Cummins Inc. Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

STOCK INCENTIVE AND STOCK OPTION PLANS

STOCK INCENTIVE AND STOCK OPTION PLANS

12 Months Ended

Dec. 31, 2018

Disclosure of Compensation Related Costs, Share-based Payments [Abstract]

NOTE 16. STOCK INCENTIVE AND STOCK OPTION PLANS

In May of 2017 the Board of Directors approved an amendment to the shareholder approved stock incentive plan (the Plan) to increase the number of available shares. The revised Plan allows for the granting of up to 8.5 million total shares of equity awards to executives, employees and non-employee directors. Awards available for grant under the Plan include, but are not limited to, stock options, stock appreciation rights, performance shares and other stock awards. Shares issued under the Plan may be newly issued shares or reissued treasury shares.

Stock options are generally granted with a strike price equal to the fair market value of the stock on the date of grant and a life of 10 years. Stock options granted have a three-year vesting period. The strike price may be higher than the fair value of the stock on the date of the grant, but cannot be lower. Compensation expense is recorded on a straight-line basis over the vesting period beginning on the grant date. The compensation expense is based on the fair value of each option grant using the Black-Scholes option pricing model. Options granted to employees eligible for retirement under our retirement plan are fully expensed at the grant date.

Stock options are also awarded through the Key Employee Stock Investment Plan (KESIP) which allows certain employees, other than officers, to purchase shares of common stock on an installment basis up to an established credit limit. For every even block of 100 KESIP shares purchased by the employee 50 stock options are granted. The options granted through the KESIP program are considered awards under the Plan and are vested immediately. Compensation expense for stock options granted through the KESIP program is recorded based on the fair value of each option grant using the Black-Scholes option pricing model.

Performance shares are granted as target awards and are earned based on certain measures of our operating performance. A payout factor has been established ranging from 0 to 200 percent of the target award based on our actual performance during the three-year performance period. The fair value of the award is equal to the average market price, adjusted for the present value of dividends over the vesting period, of our stock on the grant date. Compensation expense is recorded ratably over the period beginning on the grant date until the shares become unrestricted and is based on the amount of the award that is expected to be earned under the plan formula, adjusted each reporting period based on current information.

Restricted common stock is awarded from time to time at no cost to certain employees. Participants are entitled to cash dividends and voting rights. Restrictions limit the sale or transfer of the shares during a defined period. Generally, one-third of the shares become vested and free from restrictions after two years and one-third of the shares issued become vested and free from restrictions each year thereafter on the anniversary of the grant date, provided the participant remains an employee. The fair value of the award is equal to the average market price of our stock on the grant date. Compensation expense is determined at the grant date and is recognized over the restriction period on a straight-line basis.

Employee compensation expense (net of estimated forfeitures) related to our share-based plans for the years ended December 31, 2018, 2017 and 2016, was approximately $52 million, $39 million and $31 million, respectively. In addition, non-employee director share-based compensation expense for the years ended December 31, 2018, 2017 and 2016, was approximately $1 million, $2 million and $1 million, respectively. Shares granted to non-employee directors vest immediately and have no restrictions or performance conditions. The excess tax benefit associated with our employee share-based plans for the years ended December 31, 2018, 2017 and 2016, was $2 million, $2 million and $1 million, respectively. The total unrecognized compensation expense (net of estimated forfeitures) related to nonvested awards for our employee share-based plans was approximately $46 million at December 31, 2018 and is expected to be recognized over a weighted-average period of less than two years.

The tables below summarize the employee share-based activity in the Plan:



	Options		Weighted-average Exercise Price		Weighted-average Remaining Contractual Life (in years)	Aggregate Intrinsic Value (in millions)
Balance at December 31, 2015	2,029,686		$	115.02
Granted	984,430		109.24
Exercised	(215,890	)	87.27
Forfeited	(63,462	)	119.56
Balance at December 31, 2016	2,734,764		115.02
Granted	648,900		149.98
Exercised	(355,479	)	105.91
Forfeited	(126,816	)	125.65
Balance at December 31, 2017	2,901,369		123.49
Granted	515,320		159.06
Exercised	(140,133	)	88.74
Forfeited	(32,894	)	133.00
Balance at December 31, 2018	3,243,662		$	130.55	6.7	$	37

Exercisable, December 31, 2016	1,149,549		$	104.19	4.8	$	38
Exercisable, December 31, 2017	1,063,889		$	115.26	4.7	$	66
Exercisable, December 31, 2018	1,366,722		$	124.97	4.7	$	18

The weighted-average grant date fair value of options granted during the years ended December 31, 2018, 2017 and 2016, was $34.21, $36.86 and $25.28, respectively. The total intrinsic value of options exercised during the years ended December 31, 2018, 2017 and 2016, was approximately $9 million, $19 million and $9 million, respectively.

The weighted-average grant date fair value of performance and restricted shares was as follows:



	Performance Shares				Restricted Shares
Nonvested	Shares		Weighted-average Fair Value		Shares		Weighted-average Fair Value
Balance at December 31, 2015	420,369		$	123.88	4,254		$	111.40
Granted	169,150		98.26		8,089		117.69
Vested	(115,680	)	106.55		(2,502	)	114.57
Forfeited	(69,345	)	110.52		—		—
Balance at December 31, 2016	404,494		120.41		9,841		115.76
Granted	150,225		138.23		—		—
Vested	(85,020	)	141.50		(1,752	)	106.89
Forfeited	(58,460	)	132.52		—		—
Balance at December 31, 2017	411,239		120.84		8,089		117.68
Granted	124,700		146.50		—		—
Vested	(80,996	)	128.47		(2,696	)	117.68
Forfeited	(44,593	)	127.90		—		—
Balance at December 31, 2018	410,350		$	126.36	5,393		$	117.68

The total vesting date fair value of performance shares vested during the years ended December 31, 2018, 2017 and 2016 was $13 million, $13 million and $12 million, respectively. The total fair value of restricted shares vested was less than $1 million, $1 million and $1 million for the years ended December 31, 2018, 2017 and 2016, respectively.

The fair value of each option grant was estimated on the grant date using the Black-Scholes option pricing model with the following assumptions:



	2018		2017		2016
Expected life (years)	6		6		5
Risk-free interest rate	2.72	%	2.08	%	1.34	%
Expected volatility	25.40	%	29.97	%	30.96	%
Dividend yield	2.48	%	2.28	%	2.10	%

Expected life—The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding based upon our historical data.

Risk-free interest rate—The risk-free interest rate assumption is based upon the observed U.S. treasury security rate appropriate for the expected life of our employee stock options.

Expected volatility—The expected volatility assumption is based upon the weighted-average historical daily price changes of our common stock over the most recent period equal to the expected option life of the grant, adjusted for activity which is not expected to occur in the future.

Dividend yield—The dividend yield assumption is based on our history and expectation of dividend payouts.