UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 
 

For the Quarterly Period Ended July 2, 2006

 Commission File Number 1-4949


CUMMINS INC.

(Exact name of registrant as specified in its charter)

Indiana
(State of Incorporation)

35‑0257090
(IRS Employer Identification No.)

                                                                        500 Jackson Street
                                                                              Box 3005
                                                         Columbus, Indiana 47202-3005
                                                     
(Address of principal executive offices)

                                                                Telephone (812) 377-5000

                                           (Registrant's telephone number, including area code)

          

 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x           Accelerated filer   o            Non-accelerated filer  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  o   No x

As of July 2, 2006, there were 52,557,050 shares of common stock outstanding with a par value of $2.50 per share.

 


1



CUMMINS INC.  AND CONSOLIDATED SUBSIDIARIES

TABLE OF CONTENTS

QUARTERLY REPORT ON FORM 10-Q

 

  

Page

PART I. FINANCIAL INFORMATION

   

ITEM 1.

Condensed Financial Statements (Unaudited)

3
 

Condensed Consolidated Statements of Earnings for the three and six months ended July 2, 2006 and June 26, 2005
 

3
 

Condensed Consolidated Balance Sheets at July 2, 2006 and December 31, 2005
 

4
 

Condensed Consolidated Statements of Cash Flows for the six months ended July 2, 2006 and June 26, 2005

5

Notes to Condensed Consolidated Financial Statements


6

ITEM 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations

16

   

ITEM 3.

Quantitative and Qualitative Disclosures About Market Risk

35

   

ITEM 4.

Controls and Procedures

35

   

PART II. OTHER INFORMATION
 


 

ITEM 1.
 

Legal Proceedings
 

36
 

ITEM 1A.

Risk Factors

36

   

ITEM 2.
 


Unregistered Sales of Equity Securities and Use of Proceeds
 

36
 

ITEM 4.

Submission of Matters to a Vote of Security Holders

37

   

ITEM 6.

Exhibits

37

   

Signatures

38


2



PART I.  FINANCIAL INFORMATION

ITEM 1. Condensed Financial Statements

CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(Unaudited)

 

 

Three months ended

 

Six months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

Millions

(except per share amounts)

Net sales (includes related party sales of $397, $281, $758 and $544, respectively)

$

2,842

$

2,490

$

5,520

$

4,698

Cost of sales (includes related party purchases of $58, $52, $121 and $91, respectively)

2,170

1,940

4,249

3,692

Gross margin

672

550

1,271

1,006

                   

Operating expenses and income

Selling and administrative expenses

320

287

621

546

Research and engineering expenses

80

73

162

136

Investee equity, royalty and other income (Note 2)

(37

)

(38

(68

)

(72

)

Other operating income, net

(3

)

(1

)

(3

)

 

Operating earnings

309

231

557

399

                   

Interest income

(10

)

(4

)

(19

)

(9

)

Interest expense

26

28

53

56

Other (income) expenses, net

(6

)

(4

)

10

Earnings before income taxes and minority interests

299

207

527

342

                   

Provision for income taxes (Note 4)

67

58

152

92

Minority interests in earnings of consolidated subsidiaries

12

8

20

12

Net earnings

$

220

$

141

$

355

$

238

 

Earnings per share (Note 12)

Basic

$

4.81

$

3.20

$

7.87

$

5.40

Diluted

$

4.38

$

2.83

$

7.08

$

4.80

                           

Cash dividends declared per share

$

0.30

$

0.30

$

0.60

$

0.60

 

The accompanying notes are an integral part of the condensed consolidated financial statements.


3



 

CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

 

 

July 2,

 

December 31,

 

 

 

       2006       

 

       2005    

 

 

 

Millions
(except par value)

 

ASSETS

Current assets

Cash and cash equivalents

$

878

$

779

Marketable securities

66

61

Receivables, net

1,573

1,314

Receivables from related parties

118

109

Inventories (Note 3)

1,314

1,174

Deferred income taxes

333

363

Prepaid expenses and other current assets

139

116

 

4,421

3,916

Long-term assets

Property, plant and equipment, net of accumulated depreciation of $2,453 and $2,384

1,519

1,557

Investments in and advances to equity investees

304

278

Goodwill (Note 5)

358

358

Other intangible assets, net (Note 5)

109

100

Deferred income taxes

444

500

Other assets

182

176

Total assets

$

7,337

$

6,885

           

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities

Short-term borrowings (Note 6)

$

265

$

154

Accounts payable

1,066

904

Other accrued expenses

1,281

1,160

Total current liabilities

2,612

2,218

Long-term liabilities

Long-term debt

739

1,213

Pensions

267

396

Postretirement benefits other than pensions

533

554

Other liabilities and deferred revenue

447

415

Total liabilities

4,598

4,796

Commitments and contingencies (Note 10)

Minority interests

236

225

Shareholders' equity

Common stock, $2.50 par value, 150 shares authorized, 55.0 and 48.5 shares issued

137

121

Additional contributed capital

1,487

1,201

Retained earnings

1,686

1,360

Accumulated other comprehensive loss

Minimum pension liability adjustment

(523

)

(523

)

Foreign currency translation adjustments

(53

)

(84

)

Unrealized gain on marketable securities

1

3

Unrealized gain on derivatives

30

1

Total accumulated other comprehensive loss

(545

)

(603

)

Common stock in treasury, at cost, 2.4 and 2.0 shares

(154

)

(101

)

Common stock held in trust for employee benefit plans, 1.9 and 2.0 shares

(94

)

(97

)

Unearned compensation

(14

)

(17

)

Total shareholders' equity

2,503

1,864

Total liabilities and shareholders' equity

$

7,337

$

6,885


    The accompanying notes are an integral part of the condensed consolidated financial statements.

 


4



CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

Six months ended

 

 

July 2,

 

June 26,

2006

 

2005

Cash flows from operating activities

Millions

Net earnings

$

355

$

238

Adjustments to reconcile net earnings to net cash provided by operating activities:

Depreciation and amortization

148

144

Deferred income tax provision

74

54

Equity in earnings of investees, net of dividends

(20

)

1

Minority interests in earnings of consolidated subsidiaries

20

12

Pension expense (Note 8)

57

54

Pension contributions

(83

)

(55

)

Stock-based compensation expense (Note 13)

7

7

Tax benefit on stock options exercised

2

Translation and hedging activities

(13

)

1

Changes in current assets and liabilities:

Receivables

(249

)

(363

)

Inventories

(125

)

(88

)

Other current assets

(12

)

2

Accounts payable

147

106

Accrued expenses

5

(3

)

Changes in long-term liabilities

8

32

Other, net

36

11

Net cash provided by operating activities

355

155

Cash flows from investing activities

Capital expenditures

(102

)

(78

)

Investments in internal use software

(22

)

(15

)

Proceeds from disposals of property, plant and equipment

24

13

Investments in and advances to equity investees

(3

)

(4

)

Acquisition of businesses, net of cash acquired

(2

)

Investments in marketable securities—acquisitions

(99

)

(60

)

Investments in marketable securities—liquidations

92

69

Other, net

1

Net cash used in investing activities

(110

)

(76

)

Cash flows from financing activities

Proceeds from borrowings

54

41

Payments on borrowings and capital lease obligations

(111

)

(319

)

Net borrowings under short-term credit agreements

6

20

Distributions to minority shareholders

(11

)

(9

)

Dividend payments on common stock

(28

)

(28

)

Tax benefit on share-based awards

6

Proceeds from issuing common stock

6

12

Repurchases of common stock

(62

)

Other, net

(6

)

3

Net cash used in financing activities

(146

)

(280

)

Effect of exchange rate changes on cash and cash equivalents

(6

)

Net increase (decrease) in cash and cash equivalents

99

(207

)

Cash and cash equivalents at beginning of year

779

611

Cash and cash equivalents at end of period

$

878

$

404

 

Cash payments for:

Interest

$

55

$

61

Income taxes

$

66

$

41

The accompanying notes are an integral part of the condensed consolidated financial statements.


5



CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

NOTE 1.  NATURE OF OPERATIONS AND BASIS OF PRESENTATION

Nature of Operations

Cummins Inc. (“Cummins,” “the Company,” “Registrant,” “we,” “our,” or “us”) is a global power leader that designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and engine-related products, including filtration and emissions solutions, fuel systems, controls and air handling systems.

Basis of Presentation

The unaudited Condensed Consolidated Financial Statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results for the three and six month interim periods ended July 2, 2006 and June 26, 2005. All such adjustments are of a normal recurring nature. The Condensed Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted as permitted by such rules and regulations. The interim periods for 2006 contain 13 and 26 weeks, respectively, while the interim periods for 2005 contain 13 and 25 weeks, respectively. Certain reclassifications have been made to prior period amounts to conform to the presentation of the current period condensed financial statements.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts in the Condensed Consolidated Financial Statements.  Significant estimates and assumptions in these Condensed Consolidated Financial Statements require the exercise of judgment and are used for, but not limited to, allowance for doubtful accounts, estimates of future cash flows and other assumptions associated with goodwill and long-lived asset impairment tests, useful lives for depreciation and amortization, warranty programs, determination of discount and other rate assumptions for pension and other postretirement benefit expenses, income taxes and deferred tax valuation allowances and contingencies.  Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be different from these estimates.

You should read these interim condensed financial statements in conjunction with the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2005. Our interim period financial results for the three and six month interim periods presented are not necessarily indicative of results to be expected for any other interim period or for the entire year.  The year end condensed balance sheet was derived from audited financial statements, but does not include all disclosures required by GAAP.

