meredith Taylor - Barclays Capital

[David Russell] – I.S.I. Group

Jerry Revich - Goldman Sachs

Henry Kirn - UBS

Eli Lustgarten - Longbow Research

Andrew Casey - Wells Fargo Securities LLC

Chase Becker for Jamie Baker - Credit Suisse

Joel Tiss - Buckingham Research Group

Cummins Inc. (CMI) Q3 2009 Earnings Call October 30, 2009 10:00 AM ET

Operator

Good day ladies and gentlemen, and welcome to the third quarter 2009 Cummins Incorporated earnings conference call. My name is [Jasmine] and I’ll be your operator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today’s call, Mr. Dean Cantrell, Director of Investor Relations. You may proceed.

Dean Cantrell

Thank you Jasmine. Welcome everyone to our teleconference today to discuss Cummins’ results for the third 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 3 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.

With those formalities out of the way I’d like Tom to open with a few remarks.

Tom Linebarger

Good morning. I would like to start today by sharing some thoughts about our performance during the third quarter and then spend a few moments talking about our expectations for the first half of 2010.

Given the economic challenges we continue to face in most of our markets, the company performed extremely well in the third quarter. As you know we began taking decisive actions late in 2008 to lower spending and to adjust our manufacturing capacity to meet lower demand for our products. Those efforts have resulted in improved profitability and cash generation, despite continued weak demand in many of our end markets. Sales rose only 4% from a very low base in the second quarter, but profitability improved significantly.

Earnings before interest and tax, excluding restructuring and other charges, was 7% of sales. That compares to 4.8% of sales in the previous quarter and 3.9% of sales in the first quarter. Our cash position improved by $152 million in the quarter as a result of significantly improved working capital. Most of our end markets and channels have completed their inventory burn off and in some cases we have started to restock.

The engine and components businesses returned to profitability in the third quarter, led by increased demand in advance of the 2010 emissions changes in the U.S., recovery in China, India and Brazil and our focus on reducing costs throughout the year. Our distribution business continues to perform very well, improving segment EBIT from the second quarter despite a softening of sales.

As expected, our power generation sales declined as retail channels in the market continued to burn off inventory. Sales fell by $61 million from the second quarter and segment EBIT declined to 4.2% of sales in the quarter.

In broad terms, the global economic situation has developed over the past few months much as we expected. Economic conditions remain very weak around much of the world, with some notable bright spots in key emerging markets. For example, the China and India markets have rebounded relatively quickly and have resumed our growth, mostly for domestic demand. The Brazil economy has begun a modest recovery and is expected to return to stronger growth in 2010.

Cummins sales are reflected of the economic trends around the world. Given our strong positions in India, China and Brazil we are seeing increased demand in these markets as they start to recover. As importantly, our sales have stabilized in places such as the U.S. and Europe. Although demand remains at very low levels, it has stopped falling, which has allowed us to plan better and operate more efficiently.

Additionally, our share in key markets continues to grow as a result of our industry leading technology and strong partnerships. One example is the North American truck market where we have continued to meet challenging emissions regulations with products that use less fuel and provide drivers with excellent performance. In addition, we continue to strengthen our important partnership with PACCAR, an excellent company. PACCAR has a long history of leadership in the truck market, and our strong relationship with them has helped Cummins gain market share that has also improved PACCAR’s product offering and support network.

Based on our improving sales and profit performance, we are adjusting our financial guidance for 2009 upward from what we shared last quarter. We now expect sales to be down slightly less than 30% from last year and EBIT to be approximately 6% of sales excluding restructuring and other charges.

Despite the improvements we have seen in some of our markets, we still face considerable challenges over the next year. In particular we expect the first half of 2010 to be extremely difficult, especially in North America where the U.S. On Highway markets will be very weak as an emission cycle takes place in conjunction with the prolonged economic downturn.

Much of the recent growth and demand for engines and components in the U.S. is a result of OEM orders being placed in advance of the new EPA standards, as is typical in an emissions change year. We’re still working through our planning process for the next year and will provide more comprehensive guidance on our Q4 earnings call. But I can provide a few early thoughts on 2010. As we have said, we can expect continued weakness in the U.S. and European economies, but China, India and Brazil will be stronger. As a result of the weak economic situation we expect our revenues to be relatively flat next year in most markets with two exceptions. Domestic sales in China, India and Brazil will grow. Second, our shipments to North American On Highway markets will be lower next year due to the emissions standard change and the transition from old model trucks and engines to new model trucks and engines.

What is more, first half shipments to the truck market will be significantly lower than those in the second half. We are currently projecting North American truck and bus shipments to drop 75% in the second half of 2009 to the first half of 2010. We do expect North America end user demand for trucks to start recovering late in 2010, with freight demand and the release of OEM vehicles.

With regard to late cycle markets, while we are not expecting significant recovery for the next several quarters in power generation and marine markets, we are seeing positive trends in both mining and oil and gas markets.

One last comment about power generation. We expect flat revenue in total for the year, but by geography we expect North America and Europe to be down and emerging markets to be up.

We will continue to manage the business very conservatively in the coming quarters and do the things that have allowed us to be successful during the worst of the recessions. As a reminder, our current priorities include maintaining a realistic estimate of demand and then aligning our cost structure and manufacturing capacity with that demand; generating positive cash flow throughout the downturn; continuing to invest in the new products, business process and technology projects that are critical to our business in both the short and long run; and lastly demonstrating that we care about our customers more than anyone else, especially now when they need us most.

