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 June 29, 2008

 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 ¨

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

Large accelerated filer x    Accelerated filer    ¨         

Non-accelerated filer ¨    Smaller reporting company ¨

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

As of June 29, 2008, there were 202,701,208 shares of common stock outstanding with a par value of $2.50 per share.

Website Access to Company's Reports

Cummins maintains an internet website at www.cummins.com.  Investors can obtain copies of our filings from this website free of charge as soon as reasonably practicable after they are electronically filed with, or furnished to the Securities and Exchange Commission.



CUMMINS INC.  AND 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 Income for the three and six months ended June 29, 2008 and July 1, 2007

3

     

Condensed Consolidated Balance Sheets at June 29, 2008 and December 31, 2007

4

     

Condensed Consolidated Statements of Cash Flows for the six months ended June 29, 2008 and July 1, 2007

5

     

Condensed Consolidated Statements of Shareholders’ Equity for the six months ended June 29, 2008 and July 1, 2007

6

     

Notes to Condensed Consolidated Financial Statements

7

     

ITEM 2.

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

16

   

ITEM 3.

Quantitative and Qualitative Disclosures About Market Risk

31

   

ITEM 4.

Controls and Procedures

31

   

PART II. OTHER INFORMATION

     

ITEM 1.

Legal Proceedings

32

     

ITEM 1A.

Risk Factors

32

   

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

32

     

ITEM 4.

Submission of Matters to a Vote of Security Holders

33

     

ITEM 6.

Exhibits

34

   

Signatures

35


PART I.  FINANCIAL INFORMATION

ITEM 1. Condensed Financial Statements

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

 

 

Three months ended

 

Six months ended

 

 

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

in millions

(except per share amounts)

NET SALES (a)

$

3,887

$

3,343

$

7,361

$

6,160

Cost of  sales

3,008

2,673

5,775

4,938

GROSS MARGIN

879

670

1,586

1,222

OPERATING EXPENSES AND INCOME

Selling, general and administrative expenses

370

314

721

597

Research, development and engineering expenses

104

74

207

154

Equity, royalty and interest income from investees (Note 5)

69

52

136

88

Flood damage expenses (Note 11)

6

--

6

--

Other operating income (expense), net

--

7

(1

)

5

 

OPERATING INCOME

468

341

787

564

Interest income

4

7

10

18

Interest expense

12

14

23

30

Other (expense) income, net

(3

)

6

(13

)

15

                   

INCOME BEFORE INCOME TAXES AND MINORITY INTERESTS

457

340

761

567

Income tax expense

147

112

249

187

Minority interests in income of consolidated subsidiaries

17

14

29

23

NET INCOME

$

293

$

214

$

483

$

357

 

EARNINGS PER COMMON SHARE

Basic

$

1.50

$

1.07

$

2.47

$

1.79

Diluted

$

1.49

$

1.06

$

2.46

$

1.77

WEIGHTED AVERAGE SHARES OUTSTANDING

Basic

195.2

199.9

195.1

200.0

Dilutive effect of stock compensation awards

1.4

1.4

1.4

1.2

Diluted

196.6

201.3

196.5

201.2

CASH DIVIDENDS DECLARED PER SHARE

$

0.125

$

0.09

$

0.25

$

0.18

 

(a) Includes sales to nonconsolidated equity investees of $570 million and $1,082 million and $368 million and $822 million for the three and six months ended June 29, 2008, and July 1, 2007, respectively.
 

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



 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

 

 

June 29,

 

December 31,

 

 

 

       2008       

 

       2007       

 

 

 

in millions
(except par value)

 

ASSETS

Current assets

Cash and cash equivalents

$

522

$

577

Marketable securities

107

120

Accounts and notes receivable, net

   Trade and other

2,079

1,754

   Nonconsolidated equity investees

298

244

Inventories (Note 6)

1,924

1,692

Deferred income taxes

296

276

Prepaid expenses and other current assets

186

152

Total current assets

5,412

4,815

Long-term assets

Property, plant and equipment

4,443

4,313

     Accumulated depreciation

(2,743

)

(2,668

)

     Property, plant and equipment, net

1,700

1,645

Investments and advances related to equity method investees

629

514

Goodwill and other intangible assets, net

572

538

Deferred income taxes and other assets

642

683

Total assets

$

8,955

$

8,195

                   

LIABILITIES

Current liabilities

Current portion of long-term debt and loans payable

$

71

$

119

Accounts payable (principally trade)

1,460

1,263

Current portion of accrued product warranty

372

337

Accrued compensation, benefits and retirement costs

338

441

Other accrued expenses

695

551

Total current liabilities

2,936

2,711

Long-term liabilities

Long-term debt

586

555

Pensions and other postretirement benefits

619

633

 

Other liabilities and deferred revenue

673

594

Total liabilities

4,814

4,493

Commitments and contingencies (Note 8)

                   

MINORITY INTERESTS

309

293

                   

SHAREHOLDERS'  EQUITY

Common stock, $2.50 par value, 500 shares authorized, 221.5 and 220.4 shares issued

1,734

1,719

Retained earnings

3,087

2,660

Treasury stock, at cost, 18.8 and 18.2 shares

(634

)

(593

)

Common stock held by employee benefits trust, at cost, 6.5 and 6.5 shares

(79

)

(79

)

Unearned compensation

(7

)

(11

)

Accumulated other comprehensive loss

Defined benefit postretirement plans

(368

)

(378

)

Other

99

91

Total accumulated other comprehensive loss

(269

)

(287

)

Total shareholders’ equity

3,832

3,409

Total liabilities, minority interests and shareholders’ equity

$

8,955

$

8,195

 

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



CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

Six months ended

 

 

June 29,

 

July 1,

2008

 

2007

CASH FLOWS FROM OPERATING ACTIVITIES

in millions

Net income

$

483

$

357

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

Depreciation and amortization

158

142

Net gain on disposal of property, plant and equipment

(2

)

(4

)

Deferred income taxes                                   

14

47

Equity in earnings of investees, net of dividends

(62

)

(22

)

Minority interest in income of consolidated subsidiaries

29

23

Pension expense (Note 4)

36

49

Pension contributions

(39

)

(102

)

Other post-retirement benefits expense, net of cash payments

(5

)

(16

)

Stock-based compensation expense

17

12

Excess tax benefits on stock-based awards

(12

)

(10

)

Translation and hedging activities

8

(8

)

Changes in current assets and liabilities, net of acquisitions and dispositions:

Accounts and notes receivable

(316

)

(287

)

Inventories

(202

)

(236

)

Other current assets

(16

)

(10

)

Accounts payable

172

215

Accrued expenses

102

(39

)