Shipping and Handling Costs

Our shipping and handling costs are expensed as incurred. Those shipping and handling costs associated with operations of our inventory distribution centers and warehouse facilities are classified as "Selling and administrative expenses" in our Condensed Consolidated Statements of Earnings. For the three months ended July 2, 2006 and June 26, 2005, these costs were approximately $26 million and $28 million, respectively.  For the six months ended July 2, 2006 and June 26, 2005, these costs were approximately $59 million and $55 million, respectively.

Recently Adopted Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), “Share-Based Payment.” This standard requires financial statement recognition of compensation cost related to share-based payment transactions. Share-based payment transactions within the scope of SFAS No. 123R include stock options, restricted stock plans, performance-based awards, stock appreciation rights, and employee share purchase plans.  We implemented the revised standard in the first quarter of 2006. Prior to January 1, 2006, we accounted for stock-based employee awards issued after December 31, 2002, using the fair value method preferred by SFAS No. 123, “Accounting for Stock-Based Compensation.”  SFAS No. 123R requires the Company to estimate forfeitures in calculating the expense relating to stock-based compensation as opposed to recognizing these forfeitures and the corresponding reduction in expense as they occur.  SFAS No. 123R also requires prospective presentation of the “Tax benefit on share-based awards” as a financing activity rather than an operating activity in our Condensed Consolidated Statements of Cash Flows.  See Note 13 for the impact that the adoption of this standard had on our Condensed Consolidated Financial Statements.


6


In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of Accounting Principles Board (APB) Opinion No. 20 and FASB Statement No. 3.” This standard changes the requirements for the accounting for and reporting of a change in accounting principle and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB No. 20 required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This standard requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change.  The provisions of SFAS No. 154 are effective for fiscal years beginning after December 15, 2005.  The adoption of this standard did not have a material impact on our Condensed Consolidated Financial Statements.

Accounting Pronouncements Issued But Not Yet Effective

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140.”  SFAS No. 155 changes certain accounting requirements for certain hybrid financial instruments by permitting fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation.  The new standard also changed certain accounting requirements for interest-only and principal-only strips and other aspects of accounting for securitized financial assets.  The Company will adopt SFAS No. 155 effective January 1, 2007.  We do not expect the adoption of SFAS No. 155 to have a material impact on our Condensed Consolidated Financial Statements.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140,” that provides guidance on accounting for separately recognized servicing assets and servicing liabilities.  In accordance with the provisions of SFAS No. 156, separately recognized servicing assets and servicing liabilities must be initially measured at fair value, if practicable. Subsequent to initial recognition, the company may use either the amortization method or the fair value measurement method to account for servicing assets and servicing liabilities within the scope of this Statement. The Company will adopt SFAS No. 156 effective January 1, 2007. We do not expect the adoption of SFAS No. 156 to have a material effect on our Condensed Consolidated Financial Statements.

In July 2006, the FASB issued FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” which prescribes a recognition threshold and measurement process for recording in the financial statements, uncertain tax positions taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The Company will adopt FIN 48 effective January 1, 2007. We are currently evaluating the impact, if any, that FIN 48 will have on our Consolidated Financial Statements.

 

NOTE 2.  INVESTMENTS IN EQUITY INVESTEES

Investee equity, royalty and other income included in our Condensed Consolidated Statements of Earnings for the interim reporting periods was as follows:

 

 

Three months ended

 

Six months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 Millions

 

Dongfeng Cummins Engine Company, Ltd (DCEC)

$

7

$

13

$

12

$

28

North American distributors

12

6

21

12

Cummins Mercruiser

3

3

4

5

Chongqing Cummins

4

4

7

6

Tata Cummins

3

1

6

2

Fleetguard Shanghai

1

1

2

2

All others

4

4

8

5

Cummins share of net earnings

34

32

60

60

Royalty and other income

3

6

8

12

Investee equity, royalty and other income

$

37

$

38

$

68

$

72

 


7


NOTE 3.  INVENTORIES

Inventories included the following:      

 

 

July 2,

 

December 31,

 

 

 

  2006  

 

  2005  

 

 

 

Millions

 

Finished products

$

662

$

636

Work-in-process and raw materials

724

607

Inventories at FIFO cost

1,386

1,243

Excess of FIFO over LIFO

(72

)

(69

)

Total inventories

$

1,314

$

1,174











NOTE 4.  PROVISION FOR INCOME TAXES

Our tax rates are generally less than the 35 percent U.S. income tax rate primarily because of lower taxes on foreign earnings, export tax benefits and (for 2005) research tax credits.  The U.S. tax research credit expired on December 31, 2005 and has not yet been renewed. 

Our income tax provision for the three months ended July 2, 2006, was reduced by $28 million, or $0.55 per share, due to the favorable resolution of tax uncertainties related to prior years.  In addition, our provision for the six months ended July 2, 2006, was also impacted by a $12 million, or $0.23 per share, increase in the first quarter for the effect of new Indiana tax legislation.  As a result, our effective tax rate for the three and six months ended July 2, 2006, was 22 percent and 29 percent, respectively.  Our 2005 provision was reduced by $10 million ($6 million in the first quarter and $4 million in the second quarter) for the tax benefits of foreign dividend distributions which qualified for a special 85-percent deduction under The American Jobs Creation Act of 2004.  As a result, our effective tax rate for the three and six months ended June 26, 2005, was 28 percent and 27 percent, respectively.


NOTE 5.  GOODWILL AND OTHER INTANGIBLE ASSETS

The changes in the carrying amounts of goodwill for the six months ended July 2, 2006, were as follows:

 

 

Components

 

Power
Generation

 

Engine

 

Distribution

 

Total

 

 

 

Millions

 

Goodwill at December 31, 2005

$

332

$

13

$

7

$

6

$

358

Additions 

Disposition 

(1

)

(1

)

Translation and other

1

1

Goodwill at July 2, 2006

$

332

$

14

$

7

$

5

$

358

The components of other intangible assets with finite lives subject to amortization were as follows: 

 

 

July 2,

 

December 31,

 

 

 

2006

 

2005

 

 

 

Millions

 

Software

$

213

$

199

Accumulated amortization

(107

)

(103

)

Net software

106

96

Trademarks, patents and other

6

6

Accumulated amortization

(3

)

(2

)

Net trademarks, patents and other

3

4

Total

$

109

$

100

 


8



NOTE 6.  SHORT-TERM BORROWINGS

Short-term borrowings included the following:      

 

 

July 2,

 

December 31,

 

 

 

  2006  

 

  2005  

 

 

 

Millions

 

Loans payable

$

46

$

40

Current maturities of long-term debt

219

114

Total short-term borrowings

$

265

$

154

 


NOTE 7.  LONG-TERM DEBT

Junior Convertible Subordinated Debentures

On May 8, 2006, the Board of Directors approved the Company's plan to redeem all of the 7% convertible quarterly income preferred securities that were issued in June 2001.  On May 9, 2006, we gave the trustee our formal irrevocable notification of our intent to redeem the preferred securities.  This notification provided the holders of the preferred securities 30 days in which to convert their securities into shares of common stock.  Upon expiration of the notification period, all remaining securities not converted were redeemed for cash at a premium above liquidation value.  Substantially all of the $300 million of 7% convertible subordinated debentures outstanding were converted into shares of our common stock during the second quarter of 2006.  As a result of the conversion, approximately 6.3 million shares of common stock were issued during the second quarter which resulted in an increase of approximately $16 million to common stock outstanding and an increase of approximately $276 million to additional contributed capital.  Since substantially all holders converted their preferred securities to common stock, the loss on extinguishment of this debt to equity was insignificant.  See Note 11 to the Consolidated Financial Statements in our 2005 Annual Report to Shareholders on Form 10-K for more information regarding the preferred securities and debentures.


NOTE 8.  PENSION AND OTHER POST RETIREMENT BENEFITS

The components of net periodic pension and other postretirement benefit expense under our plans consisted of the following:

 

 

Pension

 

 

 

 

 

U.S. Plans

 

Non-U.S. Plans

 

Postretirement

 

 

 

Three months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

2006

 

2005

 

2006

 

2005

 

Millions 

Service cost

 

$

12

$

11

$

8

$

6

$

$

Interest cost

27

27

13

13

8

9

Expected return on plan assets

(32

)

(31

)

(14

)

(14

)

Amortization of prior service cost (credit)

1

1

1

(3

)

Recognized net actuarial loss

9

8

5

4

Other

1

1

Net periodic benefit cost

$

17

$

17

$

12

$

11

$

5

$

9

 

 


Pension

 

 

 

 

 

U.S. Plans

 

Non-U.S. Plans

 

Postretirement

 

 

 

Six months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

2006

 

2005

 

2006

 

2005

 

Millions 

Service cost

 

$

24

$

22

$

14

$

12

$

$

Interest cost

54

54

24

26

16

19

Expected return on plan assets

(64

)

(62

)

(25

)

(28

)

Amortization of prior service cost (credit)

2

2

1

2

(6

)

Recognized net actuarial loss

18

16

9

8

Other

1

1

Net periodic benefit cost

$

34

$

33

$

23

$

21

$

10

$

19


9



    For the three and six months ended July 2, 2006, we contributed approximately $42 million and $83 million, respectively, to our pension plans and paid approximately $23 million and $31 million, respectively, of postretirement benefits.  For the three and six months ended June 26, 2005, we contributed approximately $44 million and $55 million, respectively, to our pension plans and paid approximately $16 million and $25 million, respectively, of postretirement benefits.  We presently anticipate contributing approximately $147 million to $157 million to our pension plans and paying approximately $32 million in claims and premiums for postretirement benefits during the remainder of 2006.  These contributions and payments include payments from Company funds to either increase pension plan assets or to make direct payments to plan participants.  As a result, $267 million of pension liability was included in “other accrued expenses” on our Condensed Consolidated Balance Sheet at July 2, 2006.