The decisive actions we have taken in line with these priorities have allowed us to remain profitable and to generate significant cash during the worst recession in decades. We still have a lot of work ahead of us in 2010, but we have the people and the plans in place to position Cummins for significant profitable growth once we emerge from the recession. We are very excited about the company’s prospects for once the recovery begins in earnest, and Tim will share some of his vision for our future in a few moments.

First though I’ll turn it over to Pat to provide more details about the third quarter.

Pat Ward

Thank you Tom and good morning everyone. As Tom said we continue to face a challenging environment in all end markets as evidenced by the year-over-year decline of 31% in our revenues, though we are seeing signs of improvements in the emerging markets, as well as the On Highway market in North America, which is reflected in the 4% increase in consolidated revenues over the second quarter of 2009.

Our EBIT margins dropped from 10.3% last year to 7% of sales for the quarter, excluding restructuring and other charges, with the severe drop in revenue being the key driver in this decrease. Compared with the second quarter of 2009, sales were 4% higher but EBIT excluding restructuring and other charges increased 53% to $177 million. This was our fourth consecutive quarter of margin improvement.

Sequentially gross margins improved from 18.4% in the second quarter to 19.9% in the third quarter as a result of higher volumes in our engine and component segments, the benefit of cost reduction actions and lower material costs. We remain very focused on managing selling, admin and research and development expenditures as evidenced by the $107 million reduction compared to a year ago. Compared to the second quarter, we did see an increase in the third quarter in part due to higher research and development costs and the impact of currency movements.

Earnings per share, excluding restructuring and other charges, were $0.56 in the quarter. We have lowered our projected full year tax rate from 30% to 27%, which contributed $0.04 to EPS in the third quarter. We also recorded $22 million from restructuring and other charges in the quarter, which include severance costs associated with actions taken in our power generation and component segments as well as a fulfillment charge related to the cumulative effect of the actions taken to date.

Here are some details of the performance and full year expectations for each of our four segments. For the Engine segment, year-over-year revenues were sharply down but we did see sequential improvement in demand driven by a combination of strengthening market share and an uptick in vehicle production in North America, a stabilization of the Mexican truck market following a pre-buy in early 2008, and signs of stabilization in the construction market at least in China and Brazil. The sequential improvement in EBIT to 4.2% of sales this quarter was a solid performance for the Engine segment and was driven by higher volumes, price realization, favorable material costs and lower managed expenses, much like we expected and discussed during our last quarter call. For the full year we now expect revenues for the segment to drop 30% and EBIT margins to finish between 2.5% and 3% of sales.

In the Component segment, revenues were down 26% from a year ago but up 18% sequentially, driven by the truck market demand in North America and in Asia. Segment EBIT of 5.2% of sales was down from a year ago, affected by the steep volume decline but was a significant improvement from the loss in the second quarter. As we anticipated, this segment benefited from higher volumes and cost reduction actions. For the full year we now expect Components revenues to drop 30% year-over-year and EBIT to finish between 2% and 3% of sales.

The Power Generation segment continued to be affected by the global slowdown in non-residential construction, the lack of financing for power plants and corrections in channel inventory. Sales declined 38% from a year ago and 10% from the second quarter. This further reduction in volumes and in unfavorable revenue mix were the main reasons for the drop in EBIT margins to 4.2% of sales this quarter. Revenues dropped sequentially in Europe, the Middle East and Africa as well as in North America and the South Pacific region, but were slightly up in the BRIC countries of Brazil, Russia, India and China.

The Consumer segment recorded a small uptick for the second consecutive quarter, albeit from a relatively low base. Although we do not expect a significant recovery in Power Generation demand for the next several quarters, we do believe the third quarter was likely the low point for the segment as most of the inventory corrections in the channel are complete. Full year guidance for Power Generation revenues remains unchanged, from 30% to 35% compared to the prior year. However, EBIT was adjusted down to 7% of sales, which is at the lower end of the range of our previous guidance.

Revenues for the Distribution segment were down 27% from a year ago and down 9% versus the second quarter. The sequential drop in revenues was mainly driven by further market softness and the late cycle markets of industrial engines and power generation, particularly in South Pacific, Europe and the Middle East. Profitability improved both from prior year and prior quarter to 13% of sales, driven by a strong mix of mark-to-market revenues, better joint venture performance and favorable currency movements, more than offsetting the impact from lower sales volumes. For the full year we are maintaining our previous revenue guidance of down 15% to 20% for this segment, but are raising EBIT margin expectations to between 12.5% and 13% of sales in 2009.

And the lost topic I would like to talk about is cash flow management performance. We generated more than $400 million in cash from operating activities in the quarter, and more than $700 million year-to-date. Our inventory reductions contributed $7 to $8 million to cash flow this quarter, in line with our projection of $50 to $100 million benefit for the second half of the year as we discussed in our last call. Most of the reduction was from the Power Generation and Distribution segments.

Although we still have improvement opportunities, we believe most of the excess inventory has now been worked out of the system. At the end of September we had a cash balance of just under $700 million, up from $426 million at the start of the year and our debt to capital ratio is now 15.2%.

