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Cummins Inc. (NYSE:CMI)

Q4 2009 Earnings Call Transcript

February 2, 2010 10:00 am ET

Executives

Dean Cantrell – Director, IR

Tom Linebarger – President and COO

Pat Ward – VP and CFO

Tim Solso – Chairman and CEO

Analysts

Jerry Revich – Goldman Sachs

Henry Kirn – UBS

Meredith Taylor – Barclays Capital

Ann Duignan – J.P Morgan

Adam Uhlman – Cleveland Research

Andrew Casey – Wells Fargo Securities

Operator

Good day ladies and gentlemen and welcome to the Q4 2009 Cummins Incorporated earnings conference call. At this time all participants are in a listen-only mode. We will conduct a question and answer session towards the end of this conference. (Operator instructions).

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

Dean Cantrell

Thank you, Antwain. Welcome everyone to our teleconference today to discuss Cummins results for the fourth quarter of 2009. Participating with me today our 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 would include certain forward-looking information. And a forward-looking statement involve risks and uncertainty the company’s future results may be affected by change in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statements.

A more complete disclosure about our 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 Web site for the reconciliation of those measures to GAAP financial measures. Our press release with the copy of the financial statements and a copy of today’s webcast, presentation is available on our Web site at www.cummins.com under the heading of investors and media.

With those formalities out of the way I would like to call your attention to our upcoming Analyst Day at the New York Stock Exchange on March 16. Invitations will be sent out shortly but please mark the date on your calendars as we will discuss our new five-year outlook for the company. Turning back to the fourth quarter results we will begin our remarks with our President and Chief Operating Officer, Tom Linebarger.

Tom Linebarger

Thank you, Dean. Good morning. I want to start today by sharing some thoughts about our performance in 2009 which ended with the most profitable quarter in the Company’s history and then give you a high level look at our expectations for this year. Pat Ward will then provide greater detail on both our fourth quarter results and the 2010 outlook, and Tim Solso will share his thoughts about the Company’s long-term prospects.

As I mentioned we had an outstanding fourth quarter. All four business segments reported stronger sales and higher EBIT percentages than in the third quarter, continuing our pattern of sequential quarterly profit improvement throughout 2009. Sales of $3.4 billion in the fourth quarter were 3.4% higher than the fourth quarter of 2008, and increased 34% from the third quarter. Earnings before interest and taxes before restructuring and other charges were 11.4% of sales. Our best quarterly performance since the peak of the previous economic cycle in the second quarter of 2008.

As you will recall we entered this recession in a very strong financial position and quickly established a plan to manage the business effectively through the downturn. In simple terms, our focus throughout the recessionary period has been to one, reduce costs, two align manufacturing capacity with real demand, three, earn a solid profit and generate positive cash flow despite dramatic reduced volumes, four, invest in projects and technologies critical to our growth, and fifth, continue to demonstrate to our customers that we care about their success more than anyone else.

I think our results in 2009 speak to our success in managing all these priorities. And I’m proud of the work that Cummins employees did to make this year a strong one despite the challenges we face.

Our efforts to lower working capital resulted in $442 million reduction in inventory in 2009, which contributed significantly to our improved cash position. We also strengthened our supply chain management system, which we expect to yield higher productivity and lower costs in 2010 and beyond.

We used our rings of defense approach to lower cost across our manufacturing systems quickly moving to reduce capacity and becoming more efficient in our manufacturing processes as volumes drop.

For example, we took advantage of the volume slow down in the first half of 2009 to better synchronize flows at a number of our plants and distribution centers. That work paid dividends in the fourth quarter, providing significant leverage as volumes increased.

While we are talking about our manufacturing operations I want to take a moment to recognize all the people who work in Cummins manufacturing plants or in our suppliers’ plants around the world.

2009 was a challenging year for our plants and for our suppliers. We began by making deep cuts in our plants to stay in front of rapidly falling demand across most of our markets. Then within a few months of hitting bottom, demand at many of our locations returned to record or near record levels.

By working together we were able to minimize the impact of the steep volume drop early in the year, take full advantage of the rapid increase late in the year. This was especially true in our U.S. engine and components plants, where we worked nearly non-stop to keep up with the temporary spike in demand during the fourth quarter in advance of the 2010 emissions standards change.

For example, production of our Jamestown Engine Plant was at its highest level ever during the fourth quarter. Today, just a month later volumes have dropped by 75%.

We now have more than 400 workers on voluntary temporary leave for most of the first half of 2010. That kind of rapid change is exceedingly disruptive to the business and extremely hard on our people and our suppliers, but we managed to do it successfully in 2009 and we have plans in place to remain profitable in our engine business in the first half of 2010 despite the very low volumes forecast for North America.

Another positive story in 2009 was the value of our strong presence in key emerging markets. Tim will talk more about the impact. We expect China, India and Brazil to have on our long-term growth. But these markets continue to play a major role in our current success.

All three markets rebounded from the downturn more quickly and more strongly than mature markets such as the U.S. and Western Europe. Domestic demand in China in India have already returned to pre-recession levels. And our India operations report their best results ever in the fourth quarter.

Our engine joint ventures in China reported strong improvement in the fourth quarter leading to an overall increase in JV earnings of 31% compared to the fourth quarter of 2008.

In addition, Cummins products continue to perform well in 2009 as can be seen by share gains in many markets around the world. For example, we ended 2009 with 50% share of the North America Class 8 heavy-duty truck engine market, up from 45% at the end of 2008.

Our share of the North American medium-duty truck engine market was 41% from 38% at the end of 2008. Our industry-leading market share in the Brazilian truck market grew from 33% to 36% in 2009. And our share of the medium and heavy-duty commercial vehicle engine market in India jumped from 33% at the end of 2008 to 47% today due to greater penetration of Tata Motors and the improved success Tata is having in the market.