The Company incurred expenses of $5 million each period for the three months ended July 2, 2006 and June 26, 2005 relating to our defined contribution plans.  The Company incurred expenses of $18 million and $17 million for the six months ended July 2, 2006 and June 26, 2005, respectively, relating to our defined contribution plans.


NOTE 9.  PRODUCT WARRANTY LIABILITY

A summary of the activity in our current and long-term warranty liability accounts, as well as our deferred revenue accounts, for the six month interim periods follows:

 

 

Six months ended

 

 

 

July 2,

 

June 26,

 

 

 

2006

 

2005

 

 

 

Millions

Balance, beginning of period

$

581

$

495

Provision for warranties issued

167

135

Deferred revenue on extended warranty contracts sold

39

30

Payments

(144

)

(103

)

Amortization of deferred revenue on extended warranty contracts

(17

)

(11

)

Changes in estimates for pre-existing warranties

(1

)

(6

)

Foreign currency translation

3

(2

)

Balance, end of period

$

628

$

538

          The amount of deferred revenue related to extended coverage programs at July 2, 2006, was $150 million. 

At July 2, 2006, we had $25 million of receivables related to estimated supplier recoveries of which $17 million was included in “Receivables, net” and $8 million was included in “Other assets” on our Condensed Consolidated Balance Sheets.


NOTE 10.  COMMITMENTS AND CONTINGENCIES

We are defendants in a number of pending legal actions, including actions related to the use and performance of our products. We carry product liability insurance covering significant claims for damages involving personal injury and property damage. We also establish reserves for matters in which losses are probable and can be reasonably estimated. In the event we are determined to be liable for damages in connection with actions and proceedings, the unaccrued portion of such liability is not expected to be material. We also have been identified as a potentially responsible party at several waste disposal sites under U.S. and related state environmental statutes and regulations and may have joint and several liability for any investigation and remediation costs incurred with respect to such sites. We deny liability with respect to many of these legal actions and environmental proceedings and are vigorously defending such actions or proceedings. We have established reserves that we believe are adequate for our expected future liability in such actions and proceedings where the nature and extent of such liability can be reasonably estimated based upon presently available information.

U.S. Distributor Financing

Since 1997 we have had an operating agreement with a financial institution that requires us to guarantee revolving loans, equipment term loans and leases, real property loans and letters of credit made by the financial institution to certain independent Cummins and Onan distributors in the United States, and to certain distributors in which we own an equity interest.  The agreement has been amended, supplemented or otherwise modified several times since 1997 and in the first quarter of 2006, we amended, restated and simplified the terms of the operating agreement and removed the Cummins guarantee of distributor borrowings. 

 


10


If any distributor defaults under its financing arrangement with the financial institution, and the maturity of amounts owed under the agreement is accelerated, then we are required to purchase from the financial institution at amounts approximating fair market value certain property, inventory and rental generator sets manufactured by Cummins that are secured by the distributor's financing agreement. 

The operating agreement will continue in effect until February 7, 2007 and may be renewed for additional one-year terms.

Residual Value Guarantees

We have various residual value guarantees on equipment leased under operating leases.  The total amount of these residual value guarantees at July 2, 2006, was $9 million.

Other Guarantees

In addition to the guarantees discussed above, from time to time we enter into other guarantee arrangements, including guarantees of non-U.S. distributor financing and other miscellaneous guarantees of third party obligations. The maximum potential loss related to these other guarantees was $22 million at July 2, 2006.

We have arrangements with certain suppliers that require us to purchase minimum volumes or be subject to monetary penalties.  The penalty amounts are less than our purchase commitments and essentially allow the supplier to recover their tooling costs.  At July 2, 2006, if we were to stop purchasing from each of these suppliers, the amount of the penalty would be approximately $20 million.  However, based on current forecasts, we do not anticipate paying any penalties under these contracts.

Indemnifications

Periodically, we enter into various contractual arrangements where we agree to indemnify a third party against certain types of losses. Common types of indemnifications include:

*         product liability and license, patent or trademark indemnifications,

*         asset sale agreements where we agree to indemnify the purchaser against future environmental exposures related to the asset sold, and

*         any contractual agreement where we agree to indemnify the counter‑party for losses suffered as a result of a misrepresentation in the contract.

We regularly evaluate the probability of having to incur costs associated with these indemnifications and accrue for expected losses that are probable.  Because the indemnifications are not related to specified known liabilities and due to their uncertain nature, we are unable to estimate the maximum amount of the potential loss associated with these indemnifications.

Joint Venture and Other Commitments

As of July 2, 2006, we have committed to invest $11 million into two joint ventures that were formed during 2005.


NOTE 11.  COMPREHENSIVE EARNINGS

A reconciliation of our net earnings to comprehensive earnings was as follows:

 

 

Three months ended

 

Six months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

Millions

Net earnings

$

220

$

141

$

355

$

238

Other comprehensive earnings (loss), net of tax:

Change in cumulative translation adjustment

22

(26

)

31

(33

)

Unrealized loss on marketable securities

(1

)

(2

)

(1

)

Unrealized gain (loss) on derivatives

22

(4

)

29

(6

)

Comprehensive earnings

$

263

$

111

$

413

$

198

11



NOTE 12.  EARNINGS PER SHARE

We calculate basic earnings per share (EPS) of common stock by dividing net earnings by the weighted-average daily number of common shares outstanding for the period. The calculation of diluted EPS reflects the potential dilution that occurs if share based awards or debt securities are exercised or converted into common stock and the effect of the exercise or conversion reduces EPS.  We exclude shares of common stock held by our Retirement Savings Plan in the Employee Benefits Trust from the calculation of the weighted-average common shares outstanding until those shares are distributed from the trust.  The following is a reconciliation of net earnings and weighted-average common shares outstanding for purposes of calculating basic and diluted net earnings per share:

 

 

Three months ended

 

Six months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 Millions

(except per share amounts)

 

Net earnings for basic EPS

$

220.1

$

141.2

$

354.7

$

237.8

Interest on junior convertible subordinated debentures, net of tax

2.7

3.2

5.9

6.5

Net earnings for diluted EPS

$

222.8

$

144.4

$

360.6

$

244.3

Weighted-average common shares outstanding:

Basic

45.7

44.1

45.0

44.0

Dilutive effect of stock compensation awards

0.4

0.6

0.4

0.6

Dilutive effect of junior convertible subordinated debentures

4.7

6.3

5.5

6.3

Diluted

50.8

51.0

50.9

50.9

Earnings per share:

Basic

$

4.81

$

3.20

$

7.87

$

5.40

Diluted

$

4.38

$

2.83

$

7.08

$

4.80


NOTE 13.   STOCK INCENTIVE AND STOCK OPTION PLANS

In September 2003, our shareholders approved the 2003 Stock Incentive Plan (The Plan). The Plan allows for the granting of up to 2.5 million stock-based awards to executives and employees, of which one-half must be in the form of stock options. Awards available for grant under the plan include, but are not limited to, stock options, stock appreciation rights, performance shares, restricted stock and other stock awards. Stock options are generally granted with a strike price equal to the fair market value of the stock on the date of grant, a life of 10 years and a two-year vesting period.

The performance shares are granted as target awards and are earned based on the Company’s return on equity (ROE) performance. A payout factor has been established ranging from zero to 200 percent of the target award based on the actual ROE performance during the two-year period. Any shares earned are then restricted for one additional year. Employees leaving the Company prior to the end of the restriction period forfeit their shares. 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.

Under the stock incentive plan, 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 are released after two years and one-third of the shares issued are released each year thereafter on the anniversary of the grant date, provided the participant remains an employee. Compensation expense is determined at the grant date and is recognized over the four-year restriction period on a straight-line basis.

Prior to January 1, 2006, we accounted for stock-based employee awards granted on or after January 1, 2003, utilizing the fair value method preferred by SFAS No. 123, “Accounting for Stock-Based Compensation.”   For awards granted prior to January 1, 2003, we applied the disclosure-only provisions of SFAS No. 123.  In accordance with SFAS No. 123, we applied APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for our plans prior to January 1, 2003 and accordingly, did not recognize compensation expense for these plans because we granted options at exercise prices equal to the market value of our stock on the grant date.


12


Effective January 1, 2006, we adopted SFAS No. 123R, “Share-Based Payment,” which revised SFAS No. 123 and supercedes APB No. 25.  We adopted this statement using the modified prospective transition method which does not require the restatement of prior periods.  SFAS No. 123R requires the recognition of expense for share-based payments to be recorded in the consolidated financial statements based on the grant date fair value and to be recognized over their vesting periods.   Under SFAS No. 123R, the Company is required to select a valuation technique or option-pricing model that meets the requirements of the standard.  Allowable valuation models include a binomial model and the Black-Scholes model.  At the present time, the Company is continuing to use the Black-Scholes model.  Since we had previously accounted for our awards at fair value under SFAS No. 123, the impact of adopting SFAS No. 123R was not material to our consolidated financial statements.  The two most significant changes related to accounting for forfeitures and accounting for tax benefits of awards.  SFAS No. 123R requires the Company to estimate forfeitures in calculating the expense relating to share-based compensation as opposed to recognizing these forfeitures and the corresponding reduction in expense as they occur.  The cumulative adjustment recorded by the Company upon the adoption of SFAS No. 123R for the estimated forfeitures on grants outstanding on the date of adoption was not material.  Excess tax benefits related to share-based compensation are now classified as a financing activity in the statement of cash flows rather than an operating activity.  For the six months ended July 2, 2006, we had $6 million of excess tax benefits related to share-based compensation presented in our Condensed Consolidated Statement of Cash Flows as a financing activity.