We are expecting higher revenues in the fourth quarter which may require more working capital, but we remain on track to meet our objective of generating positive net cash flow for the company in 2009. We will continue to take a conservative approach in managing our balance sheet and use of cash. As Tom just said, we are planning for a very difficult environment for the company in the first half of next year and we want to make sure we have the resources to grow the business once the demand in our market starts to improve again.

That being said, we are lifting the temporary suspension of our stock repurchase program that we have had in place during this year, but will use judgment to determine when we will reenter the market.

Before we take your questions, Tim would now like to say a few words.

Tim Solso

Thanks Pat. I would like to start by underscoring two of Tom’s main points. First, I am extremely proud of our performance in the third quarter and throughout all of 2009. In many ways we have performed better during the recession than during the days of our record profits.

That can be seen in our steadily improved profitability and cash management throughout the year under difficult circumstances.

Second, I also want to make it clear that we have not worked our way through the current economic downturn. As Tom pointed out, we expect next year, especially the first six months, to be even more challenging than this year. Having said that, however, I am very excited about the long range prospects for the company for many reasons. As you know we entered the recession in the best financial position in the company’s history as a result of five years of very strong performance.

As you may recall, our priorities during that period were to reduce debt, reward our shareholders and invest in the business. Our performance over that time, during which we generated more than $4 billion cash from operations, allowed us to do all of those things. By the end of last year we had reduced our debt to less than 20% of total capital. We raised our dividend three times for a total increase of 133% from 2006 to 2008, and split our stock twice during that period. We also bought back more than $600 million of our stock from 2005 through 2008. Even with the significant stock market correction late in 2008, our average annual return to shareholders from 2003 to 2008 was 23%, well above our peer group. And we also came into the recession with access to more than $1 billion in credit at good interest rates.

Our strong balance sheet, along with our swift actions in the early months of the recession, has helped us perform well during the worst recession in decades. Not only have we earned a solid profit throughout the year which has increased each quarter, we have continued to invest in our business.

We’re in the final stages of work on our 2010 product launches and I am confident they will play an important role as we work to leverage our technical advantage in the future. In fact, we are in the midst of the largest new product introduction in our history. We are introducing four new engine platforms, ranging in size from 2.8 to 13 liters, two of which began production in China this year. For our North America On Highway markets next year, we are introducing a new 11.9 liter engine along with key component products such as the XPI Fuel System, Variable Geometry Turbo Chargers and Exhaust After Treatment Systems. We have tested our 2010 heavy duty truck engines with approximately 50 customers and we’ve run the engines in all weather conditions and across all duty cycles.

By the time we go into production in January, 2010, our new heavy duty and mid range engines will have logged approximately 5 million miles. Our fuel tests have exceeded the company’s expectations and customers are telling us how much they like the improved fuel economy and performance on the new engine. Our testing has also confirmed that our heavy duty truck engine customers can expect up to 5% improvement over Cummins current industry leading fuel economy, while mid range engine customers can expect to see up to 3% improvement. Our technological leadership is just one of a number of long range trends working in favor, as we look beyond the current economic cycle.

In addition to the new emission requirements in the U.S. beginning next year, major Cummins markets around the world will be moving to at least Euro IV and Tier 4 emission standards by 2014 for both On and Off Highway applications. As emission requirements get more stringent, it creates a significant barrier to entry for the competition and our integrated OEM customers that have lower engine volumes. Therefore it also creates a considerable opportunity for Cummins in both Engine and Components businesses. Not only does Cummins stand to increase its Engine market share around the world, but we expect other engine manufacturers to increasingly turn to our Components group for critical technologies to help their engines meet emission regulations. As a result, we are very well positioned to sell more engines worldwide and to create more Cummins owned content per engine sold, whether they’re ours or a competitors or those of the integrated OEM customers.

As we look across our businesses, we see significant opportunities in a number of other areas as well. Here are just a few examples. 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. In many of these areas, a lack of investment in central utilities has made the electricity grid unreliable or inaccessible and we expect this to remain an issue for years to come. At the same time, we have seen that central utilities in these emerging markets have difficulty keeping up with the demand during strong economic times. This will create additional opportunities for Cummins during the recovery in both distributed generation and stand-by power.

Increased infrastructure spending as a result of government stimulus efforts around the world, especially in large markets such as China, India and Brazil, should increase demand for our products in both short and long term. Our positions in large growing markets, such as China, India and Brazil, will serve us well as they return to significant GDP growth in coming years. Nearly 45% of our engines are produced in the emerging markets, with China and India our second and third largest engine markets respectively.

We have never been in a better position to take full advantage of the tremendous long term opportunities in front of us. We will focus on performance and execution during the remainder of this recession, especially in the first half of 2010. We will manage our costs, matching capacity to real demand, generate positive cash flow and invest in and introduce new products reliably.

We are now happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Meredith Taylor - Barclays Capital.

Meredith Taylor - Barclays Capital

How are you thinking about production planning heading into the fourth quarter? You know given your expectations for the soft first half of 2010, how are you thinking about ramping up capacity utilization in the fourth quarter to meet the demand for transitional stock of engines since your guidance suggests that 24% top line sequential growth. And then specifically I mean can you talk about how much you have to add back to the cost structure to do so and how we should think about what the implications would be for the first half of 2010?

