UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K

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

For the Fiscal Year Ended December 31, 2005

Commission File Number 1-4949


CUMMINS INC.

Indiana

 

35-0257090

(State of Incorporation)

 

(IRS Employer Identification No.)

 

500 Jackson Street
Box 3005
Columbus, Indiana 47202-3005

(Address of principal executive offices)

Telephone (812) 377-5000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

 

 

Name of each exchange on which registered

 

 

Common Stock, $2.50 par value

 

New York Stock Exchange

 

 

Pacific Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None.


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes x   No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o   No x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is 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.  o

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

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

 

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

The aggregate market value of the voting stock held by non-affiliates was approximately $3.4 billion at June 26, 2005.

As of February 5, 2006, there were 46,455,939 shares outstanding of $2.50 par value 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.

 




TABLE OF CONTENTS

Part

 

Item

 

 

 

Page

 

 

I

 

 

 

1

 

 

Business

 

 

3

 

 

 

 

 

 

 

 

 

 

Overview

 

 

3

 

 

 

 

 

 

 

 

 

 

Available Information

 

 

3

 

 

 

 

 

 

 

 

 

 

Competitive Strengths

 

 

4

 

 

 

 

 

 

 

 

 

 

Business Strategy

 

 

5

 

 

 

 

 

 

 

 

 

 

Our Operating Segments

 

 

7

 

 

 

 

 

 

 

 

 

 

Engine Segment

 

 

8

 

 

 

 

 

 

 

 

 

 

Power Generation Segment

 

 

10

 

 

 

 

 

 

 

 

 

 

Components Segment

 

 

11

 

 

 

 

 

 

 

 

 

 

Distribution Segment

 

 

12

 

 

 

 

 

 

 

 

 

 

Segment Financial Information

 

 

12

 

 

 

 

 

 

 

 

 

 

Supply

 

 

12

 

 

 

 

 

 

 

 

 

 

Patents and Trademarks

 

 

13

 

 

 

 

 

 

 

 

 

 

Seasonality

 

 

13

 

 

 

 

 

 

 

 

 

 

Largest Customer

 

 

13

 

 

 

 

 

 

 

 

 

 

Backlog

 

 

14

 

 

 

 

 

 

 

 

 

 

Distribution

 

 

14

 

 

 

 

 

 

 

 

 

 

Research and Engineering

 

 

14

 

 

 

 

 

 

 

 

 

 

Joint Ventures and Alliances

 

 

15

 

 

 

 

 

 

 

 

 

 

Employees

 

 

17

 

 

 

 

 

 

 

 

 

 

Environmental Compliance

 

 

18

 

 

 

 

 

 

 

1A

 

 

Risk Factors Relating to Our Business

 

 

19

 

 

 

 

 

 

 

1B

 

 

Unresolved Staff Comments

 

 

22

 

 

 

 

 

 

 

2

 

 

Properties

 

 

22

 

 

 

 

 

 

 

3

 

 

Legal Proceedings

 

 

23

 

 

 

 

 

 

 

4

 

 

Submission of Matters to a Vote of Security Holders

 

 

23

 

 

 

II

 

 

 

5

 

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

 

24

 

 

 

 

 

 

 

6

 

 

Selected Financial Data

 

 

25

 

 

 

 

 

 

 

7

 

 

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

 

 

26

 

 

 

 

 

 

 

7A

 

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

61

 

 

 

 

 

 

 

8

 

 

Financial Statements and Supplementary Data

 

 

62

 

 

 

 

 

 

 

9

 

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 

 

 

62

 

 

 

 

 

 

 

9A

 

 

Controls and Procedures

 

 

62

 

 

 

 

 

 

 

9B

 

 

Other Information

 

 

63

 

 

 

III

 

 

 

10

 

 

Directors and Executive Officers of the Registrant

 

 

64

 

 

 

 

 

 

 

11

 

 

Executive Compensation

 

 

65

 

 

 

 

 

 

 

12

 

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

 

65

 

 

 

 

 

 

 

13

 

 

Certain Relationships and Related Transactions

 

 

65

 

 

 

 

 

 

 

14

 

 

Principal Accountant Fees and Services

 

 

66

 

 

 

IV

 

 

 

15

 

 

Exhibits and Financial Statement Schedules

 

 

66

 

 

 

 

 

 

 

 

 

 

Index to Financial Statements

 

 

66

 

 

 

 

 

 

 

 

 

 

Signatures

 

 

123

 

 

 

 

 

 

 

 

 

 

Index to Exhibits

 

 

124

 

 

 

2




PART I

Item 1.   Business

OVERVIEW

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 have long-standing relationships with many of the leading manufacturers in the markets we serve, including DaimlerChryslerAG (DaimlerChrysler), Volvo AB, PACCAR Inc., International Truck and Engine Corporation (Navistar International Corporation), CNH Global N.V., Komatsu and Scania AB. We serve our customers through a network of more than 550 company-owned and independent distributor locations and approximately 5,000 dealer locations in more than 160 countries and territories.

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

AVAILABLE INFORMATION

Cummins files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 450 Fifth Street, NW, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Cummins) file electronically with the SEC. The SEC’s internet site is www.sec.gov.

Cummins internet site is www.cummins.com. You can access Cummins Investor Information webpage through our internet site, by clicking on the heading “Investor Information.” Cummins makes available free of charge, on or through our Investor Information website, its proxy statements, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Cummins also makes available, through our Investor Information webpage, under the link SEC filings, statements of beneficial ownership of Cummins equity securities filed by its directors, officers, 10 percent or greater shareholders and others under Section 16 of the Exchange Act.

Cummins also has a Corporate Governance webpage. You can access Cummins Corporate Governance webpage through our internet site, www.cummins.com, by clicking on the heading “Investor Information” and then the topic heading of “Governance Documents.” Cummins posts the following on its Corporate Governance webpage:

·       ISS Corporate Governance Rating,

·       Code of Conduct,

·       Corporate Governance Principles,

3




·       By-laws of Cummins Inc.,

·       Audit Committee Charter,

·       Governance and Nominating Committee Charter, and

·       Compensation Committee Charter.

Cummins Code of Conduct applies to all our employees, regardless of their position or the country in which they work. We will post any amendments to the Code of Conduct, and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange, Inc. (“NYSE”), on our internet site. The information on Cummins internet site is not incorporated by reference into this report.

You may request a copy of these documents at no cost, by contacting Cummins Inc. Investor Relations at 500 Jackson Street, Mail Code 60115, Columbus, IN 47201 (812-377-3121).

In accordance with NYSE Rules, on June 8, 2005, the Company filed the annual certification by our CEO that, as of the date of the certification, he was unaware of any violation by the company of the NYSE’s corporate governance listing standards.

COMPETITIVE STRENGTHS

We believe the following competitive strengths are instrumental to our success:

·       Leading Brands.   Our product portfolio includes products and services marketed and branded under various trademarks, tradenames and trade dress configurations throughout the world, including each of the following brands, which holds a leading position in its respective market:

·        Cummins® engines, electric power generation systems, components and parts;

·        Onan® generator sets;

·        Alternator products sold under the Stamford®, AvK® and Markon® brands;

·        Fleetguard® filtration systems and components;

·        Nelson® intake and exhaust systems and components;

·        Kuss™ automotive in-tank fuel filtration;

·        Universal Silencer™ filtration systems and silencers; and

·        Holset® turbochargers.

Our continual investment in and attention to furthering brand equity in our offerings and across our business units includes leveraging and creating brand identity, brand value and brand presence for our offerings in our markets of interest. In part, as a result of this investment and by seeking to aggregate brand strength in complementary markets, we also gain recognition in and across our markets for our offerings, continually seek new and innovative means to further develop and expand market share through our brand equity position, and strengthen customer relationships.

While our portfolio of branded assets and offerings contains a number of market leaders, we operate in a highly competitive sector and our branded offerings compete with the brands offered by other manufacturers and distributors that produce and sell similar offerings.

·       Customers and Partners.   To maintain technology leadership and a global presence in a cost-effective manner, we have established strategic alliances with a number of our leading customers. These partnerships provide us with a knowledge and understanding of our customers’ technology and business needs, and enable us to develop products and services which better meet their

4




requirements at lower costs. For example, we have both customer and supplier arrangements with Komatsu, Ltd., including manufacturing joint ventures and a product development joint venture through which we have partnered in the development of several engines. We are also the exclusive supplier of engines for Komatsu mining equipment. In addition, we have been the exclusive diesel engine supplier to DaimlerChrysler for its Dodge Ram truck since 1988, and in 2003 our exclusivity agreement was extended beyond model year 2007. We have long-term agreements with Volvo, PACCAR and International Truck and Engine Corporation for the supply of heavy-duty truck engines. These agreements afford us long-term price stability and eliminate certain dealer and end-user discounts as well as offer closer integration on product development. We also have multiple international joint ventures which manufacture heavy-duty and midrange engines, including partnerships with the Tata Group whose member company is the leading truck manufacturer in India, and Dongfeng Automotive Corporation, an engine supplier to the second largest truck manufacturer in China.

·       Global Presence.   We have a strong global presence including a worldwide distribution system, manufacturing and engineering facilities around the world and a network of global supply sources. Our worldwide presence has enabled us to take advantage of growth opportunities in international markets, with sales outside the U.S. growing from 43 percent of total consolidated net sales in 2000 to 51 percent of total consolidated net sales in 2005. For over 70 years, we have developed a distribution and service network that includes more than 550 company-owned and independent distributor locations and 5,000 independent dealers located throughout 160 countries and territories. We also have manufacturing operations and product engineering centers around the world, with facilities in the United Kingdom (UK), Brazil, Mexico, Canada, France, Australia, China, India, South Africa and Singapore. In addition, we have developed a global network of high-quality, low-cost supply sources to support our manufacturing base.

·       Leading Technology.   We have an established reputation for delivering high-quality, technologically advanced products. We continuously work with our customers to develop new products to improve the performance of their vehicles, equipment or systems at competitive cost levels. We are a leader in developing technologies to reduce diesel engine emissions, a key concern of our customers and regulators around the world. We were the first company to develop engines that were certified to meet new emissions standards governing on-highway heavy-duty diesel engines. These standards went into effect for Cummins in the U.S. on October 1, 2002. We were also the first manufacturer to receive a Tier III Certificate of Conformity from the Environmental Protection Agency (EPA) for our QSM off-highway engine that met the January 2005 emissions standards. We have also developed low-emission, high-performance natural gas engines as an alternative-fuel option for the on-highway, industrial and power generation markets. Our technology leadership enables us to develop integrated product solutions for the power generation and filtration markets, allowing our customers to use a single high-performance, low-cost system as opposed to multiple components from different suppliers.

BUSINESS STRATEGY

The five key elements of our business strategy are as follows:

·       Aggressively Pursue Cost Leadership.   In many of our markets, product or system cost is a critical performance parameter for our customers. To achieve cost leadership, we will continue to leverage our innovative technology, economies of scale, global presence and customer partnerships. Beginning in 2000, we have focused on reducing costs and lowering our breakeven point to maintain a competitive advantage and to deliver quality products to our customers. The following key initiatives are integral to this strategy:

5




·        Six Sigma.   Since the program’s inception in 2000, we have not only applied Six Sigma to manufacturing processes and in the initial design of new products, but also expanded the program to include processes with customers, suppliers and distributors. Six Sigma yields not only significant cost savings and improved quality, it strengthens our relationships with these important stakeholders and contributes to developing long-term relationships.

·        Global Sourcing.   Our cost reduction efforts in supply chain management include global procurement from less expensive international markets such as China, India, Eastern Europe and Brazil which has resulted in significantly reducing the cost of purchased materials and services during the last six years.

·        Technical Productivity.   We have managed our research and development costs through a number of initiatives including a) conducting research and development off-shore at our technical center in India, b) cost-sharing arrangements with OEM customers and joint venture partnerships and c) by using analysis-led design to eliminate capital-intensive prototypes through virtual computer modeling. In 2004, we signed an agreement with Dongfeng Cummins Engine Co., Ltd. (DCEC) for a research facility in China that is expected to open in mid-2006. These initiatives have helped us to continue to be a technology leader, while maintaining our research and engineering expense at approximately 2.8 percent of consolidated net sales for 2005.

·       Expand into Related Markets.   We will continue to focus growth initiatives in related businesses where we can use our existing investments in products or technology, leading brand names or market presence to establish a competitive advantage. Furthermore, we will target related markets that offer higher rates of growth, attractive returns and more stable cash flows through product and end market diversity. Specific growth opportunities are outlined below.

·        Our Engine segment has made significant progress toward meeting 2007 and 2010 on-highway emissions standards. In addition, our strategy includes the development of engines for the growing oil and gas, marine and SUV/light pickup truck markets.

·        Our Power Generation segment is focused on increasing sales of standby power, mobile and auxiliary power, distributed generation, alternators and power electronics and controls, such as transfer switches and switchgear.

·        Our Components segment will leverage the Company’s filtration, exhaust, fuel systems, turbocharger and engine technologies to provide integrated solutions for its customers and meet increasingly stringent emissions requirements.

·        Our Distribution segment is growing through the expansion of the aftermarket parts and service business by capitalizing on its global customer base and fast growth markets in China, India and Russia. Our strategy also includes increasing our ownership interest in key portions of the distribution channel.

·       Maximize Shareholder Value.   Return on equity is a primary measure of our consolidated financial performance. We report the performance of our operating segments based on segment EBIT. Segment EBIT is earnings before interest, taxes, minority interests, preferred dividends and cumulative effect of accounting changes and segment average net assets is net assets excluding debt, taxes and adjustments to the minimum pension liability.

6




·       Leverage Complementary Businesses.   Strong synergies and relationships exist between our operating segments in the following areas:

·        Shared Technology.  In addition to common platforms of base product technology, our operating segments have technical capabilities which can be applied commercially to provide integrated solutions for our customers. The operating segments also realize synergies in the development and application of broader technology tools (such as information technology).

·        Common Channels and Distribution.  All operating segments utilize a common distribution channel, which provides access to a full range of our products and also provides economies of scale.

·        Shared Customers and Partners.  There is substantial commonality in customers and partners between operating segments, which allows us to build strong customer relationships and provides opportunity for expanded product offerings.

·        Corporate Brand and Image.  All operating segments benefit from the established and respected corporate brand.

·       Ensuring and Reinforcing a Strong Performance Ethic.  We have performance management systems around the globe based on doing what we say we will do, in terms of financial performance, meeting customer and partner expectations and demonstrating our corporate core values.

Capital expenditures for 2006 will increase to support our growth, and will include investments to increase capacity and to fund our new products. Our investments in capacity improvement are focused, cut across all of our businesses and are designed for rapid return on investment. Our capital spending decisions are made to ensure that we do not negatively impact our return on equity. We continue to invest more of our capital in low-cost regions of the world to further leverage our opportunities for cost reduction. We currently expect capital expenditures for 2006 to be approximately $250 million dollars to support these initiatives. This investment level is below our expected depreciation and amortization for this period.

One of our goals is to regain an investment grade credit rating from the rating agencies. To achieve this goal, we have focused on increasing earnings, reducing fixed costs in our businesses, managing risks aggressively, improving cash flow and reducing debt levels and other underfunded obligations.

OUR OPERATING SEGMENTS

We operate four complementary operating segments that share technology, customers, strategic partners, brands and our distribution network to gain a competitive advantage in their respective markets. With our size and global presence, we provide world-class products, service and support to our customers in a cost-effective manner. In each of our operating segments, we compete worldwide with a number of other manufacturers and distributors that produce and sell similar products. Our products primarily compete on the basis of price, performance, fuel economy, speed of delivery, quality and customer support.

We made certain leadership changes effective May 2, 2005, within our management team. In connection with these changes, certain modifications were made to our internal reporting. These modifications are summarized below:

·       The Filtration and Other segment was renamed the Components segment and now includes operating results of the fuel systems business which were previously included in the Engine segment. Historically, the fuel systems business transferred product within the Engine segment at cost. Beginning in the third quarter, those transfers now use a cost-plus based transfer price. As a result of this change, segment EBIT increased for the Components segment and decreased for the Engine segment but there was no impact to consolidated earnings. Revenues of the Components

7




segment were also increased to reflect transfers to the Engine segment and eliminations were increased by a corresponding amount.

·       The North American distribution business was combined with the International Distribution segment and renamed the Distribution segment. Previously, the North American distribution business was reported in the Engine and Power Generation segments as investee equity and included the results of a partially-owned distributor that is consolidated. As a result, revenues of the Engine segment were increased to reflect sales to the consolidated distributor that were previously eliminated and decreased for the revenues of the consolidated distributor which are now included in the Distribution segment. In addition, this change also caused investee equity earnings in the Engine and Power Generation segments to decrease while investee equity earnings in the Distribution segment increased by a corresponding amount.

Engine Segment

Our Engine segment manufactures and markets a broad range of diesel and natural gas-powered engines under the Cummins brand name for the heavy-and medium-duty truck, bus, recreational vehicle (RV), light-duty automotive, agricultural, construction, mining, marine, oil and gas, rail and governmental equipment markets. We offer a wide variety of engine products with displacement from 1.4 to 91 liters and horsepower ranging from 31 to 3,500. In addition, we provide a full range of new parts and service, as well as remanufactured parts and engines, through our extensive distribution network. The Engine segment is our largest operating segment, accounting for approximately 56 percent of total sales before intersegment eliminations in 2005.

The principal customers of our heavy-and medium-duty truck engines include truck manufacturers, such as International Truck and Engine Corporation (Navistar International Corporation), Volvo Trucks North America, PACCAR and Freightliner, manufacturers of school, transit and shuttle buses and manufacturers of construction, agricultural and marine equipment. The principal customers of our light-duty on-highway engines are DaimlerChrysler and manufacturers of RVs.

In the markets served by our Engine segment, we compete with independent engine manufacturers as well as OEMs who manufacture engines for their own products. Our primary competitors in North America are Caterpillar, Inc., Detroit Diesel Corporation, Mack Trucks, Inc. and International Truck and Engine Corporation (Engine Division). Our primary competitors in international markets vary from country to country, with local manufacturers generally predominant in each geographic market. Other engine manufacturers in international markets include Mercedes Benz, Volvo, Renault Vehicules Industriels, Scania, Weichai Power Co. Ltd. and Nissan Diesel Motor Co., Ltd.

Our Engine segment organizes its engine, parts and service businesses around the following end-user markets:

Heavy-Duty Truck

We manufacture a complete line of diesel engines that range from 310 horsepower to 565 horsepower serving the worldwide heavy-duty truck market. We offer the ISM and ISX engines and in Australia, the Signature 620 series engines, which we believe comprise the most modern product engine line in our industry. Most major heavy-duty truck manufacturers in North America offer our diesel engines as standard or optional power. In 2005, we held a 26 percent share of the Group II engine market for NAFTA heavy-duty trucks. We are also the market leader in Mexico and South Africa. Our largest customer for heavy-duty truck engines in 2005 was International Truck and Engine Corporation (Navistar International Corporation) with sales representing almost 9 percent of consolidated net sales.

8




In recent years we have entered into long-term supply agreements with three key customers to improve customer service and increase market share. In 2000, we entered into a long-term agreement with Volvo Trucks North America, Inc. under which we act as its sole external engine supplier. In 2001, we entered into long-term supply agreements with PACCAR and International Truck and Engine Corporation (Navistar International Corporation) covering our heavy-duty engine product line. These supply agreements provide long-term, stable pricing for engines and eliminate certain dealer and end-user discounts, in order to provide our customers with full responsibility for total vehicle cost and pricing. In addition, these agreements provide for joint work on engine/vehicle integration with a focus on reducing product proliferation. These efforts are expected to reduce product cost while creating enhanced value for end-users through better product quality and performance. The joint sales and service efforts also will provide better customer support at a significantly reduced cost to the partners.

Medium-Duty Truck and Bus

We manufacture a product line of medium-duty diesel engines ranging from 185 horsepower to 315 horsepower serving medium-duty and inter-city delivery truck customers worldwide. We believe that our ISB, ISC and ISL series diesel engines comprise the most advanced product line in the industry. We sell our ISB and ISC series engines and engine components to medium-duty truck manufacturers in Asia, Europe and South America. In 1990, we entered the North American medium-duty truck market and for the year ended 2005 our market share for diesel powered medium-duty trucks had grown to approximately 15 percent. Freightliner LLC, (a division of DaimlerChrysler), PACCAR, Ford and Volkswagen AG are our major customers in this worldwide market.

We also offer our ISB and ISC diesel engines and alternative-fuel engines for school buses, transit buses and shuttle buses and our B and C series engines for natural gas applications, which are focused primarily on transit and school bus markets. The demand for alternative-fuel products continues to grow both domestically and internationally. Cummins Westport Inc., a joint venture formed in 2001 with Westport Innovations, Inc., offers low-emission, propane and natural gas engines that are currently used in municipal transportation markets in Los Angeles, Boston, Salt Lake City, Vancouver, BC and Beijing, China.

Light-Duty Automotive

We are the exclusive provider of diesel engines used by DaimlerChrysler in its Dodge Ram trucks. Our relationship with DaimlerChrysler extends over 15 years, and in 2005 we shipped over 160,000 engines for use in Dodge Ram trucks. In 2005, DaimlerChrysler was our largest customer. In 2003, our selection as the exclusive diesel power provider for Dodge Ram truck models was extended to include the 2007 model year. The Dodge Ram Heavy-Duty Cummins Turbo offers best in class 610 lb-ft of torque and 325 horsepower, and we expect this popular engine will continue to result in strong sales volumes with the availability of our engine in the new Dodge Ram Mega Cab model.

We are the leading manufacturer of diesel engines for use in the Class A motorhome market, with a market share representing over 50 percent of the diesel engines in retail Class A motorhome sales. The diesel segment of the Class A motorhome market has grown from 39 percent in 2000 to approximately 48 percent in 2005, indicating a growing preference for diesel power for this application.

Industrial

Our medium-duty, heavy-duty and high-horsepower engines power a wide variety of equipment in the construction, agricultural, mining, rail, government, oil and gas, power generation, commercial and recreational marine applications throughout the world. Our major construction OEM customers are in North America, Europe, South Korea, Japan and China. These OEMs manufacture approximately one million pieces of equipment per year for a diverse set of applications and use engines from our complete

9




product range. Agricultural OEM customers are primarily in North America, South America and Europe, serving end-use markets that span the globe. In the marine markets, our joint venture, Cummins MerCruiser Diesel Marine, is the market share leader in the North American and South Pacific recreational boat segments for power ranges in which we participate. Our engines are sold to both recreational and commercial boat builders, primarily in North America, Europe and Asia. We offer a full product line of high-horsepower engines for mining applications that compete in all segments from small underground mining equipment to 400-ton haul trucks. We offer the broadest engine line-up in the mining industry, where we occupy the number two market position. Our QSK78 engine, launched in 2000, extended our mining products up to 3,500 horsepower, the largest in the mining industry. In this market, we continue to be the exclusive external supplier of engines to Komatsu, a large construction and mining equipment OEM. Our sales to the rail market are primarily to railcar builders in Europe and Asia, and we are a leader in the worldwide railcar market. With our QSK60 and QSK78 engines, we expect to move into a larger proportion of the locomotive and railcar markets outside North America and commercial marine markets worldwide. Government sales represent a small portion of the high-horsepower market and are primarily to defense contractors in North America and Europe. Our high-horsepower engines allow us to offer our customers in the oil and gas business a full line of high-horsepower products.

Power Generation Segment

The Power Generation segment represented 17 percent of our total sales before intersegment eliminations in 2005. This operating segment is one of the most integrated providers of power solutions in the world, designing or manufacturing most of the components that make up power generation systems, including engines, controls, alternators, transfer switches and switchgear. This operating segment is a global provider of power generation systems, components and services for a diversified customer base to meet the needs for standby power, distributed generation power, as well as auxiliary power needs in specialty mobile applications. Standby power solutions are provided to customers who rely on uninterrupted sources of power to meet the needs of their customers. Distributed generation power solutions are provided to customers with less reliable electrical power infrastructures, typically in developing countries. In addition, it provides an alternative source of generating capacity, which is purchased by utilities, independent power producers and large power customers for use as prime or peaking power and is located close to its point of use. Mobile power provides a secondary source of power (other than drive power) for mobile applications.

Our power generation products are marketed principally under the Cummins Power Generation, Onan, and Cummins Power Rent brands and include diesel and alternative-fuel electrical generator sets for commercial, institutional and consumer applications, such as office buildings, hospitals, factories, municipalities, utilities, universities, RVs, boats and homes. We are the worldwide leader in auxiliary generator sets for RVs, commercial vehicles and recreational marine applications. Our rental business provides power equipment on a rental basis for both standby and prime power purposes. Our energy solutions business provides full-service power solutions for customers including generating equipment, long-term maintenance contracts and turnkey power solutions.

Newage AVK/SEG (Newage) is a leader in the alternator industry and supplies its products internally as well as to other generator set assemblers. Newage products are sold under the Stamford, AVK and Markon brands and range in output from 0.6 kVA to 30,000 kVA. We also sell reciprocating generator drive engines across a large power range to other generator set assemblers.

This operating segment continuously explores emerging technologies, such as microturbines and fuel cells, and provides integrated power generation products utilizing technologies other than reciprocating engines. We use our own research and development capabilities as well as leveraging business partnerships to develop cost-effective and environmentally sound power solutions.

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Our customer base for power generation products is highly diversified, with customer groups varying based on their power needs. China, India, the Middle East and Brazil are four of our largest geographic markets outside of North America.

This operating segment competes with a variety of engine manufacturers and generator set assemblers across the world. Caterpillar remains our primary competitor as a result of its acquisition of MAK Americas Inc., Perkins Engines Inc. and FG Wilson Inc., as well as Volvo and DaimlerChrysler, through its acquisition of Detroit Diesel Corporation, are other major engine manufacturers with a presence in the high-speed generation segment of the market. We also compete with Kohler, Generac, SDMO and other regional generator set assemblers. Newage competes globally with Emerson Electric Co., Marathon Electric and Meccalte, among others.

Components Segment

Our Components segment produces filters, silencers and intake and exhaust systems under the Fleetguard, Nelson, Kuss and Universal Silencer brand names and is the largest worldwide supplier of turbochargers for commercial applications through our Holset brand. This segment manufactures filtration and exhaust systems for on-and off-highway heavy-duty equipment and is a supplier of filtration products for industrial and passenger car applications, exhaust systems for small engine equipment and silencing systems for gas turbines. In addition, we operate an emission solutions business through which we develop systems to help our customers meet increasingly stringent emissions standards and a fuel systems business which to date has primarily supplied our Engine segment. In 2005, our Components segment accounted for approximately 17 percent of our total sales before intersegment eliminations.

We are the world’s leading supplier of filtration, exhaust, coolant, and chemical products offering over 30,000 products including air, coolant, fuel and hydraulic filters, antifreeze and coolant additives, catalysts, particulate filters, controllers and other filtration systems to OEMs, dealer/distributor and end-user markets. Its products are produced and sold in global markets, including North America, South America, Europe, Asia, Africa and Australia. In a recent North America on-highway truck market survey published by a leading independent market research company, Fleetguard ranked as the top brand preference for diesel engine air, oil, fuel and coolant filtration products. Our Components segment also makes products for the automotive specialty filtration market and the industrial filtration market through our Kuss subsidiary, located in Findlay, OH, and Universal Silencer, located in Stoughton, WI. Our Fleetguard and emissions solutions business revenue is split with 48 percent being from first-fit OEM customers and 52 percent from replacement part business.

Holset designs, manufactures and markets turbochargers for diesel engine applications with manufacturing facilities in five countries and sales and distribution worldwide. Holset provides critical technologies for engines to meet challenging performance requirements and worldwide emissions standards, including variable geometry turbochargers, and is the market leader in turbochargers for heavy-duty equipment.

The fuel systems business designs and manufactures new and replacement fuel systems primarily for heavy-duty on-highway diesel engine applications. Our Engine segment and Scania are the primary customers for the fuel systems business. Scania is our partner in two joint ventures within the fuel systems business. The Cummins Scania HPI joint venture currently manufactures fuel systems that are used by both companies in current products. In August 2005, the Cummins Scania XI joint venture was formed to design, develop and manufacture the next generation of fuel systems for use in 2007 and beyond.

Customers of our Components segment generally include truck manufacturers and other OEMs that are also customers of our Engine segment, such as CNH Global N.V., International Truck and Engine, Volvo and other manufacturers that use Fleetguard filtration products in their product platforms, such as

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Honda. Our customer base for replacement filtration parts is highly fragmented, and primarily consists of various end-users of filtration systems.

Our Components segment competes with other manufacturers of filtration systems and components and turbochargers. Our primary competitors in these markets include Donaldson Company, Inc., Clarcor Inc., Mann+Hummel Group, Tokyo Roki Co., Ltd. and Honeywell International.

Distribution Segment

In 2005, Distribution segment sales accounted for 10 percent of our total sales before intersegment eliminations. Our Distribution segment consists of 17 company-owned distributors and 10 joint ventures that distribute the full range of our products and services to end-users at 233 locations in over 90 countries and territories. In North America, this network is comprised of partially-owned distributors. Internationally, our network consists of partially-owned and wholly-owned distributors. Through this network, our trained personnel provide parts and service to our customers, as well as full-service solutions, including maintenance contracts, engineering services, and integrated products where we customize our products to cater to specific end-users. Our company-owned distributors are located in key markets, including North America, India, China, Japan, Australia, the U.K. and South Africa. Our distributors also serve the dealers and end-users in their territories by providing product maintenance, repair and overhaul services.

Our Distribution segment serves a highly diverse customer base consisting of various end-users in the specific geographic markets in which our distributors are located.

Each distributor that we own or operate in a particular geographic region competes with other distributors and dealers that offer similar products within that region. In many cases, competing distributors and dealers are owned by, or affiliated with, OEMs of those competing products.

SEGMENT FINANCIAL INFORMATION

Financial information about our operating segments is incorporated by reference from Note 19 to the Consolidated Financial Statements.

SUPPLY

We have developed and maintain a world-class supply base in terms of technology, quality and cost. We source our materials and manufactured components from leading suppliers both domestically and internationally. We have adequate sources of supply of raw materials and components. We machine and assemble some of the components used in our engines and power generation units, including blocks, heads, rods, turbochargers, camshafts, crankshafts, filters, exhaust systems, alternators and fuel systems. We also have arrangements with certain suppliers who are the sole source for specific products or supply items. Between 75 and 85 percent of our total raw material and component purchases in 2005 were purchased from suppliers who are the sole source of supply for a particular supply item. Although we elect to source a relatively high proportion of our total raw materials and component requirements from sole suppliers, the majority of these supply items can be purchased from alternate suppliers with the appropriate sourcing plan. We are also developing suppliers in many global or low-cost locations to serve our businesses across the globe and provide alternative sources in the event of disruption from existing suppliers. In addition, we maintain dual sourcing at a commodity level on many of our sole sourced part numbers. Our supply agreements vary according to the particular part number sourced. However, these agreements typically include standard terms relating to cost (including cost reduction targets), quality and delivery. Our supply agreements also typically include customary intellectual property provisions that contain prohibitions on the use of our intellectual property by the suppliers for any purpose other than their performance of the supply agreements, and indemnity covenants from suppliers for breach by them of intellectual property

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rights of third parties in performance of the agreements. The duration of our more important supply agreements varies but typically ranges between three and five years. Many of our supply agreements include early termination provisions related to failure to meet quality and delivery requirements. In order to reduce the risk of dependency, the raw materials and components from single source suppliers are reviewed periodically to ensure a second source or alternative exists to guarantee supply.

PATENTS AND TRADEMARKS

We own or control a significant number of patents and trademarks relating to the products we manufacture. These have been granted and registered over a period of years. Although these patents and trademarks are generally considered beneficial to our operations, we do not believe any patent, group of patents, or trademark (other than our leading brand house trademarks) is considered significant in relation to our business.

SEASONALITY

While individual product lines may experience modest seasonal declines in production, there is no material effect on the demand for the majority of our products on a quarterly basis. However, our Power Generation segment normally experiences seasonal declines in the first quarter of the fiscal year due to general declines in construction spending and our Distribution segment normally experiences seasonal declines in first quarter business activity due to holiday periods in Asia and Australia.

LARGEST CUSTOMER

We have thousands of customers around the world and have developed long-standing business relationships with many of them. DaimlerChrysler is our largest customer, accounting for approximately 12 percent of our consolidated net sales in 2005, primarily relating to sales of our ISB engine for use in Dodge Ram trucks and sales of our medium-duty engines to the Freightliner division of DaimlerChrysler. While a significant number of our sales to DaimlerChrysler are under long-term supply agreements, these agreements provide for the supply of DaimlerChrysler’s engine requirements for particular vehicle models and not a specific volume of engines. The loss of this customer or a significant decline in the production level of DaimlerChrysler vehicles that use our engines would have an adverse effect on our business, results of operations and financial condition. We have been an engine supplier to DaimlerChrysler for more than 15 years. A summary of principal customers for each operating segment is included in our segment discussion.

In addition to our agreements with DaimlerChrysler, we have long-term heavy-duty engine supply agreements with International Truck and Engine Corporation, PACCAR and Volvo Trucks North America. Collectively, our net sales to these three customers was less than 19 percent of consolidated net sales in 2005 and individually, was less than 9 percent of consolidated net sales for each customer. As with DaimlerChrysler, these agreements contain standard purchase and sale agreement terms covering engine and engine parts pricing, quality and delivery commitments, as well as engineering product support obligations. The basic nature of our agreements with OEM customers is that they are long-term (generally five years or longer) price and operations agreements that assure the availability of our products to each customer through the duration of the respective agreements. There are no guarantees or commitments by these customers of any kind regarding volumes or market shares, except in the case of DaimlerChrysler, which has committed that Cummins will be its exclusive diesel engine supplier for the Dodge Ram heavy-duty pickup truck. Agreements with OEMs contain bilateral termination provisions giving either party the right to terminate in the event of a material breach, change of control or insolvency or bankruptcy of the other party.

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BACKLOG

Demand in many of our markets has grown rapidly in the last two years resulting in longer lead times. However, while we have supply agreements with some truck and off-highway equipment OEMs, most of our business is transacted through open purchase orders. These open orders are historically subject to month-to-month releases and are subject to cancellation on reasonable notice without cancellation charges and therefore are not considered firm.

DISTRIBUTION

For over 70 years, we have been developing a distribution and service network that includes more than 550 independent distributor locations and 5,000 independent dealers in 160 countries and territories. In North America, this network is comprised of independent and partially-owned distributors. Internationally, our network consists of independent, partially-owned, and wholly-owned distributors. Most distributors sell the full range of our products, as well as complementary products and services. Our Distribution segment operates within this network with 17 company-owned distributors and 10 joint ventures in 233 locations across 90 countries and territories.

Our licensing agreements with independent and partially-owned distributors generally have a three-year term and are restricted to specified territories. Our distributors develop and maintain a network of dealers with which we have no direct relationship. The distributors are permitted to sell other, noncompetitive products only with our consent. We license all of our distributors to use our name and logo in connection with the sale and service of our products, with no right to assign or sublicense the marks, except to authorized dealers, without our consent. Products are sold to the distributors at standard domestic or international distributor net prices, as applicable. Net prices are wholesale prices we establish to permit our distributors an adequate margin on their sales. Subject to local laws, we can refuse to renew these agreements at will, and we may terminate them upon 90-day notice for inadequate sales, change in principal ownership and certain other reasons. Distributors also have the right to terminate the agreements upon 60-day notice without cause, or 30-day notice for cause. Upon termination or failure to renew, we may be required to purchase the distributor’s current inventory and may, at our option purchase other assets of the distributor, but are under no obligation to do so.

Our distribution capability is a key element of our business strategy and competitive position, particularly in our efforts to increase customer access to aftermarket replacement parts and repair service. There are more than 5,000 locations in North America, primarily owned and operated by OEMs or their dealers, at which Cummins trained service personnel and parts are available to service, maintain and repair our engines. We also have parts distribution centers located strategically throughout the world in order to serve our customers and distributors.

Financial information about wholly-owned distributors, partially-owned distributors consolidated under FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities,” (FIN 46R), issued by the Financial Accounting Standards Board (FASB), and distributors accounted for under the equity method are incorporated by reference to Notes 1, 2 and 3 to the Consolidated Financial Statements.

RESEARCH AND ENGINEERING

Our research and engineering program is focused on product improvements, innovations and cost reductions for our customers. In 2005, our research and engineering expenditures were $278 million compared to $241 million in 2004. Of this amount, approximately 27 percent, or $76 million, was directly related to the development of heavy-duty and medium-duty engines that are designed to comply with the 2007 emissions standards.

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In the Engine segment, we continue to invest in system integration and in technologies to meet increasingly more stringent emissions standards. We have focused our engine technology development on four critical subsystems: combustion, air handling, electronic controls and exhaust aftertreatment. We were the first diesel engine manufacturer to have an engine certified by the EPA as being in compliance with the current EPA standards. We also were the first engine manufacturer to announce a low-cost combustion-only emission solution for Tier III industrial diesel engines that does not require exhaust gas recirculation nor exhaust aftertreatment. In addition, we were the first company to demonstrate a prototype vehicle that meets EPA 2007 gasoline-equivalent “Tier II Bin 5” emission levels.

In Power Generation, our product engineering focus is to develop products with the best performance at the lowest cost for our customers. Our power electronics technology development is aimed at applying digital electronics to eliminate multiple gen-set controllers and achieve higher levels of system integration and control. We meet the most advanced emission standards around the world, employing both combustion and exhaust aftertreatment technologies. Looking to future low-emission power generation technologies, we have a Department of Energy funded program to develop a solid oxide fuel cell system for vehicle auxiliary power generation and for smaller stationary power generation applications.

In Components, we are building on our strengths in design integration to develop modules that integrate multiple filtration functions into a single engine subsystem component. We are developing new filter media and technologies that support low-emission engines, including exhaust aftertreatment, closed crankcase ventilation, fuel systems and centrifugal soot removal.

In 2003, we established Cummins Research and Technology India Private Ltd. (CRTI). This partially-owned subsidiary provides analytical services such as structural dynamics, computational fluid dynamics, and design to all Cummins entities. CRTI is located in Pune, India. In 2004, we signed a joint venture agreement with DCEC for a research facility in China that is expected to open in mid-2006. The Cummins East Asia Research and Development Co., Ltd. will provide engineering and technical services for the full range of Cummins products manufactured in China, including diesel and natural gas engines, power generators, turbochargers and filtration products.

JOINT VENTURES AND ALLIANCES

We have entered into a number of joint venture agreements and alliances with business partners and affiliates in various areas of the world to increase our market penetration, expand our product lines, streamline our supply chain management and develop new technologies with the primary joint ventures being the following:

·       Cummins India Ltd.   We are the majority owner of Cummins India Ltd. (CIL), which is a publicly listed company on various exchanges in India. This business entity developed from a partnership established in 1962 with the Kirloskar family. CIL produces midrange, heavy-duty and high-horsepower engines, as well as generators for the Indian and export markets. CIL also produces compressed natural gas spark-ignited engines licensed from the Cummins Westport (CWI) joint venture. We consolidate the results of Cummins India Ltd. in our Consolidated Financial Statements.

·       Consolidated Diesel Company.   Consolidated Diesel Company, located in the U.S., is a joint venture with CNH Global N.V. that began with Case Corporation in 1980. This partnership produces Cummins B series, C series and ISL Series engines and engine products for on-highway and industrial markets in North America and Europe. Effective March 28, 2004, we adopted the provisions of FIN 46R for this entity and its results are now consolidated in our Consolidated Financial Statements (see Note 2 to the Consolidated Financial Statements).

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·       Cummins/Komatsu Arrangements.   We have formed a broad relationship with Komatsu Ltd., including three joint ventures and numerous exclusive supply arrangements. Two joint ventures were formed in 1992, one to manufacture Cummins B Series engines in Japan, the other to build high-horsepower Komatsu-designed engines in the U.S., Cummins Komatsu Engine Corporation (CKEC). In 1997, we established a third joint venture in Japan to design the next generation of industrial engines. Effective March 28, 2004, we adopted the provisions of FIN 46R for CKEC and its results are now consolidated in our Consolidated Financial Statements (see Note 2 to the Consolidated Financial Statements).

·       Cummins/Dongfeng Joint Ventures.   In 1985, we licensed Dongfeng Motor Company (Dongfeng), the second largest truck manufacturer in China, to manufacture Cummins B Series engines. In 1993, Dongfeng established a subsidiary, Dongfeng Automotive Corporation (DFAC), which became the licensee. In 1995, we partnered with DFAC and formed a joint venture, DCEC, for the production of our C Series engines. In 1998, we established a wholly-owned subsidiary, Cummins (Xiangfan) Machining Company Ltd. (CXMC), in an adjacent facility to DCEC to manufacture B Series cylinder blocks and cylinder heads. In April 2003, the assets of DFAC’s B series manufacturing entity and the assets of CXMC were invested into the existing joint venture, DCEC. The expanded joint venture, with annual capacity of approximately 130,000 units, produces Cummins B, C and L series four-to nine-liter mechanical engines and will produce full-electronic diesel engines with a power range from 100 to 370 horsepower beginning in 2006. In 2004, Cummins invested a B series connecting rod machining line into CXMC to supply DCEC. We also have a joint venture with Dongfeng that manufactures filtration systems, Shanghai Fleetguard Filter Co., Ltd and in 2005 expanded the relationship to include exhaust systems. In 2003, Nissan Motor Co., Ltd. acquired 50 percent ownership of Dongfeng. In 2004, we signed a joint venture agreement with DCEC for a research facility in China that is expected to open in mid-2006. The facility will provide engineering and technical services for the full range of Cummins products manufactured in China, including diesel and natural gas engines, power generators, turbochargers and filtration products. In late 2005, the Cummins Westport (CWI) joint venture engaged DCEC to produce the CWI natural gas engines in China.

·       Tata Group Joint Ventures.   In 1992, we formed a joint venture with Tata Motors Ltd., the largest automotive company in India and a member of the Tata group of companies. The joint venture, Tata Cummins Limited, manufactures the Cummins B Series engine in India for use in trucks manufactured by Tata Motors, as well as for various Cummins industrial and power generation applications.  Holset Engineering Company Ltd., one of our wholly-owned subsidiaries, also formed a joint venture for the manufacturer of turbochargers, Tata Holset Ltd.

·       Chongqing Cummins.   In 1995, we formed a joint venture with China National Heavy-Duty Truck Corporation in Chongqing, China. The shares of this venture are now owned jointly by us and the Chongqing Heavy Duty Vehicle Group. The joint venture, Chongqing Cummins Engine Company Ltd. (CCEC), manufactures several models of our heavy-duty and high-horsepower diesel engines in China.

·       Shaanxi/Cummins.   In 2005, we formed the Xian Cummins Engine Company (XCEC) joint venture with Shaanxi Heavy Vehicle Group Co., and Shaanxi Heavy Duty Truck Co., Ltd. in Xian, China. The joint venture will manufacture the Cummins ISM heavy-duty diesel engine for use in Shaanxi trucks and for sale to outside customers.

·       The European Engine Alliance (EEA).   The EEA was established in 1996 as a joint venture between our Company and two Fiat Group companies, Iveco N.V. (trucks and buses) and CNH Global (agricultural and construction equipment), to develop a new generation of 4, 5 and 6-liter engines based on our 4B and 6B Series engines.

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·       Cummins/Scania Joint Ventures.   In 1999, we formed a joint venture with Scania to produce fuel systems for heavy-duty diesel engines. We own 70 percent of this joint venture and its results are included in our Consolidated Financial Statements. In August 2005, we signed a joint venture agreement with Scania to produce the next generation fuel systems for heavy-duty on-highway trucks.  This joint venture, Cummins-Scania XPI Manufacturing LLP, is a 50-50 joint venture that builds upon other Cummins-Scania partnerships.

·       Cummins/Westport Joint Venture.   In 2001, we formed a joint venture with Westport Innovations Inc., located in British Columbia, Canada, to develop and market low-emissions, high-performance natural gas engines for on-highway, industrial and power generation markets. In 2003, the joint venture agreement was modified to focus the joint ventures’ efforts on the marketing and sale of automotive spark-ignited natural gas engines worldwide. The new agreement also provides for joint technology projects between Westport and Cummins on low-emission technologies of mutual interest.

·       Newage AVK/SEG Joint Venture.   In 2001, Newage International Ltd., which operates within our Power Generation segment, formed a joint venture with AVK/SEG Holding GmbH & Co. KG, a German holding company that directly owned shares of AVK and SEG, which manufactured alternators and power electronics, respectively. Effective March 28, 2004, we adopted the provisions of FIN 46R for AVK/SEG and its results are now consolidated in our Consolidated Financial Statements. In the second quarter of 2004, AVK/SEG was liquidated and we now own 100 percent of AVK. As a result of events that occurred in 2004 and 2005, we now own 51 percent of SEG.

·       Cummins MerCruiser Diesel Marine LLC.   In 2002, we formed a joint venture with Mercury Marine, a division of Brunswick Corporation, to develop, manufacture and sell recreational marine diesel products, including engines, sterndrive packages, inboard packages, instrument and controls, service systems and replacement and service parts and assemblies, complete integration systems and other related products.

In addition to these primary joint ventures and agreements, we also have equity interests in several of our North American distributors who distribute the full range of our products and services to customers and end-users. We have also entered into numerous joint ventures around the world where we provide engine components, such as turbochargers, alternators and filtration products. In Turkey, we have a license agreement with BMC Sanayi that provides for the manufacture and sale of our B and C Series engines. We will continue to evaluate joint venture and partnership opportunities in order to penetrate new markets, develop new products and generate manufacturing and operational efficiencies.

Financial information about our investments in joint ventures and alliances is incorporated by reference from Notes 1, 2 and 3 to the Consolidated Financial Statements. Financial information about geographic areas is incorporated by reference from Note 19 to the Consolidated Financial Statements.

EMPLOYEES

As of December 31, 2005, we employed approximately 33,500 persons worldwide.

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ENVIRONMENTAL COMPLIANCE

Product Environmental Compliance

Our engines are subject to extensive statutory and regulatory requirements that directly or indirectly impose standards governing emissions and noise. Our products comply with emissions standards that the EPA, the California Air Resources Board (CARB) and other state regulatory agencies, as well as other regulatory agencies around the world, have established for heavy-duty on-highway diesel and gas engines and off-highway engines produced through 2005. Our ability to comply with these and future emissions standards is an essential element in maintaining our leadership position in regulated markets. We have made, and will continue to make, significant capital and research expenditures to comply with these standards. Failure to comply with these standards could result in adverse effects on our future financial results.

EPA Engine Certifications

In the fourth quarter of 2002, we implemented new on-road emissions standards. These were implemented in accordance with the terms of a 1998 consent decree that we and a number of other engine manufacturers entered into with the EPA, the U.S. Department of Justice (DOJ) and CARB. The consent decree was in response to concerns raised by these agencies regarding the level of nitrogen oxide emissions from heavy-duty diesel engines. Engines sold through 2005 are still subject to these emissions levels, and will continue to be until January 1, 2007, when new standards come into effect.

The consent decree also required us to pull forward by one year (to January 1, 2005) the implementation of Tier III emissions standards for off-road engines in the 300 to 749 horsepower range. This development was finished early in 2004 and all testing and EPA/CARB certification was concluded. Sales of these engines commenced January 1, 2005.

Federal and California regulations require manufacturers to report failures of emissions-related components to the EPA and CARB when the failure rate reaches a specified level. At higher failure rates, a product recall may be required. In 2005, we submitted 128 reports to the EPA relating to 44 different defects affecting EGR valves, fan speed software and data plates. None of these defects resulted in a campaign of a material nature.

Emissions standards in international markets, including Europe and Japan, are becoming more stringent. We believe that our experience in meeting U.S. emissions standards leaves us well positioned to take advantage of opportunities in these markets as the need for emissions control capability grows.

In December 2003, we announced that we will meet the 2007 U.S. EPA heavy-duty on-highway emissions standards by combining our existing cooled Exhaust Gas Recirculation (EGR) technology with particulate matter (PM) filters. Cooled EGR is the same technology that we have used since April 2002 and was selected after reviewing other aftertreatment technologies such as NOx adsorbers and selective catalytic reduction (SCR). Our experience with particulate filters and the availability of ultra-low-sulfur diesel fuel combine to give us the confidence in meeting these tough standards in the U.S. Additionally, while we believe the EGR/PM filter combination is the right solution for 2007 in the U.S., we have selected SCR as the right technology to meet on-highway Euro IV emissions standards and certain off-highway applications.

Other Environmental Statutes and Regulations

We believe we are in compliance in all material respects with laws and regulations applicable to our plants and operations. During the last five years, expenditures for environmental control activities and environmental remediation projects at our facilities in the U.S. have not been a substantial portion of annual capital outlays and are not expected to be material in 2006.

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Pursuant to notices received from federal and state agencies and/or defendant parties in site environmental contribution actions, we have been identified as a Potentially Responsible Party (PRP) under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended or similar state laws, at approximately 16 waste disposal sites. Based upon our experiences at similar sites we believe that our aggregate future remediation costs will not be significant. We have established accruals that we believe are adequate for our expected future liability with respect to these sites.

Item 1A.                Risk Factors Relating to Our Business

Set forth below and elsewhere in this Annual Report on Form 10-K are some of the principal risks and uncertainties that could cause our actual business results to differ materially from any forward-looking statements contained in this Report. In addition, future results could be materially affected by general industry and market conditions, changes in laws or accounting rules, general U.S. and non-U.S. economic and political conditions, including a global economic slow-down, fluctuation of interest rates or currency exchange rates, terrorism, political unrest or international conflicts, political instability or major health concerns, natural disasters or other disruptions of expected economic and business conditions. These risk factors should be considered in addition to our cautionary comments concerning forward-looking statements in this Report, including statements related to markets for our products and trends in our business that involve a number of risks and uncertainties. Our separate section in Item 7 below, “Disclosure Regarding Forward-Looking Statements,” should be considered in addition to the following statements.

Our business is affected by the cyclical nature of the markets we serve.

Our financial performance depends, in large part, on varying conditions in the markets and geographies that we serve. Demand in these markets and geographies fluctuates in response to overall economic conditions and is particularly sensitive to changes in interest rate levels and fuel costs. Our sales are also impacted by OEM inventory levels and production schedules and stoppages. Economic downturns in the markets we serve generally result in reductions in sales and pricing of our products, which could reduce future earnings and cash flow.

Our products are subject to substantial government regulation.

Our engines are subject to extensive statutory and regulatory requirements governing emissions and noise, including standards imposed by the EPA, state regulatory agencies, such as the CARB, and other regulatory agencies around the world. In some cases, we may be required to develop new products to comply with new regulations, particularly those relating to air emissions. For example, under the terms of a consent decree that we and a number of other engine manufacturers entered into with the DOJ, the CARB and the EPA, we were required to develop new engines to comply with stringent emissions standards by October 1, 2002. While we were able to meet this deadline, our ability to comply with other existing and future regulatory standards will be essential for us to maintain our position in the engine markets we serve. Currently, we believe we are on schedule to meet all deadlines for known future regulatory standards.

We have made, and will be required to continue to make, significant capital and research expenditures to comply with these regulatory standards. Further, the successful development and introduction of new and enhanced products are subject to risks, such as delays in product development, cost over-runs and unanticipated technical and manufacturing difficulties. Any failure to comply with regulatory standards affecting our products could subject us to fines or penalties, and could require us to cease production of any non-compliant engine or to recall any engines produced and sold in violation of the applicable standards. See “Business—Environmental Compliance—Product Environmental Compliance” for a complete discussion of the environmental laws and regulations that affect our products.

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Our products are subject to recall for performance related issues.

We are at risk for product recall costs. Product recall costs are costs incurred when we decide, either voluntarily or involuntarily, to recall a product through a formal campaign to solicit the return of specific products due to a known or suspected performance issue. Costs typically include the cost of the product, part or component being replaced, customer cost of the recall and labor to remove and replace the defective part or component. When a recall decision is made, we estimate the cost of the recall and record a charge to earnings in that period in accordance with FASB Statement of Financial Accounting Standards (SFAS) No. 5,  “Accounting for Contingencies.”  In making this estimate, judgment is required as to the quantity or volume to be recalled, the total cost of the recall campaign, the ultimate negotiated sharing of the cost between us and the customer and, in some cases, the extent to which the supplier of the part or component will share in the recall cost. As a result, these estimates are subject to change.

We cannot assure that our truck manufacturers and OEM customers will continue to outsource their engine supply needs.

Some of our engine customers, including Volvo and DaimlerChrysler, are truck manufacturers or OEMs that manufacture engines for their own products. Despite their engine manufacturing abilities, these customers have chosen to outsource certain types of engine production to us due to the quality of our engine products and in order to reduce costs, eliminate production risks and maintain company focus. However, we cannot assure that these customers will continue to outsource engine production in the future. Increased levels of production insourcing could result from a number of factors, such as shifts in our customers’ business strategies, acquisition by a customer of another engine manufacturer, the inability of third-party suppliers to meet product specifications and the emergence of low-cost production opportunities in foreign countries. Any significant reduction in the level of engine production outsourcing from our truck manufacturer or OEM customers could significantly impact our revenues and, accordingly, have a material adverse affect on our business, results of operations and financial condition.

Our largest customer accounts for a significant share of our business.

Sales to DaimlerChrysler accounted for approximately 12 percent of our consolidated net sales for 2005, primarily relating to sales of our ISB engine for use in the Dodge Ram truck and sales of our heavy-and medium-duty engines to its Freightliner division. While a significant amount of our sales to DaimlerChrysler are under long-term supply agreements, these agreements provide for the supply of DaimlerChrysler’s engine requirements for particular models and not a specific number of engines. Accordingly, the loss of DaimlerChrysler as a customer or a significant decline in the production levels for the vehicles in which DaimlerChrysler uses our products would have an adverse effect on our business, results of operations and financial condition.

Our manufacturing operations are dependent upon third-party suppliers, making us vulnerable to supply shortages.

We obtain materials and manufactured components from third-party suppliers. A significant number of our suppliers representing 75 to 85 percent of our total raw material and component purchasers in 2005 are the sole source for a particular supply item, although the majority of these materials and components can be obtained from other suppliers. Any delay in our suppliers’ abilities to provide us with necessary materials and components may affect our capabilities at a number of our manufacturing locations, or may require us to seek alternative supply sources. Delays in obtaining supplies may result from a number of factors affecting our suppliers including capacity constraints, labor disputes, the impaired financial condition of a particular supplier, suppliers’ allocations to other purchasers, weather emergencies or acts of war or terrorism. Any delay in receiving supplies could impair our ability to deliver products to our customers and, accordingly, could have a material adverse effect on our business, results of operations and financial condition.

20




We may be adversely impacted by work stoppages and other labor matters.

As of December 31, 2005, we employed approximately 33,500 persons worldwide. Approximately 12,500 of our employees worldwide are represented by various unions under collective bargaining agreements with various unions that expire between 2006 and 2010. While we have no reason to believe that we will be impacted by work stoppages and other labor matters, we cannot assure that future issues with our labor unions will be resolved favorably or that we will not encounter future strikes, further unionization efforts or other types of conflicts with labor unions or our employees. Any of these factors may have an adverse effect on us or may limit our flexibility in dealing with our workforce. In addition, many of our customers have unionized work forces. Work stoppages or slow-downs experienced by our customers could result in slow-downs or closures at vehicle assembly plants where our engines are installed. If one or more of our customers experience a material work stoppage, it could have a material adverse effect on our business, results of operations and financial condition.

Our products involve risks of exposure to product liability claims.

We face an inherent business risk of exposure to product liability claims in the event that our products’ failure to perform to specifications results, or is alleged to result, in property damage, bodily injury and/or death. We may experience material product liability losses in the future. While we maintain insurance coverage with respect to certain product liability claims, we may not be able to obtain such insurance on acceptable terms in the future, if at all, and any such insurance may not provide adequate coverage against product liability claims. In addition, product liability claims can be expensive to defend and can divert the attention of management and other personnel for significant periods of time, regardless of the ultimate outcome. An unsuccessful defense of a product liability claim could have a material adverse affect on our business, results of operations and financial condition and cash flows. In addition, even if we are successful in defending against a claim relating to our products, claims of this nature could cause our customers to lose confidence in our products and our Company.

Our operations are subject to extensive environmental laws and regulations.

Our plants and operations are subject to increasingly stringent environmental laws and regulations in all of the countries in which we operate, including laws and regulations governing emissions to air, discharges to water and the generation, handling, storage, transportation, treatment and disposal of waste materials. While we believe that we are in compliance in all material respects with these environmental laws and regulations, we cannot assure that we will not be adversely impacted by costs, liabilities or claims with respect to existing or subsequently acquired operations, under either present laws and regulations or those that may be adopted or imposed in the future. We are also subject to laws requiring the cleanup of contaminated property. If a release of hazardous substances occurs at or from any of our current or former properties or at a landfill or another location where we have disposed of hazardous materials, we may be held liable for the contamination, and the amount of such liability could be material.

We are exposed to political, economic and other risks that arise from operating a multinational business.

Approximately 51 percent of our net sales for 2005 were derived from sources outside the United States. Accordingly, our business is subject to the political, economic and other risks that are inherent in operating in numerous countries. These risks include:

·       the difficulty of enforcing agreements and collecting receivables through foreign legal systems;

·       trade protection measures and import or export licensing requirements;

·       tax rates in certain foreign countries that exceed those in the United States and the imposition of withholding requirements on foreign earnings;

·       the imposition of tariffs, exchange controls or other restrictions;

21




·       difficulty in staffing and managing widespread operations and the application of foreign labor regulations;

·       required compliance with a variety of foreign laws and regulations; and

·       changes in general economic and political conditions in countries where we operate, particularly in emerging markets.

As we continue to expand our business globally, our success will depend, in part, on our ability to anticipate and effectively manage these and other risks. We cannot assure that these and other factors will not have a material adverse affect on our international operations or on our business as a whole.

We are subject to currency exchange rate and other related risks.

We conduct operations in many areas of the world involving transactions denominated in a variety of currencies. We are subject to currency exchange rate risk to the extent that our costs are denominated in currencies other than those in which we earn revenues. In addition, since our financial statements are denominated in U.S. dollars, changes in currency exchange rates between the U.S. dollar and other currencies have had, and will continue to have, an impact on our earnings. While we customarily enter into financial transactions to address these risks, we cannot assure that currency exchange rate fluctuations will not adversely affect our results of operations and financial condition. In addition, while the use of currency hedging instruments may provide us with protection from adverse fluctuations in currency exchange rates, by utilizing these instruments we potentially forego the benefits that might result from favorable fluctuations in currency exchange rates.

We also face risks arising from the imposition of exchange controls and currency devaluations. Exchange controls may limit our ability to convert foreign currencies into U.S. dollars or to remit dividends and other payments by our foreign subsidiaries or businesses located in or conducted within a country imposing controls. Currency devaluations result in a diminished value of funds denominated in the currency of the country instituting the devaluation. Actions of this nature, if they occur or continue for significant periods of time, could have an adverse effect on our results of operations and financial condition in any given period.

We face significant competition in the markets we serve.

The markets in which we operate are highly competitive. We compete worldwide with a number of other manufacturers and distributors that produce and sell similar products. Our products primarily compete on the basis of price, performance, fuel economy, speed of delivery, quality and customer support. There can be no assurance that our products will be able to compete successfully with the products of these other companies. Any failure by us to compete effectively in the markets we serve could have a material adverse effect on our business, results of operations and financial condition. For a more complete discussion of the competitive environment in which each of our segments operates, see “Business—Our Operating Segments.”

Item 1B.               Unresolved Staff Comments

None.

Item 2.                        Properties

Our worldwide manufacturing facilities occupy approximately 15 million square feet, including approximately nine million square feet in the U.S. Principal manufacturing facilities in the U.S. include our plants in Southern Indiana, Wisconsin, New York, Iowa, Tennessee, Georgia, Ohio and Minnesota, as well as an engine manufacturing facility in North Carolina, which is operated in partnership with CNH Global N. V.

22




Manufacturing facilities outside of the U.S. include facilities located in the U.K., Brazil, India, Mexico, Canada, France, China, South Africa and Australia. In addition, engines and engine components are manufactured by joint ventures or independent licensees at manufacturing plants in the U.K., France, China, India, Japan, Pakistan, South Korea, Turkey and Indonesia.

Item 3.                        Legal Proceedings

We are, at any one time, party to a number of lawsuits or subject to claims arising out of the ordinary course of our business, including actions related to product liability, patent, trademark or other intellectual property infringement, contractual liability, workplace safety and environmental claims and cases, some of which involve claims for substantial damages. We and our subsidiaries are currently defendants in a number of pending legal actions, including actions related to use and performance of our products. While we carry product liability insurance covering significant claims for damages involving personal injury and property damage, we cannot assure that such insurance would fully cover the costs associated with a judgment against us with respect to these claims. We also establish reserves for matters in which losses are probable and can be reasonably estimated. We have also been identified as a PRP at 16 waste disposal sites under federal and state environmental statutes, three of which we expect could result in monetary sanctions, exclusive of interest and costs, of $100,000 or more based upon our estimated proportional volume of waste disposed at these sites. These sites and our estimated exposure are as follows: the Operating Industries, Inc. Site in Monterey Park, CA ($211,000), the Casmalia Site in Santa Barbara, CA ($150,000) and the Double Eagle Refinery Site in Oklahoma City, OK ($100,000). In addition to these three sites, we have been contacted as a possible PRP at 13 other sites. At several of these sites, we have had no follow-up contact from the relevant regulatory agencies since an initial communication in the early to mid-1990s. We believe our liability at these 13 other sites would be de minimis absent the imposition of liabilities that otherwise would be the responsibility of other PRPs. More information with respect to our environmental exposure can be found under “Environmental Compliance-Other Environmental Statutes and Regulations.” We deny liability with respect to many of these legal actions and environmental proceedings and are vigorously defending such actions or proceedings. While we have established accruals that we believe are adequate for our expected future liability with respect to our pending legal actions and proceedings, we cannot assure that our liability with respect to any such action or proceeding would not exceed our established accruals. Further, we cannot assure that litigation having a material adverse affect on our financial condition will not arise in the future.

Item 4.                        Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of our security holders during the last quarter of the year ended December 31, 2005.

23




PART II

Item 5.                        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

(a)   Our common stock, par value $2.50 per share, is listed on the NYSE and the Pacific Stock Exchange under the symbol “CMI.” For information about the quoted market prices of our common stock, information regarding dividend payments and the number of common stock shareholders, see Selected Quarterly Financial Data on page 122 of this report. For other matters related to our common stock and shareholders’ equity, see Notes 14 and 17 to the Consolidated Financial Statements.

(b)   Use of proceeds—not applicable.

(c)   The following information is provided pursuant to Item 703 of Regulation S-K:

 

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

Period

 

(a) Total
Number of
Shares
Purchased

 

(b) Average
Price Paid
per Share

 

(c) Total Number of
Shares Purchased
as Part of Publicly
Announced
Plans or Programs

 

(d) Maximum
Number of Shares
that May Yet Be
Purchased Under the
Plans or Programs

 

September 26–October 23, 2005

 

 

 

 

 

$

 

 

 

 

 

 

2,498,100

 

 

October 24–November 20, 2005

 

 

75,400

 

 

 

86.33

 

 

 

75,000

 

 

 

2,423,100

 

 

November 21–December 31, 2005

 

 

358,745

 

 

 

87.92

 

 

 

357,600

 

 

 

2,065,500

 

 

Total

 

 

434,145

 

 

 

$

87.64

 

 

 

432,600

 

 

 

 

 

 

 

In a series of authorizations beginning in 1994, our Board of Directors authorized the purchase of up to 8 million shares of Cummins common stock in the open markets. In September of 2005, our Board of Directors ratified all prior authorizations for the repurchase of Cummins common stock and we publicly announced our intention to purchase, at prices to be determined, approximately $100 million of our common stock over the next two years. At the time of the ratification and announcement, approximately 2.5 million shares were eligible to be repurchased.

During the fourth quarter of 2005, 1,545 shares were repurchased from employees in connection with the Company’s Key Employee Stock Investment Plan which allows certain employees, other than officers, to purchase shares of common stock of the Company on an installment basis up to an established credit limit. Loans are issued for five-year terms at a fixed interest rate established at the date of purchase and may be refinanced after its initial five-year period for an additional five-year period. Participants must hold shares for a minimum of six months from date of purchase and after shares are sold, must wait six months before another share purchase may be made. There is no maximum amount of shares that the Company may purchase under this plan.

According to our bylaws, we are not subject to the provisions of the Indiana Control Share Act. However, we are governed by certain other laws of the State of Indiana applicable to transactions involving a potential change of control of the Company.

24




Item 6.                        Selected Financial Data

The selected financial information presented below for the five year period ended December 31, 2005, was derived from our Consolidated Financial Statements. This information should be read in conjunction with the Consolidated Financial Statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

 

For the years ended December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

Millions, except per share

 

Consolidated Statements of Earnings Data

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

9,918

 

$

8,438

 

$

6,296

 

$

5,853

 

$

5,681

 

Gross margin

 

2,186

 

1,680

 

1,123

 

1,045

 

1,013

 

Investee equity, royalty and other income

 

131

 

120

 

74

 

29

 

10

 

Restructuring, impairment and other charges and (credits) 

 

 

 

 

(8

)

126

 

Interest expense

 

109

 

111

 

90

 

61

 

77

 

Dividends on preferred securities of subsidiary trust

 

 

 

11

 

21

 

11

 

Earnings (loss) before cumulative effect of change in accounting principles

 

550

 

350

 

54

 

79

 

(103

)

Net earnings (loss)

 

550

 

350

 

50

 

82

 

(103

)

Earnings (loss) per share before cumulative effect of change in accounting principles:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

12.43

 

$

8.30

 

$

1.37

 

$

2.06

 

$

(2.70

)

Diluted

 

11.01

 

7.39

 

1.36

 

2.06

 

(2.70

)

Net earnings (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

12.43

 

$

8.30

 

$

1.28

 

$

2.13

 

$

(2.70

)

Diluted

 

11.01

 

7.39

 

1.27

 

2.13

 

(2.70

)

Dividends declared per share

 

1.20

 

1.20

 

1.20

 

1.20

 

1.20

 

Consolidated Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

6,885

 

$

6,510

 

$

5,126

 

$

4,837

 

$

4,311

 

Long-term debt

 

1,213

 

1,299

 

1,380

 

999

 

915

 

Mandatorily redeemable preferred securities

 

 

 

 

291

 

291

 

Shareholders’ equity

 

1,864

 

1,401

 

949

 

841

 

983

 

 

See Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Notes to Consolidated Financial Statements for a discussion of “Dividends on preferred securities of subsidiary trust,” “Long-term debt” and the “Cumulative effect of change in accounting principles.”

25




Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

Certain prior year amounts included in this section have been reclassified to conform to the current year presentation. All references to per share amounts are diluted per share amounts.

OVERVIEW

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with—our Consolidated Financial Statements and the accompanying notes to those financial statements. This overview summarizes the MD&A which includes the following sections:

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

·       Results of Operations—an analysis of our consolidated results of operations for the three years presented in our Consolidated Financial Statements.

·       Operating Segment Results and Outlook—an analysis of the performance of each of our reportable operating segments for each of the three years presented in our Consolidated Financial Statements and an analysis of the business outlook for each of those segments for the upcoming year.

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

·       Application of Critical Accounting Estimates—a summary of our critical accounting estimates and our policies relating to the application of those estimates.

·       Recently Adopted Accounting Pronouncements—a summary of newly adopted accounting pronouncements and their impact to our financial position, results of operations and cash flows.

·       Accounting Pronouncements Issued But Not Effective—A summary of recently issued accounting pronouncements which are not yet effective and we have not yet adopted.

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

26




EXECUTIVE SUMMARY AND FINANCIAL HIGHLIGHTS

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

Our 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 RVs, 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 selling engines, generator sets and alternators and providing rental of power equipment for both standby and prime power uses. The Components segment includes sales of filtration products, exhaust systems, turbochargers and fuel systems. The Distribution segment includes wholly-owned and partially-owned distributorships engaged in selling engines, generator sets, and service parts, 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 and the price of crude oil (fuel costs). OEM inventory levels, production schedules and work stoppages also impact our sales. Economic downturns in the markets we serve generally result in reduced sales, which affect our profits and cash flow.

27




We continued our strong performance in 2005 with record net sales and net earnings. Net earnings were $550 million, or $11.01 per diluted share, on sales of $9.9 billion, compared to 2004 net earnings of $350 million, or $7.39 per diluted share, on sales of $8.4 billion. The earnings improvement was driven by an 18 percent increase in net sales and a 30 percent increase in gross margin, as our segments continue to benefit from high levels of demand, pricing actions and our focus on cost improvements. All of our segments reported increased sales in 2005 with particularly strong demand in the North American heavy-duty truck market where engine sales increased 26 percent and total on-highway related sales accounted for 47 percent of the increase in sales as our market share continues to strengthen compared to a year ago. Our joint ventures and equity method investees contributed $131 million to our earnings in 2005 compared to $120 million in 2004, primarily due to an increase in equity earnings of $8 million from our North American distributors and an increase in equity earnings of $7 million from CCEC, offset by a decrease in equity earnings of $7 million from DCEC. Overall, 2005 was an exceptionally strong financial year for Cummins and we believe the programs we have in place position us for another year of growth in sales and profitability in 2006.

 

 

Years ended December 31,

 

 

 

2005

 

2004

 

2003

 

 

 

Millions

 

Consolidated Results

 

 

 

 

 

 

 

Net sales

 

$

9,918

 

$

8,438

 

$

6,296

 

Gross margin

 

2,186

 

1,680

 

1,123

 

Investee equity, royalty and other income

 

131

 

120

 

74

 

Operating earnings

 

894

 

539

 

163

 

Net earnings

 

550

 

350

 

50

 

Diluted earnings per share

 

$

11.01

 

$

7.39

 

$

1.27

 

 

During 2005, we continued to strengthen our balance sheet, improve our cost structure and diversify our geographic markets. Some of the transactions and events that highlight this are as follows:

·  In February 2005, we signed a feasibility study agreement with Shaanxi Automobile Group Company Ltd. on the formation of a joint venture to produce Cummins ISM 11-liter heavy-duty engine in China. In September 2005, we signed an agreement to form a 50/50 joint venture company, Xi’an Cummins Engine Company, to produce the Cummins ISM engine in Xi’an, the capital city of western China’s Shaanxi Province. Under the terms of the agreement, the partners will invest $24 million in the joint venture. Construction of the manufacturing facility began in the fourth quarter of 2005 with production expected to start in the fourth quarter of 2006.

·  In March 2005, we repaid our $225 million 6.45% notes on their maturity date from available cash. The notes were issued in 1998. The payment had the impact of reducing our debt-to-capital ratio by 3.7 percentage points, and a reduction in our annual interest expense of approximately $7 million, net of a pre-tax gain related to the early termination of an interest rate swap agreement.

·  In May 2005, we undertook a strategic reorganization designed to further promote execution and growth among Cummins operating segments. As a result of the reorganization, certain changes were required in the presentation of our segment information.  Specifically, the fuel systems business was moved from the Engine segment to the Filtration and Other segment, which was renamed the Components segment. Results of our North American distribution business, previously reported in the Engine segment and the Power Generation segment, were combined with the International Distributor segment and renamed the Distribution segment. Prior period segment results were restated to conform to the new reorganization beginning with the second quarter.

28




·  In September 2005, we announced our intention to repay our $250 million 9.5% notes in December 2006, the first call date for the debt. The notes were issued in November 2002 and are expected to be repaid using cash generated from operations. In addition, we also announced our intention to repurchase up to $100 million of our common stock. As of December 31, 2005, we had repurchased $38 million of our common stock under this program.

·  During 2005, we made contributions of approximately $151 million to our pension plans.

·  During 2005, we reduced our annual tax expense by $16 million of tax benefits on dividend distributions from foreign operations which qualify for a special one-year 85-percent deduction under the American Jobs Creation Act of 2004 (Jobs Act.)

RESULTS OF OPERATIONS

2005 vs. 2004

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

 

 

Millions

 

 

 

Net sales

 

$

9,918

 

$

8,438

 

 

$

1,480

 

 

 

18

%

 

Cost of sales

 

7,732

 

6,758

 

 

974

 

 

 

14

%

 

Gross margin

 

2,186

 

1,680

 

 

506

 

 

 

30

%

 

Operating expenses and income

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling and administrative expenses

 

1,145

 

1,015

 

 

130

 

 

 

13

%

 

Research and engineering expenses

 

278

 

241

 

 

37

 

 

 

15

%

 

Investee equity, royalty and other income

 

(131

)

(120

)

 

(11

)

 

 

9

%

 

Other operating expenses

 

 

5

 

 

(5

)

 

 

100

%

 

Operating earnings

 

894

 

539

 

 

355

 

 

 

66

%

 

Interest income

 

(24

)

(12

)

 

(12

)

 

 

100

%

 

Interest expense

 

109

 

111

 

 

(2

)

 

 

2

%

 

Other expenses

 

11

 

8

 

 

3

 

 

 

38

%

 

Earnings before income taxes and minority interests

 

798

 

432

 

 

366

 

 

 

85

%

 

Provision for income taxes

 

216

 

56

 

 

160

 

 

 

NM

 

 

Minority interests in earnings of consolidated subsidiaries

 

32

 

26

 

 

6

 

 

 

23

%

 

Net earnings

 

$

550

 

$

350

 

 

$

200

 

 

 

57

%

 

 

Net Sales

Net sales increased in all segments with the primary driver being a $1,233 million, or 23 percent, increase in Engine sales due to strong demand from heavy- and medium-duty truck OEMs, higher engine volumes for industrial and stationary power applications and increased shipments of light-duty engines. Engine and part sales to on-highway markets were 20 percent higher compared to last year with increased volumes in all market segments. Power Generation sales increased $157 million, or 9 percent, due to increased demand for commercial generator sets, generator drives, and alternators, partially offset by a moderate decrease in rental revenue and a slight decrease in sales to the consumer market. Components sales increased $217 million, or 12 percent, primarily reflecting increased demand from first-fit OEMs and the aftermarket channel. Distribution sales increased $218 million, or 22 percent, primarily due to increased demand for engines and power generation products internationally and sales growth from distributor acquisitions. See our “Operating Segment Results and Outlook” section for further details on sales by segment.

29




Gross Margin

Gross margin improved primarily due to increased sales, the related absorption benefits on fixed manufacturing costs, and changes in sales mix, all of which increased gross margin by $453 million. In addition, pricing actions of $145 million in the current year enabled us to more than offset the increased material costs of steel and other commodities of $130 million. Other factors which impacted gross margin to a lesser extent were slightly increased warranty costs, the favorable impact of currency exchange rates and other miscellaneous cost reductions. As a result of the foregoing, gross margin percentage increased to 22.0 percent in 2005 from 19.9 percent in 2004.

Warranty expense as a percent of sales decreased slightly to 2.7 percent in 2005 compared to 3.1 percent in 2004.

Selling and Administrative Expenses

Selling and administrative expenses increased primarily due to higher compensation and related expenses of approximately $72 million, which included salaries, variable compensation and fringe benefits, as a result of improved financial performance of the company. In addition, incremental staffing added to the increased compensation and related expenses. Shipping and handling costs increased by approximately $11 million due to increased sales volumes. Other factors increasing selling and administrative to a lesser extent included marketing and administrative expenses, consulting fees and other outside services, which combined accounted for $23 million of the increase.  Overall selling and administrative expenses were 11.5 percent of sales in 2005 compared to 12.0 percent of sales in 2004.

Research and Engineering Expenses

Research and engineering expenses increased primarily due to increased compensation expense and consulting and outside services, as well as higher spending on prototype development programs for future products. The Engine segment accounted for $38 million of the increase in research and engineering expenses along with a slight increase in the Components segment, offset by a slight decrease in the Power Generation segment. Other miscellaneous research and development expenses increased as well, however they were not significant individually or in the aggregate.

Investee Equity, Royalty and Other Income

Investee equity, royalty and other income increased primarily due to improved earnings from our North American distributors of $8 million and improved earnings from CCEC of $7 million. These increases were partially offset by decreased earnings from DCEC of $7 million due to reduced demand in China’s truck market in response to regulatory changes.

Other Operating Expense

The major components of other operating expenses are royalty income, amortization of intangible assets and loss on sale of fixed assets. The fluctuation from 2004 to 2005 was primarily due to a decrease in the loss on sale of fixed assets.

Interest Income

Interest income increased primarily due to higher average cash balances in 2005 compared to 2004. The increased cash balances are due to increased earnings and stronger cash flows from operations in 2005.

30




Interest Expense

Interest expense decreased slightly due to a combination of factors. Interest expense on debt in the current year was lower due to the repayment of long-term debt in the first quarter. The lower interest expense on debt was partially offset by increased interest expense on capital leases related to power generation equipment due to the conversion of operating leases to capital leases in late 2004.

Other Expense

The major components of other expense include foreign currency exchange gains and losses, bank charges and other miscellaneous expenses. The increase in other expense in 2005 compared to 2004 is primarily due to an increase in foreign currency exchange losses and a decrease in the gain on sale of marketable securities. These increases to other expense were partially offset by write-downs of investments in 2004 that did not recur in 2005.

Provision for Income Taxes

The higher 2005 tax provision reflects the increase in earnings before taxes. Our effective tax rate is normally below the U.S. corporate income tax rate of 35 percent, primarily because of research tax credits and reduced taxes on export earnings. Our 2005 effective tax rate of 27 percent is below the statutory rate because of the following nonrecurring benefits:

·  The Jobs Act included a special one-year 85-percent dividend deduction for qualifying dividends repatriated from foreign operations in 2005. We used these one-time rules to reduce our 2005 income tax provision by $16 million.

·  During the fourth quarter of 2005, we had a favorable resolution of prior year tax positions which had been in dispute resulting in an $8 million reduction of our 2005 tax provision.

Excluding the unusual or nonrecurring benefits described above, our 2005 effective tax rate was 30 percent. This rate was lower than the 35 percent U.S. tax rate, primarily because of U.S. export tax benefits and research tax credits along with lower taxes on foreign earnings, especially foreign joint venture equity earnings recorded net of foreign taxes. We expect our 2006 effective tax rate to increase, but remain well below 35 percent. The Jobs Act phases out the export tax benefits (reduced 20 percent for 2005, 40 percent for 2006 and repealed thereafter) that have been a key factor in our low tax rate. Export benefits are replaced with a new U.S. manufacturer’s tax deduction which phases in beginning in 2005. However, we do not expect the manufacturer’s deduction to produce a comparable level of benefits.

Minority Interests in Earnings of Consolidated Subsidiaries

The increase in minority interests was primarily attributable to higher earnings at Cummins Eastern Canada LLP, a 51 percent owned-subsidiary and Cummins India Limited, a 51 percent owned-subsidiary. These two subsidiaries account for over seventy percent of the total minority interest in 2005. The remainder of the increase in minority interests was attributable to a combination of immaterial increases and decreases in earnings at the remaining consolidated subsidiaries.

31




2004 vs. 2003

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

 

 

Millions

 

 

 

Net sales

 

$

8,438

 

$

6,296

 

 

$

2,142

 

 

 

34

%

 

Cost of sales

 

6,758

 

5,173

 

 

1,585

 

 

 

31

%

 

Gross margin

 

1,680

 

1,123

 

 

557

 

 

 

50

%

 

Operating expenses and income

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling and administrative expenses

 

1,015

 

830

 

 

185

 

 

 

22

%

 

Research and engineering expenses

 

241

 

200

 

 

41

 

 

 

21

%

 

Investee equity, royalty and other income

 

(120

)

(74

)

 

(46

)

 

 

62

%

 

Other operating expenses

 

5

 

4

 

 

1

 

 

 

25

%

 

Operating earnings

 

539

 

163

 

 

376

 

 

 

NM

 

 

Interest income

 

(12

)

(13

)

 

1

 

 

 

8

%

 

Interest expense

 

111

 

90

 

 

21

 

 

 

23

%

 

Other expenses (income)

 

8

 

(5

)

 

13

 

 

 

NM

 

 

Earnings before income taxes, minority interests, dividends on preferred securities of subsidiary trust, and cumulative effect of change in accounting principles

 

432

 

91

 

 

341

 

 

 

NM

 

 

Provision for income taxes

 

56

 

12

 

 

44

 

 

 

NM

 

 

Minority interests in earnings of consolidated subsidiaries

 

26

 

14

 

 

12

 

 

 

86

%

 

Dividends on preferred securities of subsidiary trust

 

 

11

 

 

(11

)

 

 

100

%

 

Earnings before cumulative effect of change in accounting principles

 

350

 

54

 

 

296

 

 

 

NM

 

 

Cumulative effect of change in accounting principles, net of tax

 

 

(4

)

 

4

 

 

 

100

%

 

Net earnings

 

$

350

 

$

50

 

 

$

300

 

 

 

NM

 

 

 

Net Sales

All segments experienced strong increases in sales with the primary driver being a $1,842 million, or 51 percent increase, in Engine sales due to strong demand from heavy- and medium-duty truck OEMs, increased shipments of light-duty engines, and higher engine shipments to industrial OEMs. Engine and parts sales to on-highway markets were 41 percent higher than 2003 with increased shipments in all market segments, except bus applications. Power Generation sales increased $513 million, or 39 percent, due to increased demand for generator sets and alternators in international markets, as well as continued robust demand for RV and other consumer power generation products. Components sales increased $491 million, or 38 percent, primarily because of increased demand from North American OEMs, and Distribution sales increased $304 million, or 45 percent, primarily because of strong demand for power generation products. See our “Operating Segment Results and Outlook” section for further details on sales by segment.

Gross Margin

Gross margin increased primarily due to increased sales volume of $525 million and the related absorption benefits on fixed manufacturing costs of $125 million. These increases to gross margin were partially offset by increased warranty expenses of $69 million and higher material costs for steel and copper of $53 million. Other factors impacting gross margin to a lesser extent included favorable foreign currency translation and a one-time charge for inventory valuation. As a result of the foregoing, our gross margin percentage increased to 19.9 percent in 2004 from 17.8 percent in 2003.

32




Warranty expense as a percent of sales was relatively flat at 3.1 percent in 2004 compared to 3.0 percent in 2003.

Selling and Administrative Expenses

Selling and administrative expenses increased primarily due to higher compensation and related expenses of $111 million due to improved financial performance and increased marketing program expenses of $18 million. Other factors contributing to the increased selling and administrative expenses to a lesser extent were the unfavorable impact of fluctuating foreign exchange rates and increased consulting expenses, primarily Sarbanes-Oxley implementation costs. In addition, approximately $34 million of the increase in selling and administrative expenses resulted from consolidating entities under FIN 46R. Overall, selling and administrative expenses were 12.0 percent of sales in 2004 as compared to 13.2 percent of sales in 2003.

Research and Engineering Expenses

Research and engineering expenses increased primarily because of higher spending on 2005 and 2007 product development programs as well as increased compensation expense due to incremental staffing and increased variable compensation. Approximately $4 million of the increase in research and engineering expenses resulted from consolidating variable interest entities (VIEs) in 2004. There were increases in other general research and developmental expenses, none of which were significant.

Investee Equity, Royalty and Other Income

Investee equity, royalty and other income increased significantly, primarily due to improved earnings from our expanded joint venture in China, DCEC, where our earnings increased $19 million, and our North American distributor joint ventures, where earnings increased $9 million. We also saw increases to a lesser extent at our joint venture in India, Tata Cummins Ltd, and Cummins MerCruiser, our global marine joint venture.

Other Operating Expense

The major components of other operating expense are royalty income, amortization of intangible assets and loss on sale of fixed assets. The slight increase from 2003 to 2004 is primarily due to a combination of an increase in loss on sale of fixed assets and an increase in amortization of intangibles offset by an increase in royalty income as a result of increased sales volumes.

Interest Expense

Interest expense increased primarily due to the consolidation of VIEs in 2004 and the adoption of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150), which required prospective classification of dividends on our preferred securities as interest expense, and interest from capital leases for power generation equipment.

33




Other Expense (Income)

The major components of other expense (income) include impairment losses, foreign currency exchange gains and losses, bank charges, and other miscellaneous expenses. Other expense (income) fluctuated primarily due to an investment write-down in 2004.

Provision for Income Taxes

The higher 2004 tax provision reflects the increase in profit before taxes. Our effective tax rate is normally below the U.S. corporate income tax rate of 35 percent, primarily because of research tax credits and reduced taxes on export earnings. Our 2004 effective tax rate of 13 percent is also low not only because of the normal favorable effects of research credits and export tax benefits, but also because of the following nonrecurring benefits:

·       As a result of continued earnings improvement and improved economic outlook, we reassessed the treatment of 2002 and 2003 foreign tax credits previously recognized as tax deductions and determined they could be used as full tax credits. The more favorable treatment of these credits reduced our 2004 income tax provision by $25 million.

·       As a result of improved cash flow during 2004, we filed amended U.S. income tax returns to claim additional export tax benefits related to prior years which we had previously forgone to avoid the associated tax payments required on the non-exempt export income of our foreign sales corporation. These additional export tax benefits related to prior years reduced our 2004 income tax provision by $11 million.

·       The 2004 earnings improvement also caused us to reassess our ability to realize state tax benefits from net operating losses generated in prior years. Previously, we had provided a valuation allowance to reduce the recorded tax value of these loss carryforwards to a lower estimated realizable value. Our reassessment determined that $16 million of this allowance was no longer needed and was recorded as a reduction of our 2004 income tax expense.

·       In conjunction with our reassessment of the realizable value of state tax benefits, we also recognized a change in the estimated average state income tax rate used to value our deferred tax assets. This rate change reduced our 2004 income tax expense by $9 million.

Excluding the unusual or nonrecurring benefits described above, our 2004 effective tax rate was 27 percent. This rate was lower than the 35 percent U.S. tax rate, primarily because of export tax benefits and research tax credits generated by 2004 operations.

Minority Interests in Earnings of Consolidated Subsidiaries

Approximately one-half of the increase in minority interests in 2004 compared to 2003 resulted from higher earnings at Wuxi Holset Ltd , a 55 percent owned subsidiary, and Cummins India Limited. The remainder of the increase in minority interests is attributable to consolidating VIEs in 2004.

Dividends on Preferred Securities

Effective July 1, 2003, these dividends were prospectively classified as interest expense in our Consolidated Statements of Earnings in accordance with SFAS 150. A description of our obligation relating to these preferred securities is provided in Note 11 to the Consolidated Financial Statements.

Cumulative Effect of Change in Accounting Principles

In 2001, we entered into a sale-leaseback agreement whereby we sold and leased back heavy-duty engine manufacturing equipment from a grantor trust wholly-owned by a financial institution. In

34




December 2003, the grantor trust, which acts as a lessor in the sale-leaseback transaction, was consolidated when we adopted FASB Interpretation No. 46R, Consolidation of Variable Interest Entities,” (FIN 46R), issued by the Financial Accounting Standards Board (FASB). Under FIN 46R, the lessor trust was deemed a VIE and we were deemed the primary beneficiary of the trust by virtue of our guaranteeing the leased equipment’s residual value. Accordingly, we recorded the cumulative effect of consolidating the VIE in our Consolidated Financial Statements as a change in accounting principle as of December 31, 2003. See Note 2 to the Consolidated Financial Statements for a description of the change in accounting and Note 18 for a description of the original leasing transaction. The consolidation of the VIE did not impact our 2003 Consolidated Statements of Earnings, other than the cumulative effect at December 31, 2003, nor did it affect compliance with any of our debt covenants.

OPERATING SEGMENT RESULTS AND OUTLOOK

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 RVs, 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 selling engines, generator sets and alternators and providing rental of power equipment for both standby and prime power uses. The Components segment includes sales of filtration products, exhaust systems, turbochargers and fuel systems. The Distribution segment includes wholly-owned and partially-owned distributorships engaged in selling engines, generator sets, and service parts, performing service and repair activities on our products and maintaining relationships with various OEMs.

We use segment EBIT (defined as earnings (loss) before interest, taxes, minority interests, preferred dividends and cumulative effect of change in accounting principles) as a primary basis for the chief operating decision-maker to evaluate the performance of each of our operating segments. Segment amounts exclude certain expenses not specifically identifiable to segments.

The accounting policies of our operating segments are the same as those applied in the Consolidated Financial Statements. We prepared the financial results of our operating segments on a basis that is consistent with the manner in which we internally disaggregate financial information to assist in making internal operating decisions. We have allocated certain common costs and expenses, primarily corporate functions, among segments differently than we would for stand-alone financial information prepared in accordance with GAAP. These include certain costs and expenses of shared services, such as information technology, human resources, legal and finance. We also do not allocate debt-related items, minimum pension liabilities or income taxes to individual segments. Segment EBIT may not be consistent with measures used by other companies.

35




A summary of operating results by segment for the years ended December 31, is shown below:

 

 

Engine

 

Power
Generation

 

Components

 

Distribution

 

Eliminations

 

Total

 

 

 

Millions

 

2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

6,657

 

 

$

1,999

 

 

 

$

2,000

 

 

 

$

1,191

 

 

 

$

(1,929

)

 

$

9,918

 

Investee equity, royalty and other income

 

80

 

 

9

 

 

 

8

 

 

 

34

 

 

 

 

 

131

 

Segment EBIT

 

582

 

 

145

 

 

 

89

 

 

 

107

 

 

 

(16

)

 

907

 

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

5,424

 

 

$

1,842

 

 

 

$

1,783

 

 

 

$

973

 

 

 

$

(1,584

)

 

$

8,438

 

Investee equity, royalty and other income

 

80

 

 

6

 

 

 

9

 

 

 

25

 

 

 

 

 

120

 

Segment EBIT

 

328

 

 

60

 

 

 

84

 

 

 

79

 

 

 

(8

)

 

543

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

3,582

 

 

$

1,329

 

 

 

$

1,292

 

 

 

$

669

 

 

 

$

(576

)

 

$

6,296

 

Investee equity, royalty and other income

 

48

 

 

3

 

 

 

7

 

 

 

16

 

 

 

 

 

74

 

Segment EBIT

 

62

 

 

(19

)

 

 

86

 

 

 

51

 

 

 

1

 

 

181

 

 

The tables below reconcile the segment information to the corresponding amounts in the Consolidated Financial Statements:

 

 

Years ended December 31,

 

 

 

2005

 

2004

 

2003

 

 

 

Millions

 

Segment EBIT

 

$

907

 

$

543

 

$

181

 

Less:

 

 

 

 

 

 

 

Interest expense

 

109

 

111

 

90

 

Earnings before income taxes, minority interests, dividends on preferred securities of subsidiary trust and cumulative effect of change in accounting principle

 

$

798

 

$

432

 

$

91

 

 

We made certain leadership changes effective May 2, 2005, within our management team. In connection with these changes, certain modifications were made to our internal reporting. These modifications are summarized below:

·       The Filtration and Other segment was renamed the Components segment and now includes operating results of the fuel systems business which were previously included in the Engine segment. Historically, the fuel systems business transferred product within the Engine segment at cost. Beginning in the third quarter, those transfers now use a cost-plus based transfer price. As a result of this change, segment EBIT increased for the Components segment and decreased for the Engine segment but there was no impact to consolidated earnings. Revenues of the Components segment were also increased to reflect transfers to the Engine segment and eliminations were increased by a corresponding amount.

·       The North American distribution business was combined with the International Distribution segment and renamed the Distribution segment. Previously, the North American distribution business was reported in the Engine and Power Generation segments as equity from investees and included the results of a partially-owned distributor that is consolidated. As a result, revenues of the

36




Engine segment were increased to reflect sales to the consolidated distributor that were previously eliminated and decreased for the revenues of the consolidated distributor which are now included in the Distribution segment. In addition, this change also caused earnings from equity investees in the Engine and Power Generation segments to decrease while earnings from equity investees in the Distribution segment increased by a corresponding amount.

Due to the extent of intersegment sales activity and certain seasonality in inventory levels during the year, we have presented the elimination of intersegment profit in inventory resulting from intersegment transactions in the eliminations column of our segment reporting (see Note 19 to the Consolidated Financial Statements). This presentation better aligns segment revenues with segment costs and presents segment EBIT as if each segment was an independent, stand-alone entity.