Compensation expense (net of forfeitures) related to our share-based plans for the three and six months ended July 2, 2006, was approximately $4 million and $7 million, respectively.  Compensation expense (net of forfeitures) related to our share-based plans for the three and six months ended June 26, 2005, was approximately $4 million and $7 million, respectively.  The excess tax benefit associated with option exercises and share vesting during the three and six months ended July 2, 2006, was approximately $1 million and $6 million, respectively.  The excess tax benefit associated with option exercises and share vesting during the three and six months ended June 26, 2005, was approximately $1 million and $2 million, respectively.  The total unrecognized compensation expense (net of expected forfeitures) related to nonvested awards was approximately $36 million at July 2, 2006 and was expected to be recognized over a weighted-average period of 1.6 years.

The table below summarizes the activity in our stock option plans:

 

 

Options

 

Weighted-average
Exercise Price

 

Balance, December 31, 2005

399,700

$

44.59

Granted

450

105.24

Exercised

(162,180

)

45.17

Forfeited

Expired

Balance, July 2, 2006

237,970

$

44.31

 

 

 

 

 

 

 

Exercisable, July 2, 2006

 

237,970

 

 

$

44.31

 

The weighted-average grant date fair value of options granted by the Company during the three and six months ended July 2, 2006, was $105.74 and $105.24, respectively.  The total intrinsic value of options exercised during the three and six months ended July 2, 2006, was approximately $4 million and $11 million, respectively.  The weighted-average grant date fair value of options granted by the Company during the three and six months ended June 26, 2005, was $68.22 and $69.89, respectively.  The total intrinsic value of options exercised during the three and six months ended June 26, 2005, was approximately $5 million and $12 million, respectively.


13



The weighted-average grant date fair value of performance and restricted shares at July 2, 2006 and during the first six months of 2006 is as follows:

 

Performance Shares

 

 

Weighted-average
Fair Value

 

Nonvested at December 31, 2005

722,650

$

56.27

Granted

174,684

98.82

Vested

(246,800

)

48.05

Forfeited

(11,545

)

52.36

Nonvested at July 2, 2006

638,989

$

71.15

 

Restricted Shares

 

 


Weighted-average
Fair Value

 

Nonvested at December 31, 2005

1,000

$

74.87

Granted

50,000

107.85

Vested

Forfeited

Nonvested at July 2, 2006

51,000

$

107.20

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

Six months ended

July 2,

 2006

 

June 26,

2005

Expected life (years)

7

7

Risk-free interest rate

4.9

%

4.1

%

Expected volatility

26.4

%

38.8

%

Dividend yield

1.8

%

2.5

%

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 the Company’s employee stock options.

Expected volatility – The expected volatility assumption is based upon the weighted-average historical daily price changes of the Company’s 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 the Company’s history and expectation of dividend payouts.

The table below summarizes stock option information for options outstanding, all of which are currently exercisable at July 2, 2006:

 

 

 

 

Options Outstanding  and Exercisable

Exercise Price Range

 

 

 

Number of
Options

 

Weighted-average
Remaining
Contractual Life

 

Weighted-average
Exercise Price

 

Aggregate Intrinsic Value

$23.95 – 35.92

650

2.2

$

32.01

$

58,655

$35.93 – 53.89

213,570

4.6

42.89

16,949,220

$53.90 – 107.44

23,750

2.0

57.43

1,539,550

237,970

4.3

$

44.31

$

18,547,425

14



NOTE 14.  OPERATING SEGMENTS

Our reportable operating segments consist of the following: Engine, Power Generation, Components and Distribution. This reporting structure is organized according to the products and markets each segment serves. We use segment EBIT (defined as earnings before interest expense, income taxes and minority interests) as the primary basis for the chief operating decision-maker to evaluate the performance of each operating segment.  

A summary of operating results by segment for the three and six month periods is shown below:

 

 

Engine

 

Power
Generation

 

Components

 


Distribution

 

Eliminations

 

Total

 

 

 

Millions

 

Three months ended July 2, 2006

Net sales

$

1,896

$

598

$

563

$

336

$

(551

)

$

2,842

Investee equity, royalty and other income

18

3

2

14

37

Segment EBIT

190

56

34

36

9

325

                                           

Three months ended June 26, 2005

Net sales

$

1,667

$

493

$

511

$

297

$

(478

)

$

2,490

Investee equity, royalty and other income

25

3

2

8

38

Segment EBIT

156

35

21

26

(3

)

235

                                           

Six months ended July 2, 2006

Net sales

$

3,717

$

1,134

$

1,118

$

653

$

(1,102

)

$

5,520

Investee equity, royalty and other income

35

6

4

23

68

Segment EBIT

369

101

65

67

(22

)

580

                                           

Six months ended June 26, 2005

Net sales

$

3,147

$

920

$

984

$

550

$

(903

)

$

4,698

Investee equity, royalty and other income

50

4

4

14

72

Segment EBIT

273

50

44

46

(15

)

398

A reconciliation of our segment information to the corresponding amounts in the Condensed Consolidated Financial Statements is shown in the table below:

 

 

Three months ended

 

Six months ended

 

 

 

July 2,

 

June 26,

 

July 2,

 

June 26,

 

 

 

2006

 

2005

 

2006

 

2005

 

Millions

Segment EBIT

$

325

$

235

$

580

$

398

Less:

Interest expense

26

28

53

56

Earnings before income taxes and minority interests

$

299

$

207

$

527

$

342

  
15



ITEM 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations

Certain prior year amounts included in this section have been reclassified to conform to the current year presentation.

OVERVIEW

The following Management's Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our Consolidated Financial Statements and related Notes to Consolidated Financial Statements in the “Financial Statements” section of our 2005 Annual Report on Form 10-K. All references to earnings per share amounts are diluted per share amounts.  Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions.  Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under “RISK FACTORS RELATING TO OUR BUSINESS” included in Part I of our 2005 Annual Report on Form 10-K and “Disclosure Regarding Forward-Looking Statements” presented at the end of this section.  This overview summarizes the MD&A which includes the following sections:

*      Executive Summary and Financial Highlights – a brief discussion providing an overview of our Company, highlighting the significant events affecting our Company and a summary of our Company’s financial performance.

*      Results of Operations – an analysis of our consolidated results of operations for the periods presented in our Condensed Consolidated Financial Statements.

*      Operating Segment Results – an analysis of the performance of each of our reportable operating segments for the periods presented in our Condensed Consolidated Financial Statements.

*      Liquidity and Capital Resources – an analysis of cash flows, sources and uses of cash, off balance sheet arrangements and contractual obligations.

*      Disclosure Regarding Forward-Looking Statements – cautionary information about forward-looking statements and a description of certain risks and uncertainties that could cause our actual results to differ materially from our historical results or our current expectations or projections.


16



EXECUTIVE SUMMARY AND FINANCIAL HIGHLIGHTS

We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and engine-related products, including filtration and aftertreatment devices, fuel systems, controls and air handling systems. We sell our products to Original Equipment Manufacturers (OEMs), distributors and other customers worldwide. We have long-standing relationships with many of the leading manufacturers in the markets we serve, including DaimlerChrysler AG (DaimlerChrysler), Volvo AB, PACCAR Inc., International Truck and Engine Corporation (Navistar International Corporation), CNH Global N.V., Komatsu and Scania AB. We serve our customers through a network of more than 550 company-owned and independent distributor locations and approximately 5,000 dealer locations in more than 160 countries and territories.

Our financial performance depends, in large part, on varying conditions in the markets we serve, particularly the on-highway, construction and general industrial markets. Demand in these markets tends to fluctuate in response to overall economic conditions and is particularly sensitive to changes in interest rate levels and the price of crude oil (fuel costs). OEM inventory levels, production schedules and work stoppages also impact our sales. Economic downturns in the markets we serve generally result in reduced sales, which affect our profits and cash flow.

We maintain an internet website at www.cummins.com.  Investors can obtain copies of our filings with the Securities Exchange Commission (SEC) from this website free of charge, as well as from the SEC website at www.sec.gov.