Finally, we built on our reputation as a technical leader in 2009 by once again being among the first companies in our industry to have the full range of our product certified to the 2010 emission standards.

Our 2010 heavy-duty engines which are in production today, will provide our customers with a 5% fuel economy improvement over our previous models with no drop of performance or dependability. Medium-duty customers will see a corresponding 3% improvement in fuel economy.

In order to achieve those fuel economy gains while meeting significantly tougher emission standards we launched our XPI fuel systems for heavy-duty engines and our selective catalytic reduction exhaust after-treatment system. Those products represent just part of our investment in the largest product year in Cummins history.

We also began production of a new light-duty engine in China in 2009. A new line of small commercial generator sets manufactured in India and a revolutionary new fuel filter for use on a Dodge Ram Pickup Truck.

2010 will be another significant year of new products for Cummins including launch of the 11.9 liter ISX engine in the U.S. and a second light-duty engine in China.

We are very proud of our performance in 2009. But unfortunately the downturn is not yet completely behind us. In fact, as you have heard us say before we expect the first half of 2010 to be at least as challenging as the first six months of 2009. As a result of the large run up in engine sales in North America late last year in advance of the emissions changeover we expect a corresponding drop in engine demand in the first half of 2010.

Based on our current orders and forecast for the first part of this year, North American truck and bus engine shipments could fall by as much as 80% in the first half of 2010 compared to the second half of 2009. This translates into a 50% drop in our externally reported revenue for heavy-duty truck and medium-duty truck and bus in the first half of 2010 compared to the second half of 2009.

We do expect the North American truck and bus engine markets to improve in the second half of the year. We also expect to see improvement in other engine markets including light-duty automotive, construction, mining and the truck markets outside the U.S.

But we estimate that this temporary drop in North America will result in engine segment revenues being flat for the year when compared to 2009. Our Components businesses which are closely linked to our engine sales also will be affected by the large drop in engine volumes in North America.

However, higher content on the 2010 engines, improved costs and increased truck sales in emerging markets will more than offset this drop in North American demand and improved profitability in our Component segment.

Strengthening economies in China, India and Latin America will offset continued weakness in the U.S. and Western Europe for our power generation business, where we are forecasting 2010 to be flat with 2009 in terms of both sales and EBIT.

Our distribution business is expected to continue performing well. Sales of forecast to grow by 20% on higher demand in emerging markets and the Company’s decision to acquire a greater ownership stake in a large North American distributor.

Major area of focus for us this year will be to ensure that our new product introductions are as successful as possible. The early reviews for the 2010 engines and components have been very good. We are devoting significant resources to assure the best quality launch for these new products.

Despite the challenges we expect this year our strong financial position will allow us to increase our capital investment and critical technologies and new growth opportunities for 2010 and beyond. Our current plans call for us to invest approximately 30% more capital in the business than we did in 2009.

In taking together we are forecasting 2010 to look a lot like 2009 in terms of sales and profits. Our initial guidance for this year is for sales of an $11 billion and EBIT of 7% of sales, with a second half of the year expected to be better than the first half across all of our business segments.

We have a lot of work ahead of this year, but if we continue to manage the business conservatively and execute the strategies we have in place I am confident 2010 will be another year of solid financial performance for Cummins.

I will now turn it over to Pat who will give you more details about our 2009 performance and our plans for this year.

Pat Ward

Thank you, Tom, and good morning, everyone. As Tom said, 2009 was a significant challenge given the global economic recession that has impacted every part of our business. We came into 2009 with two financial goals, one to deliver solid profits and two to deliver positive cash flow. And as you can see from the results we reported today we delivered on our commitments and achieved both of these financial goals.

Two-year revenues for the company were $10.8 billion, down 25% from the previous year. Despite this unprecedented drop in demand, EBIT before restructuring and other charges was $774 million or 7.2% of sales compared to $1.26 billion or 8.8% of sales for the previous year. And earnings per share excluding the restructuring and other charges finished at $2.49. All four business segments were profitable were at $2.49.

All four business segments were profitable in 2009 despite the severe drop in demand. The Company also significantly improved its cash position in the year, which is essential to preserving our ability to pursue profitable growth opportunities in the future. I will talk more on this later.

Now, let me move on to the fourth quarter and share some more details in our performance. Revenues of $3.4 billion were 34% higher than the prior quarter and 3% higher than the fourth quarter of 2008. Sequentially, gross margins improved from 19.9% in the third quarter to 22.7% in the fourth quarter as a result of stronger volumes, benefit of cost reduction actions and lower material costs.

We remain focus on managing selling, admin and reception development expenditure. Although it came down as a percent of sales in the quarter, we did see an increase in dollar terms in part due to increased investment and research and development and the impact of higher compensation accruals.

Joint venture income increased to $67 million and 18% improvement over a third quarter levels from improved results in China and in India. EBIT margins before restructuring and other charges improved to 11.4% of sales, marking a fourth consecutive quarter of margin improvement.

Earnings per share excluding restructuring and other charges were $1.37 in the quarter. In our previous call we gave you that a full-year effect of tax rate would be 27%. However, one-time tax benefits of $29 million or $0.15 per share more than offset upward pressure from stronger domestic earnings in the fourth quarter resulting in an effective tax rate of 24.4% for 2009 and 22.5% for the fourth quarter.

Turning to each of our four business segments, I would now like to briefly highlight the performance in the fourth quarter and the 2010 revenue and profitability that we had.

