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Executives

Dean Cantrell - Director of IR

Tim Solso

Analysts

Jamie Cook - Credit Suisse

Eli Lustgarten - Longbow Securities

Andy Casey - Wachovia Securities

Charlie Rentschler - Wall Street Access

Peter Nesvold - Bear Stearns

Chairman and Chief Executive Officer

Jean Blackwell - EVP, CFO and Chief of Staff

Tom Linebarger - EVP, President, Power Generation

Cummins Inc. (CMI) Q1 FY08 Earnings Call April 30, 2008 10:00 AM ET

Operator

Good day, ladies and gentlemen and welcome to the First Quarter Cummins Incorporated Earnings Conference Call. My name is Serita [ph] and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating 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. You may proceed.

Dean Cantrell - Director of Investor Relations

Thank you, Serita. Welcome everyone to our teleconference today to discuss Cummins results for the first quarter of 2008. Participating with me today are Chairman, Tim Solso; our Chief Financial Officer, Jean Blackwell; our President and Chief Operating Officer, Joe Loughrey; and President of our Power Generation Business, Tom Linebarger. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about forward-looking statements begins on page 3 of our 2007 Form 10-K and it applies to this teleconference.

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

Before we review our first quarter performance, Tim will share his thoughts on the underlying drivers of growth at Cummins and some recent examples of our technology leadership and investment in the future.

Tim Solso - Chairman and Chief Executive Officer

Good morning and thank you Dean. Let me begin by saying that I am very pleased with Cummins first quarter results. Our ongoing success reaffirms my belief in the company's core strengths and our strategy of investing in businesses that are performing well today. It has significant promise for profitable growth tomorrow. As many of you will recall last September, we announced new long-term profitable growth targets for our businesses. These targets are aggressive but attainable and are based on the positive impact today’s significant market trends will have on Cummins future. I would like to review these trends again with you.

The first trend benefiting us is the demand for greater fuel economy and energy independence. In the last three years, the price of oil has more than doubled. This price explosion has led to increased political interest in energy independence and improvements in fuel economy through tougher corporate average fuel economy or CAFE standards for cars and light trucks. Recently the US Department of Transportation announced a proposed rule that would require light trucks to achieve 28.6 miles per gallon up from 23.5 by 2015.

Last year, President Bush signed a bill that requires new trucks and passenger cars to meet a fleet wide average of 35 miles per gallon by 2020. Diesel-powered engines offer positive solutions on both fronts. First, diesel already delivers 30% better fuel economy than gasoline and as a result 30% less carbon dioxide emissions. Secondly, the EPA has estimated that if just one-third of our passenger cars were powered by diesel engines, we would save up to 1.4 million barrels of oil per day in the United States. That number is equal to the amount of oil from the United States currently imports daily from Saudi Arabia. Diesel already plays a significant role in the US economy and its reach is growing. J.D. Power is predicting that sales of diesel-powered cars will more than triple by 2015. Expectations are that diesels will move from 3.2% to 10% market share. This expanding interest in the benefits of clean diesel reinforces our expectations for Cummins new light-duty diesel engine, which will be available in 2010. Chrysler and now Nissan will be our first customers for this platform.

The second global trend playing to Cummins strength in our Power Generation business is the growing demand for power. In this country shortages or blackouts during times of peak use can often be traced to a lack of investment in generation and distribution systems. A recent study show that if the US electric utilities are to meet the countries growing generating and distribution demands, they will need to invest $1.5 trillion between now and 2030. One alternative to power company investments is the use of distributed generation with combined heat and power applications. These campus like operations, which are located close to the customer boost reliability and reduce energy cost. In December, President Bush signed into law, The Energy Independence and Security Act, which for mostly use distributed generation. As a result, we expect to see even more interest in this type of operation in the future.

Shortages also exist globally particularly in developing countries where efforts to modernize require significant amounts of power that do not currently exist. For example, South Africa is facing major power shortages and rising prices for electricity, a factor that is interrupted production in the country's gold, platinum and diamond mines. These and other shortages increased power generation sales by 17% this quarter over last year. With the strongest growth occurring at our international markets, Asia grew 44%, India 36%, Africa, 33% and the Middle East 21%. The good news for us is that the consumers are unwilling to be without power and as a result are investing in our generator sets to ensure they have electricity when they need it. Because building power plants and creating distribution systems is complex, costly and time-consuming, commercial generator sets will be in an area of continued future growth for Cummins.

The next trend that provides us with an advantage is that global adoption of tougher diesel engine emission standards, an area, which we operate very effectively. While we are all aware of the tough 2010 emission regulations in the United States and Canada, many other countries are moving to Euro 4 standards for particular matter and NOx control between now and 2014. That is occurring in both on and off highway markets. In addition to these changes, we expect on-board diagnostic requirements to get tougher and regulation of carbon emissions and idling to increase.

Across our entire line up off-highway and on-highway engines, Cummins is able to meet increasingly stringent emission regulations with speed and efficiency primarily because of two competitive advantages. First, we benefit from an integrated business structure that enables us to tap the core competencies of Cummins Emission Solutions, Turbo Technologies, Fuel Systems and Filtration. These four businesses along with the engine business work together to provide fully integrated systems with superior technology for the markets they serve.

