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Cummins, Inc. (NYSE:CMI)

Q4 FY07 Earnings Call

February 1, 2008, 10:00 AM ET

Executives

Dean Cantrell - Director, IR

Tim Solso - Chairman and CEO

Jean Blackwell - EVP, CFO and Chief of Staff

Joe Loughrey - President and COO

Analysts

Peter Nesvold - Bear Stearns & Co.

Andy Casey - Wachovia securities

Stephen Volkmann - J.P. Morgan Securities

Jamie Cook - Credit Suisse - North America

Joel Tiss - Lehman Brothers

Charlie Rentschler - Wall Street Access

Operator

Good day ladies and gentlemen, and welcome to the Fourth Quarter 2007 Cummins, Inc. Earnings Conference Call. My name is Towanda, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will facilitate a question-and-answer session towards the end of this conference. [Operator Instructions].

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

Dean Cantrell - Director, Investor Relations

Thank you, Towanda. Welcome everyone to our teleconference today to discuss Cummins' results for the fourth quarter of 2007. Participating with me today, our Chairman, Tim Solso; our Chief Financial Officer, Jean Blackwell; and our President and Chief Operating Officer, Joe Loughrey. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about forward-looking statements begins on page 61 of our 2006 Form 10-K, and it applies to this teleconference.

During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation is available on our website at www.cummins.com under the heading of Investors and Media.

Before we review our fourth quarter performance, Tim will summarize our accomplishments of 2007 and provide his outlook for 2008.

Tim Solso - Chairman and Chief Executive Officer

Good morning. This time last year, we predicted that our 2007 results would be strong, but would not match Cummins' record setting pace of 2006, primarily because of the projected 50% decline in the North American heavy-duty truck market as a result of emission regulations changing January 1st, 2007.

Today, I am pleased to report that instead of being just another good year, 2007 was a record setter and an outstanding year in many respects. Sales exceeded $13 billion, a 15% increase over 2006. Net earnings were $739 million, compared to $715 million for the previous year. Earnings before interest and taxes were $1.2 billion or 9.4% of sales. This time last year, we had confidence in our technology and product performance, but knew the North American heavy-duty truck market would be softer in an emissions change year.

As a result, we did not forecast this level of overall company performance for 2007. However, as the year unfolded, both the strength of power generation market and our North American heavy-duty engine share were better than anticipated. As a result, we increased our guidance and ended up at $3.70 per share, which is approximately 45% higher than was expected at the beginning of the year. This fourth straight year of record sales and profits reinforces our value commitment to Cummins' shareholders. As of the end of 2007 our investors enjoyed a five-year average annual total return of 58%.

Other actions that reflect our commitment to growing shareholder value include a 67% increase in our dividend in the last 18 months and ongoing stock repurchase plans. Over the last 25 months, we have purchased almost $500 million in stock, and in December we announced plans to buyback another $500 million.

Our success in 2007 was driven by increased sales in all of our segments. The Power Generation, Distribution and Engine business segments once again delivered excellent results. They had record revenues, increased share in many of their markets, and offered innovative products and services that delighted Cummins' customers around the world.

The Component segment also experienced a growing demand for its products, which provides significant value to both Cummins and our customers. These critical technologies performed well and the segment hit its revenue goals. These are the technologies that allowed us to produce a 2010 certified heavy-duty pickup truck engine for Chrysler three years in advance, as well as the non-SCR solution for heavy-duty engines in 2010.

Components' 2007 financial performance was better than in 2006, which shows progress. However, because of operational issues in two of its four businesses, components failed to hit its profit target this year, otherwise Cummins performance would have been even better. To ensure this group's success in the future, we recently moved three of our best operations people into key roles in this segment. Their focus is on fixing operational issues and turning sales growth into increased profits, particularly in the emission solutions and turbo technology businesses. We have a proven track record of dealing with operational challenges as illustrated by the turnarounds in heavy-duty engine and power generation businesses in the 2002 and 2004 timeframes. So, we remain very optimistic about our components' ability to achieve significant sales and profit gains.

Along with our financial success during 2007, we are proud of several major business and product accomplishments. We announced a large number of exciting new products that were launched or will be introduced during the next several years, including engines that meet U.S. 2010, Euro 4 and Tier IV and Tier II high horsepower emission standards. We also started production of the new world class XPI Common Rail Fuel System and Closed Crankcase Ventilation Systems from our filtration division.

As a result of our outstanding technology, Cummins' heavy duty monthly market share averaged above 40% for the last two-thirds of the year. In my 36 years at Cummins, I cannot remember this large a market share shift. We also enjoyed growing marketing leadership around the world including transit bus, power generation, marine, medium-duty trucks, recreational vehicles and other markets.

Power generation continued its trend of great results, going from an EBIT loss of $19 million in 2003 to $334 million in EBIT in 2007. Distribution sales more than doubled in four years, growing to $1.5 billion in 2007. Cummins earned a prestigious award for customer satisfaction from JD Power and Associates for heavy-duty engine performance, cost of ownership and warranty. And finally, for the second time in five years, Cummins received recognition as Diesel Progress magazine's Newsmaker of the Year. We were recognized for the early launch of the 2010 ready Dodge Ram and its innovative NOx absorber, the announcement of our non-SCR solution for 2010 heavy-duty trucks and the unveiling of our Tier IV off-highway strategy.

It's difficult to discuss Cummins prospects for 2008 without acknowledging the prospect of a U.S. recession. I don't pretend to be to an economist, but I do know our business. I talked to our customers, our partners and our people and I am confident that despite the potential for economic road bumps in the near future, Cummins will do well in 2008 and beyond. In fact, I am predicting that 2008 will be our fifth straight year of record performance.