Changes in long-term liabilities

47

37

Other, net

(6

)

8

Net cash provided by operating activities

406

156

           

CASH FLOWS FROM INVESTING ACTIVITIES

Capital expenditures

(201

)

(108

)

Investments in internal use software

(36

)

(28

)

Proceeds from disposals of property, plant and equipment

10

19

Investments in and advances to equity investees

(41

)

(28

)

Acquisition of businesses, net of cash acquired

(76

)

(20

)

Investments in marketable securities—acquisitions

(158

)

(194

)

Investments in marketable securities—liquidations

159

191

Other, net

(13

)

(8

)

Net cash used in investing activities

(356

)

(176

)

           

CASH FLOWS FROM FINANCING ACTIVITIES

Proceeds from borrowings

77

4

Payments on borrowings and capital lease obligations

(101

)

(115

)

Net borrowings under short-term credit agreements

1

(8

)

Distributions to minority shareholders

(6

)

(10

)

Dividend payments on common stock

(51

)

(38

)

Repurchases of common stock

(45

)

(36

)

Excess tax benefits on stock-based awards

12

10

Other, net

2

(6

)

Net cash used in financing activities

(111

)

(199

)

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS

6

5

Net decrease in cash and cash equivalents

(55

)

(214

)

Cash and cash equivalents at beginning of year

577

840

CASH AND CASH EQUIVALENTS AT END OF PERIOD

$

522

$

626

 

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

 



 

CUMMINS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Unaudited)

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

Common

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Other

 

 

 

Stock

 

 

 

Total

 

 

 

Common

 

paid-in

Retained

Comprehensive

Treasury

Held in

 

Unearned

Shareholders’

 

 

 

Stock

 

Capital

Earnings

 Loss

Stock

Trust

 

Compensation

Equity

 

 

in millions

BALANCE AT DECEMBER 31, 2006

$

137

$

1,500

$

2,009

$

(526

)

$

(212

)

$

(92

)

 $

(14

)

$

2,802

Comprehensive income:

 

   Net income

 

 

 

 

357

 

 

 

 

 

 

 

 

357

   Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized gain on derivatives

 

 

 

 

 

 

4

 

 

 

 

 

 

4

Foreign currency translation adjustments

 

 

 

 

 

 

74

 

 

 

 

 

 

74

Change in pensions and other postretirement defined benefit plans

 

 

 

 

 

 

(25

)

 

 

 

 

 

 

(25

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

410

Issuance of shares

1

6

 

 

 

 

3

 

 

 

 

10

Stock splits

138

(138

)

 

 

 

 

 

 

 

 

 

 

 

 

Acquisition of shares

 

 

 

 

 

 

 

 

(36

)

 

 

 

 

(36

)

Cash dividends on common stock

 

 

 

 

(38

)

 

 

 

 

 

 

 

 

(38

)

Stock option exercises

 

 

1

 

 

 

 

 

 

 

1

Other shareholder transactions

 

 

8

1

 

 

 

 

 

 

1

 

10

BALANCE AT JULY 1, 2007

$

276

$

1,377

$

2,329

$

(473

)

$

(245

)

$

(92

)

$

(13

)

$

3,159

 

BALANCE AT DECEMBER 31, 2007

$

551

$

1,168

$

2,660

$

(287

)

$

(593

)

$

(79

)

$

(11

)

$

3,409

Comprehensive income:

   Net income

 

 

 

 

483

 

 

 

 

 

 

 

 

 

483

 

   Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized loss on marketable securities

 

 

 

 

 

 

(4

)

 

 

 

 

 

 

(4

)

Unrealized gain on derivatives

 

 

 

 

 

 

18

 

 

 

 

 

 

 

18

 

Foreign currency translation adjustments

 

 

 

 

 

 

(6

)

 

 

 

 

 

 

(6

)

Change in pensions and other postretirement defined benefit plans

 

 

 

 

 

 

12

 

 

 

 

 

 

 

12

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

503

 

Effect of changing pension plan measurement date pursuant to SFAS No. 158

 

 

 

 

(5

)

(2

)

 

 

 

 

 

 

(7

)

Issuance of shares

3

 

(1)

 

 

 

 

 

 

 

 

 

 

 

2

 

Acquisition of shares

 

 

 

 

 

 

 

 

(45)

 

 

 

 

 

(45)

 

Cash dividends on common stock

 

 

 

 

(51

)

 

 

 

 

 

 

 

 

(51

)

Stock option exercises

 

 

(1

)

 

 

 

 

4

 

 

 

 

 

3

 

Other shareholder transactions

 

 

14

 

 

 

 

 

 

 

 

 

4

 

18

 

BALANCE AT JUNE 29, 2008

$

554

 

$

1,180

 

$

3,087

 

$

(269

)(1)

$

(634

)

$

(79

)

 $

(7

)

$

3,832

 

(1) Comprised of defined benefit postretirement plans of $(368) million, foreign currency translation adjustments of $76 million, unrealized gain on marketable securities of $2 million and unrealized gain on derivatives of $21 million.

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



CUMMINS INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

NOTE 1.  NATURE OF OPERATIONS

Cummins Inc. ("Cummins," "the Company," "the 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 component products, including filtration and emissions solutions, fuel systems, controls and air handling systems. We were founded in 1919 as one of the first manufacturers of diesel engines and are headquartered in Columbus, Indiana. We sell our products to Original Equipment Manufacturers (OEMs), distributors and other customers worldwide. We serve our customers through a network of more than 500 company-owned and independent distributor locations and approximately 5,200 dealer locations in more than 190 countries and territories.
 

NOTE 2.  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 of operations, financial position and cash flows. 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. Certain reclassifications have been made to prior period amounts to conform to the presentation of the current period condensed financial statements. 

Our reporting period ends on the Sunday closest to the last day of the quarterly calendar period. The second quarter of 2008 and 2007 ended on June 29, and July 1, respectively. The interim periods for both 2008 and 2007 contain 13 weeks. Our fiscal year ends on December 31, regardless of the day of the week on which December 31 falls.

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.

Comprehensive income is comprised of net income, as well as adjustments for foreign currency translation, marketable securities, derivative instruments designated as cash flow hedges and pension and other postretirement defined benefits. Total comprehensive income for the three and six months ended June 29, 2008, was $272 million and $503 million, respectively. Total comprehensive income for the three and six months ended July 1, 2007, was $254 million and $410 million, respectively.

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, 2007. 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 data was derived from audited financial statements, but does not include all disclosures required by GAAP.
 