We experienced another strong operating performance in the second quarter of 2006 with net earnings of $220 million, or $4.38 per diluted share, on net sales of $2.8 billion, compared to second quarter 2005 net earnings of $141 million, or $2.83 per diluted share, on net sales of $2.5 billion.  Year-to-date 2006 net earnings were $355 million, or $7.08 per diluted share, on net sales of $5.5 billion, compared to year-to-date 2005 net earnings of $238 million, or $4.80 per diluted share, on net sales of $4.7 billion.  Second quarter net earnings and sales were a record for Cummins as we continue to benefit from improved economic conditions resulting in high levels of demand across our businesses, as well as increased share in a number of markets and our focus on cost reduction.  All of our segments reported sales increases in the second quarter and year to date compared to the same periods a year ago, with particularly strong demand in the North American heavy-duty truck market where engine sales increased 19 percent year to date and our market share increased slightly compared to the same period in 2005.  Overall, our Engine segment net sales were up $570 million, or 18 percent, year to date.  In addition, net sales increased at our Power Generation segment (up $214 million, or 23 percent), Components segment (up $134 million, or 14 percent) and Distribution segment (up $103 million, or 19 percent) on a year to date basis. 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended

 

Six months ended

 

 

 

July 2, 2006

 

June 26, 2005

 

July 2, 2006

 

June 26, 2005

 

Consolidated Results

 

Millions

(except earnings per share )

 

Net sales

$

2,842

$

2,490

$

5,520

$

4,698

Gross margin

672

550

1,271

1,006

Investee equity, royalty and other income

(37

)

(38

)

(68

)

(72

)

Operating earnings

309

231

557

399

Net earnings

220

141

355

238

Diluted earnings per share

$

4.38

$

2.83

$

7.08

$

4.80

 During the first six months of 2006, we continued our commitment to building a strong balance sheet, investing in profitable growth around the globe and returning value to our shareholders.  Some of the transactions and events that highlight this are as follows:

*      In January 2006, we signed a joint venture agreement with KAMAZ Inc., the largest vehicle manufacturer in Russia, to produce B Series engines under the name ZAO Cummins Kama.  The joint venture will build on the Cummins and KAMAZ relationship that dates back to the early 1980s.  Among the customers of the new company are KAMAZ trucks and buses, as well as trucks, buses and agricultural equipment produced by other manufacturers in Russia, Belarus and the Ukraine.


17


*      In March 2006, we signed a feasibility study with Beiqi Foton Motor Company on the formation of a 50/50 joint venture company to produce two types of light-duty diesel engines for use primarily in the commercial market.  Beijing Foton Cummins Engine Company will be based in Beijing and will produce engines based on Cummins designs.  The feasibility study will outline the parameters of the partnership and is the final step before a joint venture agreement is signed.  The joint venture is expected to begin operation in 2006, with production starting as early as 2008.

*      Our level of debt at July 2, 2006, has decreased by $363 million since December 31, 2005 and our debt-to-capital ratio has improved to 28.6 percent at July 2, 2006, from 42.3 percent at December 31, 2005.  As previously announced, we intend to repay our $250 million 9.5% notes in December 2006, the first call date for the debt.  The notes were issued in 2002 and are expected to be repaid using cash generated from operations.

*      On May 8, 2006, the Board of Directors approved the Company's plan to redeem all of the 7% convertible quarterly income preferred securities that were issued in June 2001.  On May 9, 2006, we gave the trustee our formal irrevocable notification of our intent to redeem the preferred securities.  As a result, substantially all of the related $300 million of 7% convertible subordinated debentures outstanding were converted into shares of our common stock.

*      During the first six months of 2006, we made contributions of approximately $83 million to our pension plans.

*      During the second quarter of 2006, we completed our previously announced share repurchase program.  Share repurchases for the second quarter totaled $26 million, bringing our total repurchased since the announcement in September 2005 to $100 million.  In July 2006, the Board of Directors gave authorization the Company to acquire up to two million shares of Cummins common stock in addition to what has been acquired under previous authorizations.  In addition, the Board also voted to increase the quarterly cash dividend per share by 20 percent to $0.36 per share.

RESULTS OF OPERATIONS

Three Months Ended - 2006 versus 2005

 

 

Three Months Ended

 

Change

 

 

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

 

 

$ in millions

 

 

 

Net sales

$

2,842

$

2,490

$

352

14

Cost of sales

2,170

1,940

230

12

%

Gross margin

672

550

122

22

%

Operating expenses (income)

Selling and administrative expenses

320

287

33

11

%

Research and engineering expenses

80

73

7

10

%

Investee equity, royalty and other income

(37

)

(38

)

1

3

%

Other operating income, net

(3

)

3

NM

Operating earnings

309

231

78

34

%

Interest income

(10

)

(4

)

(6

)

NM

   Interest expense

26

28

(2

)

7

%

    Other income, net

(6

(6

)

NM

Earnings before income taxes and minority interests

299

207

92

44

Provision for income taxes

67

58

9

16

Minority interests in earnings of consolidated subsidiaries

12

8

4

50

%     

Net earnings

$

220

$

141

$

79

56

Net Sales

Net sales increased in all segments.  Engine sales were up $229 million, or 14 percent, due to strong demand from heavy- and medium-duty truck OEMs, higher engine volumes for industrial applications and increased shipments of light-duty automotive engines.  Engine and part sales to on-highway markets were 15 percent higher compared to last year with increased volumes in all market segments.  Power Generation sales increased $105 million, or 21 percent, due to increased demand across all product lines. Components sales increased $52 million, or 10 percent, due to increased volume within all of our Components businesses.  Distribution sales increased $39 million, or 13 percent, primarily due to increased demand for power generation products followed by increased parts and service volumes.  See our “Operating Segment Results” section for further details on sales by segment.   
 


18


Gross Margin

Gross margin improved primarily due to increased sales, the related absorption benefits on fixed manufacturing costs, and changes in sales mix, all of which increased gross margin by $115 million.  In addition, $18 million of price realization, net of increased product costs, improved gross margin in the current period compared to the same period in the prior year.  These increases in margin were partially offset by increased warranty expenses of $14 million, primarily as a result of the increased volumes.  Other factors which impacted gross margin to a lesser extent were the impact of currency exchange rates, material costs and other miscellaneous fluctuations. 

Warranty expense as a percent of sales increased slightly to 2.9 percent in the second quarter of 2006 compared to 2.7 percent in the second quarter of 2005.    

Selling and Administrative Expenses

Selling and administrative expenses increased primarily due to higher compensation and related expenses of approximately $10 million, which included salaries, variable compensation and fringe benefits, as a result of improved financial performance of the company.  Other factors affecting selling and administrative to a lesser extent included increased consulting fees and other outside services of $7 million, increased marketing and administrative expenses of $4 million and increased travel expenses of $5 million.  The remaining change in selling and administrative expenses is due to a combination of increases in various other miscellaneous expenses, none of which were significant individually, partially offset by a favorable foreign currency impact.  Overall selling and administrative expenses were 11.3 percent of sales in the second quarter of 2006 compared to 11.5 percent of sales in the second quarter of 2005.

Research and Engineering Expenses

Research and engineering expenses increased primarily due to increased compensation expense and consulting and outside services.  We had significant research and engineering expenses across the Engine and Components segments related to new product development for 2007 and beyond as well as research and engineering expenses for growth platforms across geographies.  The Engine and Components segments each had increases in research and development of $4 million.  Fluctuations in other miscellaneous research and development expenses were not significant individually or in the aggregate.

Investee Equity, Royalty and Other Income

Investee equity, royalty and other income decreased slightly primarily due to a decrease in earnings from Dongfeng Cummins Engine Company, Ltd. (DCEC) of approximately $6 million due to a continued disruption in demand in the automotive markets caused by changes in China’s regulatory environment regarding vehicle weight restrictions.  In addition, royalty and other income from equity investees decreased by $3 million.  The decrease in earnings from DCEC and royalty and other income was mostly offset by improved earnings from our North American distributors of $6 million and an increase in earnings from Tata Cummins Ltd. of $2 million.

Other Operating Income, Net

The major components of other operating income are royalty income, amortization of intangible assets and loss on sale of fixed assets.  The fluctuation from the second quarter of 2005 to the second quarter of 2006 was primarily due to a combination of a $2 million loss on the write-down of fixed assets and a decrease in royalty income.  Other fluctuations in other operating income were not significant individually or in the aggregate.

Interest Income

Interest income increased primarily due to higher average cash balances in the second quarter of 2006 compared to the second quarter of 2005.  The higher average cash balances are due to increased earnings and stronger cash flows from operations in 2006.

Interest Expense

Interest expense decreased due to lower debt balances in the second quarter of 2006 as compared to the same period in 2005. 
 


19


Other Income, Net

The major components of other income include foreign currency exchange gains and losses, bank charges and other miscellaneous income and expenses.  There were not any individual fluctuations in the components of miscellaneous income and expenses that were significant.

Provision for Income Taxes

Our tax rates are generally less than the 35 percent U.S. income tax rate primarily because of lower taxes on foreign earnings, export tax benefits and (for 2005) research tax credits.  The U.S. tax research credit expired on December 31, 2005 and has not yet been renewed. 

Our income tax provision for the three months ended July 2, 2006, was reduced by $28 million, or $0.55 per share, due to the favorable resolution of tax uncertainties related to prior years.  As a result, our effective tax rate for the three months ended July 2, 2006, was 22 percent.  Our 2005 provision was reduced by $4 million in the second quarter for the tax benefits of foreign dividend distributions which qualified for a special 85-percent deduction under The American Jobs Creation Act of 2004.  As a result, our effective tax rate for the three months ended June 26, 2005, was 28 percent.

The effective tax rate for the remainder of the year is expected to approximate 32 percent absent any additional discrete period activity.

Minority Interests in Earnings of Consolidated Subsidiaries

Minority interest is primarily attributable to Cummins Eastern Canada LLP, a 51 percent owned subsidiary and Cummins India Limited, a 51 percent owned subsidiary.  These two subsidiaries account for nearly 60 percent of the total minority interest in the second quarter of 2006.  Earnings at both of these subsidiaries increased in the second quarter of 2006 compared to the second quarter of 2005, resulting in an increase in minority interest expense.  The remainder of the increase in minority interests was attributable to a combination of immaterial increases and decreases in earnings at the remaining consolidated subsidiaries.