The reasons are simple; first, Cummins is more diversified and better able to handle the cyclical nature of our businesses than at anytime in our history. Even if some markets have softened, new ones have emerged, such as oil and gas and like construction.

Secondly, Cummins' advanced technology has opened new doors for our products and will drive our longer term growth. In particular, our technology will play an important role in markets related to more stringent emission standards, better fuel economy, generating electricity and the needs of developing countries such as China, India, Brazil, Russia, Vietnam and Nigeria.

Third, we have already increased our capital investment in many parts of the world in anticipation of these growing markets. We consider new plants and facilities particularly in China and India as a primarily requisite for being a significant participant in these markets. Along with the manufacturing and technical centers we built in recent years, we are planning 19 new plants and 42 capacity expansion plans... projects, many of which are under way. These include fuel system plants in Sweden and China, our light-duty project with Foton in Beijing and major expansions in India for both medium and high horsepower engines, power generation and turbochargers.

Over the next five years, our consolidated entities will spend $2.5 billion in capital expenditures. Together with our partners, we will spend another $1 billion in capital expenditures in our joint ventures. Most of these investments will drive profitable growth in the future as new engine platforms begin production in 2009 and 2010. Investments such as low and high horsepower engine capacity fuel systems, turbochargers and after treatment will pay more immediate returns.

In early January, I traveled throughout India and China to see our newest facilities and talk about our growing presence in those countries with Cummins employees, partners and OEM customers. In India, I visited new plants for our power generation, generator technologies, high horsepower and filtration businesses, all of which are experiencing solid growth in that region.

In China, I met with our joint venture partners including Dongfeng, Shaanxi and Foton, all of which will play a major role in our joint venture growth. I also visited plant expansions for turbo technologies and generator technologies, along with two new filtration plants and our light-duty diesel plant, which is under construction. This trip reinforce my belief that we are well prepared to take advantage of the significant growth occurring in this part of the world.

Our total capital investment for these two countries through 2009 including the investments from our joint venture partners is close to $600 million. Along with our willingness to invest capital and our quest for profitable growth, we are talking with potential new partners such as Vinamotor in Vietnam. The reason for this strategy is clearly obvious. Our access to these markets is made easier by our joint venture relationships, which allow us to partner with established global companies, such as Dongfeng in China, Tata in India, and KAMAZ in Russia, with limited investments and volume commitments providing good returns.

A fourth reason for my optimism is the improvement in our ability to deliver bottom line performance. We have focused on margins and controlling costs, and as a result, over the past several years, we have grown EBIT at four times the rate of sales.

Finally, our balance sheet is in good shape with less debt, good cash flow and fully qualified pensions. This financial help gives us the flexibility to invest in people, products, facilities and technologies. We need to capture profitable growth opportunities when they arise.

These are exciting times for Cummins. We have outstanding products and technology, leadership, expanding markets and growing share, a disciplined approach to investments and a strong balance sheet. Our people are extremely well prepared to take advantage of the profitable growth opportunities before us, and they will.

Now, I will turn the teleconference over to Jean, who will provide more details on 2007 and give our guidance and promising outlook for 2008.

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

Thank you, Tim. Let me start by giving you my perspective on our results. We delivered the year a $3.70 per share, another record year for net earnings. I am very proud that we achieved what we said we would. Even with the significant downturn in the North American heavy-duty truck market in 2007 due to the emissions change, our net earnings as a percent of sales exceeded our performance in 2005, the last year before the pre-buy. As a result, we surpassed our targeted return on equity and return on average net asset metrics for the fourth consecutive year.

We reported record quarterly and annual sales in all of our segments. We saw a year-over-year growth in nearly every end market, and stronger international sales for the fourth time in the last five years. But more importantly, three of our operating segments demonstrated year-over-year improvement in both, quarterly and annual EBIT margins.

Profitable growth, that's what's important. We expect earnings growth to accelerate again in 2008, faster than the top line as every segment improve the operating performance. As Tim said, we are anticipating another record year in 2008. We are predicting strong sales growth and nearly 20% EBIT growth.

Before we discuss our 2008 outlook in greater detail, let me highlight our Q4 results for each segment. Power Generation and Distribution had a spectacular fourth quarter. Global Power Generation sales increased 28% with double-digit growth seen in every geographic region. Segment earnings rose 39%, a significant price realization off that higher material cost.

The Distribution segment sales grew 21% versus the same quarter last year. Sales of engines and power generation products were sharply higher, especially in Europe, the Middle East and Africa. Segment earnings improved 44% benefiting from the broad market growth as well as record earnings from its joint ventures.

We have said all along that the engine business would have lower margins year-over-year, due to cost associated with the release of new products in North America to meet the 2007 EPA emissions regulation. Compared to the third quarter, the segment EBIT dipped to 5.6% of sales for three reasons: First, higher costs to get facilities ready for future new products, some of which will continue into 2008. Second, lower overhead recovery from significantly lower heavy-duty and pickup truck volumes, and third, higher research and development expense for future emission regulations in new products.

However, I feel really good about the potential for margin improvement in the engine business this year. We are seeing positive incremental margins from the new 07 products and expect further improvement as volumes pick up. Our EPA 07 products continue to perform well in the market, so we should also begin to see warranty accrual rates trend downward later in the year.

The Components segment posted a 6% EBIT margin in the fourth quarter, better than last year and last quarter, the less than the margins we've targeted. Clearly, we are not satisfied with these results. Let me remind you that our segment EBIT target is 7% moving to 9% longer term. Let me walk you through each of the four businesses in the Components segment.