Engine segment revenues of $2.2 billion were 51% higher than the prior quarter as a result of stronger demand in the emerging markets and from the transition engines in North America ahead of the 2010 emission deadline. This segment also benefited from increased demand for the Dodge Ram engine, higher aftermarket revenues and demand stabilization and industrial and power generation markets.

If we compare to the prior year, revenues were up 12%. Demand for transition engines, market share gains in the North American truck markets and the light-duty automotive production increase more than offset a significant drop in later cycle engine sales for the industrial and power generation markets.

Segment EBIT margins were 9.7% in the quarter compared to the 4.2% EBIT margins delivered in the third quarter. The Engine segment has clearly benefited from the cost reduction initiatives taken early in the year as well as lower material costs.

In 2010, we expect another challenging year for the segment. Our On-Highway engine shipments were underperformed the truck Boston recreational vehicle markets in North America due to the transitional engine shift in advance of EPA 10.

We forecast production of Navistar Class 8 heavy-duty trucks to grow 30% in 2010, however, our heavy-duty truck engine revenues will be down 18%. Revenues from the medium-duty truck and bus markets are forecasted to be down 19% for the same reason despite growth in the North American, Brazilian and European truck production.

Revenues to the light-duty automotive and recreational vehicle market are projected to grow 23% with higher engine shipments for the Ram Pickup Truck more than offsetting the negative effect of transition engines to the RV market.

For the industrial markets we forecast revenues to increase by 17% in 2010, mainly driven by stronger demand in the mining, oil and gas and construction markets.

Higher commodity places are stimulating OEM capital expenditures from new equipment in mining and oil and gas markets while infrastructure stimulus programs in China, India and Brazil are supporting domestic OEMs and imports for the construction markets. For the total Engine segment despite the lower volumes we expect close to flat revenues in 2010 and EBIT margins in the range of 3% to 4% of sales.

Now, let me move on to the Component segment which also had terrific financial performance in the quarter. Revenues were up 24% from prior quarter, driven by the demand for transition engines in North America, global aftermarket recovery and some sequential OEM improvement in China, India and Europe.

EBIT margins improved to 10% of sales on the leverage of the higher volumes. Year-over-year stronger demand in the On-Highway markets in North America, China and India more than offset weakness in Europe and drove revenues up 8%.

The Component segment EBIT margin benefited from the cost reduction initiatives taken earlier in the year lower material cost and higher volumes. Despite the proof of lot of demand for transition engines in North America into 2009 we expect 2010 components revenues to increase 10% from higher price and technology content on the EPA 2010 products from higher truck production and emerging markets in Europe and from growth in aftermarket demand. We are forecasting EBIT margins for the segment between 6.5% and 7.5% of sales.

In the Distribution segment revenues were up 15% sequentially. EBIT margins were up from 13% in the prior quarter to 13.8% of sales mainly from higher volumes and favorable currency benefits from a weaker U.S. dollar.

Compared to the same quarter last year, revenues were down 13% as a global slowdown largely impacted demand for new engines and power generation equipment. However, the favorable mix to what aftermarket and service revenues on effective cost reduction initiatives strengthen EBIT margins. Strong joint venture income and favorable currency movements also contributed to this performance.

In 2010, revenues for the Distribution segment are expected to increase by 20%. Half of those growths will come from the consolidation of a western Canada distributor in which we increased our ownership of 50% to 80% at the beginning of the year. We are forecasting the segment EBIT margin in the range of 11% to 12% of sales as the consolidation will have a dilutive effect of approximately 1%.

And finally, in the Power Generation segment, revenues were up 9% sequentially, mainly driven by demand in emerging markets. Higher volumes and cost reduction initiatives positively impacted EBIT, which improved from 4.2% in the third quarter to 5.7% of sales. Year-over-year revenues were down 32% with most regions impacted. The lower volumes contributed to drop in EBIT margins from last year’s 8.5% of sales.

In 2010, for Power Gen, we expect flat revenues and EBIT margins between 6.5% and 7.5% of sales. As demand dropped more significantly in the second half of 2009 for this business we expect end of China destocking and continued recovery in the emerging markets to offset continued weakness in North America and Europe in 2010.

As Tom just mentioned we are projecting total Cummins revenues to be $11 billion in 2010 with EBIT margins of 7% of sales. Compared to 2009 results, the temporary impact on volumes of the 2010 emissions standards has a negative impact on EBIT of 1.3%. This is offset by EBIT improvements of 0.5% from stronger joint venture income and the net 0.6% in a combination of pricing and cost movements.

As was the case in 2009 we expect EBIT to increase sequentially as we move through the year. We are currently projecting the effective tax rate for 2010 to increase to 32%, primarily as a result of the research types credit not yet being extended.

And finally, let me come to the balance sheet and cash flow. Our cash balance improved by over $500 million more than double the amount at the beginning of the year. We generated more than $1.1 billion in cash from operating activities for the full year. A record for the company. A large part of this was due to the reduction in inventory levels of over $400 million. Debt to capital was 14.9% at the end of the year.

Our strong financial position gives us the flexibility to invest in future profitable growth opportunities. As you heard from Tom, we plan to increase capital investments in 2010 to $400 million, up almost 30% from 2009.

As mentioned on our last call, we have left that the temporary suspension of our stock repurchase program that we had in place during most of 2009 and will accelerate the repurchase bonds in 2010.

We also remain committed to sustainable increases in our dividend and will review this with our board during the year. Now, before we take your questions, Tim would like to say a few words.

Tim Solso

As you have already heard this morning we had an outstanding fourth quarter and a very strong 2009 given the difficult economic environment in which we continued to operate. And as Tom has already mentioned we expect the first half of 2010 to be challenging especially in the North American truck markets, which will put significant pressure on our engine and components businesses.