Tom Linebarger

It’s an excellent question. Obviously we’ve been doing a lot of planning on exactly that plan. Because of the fact that we’ve had some time to think about how this is going to go, given the expected demand increase at the end of this year, we’ve been thinking about it all year. And we are managing that process in my opinion extremely well. The Engine business and Components businesses have both managed to add cost as flexibly as possible. So we have what we call rings to defend in each of our plants that allow us to add people back, add overtime, bring in temporary workers, have down days and on days which give us the ability to be up at very high levels of production in Q3 and Q4 and then down at varied levels of production in Q1 and Q2, with very little fixed cost addition.

There’s no question that it’s difficult to manage and we’re trying to figure out how to minimize the fixed cost addition. But I think we’re doing an excellent job and I think we will not add fixed cost structure in any significant degree in Q3 and Q4. A little bit here and there, but not a significant amount anywhere.

What we’re also trying to do though is make sure that our overhead levels, which is what Tim and I were talking about, making sure our overhead levels stay low even as we have more and more investments to make in new products and growth areas. We need to keep our overhead costs down so that as we carry through the first half of next year, our financial performance remains good.

Meredith Taylor - Barclays Capital

And then you know you certainly noted the first half headwinds in On Highway truck and bus and can you calibrate a little more specifically how you’re thinking about the second half of the year?

Tom Linebarger

Yes. Our view is that just by the nature of the transition, there’ll be improvements in the second half of the year. So even without significant improvements in freight, etc., there’ll be improvements because the OEMs will be launching new truck models. And as they launch them there’s just a transition period. So as they get launched, they get their engines in, there’ll be more new product in the market and of course as customers become more comfortable with the new trucks and new engines, that just drives increased demand.

We also hope that there’s some improvement in freight and other drivers of demand. But as we said in our remarks we’re really not planning for that. We hope there is but we’re planning pretty conservatively that not much economic improvement in the U.S. in 2010. And so most of the increase in demand will just come from the transition that happens in every emissions hurdle year.

Meredith Taylor - Barclays Capital

I guess I was just trying to get to more specific range in terms of how you’re looking at second half of the year versus first half of the year, since you were pretty specific around how much you think first half could be down.

Tom Linebarger

Right. And we will definitely provide that in our Q4 earnings call. So you can anticipate we’ll be able to give you much better view then of quarter by quarter performance, and I’m sorry we don’t have more details yet. But this is kind of our planning period. We’re going through all the markets and all the territories to make sure we have a good handle on numbers, both production and sales. So again by the Q4 earnings call we’ll have good detail for you on that.

Operator

Your next question comes from [David Russell] – I.S.I. Group.

[David Russell] – I.S.I. Group

Regarding the announcement from the courts recently or the EPA about Navistar and the EPA may reconsider their ’09 guidance for the industry for the ‘010 emissions, you know basically an order of stay for the proceedings for about 60 days, can you take us through your thoughts on that and what the implications could be?

Tom Linebarger

Yes, David, as you guessed it’s not our case. We’re not experts in what’s intended by the parties but I can tell you what our take on it is. Essentially what Navistar’s seeking is a delay in the 2010 regulations and to quote our general counsel “they’re grasping at straws.” So they’re looking for ways to slow it down and us and the rest of the industry’s ready to go. And so they put a suit in as a way to do it. The EPA has us holding all the cards here. For one, the guidance document they’re talking about is not a regulation, it’s just a guidance document. So it has no effect, no legal effect one way or the other whether the guidance document’s in place or not in place or whatever.

The way I interpret the stay is just that the EPA just wants more time to form its case. Its in the middle of doing all its work to get ready for 2010 among other things and so they’re just taking more time to finish the case. But it’s our view that the case has no merits and will not succeed in any way and that by the time the case is even heard, we’ll already be making engines and customers will be selling trucks.

Tim Solso

Let me add to that is that we’ve submitted all certification for all of our engines for 2010 and are waiting momentarily for those to be approved by both EPA and subsequently the CARB in California. And I would just again that you can look at the complications of the legal case, but the bottom line is it will have zero impact on Cummins.

[David Russell] – I.S.I. Group

The idea that truckers having something else to think about for buying trucks next year, obviously the issue Navistar feels how the truck maybe is handled when they’re non-compliant and with the urea tanks empty, how quickly a truck de-rates or however the EPA might want to address tightening those regulations. Your take, net net, no impact on how you’re going to approach ‘010 at this stage? And you don’t think the trucker has an incremental worry of what could change around its SCR trucks for ‘010?

Tom Linebarger

Right.

[David Russell] – I.S.I. Group

Then real quick on the second half ’09, first half ‘010 truck engine volumes, you said down 75% if I remember that correctly. Obviously that’s just taking the implied fourth quarter engine revenue for heavy truck and then doing the math, I mean you’re basically saying like $138 million revenue each of the first two quarters in heavy truck which is obviously the lowest you’ve ever printed since the day it’s been coming out. What kind of market share are you assuming for yourself in not just the first half but even thinking through ‘010? And what kind of industry builds are you assuming in your base case?

Tom Linebarger

Well let me first talk about market share. As you guessed, the transition period’s going to be a difficult time to think about market share because there each of the truck manufacturers will be dealing with this transition period, whether they have engines they had before and engines they’re making in the new market. But our view is that Cummins market share will remain strong during 2010. We expect as international does not offer our engines over the course of 2010 that our market share will drop some, but our view is that you know it won’t drop very much because our feeling is that our customers will strengthen their truck market positions.