During the second half of 2007, filtration demonstrated operating margins above the long term 9% segment target. Startup cost on the XPI joint venture lowered the margins in the fuel systems business somewhat in Q4, but overall for the year, they are in track with our expectations. On the whole, both are performing well with no surprises.

Leadership changes were made early in 2007 with the appointment of Jim Lyons to head Turbo Technologies. Jim brings a wealth of manufacturing experience to this business. As a result of his focus on delivery and improvement in manufacturing processes, this business showed improvement every quarter in 2007. Operating margins will remain below the segment target in 2008 but are expected to prove... improve year-over-year.

As you are aware, emission solutions did not make the progress we had hoped. This business added only $12 million incremental EBIT on a $300 million additional revenue in 2007. We have high-quality products that are delighting customers and are in very high demand, as evidenced by the 200% growth in sales. Our focus remains on fixing the operational issues in this business.

We recently announced a new leader for this business, Srikanth Padmanabhan. He has an excellent track record driving manufacturing improvements in our Generator Technologies businesses. As we had forecasted for the fourth quarter, Emission Solutions did eliminate the expedited premium air freight in its South African facility. However, the business experienced higher than expected material cost and lower overhead recovery. Emission Solutions operating margins will remain below the segment target in 2008, but we look forward to significant year-over-year improvement in its results.

Finally, we have asked Rich Freeland to head our Components Group. Rich has significant operations experience. He led the Distribution Business for the last two and a half years and formerly led the Fuel Systems Business and many of our manufacturing plants in the Engine Business. Our actions to improve operating margins in components are only part of the reason for our optimism in 2008. We see profitable growth in all of the segments. Our 2008 guidance reflects earnings growth growing faster than revenue.

So, let me turn to our view of company performance in 2008. We've assumed relatively slow growth in the U.S. economy, but still anticipate Cummins revenue will grow 12% in 2008. Slide 16 illustrates that more than half of the growth will come from market growth and share penetration.

Let me first discuss the U.S. truck market. We expect to see double-digit growth from the supplied engines to the U.S. truck markets. We are forecasting the NAFTA Class 8 Group 2 truck build at 205,000 units, 16% higher than 2007. However, we believe our heavy-duty engine production will grow 35% to 40%, as we enjoy a full year of our 2007 market share gains.

We also expect our shipments to the global medium-duty truck and bus markets to grow 25% to 30%. We are forecasting the markets outside of the U.S. to grow while the medium-duty truck market here will remain soft. The recovery in engine volumes and Cummins higher share in the on-highway engine market will also strengthen component segments by 20% to 25%.

The global industrial engine and power generation markets are expected to continue to grow, especially in markets served by high horsepower engines where we've been adding capacity. Demand remains driven by global non-residential construction activity and investment in the extraction and transportation of natural resources. We forecast nearly 12% to 16% growth in both, the Power Generation segment and the Industrial Engine market that serve the construction, mining, and commercial marine markets.

The heavy-duty pickup truck market is one of the few markets where we are seeing the impact of economic uncertainty. Although, we continue to enjoy high diesel market share and have broadened our offering into chassis cab, demand for heavy-duty pickup trucks are expected to soften 10% to 15% due to the U.S. economy. All of this revenue growth translates into nearly 20% growth in EBIT in 2008.

Slide 17 illustrates that while we continue to invest in profitable growth around the world, we will continue to leverage our operating expenses to increase earnings. We have also implemented some price increases in 2008 and offset aggressive cost reduction targets for Six Sigma and low-cost country sourcing.

We expect these initiatives in 2008 to enable us to yield a 10% EBIT margin. Let me remind you that our first quarter is seasonally our lowest quarter. This year will be no different, especially with the recent heavy snowfall across China that has idled all of our Chinese facilities prior to their New Year holiday.

Now for a moment, let's talk about segment targets on slide 18. Power Generation will continue to operate above its target margins. Engines will improve upon 2007, even as it invests heavily in people, products, facilities and technology in 2008. The initial costs associated with distributor acquisitions and consolidations are expected to dilute the distribution EBIT margins slightly in 2008. Components will continue to improve from 5.2% in 2007 and should achieve an EBIT margin between 6% and 7% in 2008.

The acceleration in our earnings and improvements in working capital management will generate strong operating cash flow to fund our growth and shareholder return initiatives. Our efforts to do a better job of controlling inventory and receivables growth should result in an improvement in working capital in 2008, getting us back within our target range of 16.5% to 17.5%.

Capital expenditures are expected to run $550 million to $600 million or nearly 4% of sales in 2008. We will partially offset the increased capital spending with lower pension funding, since we achieved our global funding goal in 2007.

In summary, the drivers of the longer term 12% earnings growth story we outlined in September at our Analyst Day, continue to fuel our growth. We know how to improve the operational performance and components, and we will be successful. 2008 will be another record year for earnings growth.

We will now take your questions.

Question And Answer

Operator

[Operator Instructions]. Your first question comes from the line of Mr. Peter Nesvold with Bear Sterns. Please proceed.

Peter Nesvold - Bear Stearns & Co.

Hey guys.

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

Hi.

Tim Solso - Chairman and Chief Executive Officer

Good morning.

Peter Nesvold - Bear Stearns & Co.