Second, we have worldwide experience and leadership with a wide range of proven technologies. Cummins continues to execute this carefully planned product strategy, anticipating changes and investing in research and development necessary to meet customer needs and environmental goals. Cummins engines are in more demand around the world as the machine requirements become tougher. The final trend that favorably impacts Cummins is the economic growth occurring in several emerging markets.

As you know, we are well established in markets like India, which is growing at 8% per year, and China with a growth rate of 9% to 11% a year. We're also successfully expanding our presence in Russia while better positioning ourselves in new emerging markets like Turkey, Nigeria, and Vietnam, all of which are growing faster than the world at large. Like other industrial companies, we are negatively affected by rising commodity prices. However, on the flipside, we are benefiting from the growth in iron-ore, copper and oil and gas exports from Russia, Brazil and South Africa where machine re-powered by Cummins is used to extract and transport these materials. In addition, the wealth from commodity exports is being invested in infrastructure development, which increases the use of our engines in construction and power generation systems, transit buses and trucks. That situation is unlikely to change in the near term.

So based on these significant trends, the demand for power and fuel economy, tougher emission standards and growth in emerging markets, we continue to be very optimistic about our long-term future. We are equally positive about our prospects for near-term success and continue to believe that 2008 will be another record year for Cummins, our fifth in a row.

At the teleconference in January, I said the reason for optimism about 2008 as well for our future is based on our diversification, technical leadership, increased capital investment, improved operating performance, and a strong balance sheet. These continue to be strong. In the area of technology leadership, for example, we unveiled our Tier 4 off-highway product line at the recent [inaudible] this past quarter. These products will maintain or increase power outputs compared to Tier 3 and will improve fuel efficiency by up to 5% depending on the rating and duty cycles. Along with our technology advantage, our strong balance sheet continues to allow us to invest today in future profitable growth opportunities.

Some of the examples of the exciting things happening at Cummins include our investment in the light-duty diesel engine platforms both in the United States and China is attracting new customers like Nissan. Our new fuel system plant in Wuhan, China began production in April to support advanced fuel system needs of tougher emission standards in that country. Cummins India Ltd inaugurated its new high horsepower engine manufacturing facility in Pune in March. CIL has invested $20 million in this facility and that products manufactured here are for major customers around the world.

Finally, our focused on improved operating performance continues to pay off as we are experiencing greater revenue and profit growth from outside the United States. In fact, 57% of our sales were from outside the US in the first quarter, which illustrates the strength of our global markets. In addition, we are experiencing improvements in engine business and components and ongoing strong contributions from power generation and distribution.

Before turning the teleconference over to Jean, I'd like to take a minute and extend my thanks and gratitude for her outstanding contribution to the company these last five years as Chief Financial Officer. Jean stepped into the position of CFO, and Head of the Finance Organization at my strong insistence, and helped us navigate through some very tough times into the financial success we are having today. She did a remarkable job and I'd like to thank her. Her new role as CEO of Cummins Foundation and leader of our new corporate responsibility initiatives will also be a challenging one and I'm glad to have her onboard in that position.

I'd also like to welcome Pat Ward, who becomes our new CFO effective May 1. Pat has had extensive financial experience in several leadership positions throughout Cummins. He has been with the company since 1987, and most recently served as a Controller of the Engine and Power Generation businesses. I think he will do a great job for us.

Now I will turn the teleconference over to Jean, who will provide more details on the first quarter and discuss the outlook for 2008.

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

Thank you. Tim said our first quarter was extremely strong. Revenues rose 23%, and even more important EBIT continue to grow faster than sales. All four operating segments were more profitable than last year. And equally as important, we had significantly higher cash flow from operations than last year and in what is seasonally our slowest quarter.

Our ability to grow earnings faster than sales is further evidenced that our strategies are working. We continue to rely heavily on fixed segment and global sourcing to achieve our goal of being a low-cost producer, which is critical in times like these. Our initiatives to diversify the business through end-markets and geographies are leading to further growth and revenues outside the US as Tim just mentioned. Our efforts to deepen relationships with customers are continuing to pay dividend. This is illustrated by our growing market share in the North American heavy and medium-duty truck markets and by Nissan's recent announcement to source engines from Cummins for its new light commercial vehicles in the US

Our leadership position in developing countries remains strong particularly in areas that are profiting from the export of commodities and investing in their local infrastructure. For example, the engine segment is forecasting double-digit growth this year on the sale of engines for mining, commercial marine, agriculture and construction. The power generation segment has a backlog well into 2009 due to increasing demand for standby generators and distributed power equipment above 1 megawatt.

The medium-duty truck and bus markets in Brazil, China, India and Eastern Europe remained strong and also are benefiting our turbocharger and fuel systems businesses. Our distribution channel is enjoying an aftermarket firm from the rapidly growing population of Cummins products worldwide. All of this good news gives us confidence we will grow earnings 20% this year despite some headwinds such as weak consumer markets in the US for both engines and low-end generators, cost pressure from the metal markets and foreign currency, our heavy investment in future growth opportunities and continued high introduction costs associated with 2007 products.