So when we do the Q4 earnings call we’ll be able to give you a much better detailed view of how that market share will transition over the year. But our view is our market share will stay very, very strong during 2010. And I think you know this because you’ve been following us for a while, David, but from our point of view we feel great about our truck market share but we built the truck market business on assuming we could be at market share levels way down near 20% if we needed to and still be profitable. And really what we’re measuring the performance of our truck business on is what’s our profitability and what’s the quality and capability of our engines and how they serve customers. And we feel very good about that in 2010 and onward.

But as you say the drop that we’re going to see in Q1 and Q2 is really putting us to the test. To the earlier question we got about how to flexibly cycle down in capacity and then ramp back up and obviously coming off a very high production level in Q4, so that’s the challenge we’re all talking about and it’s definitely the challenge we’re up to.

Operator

Your next question comes from Jerry Revich - Goldman Sachs.

Jerry Revich - Goldman Sachs

Tim, can you elaborate on the opportunities you see for your Components business on Tier 4 interim? Perhaps discuss some of the engine platforms where you’ve already reached supply agreements?

Tom Linebarger

Let me step in for Tim. The Off Highway Tier 4 side again presents significant opportunities for our Components business. Because Tier 4 is what’s driving now the Off Highway markets that have to do after treatment much more sophisticated air handling, both of which play to our strengths from a components point of view. So we not only have a components business that goes with Cummins engines but we also have components business with outside customers, partners of Cummins, on Off Highway engines in Tier 4.

There’s no question that if you look at kind of the order of things, we’ve been working most aggressively in the Components business on meeting On Highway 2010 customers first. But now our focus will quickly switch to figuring out how to meet Tier 4 needs as we finish launching 2010.

Tim Solso

I would just add or back up where you’ve head me talk about it before is that if you take the four Components businesses that we have and each of their sub-systems, when we integrate it with the Engine we tend to get an advantage as far as cleaner air as well as better fuel economy. And so we are now operating after probably four years where our components companies are working very close together with the same customer. So we’re offering that advantage and whether it’s Tier 4 or other emission requirements, those opportunities seem to be expanding, even in developing markets.

I think the one company in our Components business that particularly has some opportunity is the emissions solutions business because all of these engines that meet requirements in the future are going to need exhaust after treatment devices. And they’re one of the best in the markets today.

Dean Cantrell

And Jerry, this is Dean, obviously we’re very excited about the opportunity that Tier 4 will present for the Component segment but it’s a little premature to start announcing which contracts we have. We obviously don’t want to get ahead of our customers. So I think you can anticipate that at the upcoming trade shows that you’ll see in the spring, you’ll see a lot more announcements from a number of the OEMs about what their line up is for Tier 4. And obviously we’ll be there to point out where our components are on their engines or our engines and their equipment.

Jerry Revich - Goldman Sachs

And Tom I’m wondering if you could give us an update on the timing of the Photon Cummins Production Plant. It looks like you incurred some start up costs this quarter. I’m wondering if you could step us through the timing of the ramp there.

Tom Linebarger

Yes. We did hit our launch dates on the 3.8 and the 2.8 is also launching the first rating this quarter and the second rating will be next year. So we’re okay on the launch times but you’re right about the volumes. The volume ramp up is slower. What that reflects mostly is that in China the transition to Euro III and Euro IV emissions levels has gone slower than the market anticipated and what we anticipated when we put the joint venture together. But the engine’s working great. It’s on its cost target, it’s on its performance target. We’re engineering into the Photon vehicles and we’re also exploring with customers outside China to use the engine. So we feel great about where the engine is and the position. We feel disappointed with the ramp up in China as a result of the delay in the application of the emissions standards, but that will right itself. It just is going to take a longer time than we thought.

Jerry Revich - Goldman Sachs

Lastly Tom can you talk about the drivers or your expectations on improved power gen margins in the fourth quarter versus third quarter on pretty similar sales volumes?

Tom Linebarger

Yes. Again as I mentioned, as the market has cycled down we’ve had to clear out the inventory in the channel and we’ve had uncertain new levels of demand. So we haven’t had our cost structure matched to the actual demand. And as you know power gen fell later. So a number of our cost reduction actions were done in the power generation in second and third quarters. As a matter of fact Pat talked about the restructuring charge in third quarter, a big chunk of that was related to power gen cost reduction. So they’re just later to the cycle in terms of taking the cost out related to lower manufacturing levels. They’ve now stabilized. Demand has stabilized. Inventory’s cleared out. And so what we have is just a much more stable environment for them to work from and a lower cost base now that we’ve taken the actions. So it’s the same kind of things we saw in the other businesses, it’s just two quarters later.

Pat Ward

And just add some more technical to that, power gen did reduce their salaried workforce by 10% in the third quarter. So as Tom said the way to cycle business, engines and components are after us in the first half of the year and power gen after it [inaudible]. So I think that gives us confidence of the Q4 recovery in margins.

Operator

Your next question comes from Henry Kirn – UBS.

Henry Kirn - UBS

Wondering if you could chat a little bit about how currency may have impacted this quarter’s earnings. And then going forward what’s baked into your guidance?