I guess, as I go though the segment guidance, power gen jumps out a little bit at me here. You're coming off a two straight years of plus 20% type growth. So you are... the guidance seems to discount... meaningful deceleration in the growth from kind of plus 20% to 10% to 15% and the margins are slightly above 10%. I mean, you did about 11% I believe in '07, so there is actually a margin contraction discounted into the guidance and I guess, I would just hope to get a little more color... what's driving those two assumptions in the outlook for '08?

Tim Solso - Chairman and Chief Executive Officer

I just... I think that... that's our view the 29% from last year was an exceptional year. Right now, on the high horse power, the larger generator sets we have restricted by capacity particularly from the high horse power engines, but also the larger alternators. The RV business we think will be soft during the year, flat to soft, so we're just being conservative with that. Power generation had a great year last year and they are going to have a good year in 2008.

Peter Nesvold - Bear Stearns & Co.

Is there anything to... I mean when I look at it, I mean just frankly, it seems awfully conservative in the context of what we've seen in the last couple of years and is there anything in pricing that you are seeing? Is it mix or both of those items turning flat from what you saw in '07 or up or what?

Tim Solso - Chairman and Chief Executive Officer

For pricing, again it depends on the region and so forth, but is in the 4% to 5% range. And we're assuming that material cost will go up in the same range. So we're... there will not be margin expansion as there has been in the last couple of years.

Peter Nesvold - Bear Stearns & Co.

Okay, that's fair. Other thought, I guess initially when I saw the outlook it was little confusing, the CapEx was going up but you are seeing margin expansion. I think you outlined it pretty well in slide 17 with how much you are investing into the growth... margins again at slide 17. How quickly do you get a payback from something like that? So... how... if we looked out into 2010 or so I mean, when does that start to give you a bit of a sling shot on margins?

Tim Solso - Chairman and Chief Executive Officer

Well, I think the expansion of our heavy-duty engine, which we're increasing in the 15% and we've increased the capacity of the high horse power by 15%, we will do another 15% by the end of the year, allows us to get more volume which gives us some benefits with the margins.

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

And I think --

Peter Nesvold - Bear Stearns & Co.

Yes.

Joe Loughrey - President and Chief Operating Officer

Peter, I was just going to say... this is Joe, I was just going to say that the investments we are making in high horse power side of our business, we should see pay-off in '09. I mean, we are already seeing day-to-day increases as the numbers go up. But just given some of the jumps as we go through the second half of this year, we will see benefit pay-off beginning in... more substantially in '09. And then while 2010 may... who knows at this point, but obviously maybe a down market, given down... given emissions changes. We are investing on the presumption in several of our markets that with certain OEMs we will continue to gain share. And we will be able to payback on that investment very quickly as we begin moving through 2010 and beyond on... at that side of the coin. That will also be a plus that's not just an engine comment by the way, that's also a components comment.

Peter Nesvold - Bear Stearns & Co.

Got you. And then just last quick question, I will jump back in the queue. What's discounted into the outlook as far as joint venture income growth because I think this is the first time that you haven't sort of broken that out separately?

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

I think we said 5% to 10% growth in joint venture income, part of that is, this is also a heavy year for investment in some of our joint ventures. So, that's the range we are seeing.

Peter Nesvold - Bear Stearns & Co.

Got you.

Joe Loughrey - President and Chief Operating Officer

Peter that's broken out on slide 15.

Peter Nesvold - Bear Stearns & Co.

Okay I missed that, thank you all. I will jump back in the queue.

Operator

And your next question comes from the line of Mr. Andy Casey with Wachovia Securities. Please proceed.

Andy Casey - Wachovia securities

Thanks, good morning every body.

Tim Solso - Chairman and Chief Executive Officer

Good morning Andy.

Andy Casey - Wachovia securities

Before I do some nitpicking on the quarter and outlook, can you talk about what Q4's total year-to-year percentage decline in U.S. and Canadian Dodge Ram and RV, heavy-duty and medium-duty truck for the industry was in the quarter on a combined basis? And then did... have you ever seen that sort of decline rate in any prior quarter that you can remember?

Tim Solso - Chairman and Chief Executive Officer

The pick up truck business was down 13%, it was particularly down in the fourth quarter where we had some shutdown days at the CMEP plant, where that engine is produced. We... our volumes were somewhere around 160,000 in 2006, last year they were 140,000 and this year we are predicting somewhere around 125,000.

So that business is pretty soft. But what I'd add back to that is the dieselization rate of the pickup truck is over 80%, where its competitors average somewhere between 55% and 70%, and they basically have one-third of the market. So, they gain market share in the heavy-duty market maybe a third relative to their overall pickup truck share at around 23%. So, the product is performing well, there is no issues there, it is just that... with the state of talk on recession and so forth that market is going to be down.

So, this year or '07 was the first down year that I can remember other than the modular [ph] changes that we had in the 2000 timeframe and then next year, it will be down so we would have two consecutive down years.

Andy Casey - Wachovia securities

I guess the spirit of the question Tim is, a large chunk of the investor base is concerned about the North American market in the next couple of quarters or so. And what I would say is in the quarter you had heavy truck on an industry basis down 51%, medium truck down 30%, it sounds like the heavy pick-up truck was down some where in excess of 40% and you still posted 9% margins and 7% earnings growth. Would Q4 be the worst year-over-year decline in those three combined markets that you've seen?

Tim Solso - Chairman and Chief Executive Officer

Well, certainly in the pickup truck business, I'd... can you help me on the heavy-duty, medium business?

Joe Loughrey - President and Chief Operating Officer

Andy, this is Joe. In general, I think in general at this point in time based on the way we see '08 and each of the respective markets, you kind of asked about, the answer to your question is yes. One little detail to add, part of our issue from third quarter, fourth quarter in Chrysler is that volume was cut more than half from well over 40,000 to just slightly over 20,000 units from quarter-to-quarter.