NOTE 3. RECENTLY ADOPTED AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Accounting Pronouncements Recently Adopted

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 157, "Fair Value Measurements" (SFAS 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  The adoption of SFAS 157, effective January 1, 2008, did not have a material impact on our Condensed Consolidated Financial Statements.  See Note 9 for further information regarding the adoption of this standard.

Accounting Pronouncements Issued But Not Yet Effective

In December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business Combinations" (SFAS 141R), which is effective for fiscal years beginning after December 15, 2008.  SFAS 141R makes significant changes to both the accounting and disclosures related to the acquisition of a business and could materially impact how we account for future business combination transactions.  Because the standard will only impact transactions entered into after January 1, 2009, SFAS 141R will not impact our Condensed Consolidated Financial Statements upon adoption.

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements" (SFAS 160), which is effective for fiscal years beginning after December 15, 2008.  SFAS 160 amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (ARB 51) and establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the accounting for future ownership changes with respect to those subsidiaries. For Cummins, the most significant impact of the standard, at adoption, will be to reclass our minority interests ($309 million at June 29, 2008) to be included as a part of equity, which may affect certain performance and equity ratios.  We are currently evaluating the potential additional impact that SFAS 160 may have on our Condensed Consolidated Financial Statements.

In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities" (SFAS 161), which is effective for fiscal years beginning after November 15, 2008. SFAS 161 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133) and requires enhanced disclosures about a company’s derivative and hedging activities. We do not expect the adoption of SFAS 161 to have a material impact on our Condensed Consolidated Financial Statements, but are still evaluating the additional disclosure requirements.

NOTE 4.  PENSION AND OTHER POSTRETIREMENT BENEFITS

We sponsor both funded and unfunded domestic and foreign defined benefit pension and postretirement plans. Contributions to these plans for the three and six month periods ended June 29, 2008 and July 1, 2007, respectively were as follows:

 

 

Three months ended

 

Six months ended

 

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

in millions

 

 

Defined benefit plans:

     Voluntary

$

12

$

20

24

60

     Mandatory

14

41

30

68

Total defined benefit plans

$

26

$

61

54

128

Defined contribution plans

$

8

$

4

18

15












We presently anticipate contributing $90 million to $100 million to our defined benefit pension plans in 2008 and paying approximately $60 million in claims and premiums for other postretirement benefits. The $90 million to $100 million of contributions for the full year includes voluntary contributions of $70 million to $75 million. These contributions and payments include payments from Company funds to either increase pension assets or to make direct payments to plan participants.

In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)" (SFAS 158). This statement requires balance sheet recognition of the overfunded or underfunded status of pension and postretirement benefit plans. In addition, the measurement date (the date at which plan assets and the benefit obligation are measured) is required to be the company’s fiscal year end. Except for the measurement date provisions, which are not effective until fiscal years ending after December 15, 2008, the provisions of SFAS 158 were effective for fiscal years ending after December 15, 2006 and as such, were adopted during 2006.

We have adopted the measurement date provisions of SFAS 158 effective January 1, 2008. The majority of our pension and postretirement plans previously used a November 30 measurement date. All plans are now measured at December 31, consistent with the company’s fiscal year end. The non-cash effect of the adoption of the measurement date provisions of SFAS 158 decreased shareholders’ equity by approximately $7 million ($5 million after-tax) and increased long-term liabilities by approximately $10 million. There was no effect on our results of operations.



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

 

 

Pension

 

Postretirement

 

 

 

U.S. Plans

 

Non-U.S. Plans

 

Benefits

 

 

 

Three months ended

 

 

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

 

 

2008

 

2007

2008

 

2007

 

2008

 

2007

 

in millions 

Service cost

 

$

12

$

12

$

7

$

8

$

$

Interest cost

29

27

16

16

8

7

Expected return on plan assets

(38

)

(35

)

(19

)

(18

)

Amortization of prior service cost (credit)

(1

)

1

1

(2

)

(2

)

Recognized net actuarial loss (gain)

5

8

5

7

(1

)

Net periodic benefit cost

$

8

$

11

$

10

$

14

$

5

$

5

           

 

 

Pension

 

Postretirement

 

 

 

U.S. Plans

 

Non-U.S. Plans

 

Benefits

 

 

 

Six months ended

 

 

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

 

 

2008

 

2007

2008

 

2007

 

2008

 

2007

 

in millions 

Service cost

 

$

24

$

23

$

14

$

16

$

$

Interest cost

58

54

32

31

16

15

Expected return on plan assets

(76

)

(70

)

(38

)

(35

)

Amortization of prior service cost (credit)

(1

)

2

2

(5

)

(5

)

Recognized net actuarial loss (gain)

10

16

10

13

(1

)

Net periodic benefit cost

$

16

$

22

$

20

$

27

$

10

$

10


NOTE 5.  EQUITY, ROYALTY AND INTEREST INCOME FROM INVESTEES

Equity, royalty and interest income from investees included in our Condensed Consolidated Statements of Income for the interim reporting periods was as follows:

 

 

 

Three months ended

 

Six months ended

 

 

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 in millions

 

North American distributors

$

24

$

22

$

46

$

37

Dongfeng Cummins Engine Company, Ltd

20

11

34

17

Chongqing Cummins Engine Company, Ltd

7

5

14

10

Tata Cummins Ltd.

2

4

7

6

Cummins MerCruiser Diesel Marine LLC.

2

4

6

7

Shanghai Fleetguard Filter Co. Ltd.

2

2

5

3

All others

6

2

13

3

Cummins share of net earnings

63

50

125

83

Royalty and interest income

6

2

11

5

Equity, royalty and interest income from investees

$

69

$

52

$

136

$

88


NOTE 6.  INVENTORIES

Inventories included the following:      

 

 

 

June 29,

 

December 31,

 

 

 

  2008  

 

  2007  

 

 

 

in millions

 

Finished products

$

945

$

770

Work-in-process and raw materials

1,075

1,007

Inventories at FIFO cost

2,020

1,777

Excess of FIFO over LIFO

(96

)

(85

)

Total inventories

$

1,924

$

1,692

 

NOTE 7.  PRODUCT WARRANTY LIABILITY

We charge the estimated costs of warranty programs, other than product recalls, to income at the time products are shipped to customers. We use historical claims experience to develop the estimated liability. We review product recall programs on a quarterly basis, and if necessary, record a liability when we commit to an action. We also sell extended warranty coverage on several engines. The following is a tabular reconciliation of the product warranty liability, including the deferred revenue related to our extended warranty coverage:

 

 

Six months ended

 

 

 

June 29,

 

July 1,

 

 

 

2008

 

2007

 

 

 

in millions

Balance, beginning of period

$

749

$

652

Provision for warranties issued

218

182

Deferred revenue on extended warranty contracts sold

43

32

Payments

(175

)

(150

)

Amortization of deferred revenue on extended warranty contracts

(31

)

(24

)

Changes in estimates for pre-existing warranties

50

(13

)

Foreign currency translation

3

Balance, end of period

$

854

$

682

The amount of deferred revenue related to extended coverage programs at June 29, 2008, was $200 million. At June 29, 2008, we had $16 million of receivables related to estimated supplier recoveries of which $7 million was included in "Trade and other" receivables and $9 million was included in "Deferred income taxes and other assets" on our Condensed Consolidated Balance Sheets.