Looking beyond 2010, however, I believe we are positioned for an extended period of significant growth. And a lot of my confidence in our future comes from the way which we have performed over the past year. We have talked to you in previous quarters about the impact our early and decisive response to the downturn had on our ability to remain profitable and generate cash during the worst of the recession last year.

Those efforts put us in a position to emerge from the recession and even stronger company. We have taken a significant amount of cost out of our manufacturing system, which allows us to fully leverage demand increases such as those we saw in our engine and component businesses in the fourth quarter of 2009.

The fact that we are in a position to remain profitable and those businesses in the first half of this year despite a huge expected downturn swing in volume from the end of last year also shows just how flexible our manufacturing system has become.

We also continue to make heavy use of Six Sigma to drive quality improvements and lower our costs across the company. Our Six Sigma savings in 2009 were nearly $500 million well above our target and all our business units exceeded their goals for the year.

Also our performance in large international markets such as China, India and Brazil contributed significantly to our outstanding performance in the fourth quarter and will play an even larger role in our future success. In particular, the China and India economies have bounced back strongly from their brief downturn late in 2008 and early in 2009.

While our business in those two countries fell in 2009 from record levels in 2008 our fourth quarter results were very strong. In fact, the fourth quarter was our best ever in India where the total size of our business in 2009 was more than $1.3 billion. We expect our business in India to be close to 2008 levels by the end of 2010. And with the Indian economy projected to grow at a rate of 7% or 8% a year for the next several years this region will be increasingly important to Cummins in the future.

This story is similar in China which was a $1.7 billion business for us in 2009. We expect consolidated and unconsolidated sales in China to grow to well over $2.3 billion this year. The long-term prospects for Cummins in China also are very good with the Chinese economy expected to grow at 8% to 9% a year from the 2011 through to 2014. As in India, all our business segments are well represented in China.

We are also well-positioned to continue our growth in Brazil where we are the clear market leader in the truck engine market. Prior to 2009, our business in Brazil had grown at 32% a year since 2003 and reached $900 million in 2008. After a slight contraction in 2009, the Brazilian economy is expected to return to solid growth rates of 4% to 6% a year for the next several years starting in 2010.

In addition, large international events in Brazil including the world cup in 2014 and the Olympics in 2016 will require significant investment in infrastructure which plays to Cummins strengths in that market.

Our commitment to these large emerging markets has diversified our business and played a key role in allowing Cummins to remain profitable through the worst global downturn in decades.

Given the expected long-term economic growth projected for these markets the broad reach of our products and our technical advantage when it comes to meeting future emissions standards, China, India and Brazil will play even larger role in our future success.

We will share more details of our plans for sustained long-term growth at our Analyst Day in March. But I also want to talk a little bit about our work to continue to invest in the business throughout the downturn and what it means for our future.

Our strong balance sheet coming into the downturn and our performance during 2009 allowed us to generate the cash we needed to invest in the largest product launch in our history. As you heard Tom say, we have received EPA certification for our 2010 On-Highway engines which are in production now.

More importantly for our future growth we improved our cash position by more than $500 million which will allow us to invest even more heavily in new products, technologies and capacity going forward.

As you heard Pat say, we will spend $400 million on capital expenditures this year. That money will go toward new products and significant investments in facilities to increase capacity and support for our current products.

Finally, we will continue invest in profitable growth opportunities made possible by our technical leadership, especially in the components businesses as well by favorable long-term growth trends. These include increased infrastructure spending in many parts of the world and expected rise in demand for reliable power and emerging markets such as the Middle East and Africa.

As you heard throughout our remarks this morning, 2009 was an outstanding year given the challenging economic environment. We generated a solid profit, significantly increased our cash position and reduced inventory by more than $400 million.

Our performance in 2009 especially in the second half of the year is an example of what you can expect from Cummins once the recovery takes hold around the world. Our strong position today will allow us to get through a very challenging first half of the year in 2010 and will be the foundation for what I think will be a period of tremendous growth for Cummins beginning next year. Thank you and we will be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Your first question comes from the line of Jerry Revich with Goldman Sachs. Please proceed with your question.

Jerry Revich – Goldman Sachs

Hi, good morning

Tom Linebarger

Good morning, Jerry.

Jerry Revich – Goldman Sachs

You outlined 30% to 40% sales growth for your China businesses in 2010. I’m wondering if you can rank order for us the businesses where you see the highest growth, power gen, Off-Highway, On-Highway and also can you talk about what kind of top-line contribution you’re looking for from Foton Cummins with that net mix is that about $100 million or so?

Tom Linebarger

Let me start with the point that our business is, as Tim said, we’ve all of our business represented there, but our automotive businesses far and away are largest there. So the biggest component of dollar sales growth will be in the truck business. From a percentage basis, off hand, I couldn’t give you each one of the growth numbers. But all will be growing significantly in the year and as we talked about in our remarks the power generation business there will be growing and will be offsetting weaker markets and developing world.

Pat Ward

By individual markets, Jerry, I think obviously a lot of the truck markets that we have there in China that are in the joint venture side of the ledger are going to probably be up to 30% while power generation which will be on the consolidated revenue side of the ledger will be up more 30% to 35% components slightly below that at about maybe 25% in some of the industrial engine markets probably in the low teens.

Tim Solso

As far as the full-time joint venture we introduced a 3.8 liter engine this past year. The volumes haven’t materialized and now we are introducing the 2.8 liter engine. So I would not see Foton contributing a lot this year our position for growth going forward. So this is still a pretty heavy investment time both technically and introducing new products.