Six Months Ended - 2006 versus 2005

 

 

Six Months Ended

 

Change

 

 

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

 

 

$ in millions

 

 

 

Net sales

$

5,520

$

4,698

$

822

17

Cost of sales

4,249

3,692

557

15

%

Gross margin

1,271

1,006

265

26

%

Operating expenses (income)

Selling and administrative expenses

621

546

75

14

%

Research and engineering expenses

162

136

26

19

%

Investee equity, royalty and other income

(68

)

(72

)

4

6

%

Other operating income, net

(1

)

(3

)

2

67

%

Operating earnings

557

399

158

40

%

Interest income

(19

)

(9

)

(10

)

NM

   Interest expense

53

56

(3

)

5

%

    Other (income) expenses, net

(4

10

(14

)

NM

Earnings before income taxes and minority interests

527

342

185

54

Provision for income taxes

152

92

60

65

 %

Minority interests in earnings of consolidated subsidiaries

20

12

8

67

%     

Net earnings

$

355

$

238

$

117

49

 
20


Net Sales

Net sales increased in all segments.  Engine sales were up $570 million, or 18 percent, due to strong demand from heavy- and medium-duty truck OEMs, higher engine volumes for industrial applications and increased shipments of light-duty engines.  Engine and part sales to on-highway markets were 19 percent higher compared to last year with increased volumes in all market segments.  Power Generation sales increased $214 million, or 23 percent, due to increased demand across all product lines. Components sales increased $134 million, or 14 percent, due to increased volume within all of our Components businesses led by our filtration business.  Distribution sales increased $103 million, or 19 percent, primarily due to increased demand for power generation products followed by increased parts, engine and service volumes.  See our “Operating Segment Results” section for further details on sales by segment.   

Gross Margin

Gross margin improved primarily due to increased sales, the related absorption benefits on fixed manufacturing costs, and changes in sales mix, all of which increased gross margin by $255 million.  In addition, $41 million in price realization, net of increased product costs, improved gross margin in the current period compared to the same period in the prior year.  These increases in margin were partially offset by increased warranty expenses of $37 million, primarily as a result of the increased volumes.  Other factors which impacted gross margin to a lesser extent were the impact of currency exchange rates and other miscellaneous fluctuations. 

Warranty expense as a percent of sales increased slightly to 3.0 percent in the first six months of 2006 compared to 2.7 percent in the first six months of 2005.    

Selling and Administrative Expenses

Selling and administrative expenses increased primarily due to higher compensation and related expenses of approximately $27 million, which included salaries, variable compensation and fringe benefits, as a result of improved financial performance of the company.  In addition, incremental staffing added to the increased compensation and related expenses.  Shipping and handling costs increased by approximately $4 million due to increased sales volumes.  Other factors affecting selling and administrative to a lesser extent included increased consulting fees and other outside services of $16 million, increased marketing and administrative expenses of $10 million and increased travel expenses of $10 million.  The remaining change in selling and administrative expenses is due to a combination of increases in various other miscellaneous expenses, none of which were significant individually, partially offset by a favorable foreign currency impact.  Overall selling and administrative expenses were 11.3 percent of sales in the first six months of 2006 compared to 11.6 percent of sales in the first six months of 2005.

Research and Engineering Expenses

Research and engineering expenses increased primarily due to increased compensation expense and consulting and outside services, as well as higher spending on development programs for future products.  We had significant research and engineering expenses across the Engine and Components segments related to new product development for 2007 and beyond as well as research and engineering expenses for growth platforms across geographies.  The Engine segment accounted for $14 million of the increase in research and engineering expenses along with an increase in the Components segment of $10 million.  Fluctuations in other miscellaneous research and development expenses were not significant individually or in the aggregate.

Investee Equity, Royalty and Other Income

Investee equity, royalty and other income decreased slightly primarily due to a decrease in earnings from Dongfeng Cummins Engine Company, Ltd. (DCEC) of approximately $16 million due to a continued disruption in demand in the automotive markets caused by changes in China’s regulatory environment regarding vehicle weight restrictions.  The decrease in earnings from DCEC was partially offset by improved earnings from our North American distributors of $9 million and improved earnings from Tata Cummins Ltd. of $4 million.

Other Operating Income, Net

The major components of other operating income are royalty income, amortization of intangible assets and loss on sale of fixed assets.  The fluctuation from the first six months of 2005 to the first six months of 2006 was primarily due to a decrease in royalty income.  Other fluctuations in other operating income were not significant individually or in the aggregate.
 


21


Interest Income

Interest income increased primarily due to higher average cash balances in the first six months of 2006 compared to the first six months of 2005.  The higher average cash balances are due to increased earnings and stronger cash flows from operations in 2006.

Interest Expense

Interest expense decreased slightly due to lower debt balances in the first six months of 2006 as compared to the same period in 2005. 

Other (Income) Expense, Net

The major components of other income include foreign currency exchange gains and losses, bank charges and other miscellaneous income and expenses.  The fluctuation in other income in the first six months of 2006 compared to the first six months of 2005 is due to a decrease in foreign currency exchange losses of approximately $6 million and fluctuations in the components of miscellaneous income and expenses, none of which were individually significant.

Provision for Income Taxes

Our tax rates are generally less than the 35 percent U.S. income tax rate primarily because of lower taxes on foreign earnings, export tax benefits and (for 2005) research tax credits.  The U.S. tax research credit expired on December 31, 2005 and has not yet been renewed. 

Our income tax provision for the six months ended July 2, 2006, was reduced by $28 million, or $0.55 per share, due to the favorable resolution of tax uncertainties related to prior years.  In addition, our provision for the six months ended July 2, 2006, was also impacted by a $12 million, or $0.23 per share, increase in the first quarter for the effect of new Indiana tax legislation.  As a result, our effective tax rate for the six months ended July 2, 2006, was 29 percent.  Our 2005 provision was reduced by $10 million ($6 million in the first quarter and $4 million in the second quarter) for the tax benefits of foreign dividend distributions which qualified for a special 85-percent deduction under The American Jobs Creation Act of 2004.  As a result, our effective tax rate for the six months ended June 26, 2005, was 27 percent.

The effective tax rate for the remainder of the year is expected to approximate 32 percent absent any additional discrete period activity.

Minority Interests in Earnings of Consolidated Subsidiaries

Minority interest is primarily attributable to Cummins Eastern Canada LLP, a 51 percent owned-subsidiary and Cummins India Limited, a 51 percent owned-subsidiary.  These two subsidiaries account for nearly 60 percent of the total minority interest in the first six months of 2006.  Earnings at both of these subsidiaries increased in the first six months of 2006 compared to the first six months of 2005, resulting in an increase in minority interest expense.  The remainder of the increase in minority interests was attributable to a combination of immaterial increases and decreases in earnings at the remaining consolidated subsidiaries.

OPERATING SEGMENT RESULTS

Our reportable operating segments consist of the following: Engine, Power Generation, Components, and Distribution. This reporting structure is organized according to the products and markets each segment serves.  We use segment EBIT (defined as earnings before interest expense, income taxes and minority interests) as the primary basis for the chief operating decision-maker to evaluate the performance of each operating segment.

Following is a discussion of operating results for each of our business segments.
 


22


 

Engine Results

Three Months Ended - 2006 versus 2005

The net sales, investee income and segment EBIT for Engine were as follows:

 

 

Three months ended 

 

Change

 

$ in millions  

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

1,896

$

1,667

$

229

14%

Investee equity, royalty and other income

18

25

(7

)

28%

Segment EBIT

190

156

34

22%

Segment EBIT as a percentage of net sales

10.0%

9.4%

0.6 percentage point

The increase in net sales for this segment was primarily due to strong demand across most markets, particularly the light-duty automotive market with strong engine volumes to DaimlerChrysler and the North American heavy-duty truck market along with strong industrial market volumes. Total on-highway-related sales were 64 percent of Engine segment net sales during the second quarter of 2006, compared with 63 percent during the second quarter of 2005.

The improvement in segment EBIT was primarily due to the higher engine volumes across most major markets, the accompanying gross margin benefits of higher absorption of fixed manufacturing costs and a slight improvement in pricing.  Gross margin increased $51 million, or 16 percent, quarter over quarter.  Selling and administrative expenses increased $13 million, or 10 percent, quarter over quarter, however selling and administrative expenses as a percentage of net sales decreased slightly.  Research and engineering expenses increased $4 million, or 7 percent, compared to the same quarter last year and decreased slightly as a percentage of net sales compared to the prior period.

In addition, earnings from joint ventures decreased compared with the second quarter of 2005, primarily due to a $6 million decrease in earnings at DCEC due to a continued disruption in demand in the automotive markets caused by changes in China's regulatory environment regarding vehicle weight restrictions.

A summary and discussion of Engine net sales by market follows:

 

 

Three months ended

 

Change

 

$ in millions 

 

July 2 , 2006

 

June 26, 2005

 

Amount

 

Percent

 

Heavy-duty truck

$

618

$

553

$

65

12%

Medium-duty truck and bus

247

228

19

8%

Light-duty automotive and RV

341

269

72

27%

Total on-highway

1,206

1,050

156

15%

Industrial

516

458

58

13%

Stationary power

174

159

15

9%

Total net sales

$

1,896

$

1,667

$

229

14%

A summary of unit shipments by engine classification (including unit shipments to Power Generation) follows:

 

 

Three months ended

 

Change

 

 

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Midrange

121,800

101,600

20,200

20%

Heavy-duty

31,400

27,500

3,900

14%

High-horsepower

4,000

3,800

200

5%

Total unit shipments

157,200

132,900

24,300

18%


23



Heavy-Duty Truck

The increase in sales to the heavy-duty truck market was primarily driven by the North American truck market as OEMs work to meet growing demand from truck fleets adding capacity to meet the increase in freight tonnage and replacing trucks ahead of the 2007 change in emissions standards.  Global unit shipments of heavy-duty truck engines were up 14 percent in the second quarter of 2006, compared to the second quarter of 2005, with North American shipments up 14 percent and international shipments up 19 percent.