Our gross margin looked strong increasing by 80 basis points year-over-year. The higher gross margin was achieved despite some cost due to higher warranty. The higher warranty charge was due to a change in estimates primarily due to older products and early introduction issues. These issues have been fixed and do not affect our accrual rates on sales going forward which is about 3.1% of sales. Our ongoing accrual rates should be in the range of 3.1% of sales for the rest of the year and should continue to improve over time as we expect it.

The Engine segment had a record quarter for both revenue and EBIT. EBIT was 52% higher on sales that were 25% greater than the same quarter last year. Emission pre-buy demand for on-highway engines in Mexico and China accounted a weaker North American truck market. Higher prices and better margins on our industrial markets helped us to achieve improved EBIT margin.

If you look at the market outlook on slide 20, you can see we expect OEMs to keep North American Class 8 truck builds at 2007 levels. However, Cummins production of heavy-duty engine volumes will experience double-digit growth because of our increased share in this market. For the same reason, we expect shipments to the global medium-duty truck and bus markets to grow 25% to 30%. The heavy-duty pickup truck market will likely decline by 15% to 20% this year because of economic uncertainty in the US. Still, we continue to enjoy a high diesel share in this market and are selling more engines for the chassis cab truck. Even though we will have cost increases in steel and its alloys and expenses related to pre-production activity for our new engine platforms, we are confident the Engine segment will finish the year close to 8.5% target margins.

The Distribution segment also had a strong quarter with 44% higher sales. Organic growth in all product categories and in every geographic regions including North America represented most of the increase. The acquisition of the distributor at the beginning of 2008 added $37 million to revenue. Compared to last year distribution reported 26% higher segment EBIT from a strong performance in our international distributors and joint ventures in North America. For the full year we expect the segment to run slightly below 11% EBIT due to cost associated with acquisition and investments in new territories.

The Component segment reported another quarterly record for revenue. This performance was once again driven by the Turbocharger and Emission Solutions businesses. The Turbo business experienced strong growth in North America, Europe and Asia. A combination of new products, greater share of heavy-duty and midrange engines in the market and heavy demand for high horsepower engines contributed to the 49% revenue growth over 2007. Demand for clean diesel engines in on-highway markets in North America and Europe provided the catalyst for 63% revenue growth in Emission Solutions.

Fuel systems experienced 15% higher revenues due to the recovery and sales of heavy-duty and midrange engines. Excluding revenues from the exit of two businesses in 2007, filtration reported 11% increase in revenues this quarter. Segment in EBIT increased more than 50% due to improvement in three of the four businesses.

In addition to volume, the Turbocharger business benefited from price realization and cost improvement, while the Filtration business continued to prosper in part because its exited businesses that were a drag on its profit margins. We are focused on getting the Emission Solutions business on track. New leadership is implementing initiatives to improve manufacturing efficiency, product cost and pricing. Although we are already seeing manufacturing improvements, it will take time for the positive impact to these changes to flow to the bottom line. Emission Solutions is probably a year behind schedule in achieving its targeted contribution to the component target margin. However, we still expect the overall segments to reach the low-end of its 6% to 7% guidance for the full-year.

Power Generation reported 17% higher revenue than last year, primarily in the commercial and alternative businesses where there is strength in all regions, particularly for generators above 1 Megawatt. In addition, higher metal cost were offset by higher prices for our products, still segment EBIT rose only slightly compared to last year. The smaller EBIT increase was primarily due to two reasons. First, weakness in the consumer business in North America and second the increased investment in sales force and infrastructure costs associated with growth in Power Generation markets globally. In addition, supply constraints involving the high horsepower engines and alternators remained a challenge for this business. However for the full year, we still expect Power Generation to perform slightly above its 10% target EBIT margin.

In summary, we are maintaining our revenue guidance of at least 12% growth, although we anticipate some upside as the year unfolds. We expect to deliver 10% EBIT margin for the full year, and we are adjusting our effective tax rate downward to 34% on stronger foreign earnings particularly in the UK. Furthermore, we have reviewed our capital spending plans as part of our ongoing disciplined investment approach and will continue as previously announced. Most of our investment is to keep pace with increased demand for both our existing and new products and to bring new emission-compliant products to the market worldwide. We will continue to review our capital spending quarterly, but at this point we see greater risk in delaying our investments and feel very comfortable moving forward.

So to reiterate, we are maintaining a strong balance sheet and disciplined approach to investing in future growth opportunities. Our focus on being the low-cost producer and expanding into related markets globally has enabled us to achieve our target margins even with the cost pressures that we and everyone else are facing and the introduction of great new products with the focus on the value to the customer will result in strong growth in 2008 and beyond for Cummins. We will now take your questions.

Question and Answer

Operator

[Operator Instructions]. And your first question comes from the line of Jamie Cook of Credit Suisse. You may proceed.

Jamie Cook - Credit Suisse

Hi, good morning and congratulations.

Tim Solso - Chairman and Chief Executive Officer

Thank you.

Jamie Cook - Credit Suisse

I guess, my first question has to do with the engine guidance, you're increasing your sales forecast to up 10% to 15%, which is higher than the previous year. EBIT forecast, isn't really unchanged in your first quarter margins and engine were pretty good at 8.8%, which could imply lower margins in the back-half of the year. So was there anything unusual on the first quarter margin and why would profitability be declining in the remaining nine months?

Tim Solso - Chairman and Chief Executive Officer

There was nothing unusual in the first quarter. This is Tim. I think if we look at some of the challenges for the rest of the year, first of all, we anticipate some commodity increases, I think Jean referred a little bit to that. Our consumer markets and the pickup truck market is down considerably and I think our view is if there is a continued risk in those markets I think the volumes in Mexico which have been relatively strong will change in the second half of the year and that's because there are emission changes in the middle of the year so you've got a pre-buy no-buy kind of situation there. And we continue to invest considerable amounts in the four engine platforms that we are developing right now. So you'll see some of the JV income lower in the second half as those investments are made from those things. So those are issues that allow us to say that we are going to meet our targets but we don't want to say that we're going to do better than that.

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

I might add just a couple of quick points to that. If you look at joint venture Tim mentioned Mexico, but China also has an emission standard that goes into effect from the second half of the year that will impact the joint venture earnings in the engine business and also as Tim mentioned, commodity, the impact was not as great in Q1 but we anticipate a larger impact in the rest of the year.

Jamie Cook - Credit Suisse

And then should I... I guess should I, as I look at your full guidance, full-year guidance I guess I've the same issue because your first quarter was up. Your EPS was up 36% just looking your revenue and your margin target implies EPS should probably be up about 20% for the full year which remains… which suggest the remaining nine months are only up 16% to 17% outside of macro and some of the material costs, is there anything out there that are missing, when I look at your full-year guidance were in the first quarter.

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

Yes. Just a couple of things I might mention. First, if you compare when you're comparing Q1 to Q1, remember Q1 of last year was a very low quarter for... it was right after the emissions change. And second, in some markets, there are some capacity constraints that will take a while, but third as Tim mentioned, there is a lot of investment particularly in the second half of the year in lot of our growth platforms.

Jamie Cook - Credit Suisse

Tim, when we look at your first quarter came in line basically where you thought even though you don't give quarterly guidance?

Tim Solso - Chairman and Chief Executive Officer

I think I'd just say we are pleased with the first quarter.

Jamie Cook - Credit Suisse

Okay. I'll get back in queue. I appreciate it. Congratulations.

Tim Solso - Chairman and Chief Executive Officer

Thanks Jamie.

Operator

And your next question comes from the line of Eli Lustgarten of Longbow Securities. You may proceed.

Eli Lustgarten - Longbow Research

Good morning and quite a quarter.

Tim Solso - Chairman and Chief Executive Officer

Thank you.

Eli Lustgarten - Longbow Research

A couple of questions. One, can you quantify the impact of foreign currency on revenue and earnings to us because I mean you blew away our numbers I guess in the quarter and volume. How much is currencies both in top line and bottom line?

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

If you look at obviously as you know it flowed through a lot of lines.

Eli Lustgarten - Longbow Research

Yes, I know.

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

But if you look at the top line growth, it was about $200 million…

Tim Solso - Chairman and Chief Executive Officer

$120 million.

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

$120 million. Sorry. I’ve got my numbers backwards there, $120 million to the top line and about $1 million positive to EBIT. So it was fairly negative to the bottom line but somewhat significant on the top line.

Eli Lustgarten - Longbow Research

And I assume you have any currency... in this forecast, you have currency changing at all as you go forward, how do you handle that in the outlook, or you're just... you're treating as currency neutral, just before currency?

Tim Solso - Chairman and Chief Executive Officer

We are not in the business of forecasting which way the currencies are going to move.

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

So, we generally don't build in lots of movements in our forecast going forward.

Eli Lustgarten - Longbow Research

So your 12% top line is sort of currency neutral at this point?

Tim Solso - Chairman and Chief Executive Officer

Yes.

Eli Lustgarten - Longbow Research

So, the upside obviously, with first quarter currency, you had some upside from that. Secondly, in the engine numbers, can you give us... in order to get I guess, the light-duty vehicle to be down 50% to 20%.you've got to have some very negative numbers coming in the next couple of quarters in that sector just to get heavy-duty up as much, you got to have some very… you got to have the rest of the year look as good as the first quarter in heavy-duty. Can you take us through the engine, specifically because as I said, in order to get light-duty and RV to be down 15% to 20%, you said probably down 15% to 25% for next couple of quarters?

Tim Solso - Chairman and Chief Executive Officer

Yes, I mean... in terms of... we are not saying that we see volumes further down in the future than they have been recently, first point right? So, Jean's comment earlier in her remarks was not intended to say we see further drops from shipment rates as we look to the future, right? So it's already built into our forecast at this point. And--.

Eli Lustgarten - Longbow Research

So it’s the comparison to that just... for example, light-duty, auto, and vehicle, pardon me if I 'm interrupting, stays at similar rates to the first quarter for the next couple of quarters, which would give you the negative comparisons?