NOTE 8.  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 these and other 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 Guarantees

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 distributors in the United States, and to certain distributors in which we own an equity interest. 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. 

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 to be in effect until February 7, 2009.
 

Residual Value Guarantees

We have various residual value guarantees on equipment leased under operating leases. The total amount of these residual value guarantees at June 29, 2008, was $8 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 is $4 million at June 29, 2008.

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 in most instances. At June 29, 2008, if we were to stop purchasing from each of these suppliers, the amount of the penalty would be approximately $111 million, of which $93 million relates to a new contract executed in the second quarter of 2008. We entered into this contract with an engine parts supplier that would require a maximum penalty of $93 million from 2008 to 2013, if we did not meet our minimum purchase requirements for all six years. However, based on current forecasts, we do not anticipate paying any penalties under these contracts.  This arrangement enables us to secure critical components important to our growth.

In July 2008, Beijing Foton Cummins Engine Company (BFCEC), a 50% owned entity accounted for under the equity method,  entered into a line of credit agreement for borrowing capacity of up to $175 million (at current exchange rates).  The line will be used primarily to fund equipment purchases for the new manufacturing plant.  As a part of this transaction, we guaranteed 50% of any outstanding borrowings up to a maximum guarantee of $88 million (at current exchange rates).  As BFCEC borrows funds under this line, we will record a liability for the fair value of this guarantee in accordance with FASB Interpretation No. 45.  The liability will be adjusted quarterly as the balance in the line of credit changes.  The offset to this liability will be an increase in our investment in the joint venture.
 

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:

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 Commitments

As of June 29, 2008, we have committed to invest $3 million into existing joint ventures. It is expected that $1 million will be funded in 2008, while $2 million will be funded in 2009.

NOTE 9.  FAIR VALUE OF FINANCIAL INSTRUMENTS

In September 2006, the FASB issued SFAS 157, which defines fair value, establishes a market-based framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures. SFAS 157 is effective for financial assets and financial liabilities for fiscal years beginning after November 15, 2007.  FASB Staff Position (FSP) 157-2 "Partial Deferral of the Effective Date of Statement No. 157" (FSP 157-2), deferred the effective date of SFAS 157 for most non-financial assets and non-financial liabilities to fiscal years beginning after November 15, 2008.  We adopted this statement prospectively for our fiscal year beginning January 1, 2008, except for non-financial assets and non-financial liabilities as deferred until January 1, 2009, by FSP 157-2.  SFAS 157 does not require retroactive restatement of prior periods. The adoption of SFAS 157 did not materially impact our consolidated financial statements.

As defined in SFAS 157, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). We utilize market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. We primarily apply the market approach for recurring fair value measurements and utilize the best available information. Accordingly, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The company is able to classify fair value balances based on the observability of those inputs. SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurement). The three levels of the fair value hierarchy defined by SFAS 157 are as follows:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. Level 1 primarily consists of financial instruments such as exchange-traded derivatives, listed equities and publicly traded bonds.

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reported date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors, and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace throughout the full term of the instrument, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace. Instruments in this category include non-exchange-traded derivatives such as over-the-counter forwards and options.

Level 3 – Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management's best estimate of fair value. At each balance sheet date, the company performs an analysis of all instruments subject to SFAS 157 and includes in level 3 all of those whose fair value is based on significant unobservable inputs. At June 29, 2008, we did not have any level 3 financial assets or liabilities.

The majority of the assets and liabilities we carry at fair value are available-for-sale (AFS) securities and derivatives.  AFS securities are derived from level 1 or level 2 inputs.  The predominance of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services.

The fair value measurement of derivatives results primarily from level 2 inputs. Many of our derivative contracts are valued utilizing publicly available pricing data of contracts with similar terms. In other cases, the contracts are valued using current spot market data adjusted for the appropriate current forward curves provided by external financial institutions. We participate in commodity swap contracts, currency forward contracts, and interest rate swaps. We enter into hedging transactions with banking institutions that have strong credit ratings, and thus the credit risk associated with these contracts is not considered significant.  For more discussion regarding our derivative instruments, see Note 18 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.

The following table summarizes the fair value of our financial instruments at June 29, 2008:

 

 

Fair Value Measurements Using

 

Quoted Prices in Active Markets for Identical Assets 
(Level 1)

 

Significant Other Observable Inputs 
(Level 2)

 

Significant Unobservable Inputs  
(Level 3)

 

Total

 

in millions

Available-for-sale securities

$

53

$

54

$

$

107

Net derivative asset (1)

38

38

Total

$

53

$

                92

$

$

145

 
(1)Includes approximately $2 million of Level 2 derivative liabilities, which are netted against derivative assets.

 

 

 

 

 

 



NOTE 10.   ACQUISITION OF BUSINESSES


During the first six months of 2008, we purchased a majority interest in two previously independent North American distributors in order to increase our ownership interests in key portions of the distribution channel. The acquisitions were accounted for under the purchase method of accounting and resulted in an aggregate purchase price of $76 million which we funded with $54 million of borrowings and $22 million of cash. The assets of the acquired businesses were primarily accounts receivable, inventory and fixed assets. No goodwill was generated from either transaction. During the first three months of 2007, we purchased the remaining interest in a manufacturing joint venture and acquired ownership of an international independent distributor for approximately $20 million. We recorded goodwill of $13 million for these two transactions.


NOTE 11.   FLOOD DAMAGE


In June 2008, Columbus, Indiana experienced significant flooding which impacted some of our facilities. One manufacturing facility was partially flooded. Our technical center, which houses engineering staff and contains dynamometer test cells and labs, was more severely impacted by the event which caused temporary displacement of the engineering workforce and suspension of testing for approximately five weeks. Critical testing was transferred to other Cummins facilities and external suppliers to minimize the interruption. 

We have insurance, subject to a deductible, which covers the physical damage to the facilities, costs of clean up and repair and business interruption that will limit the economic impact of this event to the company. In the second quarter of 2008, we recorded a charge of $6 million representing the insurance deductible for this event and we anticipate that all other costs will be reimbursed through our insurance coverage.  The clean up costs are estimated to range from $45 million to $50 million and will be spent over the remainder of 2008. We estimate the replacement value of assets impacted was approximately $90 million and we anticipate that asset replacements will be reflected in capital spending over the next six quarters. Most of these assets were fully depreciated at the time of the flood.   Although this claim is significant we believe we have sufficient insurance coverage after this claim for any future events.

We are using our research and engineering facilities in other regions not impacted by the flood to continue our engineering and development activities. We have already resumed operations in our test cells and will secure additional testing capacity outside our facility at additional cost.

We are confident that our insurance coverage will limit the impact of this event.


NOTE 12.  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

 

Non-segment items(1)

 

Total

 

 

 

in millions

 

Three months ended June 29, 2008

External sales

$

2,030

$

692

$

584

$

581

$

$

3,887

Intersegment sales

356

246

271

(873

)

   Total sales

2,386

938

855

581

(873

)

3,887

Depreciation and amortization(2)

46

11

18

7

82

Research, development and engineering expense

70

10

24

104

Equity, royalty and interest income from investees

32

6

3

28

69

Interest income

2

1

1

4

Segment EBIT

221

115

77

68

(12

)

469

Three months ended July 1, 2007

External sales

$

1,855

$

605

$

516

$

367

$

$

3,343

 

Intersegment sales

254

164

241

1

(660

)

 

   Total sales

2,109

769

757

368

(660

)

3,343

 

Depreciation and amortization(2)

46

10

15

3

74

Research, development and engineering expense

51

9

14

74

Equity, royalty and interest income from investees

25

4

(1

)

24

52

Interest income

6

1

7

Segment EBIT

186

88

48

46

(14

)

354

Six months ended June 29, 2008

External sales

$

3,915

$

1,273

$

1,151

$

1,022

$

$

7,361

Intersegment sales

680

452

524

4

(1,660

)

   Total sales

4,595

1,725

1,675

1,026

(1,660

)

7,361

Depreciation and amortization(2)

90

22

33

11

156

Research, development and engineering expense

140

20

47

207

Equity, royalty and interest income from investees

65

11

7

53

136

Interest income

5

2

2

1

10

Segment EBIT

415

193

114

117

(55

)

784

Six months ended July 1, 2007

External sales

$

3,377

$

1,136

$

971

$

676

$

$

6,160

Intersegment sales

497

308

443

1

(1,249

)

   Total sales

3,874

1,444

1,414

677

(1,249

)

6,160

Depreciation and amortization(2)

87

20

29

5

141

Research, development and engineering expense

103

17

34

154

Equity, royalty and interest income from investees

42

7

(2

)

41

88

Interest income

14

3

1

18

Segment EBIT

314

165

72

85

(39

)

597

(1) Includes intersegment sales and profit in inventory eliminations and unallocated corporate expenses including flood related expenses.

(2) Depreciation and amortization as shown on a segment basis excludes the amortization of debt discount that is included in the Condensed Consolidated Statements of Income as Interest expense.



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

 

 

Three months ended

 

Six months ended

 

 

 

June 29,

 

July 1,

 

June 29,

 

July 1,

 

 

 

2008

 

2007

 

2008

 

2007

 

in millions

Segment EBIT

$

469

$

354

$

784

$

597

Less:

Interest expense

12

14

23

30

Income before income taxes and minority interests

$

457

$

340

$

761

$

567

NOTE 13.  SUBSEQUENT EVENTS

New Revolving Credit Agreement

On June 30, 2008, we entered into a Three-Year Revolving Credit Agreement, (the "Credit Agreement"), with a syndicate of lenders and issuers named therein. The Credit Agreement provides a $1.1billion senior unsecured revolving credit facility (the "Credit Facility"), the proceeds of which are to be used to provide working capital or for other general corporate purposes of Cummins.

The Credit Facility matures on June 30, 2011.  The Credit Facility is unsecured and amounts payable under it will rank pro rata with all other unsecured, unsubordinated indebtedness of Cummins. Borrowings under the Credit Facility will primarily be denominated in U.S. dollars.  A portion of the Credit Facility, up to $200 million, is available for Letters of Credit denominated in U.S. dollars or Alternate Currencies.  In addition, up to $200 million of the Revolving Credit Facility will be available in Pounds Sterling or Euros. A portion of the Credit Facility, up to $100 million, is available for swingline loans denominated in U.S. dollars.  Loans will bear interest at (i) a base rate or (ii) a rate equal to LIBOR plus an applicable margin based on the credit ratings of Cummins outstanding senior unsecured long-term debt. Based on our current long-term debt ratings, the applicable margin on LIBOR loans will be 0.75% per annum. Loans may be prepaid without premium or penalty, subject to customary breakage costs.

The Credit Facility replaces a $650 million in aggregate principal amount of revolving credit facility (Former Credit Agreement) maintained by Cummins which was terminated effective June 30, 2008.

The Credit Agreement includes covenants substantially similar to those in the Former Credit Agreement, including, among others, (a) a leverage ratio, (b) fixed charge coverage ratio, (c) limitations on priority indebtedness, (d) limitations on our ability to consummate a merger, consolidation or sale of all or substantially all of our assets and (e) limitations on our ability to change the nature of our business.

The obligation of Cummins to pay amounts outstanding under the Credit Facility may be accelerated upon the occurrence of an “Event of Default” as defined in the Credit Agreement. Such Events of Default include, among others, (a) Cummins failure to pay the principal of, or interest on, borrowings under the Credit Facility, (b) any representation or warranty of Cummins in the Credit Agreement proving to be materially false or misleading, (c) Cummins breach of any of its covenants contained in the Credit Agreement, and (d) the bankruptcy or insolvency of Cummins.
 

Joint Venture Transaction

In July 2008, we entered into a transaction with two Fiat group companies to (1) sell our one-third interest in the European Engine Alliance (EEA) joint venture and simultaneously (2) purchase the remaining 50% interest in Consolidated Diesel Corporation (CDC).  As a result, we now own 100% of CDC and no longer have an ownership interest in EEA.  On a net basis, Cummins received approximately $4 million from the two transactions, subject to post-closing adjustments.



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

 

Cummins Inc. and its consolidated subsidiaries are hereinafter sometimes referred to as "Cummins," "the Company," "the registrant," "we," "our," or "us."

CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING INFORMATION

Certain parts of this quarterly report contain forward-looking statements that are based on current expectations, estimates and projections about the industries in which we operate and management’s beliefs and assumptions. Forward-looking statements are generally accompanied by words, such as "anticipates," "expects," "forecasts," "intends," "plans," "believes," "seeks," "estimates" or similar expressions. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which we refer to as “future factors,” which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Future factors that could cause our results to differ materially from the results discussed in such forward-looking statements are discussed below. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Future factors that could affect the outcome of forward-looking statements include the following:

In addition, such statements could be affected by general industry and market conditions and growth rates, general domestic and international economic conditions, including the price of crude oil (diesel fuel), interest rate and currency exchange rate fluctuations and other future factors.



ORGANIZATION OF INFORMATION

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") was prepared to provide the reader with a view and perspective of our business through the eyes of management and should be read in conjunction with our Consolidated Financial Statements and related Notes to Consolidated Financial Statements in the "Financial Statements" section of our 2007 Annual Report on Form 10-K. Our MD&A is presented in the following sections:



EXECUTIVE SUMMARY

We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and engine-related component products, including filtration and exhaust aftertreatment, 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 Chrysler LLC, Daimler AG, Volvo AB, PACCAR Inc., International Truck and Engine Corporation (Navistar International Corporation), CNH Global N.V., Komatsu, Scania AB, Ford Motor Company and Volkswagen. We serve our customers through a network of more than 500 company-owned and independent distributor locations and approximately 5,200 dealer locations in more than 190 countries and territories.

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. This type of reporting structure allows management to focus its efforts on providing enhanced service to a wide range of customers. The Engine segment produces engines and parts for sale to customers in on-highway and various industrial markets. The engines are used in trucks of all sizes, buses and recreational vehicles, as well as various industrial applications including construction, mining, agriculture, marine, oil and gas, rail and military. The Power Generation segment is an integrated provider of power systems which sells engines, generator sets and alternators and rents power equipment for both standby and prime power uses. The Components segment includes sales of filtration products, exhaust aftertreatment systems, turbochargers and fuel systems. The Distribution segment includes wholly-owned and partially-owned distributorships engaged in wholesaling engines, generator sets, and service parts, as well as performing service and repair activities on our products and maintaining relationships with various OEMs throughout the world.

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. Our sales may also be impacted by OEM inventory levels and production schedules and stoppages. Economic downturns in markets we serve generally result in reductions in sales and pricing of our products. As a worldwide business, our operations are also affected by political, economic and regulatory matters, including environmental and emissions standards, in the countries we serve. However, our geographic diversity and broad product and service offerings have helped limit the impact of any one industry or customer and the economy of any single country upon our consolidated results. In the first six months of 2008, softness in the pick-up truck, recreational vehicle, and recreational marine markets worsened and evidence of a downturn in the United States economy became more evident in the second quarter. Despite these unfavorable conditions, we reported increased net sales and net income for the three and six month periods over the same periods in 2007 which represented the highest reported quarterly net sales and net income in our history. Approximately 54 percent of our 2007 sales came from countries other than the United States and that trend grew to 59 percent in the first six months of 2008, including 61 percent in the second quarter. The diversity of our business portfolio has contributed to the significant organic growth we have experienced over the past several years and is continuing into 2008.



RESULTS OF OPERATIONS

 

 

 

Three Months Ended

 

Favorable/

(Unfavorable)

 

Six Months Ended

 

Favorable/ (Unfavorable)

 

June 29,

July 1,

 

 

 

 

 

June 29,

 

July 1,

 

 

 

 

2008

2007

 

Amount

 

Percent

 

2008

 

2007

 

Amount

 

Percent

 

 

$ in millions

 

 

 

$ in millions

 

 

 

Net sales

$

3,887

$

3,343

$

544

16

%

$

7,361

$

6,160

$

1,201

19

Cost of sales

3,008

2,673

(335

)

(13

)%

5,775

4,938

(837

)

(17

)%

Gross margin

879

670

209

31

%

1,586

1,222

364

30

%

Operating expenses and income

 

 

Selling, general and administrative expenses

370

314

(56

)

(18

)%

721

597

(124

)

(21

)%

Research, development and engineering expenses

104

74

(30

)

(41

)%

207

154

(53

)

(34

)%

Equity, royalty and interest income from investees

69

52

17

33

%

136

88

48

55

%

Flood damage expenses

6

(6

)

NM

6

 

(6

)

NM

Other operating income (expense), net

7

(7

)

(100

)%

(1

)

5

(6

)

NM

Operating income

468

341

127

37

%

787

564

223

40

%

Interest income

4

7

(3

)

(43

)%

10

18

(8

)

(44

)%

Interest expense

12

14

2

14

%

23

30

7

23

%

Other (expense) income, net

(3

)

6

(9

)

NM

(13

)

15

(28

)

NM

Income before income taxes and minority interests

457

340

117

34

%

761

567

194

34

%

Income tax expense

147

112

(35

)

(31

)%

249

187

(62

)

(33

)%

Minority interest in income of consolidated subsidiaries

17

14

(3

)

(21

)%

29

23

(6

)

(26

)%

Net income

$

293

$

214

$

79

37

%     

$

483

$

357

$

126

35

%     

Net Sales

Net sales for the three and six months ended June 29, 2008, increased in all segments over the same periods in 2007, with record quarterly sales in all four business segments. The Engine segment led the increase in net sales for both the three and six month periods. Total sales in this segment increased $277 million, or 13 percent, and $721 million, or 19 percent, for the three and six month periods, respectively. The Engine segment benefited from an increase in our market share in the North American (includes the Unites States and Canada and excludes Mexico) heavy-duty truck, medium-duty truck and bus markets, strong demand in Latin American medium-duty truck, Mexican heavy-duty truck and international industrial markets. Engine segment sales were partially offset by a significant reduction in demand in light-duty automotive sales in North America. Power Generation segment sales increased $169 million, or 22 percent, and $281 million, or 19 percent, for the three and six months ended June 29, 2008, respectively, led by increased sales in our commercial and alternator businesses. Components segment sales increased $98 million, or 13 percent, and $261 million, or 18 percent, for the three and six months ended June 29, 2008, respectively, due to stronger sales in our turbocharger, fuel systems and emission solutions businesses. Similar demand drivers caused an increase in Distribution segment sales of $213 million, or 58 percent, and $349 million, or 52 percent, for the three and six months ended June 29, 2008, respectively. In addition, the acquisition of a majority ownership interest in two previously independent North American distributors during the first half of 2008 added approximately $63 million and $100 million of net sales to the Distribution segment for the three and six month periods, respectively. Intersegment sales increased $213 million, or 32 percent, and $411 million, or 33 percent, for the three and six months ended June 29, 2008, respectively, compared to the same periods in 2007.