Jerry Revich – Goldman Sachs

Thank you. And Pat, I’m wondering if you can give us a little preview of your analyst meeting. In the last cycle you meaningfully increased your distribution business investment with very nice returns. Can you just give us a big picture of you what incremental investment opportunities you are targeting at the early stages of this cycle?

Pat Ward

I think, Jerry, I would rather wait till we get to March before we start to divulge all information about where we are going to grow, where we are going to invest into the future.

Jerry Revich – Goldman Sachs

Okay. And Tim, I’m wondering if you could give us an update on opportunities you see for your components business on tier-4 interim now that your customers are closer to the production stages on their tier-4 engines.

Tim Solso

Yes, as you suggested, Jerry, definitely our components businesses will be participating in helping engine and equipment makers reach tier-4 interim both U.S. and equivalent in Europe. So that represents a growth opportunity for our components business.

Dean Cantrell

And Jerry, this is Dean. Just to add on, I think as I talked to everyone in the last quarter call, if you look forward to the Obama show in Munich, Germany in April, I think that’s where you’re going to see a lot of the release of each of the engines that we’ll have for tier-4, we’re obviously, we’re going to have the variable geometry Turbo charger, the XPI fuel system, direct flow filters as well as diesel particular filter sign on each of those engines out there.

I think you will start to see here during the quarter, I’ve been working with some of the businesses as they are starting to prepare press releases about some of the OEM announcements about using Cummins for tier-4 interim. And whether being the European market or in the U.S. market and I think you’ll start to see of those press releases starting to hit the wire here shortly.

Jerry Revich – Goldman Sachs

Thank you very much. We will look forward to those.

Operator

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

Henry Kirn – UBS

Hey, good morning, guys.

Tom Linebarger

Hey, Henry.

Pat Ward

Good morning.

Henry Kirn – UBS

The power gen guidance looks like the fourth quarter run rate says about flat. Could you talk about the cadence or revenues as we go through the year and maybe some of the sign posts that you’re looking to that, let’s say the developed markets could start getting better here?

Tom Linebarger

Henry, the first quarter, you probably remember from previous years is seasonally a little weaker so we’d expect that again here. And then we normally see the other market seasonally are about equal. Because we expect to see some recovery we will expect increases quarter-on-quarter as I said that’s true for every business, also true for power gen. And I think for the developed markets, the best statistic out there is non-res capital spending, which as you know, is not doing so well now in the U.S. or Europe.

So that’s one of the reasons we have a relatively conservative view about those markets and their recovery. I will say that the signs we’re seeing on the order boards are that orders have bottomed out. We will see what that means in terms of actual sales next year. But right now we’re least optimistic that things have bottomed out, but non-res construction spending still not good. So what that’s going to mean and when that’s going to turn we’re just not sure.

Tim Solso

And the inventory correction is done now too.

Tom Linebarger

It’s behind us, yes.

Henry Kirn – UBS

Thank you. And what visibility do you have currently into the back half recovery for North American trucks and maybe dove tailing with that. Could you talk a little bit about what market shares baked into your guidance and maybe when you expect the OEMs to begin to take delivery of the 2010 standard engines?

Tom Linebarger

Okay. Three questions. The first question I think was about market size. And we’ve been assuming for North America 130,000 by our definition trucks for the 2010 year. When exactly what month that turns and when it turns back and what 2011 going to be we’re not sure. Right now what we’re reading is 2011 is expected to bounce up quite a bit and maybe even back to replacement demand, which will be terrific. I hope it does. I think there’s a lot of people waiting and watching and we’ll see what happens with that. Was question number two market share?

Henry Kirn – UBS

Yes, sorry, it was really more about the visibility into the back half recovery. What signs you see today that give you confidence in the back half recovery and then what you expect for your market share and what you bake into guidance?

Tom Linebarger

In terms of signs, obviously, the couple things we look for are, first, that we’re looking at replacement cycles and clearly, there’s a lot of trucks that are out there for a long time. And so I think replacement cycles would suggest that people want to replace their trucks. On the other hand with freight business down because the U.S. economy and the fact that some of the trucks have been parked and are therefore not being used. That’s kind of the counter effect. We’re just watching like everybody else.

Henry, I would say I don’t think we have unique insight. There’s a lot of market data in ACT, I think we’re just talking to our customers and watching that data and we do a lot of talking to end customers and I think the information is widely available on that. I’m sorry. That’s not much else that you already read I guess.

Henry Kirn – UBS

No, I appreciate that. And the market share did you have any comment there?

Tom Linebarger

I think the way we’re viewing market share, as you guess, we get a lot of questions about that. The way we’re thinking of market share is I think we said before our view is that our goal in the business is to serve our customers effectively and earn a good return on our capital. So market share is not something we see as objective.

We’re pretty pleased with where we are and helps us, of course, achieve those objectives, but it’s not our end goal, and frankly, it’s pretty difficult to predict at this stage. We think we’re in a great position with leading OEMs in the business. We’ve increased our share significantly at PACCAR, which is an excellent company. They are leading in the market today and we expect them to continue their strength and that will help us a lot.

We’re also growing our position in freightliner, we come into their heavy-duty trucks, where nearly exclusive on medium-duty trucks and we have a strong position still with Volvo and we expect to leverage those positions and frankly, the strength of our engine offering in their strong trucks to gain share. So the share picture is not only a function of where we’re released, but a function of how those trucks and engines do in the marketplace and we feel really good about where we’re with those trucks and engines. So I guess best thing to do is just see what happens, but we’re feeling really good about where we are.

Henry Kirn – UBS

Thanks a lot. Congratulations on a great quarter.

Operator

Your next question comes from the line of Meredith Taylor with Barclays Capital. Please proceed with your question.

Meredith Taylor – Barclays Capital

Hi, good morning and congratulations on the quarter. I’m hoping we can talk a little bit about the components business. You’re clearly looking for some significant margin improvement in 2010. Can you walk us through how much of this is going to be coming from volume? Assumptions around volume leverage versus mix, versus the continued progress of cost take-out, better price, cost, etc., if you can just kind of walk us through the puts and takes I think that would be very helpful.

Pat Ward

Hi, Meredith, this is Pat. Let me give you the big picture and then Dean can chime in with the rest of it. I think from looking at components in 2010 going from 4% for the full-year ‘09 to the guidance of between 6.5% and 7.5% of sales for 2010, those three or four different factors are driving now. They’re all pretty much even way I look at it. So the way thing to get the pricing is much be the same.

The impact of the increased content and the pricing we can get for that is clearly one of those factors. Likewise, there will be additional volume. And we expect to see again one-fifth of the improvement coming from additional volume. Pricing on existing products will increase by pretty much a same factor and in between cost reduction and material costs we also expect those to contribute each of them fifth of the improvement year-over-year. So when I go from four to say the midpoint of that guidance of seven you can look at those five factors and apply an equal weight into each of the five of them to figure out how we get it.

Meredith Taylor – Barclays Capital

Okay, that’s very helpful. And then you were quite specific in terms of the cadence of first half of 2010 versus second half of 2009 for the engine business. But a little less clear in terms of what we will be looking for on the component side of the business, could you give us some more clarity there?

Tim Solso

In terms of what the fall off is from the second half of ‘09 for components?

Meredith Taylor – Barclays Capital

First half of '10 versus second half of '09 from a revenue perspective exactly and then how we should think about the ram as we move through the year.

Tim Solso

For components, Meredith, it’s not going to be as drastic a fall off as the engine business. And it’s partly because of the different mix that each of the four businesses within components has to the EPA 10 emissions standard. So on the one hand with our filtration business predominantly aftermarket so it’s not going to be affected by the EPA 10 transition. The turbo charger and the fuel systems business are obviously a little bit more exposed to the EPA 10, fuel systems the most exposed to the EPA 10 transition.

Turbo chargers at least has exposure to a lot of the emerging markets where we talked about earlier where we do see strengths in the truck market in China and in India and in Brazil and that will help their side of the business there. But the U.S. side of their business will fill a similar fall off in demand much like the medium-duty truck and heavy-duty truck businesses will feel.

And then emissions solutions is I think you can think about its revenue moving more in sync with what you might be modeling for the various truck OEMs in the market, because they are allowed under the EPA regulations up to shift the exhaust systems up to 90 days after the engines. They’re not going to see the precipitous fall off by the engine business will in the first quarter. Their low point will probably be in the second quarter as we would expect the truck OEMs, their build rates in the second quarter of 2010.

Pat Ward

Meredith, just to give you some additional information there, I think you should expect anywhere between a 5% and 7% drop in revenues if you look at the first half of 2010 compared to the second half of 2009 for the segment.

Meredith Taylor – Barclays Capital

Okay. That’s great. Thanks so much.

Operator

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

Ann Duignan – J.P. Morgan

Hi and I can hear, good morning, guys.

Tom Linebarger

Good morning, Ann.

Ann Duignan – J.P. Morgan

Good morning. I just wanted to take a step back to the heavy-duty market share comments. You said in your opening remarks that you expect to under perform the market in 2010, only because of the pull forward which implies that you really do not anticipate any share loss. You ended the year of 50% market share, about 15% of the shares through Navistar which has gone in effect. I know you don’t want to obsess over market share, but you must be using market share as guidance for your own planning progress. Can you walk us through what your share forecasts are for each quarter or at least first half, back half?

Tom Linebarger

Again, the difficulty we have with that and I understand the question well. The difficulty of providing the answer is we know where we’re released, what we don’t know was what those truck players are going to earn with share and what relationship our engine has with them gaining that share, we don’t know the answer to it. We have a view but we don’t know the answer. And so I think what I don’t want you to get is the idea that we don’t notice that Navistar, we know Navistar won’t be buying our 2010 engine. That’s we’re clear about that.

We’re also clear that we’ll be adding some share of freightliner versus previous and we think and we’ve been adding share regularly at PACCAR and we believe the offering that we have with those customers will do really, really well in the market. Again, it remains to be seen. So it’s hard to predict exactly what it is. We have an assumption as you guess, right now, what I guess our projections for the business reflect what we think is going to happen both in terms of the market and what position we’ll operate in the market, what the market share will have.

Tim Solso

The other element that creates uncertainty is that we believe that our engine will have a substantial fuel economy advantage over the EGR engine that Navistar will have. And as that plays out in the marketplace that difference in fuel economy is enough to move market share significantly. And so what I say is, let’s see what happens in the second half of the year. So far so good with the products that we released and the way we test them. We got over 5 million miles of testing and so we think we know what we’re doing.

Dean Cantrell

Ann, this is Dean. I think it’s important what Tim mentioned. It’s really the second half of the year around market share is really the more relevant thing for everyone to be watching. I think the first half of 2010 is going to be nothing more than reflection of what pull forward of demand we saw in fourth quarter of ‘09. So I don’t think when you go to look at the market share outlet I don’t think the data in the first six months of 2010 is going to be reflective of who’s buying what.

It’s going to be more reflective of who bought what in the fourth quarter of '09. I think once we get into the second half of the year, to Tim’s point that’s where really the proof is going to be is to customer response to the engines that are available out there and how our engines are helping to make everyone in trucks better in the marketplace and that’s to Tom’s point the performance of those and how the truck OEMs favor in the market share picture in the second half of 2010 is going to be more important.

Ann Duignan – J.P. Morgan

Yes, I appreciate that and I don’t disagree. Just again just to reiterate then I think what you’re saying is that you’d anticipate your existing customers would move with you to other OEMs, primarily because of the fuel efficiency that your engine can offer. Is that a fair statement?

Tom Linebarger

Yes.

Ann Duignan – J.P. Morgan

Okay. And then just a follow-up on the industrial segment given the tier-4 interim hurdle we have in 2011. Could you expect any stockpiling by any of your industrial customers towards the end of 2010 as they transition? I mean obviously probably not as noticeable as in On-Highway. But would you anticipate some stockpiling towards the end of 2010?

Dean Cantrell

In the U.S. we don’t expect much at all. Because there is a T-PIN structure inside of the rule where people can transition and that’s actually we’ve seen it in place before in previous rule than it, it didn’t resulted in not much of a pre-buy. In fact, none. In Europe the rules are a little different and so there is may be some pre-buy in Europe. And we are anticipating some. We don’t have a good estimate for how much, frankly right now, but we do expect some.

Ann Duignan – J.P. Morgan

Okay. And any just remind me of the mix in the industrial business your Europe versus the U.S.?

Tom Linebarger

We’re predominantly more outside of the U.S. in recent years, obviously with the strength of a lot of the export activity into the emerging markets. So a lot of what we sell in terms of industrial engines into the European markets although some of it is used in domestic markets in Europe. Obviously, a lot of our OEM customers in Europe are big exporters to other parts of the world.

So that’s another wrinkle in the equation when you ask us to try to figure out what sort of pre-buy it will obviously depend upon where the engines and the construction agricultural equipment is being used in the world and as you know Japan, North America and Europe are the ones that are moving to this next emission standard but the emerging markets could still be lagging behind. There is a significant demand which will not be affected by tier-4 interim at all.

Ann Duignan – J.P. Morgan

I have taken up enough time. I will get back in line. Thanks, guys.

Operator

Your next question comes from the line of Adam Uhlman with Cleveland Research. Please proceed with your question.

Adam Uhlman – Cleveland Research

Hi, good morning, guys.

Pat Ward

Good morning, Adam.

Adam Uhlman – Cleveland Research

I guess just to start with a clarification it looks like the heavy-duty/medium-duty volumes were for the fourth quarter were much stronger than the guidance for the quarter. And I guess I’m wondering where or how you came up with the extra passage to ship those units in the fourth quarter and it seems that the extra shipments in the quarter could raise some eyebrows that EPA with their new anti-stockpiling rules. I’m wondering if you could walk through that and talk about any discussions that you had with EPA.

Tom Linebarger

Yes, let me start first with the demand did exceed our expectations. We did expect high demand, but it did exceed our expectations to some degree. And we worked hard to meet it as I talked about in my remarks it was not easy at all. Frankly, we were at the end stretch just about as thin as we can get both in terms of our own capacity and our suppliers capacity to make it. Again, I think what you saw was our plants ramping up very, very quickly as a result of terrific response by our plants and our suppliers that supply those parts. We were ready and we’re wanting to make sure we could capture demand as it came and so I guess I feel good about how we reacted to that. But it was essentially flexibly adding resources and the plants adding shifts working over time and normal things you could expect.

Second point is that the EPA has already, this is not the first time they’ve had a pre-buy or transition engines purchased and so they regularly utilize the rule they have to say you people can have reasonable transition. And I think that’s basically what the rule of the industry works to. The EPA went to work on a more specific rule but has not released one. So there’s nothing else in place today except the reasonableness rule. And the way that we view that is that we think we get orders from customers and as long as the customer give us a legitimate order we ship the legitimate order and then our customers are really responsible for figuring out what they need to transition.

And I guess one thing to keep in mind on that is that it sounds straightforward, but they are transitioning many, many models of vehicles, not just one. So they got to understand how to get each engine, engineered into each model and frankly, is a bit of a challenge to get all that done and cut over. And so that’s I think what a lot of them are managing is that’s the transition especially in an environment where truck demand has been very low and the engineering costs are high. That’s a challenging environment for them. So that’s what they’re trying to manage to do. I’m sure the EPA is trying to thinking through that as well as trying to make sure people move ahead and get the new engines in. Both are legitimate concerns.

Tim Solso

I want to add just something, this is Tim, about the Jamestown plant which is where we produced the heavy-duty engines. The work rules are incredibly flexible and we’ve had a work force that really, really understands customers and wants to meet demand. We had secretaries from the office working out in the shop supporting the assembly lines. We visited that plant during the quarter to witness it as well as thank the employees. The leadership was very, very straightforward in saying, this is going to happen in the first quarter.

And one remarkable thing is that people made a lot on over time but we had over 450 volunteers to take leave of absence for up to the first six months of this year, so no one had to permanently lose their job. And that’s just the kind of atmosphere we have in there and that’s why we were able to raise the bill rates to the level we were. We really struggled with the supply base, but they also really came through for us.

And the Rocky Mount Engine Plant you could say the same thing. Incredible results for the quarter. CMEP where we produced Chrysler engines which as you know have been an incredibly rocky road for 2009. We produced a whole bunch engines for them in the fourth quarter too and exactly the same way. When I made my remarks about this it really was remarkable performance by our employees.

Adam Uhlman – Cleveland Research

Okay. Great. Thanks. And then, Pat, could you talk about the material cost outlook and thoughts on warranty expense that’s baked into the guidance for this year?