Pat Ward

Let me take the first part of that. In the third quarter compared to the second quarter with the dollar weakening, it certainly helped our sales by about just under 2%. So of that 4% growth you see in quarter over quarter, a little less than half of that was sales. On the bottom line it imparted about $50 million. Those are fairly significant one other factor in that $50 million which is a fairly large number. If you recall back in Q2, we did report some negative losses on re-measurement and unrealized from [inaudible] actions. And that was about $9 million back in Q2. We had zero in Q3. So the real operating performance of the FX movement in the third quarter was much closer to $6 million net benefit on the bottom line than the $50 I just gave you. But it was somewhat helpful to pretty much all of the businesses, and particularly Engine business and the Distribution business, third quarter versus second quarter.

I think we’d expect to see for the fourth quarter some continued benefit there, given the way the currencies are moving. It should not be as significant on the bottom line, fourth quarter versus third quarter though.

Henry Kirn – UBS

And within the power gen segment, could you talk a little bit about the global competitive dynamics there and how pricing is holding up, maybe region by region or product type by product type? Whichever is more appropriate.

Tom Linebarger

I can talk a little bit about that. Clearly in the developed markets, in Europe and the U.S., sales have fallen significantly and as I said in my earlier remarks I expect sales to be down in 2010 in those regions versus 2009. On the other hand in the developing markets, China and India specifically, things dropped but they have already started back up and we expect them to recover and be stronger in 2010 versus 2009. So competitive dynamics are as you’ve guessed different by market.

The thing that I’ve noticed about this downturn versus the previous power generation downturn though is the major competitors in the market are behaving more sensibly with regard to price. It doesn’t mean that there aren’t individual dealers who are discounting if they have inventory or something like that. But there was significant negative impacts on price in the last downturn, not so much of that now. The trend in prices reasonably good. Again as I say there are spots where prices are more competitive, but we did not lower price this year across the board and we are not expecting to and we’re not expecting to next year either. And there’s some here and there, but not a major trend downward. And that’s a big improvement over the last downturn.

Pat Ward

And just to add on to that, Henry, if you go back to the last guidance on between the fourth quarter of 2002 and the second quarter of 2003, power gen were losing between 5% and 7% EBIT across that period. We think we’re at the trough of the power gen business and cycle just now and we’re down at 4% so about half of that improvement is because we’re being much more disciplined on pricing than what we were 6, 7 years ago as Tom just said.

Operator

Your next question comes from Eli Lustgarten - Longbow Research.

Eli Lustgarten - Longbow Research

Did you say the engine business would be down 40% for the year or 30%? I couldn’t exactly.

Pat Ward

30%. Three-zero. Sorry.

Eli Lustgarten - Longbow Research

Can we talk a little bit about the components business in the first half of 2010. There’s a big drop in engine. You know when we talk about a 75% drop from second half ’09 to first half 2010. I mean is the components business facing the same kind of issue or is it somewhat less because of the new engines you’re [drawn] or give me some idea of how that will play out.

Tom Linebarger

Eli, first I just want to make sure that I clarify one thing. The $0.75 drop is on the On Highway North American truck markets. Not the engine business. You got that. Right? Right. Okay, and then with regard to how the components business is affected, so they will be affected in a volume way on their applications in North American truck and bus in a similar way. But remember that they will add content. So we do have new component things like SCR on the heavy duty truck engines for example, so the components business will have more content which will mute the effect. Secondly if you think about their mix of business, they also have a broader mix. Some of our components business for example filtration, it has a significant after market component. The turbo charger business has a broad mix of customers outside of North America. So you can expect a more muted effect on the components business than you would on the engine business, both because of content changes and because of a broader spread of demand.

Eli Lustgarten - Longbow Research

Is that enough to cut it in half or better than that? Or is that the magnitude you look at? Because it’s going to be a material number. I’m just trying to gauge.

Tom Linebarger

Well again because the number I gave was only the truck and bus number, and so you need to think about that as compared to the whole. I think the best way for you to kind of get to what you’re after is get your numbers after the Q4 call where we can go through market by market. I mean because I think to give you the answer that you need, I need to understand much more about all of the other markets that I don’t have yet figured out. So I think the point is it will be muted, exactly what percentage I think we just don’t know yet.

Eli Lustgarten - Longbow Research

I knew it was in the engine business, auto and RV business are you know that’s not exactly where the demand is, in the sector, even though RV I guess has picked up slightly. Do you have any feeling for what’s going on fourth quarter and how you would look at 2010 as we go into that part of that business?

Tom Linebarger

I just want to clarify your question, Eli. You’re asking what’s going to happen with RV business in Q4?

Eli Lustgarten - Longbow Research

Yes, the RV and with the rest of light duty auto.

Tom Linebarger

Yes. So let me first talk about Chrysler and then we’ll add RV. In Chrysler as you know we only recently started back with Chrysler. They’ve opened up their truck plants and are ordering diesel engines again which we’re quite happy about. And so what they’re in kind of a recovery and re-stocking mode so we are seeing some increases in demand. They’re not reflecting big increases in end user demand yet. What they’re reflecting is them kind of getting back up and running again. So we expect our Q4 to be strong but I don’t think you know we’re not expecting to be back anywhere near levels we were before or anything like that. So we’re pleased to be back in business but I think we need to remain relatively conservative about how things are going to go forward from here.