Gross Margin

Gross margins for the three and six months ended June 29, 2008, improved primarily due to increased volumes and higher price realization which were partially offset by increased costs for new products and increased warranty expenses. The following table presents the significant drivers impacting gross margins for the three and six months ended June 29, 2008, to the comparable periods of 2007:



 

 

Three months ended

 

Six months ended

 

 

 

2008 vs. 2007

 

 

change in millions

Volume

$

67

$

180

Price

97

180

Product mix

42

76

Production costs

5

(10

)

Currency

19

35

Warranty expense

(24

)

(100

)

Other

3

3

Total

$

209

$

364


Gross margin as a percentage of sales for the three and six month periods increased by 2.6 percentage points and 1.7 percentage points, respectively, as margin percentages increased in all four business segments. Engine segment margins increased for the three months ended June 29, 2008, primarily due to more favorable sales mix in the on-highway markets and improved engine and parts pricing which was partially offset by an increase in warranty expense. Engine segment margins increased in the first six months of 2008, compared to the same period in 2007, primarily due to higher engine volumes across most on-highway markets, the accompanying gross margin impact of higher absorption of fixed manufacturing costs, improved engine and parts pricing and more favorable sales mix in the on-highway markets. This was partially offset by an increase in warranty expense. Power Generation segment margins improved, for both the three and six month periods, primarily due to significant price realization, net of increased material costs, increased volumes and a more favorable product mix. The Components segment margins improved significantly, for both the three and six month periods, through price realization, manufacturing efficiencies and increased volumes in most of our businesses. The Distribution segment experienced improved margins, for both the three and six month periods, due to increased organic and acquisition related sales growth.  

The provision for warranties issued for the three and six months ended June 29, 2008, were 2.9 percent and 3.0 percent of consolidated sales, compared to 3.1 percent and 3.0 percent for the same periods in 2007, respectively.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the three and six months ended June 29, 2008, increased compared to the same periods in 2007,  primarily due to increased compensation and related expenses of $13 million and $38 million, increased consulting expenses of $9 million and $27 million and the acquisition of a majority ownership interest in two previously independent North American distributors during the first six months of 2008. Increased compensation and related expenses included salaries, variable compensation, and fringe benefits across the businesses in support of higher volumes and our growing business. Overall, selling, general and administrative expenses increased slightly as a percent of sales to 9.5 percent in 2008 compared to 9.4 percent in 2007 and 9.8 percent in 2008 compared to 9.7 percent in 2007 for the three and six month periods, respectively.

Research, Development and Engineering Expenses

Research, development and engineering expenses for the three and six months ended June 29, 2008, increased compared to the same periods in 2007 primarily due to higher spending on development programs for future products as well as increased compensation expense and related expenses. The increase in research, development and engineering expenses in the Engine segment relates to new product development for 2010 as well as research, development and engineering expenses for growth platforms across geographies. Increased compensation and related expenses include salaries, variable compensation, and fringe benefits, partially due to an increased number of employees to provide for our growing business. The Engine and Components segments accounted for $19 million and $10 million of the increase for the three month period and $37 million and $13 million of the increase for the six month period, respectively. Fluctuations in other miscellaneous research, development and engineering expenses were not significant individually or in the aggregate.

Equity, Royalty and Interest Income From Investees

Equity, royalty and interest income from investees for the three and six months ended June 29, 2008, increased compared to the same periods in 2007, primarily due to a $9 million and $17 million increase in earnings from Dongfeng Cummins Engine Company, Ltd., a $2 million and $9 million increase from our North American distributors and a $2 million and $4 million increase from Chongqing Cummins Engine Company Limited for the three and six month periods, respectively. Other joint ventures with increases for the six months ended June 29, 2008, compared to the same period in the prior year included Shanghai Fleetguard Filter Co., Ltd. and Tata Cummins Ltd.

Other Operating Income (Expense), Net

Other operating income (expense) for the three months ended June 29, 2008, decreased from income in 2007 to zero in 2008 while other operating income (expense) for the six months ended June 29, 2008, decreased from income in 2007 to expense in 2008. The major components of other operating income (expense) are royalty income, amortization of intangible assets and gains and losses on sale of fixed assets. The decrease in other operating income for the three and six months ended June 29, 2008, compared to the same periods for 2007, was primarily due to a $5 million decrease in gains on the sale of assets for both periods in 2008 and an increase in the amortization of other intangibles of $3 million and $5 million for the three and six month periods of 2008, respectively. The decrease in other income for the six month period of 2008 was partially offset by an increase in royalty income of $3 million during the first quarter of 2008. Other fluctuations in other operating income (expense) were not significant individually or in the aggregate. 

Interest Expense

Interest expense for the three and six months ended June 29, 2008, decreased compared to the same periods in 2007 due to lower average debt balances.

Flood Damage Expenses


In June 2008, Columbus, Indiana experienced significant flooding which impacted some of our facilities. One manufacturing facility was partially flooded. Our technical center, which houses engineering staff and contains dynamometer test cells and labs, was more severely impacted by the event which caused temporary displacement of the engineering workforce and suspension of testing for approximately five weeks. Critical testing was transferred to other Cummins facilities and external suppliers to minimize the interruption. 

We have insurance, subject to a deductible, which covers the physical damage to the facilities, costs of clean up and repair and business interruption that will limit the economic impact of this event to the company. In the second quarter of 2008, we recorded a charge of $6 million representing the insurance deductible for this event and we anticipate that all other costs will be reimbursed through our insurance coverage. The clean up costs are estimated to range from $45 million to $50 million and will be spent over the remainder of 2008. We estimate the replacement value of assets impacted was approximately $90 million and we anticipate that asset replacements will be reflected in capital spending over the next six quarters. Most of these assets were fully depreciated at the time of the flood. We will record an involuntary conversion gain for the difference between the insurance recovery of actual costs to replace the assets and the book value, which was approximately $8 million at the time of the flood. This gain will be recognized as the assets are replaced over the next six quarters, with the majority recognized in the next four quarters. Although this claim is significant we believe we have sufficient insurance coverage after this claim for any future events.

We are using our research and engineering facilities in other regions not impacted by the flood to continue our engineering and development activities. We already resumed operations in our test cells and will secure additional testing capacity outside our facility at additional cost.

We are confident that our insurance coverage will limit the impact of this event.


Other (Expense) Income, Net


Other (expense) income for the three and six months ended June 29, 2008, decreased from income in 2007 to expense in 2008. The major components of other (expense) income include foreign currency exchange gains and losses, bank charges and other miscellaneous income and expenses. The fluctuation in other (expense) income was due to foreign currency exchange losses of approximately $6 million and $17 million for the three and six months ended June 29, 2008, compared to foreign currency exchange gains of $1 million and $10 million for the  same periods in 2007. The unfavorable impact was primarily due to a weaker U.S. dollar, particularly compared to the Euro. There were no individual fluctuations in the components of miscellaneous income and expenses that were significant.