Medium-Duty Truck and Bus

The increase in medium-duty truck and bus revenues is due to our growing position with North American OEMs in the medium duty truck market and increased shipments of  bus engines in North America and internationally.  Shipments of medium-duty truck engines were up 19 percent to North American OEMs and down 16 percent to international OEMs compared with the second quarter of 2005.  The increase in medium-duty truck engine shipments in North America is due to an overall increase in demand and growing penetration at key OEMs. The decrease in shipments to international OEMs is primarily due to changes in emissions standards in Brazil to Euro III effective January 1, 2006.  Sales of bus engines and parts increased in the second quarter of 2006 compared to the second quarter of 2005 due to strong demand from North American OEMs with shipments up 48 percent while international shipments were up slightly at 2 percent.  The increase in the North American transit bus market is being driven by our increased market share.

Light-Duty Automotive and RV

Sales of light-duty automotive engines increased as a result of higher volumes. Total light-duty automotive unit shipments were approximately 49,700 in the second quarter of 2006, an increase of 23 percent compared to the same period in 2005. Most of the increase in light-duty automotive sales was driven by continued demand from DaimlerChrysler with increased shipments of approximately 7,700 units, or a 21 percent increase compared to the second quarter of 2005. Global engine shipments to recreational vehicle OEMs increased by 41 percent in the second quarter of 2006 compared with the same period in 2005 due to new product introductions and growing penetration at key OEMs.

Industrial

Total sales were up in all industrial markets, except for rail, primarily due to strong demand in those markets. Unit shipments increased 23 percent in the second quarter of 2006 compared to the same period in 2005. Approximately 53 percent of the shipments were to North American markets and 47 percent to international markets in the second quarter compared to 56 percent and 44 percent, respectively, for the same period in 2005.  The overall change in the geographic sales mix is due to the continued strength of the international construction market which is being driven by strong demand in China.  Shipments to the construction market increased 23 percent in total and increased 35 percent internationally.  The other market showing a significant increase was the oil and gas market with a 54 percent increase in shipments.  The shipments to the oil and gas market have increased as sustained oil and natural gas prices continue to drive activity and investments in new equipment.  Other industrial markets had modest increases in shipments compared to the same period in 2005.

Stationary Power

The increase in sales to stationary power markets is due to the increased net sales to our Power Generation segment.  These net sales are eliminated in our Condensed Consolidated Statements of Earnings.  See the Power Generation Results for a discussion of the increase in net sales. 

Six Months Ended - 2006 versus 2005

The net sales, investee income and segment EBIT for Engine were as follows:

 

 

Six months ended 

 

Change

 

$ in millions  

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

3,717

$

3,147

$

570

18%

Investee equity, royalty and other income

35

50

(15

)

30%

Segment EBIT

369

273

96

35%

             

Segment EBIT as a percentage of net sales

9.9%

8.7%

1.2 percentage points

The increase in net sales for this segment was primarily due to strong demand across most markets, particularly the light-duty automotive market with strong engine sales to DaimlerChrysler and the North American heavy-duty truck market along with strong industrial market sales. Total on-highway-related sales were 63 percent of Engine segment net sales during the first six months of 2006 and 2005.
 


24


The improvement in segment EBIT was primarily due to the higher engine volumes across most major markets, the accompanying gross margin benefits of higher absorption of fixed manufacturing costs, pricing, and efficiencies, all of which resulted in a one percentage point improvement in gross margin percentage in the first six months of 2006 compared to the same period last year.  Gross margin increased $144 million, or 25 percent, for the first six months of 2006 compared to the same period last year.  Selling and administrative expenses increased $34 million, or 13 percent, however selling and administrative expenses as a percentage of net sales decreased slightly.  Research and engineering expenses increased $14 million, or 14 percent, compared to the first six months of 2005 and decreased slightly as a percentage of net sales compared to the prior period.

In addition, earnings from joint ventures decreased compared with the first six months of 2005, primarily due to a $16 million decrease in earnings at DCEC due to a continued disruption in demand in the automotive markets caused by changes in China’s regulatory environment regarding vehicle weight restrictions.

A summary and discussion of Engine net sales by market follows:

 

 

Six months ended

 

Change

 

$ in millions 

 

July 2 , 2006

 

June 26, 2005

 

Amount

 

Percent

 

Heavy-duty truck

$

1,226

$

1,047

$

179

17%

Medium-duty truck and bus

462

419

43

10%

Light-duty automotive and RV

672

524

148

28%

Total on-highway

2,360

1,990

370

19%

Industrial

997

857

140

16%

Stationary power

360

300

60

20%

Total net sales

$

3,717

$

3,147

$

570

18%

A summary of unit shipments by engine classification (including unit shipments to Power Generation) follows:

 

 

Six months ended

 

Change

 

 

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Midrange

236,300

192,700

43,600

23%

Heavy-duty

61,500

52,400

9,100

17%

High-horsepower

7,700

6,900

800

12%

Total unit shipments

305,500

252,000

53,500

21%

Heavy-Duty Truck

The increase in sales to the heavy-duty truck market was primarily driven by the North American truck market as OEMs work to meet growing demand from truck fleets adding capacity to meet the increase in freight tonnage and replacing trucks ahead of the 2007 change in emissions standards.  Global unit shipments of heavy-duty truck engines were up 18 percent in the first six months of 2006, compared to the first six months of 2005, with North American shipments up 19 percent and international shipments up 12 percent.

Medium-Duty Truck and Bus

The increase in medium-duty truck and bus revenues is due to strong demand, our growing position with North American OEMs in the medium duty truck market and increased shipments of  bus engines in North America and internationally.  Shipments of medium-duty truck engines were up 21 percent to North American OEMs and down 15 percent to international OEMs compared with the first six months of 2005.  The increase in medium-duty truck engine shipments in North America is due to our increased penetration in this market and an overall increase in demand. The decrease in shipments to international OEMs is due to changes in emissions standards in Brazil to Euro III effective January 1, 2006.  Sales of bus engines and parts increased in the first six months of 2006 compared to the first six months of 2005 due to strong demand from North American OEMs with shipments up 48 percent while international shipments were up 15 percent.


25


Light-Duty Automotive and RV

Sales of light-duty automotive engines increased as a result of higher volumes. Total light-duty automotive unit shipments were approximately 99,100 in the first six months of 2006, an increase of 29 percent compared to the same period in 2005. Most of the increase in light-duty automotive sales was driven by continued demand from DaimlerChrysler with increased shipments of approximately 20,400 units, or a 29 percent increase compared to the first six months of 2005. Engine shipments to recreational vehicle OEMs increased by over 17 percent in the first six months of 2006 compared with the same period in 2005due to new product introductions and growing penetration at key OEMs.

Industrial

Total sales were up in all industrial markets, except for rail, primarily due to strong demand in those markets. Unit shipments increased 26 percent in the first six months of 2006 compared to the same period in 2005. Approximately 53 percent of the shipments were to North American markets and 47 percent to international markets in the first six months compared to 58 percent and 42 percent, respectively, for the same period in 2005.  The overall change in the geographic sales mix is due to the continued strength of the international construction market which is being driven by strong demand in China.  Total shipments to the construction market increased 26 percent largely because international shipments increased 45 percent.  Other markets showing significant increases in shipments were the mining market and the oil and gas market with increases of 8 percent and 62 percent, respectively.  The mining market demand is up as the strength in commodity prices is driving investment in mining capacity.  The sales to the oil and gas market have increased as sustained oil and natural gas prices continue to drive activity and investments in new equipment.  Other industrial markets had modest increases in shipments compared to the same period in 2005.

Stationary Power

The increase in sales to stationary power markets is due to the increased net sales to our Power Generation segment.  These net sales are eliminated in our Condensed Consolidated Statements of Earnings.  See the Power Generation Results for a discussion of the increase in net sales.

Power Generation Results

Three Months Ended – 2006 versus 2005

The net sales, investee income and segment EBIT for Power Generation were as follows:

 

 

Three months ended

 

Change

 

$ in millions  

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

598

493

105

21%

Investee equity, royalty and other income

3

3

—%

Segment EBIT

56

35

21

60%

             

Segment EBIT as a percentage of net sales

9.4%

7.1%

2.3 percentage points

The increase in net sales in this segment was primarily due to increased volumes as a result of strong demand in the commercial generator set and alternator lines of business.  Our commercial and alternator businesses are up in all markets, except China.  We also saw increases in our consumer market due to strong demand in the towable recreational vehicle and marine markets.  Our power electronics and rental markets also saw increases, but at a more modest pace. 

The improvement in segment EBIT was largely attributable to strong commercial generator set sales across geographic markets as well as improved mix and price realization.  While material costs have risen period over period, we have been able to more than absorb these costs through improved pricing.  Gross margin improved $34 million, or 43 percent, in the second quarter over the same period in 2005.  Gross margin percentage improved almost three percentage points compared to the same period in 2005.  Selling and administrative expenses increased $8 million, or 17 percent, over the second quarter of 2005, however selling and administrative expenses as a percentage of net sales improved slightly in the second quarter of 2006, compared to the same period in 2005.  Research and engineering expenses increased $1 million, or 20 percent during the second quarter, compared to 2005 and research and engineering expenses as a percentage of net sales remained relatively consistent compared to the same period in 2005.