With regard to the RV business that business was as you know so low that it was hard to come up with numbers small enough to predict where it was going. And it has bottomed out, which is good. And we have seen some small increases in demand and I don’t, Pat do you have the numbers?

Pat Ward

I think Q4 we would expect the business to be up about 50% over Q3 volumes.

Tim Solso

Yes, but that’s from an incredibly low base.

I want to go back to Chrysler for a minute, too, is that again reminding everyone that their share of the heavy duty pickup truck market remains about a third and we’re over 80% dieselization in that. So the product is doing as well as it was in the marketplace. And because you know they shut down plants so we shut down the engine plant here, the volumes have been very low this year coming back in the fourth quarter. But we would expect off of that low base to have the volumes increase about 50% next year.

Eli Lustgarten - Longbow Research

Can you talk about the distribution side in the fourth quarter and particularly for next year? And with the expanded components area and new product change, does that offer a ramp up opportunity in both revenue and profits for distribution as we look out?

Tom Linebarger

No. Not so much. I think the distribution business opportunities remain similar to what we’ve been getting which is that we are as a business increasing our scope, meaning we are going to more and more markets around the world as we support our customers. And as we add markets then we bring our full range of services to those markets. And second, we are consolidating and improving the performance of distribution dealers that we have and distributors that we have by making them bigger, adding capability and reducing costs. Those are still the two primary drivers of improvement year-over-year.

I think because we see the economic situation 2010 largely being not that good, I think we’re seeing distribution business opportunities with regard to big sales increases and that’s not so much so. But I think we’ll continue to improve performance in the distribution in the two ways that I mentioned.

Tim Solso

Remember the distributors sell whole engines into smaller OEMs like construction markets and that type of thing, and those markets aren’t coming back. As well as into selling generator sets in the power generation market. So to the degree that one of our distributors sees that as a significant portion of their business, it won’t be coming back. Not at least in 2010.

Operator

Your next question comes from Andrew Casey - Wells Fargo Securities LLC.

Andrew Casey - Wells Fargo Securities LLC

A clarification point, assuming flat volumes specifically a question on this NAFTA truck stuff. If the truck share decreases in the second half of 2000 to modestly your emission content still goes up in Class 8 to medium duty so total Cummins revenue for that regional truck market likely goes up. Is that about right?

Tim Solso

So, I think the math you’re doing is, your question is if our share decreases but our content goes up, do they offset each other?

Andrew Casey - Wells Fargo Securities LLC

Yes. If it’s a modest share. I just want to clarify essentially.

Tim Solso

Yes. What I’d say is I couldn’t give you the answer for 2010 and the second half because there’s too many details to figure out and too many confounding effects. Like what happens to the truck share of our customers. You know what is the total volume one quarter versus next. So I can’t say. But the general point is still right. We don’t expect a significant share loss. There’ll be some. We do think we’re going to add more content and we do think that our customers that are using our engines are going to do better than the folks that aren’t using our engines. So those things are all true.

Whether it exact offsets or something I think we just need to get more of the details before we’ll know that.

Andrew Casey - Wells Fargo Securities LLC

And then the 75% sequential drop you discussed earlier, does that include medium duty or is that just Class 8?

Tim Solso

That does include medium duty also.

Tom Linebarger

It includes our medium duty truck in box as well as the Class 8. Does not include the LDA.

Tim Solso

Yes, not Chrysler.

Andrew Casey - Wells Fargo Securities LLC

Now moving on to a bit of a bigger part of the business, power gen, the comment about Q3 being the low point due to the end of inventory de-stocking. Other than the regions can you talk about the trends you’re seeing in commercial products within power gen? Is that uniformly down or more mixed like some of the regional comments you made earlier, Tom?

Tom Linebarger

Yes. The comments I mentioned apply to commercial in the sense that we are seeing commercial generators hit business stronger. In China and India specifically we are seeing growth in demand there. And the second thing is that from a trough point of view we have seen a pick up in order rates this quarter for forward orders. So you know we’re not ready to count our chickens or anything but the point is the trough comment comes from the fact that we are seeing some offsetting improvement in China and India and we did see order rates pick up for Ford orders a little bit. Those are both good signs.

As I also said though I don’t think it’s not going to be great. I mean we don’t think Q1 and Q2 are going to be terrific quarters for power gen. We think there’s still going to be a slow recovery because the U.S. and Europe are going to be down year-over-year.

Andrew Casey - Wells Fargo Securities LLC

And if we look directly at the U.S., you know obviously we’re seeing the RV market come up from extremely low levels. And typically that tends to be your early cycle indicator in that power gen segment. What is your normal lag time between the improvement there and what you typically would see in the commercial products?

Tom Linebarger

When I was in power gen, Andy, we did some analysis on that. And the problem is that the lag time moved every cycle far enough that it was difficult to use as a predictor. The two things that affect it are non-res capital spending, so when non-res capital spending comes back then commercial products start to go. But as you know the relationship between GDP or other cycle markets and non-res construction spending isn’t stable. There is a lag but it’s not a stable lag. So we just don’t really know on that point.

And the second thing is that the international segments confound it also. For example, India, here is it booming and non-res construction’s building trends are terrible in the U.S. but India’s going. So it’s just difficult to say. I understand what you’re asking and I wish I had a good lag set of quarters to give you but I just don’t.