So that was the... that's part of your observation about the size of the drop. So, the other thing to keep in mind as you are looking forward through '08 is while we will be moving a little counter trendy, if that's a phrase that makes any sense, in particularly heavy-duty, medium-duty, medium-duty RV, medium-duty bus, even medium-duty Europe for that matter, where our share will continue to grow, regardless of what happens to the actual market size.

And if you look at how we started the year and what was going on in each of those markets and how things have played through during the course of the year in our mature markets with lower GDPs as a percent of sales, we are actually going to see a reasonable amount of share growth that will help us offset, in some cases completely, and in other cases, close to what's actually going on in each of those respective markets.

Tim Solso - Chairman and Chief Executive Officer

Let me add a couple of... just to your point about people are concerned about certain markets. But overall, we've assumed slow growth in the U.S. and Western Europe, but the emerging markets that we're in are growing anywhere from 6% to 10% in the businesses that we're in, in those markets are growing faster than that because we are investing in infrastructure; roads, power generation, and so forth. So, our businesses in China and India are just remarkable. I spend 18 days this month in detailed visits in both of those countries, and I am very, very confident that with the capacity constraints that we have that we are going to be able to meet our growth targets there.

And also now, China seeing some power shortages and Brazil is anticipating power shortages in late 08 and 2009, so those are going to be good power generation markets on top of the Middle East and some of the other businesses that we have. And then also, these emission regulations are starting to be implemented in different countries. And again, as Joe was saying, I think that's one of the reasons we are starting to get some share gain.

So, yes, not all markets are as terrific perhaps as they have been in the last couple of years, but we are still anticipating the kind of growth that Jean was talking about.

Andy Casey - Wachovia securities

Sure. Before I move on to the nitpick stuff, I guess to further the point, the U.S. and Canadian on-highway markets, Europe outside of the Dodge Ram basically projecting growth for various reasons above market. So it appears as if your North American on-highway business is kind of coming out of an 07 truck, is that about right?

Tim Solso - Chairman and Chief Executive Officer

It's still... yes, that's right. But it will be stronger in the second half than it is in the first half. Essentially, we said the heavy-duty market will go up 15%, and we would go up 30%. And in the medium duty when you consider the international, we think the market in U.S. will be flat to down to 5%, but our production will be up 25% to 30%.

Andy Casey - Wachovia securities

Okay. Thanks for that. The nitpick stuff on the quarter, the 3.4% warranty expense. We talked about that same level as a percent of sales in the third quarter and I kind of thought that would revert to 3%. Where are we in our outlook for 08?

Joe Loughrey - President and Chief Operating Officer

What I think we said in the last teleconference, Andy... this is Joe, is that we expected the year to end up on average above 3%.

Andy Casey - Wachovia securities

Okay.

Joe Loughrey - President and Chief Operating Officer

A couple of comments relative to the number is; right now we are I guess even from the last quarter increasingly pleased about what's happening with the reliability of our product. It's still a little early days for us to confirm where we are hoping to be. But, we are expecting as is our plan and as we go through the course of the year and get more data that reliability will continue to improve and have some positive impact on product coverage cost as a percent of sales, presuming we don't get any big surprises in mix in our business given the nature of next year.

So we are going to start the year pretty close to where we ended the year from the point of view of product coverage cost as a percent of sales, largely because we have locked into product coverage rates that we aren't changing at all or much until we get enough experience over several quarters to feel good about where we are. But, I want to kind of emphasize here right now. Things are going well and subject to any issues as we get more and more higher mileage that we haven't seen, we are expecting we will end that by the end of the year, we will be doing... we will be able to talk about significant improvements in the reliability of our product and how it will be reflected in product coverage cost.

Andy Casey - Wachovia securities

Okay and thanks. Two quick ones and then a longer term, the 07 base that you're looking at for the 205,000 07... 08 heavy-truck forecast, what is that?

Joe Loughrey - President and Chief Operating Officer

176.

Andy Casey - Wachovia securities

Okay. And then on the light-duty diesel engines to the heavy pickup market, have you shipped any of those in 08 so far?

Tim Solso - Chairman and Chief Executive Officer

The light-duty diesel below 8,500 pounds.

Joe Loughrey - President and Chief Operating Officer

No, no, he said heavy duty.

Tim Solso - Chairman and Chief Executive Officer

The heavy duty.

Joe Loughrey - President and Chief Operating Officer

The CMEP shipping.

Tim Solso - Chairman and Chief Executive Officer

Have we been shipping engines? Yes.

Andy Casey - Wachovia securities

Okay.

Tim Solso - Chairman and Chief Executive Officer

Sorry, I misunderstood.

Andy Casey - Wachovia securities

Okay.

Joe Loughrey - President and Chief Operating Officer

And remember, Andy, I think in their announcement back in December, our customer talked about its Mexico facility being down just half the time as some of their U.S. facilities, and it's the Mexico facility that we ship to.

Andy Casey - Wachovia securities

I appreciate it. I just wanted to confirm something. Then on the longer term, the 2010 discussion, can you talk about what customer response you've had for that so far, and then I'll let it off. Thanks.

Joe Loughrey - President and Chief Operating Officer

Customer response in terms of our 2010 announcement?

Andy Casey - Wachovia securities

Yes.

Joe Loughrey - President and Chief Operating Officer

It's been terrific, both at the OEM level, heavy, and frankly medium, and as well as the end user level. A lot of good questions and a lot of great discussions, but for the most part, just want to remind you, our significant OEMs, that was not a new announcement for them because they were either... they've been working with us for sometime on what the right choices were, up to the announcement date. But, the reaction is very positive to our 2010 technology announcement.

Tim Solso - Chairman and Chief Executive Officer

When I've been out with some of the... this is Tim again, out with the fleet, both Joe and I visited ATA at different times and the non-SCR solution was the buzz, because basically people were expecting to have to use SCR and then have all of the added issues around using urea and so forth. And the fact that they aren't going to have to have extra tanks and worry about whether the infrastructure is developed is very popular and people are excited about it. So, I think the response was even better than what we had anticipated.

Andy Casey - Wachovia securities

Thank you very much.

Operator

Your next question comes from the line of Stephen Volkmann with J.P. Morgan Securities. Please proceed.

Stephen Volkmann - J.P. Morgan Securities

Hi. Good morning.

Tim Solso - Chairman and Chief Executive Officer

Good morning, Steve.

Stephen Volkmann - J.P. Morgan Securities

Just a little bit of drill down, if we could on the engine business. I guess, the margin there was just a little bit lower than what I was expecting and maybe that was just me, but you talk about higher costs for new product development and higher R&D, both of those things I guess I was a little surprised that you say that the '07 change in the release because I wouldn't expect anything for the '07 to kind of kick up in the fourth quarter? So maybe I just read that wrong? And second, it seems like those things are likely to continue going forward as we come through the next couple of years of development on the new stuff. So, maybe we can just drill into that for a minute.

Joe Loughrey - President and Chief Operating Officer

This is Joe; I can make a couple of comments and see if they are helpful. If you kind of look at where we were at the end of '06 fourth quarter versus where we are at the... where we were at the end of '07, is kind of one way of looking at it. The prime differences that drove the margin reduction were significantly lower number of automotive units.

Some mix, meaning, the mix percentage shifted to a higher content of lower margin engines than higher margin engines. Their product coverage cost which we've already talked about is higher and directly related to the '07 engines and versus the '06 quarter. And, we had some absorption issues at least relative to the fourth quarter of '06 particularly related to the Chrysler... the drop in the Chrysler volume from where we were. So, those were some of the contributing factors.

As we look through the course of next year through '08, a few things. We're expecting that overall volume will be a little better as move into the first quarter of next year, we are going to get a few pricing pops not many, but both on the parts and the engines side, but that will benefit us.

And we will... as we go through the course of the year then continue to make progress on cost reduction that will contribute to margin improvement through the course of the year as we kind of smooth out flows, get things working even better than they are right now with our supply base in that regard and continue to refine and improve our process given the changes we made for '07. So, I think in the engine business, we are expecting a relatively significant improvement in gross margin from Q4 '07 to Q1 '08 and then continuous improvement as we go through the course of the year.

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

And... this is Jean. As part of your question is will some of the investments in growth continue, yes. That is something we... and which is a comment as to why the engine business margins might be slightly below the targeted range. The investments and growth will continue, but as Joe said what the... what will improve is both absorption and impact of some of our cost reduction activities as well as the pricing issue. So, that's why we expect to see improved margins Q4 to Q1 and then beyond.

Stephen Volkmann - J.P. Morgan Securities

Okay.

Joe Loughrey - President and Chief Operating Officer

And one thing that maybe add just there in the engine business when we talk about investment in new products as we're working our way towards the 2010 introduction and working our way to the LDD introduction, we are spending money on new products in terms of up fitting and getting plants ready beyond what you would see in an R&D line, alright. So, and that... and we had a little extra pop relative to the rest of the year in the fourth quarter, but that spending will continue to be... do to that spending as we work our way though the course of the year. But again, expect margins to... in the engine business to continue to improve.

Tim Solso - Chairman and Chief Executive Officer

Essentially for a long-term planning you should assume that our R&D expense will be 3% of sales. We are budgeting $440 million for 2008.

Stephen Volkmann - J.P. Morgan Securities

Great. That's very helpful. And then, just one quick follow-up, lots of spending going up in various different places for investment. I am just wondering how that leaves us with respect to share repurchase going forward and where that kind of fits on your priority list?

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

Well, as you know, over the last couple of years, we have repurchased about $500 million worth of stock and we just recently announced another $500 million. What we have said and we will continue to say is that you should always anticipate we would at least cover compensation programs, but we will continue to be in share repurchase mode over the next few years.

Tim Solso - Chairman and Chief Executive Officer

In other words, just we will continue share repurchases on an ongoing basis, on a regular basis. We may vary the amounts, but that's the way we've done it the last two years.

Stephen Volkmann - J.P. Morgan Securities

Okay, but sounds like no change in philosophy there?

Tim Solso - Chairman and Chief Executive Officer

Correct.

Stephen Volkmann - J.P. Morgan Securities

Great, thanks.

Operator

Your next question comes from the lines of Jamie Cook with Credit Suisse. Please proceed.

Jamie Cook - Credit Suisse - North America

Hey, good morning.

Joe Loughrey - President and Chief Operating Officer

Good morning, Jamie.

Jamie Cook - Credit Suisse - North America

I guess some, I was sort of shocked by the engine margins, I am sort of would sieve on that. Can you just... one of the things you mentioned was higher cost related to getting facilities ready that hurt the margins in the engine business. Did you guys quantify that? And if not, could you tell us how big that was in the quarter?

Joe Loughrey - President and Chief Operating Officer

Relative to the fourth quarter of '06?

Jamie Cook - Credit Suisse - North America

Well, you just said higher costs related to getting facilities ready, that hurt your fourth quarter margins, how big was that in this fourth quarter?

Joe Loughrey - President and Chief Operating Officer

Maybe in and around all together around 70 basis points.

Jamie Cook - Credit Suisse - North America

Okay, all ready. And then I guess just my next question, on the component side were sort of disappointing on the margins again outside of the management changes, I mean how comfortable do you feel that we can sort of... at some point get to the longer term goal, I think of 7% to 9% and how should we think about margins as we progress throughout the quarters?

Joe Loughrey - President and Chief Operating Officer

Good question. I think first, Jean laid out a pretty good summary in her remarks about where we are and just as a reminder we have got four businesses, one above the target range is 7% to 9%, the other running just below the lower end of it, but on average the last couple of years about at the lower end of that target. And two others that aren't doing as well though one, has had an improvement plan all year, has done better quarter-to-quarter and we are very confident is going to continue to make progress towards the 7% number.

The fourth one which is the emission solutions business is the one where we've had our issues, where we still have had our issues through last year. On the plus side, their go-to-market strategy that we developed many years ago has worked extremely well. And the product that was designed is also working extremely well and we are very pleased with that side.

The other side of the coin, the business grew by a factor of three, three times in terms of sales from '06 to '07 that was more volume came at us than we anticipated. So that was a failing on our part and though exciting. And therefore... and ramp up costs were more significant than we anticipated and we didn't do as well in some of our plants as we thought as we wanted to do in terms of the ramp up process. So, premium freight, over time, flow mess ups, I mean all kinds of issues that this didn't go well throughout the year and we were disappointed with how the year ended.

However, as Jean pointed out in her remarks, and I know Tim has said it before, the problems we have in that business are ones we know how to fix, it's not a market positioning issue or go-to-strategy issue, its not a design or technical issue in terms of how well the product works versus other choices, its operational issues in terms of getting each and every one of our plants working as well as it needs to work in order to hit our cost and profit targets.

So, like we did at the beginning of the year, putting a significant operations person in charge of our turbo business and we've seen the changes through the course of the year in terms of the improvements that have been made, first on delivery and quality and now gradually on margin improvement. We've made some shifts on the emission solution side of things to put someone in-charge who has got a great track record of running the business within Cummins, it's even bigger than emission solutions with a lot of operations experience. So, while we are behind where we wanted to be from the timing point of view, we have no doubt whatsoever that we will get to the 7% target range and work our way from that up towards the 9% range.

Jamie Cook - Credit Suisse - North America

And, then I guess, my last question is just sort for Tim, Tim, philosophically... well, a philosophical question for Tim I guess. Tim, you mentioned, you made a good point in your prepared comments when you said you guys originally gave guidance for '07 and you came in 45% better than as we sit here today. So, I guess as you look at your guidance for 2008, you have companies that put out guidance, every one always assumes that they are too conservative, so the street goes above that. How should we think about your guidance this year? Do you think you are taking... should we still view this guidance as sort of a conservative approach, should we view this as this is really the best you think you can do? I am just trying to get a feel for how I should look at it.

Tim Solso - Chairman and Chief Executive Officer

Let me put it this way. We wouldn't put it out there, if we weren't confident. I think the issues quite frankly in the third quarter and this quarter is the consensus was higher than what we would have suggested, and I think there has been some issues around that. So the guidance we are trying to do is be more transparent than what we have been in the past in giving information. But, you should take the guidance as what it is and we have a confidence that is. It should not be considered aggressive nor should it be considered conservative.

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

And I think, just a one quick point. There was some things that happened in 2007 that I am not sure anybody could have been anticipated, the markets changed a lot more particularly in power generation than we thought, plus some of the share shift that Tim talked about. I think everyone would have thought we were nut, if we would have projected that level of share shift in 2007. So I think to Tim's point, we're trying to give you our best thinking, right now. So, I think it's a pretty balanced approach in terms of our guidance.

Jamie Cook - Credit Suisse - North America

Thank you. I'll get back in queue.

Operator

Your next question comes from the line of Mr. Joel Tiss with Lehman Brothers. Please proceed.

Joel Tiss - Lehman Brothers

Mr. Joel Tiss, I've been upgraded. How are you doing guys?

Tim Solso - Chairman and Chief Executive Officer

Good morning, Joel.

Joel Tiss - Lehman Brothers

Just... one or two like bigger pictures and then just like Andy one nitpicky one for Jean. Can you... it's a little unclear to me, are you baking in a recession in the U.S. into your estimates or are you just sort of it floating around in the back of your mind, and you're not sure which way it's going to go and you're conscious of it or whatever?

Tim Solso - Chairman and Chief Executive Officer

We are not baking a recession. We have certainly lowered our economic forecasts from where they were, say six months ago, but I'd say slow growth. We are somewhere between... our assumptions are somewhere around... between 1% and 2%. And it's more important in our businesses to look at the specific markets rather than the general conditions. Clearly, the recession or slower economy as well as the housing market hurts the pickup truck business, but you can see what we've baked in there. And again, the medium-duty truck business was probably going to be down 5%, which again would reflect our view of the economies, but both our international markets and our share gain compensate for that.

And overseas, we're not... again in the emerging markets, we're anywhere from 6% to 10%, and quite frankly, those markets have been growing faster than that, and clearly, the businesses that we're in around infrastructure growing even faster than that. So, I don't view 2008 as a recessionary year, but the certain economies, the U.S. and Europe in particular will be very slow.

Joel Tiss - Lehman Brothers

Okay. And just another sort of philosophical, PACCAR try to float the idea that maybe there is not going to be a pre-buy, or if there is, it's going to be muted. Can you just give us a couple little talking points to think about for 2009?

Joe Loughrey - President and Chief Operating Officer

This is Joe. It's a good question, and it's one clearly the industry is looking hard at, because once again, the volume of inventoried engines, so toe speak, going from 06 into 07 was relatively high. I think, part of the reason, not just PACCAR, but others are looking hard at this question is in part related to the announcement we made about our product, is that... is where we will be from our reliability and a fuel economy point of view, given in particular no SCR. And what does that say about end user willingness to buy in 2010 versus building banks, so to speak, or buying more trucks in 2009. I frankly don't think anyone really knows the answer to the question.

But the differences, the things that will be evaluated is at least from a Cummins' engine point of view, two really good introductions over the last, couple of changes from a reliability and a fuel economy point of view, and giving the market a sense that not... that they don't have to expect huge change in 2010. So, therefore, they should be confident that what they experienced in the last two will be at least repeated. That will be something both, end users from a buying point of view and OEMs will be talking about and working through. So, there is some prospect. We won't see as much of a pre-buy, but it is too early to tell.

Joel Tiss - Lehman Brothers

Okay. And then --

Joe Loughrey - President and Chief Operating Officer

I think some of the fleets that did pre-buy in the last half of 06 in anticipation of 07, that's had a lot of trucks part, and then which was not earning obviously any revenue on that. So, those would have been burned, I think may have a different philosophy in the 09 timeframe. Again, just at looking at some numbers, we say the market is 205,000 in 08. ACT is saying 184,000 going to 282,000 in 09. So, you can see that I think the build up will start in the second half of this year and 09 should be a very strong year.

Joel Tiss - Lehman Brothers

Okay, thank you. And then as promised just a couple of pain in necks for Jean. I wonder if you could either give us the aggregate cost cutting target for the whole company, if you want to fuzz it up, or if you could give it by segment, it would be great. And then can you talk a little about why the tax rate is rising, and also the free cash flow was down over $150 million year-over-year, and I just wondered if you can give us a little color around that. Thank you.

Jean Blackwell - Executive Vice President, Chief Financial Officer and Chief of Staff

Okay. Let me deal with your second two questions first, as I think about your first question. On the tax rate, I guess, it's a good news bad news story. As we become more profitable, we move much higher to the highest tax rate. The one thing that you should assume in there is the research credit lapsed, and so if in fact that gets re-up, that would impacted by about 1%. So, it's basically as we become more profitable, it's moved up. And in terms of cash flow, the biggest reason for that is CapEx, it's the investments in growth, which have been much more significant this year than in prior years. In terms of a number around cost reduction targets by segment, I don't really have that. We've got the chart in our... in the material that you can look at for directional approach as a company.

Tim Solso - Chairman and Chief Executive Officer

The way we specifically... the reason we don't necessarily look at it as the company basis, but if you take for example, our Six Sigma effort then everybody has got a specific target to reduce cost that way although we are doing a lot more with customers with Six Sigma now than what we were in the last couple of years.

And then if you look at low cost countries sourcing their specific targets around there and there's also targets in specific plants for lean manufacturing improvement. So, again go ahead and say it.

Joe Loughrey - President and Chief Operating Officer

On chart 17 when you are look in that cost reduction, I mean that's where Tim's talking about the Six Sigma initiatives as well as the low cost countries sourcing activities and as you can see, it's about 1 full percentage point of improvement there.

Joel Tiss - Lehman Brothers

And that's helpful. Thank you.

Operator

Your next question comes from line of Mr. Charlie Rentschler with Wall Street Access. Please proceed sir.

Charlie Rentschler - Wall Street Access

Good morning everybody. I had a question about North American heavy-duty. On the basis that Caterpillar seems to be nearing an announcement about its intentions on highway heavy-duty. If they decide to get out of this business, how well fixed are you with capacity to benefit from this, realize your expanding Jamestown, but can you give us some detail about that please?

Tim Solso - Chairman and Chief Executive Officer

I don't think we are going to enter into speculation Charlie about what Caterpillar is doing. I can just tell you that Jamestown plant is increasing capacity 15% during the year here and then they have what we call burst capacity on top of that. So, we think we can meet the demands of the marketplace given our share assumptions and the size of the market for... what we are looking at is '08 and '09.

Charlie Rentschler - Wall Street Access

Okay. And just a follow-up on the non-SCR heavy-duty engine for 2010, presumably you're testing or you've got so I would assume on the road testing, but are you pleased with what you are seeing especially in terms of fuel consumption and what have you?

Joe Loughrey - President and Chief Operating Officer

Yes and yes Charlie we have had a number of trucks on the road and in customer equipment as well. And we are pleased with what we are seeing from both the reliability and the fuel economy point of view and just want to add we are building directly off of where we are. And so this is an evolution for us not a right angle turn for us. And there is going to be a lot of familiar looking stuff though some changes for OEMs and end users in 2010.

Charlie Rentschler - Wall Street Access

Thank you.

Tim Solso - Chairman and Chief Executive Officer

Our expectation on fuel economy it will be similar to what the '07 engine is.

Charlie Rentschler - Wall Street Access

Very good, thank you.

Tim Solso - Chairman and Chief Executive Officer

Thank you.

Dean Cantrell - Director, Investor Relations

Okay. I think that's all the time we have for questions today. I appreciate your participation in our fourth quarter call. And feel free to follow back up with me with additional questions. Thank you

Operator

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

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Source: Cummins, Inc. Q4 2007 Earnings Call Transcript
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