26



A summary of engine shipments used in power generation equipment by engine category follows:

 

 

Three months ended

 

Change

 

 

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Midrange

7,300

5,100

2,200

43%

Heavy-duty

1,800

1,800

—%

High-horsepower

2,400

2,100

300

14%

Total unit shipments

11,500

9,000

2,500

28%

Six Months Ended – 2006 versus 2005

The net sales, investee income and segment EBIT for Power Generation were as follows:

 

 

Six months ended

 

Change

 

$ in millions  

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

1,134

920

214

23%

Investee equity, royalty and other income

6

4

2

50%

Segment EBIT

101

50

51

102%

             

Segment EBIT as a percentage of net sales

8.9%

5.4%

3.5 percentage points

The increase in net sales in this segment was primarily due to increased volumes as a result of strong demand in the commercial generator set and alternator lines of business.  Our commercial business is up in nearly all markets, and our alternator business is up in all markets as well.  We also saw increases in our consumer market due to strong demand in the towable recreational vehicle and marine markets.  Our power electronics, energy solutions, and rental markets also saw increases, but at a more modest pace.  In addition, pricing actions from last year contributed to the increase in net sales.

The improvement in segment EBIT was largely attributable to strong commercial generator set sales across geographic markets as well as improved mix and price realization. While material costs have increased period over period, we have been able to more than absorb these costs through improved pricing Gross margin improved $66 million, or 46 percent, in the first six months of 2006 over the same period in 2005.  Gross margin percentage improved nearly three percentage points compared to the same period in 2005.  Selling and administrative expenses increased $15 million, or 16 percent, over the first six months of 2005, however selling and administrative expenses as a percentage of net sales improved by over one half of a percentage point in the first six months of 2006, compared to the same period in 2005.  Research and engineering expenses increased $3 million, or 30 percent during the first six months, compared to 2005 and research and engineering expenses as a percentage of net sales remained relatively consistent compared to the same period in 2005.

A summary of engine shipments used in power generation equipment by engine category follows:

 

 

Six months ended

 

Change

 

 

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Midrange

14,000

9,700

4,300

44%

Heavy-duty

3,500

3,300

200

6%

High-horsepower

4,500

4,000

500

13%

Total unit shipments

22,000

17,000

5,000

29%


27


 

Components Results

Three Months Ended – 2006 versus 2005

The net sales, investee income and segment EBIT for Components were as follows:

 

 

Three months ended

 

Change

 

$ in millions   

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

563

$

511

$

52

10%

Investee equity, royalty and other income

2

2

—%

Segment EBIT

34

21

13

62%

             

Segment EBIT as a percentage of net sales

6.0%

4.1%

1.9 percentage points

 Our Components segment includes the following businesses: fuel systems, filtration, aftertreatment devices and turbochargers.  Components net sales increased across all businesses and all geographic markets, but were primarily driven by strong demand in North America and Latin America for our filtration products with increases in both aftermarket volume and OEM volume.  Sales of our turbochargers increased due to increased European OEM sales.

Segment EBIT improved during the second quarter compared with the same period in 2005, primarily due to improved volume. In addition, EBIT as a percentage of net sales increased by nearly two percentage points.  Gross margin increased $21 million, or 26 percent, in the second quarter compared to the same period in 2005, and gross margin percentage improved over two percentage points compared to the same period in 2005, primarily due to volume, pricing and mix.  Selling and administrative expenses increased $5 million, or 10 percent, compared to the second quarter of 2005, and remained flat as a percentage of net sales.  Research and engineering expenses increased due to an increased investment in the development of a number of new products and critical technologies that will be launched in 2007 and beyond.  Research and engineering expenses increased $4 million, or 29 percent, compared to the second quarter of 2005 and increased by one half of a percentage point as a percentage of net sales.

Six Months Ended – 2006 versus 2005

The net sales, investee income and segment EBIT for Components were as follows:

 

 

Six months ended

 

Change

 

$ in millions   

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

1,118

$

984

$

134

14%

Investee equity, royalty and other income

4

4

—%

Segment EBIT

65

44

21

48%

             

Segment EBIT as a percentage of net sales

5.8%

4.5%

1.3 percentage points

Components net sales increased across all businesses and all geographic markets, but were primarily driven by strong demand in North America and Latin America for our filtration products with increases in both aftermarket volume and OEM volume.  Sales of our turbochargers increased primarily due to increased OEM sales.

Segment EBIT improved during the first six months compared with same period in 2005, primarily due to improved volume. In addition, EBIT as a percentage of net sales increased by over one percentage point.  Gross margin increased $40 million, or 25 percent, in the first six months compared to the same period in 2005, and gross margin percentage improved over one percentage point compared to the same period in 2005, primarily due to volume and pricing.  Selling and administrative expenses increased $10 million, or 10 percent, compared to the first six months of 2005, but decreased slightly as a percentage of net sales.  Research and engineering expenses increased due to an increased investment in the development of a number of new products and critical technologies that will be launched in 2007 and beyond.  Research and engineering expenses increased $10 million, or 37 percent, compared to the first six months of 2005 and increased by over one half of a percentage point as a percentage of net sales.


28



Distribution Results

Three Months Ended – 2006 versus 2005

The net sales, investee income and segment EBIT for Distribution were as follows:

 

 

Three months ended

 

Change

 

$ in millions   

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

336

$

297

$

39

13%

Investee equity, royalty and other income

14

8

6

75%

Segment EBIT

36

26

10

38%

             

Segment EBIT as a percentage of net sales

10.7%

8.8%

1.9 percentage points

Distribution net sales increased primarily due to strong overall demand in Europe, the Middle East and East Asia.  The higher net sales were led by increases in power generation volume followed by parts and service volume.  The reconstruction in the Middle East is the primary driver for the higher power generation volume accounting for nearly half of the increase.  Parts and service volumes were up throughout several geographies, most notably in East Asia, Europe and the Middle East.

Segment EBIT increased primarily due to higher gross margins resulting from greater sales of parts, service, and power generation equipment.  Gross margin in the second quarter of 2006 improved $6 million, or 9 percent, over the same period in 2005, however gross margin percentage decreased by nearly one percentage point due to a shift in mix.  The increase in gross margin was partially offset by higher selling and administrative expenses.  Selling and administrative expenses increased $7 million, or 13 percent; however selling and administrative expenses remained flat as a percentage of net sales in the same period. 

Also contributing to the increase in segment EBIT quarter-over-quarter was a $6 million increase in investee equity earnings.  This is primarily attributable to a $6 million increase in earnings at our North American distributors.

Six Months Ended – 2006 versus 2005

The net sales, investee income and segment EBIT for Distribution were as follows:

 

 

Six months ended

 

Change

 

$ in millions   

 

July 2, 2006

 

June 26, 2005

 

Amount

 

Percent

 

Net sales

$

653

$

550

$

103

19%

Investee equity, royalty and other income

23

14

9

64%

Segment EBIT

67

46

21

46%

             

Segment EBIT as a percentage of net sales

10.3%

8.4%

1.9 percentage points

Distribution net sales increased primarily due to strong overall demand in Europe, the Middle East and East Asia.  The higher net sales were led by increases in power generation volume followed by parts and engine volume.  The reconstruction in the Middle East is the primary driver for the higher power generation volume accounting for over half of the increase.  Parts and engine volumes were up throughout several geographies, most notably in Europe, East Asia and the Middle East.

Segment EBIT increased primarily due to higher gross margins resulting from greater sales of engines, parts, and power generation equipment.  Gross margin in the first six months of 2006 improved $23 million, or 18 percent, over the same period in 2005, and gross margin percentage decreased slightly.  The increase in gross margin was partially offset by higher selling and administrative expenses.  Selling and administrative expenses increased $16 million, or 16 percent; however selling and administrative expenses decreased one half of a percentage point as a percentage of net sales in the same period. 

Also contributing to the increase in segment EBIT year-over-year was a $9 million increase in investee equity earnings.  This is primarily attributable to a $9 million increase in earnings at our North American distributors.


29


Geographic Markets

Sales to international markets for the three and six months ended July 2, 2006, were 49 percent of total net sales, compared to 51 percent and 50 percent, respectively, for the three and six months ended June 26, 2005.

A summary of net sales (dollar amount and percentage of total) by geographic territory follows:

 

 

Three months ended,

 

Six months ended,

 

$ in millions   

 

July 2, 2006

 

June 26, 2005

 

July 2, 2006

 

June 26, 2005

 

United States

$

1,443

51%

$

1,231

49%

$

2,828

51%

$

2,361

50%

Asia/Australia

444

16%

437

18%

862

15%

795

17%

Europe/CIS

406

14%

355

14%

770

14%

683

15%

Mexico/Latin America

233

8%

174

7%

424

8%

321

7%

Canada

183

6%

186

8%

375

7%

342

7%

Africa/Middle East

133

5%

107

4%

261

5%

196

4%

Total international

1,399

49%

1,259

51%

2,692

49%

2,337

50%

Total consolidated net sales

$

2,842

100%

$

2,490

100%

$

5,520

100%

$

4,698

100%

 


30


LIQUIDITY AND CAPITAL RESOURCES

Overview of Capital Structure

Cash provided by operations is the primary source of funding our working capital requirements. At certain times, cash provided by operations is subject to seasonal fluctuations, and as a result, we may use periodic borrowings, primarily our revolving credit facility and our accounts receivable sales program, to fund our working capital requirements. As of July 2, 2006, there were no amounts outstanding under our revolving credit facility or our accounts receivable sales program.

The Company’s net debt position is as follows: