SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A2 ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 1998 CUMMINS ENGINE COMPANY, INC. Commission File Number 1-4949 Incorporated in the State of Indiana I.R.S. Employer Identification No. 35-0257090 500 Jackson Street, Box 3005, Columbus, Indiana 47202-3005 (Principal Executive Office) Telephone Number: (812) 377-5000 Securities registered pursuant to Section 12(b) of the Act: Common Stock, $2.50 par value, which is registered on the New York Stock Exchange and on the Pacific Stock Exchange. Securities registered pursuant to Section 12(g) of the Act: None. 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 if disclosures of delinquent filers pursuant to Item 405 of Regulation S-K are not contained herein and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [x] The aggregate market value of the voting stock held by non-affiliates was approximately $1.6 billion at January 29, 1999. As of January 29, 1999, there were outstanding 42.0 million shares of the only class of common stock. Documents Incorporated by Reference Portions of the registrant's definitive Proxy Statement filed with the Securities and Exchange Commission pursuant to Regulation 14A are incorporated by reference in Part III of this Form 10-K. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION _______ _____________________________________________________________ OVERVIEW ________ Net sales were a record $6.3 billion in 1998, 11 percent higher than in 1997, and 19 percent higher than in 1996. Nelson Industries, Inc., acquired in January 1998, and Cummins India Limited, which was first consolidated in the fourth quarter of 1997, added sales of $428 million. Without these additional sales, net sales for 1998 would have been $5.8 billion, an increase of 4 percent over 1997. As disclosed in Notes 3 and 4 to the Consolidated Financial Statements, the Company recorded charges in 1998 totaling $217 million, comprised of $78 million for revised estimates of additional product coverage liability for both base and extended warranty programs, $114 million of costs associated with the Company's plan to restructure, consolidate and exit certain business activities and $25 million for a civil penalty resulting from an agreement reached with the U.S. Environmental Protection Agency and the Department of Justice regarding diesel engine emissions. Excluding these charges, earnings before interest and taxes were $282 million in 1998, compared to $312 million in 1997 and $232 million in 1996. Including the charges, the Company's net loss was $21 million or $(.55) per share in 1998. Net earnings in 1997 were $212 million or $5.48 per share and $160 million or $4.01 per share in 1996. To maintain Cummins' technological leadership, the Company has been in the process of upgrading or replacing engines across all product lines. This new product development program peaked in 1998 with a record six new engine introductions. While this investment in product development offers competitive advantages, it resulted in a temporary increase in product costs and a decrease in profitability in 1998. RESULTS OF OPERATIONS _____________________ Net Sales: __________ In 1998, the Company achieved its seventh consecutive year of record sales, totaling $6.3 billion. Revenues from sales of engines were 55 percent of the Company's net sales in 1998, with engine revenues and unit shipments 8 percent and 9 percent higher, respectively, than in 1997. The Company shipped a record 403,300 engines in 1998, compared to 369,800 in 1997 and 332,300 in 1996 as follows: Unit shipments 1998 1997 1996 ________________ _______ _______ _______ Midrange engines 287,400 264,300 237,400 Heavy-duty engines 106,100 94,900 85,000 High-horsepower engines 9,800 10,600 9,900 _______ _______ _______ 403,300 369,800 332,300 _______ _______ _______ _______ _______ _______ Revenues from non-engine products, which were 45 percent of net sales in 1998, were 16 percent higher than in 1997. The major changes within non-engine revenues were in filtration, with the sales of Nelson included from the date of acquisition by Cummins, and PowerCare (which includes new parts and remanufactured engines and parts). Sales of the remaining non-engine products, in the aggregate, were essentially level with 1997. The Company's sales for each of its key segments during the last three years were: $ Millions 1998 1997 1996 __________ ______ ______ ______ Automotive markets $2,928 $2,622 $2,447 Industrial markets 1,054 1,044 863 _____ _____ _____ Engine Business 3,982 3,666 3,310 Power Generation Business 1,230 1,205 1,213 Filtration Business & Other 1,054 754 734 ______ ______ ______ $6,266 $5,625 $5,257 ______ ______ ______ ______ ______ ______ Cummins' engine business is the Company's largest business segment, producing engines and parts for sale to customers in both automotive and industrial markets. Engine business customers are each serviced through the Company's worldwide distributor network. The engines are used in trucks of all sizes, buses and recreational vehicles, as well as a variety of industrial applications including construction, mining, agriculture, marine, rail and military. Engine business revenues were $4.0 billion in 1998, a 9 percent increase over 1997 and 20 percent over 1996. Sales of $2.9 billion in 1998 for automotive markets were 12 percent higher than in 1997 and 20 percent higher than in 1996. In 1998, heavy-duty truck engine revenues were 19 percent higher than in 1997 on a 20-percent increase in units. Within the North American heavy- duty truck market, unit shipments were up 20 percent over 1997, and Cummins continued to be the market leader with a 32-percent market share. In 1998, the Company began limited production of the Signature 600, a new electronic engine designed to capture a larger share of this market. International unit shipments for the heavy-duty market in 1998 were 20 percent higher than in 1997 due to continued strong demand in European and Mexican automotive markets. Revenues from the sales of engines for medium-duty trucks in 1998 were 13 percent lower than in 1997 on a 12-percent decrease in units. In North America, the Company was affected by Ford's relocation of its production facilities, partially offset by increased sales in international markets, primarily Brazil. For the bus and light commercial vehicle market, engine revenues in 1998 were 26 percent higher than in 1997, on a 22-percent increase in unit shipments. In January, Cummins jointly announced with DaimlerChrysler a new, fully electronic engine -- the ISB -- for the Dodge Ram pickup. The increase in 1998 was due primarily to record unit shipments to DaimlerChrysler for the Dodge Ram pickup, which were 26 percent higher than in 1997 and 37 percent higher than in 1996, and continued strong demand in bus markets. In 1998, revenues from industrial markets were 1 percent higher than in 1997. Revenues from sales of engines decreased, while parts sales increased. Engine revenues in 1998 were 1 percent lower than in 1997 on an 8-percent increase in unit shipments. The variance between revenues and units resulted from lower heavy-duty and high-horsepower engine sales and a shift in product mix of midrange engine sales. The increased level of shipments was due to continued strong construction volumes in North America and Europe, partially offset by declines in worldwide agricultural markets. Sales of engines and parts into the marine market in 1998 were 6 percent lower than in 1997, due primarily to the economic turmoil in Asia. Sales into the mining market were 21 percent lower than the prior year. In 1998, Cummins announced an agreement with Komatsu, a joint venture partner, to develop a 3.3 liter engine targeted for the construction market, scheduled for release in the second half of 1999. Revenues of $1.2 billion in 1998 for power generation were 2 percent higher than in 1997 and 1 percent higher than in 1996, with sales continuing to be impacted by the economic conditions in Asia and lower sales in Europe. Without the consolidation of Cummins India Limited, power generation sales would have decreased 4 percent from 1997. Sales of the Company's generator sets continued to reflect growth in North America, which offset declines in demand for generator sets in Asia. Engine sales to generator set assemblers were down 12 percent from the prior year and sales of alternators were down 11 percent, due primarily to lower demand in Asia and the Company's change in strategy, emphasizing sales of generator sets. Sales of small generator sets for recreational vehicles and other consumer markets remained strong in North America, increasing 12 percent from 1997. Sales of $1.1 billion in 1998 for filtration and other were 40 percent higher than in 1997 and 44 percent higher than in 1996, with Nelson, acquired in January 1998, contributing sales of $311 million. International distributor sales increased 12 percent from 1997 due to the consolidation of Cummins India Limited in the fourth quarter of 1997. Net sales by marketing territory for each of the last three years were: $ Millions 1998 1997 1996 __________ ______ ______ ______ United States $3,595 $3,123 $2,925 Asia/Australia 806 898 868 Europe/CIS 791 796 759 Mexico/Latin America 468 364 260 Canada 459 318 313 Africa/Middle East 147 126 132 ______ ______ ______ $6,266 $5,625 $5,257 ______ ______ ______ ______ ______ ______ In total, international markets accounted for 43 percent of the Company's revenues in 1998. Europe and the CIS, representing 13 percent of the Company's sales in 1998, were 1 percent lower than in 1997 and 4 percent higher than in 1996. Sales to Canada, representing 7 percent of sales in 1998, were 44 percent higher than in 1997 due to the acquisition of Nelson and the relocation of certain customer production facilities. Asian and Australian markets, in total, represented 13 percent of the Company's sales in 1998, as compared to 16 percent in 1997 and 17 percent in 1996. In Asia, sales to China were essentially flat compared to 1997, while revenues in Korea decreased 64 percent, Southeast Asia declined 47 percent and sales to Japan and India were 19 percent below 1997 levels, excluding the effect of Cummins India Limited consolidation. Business in Mexico and Latin America, representing 8 percent of sales, was 29 percent higher than in 1997, but began to decline in the latter part of 1998. Sales to Latin America, including Brazil, represented 4 percent of the Company's sales in 1998 and were 28 percent higher than in 1997. Brazil individually accounted for 2 percent of sales in 1998. The recent economic events in Brazil have resulted in increased interest rates and devalued currencies in the region. Many of the Company's customers are sensitive to interest rates, which will affect sales demand. The devaluation of local currencies also could have an impact on operations, as certain of the Company's transactions are based in Brazilian currency, and could result in currency gains or losses. Sales to Mexico, representing approximately 4 percent of the Company's sales in 1998, could also potentially be affected by the economic uncertainty in Brazil. These events could reasonably be expected to have an adverse effect on the Company's business, however, the extent cannot be estimated reasonably based upon presently available information. Gross Margin: _____________ As disclosed in Note 3 to the Consolidated Financial Statements, the Company recorded special charges of $92 million for product coverage costs and inventory write-downs. The product coverage special charges of $78 million include $43 million primarily attributable to base warranty costs and $35 million for extended warranty programs. The $43 million charge attributable to base warranty costs resulted from recent claim payment information which indicated engines in the field were experiencing higher warranty costs than expected due to some specific high-cost failures on certain engines. The estimate of base warranty liability was adjusted to reflect the impact of all this new information regarding the products' performance. The $35 million charge attributable to extended warranty costs was the result of the use of improved estimating techniques to determine the liability for these costs. The special charges recorded in 1998 also include $14 million for inventory write-downs associated with the Company's restructuring and exit activities. These write-downs reflect amounts of inventory rendered excess or unusable due to the closing or consolidation of facilities. The Company's gross margin percentage before the product coverage and inventory special charges was 21.4 percent in 1998, compared to 22.8 percent in 1997 and 22.5 percent in 1996. The Company's gross margin percentage declined due to a temporary increase in product coverage costs from ISB and ISC engines and higher new product costs attributable to the production ramp-up of the ISB, ISC and Signature 600 engines. This decrease was partially offset by the benefit from higher volume and pricing. The acquisition of Nelson and consolidation of Cummins India Limited added $124 million. Gross margin percentage after the special charges was 19.9 percent. Product coverage costs, excluding the special charges, were 3.3 percent of net sales in 1998, compared to 2.6 percent in 1997 and 2.7 percent in 1996. Operating Expenses: ___________________ Selling and administrative expenses were 12.5 percent of net sales in 1998, compared to 13.2 percent in 1997 and 13.8 percent in 1996. On the 11-percent sales increase in 1998, these expenses, which include volume-variable components, were up less than 6 percent in absolute dollars. Net benefits of the Company's cost reduction and restructuring actions were partially offset by increases in expenses associated with new product launches and information systems during 1998. Research and engineering expenses were 4.1 percent of net sales in 1998, compared to 4.6 percent in 1997 and 4.8 percent in 1996. This is a result of a reduction in technical spending and certain product developments moving to the production stage. The Company's losses from joint ventures and alliances were $30 million in 1998, compared to income of $10 million in 1997. The difference was due primarily to the consolidation of Cummins India Limited and losses at the Company's joint venture with Wartsila. Cummins Wartsila is being affected by lower sales, primarily due to decreased demand in Asia, and higher product coverage expenses. In an effort to address the decline in the Company's business in Asia, to leverage overhead costs for all operations and to improve joint venture operating performance, the Company established a restructuring program in 1998. As a result of this program, the Company recorded a charge of $100 million for costs to reduce the worldwide workforce by approximately 1,100 people, as well as costs associated with streamlining certain majority-owned and international joint venture operations. The charges for majority-owned operations included $38 million for severance and related costs associated with workforce reductions in the engine and power generation businesses, primarily for administrative positions. The costs of these reductions were based on amounts pursuant to benefit programs and contractual provisions or statutory requirements at the affected operations. Approximately one-half of these 1,100 employees left the Company prior to December 31, 1998. An asset impairment loss of $22 million, calculated according to the provisions of SFAS No. 121, was recorded primarily for engine manufacturing equipment to be disposed of upon the closure or consolidation of facilities or the outsource of production. The recovery value for the equipment to be disposed of was based on estimated liquidation value. The carrying value of assets held for disposal and the effect on earnings from suspending depreciation on such assets is immaterial. The equipment write-off of $22 million was for the following: $ Millions __________ N-14 engine component assets for which production is scheduled to be outsourced in the first half of 1999 $12 Brazilian engine operation assets for which production is planned to be discontinued by the end of 1999 4 Holset Germany operations assets to be disposed of by the end of 1998 3 Other facility closures and consolidations to be completed by the end of 1998 3 Facility consolidation and other costs of $17 million included lease termination and facility exit costs of $10 million, product support costs of $3 million, and litigation and other costs of $4 million. As the restructuring consists primarily of the closing or consolidation of smaller operations, the Company does not expect these actions to have a material effect on future revenues. The charges for restructuring joint venture operations totaled $23 million, the majority of which relates to actions being taken at the Company's joint venture with Wartsila, which is part of the Company's power generation business. The charges included $11 million for employee severance and related benefits for approximately 1,200 people, $7 million for a tax asset impairment loss and $5 million for other facility and equipment-related charges. Approximately $25 million, including $12 million of payments related to employee severance, has been charged to the restructuring liabilities as of December 31, 1998. Of the total charges associated with restructuring activities, cash outlays will approximate $60 million. The program is expected to be essentially complete by the end of 1999 and yield approximately $50 million in annual savings at completion. The annual savings of $50 million are expected to come from lower depreciation of approximately $2 million and reduced employee costs of approximately $48 million and relate to actions within the engine business totaling $33 million and actions within the power generation business of $17 million. In 1998, the Company recorded a charge of $25 million for a civil penalty to be paid by the Company as a result of an agreement reached with the U.S. Environmental Protection Agency, the Department of Justice and the California Air Resources Board regarding diesel engine emissions. In addition to the civil penalty, the agreement provides a schedule for diesel engines to meet certain emission standards and requires manufacturers to continue to invest in environmental projects to further reduce oxides of nitrogen (NOx) emissions. The Company has developed extensive corporate action plans to comply with all aspects of the agreement. Additionally, three separate court actions have been filed as a result of allegations of the diesel emissions matter. The New York Supreme Court ruled in favor of the Company. This matter is now on appeal. A California State Court recently ruled in favor of the Company. A recent action was just filed in the U.S. District Court, the District of Columbia. Year 2000: __________ The Company continues to address the impact of the Year 2000 issue on its businesses worldwide. This issue affects computer systems that have date-sensitive programs that may not properly recognize the year 2000. With respect to the Company, this issue affects not only computer systems but also machinery and equipment used in production that may contain embedded computer technology. Following a review and assessment of information systems and technology used in its internal business operations and production, the Company inventoried and identified those systems and products that the Company believes may be vulnerable to Year 2000 failures and established a program to address Year 2000 issues. The Company's Year 2000 efforts are being carried out by the Company's Year 2000 Team under the leadership of the Director of Year 2000 Compliance. A Year 2000 program office has been established at each of the Company's facilities and is overseen by a Year 2000 coordinator. The Year 2000 Team maintains a reporting structure to ensure that progress is made and tracked on Year 2000 issues. In addition to internal resources, the Company has retained external resources to assist with the implementation of its Year 2000 program. The Company's program consists of the remediation, replacement or retirement of affected systems. Remediation is the alteration of a non- compliant application to make it compliant, replacement is the substitution of a non-compliant application with a compliant upgrade or product and retirement is the discarding of non-compliant applications that have been determined to be dispensable. The Company completed a substantial portion of its remediation efforts and testing in 1998, and expects to complete that process by the end of the second quarter of 1999. The Year 2000 Team will remain in place through January 1, 2000, and beyond as needed. Their role is to ensure that compliance is maintained once it is attained. The Company maintains contact with its key suppliers to obtain information relating to the status of such suppliers with respect to Year 2000 issues, placing particular emphasis on determining the Year 2000 readiness of its critical suppliers. The Company expects to incur total expenditures of approximately $45 million in connection with its Year 2000 program and remediation efforts. To date, the Company has incurred approximately $30 million in costs relating to its Year 2000 efforts. There can be no assurances that the systems or products of third parties, which the Company relies upon, will be timely converted or that a failure by a third party, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company. This is particularly true because the Company utilizes sole suppliers for certain products. The high level of skill and expertise required to develop certain components makes it impossible to change suppliers quickly. The failure of a sole supplier may lead to a delay in production. The Company continues to develop contingency plans in the event that its operations are disrupted on January 1, 2000. Such contingency plans include the stockpiling of certain business critical inventory, and identifying alternative suppliers where possible. The estimated time of completion of the Company's Year 2000 program and compliance efforts, and the expenses related to the Company's Year 2000 compliance efforts are based upon management's best estimates, which were based on assumptions of future events, including the availability of certain resources, third party modification plans and other factors. There can be no assurances that these results and estimates will be achieved, and the actual results could materially differ from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability of personnel trained in this area and the ability to locate and correct all relevant computer codes. Other: ______ Interest expense of $71 million was $45 million higher than in 1997 and $53 million higher than in 1996 due to the increased level of borrowings to support working capital on the higher sales level and to complete the acquisition of Nelson. Other income decreased $13 million in 1998 as compared to the year-ago period, primarily due to the Nelson goodwill amortization and lower royalty income. Provision for Income Taxes: ___________________________ The Company's effective income tax rate normally is below the 35% U.S. federal corporate tax rate. The lower tax rate is a result of tax benefits on export sales and tax credits on research expenses. These benefits in 1998 were more than offset by the unfavorable tax effects of nondeductible losses in foreign joint ventures and nondeductible EPA penalty and goodwill amortization. The combined effect was a 1998 income tax provision of $4 million. CASH FLOW AND FINANCIAL CONDITION _________________________________ Key elements of cash flows were: $ Millions 1998 1997 1996 __________ ______ ______ ______ Net cash used in operating and investing activities $(481) $(154) $ (66) Net cash from financing activities 471 96 110 Effect of exchange rate changes on cash (1) (1) 4 _____ _____ _____ Net change in cash $ (11) $ (59) $ 48 _____ _____ _____ _____ _____ _____ During 1998, net cash used for operating and investing activities was $481 million. The higher level of net cash requirements in 1998 was due primarily to the acquisition of Nelson, planned capital expenditures ($271 million in 1998, compared to $405 million in 1997 and $304 million in 1996) for investments in new products and for working capital. Net working capital as a percent of sales was 12.8 percent in 1998, compared to 11.6 percent in 1997. Investments in joint ventures and alliances of $22 million reflected the net effect of capital contributions and cash generated by certain joint ventures. Net cash provided from financing activities was $471 million in 1998. As disclosed in Note 6, the Company issued $765 million face amount of notes and debentures under a $1 billion registration statement filed with the Securities and Exchange Commission in December 1997. Net proceeds were used to finance the acquisition of Nelson and pay down other indebtedness outstanding at December 31, 1997. Based on the Company's projected cash flow from operations and existing credit facilities, management believes that sufficient liquidity is available to meet anticipated capital and dividend requirements in the foreseeable future. Market Risk: ____________ The Company is exposed to financial risk resulting from volatility in foreign exchange rates, interest rates and commodity prices. This risk is closely monitored and managed through the use of financial derivative contracts. As clearly stated in the Company's policies and procedures, financial derivatives are used expressly for hedging purposes, and under no circumstances are they used for speculating or for trading. Transactions are entered into only with banking institutions with strong credit ratings, and thus the credit risk associated with these contracts is considered immaterial. Hedging program results and status are reported to senior management on a monthly and quarterly basis. The following section describes the Company's risk exposures and provides results of sensitivity analyses performed on December 31, 1998. The sensitivity tests assumed instantaneous, parallel shifts in foreign currency exchange rates, commodity prices and interest rate yield curves. A. Foreign Exchange Rates Due to its international business presence, the Company transacts extensively in foreign currencies. As a result, corporate earnings experience some volatility related to movements in exchange rates. In order to exploit the benefits of global diversification and naturally offsetting currency positions, foreign exchange balance sheet exposures are aggregated and hedged at the corporate level through the use of foreign exchange forward contracts. The objective of the foreign exchange hedging program is to reduce earnings volatility resulting from the translation of net foreign exchange balance sheet positions. A hypothetical, instantaneous 10% adverse movement in foreign exchange rates would decrease earnings by approximately $4 million in the current reporting period. The sensitivity analysis ignores the impact of foreign exchange movements on Cummins' competitive position as well as the remoteness of the likelihood that all foreign currencies will move in tandem against the U.S. dollar. The analysis also ignores the offsetting impact on income of the revaluation of the underlying balance sheet exposures. B. Interest Rates The Company currently has in place an interest rate swap that effectively converts fixed-rate debt into floating-rate debt. The objective of the swap is to lower the cost of borrowed funds. A sensitivity analysis assumed a hypothetical, instantaneous, 100 basis- point parallel shift in the floating interest rate yield curve, after which rates remained fixed at the new, higher level for a one-year period. This change in the yield curve would correspond to a $2 million increase in interest expense for the one-year period. This sensitivity analysis does not account for the change in the Company's competitive environment indirectly related to changes in interest rates and the potential managerial response taken in response to these changes. C. Commodity Prices The Company is exposed to fluctuations in commodity prices through the purchase of raw materials as well as contractual agreements with component suppliers. Given the historically volatile nature of commodity prices, this exposure can significantly impact product costs. The Company uses commodity swap agreements to partially hedge exposures to changes in copper and aluminum prices. Given a hypothetical, instantaneous 10% depreciation of the underlying commodity price, with prices then remaining fixed for a 12-month period, the Company would experience a loss of approximately $3 million for the annual reporting period. This amount excludes the offsetting impact of decreases in commodity costs. Forward-looking Statements __________________________ This Management's Discussion and Analysis of Results of Operations and Financial Condition and other sections of this Form 10-K contain forward-looking statements that are based on current expectations, estimates and projections about the industries in which Cummins operates, management's beliefs and assumptions made by management. Words, such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("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. Cummins undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Future Factors include increasing price and product competition by foreign and domestic competitors, including new entrants; rapid technological developments and changes; the ability to continue to introduce competitive new products on a timely, cost-effective basis; the mix of products; the achievement of lower costs and expenses; domestic and foreign governmental and public policy changes, including environmental regulations; protection and validity of patent and other intellectual property rights; reliance on large customers; technological, implementation and cost/financial risks in increasing use of large, multi-year contracts; the cyclical nature of Cummins' business; the outcome of pending and future litigation and governmental proceedings; and continued availability of financing, financial instruments and financial resources in the amounts, at the times and on the terms required to support Cummins' future business. These are representative of the Future Factors that could affect the outcome of the forward-looking statements. In addition, such statements could be affected by general industry and market conditions and growth rates, general domestic and international economic conditions, including interest rate and currency exchange rate fluctuations, and other Future Factors. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA ___________________________________________________ See Index to Financial Statements on page 10 for a list of the financial statements filed as a part of this report. INDEX TO FINANCIAL STATEMENTS _____________________________ Page ____ Responsibility for Financial Statements 11 Report of the Independent Public Accountants 11 Consolidated Statement of Earnings 12 Consolidated Statement of Financial Position 13 Consolidated Statement of Cash Flows 14 Consolidated Statement of Shareholders' Investment 15 Notes to Consolidated Financial Statements 16 Quarterly Financial Data 28 RESPONSIBILITY FOR FINANCIAL STATEMENTS _______________________________________ Management is responsible for the preparation of the Company's consolidated financial statements and all related information appearing in this Form 10-K. The statements and notes have been prepared in conformity with generally accepted accounting principles and include some amounts which are estimates based upon currently available information and management's judgment of current conditions and circumstances. The Company engaged Arthur Andersen LLP, independent public accountants, to examine the consolidated financial statements. Their report appears on this page. To provide reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition and that accounting records are reliable for preparing financial statements, management maintains a system of accounting and controls, including an internal audit program. The system of accounting and controls is improved and modified in response to changes in business conditions and operations and recommendations made by the independent public accountants and the internal auditors. The Board of Directors has an Audit Committee whose members are not employees of the Company. The committee meets periodically with management, internal auditors and representatives of the Company's independent public accountants to review the Company's program of internal controls, audit plans and results, and the recommendations of the internal and external auditors and management's responses to those recommendations. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ________________________________________ To the Shareholders and Board of Directors of Cummins Engine Company, Inc.: We have audited the accompanying consolidated statement of financial position of Cummins Engine Company, Inc., (an Indiana corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of earnings, cash flows and shareholders' investment for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cummins Engine Company, Inc., and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Arthur Andersen LLP Chicago, Illinois, January 26, 1999. CUMMINS ENGINE COMPANY, INC. CONSOLIDATED STATEMENT OF EARNINGS __________________________________ Millions, except per share amounts 1998 1997 1996 __________________________________ ______ ______ ______ Net sales $6,266 $5,625 $5,257 Cost of goods sold 4,925 4,345 4,072 Special charges 92 - - ______ ______ ______ Gross profit 1,249 1,280 1,185 Selling & administrative expenses 787 744 725 Research & engineering expenses 255 260 252 Net expense (income) from joint ventures and alliances 30 (10) - Interest expense 71 26 18 Other income, net (13) (26) (24) Restructuring and other non-recurring charges 125 - - _____ _____ _____ Earnings (loss) before income taxes (6) 286 214 Provision for income taxes 4 74 54 Minority interest 11 - - _____ _____ _____ Net earnings (loss) $ (21) $ 212 $ 160 _____ _____ _____ _____ _____ _____ Basic earnings (loss) per share $(.55) $5.55 $4.02 Diluted earnings (loss) per share (.55) 5.48 4.01 The accompanying notes are an integral part of this statement. CUMMINS ENGINE COMPANY, INC. CONSOLIDATED STATEMENT OF FINANCIAL POSITION ____________________________________________ Millions, except per share amounts December 31, __________________________________ 1998 1997 ______ ______ Assets Current assets: Cash and cash equivalents $ 38 $ 49 Receivables 833 771 Inventories 731 677 Other current assets 274 213 _____ _____ 1,876 1,710 _____ _____ Investments and other assets: Investments in joint ventures and alliances 136 204 Other assets 144 142 _____ _____ 280 346 _____ _____ Property, plant and equipment: Land and buildings 590 495 Machinery, equipment and fixtures 2,320 2,079 Construction in process 185 392 _____ _____ 3,095 2,966 Less accumulated depreciation 1,424 1,434 _____ _____ 1,671 1,532 _____ _____ Goodwill, net of amortization of $17 and $5 384 12 _____ _____ Other intangibles, deferred taxes and deferred charges 331 165 ______ ______ Total assets $4,542 $3,765 ______ ______ ______ ______ Liabilities and shareholders' investment Current liabilities: Loans payable $ 64 $ 90 Current maturities of long-term debt 26 42 Accounts payable 340 386 Accrued salaries and wages 99 87 Accrued product coverage & marketing expenses 209 120 Income taxes payable 13 18 Other accrued expenses 320 312 _____ _____ 1,071 1,055 _____ _____ Long-term debt 1,137 522 _____ _____ Other liabilities 1,000 713 _____ _____ Minority interest 62 53 _____ _____ Shareholders' investment: Common stock, $2.50 par value, 48.1 shares issued 120 120 Additional contributed capital 1,121 1,119 Retained earnings 648 715 Accumulated other comprehensive income (167) (70) Common stock in treasury,at cost,6.1 & 6.0 shares (240) (245) Common stock held in trust for employee benefit plans, 3.6 and 3.7 shares (172) (175) Unearned compensation (38) (42) _____ _____ 1,272 1,422 _____ _____ Total liabilities & shareholders' investment $4,542 $3,765 ______ ______ ______ ______ The accompanying notes are an integral part of this statement. CUMMINS ENGINE COMPANY, INC. CONSOLIDATED STATEMENT OF CASH FLOWS ____________________________________ Millions 1998 1997 1996 ________ ______ ______ ______ Cash flows from operating activities: Net earnings (loss) $ (21) $ 212 $ 160 _____ _____ _____ Adjustments to reconcile net earnings (loss) to net cash from operating activities: Depreciation and amortization 199 158 149 Restructuring actions 110 (24) (42) Equity in (earnings) losses of joint ventures and alliances 38 (1) 11 Receivables (10) (80) (56) Inventories (26) (65) (62) Accounts payable and accrued expenses 56 (18) 28 Deferred income taxes (65) 22 17 Other (10) (4) (12) ____ ____ ____ Total adjustments 292 (12) 33 ____ ____ ____ 271 200 193 ____ ____ ____ Cash flows from investing activities: Property, plant and equipment: Additions (271) (405) (304) Disposals 7 21 26 Investments in joint ventures and alliances (22) (47) (5) Acquisitions and dispositions of business activities (468) 76 10 Other 2 1 14 ____ ____ ____ (752) (354) (259) ____ ____ ____ Net cash used in operating and investing activities (481) (154) (66) ____ ____ ____ Cash flows from financing activities: Proceeds from borrowings 711 281 200 Payments on borrowings (161) (50) (47) Net (payments) borrowings under credit agreements (30) (12) 32 Repurchases of common stock (14) (75) (34) Dividend payments (46) (45) (40) Other 11 (3) (1) ____ ____ ____ 471 96 110 ____ ____ ____ Effect of exchange rate changes on cash (1) (1) 4 ____ ____ ____ Net change in cash and cash equivalents (11) (59) 48 Cash & cash equivalents at beginning of year 49 108 60 ____ ____ ____ Cash & cash equivalents at end of year $ 38 $ 49 $108 ____ ____ ____ ____ ____ ____ Cash payments during the year for: Interest $ 56 $ 21 $ 16 Income taxes 73 42 40 The accompanying notes are an integral part of this statement. CUMMINS ENGINE COMPANY, INC. CONSOLIDATED STATEMENT OF SHAREHOLDERS' INVESTMENT __________________________________________________ Millions, except per share amounts 1998 1997 1996 __________________________________ ___________ __________ __________ Common stock: Balance at beginning of year $ 120 $ 110 $ 110 Issued to trust for employee benefit plans - 9 - Other - 1 - _____ _____ ____ Balance at end of year 120 120 110 _____ _____ ____ Additional contributed capital: Balance at beginning of year 1,119 929 926 Issued to trust for employee benefit plans - 171 - Other 2 19 3 _____ _____ _____ Balance at end of year 1,121 1,119 929 _____ _____ _____ Retained earnings: Balance at beginning of year 715 548 428 Net earnings (loss) (21) $(21) 212 $212 160 $160 ___ ____ ___ Cash dividends (46) (45) (40) ____ ____ ____ Balance at end of year 648 715 548 ____ ____ ____ Accumulated other comprehensive income: Balance at beginning of year (70) (60) (95) Foreign currency translation adjustments (43) (21) 26 Minimum pension liability adjustments (54) 12 9 Unrealized losses on securities - (1) - ___ ___ ___ Other comprehensive income (97) (97) (10) (10) 35 35 ___ ___ ___ ___ __ ___ Comprehensive income $(118) $202 $195 ____ ___ ___ ____ ___ ___ Balance at end of year (167) (70) (60) ____ ___ ___ Common stock in treasury: Balance at beginning of year (245) (169) (135) Repurchased (14) (76) (34) Issued 19 - - _____ _____ _____ Balance at end of year (240) (245) (169) _____ _____ _____ Common stock held in trust for employee benefit plans: Balance at beginning of year (175) - - Issued - (180) - Shares allocated to benefit plans 3 5 - _____ _____ ______ Balance at end of year (172) (175) - _____ _____ ______ Unearned compensation: Balance at beginning of year (42) (46) (51) Shares allocated to participants 4 4 5 ______ ______ ______ Balance at end of year (38) (42) (46) ______ ______ ______ Shareholders' investment $1,272 $1,422 $1,312 ______ ______ ______ ______ ______ ______ Shares of stock Common stock, $2.50 par value, 150.0 shares authorized Balance at beginning of year 48.1 43.9 43.9 Shares issued - 4.2 - ____ ____ ____ Balance at end of year 48.1 48.1 43.9 ____ ____ ____ ____ ____ ____ Common stock in treasury Balance at beginning of year 6.0 4.5 3.7 Shares repurchased .4 1.5 .8 Shares issued (.3) - - ___ ___ ___ Balance at end of year 6.1 6.0 4.5 ___ ___ ___ ___ ___ ___ Common stock held in trust for employee benefit plans Balance at beginning of year 3.7 - - Shares issued - 3.8 - Shares allocated to benefit plans (.1) (.1) - ___ ___ ___ Balance at end of year 3.6 3.7 - ___ ___ ____ ___ ___ ____ The accompanying notes are an integral part of this statement. CUMMINS ENGINE COMPANY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS __________________________________________ NOTE 1. ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include all significant majority-owned subsidiaries. Affiliated companies in which Cummins does not have a controlling interest, or for which control is expected to be temporary, are accounted for using the equity method. Use of estimates and assumptions as determined by management is required in the preparation of consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from these estimates and assumptions. Revenue Recognition: The Company recognizes revenues on the sale of its products, net of estimated costs of returns, allowances and sales incentives, when the products are shipped to customers. The Company generally sells its products on open account under credit terms customary to the region of distribution. The Company performs ongoing credit evaluations of its customers and generally does not require collateral to secure its customers' receivables. Foreign Currency: Assets and liabilities of foreign entities, where the local currency is the functional currency, have been translated at year-end exchange rates, and income and expenses have been translated to US dollars at average-period rates. Adjustments resulting from translation have been recorded in shareholders' investment and are included in net earnings only upon sale or liquidation of the underlying foreign investment. For foreign entities where the US dollar is the functional currency, including those operating in highly inflationary economies, inventory, property, plant and equipment balances and related income statement accounts have been translated using historical exchange rates. The resulting gains and losses have been credited or charged to net earnings. Derivative Instruments: The Company makes use of derivative instruments in its foreign exchange, commodity price and interest rate hedging programs. Derivatives currently in use are commodity and interest rate swaps, as well as foreign currency forward contracts. These contracts are used strictly for hedging, and not for speculative purposes. Refer to Note 8 for more information on derivative financial instruments. The Company enters into commodity swaps to offset the Company's exposure to price volatility for certain raw materials used in the manufacturing process. As the Company has the discretion to settle these transactions either in cash or by taking physical delivery, these contracts are not considered financial instruments for accounting purposes. These commodity swaps are accounted for as hedges. Other Costs: Estimated costs of commitments for product coverage programs are charged to earnings at the time the Company sells its products. Research & development expenditures, net of contract reimbursements, are expensed when incurred and were $228 million in 1998, $250 million in 1997 and $235 million in 1996. Maintenance and repair costs are charged to earnings as incurred. Cash Equivalents: Cash equivalents include all highly liquid investments with an original maturity of three months or less at time of purchase. Inventories: Inventories are generally stated at cost or net realizable value. Approximately 25 percent of domestic inventories (primarily heavy-duty and high-horsepower engines and engine parts) are valued using the last-in, first-out (LIFO) cost method. Inventories at December 31 were as follows: $ Millions 1998 1997 __________ ____ ____ Finished products $400 $351 Work-in-process and raw materials 387 388 ____ ____ Inventories at FIFO cost 787 739 Excess of FIFO over LIFO (56) (62) ____ ____ $731 $677 ____ ____ ____ ____ Property, Plant and Equipment: Property, plant and equipment are stated at cost. A modified units-of-production method, which is based upon units produced subject to a minimum level, is used to depreciate substantially all engine production equipment. The straight-line depreciation method is used for all other equipment. The estimated depreciable lives range from 20 to 40 years for buildings and 3 to 20 years for machinery, equipment and fixtures. Software: Internal and external software costs (excluding research, reengineering and training) are capitalized and amortized generally over 5 years. Effective January 1, 1998, the Company adopted SOP 98-1 on accounting for internal use software costs. Internal software costs capitalized in 1998 in accordance with this new rule were $9 million. Capitalized software, net of amortization, was $75 million at December 31, 1998 and $32 million at December 31, 1997. Earnings Per Share: Effective January 1, 1997, the Company adopted SFAS No. 128, a new accounting rule on calculating earnings per share. Under the new rule, basic earnings per share of common stock are computed by dividing net earnings by the weighted-average number of shares outstanding for the period. Diluted earnings per share are computed by dividing net earnings by the weighted-average number of shares, assuming the exercise of stock options when the effect of their exercise is dilutive. Shares of stock held by the employee benefits trust are not included in outstanding shares for EPS until distributed from the trust. Years prior to 1997 have been restated to reflect this new rule. Net Weighted Millions, except Earnings Average per share amounts (Loss) Shares Per share _________________ ________ ________ _________ 1998 ____ Basic $(21) 38.5 $(.55) Options - - _____ ____ ____ _____ Diluted $(21) 38.5 $(.55) ____ ____ _____ ____ ____ _____ 1997 ____ Basic $212 38.2 $5.55 Options - .5 _____ ____ ____ _____ Diluted $212 38.7 $5.48 ____ ____ _____ ____ ____ _____ 1996 ____ Basic $160 39.8 $4.02 Options - .1 _____ ____ ____ _____ Diluted $160 39.9 $4.01 ____ ____ _____ ____ ____ _____ NOTE 2. ACQUISITION: In January 1998, the Company completed the acquisition of the stock of Nelson Industries, Inc., for $453 million. Nelson, a filtration and exhaust systems manufacturer, was consolidated from the date of its acquisition. On a pro forma basis, if the Company had acquired Nelson on January 1, 1997, consolidated net sales for 1997 would have been $5.9 billion and consolidated earnings would not have been materially different. In accordance with APB Opinion No. 16, Nelson's net assets were recorded at fair value at the date of acquisition. The purchase price in excess of net assets will be amortized over 40 years. NOTE 3. SPECIAL CHARGES: In 1998, the Company recorded special charges of $92 million for product coverage costs and inventory write- downs. The product coverage special charges of $78 million included $43 million primarily attributable to the recent experience of higher- than-anticipated base warranty costs to repair certain automotive engines manufactured in previous years, and $35 million related to a revised estimate of product coverage cost liability primarily for extended warranty programs. The Company believed it was necessary to make these special charges to accrue for such product coverage costs expected to be incurred in the future on these engines currently in the field. The special charges also included $14 million for inventory write-downs associated with the Company's restructuring and exit activities. These write-downs relate to amounts of inventory rendered excess or unusable due to the closing or consolidation of facilities. The Company has committed to these facility closures and consolidations as part of a plan to reduce costs and improve operating performance. NOTE 4. RESTRUCTURING AND OTHER NON-RECURRING CHARGES: In 1998, the Company recorded charges of $125 million, comprised of $100 million for costs to reduce the worldwide workforce, as well as costs associated with streamlining certain majority-owned and international joint venture operations and $25 million for a civil penalty to be paid by the Company as a result of an agreement reached with the U.S. Environmental Protection Agency (EPA), the Department of Justice (DOJ) and the California Air Resources Board (CARB) regarding diesel engine emissions. The major components of these charges are as follows: $ Millions __________ Restructuring of majority-owned operations: Workforce reductions $ 38 Asset impairment loss 22 Facility consolidations and other 17 ___ 77 ___ Restructuring of joint venture operations: Workforce reductions 11 Tax asset impairment loss 7 Facility and equipment-related costs 5 ___ 23 ___ EPA penalty 25 ___ Total $125 ____ ____ The restructuring program was undertaken to address the decline in the Company's business in Asia, to leverage overhead costs for all operations and to improve joint venture operating performance. The charges for majority-owned operations include $38 million for severance and related costs associated with workforce reductions of approximately 1,100 people. These reductions are in the engine and power generation businesses and are primarily for administrative positions. Costs for workforce reductions were based on amounts pursuant to benefit programs and contractual provisions or statutory requirements at the affected operations. Approximately one-half of these employees left the Company prior to December 31, 1998. The asset impairment loss, calculated according to the provisions of SFAS 121, was recorded primarily for engine manufacturing equipment to be disposed of upon the closure or consolidation of facilities or the outsource of production. The recovery value for the equipment to be disposed of was based on estimated liquidation value. The carrying value of assets held for disposal and the effect on earnings from suspending depreciation on such assets is immaterial. Facility consolidation and other costs of $17 million include lease termination and facility exit costs of $10 million, product support costs of $3 million and litigation and other costs of $4 million. As the restructuring consists primarily of the closing or consolidation of smaller operations, the Company does not expect these actions to have a material effect on future revenues. The charges for restructuring joint venture operations totaled $23 million, the majority of which relates to actions being taken at the Company's joint venture with Wartsila, which is part of the Company's power generation business. The charges include $11 million for employee severance and related benefits for approximately 1,200 people, $7 million for a tax asset impairment loss and $5 million for other facility and equipment-related charges. Approximately $25 million, primarily related to employee severance, has been charged to the restructuring liabilities as of December 31, 1998. Of the total charges associated with restructuring activities, cash outlays will approximate $60 million. The program is expected to be essentially complete by the end of 1999 and yield approximately $50 million in annual savings at completion. In addition to the civil penalty, the agreement with the EPA/DOJ/CARB provides a schedule for diesel engines to meet certain emission standards and requires manufacturers to continue to invest in environmental projects to further reduce oxides of nitrogen (NOx) emissions. The Company has developed extensive corporate action plans to comply with all aspects of the agreement. Additionally, three separate court actions have been filed as a result of allegations of the diesel emissions matter. The New York Supreme Court ruled in favor of the Company. This matter is now on appeal. A California State Court recently ruled in favor of the Company. A recent action was just filed in the U.S. District Court, the District of Columbia. NOTE 5. INVESTMENTS IN JOINT VENTURES AND ALLIANCES: Investments in joint ventures and alliances at December 31 were as follows: $ Millions 1998 1997 __________ ____ ____ Consolidated Diesel $ 39 $ 32 Tata Cummins 22 16 Komatsu alliances 17 10 Chongqing Cummins 15 16 Behr America, Inc. 14 14 Dong Feng 8 7 Cummins Wartsila (6) 88 Other 27 21 ____ ____ $136 $204 ____ ____ ____ ____ Summary balance sheet information for the joint ventures and alliances was as follows: December 31, $ Millions 1998 1997 __________ ____ ____ Current assets $527 $447 Noncurrent assets 613 533 Current liabilities (406) (258) Noncurrent liabilities (455) (305) ____ ____ Net assets $279 $417 ____ ____ ____ ____ Cummins' share $136 $204 ____ ____ ____ ____ The Company has guaranteed $79 million in outstanding debt of the Cummins Wartsila joint venture as of December 31, 1998. In connection with various joint venture agreements, Cummins is required to purchase products from the joint ventures in amounts to provide for the recovery of specified costs of the ventures. Under the agreement with Consolidated Diesel, Cummins' purchases were $535 million in 1998 and $538 million in 1997. NOTE 6. LONG-TERM DEBT: Long-term debt at December 31 was: $ Millions 1998 1997 __________ ____ ____ 7.125% debentures due 2028 $249 $ - 6.45% notes due 2005 224 - Commercial paper 142 242 5.65% debentures due 2098, net of unamortized discount of $40 (effective interest rate 7.48%) 125 - 6.25% notes due 2003 125 - 6.75% debentures due 2027 120 120 8.2% notes through 2003 79 96 Guaranteed notes of ESOP Trust due 2010 63 65 10.35%-10.65% medium-term notes through 1998 - 14 Other 36 27 _____ ____ Total 1,163 564 Current maturities (26) (42) ______ ____ Long-term debt $1,137 $522 ______ ____ ______ ____ Maturities of long-term debt for the five years subsequent to December 31, 1998 are $26 million, $26 million, $25 million, $27 million and $141 million. At both December 31, 1998 and 1997, the weighted- average interest rate on loans payable and current maturities of long- term debt approximated 7 percent. The Company maintains a $500 million revolving credit agreement, maturing in 2003, under which there were no outstanding borrowings at December 31, 1998 or 1997. The revolving credit agreement supports the Company's commercial paper borrowings. In February 1998, the Company issued $765 million face amount of notes and debentures under a $1 billion Registration Statement filed with the Securities and Exchange Commission in 1997. Net proceeds were used to finance the acquisition of Nelson and pay down other indebtedness outstanding at December 31, 1997. The Company also has other domestic and international credit lines with approximately $193 million available at December 31, 1998. In 1997, the Company issued $120 million of 6.75 percent debentures that mature in 2027. Holders have a one-time option in 2007 to redeem the debentures and Cummins has a recall right after ten years. The Company has guaranteed the outstanding borrowings of its ESOP Trust. The notes were refinanced in July 1998. Cash contributions to the Trust, together with the dividends accumulated on the common stock held by the Trust, are used to pay interest and principal. Cash contributions and dividends to the Trust approximated $10 million in each year. The unearned compensation, which is reflected as a reduction to shareholders' investment, represents the historical cost of the shares of common stock that have not yet been allocated by the Trust to participants. NOTE 7. OTHER LIABILITIES: Other liabilities at December 31 included the following: $ Millions 1998 1997 __________ ____ ____ Accrued retirement & post-employment benefits $720 $487 Accrued product coverage & marketing expenses 156 111 Accrued compensation 38 34 Deferred income taxes 17 25 Other 69 56 ______ ____ $1,000 $713 ______ ____ ______ ____ NOTE 8. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT: The Company is exposed to financial risk resulting from volatility in foreign exchange rates and interest rates. This risk is closely monitored and managed through the use of financial derivative contracts. As clearly stated in the Company's policies and procedures, financial derivatives are used expressly for hedging purposes, and under no circumstances are they used for speculating or trading. Transactions are entered into only with banking institutions with strong credit ratings, and thus the credit risk associated with these contracts is considered immaterial. Hedging program results and status are reported to senior management on a periodic basis. Foreign Exchange Rates Due to its international business presence, the Company uses foreign exchange forward contracts to manage its exposure to exchange rate volatility. Foreign exchange balance sheet exposures are aggregated and hedged at the corporate level. Maturities on these instruments generally fall within the one-month and six-month range. The objective of the hedging program is to reduce earnings volatility resulting from the translation of net foreign exchange balance sheet positions. The total notional amount of these forward contracts outstanding at December 31, 1998, and December 31, 1997, were $174 million and $257 million, respectively. Interest Rates The Company manages its exposure to interest rate fluctuations through the use of interest rate swaps. Currently the Company has in place one interest rate swap that effectively converts fixed-rate debt into floating-rate debt. The objective of this swap is to lower the cost of borrowed funds. The contract was established during October 1998 with a notional value of $225 million. There were no interest rate swap contracts outstanding at December 31, 1997. Fair Value of Financial Instruments Based on borrowing rates currently available to the Company for bank loans with similar terms and average maturities, the fair value of total debt, including current maturities, at December 31, 1998, approximated $1,214 million. The carrying value at that date was $1,227 million. At December 31, 1997, the fair and carrying values of total debt, including current maturities, were $664 and $654 million, respectively. The carrying values of all other receivables and liabilities approximated fair values. NOTE 9. INCOME TAXES: The provision for income taxes was as follows: $ Millions 1998 1997 1996 _____________ ____ ____ ____ Current: U.S. Federal and state $16 $16 $22 Foreign 41 32 15 __ __ __ 57 48 37 __ __ __ Deferred: U.S. Federal and state (34) 26 - Foreign (19) - 17 __ __ __ (53) 26 17 ___ ___ __ $ 4 $74 $54 ___ ___ ___ ___ ___ ___ The Company expects to realize all of its tax assets, including the use of all carryforwards, before any expiration. Significant components of net deferred tax assets related to the following tax effects of differences between financial and tax reporting at December 31: $ Millions 1998 1997 __________ ____ ____ Employee benefit plans $300 $266 Product coverage & marketing expenses 106 64 Restructuring charges 14 9 US plant & equipment (176) (139) Net foreign taxable differences, primarily plant and equipment 6 (23) US Federal carryforward benefits: General business tax credits, expiring 2009 to 2013 43 31 Minimum tax credits, no expiration 12 10 Other net differences 12 13 ____ ____ $317 $231 ____ ____ ____ ____ Balance Sheet Classification ____________________________ Current assets $203 $129 Noncurrent assets 131 127 Noncurrent liabilities (17) (25) ____ ____ $317 $231 ____ ____ ____ ____ Earnings before income taxes and differences between the effective tax rate and US Federal income tax rates were: $ Millions 1998 1997 1996 __________ ____ ____ ____ Earnings (loss) before income taxes: US $(21) $205 $134 Foreign 15 81 80 ____ ____ ____ $ (6) $286 $214 ____ ____ ____ ____ ____ ____ Tax at 35 percent US statutory rate $ (2) $100 $ 75 Nondeductible EPA penalty 9 - - Nondeductible goodwill amortization 3 - - Research tax credits (10) (11) (6) Foreign sales corporation benefits (9) (11) (11) Differences in rates and taxability of foreign subsidiaries 15 (3) - All other, net (2) (1) (4) ____ ____ ____ $ 4 $ 74 $(54) ____ ____ ____ ____ ____ ____ NOTE 10. RETIREMENT PLANS: The Company has various contributory and noncontributory pension plans covering substantially all employees. Cummins common stock represented 9 percent of pension plan assets at December 31, 1998. Cummins also provides various health care and life insurance benefits to eligible retirees and their dependents but reserves the right to change benefits covered under these plans. The plans are contributory with retirees' contributions adjusted annually, and they contain other cost-sharing features, such as deductibles, coinsurance and spousal contributions. The general policy is to fund benefits as claims and premiums are incurred. The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for plans with accumulated benefit obligations in excess of plan assets were $1,296 million, $1,251 million, and $999 million, respectively as of December 31, 1998, and $418 million, $381 million, and $339 million, respectively, as of December 31, 1997. The assumed long-term rate of compensation increase for salaried plans was 4.25% in 1998 and 5.00% in 1997. Other significant assumptions for the Company's principal plans were: Pension Other Benefits Benefits 1998 1997 1998 1997 ____ ____ ____ ____ Weighted-average discount rate 6.5% 7.5% 6.5% 7.5% Long-term rate of return on plan assets 10.0% 10.0% For measurement purposes a 7% annual increase in health care costs was assumed for 1999, decreasing gradually to 4.25% in ten years and remaining constant thereafter. Increasing the health care cost trend rate by one percent would increase the obligation by $42 million and annual expense by $3 million. Decreasing the health care cost trend rate by one percent would decrease the obligation by $38 million and annual expense by $3 million. The Company's net periodic benefit cost under these plans was as follows: Pension Benefits Other Benefits $ Millions 1998 1997 1996 1998 1997 1996 ____________ ____ ____ ____ ____ ____ ____ Service cost $ 47 $ 41 $ 45 $ 8 $ 8 $ 9 Interest cost 123 115 104 40 41 36 Expected return on plan assets (153) (134) (116) - - - Amortization of transition asset (4) (9) (9) - - - Other 12 13 16 4 9 10 ____ ____ ____ ____ ____ ____ $ 25 $ 26 $ 40 $ 52 $ 58 $ 55 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ Pension Benefits Other Benefits $ Millions 1998 1997 1998 1997 __________ ______ ______ ______ ______ Change in benefit obligation: Benefit obligation at beginning of year $1,693 $1,491 $ 596 $ 545 Service cost 47 41 8 8 Interest cost 123 115 44 41 Plan participants' contributions 7 6 1 1 Amendments 2 4 - - Experience (gain) loss 161 128 20 26 Benefits paid (123) (96) (29) (25) Other (3) 4 - - _____ _____ _____ _____ Benefit obligation at end of year $1,907 $1,693 $ 640 $ 596 _____ _____ _____ _____ _____ _____ _____ _____ Change in plan assets: Fair value of plan assets at beginning of year $1,905 $1,555 $ - $ - Actual return on plan assets (129) 414 - - Employer contribution 34 23 28 24 Plan participants' contributions 7 6 1 1 Benefits paid (123) (96) (29) (25) Other (2) 3 - - _____ _____ _____ _____ Fair value of plan assets at end of year $1,692 $1,905 $ - $ - _____ _____ _____ _____ _____ _____ _____ _____ Funded status $ (215) $ 212 $ (640) $ (596) Unrecognized: Experience (gain) loss (a) 172 (269) 80 62 Prior service cost (b) 55 63 (11) (12) Transition asset (c) (7) (11) - - _____ _____ _____ _____ Net amount recognized $ 5 $ (5) $ (571) $ (546) _____ _____ _____ _____ _____ _____ _____ _____ Amounts recognized in the statement of financial position: Prepaid benefit cost $ 50 $ 9 $ - $ - Accrued benefit liability (232) ( 14) (571) (546) Intangible asset 104 - - - Accumulated other comprehensive income 83 - - - _____ _____ _____ _____ Net amount recognized $ 5 $ (5) $ (571) $ (546) _____ _____ _____ _____ _____ _____ _____ _____ (a) The net deferred gain (loss) resulting from investments, other experience and changes in assumptions. (b) The prior service effect of plan amendments deferred for recognition over remaining service. (c) The balance of the initial difference between assets and obligations deferred for recognition over a 15-year period. NOTE 11. COMMON STOCK: The Company increased its quarterly common stock dividend from 25 cents per share to 27.5 cents, effective with the dividend payment in June 1997. In 1998, the Company repurchased 0.4 million shares on the open market at an aggregate purchase price of $14 million. In 1997, the Company repurchased 1.3 million shares from Ford Motor Company and another 0.2 million shares on the open market at an aggregate purchase price of $75 million. The Company repurchased 0.8 million shares on the open market at an aggregate purchase price of $34 million in 1996. All of the acquired shares are held as common stock in treasury. In 1997, the Company issued 3.75 million shares of its common stock to an employee benefits trust to fund obligations of employee benefit and compensation plans, principally retirement savings plans. Shares of the stock held by this trust are not used in the calculation of earnings per share until allocated to a benefit plan. NOTE 12. SHAREHOLDERS' RIGHTS PLAN: The Company has a Shareholders' Rights Plan which it first adopted in 1986. The Rights Plan provides that each share of the Company's common stock has associated with it a stock purchase right. The Rights Plan becomes operative when a person or entity acquires 15 percent of the Company's common stock or commences a tender offer to purchase 20 percent or more of the Company's common stock without the approval of the Board of Directors. NOTE 13. EMPLOYEE STOCK PLANS: Under the Company's stock incentive and option plans, officers and other eligible employees may be awarded stock options, stock appreciation rights and restricted stock. Under the provisions of the stock incentive plan, up to one percent of the Company's outstanding shares of common stock at the end of the preceding year is available for issuance under the plan each year. At December 31, 1998, there were no shares of common stock available for grant and 1,234,875 options exercisable under the plans. The Company accounts for stock options in accordance with APB Opinion No. 25 and related interpretations. No compensation expense has been recognized for stock options since the options have exercise prices equal to the market price of the Company's common stock at the date of grant. Number of Weighted-average Shares Options exercise price _________ _____________ ________________ 1,183,275 Dec. 31, 1995 38.45 394,150 Granted 40.13 (47,475) Exercised 32.43 (19,800 Cancelled 41.00 _________ 1,510,150 Dec. 31, 1996 38.88 766,500 Granted 60.61 (294,025) Exercised 35.85 (61,775) Cancelled 42.66 _________ 1,920,850 Dec. 31, 1997 46.08 703,660 Granted 45.34 (54,075) Exercised 36.36 (27,425) Cancelled 53.80 _________ 2,543,010 Dec. 31, 1998 48.08 _________ _________ Options outstanding at December 31, 1998, have exercise prices between $15.94 and $79.81 and a weighted-average remaining life of 8 years. The weighted-average fair value of options granted was $18.61 per share in 1998 and $14.94 per share in 1997. The fair value of each option was estimated on the date of grant using a risk-free interest rate of 5.6 percent in 1998 and 6.4 percent in 1997, current annual dividends, expected lives of 10 years and expected volatility of 34 percent. A fair-value method of accounting for awards subsequent to January 1, 1996, would have had no material effect on results of operations. NOTE 14. COMPREHENSIVE INCOME: Effective January 1, 1998, the Company adopted SFAS No. 130, a new accounting rule which requires companies to report comprehensive income. Comprehensive income includes net income and all other nonowner changes in equity during a period. The tax effect on other comprehensive income is as follows: Total Foreign Minimum Other Currency Unrealized Pension Compre- Translation Losses on Liability hensive Adjustments Securities Adjustments Income ___________ __________ ___________ ______ 1998 ____ Pre-tax amount $(44) $(1) $(83) $(128) Tax (expense) benefit 1 1 29 31 ____ ___ ____ _____ Net amount $(43) $ - $(54) $ (97) ____ ___ ____ _____ ____ ___ ____ _____ 1997 ____ Pre-tax amount $(21) $(1) $ 12 $ (10) Tax (expense) benefit - - - - ____ ___ ____ _____ Net amount $(21) $(1) $ 12 $ (10) ____ ___ ____ _____ ____ ___ ____ _____ 1996 ____ Pre-tax amount $ 26 $ - $ 9 $ 35 Tax (expense) benefit - - - - ____ ___ ____ _____ Net amount $ 26 $ - $ 9 $ 35 ____ ___ ____ _____ ____ ___ ____ _____ The components of accumulated other comprehensive income are as follows: Accum- ulated Foreign Minimum Other Currency Unrealized Pension Compre- Translation Losses on Liability hensive Adjustments Securities Adjustments Income ___________ __________ ___________ ______ Balance at 12/31/95 $ (73) $ - $(22) $ (95) Change in 1996 26 - 9 35 _____ ___ ____ _____ Balance at 12/31/96 (47) - (13) (60) Change in 1997 (21) (1) 12 (10) _____ ___ ____ _____ Balance at 12/31/97 (68) (1) (1) (70) Change in 1998 (43) - (54) (97) _____ ___ ____ _____ Balance at 12/31/98 $(111) $(1) $(55) $(167) _____ ___ ____ _____ _____ ___ ____ _____ NOTE 15. SEGMENTS OF THE BUSINESS: Effective for 1998 annual reporting, the Company adopted SFAS No. 131 on segment reporting. Under the provisions of the new standard, Cummins has three reportable segments: Engine, Power Generation, and Filtration and Other. The engine segment produces engines and parts for sale to customers in automotive and 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, rail and military. The power generation segment is the Company's power systems supplier, selling engines, generator sets and alternators. The filtration and other segment includes sales of filtration products and exhaust systems, turbochargers and company- owned distributors. The Company's reportable segments are organized according to products and the markets they each serve. This business structure was designed to focus efforts on providing enhanced service to a wide range of customers. The accounting policies of the segments are the same as those described in the summary of significant accounting policies except that the Company evaluates performance based on earnings before interest and income taxes and on net assets, and, therefore, no allocation of debt-related items and income taxes is made to the individual segments. Operating segment information is as follows: Power Filtration 1998 Engine Generation and Other Total ____ ______ __________ ___________ ______ Net sales $3,982 $1,230 $1,054 $6,266 Depreciation & amortization 120 40 39 199 Income (expense) from joint ventures and alliances (4) (25) (1) (30) Earnings before interest, income taxes and special charges 136 25 121 282 Special charges 165 50 2 217 Earnings (loss) before interest & income taxes (29) (25) 119 65 Net assets 946 511 803 2,260 Investment in joint ventures and alliances 132 3 1 136 Capital expenditures 172 67 32 271 Additions to goodwill 12 2 370 384 1997 ____ Net sales $3,666 $1,205 $ 754 $5,625 Depreciation & amortization 102 34 22 158 Income (expense) from joint ventures and alliances 12 (2) - 10 Earnings (loss) before interest and income taxes 207 (2) 107 312 Net assets 1,074 531 312 1,917 Investment in joint ventures and alliances 133 65 6 204 Capital expenditures 304 79 22 405 1996 ____ Net sales $3,310 $1,213 $ 734 $5,257 Depreciation & amortization 97 31 21 149 Income (expense) from joint ventures and alliances (2) 2 - - Earnings before interest and income taxes 160 14 58 232 Net assets 784 459 249 1,492 Investment in joint ventures and alliances 114 89 4 207 Capital expenditures 242 44 18 304 Reconciliation to Consolidated Financial Statements: 1998 1997 1996 ______ ______ ______ Earnings before interest & income taxes for reportable segments $ 65 $ 312 $ 232 Interest expense 71 26 18 Income tax expense 4 74 54 Minority interest 11 - - ______ ______ ______ Net earnings (loss) $ (21) $ 212 $ 160 ______ ______ ______ ______ ______ ______ Net assets for reportable segments $2,260 $1,917 $1,492 Liabilities deducted in arriving at net assets 1,926 1,583 1,586 Deferred tax assets not allocated to segments 334 256 284 Debt-related costs not allocated to segments 22 9 7 ______ ______ ______ Total assets $4,542 $3,765 $3,369 ______ ______ ______ ______ ______ ______ Summary geographic information is listed below: $ Millions US UK Canada Other Total __________ ______ ______ ______ ______ ______ 1998 ____ Net sales (a) $3,595 $ 389 $ 459 $1,823 $6,266 Long-lived assets $1,470 $ 209 $ - $ 272 $1,951 1997 ____ Net sales (a) $3,123 $ 384 $ 318 $1,800 $5,625 Long-lived assets $1,360 $ 251 $ - $ 267 $1,878 1996 ____ Net sales (a) $2,925 $ 348 $ 313 $1,671 $5,257 Long-lived assets $1,201 $ 200 $ - $ 211 $1,612 (a) Net sales are attributed to countries based on location of customer. Revenues from the Company's largest customer represent approximately $1.1 billion of the Company's net sales in 1998. These sales are included in the engine and filtration and other segments. NOTE 16. GUARANTEES, COMMITMENTS AND OTHER CONTINGENCIES: At December 31, 1998, the Company had the following minimum rental commitments for noncancelable operating leases: $41 million in 1999, $38 million in 2000, $30 million in 2001, $25 million in 2002, $21 million in 2003 and $46 million thereafter. Rental expense under these leases approximated $70 million in 1998, $60 million in 1997 and $55 million in 1996. Commitments under outstanding letters of credit, guarantees and contingencies at December 31, 1998, approximated $195 million. Cummins and its subsidiaries are defendants in a number of pending legal actions, including actions related to use and performance of the Company's products. The Company carries product liability insurance covering significant claims for damages involving personal injury and property damage. In the event the Company is determined to be liable for damages in connection with actions and proceedings, the unreserved and uninsured portion of such liability is not expected to be material. The Company also has been identified as a potentially responsible party at several waste disposal sites under US and related state environmental statutes and regulations. The Company denies liability with respect to many of these legal actions and environmental proceedings and vigorously is defending such actions or proceedings. The Company has established reserves that it believes are adequate for its expected future liability in such actions and proceedings where the nature and extent of such liability can be estimated reasonably based upon presently available information. NOTE 17. QUARTERLY FINANCIAL DATA (unaudited): $ Millions, except First Second Third Fourth Full per share amounts Quarter Quarter Quarter Quarter Year __________________ _______ _______ _______ _______ ______ 1998 ____ Net sales $1,500 $1,635 $1,525 $1,606 $6,266 Gross profit 297 369 258 325 1,249 Net earnings (loss) 7 53 (110) 29 (21) Basic earnings (loss) per share $ .18 $ 1.39 $(2.86) $ .75 $ (.55) Diluted earnings (loss) per share .18 1.38 (2.86) .75 (.55) 1997 ____ Net sales $1,304 $1,396 $1,366 $1,559 $5,625 Gross profit 286 324 309 361 1,280 Net earnings 41 53 54 64 212 Basic earnings per share $ 1.07 $ 1.40 $ 1.41 $ 1.69 $ 5.55 Diluted earnings per share 1.06 1.38 1.38 1.66 5.48 Earnings per share for the first three quarters of 1997 have been restated to reflect the adoption of SFAS No. 128 as disclosed in Note 1. NOTE 18. ADDITIONAL INFORMATION: Long-Lived Assets: The Company evaluates the carrying value of its long-lived assets for impairment whenever adverse events or changes in circumstances indicate that the carrying value of an asset may be impaired. In accordance with SFAS 121, if the quoted market price or if not available, the undiscounted cash flows are not sufficient to support the recorded asset value, an impairment loss is recorded to reduce the carrying value of the asset to the amount of expected discounted cash flows. This same policy is followed for goodwill. Foreign Currency Gains and Losses: Total foreign currency remeasurement and transaction losses included in earnings were $5 million in 1998, $1 million in 1997 and $2 million in 1996. Foreign Exchange Forward Contracts: The notional amounts of foreign exchange forward contracts outstanding at December 31 were as follows: Millions ________ Currency 1998 1997 ________ ____ ____ British Pound $ 86 $ 90 French Franc 23 - German Mark 19 27 Australian Dollar 13 103 Canadian Dollar 11 12 Hong Kong Dollar 8 - Other 14 9 ___ ___ $174 $241 ____ ____ ____ ____ Employee Stock Plans: A fair-value method of accounting for awards subsequent to January 1, 1996, would have resulted in an increase in compensation expense of $8 million, net of tax ($.20 per share) in 1998, $6 million, net of tax ($.14 per share) in 1997 and $2 million, net of tax ($.05 per share) in 1996. Investment in Joint Ventures and Alliances: Additional summary financial information for joint ventures and alliances was as follows: Year Ended December 31 $Millions 1998 1997 1996 _________ ______ ______ ______ Net sales $1,245 $1,307 $1,328 Gross profit 25 111 84 Net earnings (loss) (105) 5 3 Cummins' share (52) 2 2 Other Income: The major components of Other Income, Net include the following: $ Millions 1998 1997 1996 __________ ____ ____ ____ Goodwill amortization $ 12 $ 2 $ 2 Interest income (9) (5) (11) Gain on sale of businesses (7) (13) (8) Rental income (6) (3) - Royalty income (5) (12) (6) Foreign currency losses 5 1 2 Gain on sale of building - - (8) Distribution system support - - 7 Other (3) 4 (2) ____ ____ ____ Total $(13) $(26) $(24) ____ ____ ____ ____ ____ ____ Restructuring and Other Non-Recurring Charges: Activity in the major components of these charges was as follows: Original Charges Balance $ Millions Provision 1998 Dec. 31, 1998 __________ _________ _______ _____________ Restructuring of majority- owned operations: Workforce reductions $ 38 $(12) $ 26 Asset impairment loss 22 - 22 Facility consolidations and other 17 (8) 9 ____ ____ ____ 77 (20) 57 ____ ____ ____ Restructuring of joint venture operations: Workforce reductions 11 - 11 Tax asset impairment loss 7 - 7 Facility and equipment- related costs 5 - 5 ____ ____ ____ 23 - 23 ____ ____ ____ Inventory write-downs associated with exit activities 14 (5) 9 ____ ____ ____ Total $114 $(25) $ 89 ____ ____ ____ ____ ____ ____ The remaining one-half of the employees to be severed related to these actions are expected to be terminated at various dates during 1999. The tax asset impairment loss relates to a write-down of the investment in the Cummins Wartsila joint venture in an amount equal to certain deferred taxes previously recorded for losses of the joint venture. The Company had been adjusting the investment in the joint venture to reflect deferred taxes associated with net operating losses for the venture. Upon review of the restructuring plan and future operating results, it was determined that certain of the associated deferred tax assets for this joint venture are less likely to be recoverable.