Andrew Casey - Wells Fargo Securities LLC

And then skipping down on the eliminations profit contribution, it’s been positive for the last couple of quarters. Is that eventually going to reverse and if so would it be as quick as Q4?

Pat Ward

It will eventually reverse, yes. As we stop to see the business grow again and build up inventory you will see what happened over the last two or three years repeat itself. I don’t think it’s going to happen to any significant extent in the fourth quarter.

Operator

Your next question comes from Chase Becker for Jamie Baker - Credit Suisse.

Chase Becker for Jamie Baker - Credit Suisse

I just had a quick question regarding the components. Specifically in the quarter did price have a positive impact? Or are we going to start seeing that more with some of the new contracts in 2010?

Tom Linebarger

The latter, Chase. It’ll be more in 2010. I think what we talked about with components in the last call was that we would see a good contribution coming from the volume uptick that they would see in some of their markets as well as the improvements and some of the restructuring actions and material cost projects that they were working on that we alluded to in the Q2 call, that they would really start to benefit their bottom line in the second half of ’09. And I think that’s clearly played out in their results here in the third quarter.

Chase Becker for Jamie Baker - Credit Suisse

Then switching back to some of the commentary that you made on the mining and oil and gas side, I know that was down sequentially in the quarter but I think at the beginning of the call you had mentioned that you saw some positive trends and was just kind of wondering if you can get a little more granular on what you’re seeing in the market.

Tom Linebarger

We are forecasting higher shipments in Q1 for mining and for oil and gas. And it’s really just because we’re beginning to see some pick up in orders you know from OEMs who are ordering equipment. The drilling market not really. But in all the other elements of the oil and gas market, that we are seeing increased engine orders and same with [inaudible]. Coal of course has still been going consistently, but even the copper mining we’re starting to see some orders.

Now it’s not what we were at. It’s not returning to the original levels, but it is an improvement off the low levels we’re seeing now and we’re beginning to see that in Q1. I don’t think it’ll affect Q4 numbers very much but in Q1 we’ll see the improvement.

Operator

Your next question comes from Joel Tiss - Buckingham Research Group.

Joel Tiss - Buckingham Research Group

And just on that power gen, that last question, do you think you’re gaining share there? Or is that just the market getting better?

Tom Linebarger

Was that power gen you’re asking about or oil and gas?

Joel Tiss - Buckingham Research Group

Oil and gas and mining.

Tom Linebarger

You know I don’t have a good view on share gain, Joel. I don’t think there’s significant share gain [inaudible]. I think that’s market. You know over the long run I think we are definitely gaining share in both. I just think in this period though there’s not a significant share gain view on that.

Joel Tiss - Buckingham Research Group

Do you think you can hold the margins that we saw in the third quarter for the full year of 2010 in the components and in the engine business? Because obviously we’re going to have whatever first half, second half, are going to be different volumes, but then we get price increases, more components in there, should be higher margins. Can you just try to balance that all together and help us frame it?

Pat Ward

Yes, Joel, as Tom said we’re working through all that stuff just now. So it would be very premature for any of us to give you a 2010 outlook at this stage. We’ll give you that on the call at the end of January. And what is very clear and one should have figured out by now is that the first quarter in particular and through to the second quarter, when you talk about detrimental margins, they’re probably going to be higher than what we’ve normally seen, just because of the significant fall off that Tom described on the North American On Highway markets in particular. If you look at some of the results we’ve seen in the third quarter both in engines and in components, both those segments produced incremental margins over 30%, higher than average. So that illustrates what happens when volumes come back, but we’re going to see a significant fall off in the first half of the year. I’m expecting to figure out when the [inaudible] is gone, but it’s going to be a higher detrimental to margin than normal.

Over the course of time it’ll come back and second half will be better. But we’ll give you a lot more technical than that in three months time.

Joel Tiss - Buckingham Research Group

You sound a little more confident than your statements in the last year about holding onto a 35% market share in the On Highway engine business. Is that the right perception?

Tom Linebarger

Well let’s be clear, Joel. The 35% number that has been used in past calls was always a worse case scenario in terms of the Class 8 market share.

Joel Tiss - Buckingham Research Group

Okay.

Tom Linebarger

I think, Joel, the way that we’re again we’re thinking about market share as follows is we’re saying to ourselves our business is built upon profitability at relatively low market share. We’re focused on the quality and performance of the product and on driving partnerships that lead to performance for our customers. You know there’s a whole bunch of variables playing out there. As you know there’s mix between 15 and 13 liter engines. There’s new engines being introduced. So there’s a whole bunch of water under the bridge to go. Our view is that if we continue to launch really good products, launch them well, support our customers, we will do very well. And some of the market share guessing I think misses the point really because it’s not just math. It’s actually how well you do with the products that you have. That’s really what drives it, not just math between what percentage of this and what percentage of that.

So we’ve got a lot of work ahead of us with our partners to make sure that our market share stays good. So that’s what we’re really trying to do.

Dean Cantrell

That’s all the time we have for today. I appreciate everyone’s attendance on the call today and obviously Claudia, Mary and I will be available for your questions for us throughout the day. Thank you everyone.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you for attending. You may now disconnect. Have a great day.

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Source: Cummins Inc. Q3 2009 Earnings Call Transcript
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