Income Tax Expense


Our effective tax rate for the three and six months ended June 29, 2008, was 32 percent and 33 percent, respectively. The current quarter includes a favorable adjustment to reduce our previously estimated annual tax rate from 34 to 33 percent, which is less than the 35 percent U.S. income tax rate primarily due to lower tax rates on increased foreign earnings. Our effective tax rate for both the three and six months ended July 1, 2007, was 33 percent.  This rate was less than the 35 percent U.S. income tax rate primarily due to research tax credits and lower taxes on foreign earnings. The effective tax rate for the remainder of the year is expected to approximate 33 percent absent any discrete period activity.


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.

Engine

Financial data for the Engine segment was as follows:

 

 

Three Months Ended

 

Favorable/ (Unfavorable)

 

Six Months Ended

 

Favorable/ (Unfavorable)

 

June 29,

 

July 1,

June 29,

 

July 1,

2008

 

2007

Amount

 

Percent

2008

 

2007

Amount

 

Percent

 

 

$ in millions

 

 

 

$ in millions

 

 

 

External sales

$

2,030

$

1,855

$

175

9

%

$

3,915

$

3,377

$

538

16

Intersegment sales

356

254

102

40

%

680

497

183

37

%

   Total sales

2,386

2,109

277

13

%

4,595

3,874

721

19

%

Depreciation and amortization

46

46

NM

90

87

(3

)

(3

)%

Research, development and engineering expenses

70

51

(19

)

(37

)%

140

103

(37

)

(36

)%

Equity, royalty and interest income from investees

32

25

7

28

 %

65

42

23

55

%

Interest income

2

6

(4

)

(67

)%

5

14

(9

)

(64

)%

Segment EBIT

221

186

35

19

%

415

314

101

32

%

 

 

Segment EBIT as a percentage of net sales

9.3

%

8.8

%

0.5 percentage points

9.0

%

8.1

%

0.9  percentage points

Sales

Engine segment sales increased for the three and six months ended June 29, 2008, over the same periods in 2007, primarily due to an increase in our market share in the North American (includes the Unites States and Canada and excludes Mexico) heavy-duty truck and medium-duty truck and bus markets, as well as strong demand in Latin American medium-duty truck, Mexican heavy-duty truck and international industrial markets. Segment sales were partially offset by a significant reduction in demand in light-duty automotive sales in North America. The increase in the North American heavy-duty  and medium-duty truck markets was primarily due to weaker demand in the first six months of 2007 resulting from the 2006 pre-buy to replace trucks ahead of the 2007 emissions regulations change. The increase in Mexican heavy-duty sales was the result of pre-buy activity ahead of Mexico’s new July 1, 2008, emissions requirements. The medium-duty truck increase was mainly driven by strong economic conditions in Brazil while the increase in bus sales was driven by market share gains in the North American bus market. Total on-highway-related sales were 54 percent and 55 percent in 2008, compared to 57 percent and 55 percent in 2007 for the three and six month periods, respectively. Industrial markets were positive compared to the same period in 2007, with increased volumes in most markets, led by the international construction, mining and commercial marine markets. The light-duty automotive decline was primarily due to the 64 percent and 45 percent decline in units sold to Chrysler during the three and six months ended June 29, 2008, over the same period in 2007, due to the deteriorating demand for light duty trucks in North America as the result of the softening U.S. economy and concerns over fuel prices. We do not expect a recovery in demand for light-duty trucks in North America in 2008.

Segment EBIT

Engine segment EBIT increased for the three months ended June 29, 2008, primarily due to a more favorable sales mix in the on-highway markets and improved engine and parts pricing which was partially offset by an increase in warranty expense. Engine segment EBIT increased in the first six months of 2008, compared to the same period in 2007, primarily due to higher engine volumes across most on-highway markets, the accompanying gross margin impact of higher absorption of fixed manufacturing costs, improved engine and parts pricing and more favorable sales mix in the on-highway markets. This was partially offset by an increase in warranty expense. Gross margin increased $65 million, or 19 percent, and $165 million, or 26 percent, and gross margin percentage improved by almost one percentage point for the three and six months ended June 29, 2008, as compared to the same periods in 2007, respectively. Selling, general and administrative expenses increased $12 million, or 9 percent, and $33 million, or 12 percent; however, selling, general and administrative expenses improved as a percentage of sales by 0.3 percentage points and 0.4 percentage points for the three and six months ended June 29, 2008, as compared to the same periods in 2007, respectively. Research, development and engineering expenses increased $19 million, or 37 percent, and $37 million, or 36 percent, and increased 0.5 percentage points and 0.4 percentage points as a percentage of sales for the three and six months ended June 29, 2008, respectively, as compared to the same periods in 2007, as a result of increased spending on emissions related programs.



A summary of Engine sales by market follows:

 

 

Three Months Ended

 

Favorable/ (Unfavorable)

 

Six Months Ended

 

Favorable/ (Unfavorable)

 

June 29,

 

July 1,

 

 

 

June 29,

 

July 1,

2008

 

2007

Amount

 

Percent

2008

 

2007

Amount

 

Percent

 

 

$ in millions

 

 

 

$ in millions

 

 

 

Heavy-duty truck

$

672

$

473

$

199

42

%

$

1,208

$

897

$

311

35

Medium-duty truck and bus

422

320

102

32

%

819

526

293

56

%

Light-duty automotive and RV

205

418

(213

)

(51

)%

479

706

(227

)

(32

)%

Total on-highway

1,299

1,211

88

7

%

2,506

2,129

377

18

%

Industrial

804

665

139

21

%

1,537

1,282

255

20

%

Stationary power

283

233

50

21

%

552

463

89

19

%

Total sales

$

2,386

$

2,109

$

277

13

%

$

4,595

$

3,874

$

721

19

%

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

 

 

Three Months Ended

 

Favorable/ (Unfavorable)

 

Six Months Ended

 

Favorable/ (Unfavorable)

 

June 29,

 

July 1,

 

 

 

June 29,

 

July 1,

2008

 

2007

Amount

 

Percent

2008

 

2007

Amount

 

Percent

Midrange

114,800

133,500

(18,700

)

(14

)%

229,000

240,700

(11,700

)

(5

)%

Heavy-duty

31,700

23,800

7,900

33

%

56,400

42,800

13,600

32

%

High-horsepower

5,500

4,700

800

17

%

10,100

9,000

1,100

12

%

Total unit shipments

152,000

162,000

(10,000

)

(6

)%