Tim Solso - Chairman and Chief Executive Officer

Right.

Joe Loughrey - President and Chief Operating Officer

Eli, essentially we were down 18% on Chrysler shipments in the first quarter and although we will have a very... probably a favorable comp at the end of the year, the intervening quarters are going to be equally as challenging.

Tim Solso - Chairman and Chief Executive Officer

15 to 20% is the number that Jean basically gave you to expect as we go through the whole year and that's kind of right where we are planning out at the moment.

Eli Lustgarten - Longbow Research

Yes. I guess the sector reported down 4.5% or something like that, could you have RV in that and RV also looks like it [inaudible], I guess, I am looking the rest of the year becomes very negative double-digit comparisons in that line?

Joe Loughrey - President and Chief Operating Officer

Well Eli, the one thing I would point out on the RV line, although it's a much smaller piece of the volume in revenue in that line item that we report remember that much like in the truck markets last year in North America, they had a very low first quarter because they were waiting until the beginning of the second quarter to transition to the new EPA '07 engine. So we do have... although the RVIA forecast is very weak for the full-year we as an engine manufacturer continuing to benefit actually from higher volumes off of a low comp last year.

Eli Lustgarten - Longbow Research

Okay. And the $37 million if we add it to distributors, is that $37 million a quarter that we're getting now?

Tim Solso - Chairman and Chief Executive Officer

He's talking about Baltimore.

Joe Loughrey - President and Chief Operating Officer

Baltimore.

Eli Lustgarten - Longbow Research

Yes. Is that $37 million a quarter of volume that’s being added?

Joe Loughrey - President and Chief Operating Officer

Essentially.

Eli Lustgarten - Longbow Research

Or something like that and the profitability is equal to what the division is doing, I guess.

Joe Loughrey - President and Chief Operating Officer

If you remove the equity method of accounting for our JV yes.

Eli Lustgarten - Longbow Research

Thank you. I'll come back and I’ll get back in the queue.

Operator

And your next question comes from the line of Andy Casey of Wachovia Securities. You may proceed.

Andy Casey - Wachovia Securities

Thanks. Good morning everybody.

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

Good morning.

Joe Loughrey - President and Chief Operating Officer

Good morning.

Andy Casey - Wachovia Securities

Just a clarification on that question Eli said, down 10% to 15%, is that for the total line or is that Dodge Ram?

Joe Loughrey - President and Chief Operating Officer

I think we said down 15% to 20% for the light-duty automotive line, which is on slide 20.

Andy Casey - Wachovia Securities

Okay. Thank you. Now on the Power Generation, didn't want you to get off easy Tom.

Tom Linebarger - Executive Vice President, President, Power Generation

Why are you including me, Andy?

Andy Casey - Wachovia Securities

The input cost inflation, how long do you think it's going to take to recover that with pricing because it looks like international demand remains extremely strong and then North America, kind of mix, but on the upper end very strong.

Tom Linebarger - Executive Vice President, President, Power Generation

Not long. So I think we got pricing increases in place already and there we'll see benefits from even next quarter. So, I think we'll begin to restore some of the margin drop next quarter and throughout the year. So, it would take us long. We've already... across all of our markets really we put in price increases. Some of them start a little later than others, but are in the first half of the year.

Andy Casey - Wachovia Securities

Okay. Thanks and then on the Industrial Engines line can you kind of talk about ability to price in some of those markets, not necessarily what you're going to price but some of your larger competitors have kind of talked about pretty good pricing environment in some of the petroleum areas and so forth?

Tim Solso - Chairman and Chief Executive Officer

And your question is...

Andy Casey - Wachovia Securities

Are you looking at the same sort of dynamics?

Tim Solso - Chairman and Chief Executive Officer

The simple answer is yes. I mean, and looking at the same sort of dynamics in all of our off-highway business from our pricing point of view. But I think, I just want to add I think through our success with Tier 3 and the excitement we've created around our approach to Tier 4 and the clarity we delivered to OEMs about what we are going to do and how we're going to do it has also created its own level of excitement in terms of conversations with OEMs as we looked grow share on that side of the business as a result of what we are doing there as well.

Andy Casey - Wachovia Securities

Okay. Thanks for that color. And then on the heavy-duty, talking about excitement in 2010 timeframe can you share with us what some of the conversations are from your end customers meaning the fleets? And then there is... it appears as if you have a pretty strong advantage given the differentiation of multiple levels that you have in that market post '09, what sort of potential incremental capacity are you looking at with respect to heavy truck engines for North America? Thanks.

Tim Solso - Chairman and Chief Executive Officer

We've... we're putting in 15% more capacity for heavy-duty trucks. It will be in place by the second half of this year.

Andy Casey - Wachovia Securities

Okay. Thank you very much.

Operator

And your next question comes from the line of Charlie Rentschler of Wall Street Access . You may proceed.

Charlie Rentschler - Wall Street Access

Good morning everybody. I am struck by the increase in R&D expenses both absolutely and as a percent of sales, I guess year-over-year it rose from 2.8% to 3%. But, my God! You are $23 million higher year-over-year in the quarter, John Wall must be doing nothing but interviewing people at this point, but can you give us...

Joe Loughrey - President and Chief Operating Officer

Talented people, Charlie.

Charlie Rentschler - Wall Street Access

I'm sorry.

Joe Loughrey - President and Chief Operating Officer

Talented people.

Charlie Rentschler - Wall Street Access

Talented people. Oh, sure. But is there any way to give us some more understanding. Is there some specific projects going on or facility as you're staffing up for or what?

Joe Loughrey - President and Chief Operating Officer

Well, we have been saying all long Charlie that right now we're doing four engine platforms which is the most we have ever done at any one period of time. So you've got light-duty diesel here, you've got light-duty diesel with two displacements in China and then you've got 13-liter engine that we are doing in China as well. So you've staffing up for that and spending money. In addition to that if you look at the components, you are also looking at the XPI fuel system, which is doing very well. You've got new turbocharger platforms that are coming out as they gain market share. Emission Solutions has got big investments right now. And we've always said that as a percent of sales not always, back in the 90s it was 5%. But now for the last several years we said our R&D expense would be 3% of sales. So, we're staying within the guidelines of what our guidance is. But we consider this engineering expenses a bet on the future, and we're going from like 890,000 engines produced last year of 1.6 million engines in 2010, and that's due to always new platforms that we're talking about. So this is a bet on the future.

Charlie Rentschler - Wall Street Access

Okay. That's very exciting. In view of the excitement around, the light-duty diesel are you are building here in the States in Columbus I don't believe you've given a whole lot of detail about it but, I mean are you ready to tell us like how big it is, how many [inaudible] displacement and when you are going to roll it out, and maybe what the kind of chassis it is going to go into?

Joe Loughrey - President and Chief Operating Officer

Well, you know, all we can say is what we've said already so far Charlie and that is we expect the introduction to be around 2010, beginning of 2010 timeframe that we have announced and has as Chrysler that it will be in Chrysler pickup truck base with the 1500 series. But that's about as far as we've taken it publicly. But you should not presume our only customer will be Chrysler and but basically we're continuing to move ahead with the plan we originally laid out the plant and the introduction of the engine and nothing is changing from that.

Charlie Rentschler - Wall Street Access

Okay, and then finally, and then I will jump off. Can you update us on how you're doing with on-highway test of your 2010 heavy-duty truck engine is that, you're still pleased with what you're seeing there?

Joe Loughrey - President and Chief Operating Officer

Absolutely. I mean given our approach, I mean very similar approach in 2010 when we took in 2007 as we try to say publicly. For the most part it varies a little by engine, we're basically building off of what we already have done. So the reliability experience we have in the intervening years and the improvements we make as a result of that experience is all built into the future product. And so right now, we're feeling really good about where we are in terms of how the test plan is going both inside the company and in trucks on the road, and also pleased with the great work going on between us and our OEMs and working together to ensure all of this goes well.

Tim Solso - Chairman and Chief Executive Officer

Just to remind Charlie, that engine will have more new common rail fuel system, the XPI fuel system, which is in production now for both ourselves as well as Scania. And the outside world is telling us that fuel system is quite remarkable probably the best in the world and has a time advantage. So that's one of the key things and we're very.... that introduction and product launch has gone as well as anything we have ever done. So we're really pleased with that and that contributes also to our positive thinking about the 2010 heavy-duty engine.

Charlie Rentschler - Wall Street Access

Okay. Thank you and keep up the fantastic job.

Tim Solso - Chairman and Chief Executive Officer

Thank you.

Operator

And your next question comes from the line of Peter Nesvold of Bear Stearns. You may proceed.

Peter Nesvold - Bear Stearns

Good morning.

Joe Loughrey - President and Chief Operating Officer

Hi, Peter.

Peter Nesvold - Bear Stearns

Question for Jean. Jean, I believe historically you’ve had a pretty sophisticated currency hedging program and when I look at some of... other companies reporting this quarter. I have been seeing some companies being able to lock in, commodity hedge gains in the quarter before they're really getting or taking surcharge pass-throughs from their suppliers. So it seems like may be some unsustainable profits at some other companies. What's been the experience at Cummins this quarter? I mean have you... how extensive are you hedged on commodities? How much of a net hit was that in the quarter and where would that show up on the income statement.

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

I have to get back to you on the numbers but we do hedge a number of things. There are some commodities that are difficult to hedge because of how they are packaged, but we hedge copper, we hedge precious metal, we hedge a number of things. I don’t know, Dean, if you have got any technical around that? But we don't do anything too aggressive or outrageous.

Tim Solso - Chairman and Chief Executive Officer

Your term sophisticated, I would not describe Cummins hedging efforts as sophisticated. We try and keep it as simple as we possibly can and that we're not into exotic derivatives and that type of thing. We do hedge currencies and try and mitigate anything both positive and negative and do a reasonable job at it.

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

And the same way on commodities we try and --.

Dean Cantrell - Director of Investor Relations

Peter, I can give you a little color on copper because that's a big one in the Power Gen business and that we make alternators where there a lot of copper in there. And all we really do is forecast demand for copper purchases, purchase forward in the center layer of contracts and we basically buy forward less than our forecasted demand. Some percentage for us to make sure that we always, we never over hedge. We settled the contracts right when we purchased the copper and that's the end of it. So it's actually quite a simple process to challenge across this forecasting the demand properly and then of course, passing on price increases to your customers because over time the price does show up. Once the contracts are up, you do see the price actually in your purchases. So it is a relatively simple process but forecasting is important and that's where we spend our time working on.

Peter Nesvold - Bear Stearns

Okay. Great. Love to be helped offline. It's nearly.. I'd like to try to get little smarter about. Jean, also in distribution, you said that a surging aftermarket was driving a very solid top line growth, which we did see in the segment but the margins were down year-over-year. Intuitively I would have expected if the aftermarket is growing that fast that you would see margin expansions. So what drove the year-over-year contraction in distribution margins?

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

Basically, as I mentioned that they did acquire one distributor early in the quarter and they are pretty aggressively investing and building a strong distribution channel around the world which is a little bit of a drag on their earnings right now but we see them continuing to improve.

Joe Loughrey - President and Chief Operating Officer

Yes, Peter. If you would have excluded the distributor acquisition in the quarter, the return on sales in the Distribution segment would've been 12.4%.

Peter Nesvold - Bear Stearns

Okay, that's helpful. And then last question on the component margins, still we've taken one step back again, but we're starting to see the two steps forward. What's been the continued overhang there because I mean you have been working on moving the capacity around, you have made leadership changes, but we just haven't seen that benefit of the margin line yet?

Joe Loughrey - President and Chief Operating Officer

Yes. You will, Peter. This is Joe. Yes, I think as we've tried to characterize and looking at the four companies where we stand right now, as we still we have one company that's basically above the 7% to 9% range. We have another company that's at the bottom end of the range but right where we expect it to be. And we have two that we'd like to be sort of well in the range that are below the range. We think at least in terms of where we are right now with particularly CTT, the turbocharger company that things we've broken some bottlenecks and things are going much better and much more strongly from the point of view our supply of product. And therefore, reducing particularly cost of goods sold for us so they've had in fact while they are not within the range yet, they've had two good quarters. Fourth quarter of last year, good quarter compared to where they have been the last year-and-a-half or more and an improved the quarter, the first quarter of this year.

So, we are expecting that while that they will continue to make improvements based on what we've seen and we are on our way to move in within the range from our turbo point of view. Our struggle is still the Emission Solutions business, we got a little bit of a setback as we went into the year, because of what's happened in terms of the increase in precious metal prices. And so we've been aggressively going after that in a variety of forms. So, that's the place where we are behind plan in terms of getting to the margins where they need to be. I think Jean said in her remarks that we're... if you go back to... I think comments I probably made at the end of '06 and the beginning of '07, we're probably around 12 months give or take a few behind plan in terms of getting to where we want to be, which is the whole segment within the range. All right? And we're pleased with the team we've put in place, we've continued to make some changes and re-arrangements in the Emission Solutions business. We've been re-thinking a little bit about what do we do, where, and we're making some changes in that regard as well, all of which we think bodes well for the future. And I think finally, we’ve become much more aggressive on the pricing side and so, particularly given but not only because of what's happened in terms of precious metal pricing and we'll begin to see some of that benefit of that as well.

Peter Nesvold - Bear Stearns

If you look at one company like Tenneco, which arguably is a comp for this business they look at it on a value-add basis. They strip out the substrates and they allow people to evaluate the margins just on the value-add piece, because substrates can be such a growing piece of it. Have you looked at it that way, and that's some kind of... is that data that you would be able to make publicly available?

Tim Solso - Chairman and Chief Executive Officer

No, not at this point. Peter, do we look at that, heck, yes. I mean in terms of understanding where we are, and therefore where are our issues, in terms of competitive pricing from suppliers as well as where we are from a fixed and variable costs in our plants themselves. So that's all part our overall analysis that we've done to try and improve performance. But we're not making that information public at this point.

Peter Nesvold - Bear Stearns

Okay. Thank you for the time.

Operator

And your next question comes from the line of Seth Weber of Banc Of America Securities. You may proceed.

Unidentified Analyst

Hi, it's actually David [inaudible] for Seth.

Joe Loughrey - President and Chief Operating Officer

Good morning, David.

Unidentified Analyst

Good morning. Can I just get an update on what you guys announced [inaudible] for year in terms of pricing, and in raw materials for the company?

Tim Solso - Chairman and Chief Executive Officer

We, if you look at the 12% growth that we have, 7% of that has to do with market growth or market share growth, 2% has to do with pricing, and the remaining 3% has to do with new products.

Joe Loughrey - President and Chief Operating Officer

And with respect to their commodity costs, we think that, that in connection or combination with the currency issues of sourcing from some of the low-cost countries that are seeing appreciation against the US dollar we think that's about a 1% drag on earnings this year.

Unidentified Analyst

Great. Thank you.

Operator

And your next question is a follow-up from the line of Eli Lustgarten of Longbow Securities. You may proceed.

Eli Lustgarten - Longbow Research

Hi, just a quick follow-up. With the ratcheting up of capital spending as we go through the year into next year how should we think about it affecting the various segments and profitability? I mean there is going to be dislocations and cost to it, do you have any suggestions how we can think about the rest of the year into next year from the impact of the higher step up in spending?

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

Well we have given targets by segments which includes... may be, I am not following your question.

Eli Lustgarten - Longbow Research

What I mean, I know that the segments are impacted, the guidance by sector is impacted by versus the first quarter and should we assume that a difference between what was... what the guidance is and probably some expected bit of volumes as the year go on which is a little margin is the impact? Is that how you see the higher capital spending, because there is going to be dislocations in impact from spending that much more this year.

Joe Loughrey - President and Chief Operating Officer

Eli, obviously, a large portion of the capital spending increase is taking places for the new engine platforms that Tim referred to, which really are coming on line, kind of in the late '09, 2010 time periods. So that's been a lot of that capital spending will actually start to become depreciation in our results.

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

But there are... I mean as we've talked about there are investments we're making in our businesses. We talked about a little bit in Power Generation, we've talked about it in connection with our joint ventures in China in the second half of the year. So there are investments and so they impacted different businesses differently. Hopefully, that helps.

Joe Loughrey - President and Chief Operating Officer

Yes. And I don't know... may be one other comment. This is Joe. Again, Eli, one other comment that might help while, the number is bigger than what we've seen most recently. The vast majority of the number we're now investing based on business we've already won for 2010 and beyond. All right and so, this is... you shouldn't be thinking of this as speculative stuff.

Eli Lustgarten - Longbow Research

I understand that.

Joe Loughrey - President and Chief Operating Officer

This is based on business already won and at volume rates in most cases that have a fast ramp-up with the ability to earn improving margins quickly as opposed to having the number of cases where we are worried about any kind of significant margin deteriorations in 2010 and beyond timeframe, because of the ramp-up in the new products associated with this investment.

Eli Lustgarten - Longbow Research

All right. Thank you. One other follow-up, is the first quarter joint venture income probably is the best we are probably going to see for the year or is it going to sustain at this level for the rest of the year, given your earlier comments?

Tim Solso - Chairman and Chief Executive Officer

It will go down.

Eli Lustgarten - Longbow Research

It’ll go down from this level for the rest of the year?

Tim Solso - Chairman and Chief Executive Officer

Yes.

Joe Loughrey - President and Chief Operating Officer

And remember on our guidance and presentation we put out, that we're expecting JV income to be really up 5% to 10% for the full year.

Eli Lustgarten - Longbow Research

That hasn't changed.

Joe Loughrey - President and Chief Operating Officer

That has not changed.

Eli Lustgarten - Longbow Research

All right. Thank you very much.

Operator

And your next question is a follow-up from the line of Andy Casey of Wachovia Securities. You may proceed.

Andy Casey - Wachovia Securities

I guess another follow-up on one of Eli's questions. The joint venture income from on-highway engines in the quarter it was a pretty substantial increase, was that totally due to market dynamics or was there any layering of these joint ventures that have been recently starting up?

Joe Loughrey - President and Chief Operating Officer

No. Andy that is purely the dynamics of what's going on in China right now with the on-highway markets or truck markets in China, where we're seeing essentially a pre-buy as they transition to the Euro III emission standard in China.

Andy Casey - Wachovia Securities

Okay.

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

Which right now is scheduled to be effective July 1, and so that's one reason why we have said that the China joint venture should become down later in the year.

Tim Solso - Chairman and Chief Executive Officer

Plus we are investing into capacity.

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

Right. Plus, yes, the investment in Forton.

Tim Solso - Chairman and Chief Executive Officer

In Forton.

Andy Casey - Wachovia Securities

Okay. And on that actually the Forton JV that company had pretty strong results of themselves recently, and I am wondering if you can get kind of give us some timing in terms of introduction of the diesel into their fleets from the joint venture?

Tim Solso - Chairman and Chief Executive Officer

We will start introduction, basically the second quarter of '09.

Andy Casey - Wachovia Securities

Okay.

Tim Solso - Chairman and Chief Executive Officer

And it'll take place over a period of time, and so we'll start with one engine family to be followed by... later by the second engine family, and we'll be moving into a range of trucks effective a very wide range of trucks from that period forward. And our material volume forecast is in the range of 400,000 units a year.

Andy Casey - Wachovia Securities

And is that like a 3, 4-year ramp time or is that?

Tim Solso - Chairman and Chief Executive Officer

Yes. it's hard to predict, but that's a reasonable guess.

Andy Casey - Wachovia Securities

Okay. Thank you very much.

Operator

And at this time, we have no further questions in queue. I would like to turn the call back over to management for closing remarks.

Dean Cantrell - Director of Investor Relations

Okay. And thank you very much everyone for attending our Q1 Earnings Call today. Feel free to contact me in the office today, if you have questions. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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Source: Cummins, Inc. Q1 2008 Earnings Call Transcript
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