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Cummins Inc. (NYSE:CMI)

Q4 2010 Earnings Conference Call

February 01, 2011 10:00 AM ET

Executives

Dean Cantrell – Director, IR

Norman Thomas Linebarger – President and CFO

Patrick Ward – VP and CFO

Theodore Solso – Chairman and CEO

Analysts

Jamie Cook – Credit Suisse

Jerry Revich – Goldman Sachs

Robert Wertheimer – Morgan Stanley

Henry Kirn – UBS

Ann Duignan – JPMorgan

Eli Lustgarten – Longbow Research

Andy Casey – Wells Fargo

Tim Denoyer – Wolfe

Timothy Thein – Citigroup

David Raso – ISI

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter 2010 Cummins Incorporated earnings conference call. My name is Ann and I will be your coordinator for today’s call. As a reminder, this conference is being recorded for replay purposes. (Operator Instructions) We will be facilitating a question and answer session following the presentation. I would now like to turn the presentation over to Mr. Dean Cantrell, Director of Investor Relations. Please proceed, sir.

Dean Cantrell

Thank you, Ann. Welcome, everyone, to our teleconference today to discuss Cummins results for the fourth quarter of 2010. Participating with me today are Chairman and Chief Executive Officer, Tim Solso; our President and Chief Operating Officer, Tom Linebarger; and our Chief Financial Officer, Pat Ward. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The company’s future results may be affected by changes in general economic conditions, and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about our forward-looking statements begins on Page 3 of our 2009 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, a copy of the financial statements and a copy of today’s webcast presentation, are 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 2011 Analyst Day in New York on Tuesday, September 13. Please mark the date on your calendars as we will reveal 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.

Norman Thomas Linebarger

Thank you, Dean. Good morning. I will start today by sharing some thoughts on our performance in the fourth quarter and for the full year. Pat will then provide greater detail on the quarter and we’ll discuss our 2011 financial guidance, while Tim will talk about our longer-term priorities.

As you can see from the results, we had an outstanding fourth quarter capping a very strong year for Cummins. Our revenues in the fourth quarter surpassed $4 billion for the first time and were 22% higher than the same period of 2009. Fourth quarter EBIT of $541 million or 13.1% of sales also was a quarterly record and was 41% higher than a year ago. Our Engine, Components and Distribution segments reported record sales and EBIT in the fourth quarter. All three segments also earned record EBIT for the year.

Our Power Generation business, which entered the downturn later than our other businesses, also saw dramatic sales and EBIT gains in the fourth quarter and full year compared to the same periods in 2009. Cummins full year sales of $13.2 billion were 22% higher than in 2009 and our second best sales year ever. Our profit results were even stronger. Earnings before interest and taxes of $1.7 billion or 12.5% of sales were more than double what we earned in 2009 and represent our highest annual EBIT ever.

We continued to return value to our shareholders in 2010 as well. In addition, to a 140% appreciation in our stock price we increased our dividend by 50% in the third quarter and repurchased $241 million in stock over the course of the year.

Our financial results in 2010 were much stronger than we had expected when the year began and can be attributed primarily to two factors which we have discussed over the past few quarters.

The first is the strong growth we experienced in China, India and Brazil where our markets returned in dramatic fashion after relatively brief downturns in 2009. For the fourth quarter, our sales in China were up 92% over the same period in 2009. In India, sales increased 12% from the same period a year ago but were up 37% for the full year. And in Brazil, sales grew by 30% quarter-over-quarter, as we continue to see strong growth as the leader in the medium-duty truck market.

I was in China last month visiting our plants and meeting with key customers and partners. The Chinese government is clearly concerned about inflation and has taken actions to reduce credit availability as well as ramping down its fiscal stimulus. These actions are likely to have some impact on economic growth in 2011 though just how much impact is not clear. I can say that at this point, demand in China remains strong in our market segments, especially in construction where infrastructure projects continue to grow, especially in second tier cities. In my discussions, our Chinese partners confirmed their long-term growth prospects and the increased role they would like Cummins to play in that growth, both domestically and internationally. I left feeling highly confident about our growth prospects, both near-term and long-term in China.

The other major contributing factor to our success in 2010 was improved productivity in our manufacturing operations around the world. The actions we took during the downturn to restructure our operations have made our plants significantly more efficient. As a result, we saw improved margins as our volumes returned in many markets. Perhaps the most satisfying aspect of our performance in 2010 was the fact that we achieved record profitability despite significant weakness in the North American on-highway markets.

For the year, our heavy-duty engine shipments in North America fell 61%, while medium-duty truck and bus shipments declined 44%. Fortunately, the declines in the North American on-highway markets were more than offset by strong gains in our industrial markets, as infrastructure spending increased around much of the world. For example, in the fourth quarter, our worldwide construction sales increased 138% and mining market shipments rose 81%.

I also want to take a moment to recognize the work done by our people involved in the 2010 new product launch for the U.S. market, which is going very well. At the end of last year, we had nearly 62,000 2010 EPA compliant engines in the market. The engines are performing well and our heavy-duty customers are reporting fuel economy improvements of 5% to 6% over our 2007 EGR only engines. One indication of the success of our product launch was Cummins market share of the large fleets in North America last year. Just under 50% of the trucks purchased by the top 50 fleets in 2010 were powered by our engines. Furthermore, we are expecting many of these companies to significantly increase the size of their orders in 2011 as they move from a trial mode to real, real building of their fleets.

Before I talk about our specific expectations for the North American truck markets in 2011, let me give you an overview of what we see for the large global truck markets in which we participate. I’ll start with China where the combined medium and heavy-duty truck market size was 1.2 million units or roughly four times the size of comparable markets in North America. We expect sales in those markets this year to be relatively flat compared to 2010, as the next level of emissions norms is being implemented.

In India, the commercial truck market, which is comparable in size to North America, is expected to grow by nearly 10% to about 350,000 units this year. In Brazil, the commercial vehicle market is forecasted to grow by 12% this year to 208,000 units. And in Europe, demand for medium duty trucks, which is our primary market, is expected to increase by 20%. Finally, we expect the U.S. heavy duty truck market to grow by 50% to nearly replacement levels of about 207,000 units in 2011. In addition, we expect to see 40% growth in the medium duty truck market to 94,000 units. The global truck market demand for this year will drive significant growth in both our engine and components businesses in 2011.

Beyond the truck markets, we are also forecasting continued growth in several other segments worldwide. For example, continued infrastructure growth in emerging markets will boost our sales to the construction markets, especially across Asia and in Brazil. Mining markets should remain as strong as demand for coal, copper and iron ore is driving capacity increases. And the demand for commercial power generation products and projects is expected to increase in the U.S., Europe and Middle East led by increased spending on data centers, infrastructure and oil and gas operations.

Given the growth we are seeing in these and other markets around the world, we are forecasting strong sales and earnings growth in 2011. Our sales guidance for 2011 is for revenues to be $16 billion, up 21% from 2010. We expect EBIT to be 13.5% of sales as we fully leverage the increased revenues while continuing to invest in future growth opportunities. This year will be important in setting the stage for future growth, which Tim will discuss. Our capital investment will increase significantly from 2010 with almost all of that investment going to help us increase capacity, add new products or develop new markets.

Let me close by saying that we are very optimistic about our opportunities in 2011 and beyond. We have aggressive plans in place to build off the success of 2010 and to take advantage of improving markets and longer-term growth trends.

I’ll now turn it over to Pat who will give you additional details about the fourth quarter as well as our guidance for 2011.

Patrick Ward

Thank you, Tom, and good morning, everyone. The results we are reporting today show solid progress within every business segment and positive momentum across nearly every region. Full year revenues for the company were $13.2 billion, an increase of 22% over the prior year. Earnings before interest and taxes were a record $1.7 billion or 12.5% of sales. This compares to $774 million before restructuring charges or 7.2% of sales in the previous year. Earnings per share finished at $5.28.

Now let me speak specifically on the fourth quarter and provide some more details on our performance. Revenue of $4.1 billion was 22% higher than both the previous quarter and the fourth quarter of 2009. Gross margins remain strong at almost 24% of sales. While spending on selling, admin and research and development came down as a percent of sales, it did increase in dollar terms due to increased investment in research and development on growth initiatives and as a result of higher compensation accruals.

Joint venture income of $90 million was 34% higher than a year ago reflecting the strength of the emerging markets. EBIT was a record $541 million or 13.1% of sales, up from 11.4% last year and up from 12.3% from the third quarter, excluding the one-time benefit from a favorable legal ruling in Brazil on the tax treatment of imports that we discussed last quarter. Earnings per share for the quarter were $1.84 and included a tax benefit of $0.09 related to the recently enacted legislation impacting the research tax credit.

Moving on to the operating segments, let me highlight the performance during 2010 and in the fourth quarter and then conclude with our revenue and profitability expectations for this year. In the Engine segment, full year sales were $7.9 billion, up 23% from last year. EBIT more than tripled from $252 million or 3.9% of sales to $809 million or 10.3% of sales. In the fourth quarter, revenues were $2.5 billion, an increase of 15% over last year. Our strength in international markets offset lower demand in North America on-highway markets. Sales were 21% higher than the prior quarter. Revenue from the on-highway truck markets benefited from the depletion of EPA 10 transition engine inventory and early signs of recovery in the North American heavy duty truck market along with strong demand in the emerging markets.

Revenue from Industrial Markets was also strong mainly due to elevated demand in advance of the Tier 4 emission change along with increased activity in oil and gas markets. Segment EBIT margins of 10.3% in the quarter compared to 9.7% last year with stronger volumes, pricing and higher joint venture income offsetting an increase in material costs. Compared to the third quarter, the EBIT percent was down slightly as the incremental volume benefit was offset by increased product coverage costs and higher SAR spending, particularly on research and development.

In 2011 we expect a strong recovery in the North American on-highway markets that will drive a 25% increase in segment revenue with EBIT margins in the range of 10% to 11% of sales. The leverage gained from this level of additional demand will be tempered by a higher mix of EPA 10 compliant engines impacting product coverage, increased investment in new product development, higher material costs and slower growth in joint venture earnings as we invest in capacity.

Moving on to the Power Generation segment. Full year sales were $2.9 billion, up 21% from last year. EBIT increased 79% to $299 million or 10.2% of sales compared to $167 million or 6.9% of sales last year. Fourth quarter revenues were $903 million up 50% from the prior year due to improving economic conditions in many global markets. The incremental volume leverage along with pricing more than offset upward pressure on commodity costs and resulted in the EBIT margin improving from 5.7% last year to 10.2%.

Compared to the prior quarter, sales were up 14% driven largely by stronger demand in the U.S., the Middle East, the U.K and Western Europe. The quarter also benefited from the completion of two significant Power Generation projects in Australia and in Nigeria. Despite the stronger sales revenues EBIT margins decreased compared to the third quarter as a result of rising commodity costs, higher product coverage and increased spending on growth initiatives.

For 2011, the Power Gen segment will continue to experience strong demand from overseas markets as well economic recovery in North America. We expect that revenue will increase 15% over 2010 levels with EBIT margins in the range of 11% to 12% of sales.

In the Components segment, full year sales were just over $3 billion up 29% from 2009. EBIT almost tripled to a record $278 million or 9.1% of sales compared to $95 million or 4% of sales last year. Fourth quarter revenues were $918 million, an increase of 25% over the previous year, driven by stronger demand in Europe, China, India and in the global after-market business.

Although North American volumes declined year-over-year due to the pre-buy activity in the fourth quarter of last year, increased product content on the EPA 10 engine models resulted in higher North America revenues. EBIT margins of 9% were down from the 10% reported in the fourth quarter of 2009. The benefits from the higher volumes were offset by some increased expense related to manufacturing operations in our Filtration and Turbocharger businesses, higher investment spending in research and development and on growth initiatives and some higher product coverage costs.

Compared to the previous quarter, sales were up 19%. Revenue increased across all four businesses within this segment driven by both the depletion of EPA 10 transition engines in North America and improved demand from OEMs in Europe, China and India. The additional operating leverage, coupled with some improvement in operational efficiencies at our manufacturing plants, improved the EBIT margin to 9% of sales, up from the 8% we reported last quarter.

For this year, demand is expected to increase in North America and Europe and remain strong in the emerging markets. Revenue is projected to increase 25% over 2010 levels and we expect the Components segment to deliver EBIT margins in the range of 10% to 11% of sales.

Finally, in the Distribution segment, full-year sales were $2.3 billion, up 30% from last year. EBIT increased to a record $297 million or 12.8% of sales compared to $235 million or 13.2% last year. During the fourth quarter, the Distribution segment took a majority interest in our former independent Boston distributor and consolidated its operations for three months. The consolidation of Cummins Western Canada and Cummins Northeast in 2010 had a dilutive impact on EBIT of 0.4% for the full year.

Fourth quarter revenues increased 44% from the prior year. Nearly half of this increase is attributable to the acquisitions of our Western Canada and Northeast distributors. EBIT margins of 11.7% were lower than last year, due to a 1% dilutive impact of the acquisitions made during 2010 and from higher spending on growth initiatives. Compared to the third quarter, sales were up 22% with notable growth in Europe, South America and the South Pacific region.

European sales benefited from pre-buy activity ahead of the Tier 4 emission change. EBIT for the quarter was 11.7%, a decrease from the prior period due to product mix shifting towards whole goods and from higher SAR spending. In 2011 we expect Distribution segment revenue to increase 15%. The volume benefit will be partially offset by additional spending on strategic initiatives and we expect EBIT margins to remain in the range of 12% to 13% of sales.

As Tom just mentioned, we are projecting total Cummins revenues to be $16 billion in 2011 with EBIT margins of 13.5% of sales. We expect the benefits of the incremental volume along with some pricing improvement to be partially offset by increases in spending on research and development programs and on growth initiatives, along with higher product coverage costs and increasing pressure from metal markets on our material costs. We are currently projecting our tax rate to be 30% in 2011.

Finally, let me turn to the balance sheet and cash flow. Our balance sheet remains strong and debt to capital was 14.4% at the end of the year and our pensions are very well funded. We generated in excess of $1 billion in cash from operating activities for the full year. Our strong balance sheet and cash position have enhanced our ability to make increased investments in research and development projects, on strategic growth initiatives and on capital expenditure programs which will lead to future profitable growth.

For example, we invested $364 million in capital expenditure projects in 2010. We plan to increase the amount for capital projects to between $600 and $650 million in 2011, with almost two-thirds of the spending targeted on expanding capacity and developing new products.

In addition, our unconsolidated joint ventures will invest over $300 million in capital expenditure projects, again primarily focused on capacity expansion and new products. As well as enabling increased investments in our business, our cash position has enabled us to increase our dividend by 50% last year and reduce the net shares outstanding by 1% through stock repurchases. We remain committed to returning value to our shareholders through sustainable increases in our dividend as well as through stock repurchases.

2010 was a terrific year for the company and we are well positioned to take advantage of the future growth opportunities.

Now before we take your questions, Tim would like to say a few words.

Theodore Solso

Thanks, Pat, and good morning. As you’ve heard from Tom and Pat discuss, the company performed well during the fourth quarter and for the entire year. To put our performance into perspective, consider the fact that our record EBIT in 2010 exceeded what we earned in our second best year of 2008 by $400 million on $1.1 billion less in sales. As a result of the actions we took during the recession, we are operating more efficiently than at any time in our history. Our performance over the past two years has set the stage for what we think is going to be an extended period of significant growth in profits.

Our business is generating record profits. We also have more than $2 billion in cash and available credit and historically low debt levels. As a result, we are well positioned to make the investments necessary to capitalize on the several long-term trends that are working in our favor. As a reminder, those trends are; we expect continued significant investment in global infrastructure over the next 20 years, which will benefit most of the markets in which we compete, especially the emerging markets. The cost of energy will continue to increase as will the disparity between supply and demand for electricity in developing economies. This will benefit our Power Generation, Engine and Components businesses.

The emission standards in markets around the world will become more stringent and challenging to meet over the next several years. Tighter emission standards play to our strengths as a technology leader and provide a barrier of entry for new competitors. These emission regulations will also be instrumental in the growth of our Components businesses, which provide many of the technologies that allow engines to meet the new standards.

And finally, the world economy will continue to become more global. Today nearly two thirds of our business comes from outside the United States compared to 40% in 2000. We are well established in large international markets and are already making new investments in newly emerging markets, such as Africa, the Middle East and Southeast Asia. For example, our combined consolidated and joint venture revenues in China grew from $1.7 billion in 2009 to $3.1 billion in 2010. In India, we went from $1.3 billion to $1.9 billion and in South America we grew from $900 million to $1.3 billion.

As we look ahead to 2011 and beyond, we see significant profitable growth opportunities for the company. As you’ve heard from Tom, we expect our growth in China, India and Brazil to continue this year although it will moderate from the explosive growth rates we experienced in 2010. We are expanding our capacity in China and India to meet the expected demand and are pursuing new markets in both countries.

In fact, I was in India two weeks ago for the dedication of the first three facilities at our new mega site location in Phaltan, where we plan to invest nearly $300 million over the next three years. This is the first time in my 40-year career that we’ve opened three plants on the same day. We also have plans to build seven more plants at this site for a total of ten. The site will allow us to significantly expand our production capacity for engines, components and generators and eventually use India as a base for exports to Asia, the Middle East and Africa.

I came away from my visit more excited than ever about the opportunities in India and the region. In addition to emerging markets, we also expect the U.S. economy to gain strength this year which should benefit all our businesses.

As you’ve already heard, the North American truck markets are poised to rebound which will benefit both our Engine and Components businesses. As Tom said, our SCR engines continue to perform well and are delivering the type of fuel economy improvements we’ve promised our customers. We remain convinced and the market is confirming that SCR is the right technology to meet the current emission standards in the United States and Europe and increasingly in other markets. As we’ve said over the past few quarters, we have a plan to aggressively pursue new growth opportunities even as we continue to invest in additional capacity to meet the demand for our current products. To do that, we will ramp up our investment in capital, R&D and people significantly starting this year.

Our capital investment will increase by almost 75% from 2010 and our R&D spending will increase by more than 40% from last year. Cummins is going to be a larger, more complex and more global company in the future. We will prioritize our work and execute our strategy so that we can take full advantage of the opportunities ahead. That’s a much different challenge than the one we faced the last two years and in many ways a more difficult one. It’s also more exciting and we are convinced that we have the people and processes in place to continue down our profitable growth path. Our people have done an outstanding job over the past two years to keep the company strong in a very difficult economic situation and I’m extremely optimistic about our future.

Thank you and we’ll take your questions now.

Question-and-Answer Session

Dean Cantrell

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

Operator

Okay. Thank you. (Operator Instructions) And our first question comes from the line of Jamie Cook with Credit Suisse. Please proceed.

Jamie Cook – Credit Suisse

Hi. Good morning.

Dean Cantrell

Good morning, Jamie.

Jamie Cook – Credit Suisse

You probably won’t be surprised by my first question. I’m trying to understand your margin guidance in Engines given the top line growth. I think it implies an 11% incremental margin, so I’m just trying to figure out if you could outline what the offsets are. I’m assuming a lot of its material costs. And what your assumptions are for pricing or putting through surcharges.

And then my follow up question is on your Power Gen guidance for top line. You’re assuming 15% growth which implies revenues of $3.3 billion which is below your Q4 run rate. So that seems conservative in particular as we hear about some strength in the developed world, in particular North America. So if you could just answer those two questions.

Patrick Ward

Okay, Jamie. I’ll take a stab at the first part and then between Tom and myself, we’ll answer the second one. Yes, you’re correct. Incremental EBIT margins, for the Engine segment, we expect to be around 11% in 2011. So the components that make that up, we get about 1.5 points of benefit from the additional volume. Warranty will be up though as we introduce these new products. We have said before that we always carry higher warranty accruals in the first couple of years of launch. So warranty will increase by 1% of sales for the Engine segment.

Pricing we expect to be positive, between 1% and 1.5% of sales for the segment. But we see that being offset by higher material costs of four tenths of a point. We will make increased investments in research and development and in growth initiatives, and that will cost about 1% of a headwind against the numbers, most of that being research and development.

Joint venture income is relatively flat in dollar terms next year. As a percent of sales it goes down, so that drives it down by about three or four tenths of a point. So there are the four or five main drivers behind the Engine business incremental margin guidance for 2011.

On Power Gen, the fourth quarter, if you look at the fourth quarter when we had $900 million sales. Keep in mind that was a 14 week quarter for the company. I think your point is still valid that there probably is still some upside if the markets do materialize as well as what we expect. But at the moment we feel the guidance of 13% growth is probably appropriate.

Norman Thomas Linebarger

Jamie, the only thing I’d add to the Power Gen guidance – we definitely recovered slower there and I think we still have a relatively conservative view about a North American recovery. There’s definitely recovery in there but it’s not – we’re not bouncing back to the levels we were and the non-res construction spending assumptions are not very aggressive. So I think – we’re watching that pretty close though. I got a little bit of pressure on Tony about that. I do feel like we have some upside and I do feel like if the non-res construction spending comes back as some people are forecasting, it’s kind of a mixed bag out there about what people are saying, but if it comes back like that, we will see stronger growth in Power Gen for sure.

Jamie Cook – Credit Suisse

But while it’s not in your guidance, are you seeing any anecdotal evidence because some of the industrial companies are starting to cite that. We’re seeing some constructive ABI numbers. So I understand what you wouldn’t...

Norman Thomas Linebarger

The answer’s yes. Jamie, we are.

Jamie Cook – Credit Suisse

Can you give me an example?

Norman Thomas Linebarger

Yes. Jamie, we are. The same kind of anecdotal evidence that you are seeing. And in fact, Tony is feeling good about his order book in North America. It’s getting better. I wouldn’t say it’s – he feels all the way there, but, yes, we’re feeling better about it. And so we’ll let the first quarter run and then we’ll see where we come out. And if we are seeing better answers on North America, you’ll see us push guidance up on Power Gen for sure. And we’re watching it really closely.

Jamie Cook – Credit Suisse

All right. Thanks. I’ll get back in queue.

Norman Thomas Linebarger

Okay.

Operator

And our next question comes from the line of Jerry Revich with Goldman Sachs. Please proceed.

Jerry Revich – Goldman Sachs

Good morning.

Theodore Solso

Hi, Jerry.

Jerry Revich – Goldman Sachs

Pat, for the Component segments, can you talk about your sales outlook by business? I guess considering the sharp ramp in Emission Solutions and Fuel Systems production, why wouldn’t the Components business deliver stronger sales growth than you’re looking for in Engines this year?

Patrick Ward

Yeah. Most of the growth in the Components segment we’ll see come through Emission Solutions and the Turbocharger business in 2011. The Fuel Systems business does recover as the North American top markets come back into play. The Filtration business does not recover to the same extent given that it is primarily an after-market business. So you’ve got two of the businesses really coming back strong. One growing with the top market and the other really is up 5% or 10% for the year. So that’s the mix by business, Jerry.

Jerry Revich – Goldman Sachs

And, Pat, can you say more about your incremental margin comments around the raw material piece? What are your assumptions for raw material in place? Let’s say we get this deal. And the metal costs are surprising for the upside here, can you just step us through the pricing announcements you’ve made in the marketplace? I think you’ve got a bunch out on the Power Gen side. Can you just give us an update for the other businesses as well? Thanks.

Patrick Ward

Well, on the material costs, we do expect a headwind of somewhere between three tenths of a percent and four tenths of a percent net. The metal market part of that is going to go up by more than 1%. And just now we’re fairly confident we can offset around three quarters of that. We will continue to work at it. But that’s one of these issues we’re going to have to pay attention to through the year as there seems to be continued upward pressure on metal markets.

On pricing for the company, we’re looking at pricing being up about 1% in 2011 versus 2010. That’s really coming through the Power Gen segment, it’s coming through parts of the Component segment, we’re seeing it in the Engine business, high horsepower engines in those markets being impacted favorably and the after-market business is also up by a couple of percent. I actually don’t have the specific numbers so maybe that’s something you could follow up with me after the call.

Jerry Revich – Goldman Sachs

Thanks, Pat. And lastly, can you give us an update on Foton Cummins and Xian Cummins production rates in the quarter and whether you expect the operating losses in those businesses to narrow in ‘11. Thanks.

Patrick Ward

On Foton, we ended up building 16,000 engines last year, so that was up from 1,000 in 2009 and the fourth quarter production, shipments were around 8,000 units, so we did see a climb through the year. Our projection for 2011 is 50,000 engines in this year, so significant growth over the 2010 level. And then for the XCEC joint venture, we ended up building about 4,000 engines last year and we see that growing to 16,000 engines in 2011.

Norman Thomas Linebarger

I think one point I noted in my opening but we do expect, despite a relatively flat truck market, for our business to grow in China and specifically, we expect our truck business in China to grow. Those are really the two reasons that we expect our BFCEC expansion into light-duty trucks to start in earnest and then XCEC which is heavy-duty engines where the market is moving much towards, up in power range, up into heavy-duty. We’re getting some traction on our XCEC joint venture with Foton so with our partner from BFCEC those are definitely, starting significant expansions in 2011 and that’s helping is grow in a relatively flat market.

Jerry Revich – Goldman Sachs

Thank you.

Operator

Our next question comes from the line of Robert Wertheimer with Morgan Stanley. Please proceed.

Robert Wertheimer – Morgan Stanley

Yes, hi. Good morning, everybody. Quick question on Industrial Engines, oil and gas was coming up strong. Can you talk a little bit about where that is within the oil and gas patch, whether it’s share or – I guess we’ve seen some companies reporting very strong oil and gas and some still not bouncing back. I know you had the potential to gain some share, so could you talk about the strength in the industrial in oil and gas please?

Norman Thomas Linebarger

Where we play most successfully in the oil and gas market is obviously in the well servicing, the frac rigs in the oil shale deposits that you see throughout the United States. That’s where we’ve seen a lot of success in those markets. You may remember back in the third quarter, we announced that we were getting into the Transmission business for the oil and gas and that will be product that will be coming online here towards the end of the year in 2011.

And so we’re really seeing a lot of good share gains in that market. We don’t play in a big way at this point in a lot of the offshore drilling. We’ve got some efforts underway through the Distribution segment to establish centers of excellence in the Singapore area to really go after that offshore drilling market opportunity as well as in Houston with the onshore land drilling that’s taking place. So there’s some more opportunities for us in that part of the market.

Robert Wertheimer – Morgan Stanley

Perfect. And I wonder if you could touch on compression as well. And then my second question would be, I guess that’s two, but the second question would be just margins on engines in the quarter. Your revenues were up quarter over quarter. Margin’s a little soft. Could you do – was that pricing or materials hitting you negative and that normalizes out in the first part of the year?

Patrick Ward

Well are you talking Q4 over Q3 or Q4 over Q4?

Robert Wertheimer – Morgan Stanley

Over Q3. Sorry.

Patrick Ward

Yes. Compared to Q3 we were down – let me see if I can find my notes on this.

Robert Wertheimer – Morgan Stanley

I had you at 8.8 ex the JVs versus 9.

Patrick Ward

Yes. So we’re down five tenths of a point. Volume is clearly a positive benefit. We did see increases in material costs. We did see product coverage going up from 3.6% to 4.7% within the segment. We did see higher spending on R&D technology cost in the quarter.

Robert Wertheimer – Morgan Stanley

Okay. Thank you.

Operator

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

Henry Kirn – UBS

Hi. Good morning, everybody.

Dean Cantrell

Good morning.

Patrick Ward

Hi, Henry.

Henry Kirn – UBS

Since your revenue run rate’s already ahead of the 2011 guidance, could you talk about how much pre-buy demand you saw from North American off-highway and Europe in the fourth quarter?

Norman Thomas Linebarger

Jerry, I think what we’ve or, Henry, we’ve talked about in the past is typically in the European market that we were aware that there were pre-buy underway. We ended up seeing probably close to 10,000 engines that were pre-bought in the European market. I can’t say that we really were seeing or have a way of identifying any pre-buy activity in the North American market. Obviously the EPA does not allow pre-buy for the Tier 4 market in the U.S. But in the European market it is allowed and we were aware of OEMs taking advantage of that.

Henry Kirn – UBS

And is it possible to give some breakdown in what you expect for JV versus non-JV EBIT in 2011?

Patrick Ward

Yes. I think that’s in the presentation that Dean put on the Web site. We expect JV income to be up around 5% in 2011. We are temporarily capacity constrained at some of the larger joint ventures, most notably the Dongfeng Cummins joint venture in Xi’an. But we’re making a significant investment in capacity to increase that by 50,000 units by the end of this year. Joint venture income grew – sorry joint venture revenues grew 28% in 2010. We expect joint venture revenues to grow around 15% to 20% in 2011.

Norman Thomas Linebarger

We also have been at capacity on the TCL Tata plant in Jamshedpur where capacity is 120,000 and they produced 146,000 last year. One of the plants that we opened two weeks ago is another engine plant that’ll have capacity of 60,000 with the possibility of going to another 120,000. And that plant will come online during the year.

Henry Kirn – UBS

Thanks a lot.

Dean Cantrell

And the TCL joint venture will actually be online this month, by the end of this month, starting production of its new 60,000 units.

Operator

And our next question comes from the line of Ann Duignan with JPMorgan. Please proceed.

Ann Duignan – JPMorgan

Hi, guys. Good morning.

Dean Cantrell

Morning, Ann.

Patrick Ward

Ann.

Ann Duignan – JPMorgan

Hi. The first just a definitional question. Product coverage, is that totally warranty costs? Or is there anything else in there like ongoing additions of technicians or fixed costs (inaudible) ?

Patrick Ward

Ann, it’s total warranty costs. There’s nothing else in there.

Ann Duignan – JPMorgan

Okay. Just wanted to make sure I got that right. And then my real question is, could you walk us through your outlook sequentially or year-over-year? North America heavy-duty versus medium-duty, just your shipments? Just given the lack of shipments Q1 this past year, what kind of ramp up should we see as we go through the year for your business?

Patrick Ward

I think on the heavy-duty truck in North America, I think about 35% to 40% of the full year shipments will take place in the first half of the year and then 60% to 65% in the second half of the year. On medium-duty truck, it’s a little bit more balanced, maybe 40% to 45% in the first half and 55% to 60% in the second half.

Ann Duignan – JPMorgan

Okay, and then just one other clarification. On the JV investments, I think you said there was an additional $300 million being invested in the joint ventures, CapEx for joint ventures. Is that 50/50 your investment and your partner’s investments around the world? Or, could just talk about what your contribution to that $300 million is.

Patrick Ward

Yes, our contribution is minimal. This is investments in the joint ventures are funding themselves. Primarily it’s Donfeng Cummins. There’s a little bit of finishing up with Tata Cummins, but relatively little investment on these capital projects that we talked about in joint ventures.

Norman Thomas Linebarger

Just to be clear, that’s not cash flow that you’re going to see in our cash flow statement, Ann, that – if you could look into the joint ventures and their cash flow statement, you would see them spending the – the joint ventures spending the $300 million in CapEx.

Ann Duignan – JPMorgan

Okay. Perfect. That’s exactly what I wanted to make sure I got right. Okay. Thanks.

Operator

And our next question comes from the line of Eli Lustgarten. Please proceed.

Eli Lustgarten – Longbow Research

Thank you. Good morning.

Norman Thomas Linebarger

Hi, Eli.

Patrick Ward

Hey, Eli.

Eli Lustgarten – Longbow Research

A little clarification. You gave us product coverage, I think you said in engines were 3.6 to 4.7. Can you give us a product coverage number for the corporation in the quarter and the year and how to work that out for 2011?

Patrick Ward

Yeah. So let me give you a little bit of overall view of what happened in product coverage. You go back to 2009, our product coverage cost was 4.1% of sales. And in our call three months ago, we had guided product coverage for 2010 to be 2.9%. It came out at 3%. So it was relatively close to the guidance we gave. For the fourth quarter, it was up at 3.9%, so it was higher than what we had seen for the earlier part of the year. But that was expected. We telegraphed that before as we introduced more 2010 products, they will carry higher warranties. We did have one or two additional campaigns on all the products, nothing to do with 2010 product, that we also increased accruals for. But overall, we came in at 3%, which was not far away from what we expected three months ago.

For 2011, we do expect product coverage for the company to increase and will be somewhere between 3.5%, 3.6% of sales for the full year. Probably starts off around 3.4% and end up around 3.7% by the fourth quarter.

Norman Thomas Linebarger

Those changes just reflect the mix of new engines versus older engines and the fact that we start with high accrual rates and bring those accrual rates down as we get more experience with the engines and our actual payments begin to match – begin to play a bigger weight in our estimate of accruals versus what our standard rate is when we launch the product, so that’s what’s happening with those rates as we go.

As Pat mentioned, we are feeling very good about the product quality of our 2010 engines so we expect the rates to come down as actual experience begins to flow in and play a larger role in the accrual rate setting process.

Eli Lustgarten – Longbow Research

And can you help me a little bit with the guidance of Engines because when I look at the – your assumptions, a lot of its EPA 10 compliant. And there’s a big price differential between EPA 10 and non-EPA 10. So how much of that 25% is because of the higher – the 25% is because of the higher prices of EPA 10 versus actual volume. I’m just trying to get some mix of how pricing because of the more expensive engine flows through here.

Norman Thomas Linebarger

I think, Eli, the way you should think about it and the way that we’re looking at it when we give you those bridge to the 2010 to the 2011, is we introduced the 2010 product in 2010. It carried a higher price increase relative to ‘09. And so as we’re bridging 2010 to 2011, we’re not really talking about price changes on EPA 10 product, we’re talking about volumes increasing.

Eli Lustgarten – Longbow Research

Yeah, but as I said, you’re going to have, a huge step up, 125% increase in heavy-duty shipments, 40%, 110% in medium-duty, and that’s all much more expensive engines versus what would have been shipped before. I just want to know whether...

Norman Thomas Linebarger

But not more expensive than was shipped in 2010, right, Eli? We didn’t ship any non-EPA compliant 2010 engines, everything had to be compliant in 2010 for us to ship, so like for like. Now if you go back to ‘09, you’re right that there’s both volume and price.

Eli Lustgarten – Longbow Research

And, I’m just trying to get some idea of that mix change, because the prices are up substantially.

Norman Thomas Linebarger

Yeah. I think maybe you could, Dean could give you that if we went back to ‘09 because we don’t have those numbers handy with us relative to ‘09. But we could definitely say okay, from ‘09 what was the volume increase and what was the price increase in terms of the mix change. We just, but because it was all in ‘09 we don’t have numbers with us handy.

Eli Lustgarten – Longbow Research

And one final question. Could you talk about market share expectations for ‘11 versus ‘10 specifically in the North American market?

Norman Thomas Linebarger

Yeah. In heavy-duty trucks, we expect to be around 35% market share for the year. We obviously started out higher when much of the transition was happening. We finished the year right around 38% for the full year and so we expect to go into that year at that run rate. We expect to be around 35%. We’ll see how we go. We’re trying to help our customers obviously take share from folks that aren’t our customers and if we do better at that, our share will be higher and we’ll be working hard to do that. Right now we’re estimating 35%.

Theodore Solso

And it will be over 50% in the medium-duty.

Eli Lustgarten – Longbow Research

Okay. All right. Thank you.

Norman Thomas Linebarger

Yeah. See you later.

Operator

Our next question comes from the line of Andrew Casey with Wells Fargo. Please proceed.

Andy Casey – Wells Fargo

Good morning, everybody.

Patrick Ward

Andy.

Andy Casey – Wells Fargo

A couple of questions, first on supply chain potential to keep up with the ramp. Are you seeing any constraints at all, whether it be within your supply chain or elsewhere?

Norman Thomas Linebarger

We do see some, Andy. There’s no one thing that’s causing issues, but we are seeing ramp up issues in high horsepower. So, as we talked on our previous call about how we had gone to work on making sure that we had enough high horsepower engines by starting early with the supply base. I’m grateful that we did that because in fact demand did come faster than we expected and we were able to stay up with the ramp. But now on the QSK60 engines where demand has really increased quickly with all the market segments that we discussed earlier, mining and power gen, et cetera we are now extending lead times a little and that’s frustrating to us so we are trying to increase capacity again to keep up. And again, most of that is supply base, right? Our issue is not assembly capacity primarily; it’s making sure supply base keeps up. So that’s one issue that we’re dealing with.

And then if you go back in the chain some Turbochargers we’ve had some issues ramping up in that area too, with suppliers. Assembly capacity is okay but keeping suppliers up has been a bit of a challenge. But again there’s nothing that’s unique or different. It’s stuff that we deal with every time we see ramp-ups. But we’re working on it pretty aggressively to make sure that we can have enough capacity to meet our growth. And Tim and Pat talked a little bit about where we are with our joint ventures and trying to expand capacity there. We’re working really hard in India and China to make sure those supply bases keep up as well because we have really big growth opportunities there and so we have a big focus on keeping supply chain free flowing.

Andy Casey – Wells Fargo

Okay. Thanks, Tom. And then if I could flip to cost. You walked through it for Engines. Could you give some sort of bridge for the Components because there was a lot of stuff that went on this year. And it looks like the 13% to 18% implied incremental margins might be a little conservative given the growth and the anticipated absence of the second half operational cost issues you encountered.

Patrick Ward

So you’re asking about the 2011 guidance on Components?

Andy Casey – Wells Fargo

Exactly, Pat.

Patrick Ward

Okay. Yes, so we go from 9% EBIT in 2010 to between 10% and 11% so call a midpoint of 10.5% this year. So my calculation, that’s 16% incremental EBIT margins which for that segment would be pretty impressive given the track record. Obviously, a big part of that is coming from volume. With sales being up 25% and given it’s going to come through in Emission Solutions business in particular. I think that will be a catalyst, if you pardon the pun, through much better margins.

We do see material costs probably close to 0.5% favorable in the Components segment compared to the average of last year but we are making some fairly significant investments in this segment also on research and development that will drive the net margin down from what you think it might have to be for an incremental basis.

Again, 10.5% – somewhere in the 10.5% range would be a – obviously a new record for the segment. And if we can get there – I think we’re getting on top of the issues that Tom talked about last quarter in our manufacturing plants and the Turbo business and Infiltration business that were dragging margins down in Q3. They were 8% there. And we got back to 9% in Q4. So we’re on track there. So you can expect to see that above 10% next year or this year.

Norman Thomas Linebarger

And really, Andy, on the incremental margin front, what we’re trying to do is balance the – gaining as much of the increased revenue we can in terms of leveraging the profits but then making sure we’re continuing to make the investments that we think continue to drive the growth forward. We’ve talked about the growth that we’re investing in India and China.

But a big growth driver for the company going forward is going to be the Component segment, too. So we are definitely, significantly – we’re taking a share of our profitability and investing it back in R&D growth in products in the Components segment because we believe that’s going to drive a lot of growth. And that’s both in emerging markets and developed markets. So that’s definitely where some of the money is going. But most of the operational issues are getting behind us now and we expect to get a lot of leverage of increased revenues in 2011.

Andy Casey – Wells Fargo

Okay. Thank you very much.

Operator

And our next question comes from the line of Tim Denoyer with Wolfe. Please proceed.

Tim Denoyer – Wolfe

Hi. Good morning.

Norman Thomas Linebarger

Morning, Tim.

Tim Denoyer – Wolfe

Quick question still on the Emissions Solutions. There’s been a couple of announcements recently in terms of the sale of the Tube business. Can you give us a sense of what kind of impact that’s going to have in terms of it and how that plays into the incremental margin discussion for components in 2011?

Patrick Ward

The size of that business is around $100 million so definitive guidance that we’ve given, the $16 billion, that is not included within that guidance at all obviously given the announcement in the last week or so. In terms of EBIT, it really doesn’t have any impact on the EBIT when you look at 2010 versus 2011 either, not material.

Tim Denoyer – Wolfe

Okay. Was that a – so non-material for the margin or the actual EBIT?

Patrick Ward

It’s not detrimental, not incremental to the EBIT margin year-over-year.

Tim Denoyer – Wolfe

Okay. And then just strategically in terms of that sale, was that just a low value-added business or what’s the rationale there?

Norman Thomas Linebarger

Yeah. So the sale of business – the strategy was trying to make sure we’re focusing on our primary commercial markets and not focusing on light-duty and passenger car and not focusing on the less value-added pieces. These pieces go back to an acquisition we did some years ago. And what we’re doing is keeping the pieces of that, that really have to do with our forward looking Emission Solutions and Filtration businesses. And the ones that really aren’t part of our segment going forward, they’re either serving markets that we don’t serve or they’re not utilizing the technology development we’re doing on Emission Solutions. And those are really the parts that we cobbled together and put into the sale.

Tim Denoyer – Wolfe

Got it. Thanks. Just one other quick one in terms of the non-segment items, Pat, there was $20 million in the fourth quarter. Can you give us a sense of what that was?

Patrick Ward

Yeah. That’s the normal elimination of profit and inter-company inventories. The levels of inter-company inventory came down at the end of the year. That’s a trend we normally see. So we were able to release some of that profit that was held up.

Tim Denoyer – Wolfe

Great. Thanks a lot.

Operator

And our next question comes from the line of Tim Thein with Citigroup. Please proceed.

Timothy Thein – Citigroup

Thank you. Good morning. First question was just going back to the Engine segment in terms of the margin outlook for 2011. Is there any way you can quantify potential mix impact from the aftermarket piece presumably, especially in heavy-duty, is going to represent a much smaller piece than it was in 2010? Is there a way to put any numbers around that?

Patrick Ward

There may be, but I don’t have it with me just now. So that’s one you need to follow up with Dean afterwards rather than guess at it.

Timothy Thein – Citigroup

Okay. And, Pat, while you’re there, did you say the total unconsolidated revenue growth that you’re projecting for this year is 15% to 20% for the whole piece? Or was that just, in the slide that’s showing China and India, up 17%? Is that what you were referring to? Or?

Patrick Ward

I was giving you all our unconsolidated joint ventures. We expect that the revenues will grow somewhere between 15% and 20% in 2011.

Timothy Thein – Citigroup

Okay. So that – again, I’m still having a harder time. I understand all the investment as it relates to the equipment ops, but if the Distribution piece, presumably that implies double-digit growth and I’m still having a hard time seeing as to why, especially that business, wouldn’t contribute more than, get you to more than 5% growth year-on-year in JV income. Can you just help me with that?

Patrick Ward

Again, we’re making fairly significant ramp up in our capacity in the joint ventures. And that’s adding cost to those businesses from what we have today. I think that the largest joint venture Dongfeng Cummins had a fantastic year in 2010. We went from 120,000 engines last year, sorry 2009, to 220,000 engines in 2010. And that is, by far, the most profitable joint venture that we have. But temporarily, capacity is constrained in that joint venture and will be for all of this year. So we’re making investments in the other joint ventures, but we’re not getting the additional profit leverage that we would have got had we had additional capacity for an additional 50,000 units at DCEC.

Timothy Thein – Citigroup

Okay. All right. Thank you.

Operator

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

David Raso – ISI

Hi. Good morning.

Norman Thomas Linebarger

David.

David Raso – ISI

A couple of small items, on the inventory, typically third to fourth quarter, your inventory goes down. This quarter I see it went up a bit and on a year-over-year basis, it’s been a while when inventory’s grown faster than sales, in this case a lot faster. You did have a couple Distribution acquisitions during the quarter so maybe that explains some of it. But can you take us through that unique action in inventories versus sales?

Patrick Ward

Yeah, I think in inventory actually we’re pretty pleased the way it came out for the year. Our inventory turns at the end of the year, were close to six which was better that what they were at the end of third quarter and much better than what they’ve been all through the year and at the end of 2009. We are ramping up as we see stronger demand come ahead of us in 2011.

When I look at working capital in total, David, I’m pretty pleased the way it came out, even though it went up in dollar terms obviously when you look at a percent of sales, it’s lower, as I said our inventory turns are better. Our receivable past dues are lower, our DSOs are much better than what they were a year ago. We only wrote off $3 million of bad debts in 2010 and we normally run at $9 million to $10 million a year. Overall, for the company, I’m feeling okay with working capital just now.

Norman Thomas Linebarger

You know what, Dave? The only thing I would add, I’m never really satisfied with inventory levels. There’s definitely improvements I think we can make but I think that the principal difference in this end-of-year situation versus prior is that we are seeing, continuing to see strong sales in Q1 and so in several of the places where we sometimes have lower inventories we actually didn’t lower inventories getting ready for sales in Q1. So that’s one seasonal or notional difference than you might see in previous years.

David Raso – ISI

Would that be related particularly to North American truck or industrial for construction, just to get some indication because it is bullish on the first quarter shipments given that inventory. It is unique, that movement.

Norman Thomas Linebarger

You’re right, but it’s all those. It’s high horsepower demand which is staying high both in Power Gen and Engines, it’s North American trucks and then it’s also construction. So all three of those areas are still staying strong and so therefore, we have higher inventory levels than we might otherwise.

Patrick Ward

The one thing to keep in mind as you build your models out for the first quarter, and this is not trying to give you colossal guidance, but keep in mind the fourth quarter was a 14-week quarter and the first quarter is a 12-week quarter. So even though demand per day is still increasing, we’ve got two fewer weeks in the first quarter than the fourth quarter when you do your models.

David Raso – ISI

As it relates to the working capital changes and cash flow, we don’t yet have the detail on the operating cash flow. But the implied operating cash flow in the quarter was about $387 million. But when you look at the balance sheet, the working capital was a use of cash of about $350 million. How do we square that up? Is it accrued expenses? Or what’s the number that gets you to that strong a cash flow for the quarter of working capital with that much of a use?

Patrick Ward

Yes let’s take that one up after the meeting. I don’t have that number in front of me just now.

David Raso – ISI

I appreciate it. Thank you.

Dean Cantrell

Okay. That’s all the – Anne, that’s all the time we have for questions today. I – we’ll be available today for your questions throughout the day so I appreciate everyone for dialing into our fourth quarter earnings call today. Thank you.

Operator

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

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