Pat Ward

Sure. On material cost we’re anticipating some favorable movement there. I think on metal markets we would see costs going against us, but the material, people have been doing it on value engineering, low-cost country sourcing, ongoing price negotiations, we do think that year-over-year material costs will be somewhere around 510s to 610s of quite margin improvement. Warranty costs, you should expect overall for the company to continue to be similar to 2009 at around 4% of sales.

Adam Uhlman – Cleveland Research

Okay, got it. And then just a clarification, this discussion of the China sales forecast up 30% to 40% in 2010. Can you help reconcile the change in JV earnings this year, up only 10% to 15%. I bet the distributor acquisition is diluting that growth a little bit, but are there other investment elements that we should be keeping in mind?

Pat Ward

It’s a little bit messy to explain correctly in the phone call so that’s one you might want to follow with Dean afterwards. Remember when we talk about China revenues back up to $2.3 billion that’s a combination of consolidated revenues on joint ventures. So you can’t really just take that growth and then look for 50% increase in joint venture line too. The joint venture income this year I think it was 214 million and we’re projecting now to be up 10% to 15% in 2010. We do see somewhere around $10 million drop because of the consolidation of Cummins West on Canada. That’s one maybe. To give you a more detail, Dean can take out in offline and he can give you the branch on China joint venture.

Adam Uhlman – Cleveland Research

Got it. Thanks.

Operator

Your next question comes from the line of Andrew Casey with Wells Fargo Securities. Please proceed with your question.

Andrew Casey – Wells Fargo Securities

Thanks a lot. Good morning, everyone.

Tom Linebarger

Hi, Andrew.

Andrew Casey – Wells Fargo Securities

Question, given this fourth quarter performance on longer-term earnings power plus whatever share repo is completed in, the earnings look like when volumes come back in the developed markets, they can be significantly higher than what you just reported this year. I’m trying to understand the impact of this capital investment increase on potential margins. How much of the 400 is related to capacity increase and has any of that related to increased expectation for unit volume outside of cycle unit volume and after truck.

Dean Cantrell

Andy, this is Dean. In terms of capacity expansion as we talked about before, we kind of break that down into whether it’s for current product or for a new product in growth opportunity. I would say for current expansion of current products, it’s probably about 30% of our CapEx spend. And with regard to new products either new growth products or emission-driven products, that’s probably closer to 35% of our capital spend. And then the remaining 35% is essentially on maintenance and cost reduction initiative.

Tim Solso

I give you just one example. I was in India earlier this month and our Tata Cummins plant in Jamshedpur produces 120,000 engines and they’re sold out, they’re on allocation. All of those engines go to Tata Motors. So we’re building a second plant and it’s about done. That will ultimately have the capacity for another 120,000, but we will do it in 60,000 increments to 90,000 to 120,000, and then you can think about the components that we make that go on that engine, for example, turbo chargers so we had to increase our capacity in turbo chargers, I was also in that plant and we’ve also increased the capacity with our power generation business. So those are examples of when we say we’re increasing capacity. And right now we’re chasing demand in some of those markets.

Tom Linebarger

Andy, the other thing that’s important about what you said and that we really are want to focus on our March meeting, investors meeting is what is the potential for where we can get in terms of sales and earnings whether our gross rates going to be what potential do we have or what role did the developing market plan that, without kind of jumping ahead to that meeting I do want to note as you did that we are increasing capital now even as we see markets not so strong, because we believe we can capture some of those growth areas in the future. So these general categories of capacity and a new product don’t tell the whole story.

We’re definitely investing both R&D dollars, significant R&D dollars and capital in programs that we think can grow the company in 2011. But also all the way out to 2015, some of the programs won’t recognize revenue until 2015. So there are big opportunities for the company. I think you hit on a key one and the fact that we’re in a position today to be able to fund those is a lot about how the company has changed in the last five years.

Tim Solso

And the other part that’s not as visible as clearly we just have disclosed what the CapEx is in our consolidated results, but there’s probably another $200 million to $250 million of CapEx being spend in those unconsolidated joint ventures that doesn’t show up in the Cummins GAAP cash flow statement. So that’s another part of the investment and the opportunity that’s taking place that maybe not as visible from a U.S. GAAP perspective.

Andrew Casey – Wells Fargo Securities

Okay. Thank you. And then just one last question. This drills down a little bit on the components line. The second half '09 margin performance was very strong and implies similar to the previous question potential upside longer-term especially to some of the targets you have out there. When you start to layer in the incremental revenue benefit from 2010, meaning the EPA emission standards, should we expect any dilution, initial dilution to margins with ramp-up benefit later on?

Pat Ward

Not sure I fully understand the question, Andrew. But let me answer it this way. I expect quarter margins to improve through the year and to be higher than 2010 and 2009 and to be higher beyond that too.

Tom Linebarger

And I think that the important point that you saw from the fourth quarter and to some degree in the third quarter is that we’ve been making improvement in our components company, in terms of cost structure, in terms of engineering the product to meet better lead, requirements for the customer and so, as we begin to get volume because volumes have been suppressed as we’ve done that work.

So margins have been improving, but not at the rate they could. Now as we bring volume on to them their ability to get leverage on their manufacturing and cost reductions is very, very large. So we do expect in fact that we’ll start to break through our hurdles for that company as now we finish the cost work and the engineering work now begin to bring volume in we do expect to start hitting our targets for that business and hopefully surpass them as we get the volumes. So that’s exactly the formula that we see, Andy, just when you that raise there.

Andrew Casey – Wells Fargo Securities

Okay. Thank you very much.

Dean Cantrell

Thank you, everyone. That’s all the time we have for questions.

Operator

Ladies and gentlemen thank you for your participation in today’s teleconference. This concludes the presentation and you may now disconnect your lines.

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Source: Cummins Inc. Q4 2009 Earnings Call Transcript
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