The impact of the above changes on operating results and net assets by segment for each year is shown in the table below:

 

 

Engine

 

Power
Generation

 

Components

 

Distribution

 

Eliminations

 

 

 

Millions

 

 

 

Increase (decrease)

 

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

 

$

(76

)

 

 

$

(35

)

 

 

$

299

 

 

 

$

117

 

 

 

$

(305

)

 

Investee equity, royalty and other income

 

 

(16

)

 

 

(7

)

 

 

 

 

 

23

 

 

 

 

 

Segment EBIT

 

 

(11

)

 

 

(9

)

 

 

 

 

 

28

 

 

 

(8

)

 

Net assets

 

 

(193

)

 

 

(3

)

 

 

108

 

 

 

88

 

 

 

 

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

 

$

(49

)

 

 

$

 

 

 

$

236

 

 

 

$

 

 

 

$

(187

)

 

Investee equity, royalty and other income

 

 

(9

)

 

 

(4

)

 

 

 

 

 

13

 

 

 

 

 

Segment EBIT

 

 

(8

)

 

 

(4

)

 

 

 

 

 

11

 

 

 

1

 

 

Net assets

 

 

(155

)

 

 

(2

)

 

 

132

 

 

 

25

 

 

 

 

 

 

Prior to January 1, 2004, intersegment transfers between the Engine segment and the Power Generation segment and between the Components segment and the Engine segment were recorded at cost and a sale was not recorded by the transferor segment. Effective January 1, 2004, all intersegment sales of the transferor segments were recorded at a market-based transfer price discounted for certain items. Unit shipments are now also reflected in the sales volumes of the transferor segments. Certain intersegment cost allocations to the transferor segments have also been eliminated. In addition, certain engines manufactured by the Engine segment and sold to Distribution through Power Generation were previously recorded as a sale by Power Generation; however, under the new methodology Power Generation now records a sale commission on such sales. We believe this change allows our segment management to focus on those pricing decisions and cost structuring actions within their control. The impact of this change on 2004 segment results follows:

·       Engine net sales increased $502 million,

·       Components net sales increased $205 million,

·       Power Generation net sales decreased $44 million, and

·       Intersegment net sales eliminations increased $663 million.

The net impact of this change did not have a material effect on segment EBIT for any of our segments. Segment results for 2003 were not restated to reflect the change to market-based transfer pricing as it was impracticable to do so.

37




Engine Results and Outlook

2005 vs. 2004

The net sales, investee income and segment EBIT for Engine were as follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

Net sales

 

 

$

6,657

 

 

 

$

5,424

 

 

 

$

1,233

 

 

 

23

%

 

Investee equity, royalty and other income

 

 

80

 

 

 

80

 

 

 

 

 

 

 

 

Segment EBIT

 

 

582

 

 

 

328

 

 

 

254

 

 

 

77

%

 

Segment EBIT as a percentage of net sales

 

 

8.7

%

 

 

6.0

%

 

 

2.7 percentage points

 

 

The increase in net sales for this segment was primarily due to strong demand across all market sectors, particularly the light-duty automotive market with record engine sales to DaimlerChrysler, and the North American heavy-duty and medium-duty truck markets. Total on-highway-related engine sales were 63 percent of Engine segment net sales in 2005, compared with 65 percent in 2004.

The improvement in segment EBIT was primarily due to the higher engine volumes across all major markets, the accompanying gross margin benefits of higher absorption of fixed manufacturing costs, pricing and favorable foreign exchange impacts, all of which resulted in a two point improvement in gross margin percentage over 2004. Gross margin increased $344 million, or 38 percent, over 2004. Selling and administrative expenses increased $63 million, or 13 percent, over 2004, however selling and administrative expenses as a percentage of net sales improved almost a full percentage point. Research and engineering expenses increased $38 million, or 24 percent, compared to 2004 and remained flat as a percentage of net sales compared to the prior period.

In addition, earnings from joint ventures remained flat compared with 2004, due to higher earnings from several joint ventures, which were offset by a $7 million decrease in earnings at DCEC in reaction to changes in the regulatory environment.

A summary and discussion of Engine net sales by market follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

Heavy-duty truck

 

$

2,139

 

$

1,700

 

 

$

439

 

 

 

26

%

 

Medium-duty truck and bus

 

918

 

693

 

 

225

 

 

 

32

%

 

Light-duty automotive

 

1,164

 

1,129

 

 

35

 

 

 

3

%

 

Total on-highway

 

4,221

 

3,522

 

 

699

 

 

 

20

%

 

Industrial

 

1,791

 

1,380

 

 

411

 

 

 

30

%

 

Stationary power

 

645

 

522

 

 

123

 

 

 

24

%

 

Total net sales

 

$

6,657

 

$

5,424

 

 

$

1,233

 

 

 

23

%

 

 

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

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

Midrange

 

419,200

 

368,700

 

 

50,500

 

 

 

14

%

 

Heavy-duty

 

107,600

 

87,200

 

 

20,400

 

 

 

23

%

 

High-horsepower

 

14,400

 

12,100

 

 

2,300

 

 

 

19

%

 

Total unit shipments

 

541,200

 

468,000

 

 

73,200

 

 

 

16

%

 

 

38




Heavy-Duty Truck

The increase in sales to the heavy-duty truck market was primarily driven by the recovery in the North American truck market as OEMs increased build rates to meet the growing demand from truck fleets replacing aging equipment and adding capacity. Unit shipments of heavy-duty truck engines were up 27 percent in 2005, compared to 2004, with North American shipments up 26 percent and international shipments up 33 percent.

Medium-Duty Truck and Bus

The increase in medium-duty truck and bus revenues is due to increased shipments of medium-duty truck and bus engines in North America and internationally. Shipments of medium-duty truck engines were up 24 percent to North American OEMs and up 12 percent to international OEMs compared with 2004. The increase in medium-duty truck engine shipments was driven primarily by economic growth as demand in this market typically correlates with demand in the heavy-duty market. Sales of bus engines and parts increased in 2005 compared to 2004 due to strong demand from North American OEMs with shipments up 53 percent and international shipments up 48 percent. International shipments were up due to strong demand in Asia and Latin America, slightly offset by lower volumes in Europe.

Light-Duty Automotive

Sales of light-duty automotive engines increased as a result of higher volumes. Total unit shipments were 187,000 in 2005, an increase of 4 percent compared to 2004. Most of the increase in light-duty automotive sales was driven by continued demand from DaimlerChrysler with record shipments of 160,000 units, or a 4 percent increase compared to 2004. Engine shipments to RV OEMs remained flat in 2005 compared with 2004.

Industrial

Total sales were up in most industrial markets, primarily due to strong demand as the capital goods sector of the economy expands. Unit shipments increased 24 percent year-over-year reflecting a slight change in sales mix to higher-priced engines. Approximately 56 percent of the shipments were to North American markets and 44 percent to international markets compared to 52 percent and 48 percent, respectively, in 2004. Both the construction and agricultural markets had increased sales of approximately 28 percent in 2005 over 2004, while sales for the mining and marine markets increased 34 percent and 43 percent, respectively, during the same time period. These markets make up over 90 percent of the total industrial market. The increased sales in these markets were seen both in North American and international markets with the exception of a slight decrease in sales to the international agriculture market.

Stationary Power

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

2004 vs. 2003

The net sales, investee income and segment EBIT for Engine were as follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

Net sales

 

 

$

5,424

 

 

 

$

3,582

 

 

 

$

1,842

 

 

 

51

%

 

Investee equity, royalty and other income

 

 

80

 

 

 

48

 

 

 

32

 

 

 

67

%

 

Segment EBIT

 

 

328

 

 

 

62

 

 

 

266

 

 

 

NM

 

 

Segment EBIT as a percentage of net sales

 

 

6.0

%

 

 

1.7

%

 

 

4.3 percentage points

 

 

39




The increase in net sales for this segment was primarily due to the economic recovery evidenced by strong demand across all market sectors, particularly the North American heavy-duty and medium-duty truck markets and the light-duty automotive market with record engine sales to DaimlerChrysler. Total on-highway-related engine sales were 65 percent of Engine segment net sales in 2004 compared to 70 percent in 2003.

The improvement in segment EBIT was primarily a result of improved gross margin resulting from higher engine volumes and service part sales and the accompanying benefits of fixed cost absorption at our manufacturing plants along with the consolidation of heavy-duty test and assembly operations. Gross margin improved $361 million, or 66 percent, over 2003. Gross margin percentage improved almost 1.5 percentage points over the prior period. Selling and administrative expense and warranty expense also increased due to the increase in sales volume and were the primary offsets to the improved gross margins. Selling and administrative expenses increased $75 million, or 19 percent, over 2003, however selling and administrative expenses as a percentage of net sales improved almost 2.5 percentage points. Research and engineering expenses increased $30 million, or 23 percent, compared to 2003 but improved almost a full percentage point as a percentage of net sales compared to the prior period. Another item affecting segment EBIT in 2004 versus 2003 to a lesser extent was steel surcharges from higher steel prices.

In addition, earnings from joint ventures increased $32 million compared to 2003, primarily from higher volumes which resulted in a $19 million improvement in earnings from DCEC.

A summary and discussion of Engine net sales by market follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

Heavy-duty truck

 

$

1,700

 

$

1,098

 

 

$

602

 

 

 

55

%

 

Medium-duty truck and bus

 

693

 

468

 

 

225

 

 

 

48

%

 

Light-duty automotive

 

1,129

 

929

 

 

200

 

 

 

22

%

 

Total on-highway

 

3,522

 

2,495

 

 

1,027

 

 

 

41

%

 

Industrial

 

1,380

 

1,087

 

 

293

 

 

 

27

%

 

Stationary power

 

522

 

n/a

 

 

522

 

 

 

NM

 

 

Total net sales

 

$

5,424

 

$

3,582

 

 

$

1,842

 

 

 

51

%

 

 

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

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

Midrange

 

368,700

 

280,800

 

87,900

 

 

31

%

 

Heavy-duty

 

87,200

 

52,600

 

34,600

 

 

66

%

 

High-horsepower

 

12,100

 

8,900

 

3,200

 

 

36

%

 

Total unit shipments

 

468,000

 

342,300

 

125,700

 

 

37

%

 

 

Heavy-Duty Truck

The increase in sales to the heavy-duty truck market resulted from strong demand in the North American truck industry driven primarily by economic growth and the related increase in freight tonnage and higher replacement demand for trucks. Unit shipments of heavy-duty truck engines were up 70 percent in 2004, compared to 2003, with North American shipments up 97 percent and international shipments up 26 percent.

40




Medium-Duty Truck and Bus

The increase in medium-duty truck and bus revenues is due to increased shipments of medium-duty truck engines in North America and internationally. Shipments of medium-duty truck engines were up 93 percent to North American OEMs and up 36 percent to international OEMs compared to 2003. The increase in medium-duty truck engine shipments was driven primarily by economic growth as demand in this market typically correlates with demand in the heavy-duty market. Worldwide shipments of bus engines were down 10 percent in 2004 compared to 2003. Most of the decline occurred in international markets with some demand recovery in China where volumes were up compared to 2003. However, lower sales to India and Europe/CIS more than offset the increase.

Light-Duty Automotive

Sales of light-duty automotive engines increased as a result of higher volumes. Total unit shipments were 180,000 in 2004, an increase of 20 percent compared to 2003. Most of the increase in light-duty automotive sales was driven by strong demand from DaimlerChrysler with shipments of 154,300 units, or a 20 percent increase compared to 2003. Engine shipments to RV OEMs decreased slightly, down 3 percent in 2004, compared to 2003, partially as a result of higher shipments in 2003 in advance of new product introductions and slightly lower market share in 2004.

Industrial

Total sales were up in all industrial markets, except for the government market which remained relatively flat. As is the case for the other engine markets, the increase in sales is primarily a function of volume. Unit shipments increased 26 percent year-over-year reflecting a slight change in sales mix to lower-priced engines. Approximately 52 percent of the shipments were to North American markets and 48 percent to international markets compared to 39 percent and 61 percent, respectively, in 2003. The shift between international and North American markets is due to the consolidation of entities in the North American market as a result of the adoption of FIN 46R in 2004. See Note 2 to the Consolidated Financial Statements. Overall growth in industrial markets was driven by strong demand in 2004 as the capital goods sector of the economy experienced a significant recovery.

Stationary Power

Engine net sales to stationary power markets were $522 million in 2004. This new sales category arose from a change in 2004 where all intersegment engine sales from Engine to Power Generation are recorded at a market-based transfer price. Prior to 2004, intersegment transfers were recorded at cost and a sale was not recorded by Engine. Segment financial results for 2003 were not restated to reflect this change as it was impracticable to do so.

41




Outlook for 2006

As in 2004, this segment experienced much stronger than expected volumes in virtually all of its markets in 2005. Most indicators point toward continued improvement, however at a more moderate pace in most markets in 2006. We currently expect the North American heavy-duty truck market to remain flat in 2006 at approximately 315,000 units. While 2005 demand was driven partially from fleets adding capacity as freight volume increased, the majority of the increase resulted, similar to 2004, from the replacement of aging vehicles and improved industry financial health. In 2006, the market size increase will be primarily driven by increased freight tonnage and truck replacement. We project our sales to the North American heavy-duty truck market to increase due to some potential increase in our market share. We also expect sales of our midrange engines to the medium-duty markets to increase in 2006, as economic indicators for this market historically correlate with those of the heavy-duty market. Currently, we estimate our engine volumes for the medium-duty truck market to increase 10 percent in 2006, including an increase in market share. Sales of our 5.9 liter turbo diesel engine to DaimlerChrysler reached record levels in 2005 and we anticipate 2006 volumes will increase with a full year of availability of our engine in DaimlerChrysler products as demand for diesel-powered light vehicles increases. Our industrial markets expect continued growth in 2006, particularly overall demand for high-horsepower applications in the mining, marine, and oil and gas markets. We believe the favorable economic environment this segment has benefited from the past two years will continue in 2006. As a result of the growth anticipated in most markets, we anticipate this segment will incur an increase in sales, though not as strong as 2005 experienced, and we expect profitability to improve over 2005 as well.

Power Generation Results and Outlook

2005 vs. 2004

The net sales, investee income and segment EBIT for Power Generation were as follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

Net sales

 

 

$

1,999

 

 

 

$

1,842

 

 

 

$

157

 

 

 

9

%

 

Investee equity, royalty and other income

 

 

9

 

 

 

6

 

 

 

3

 

 

 

50

%

 

Segment EBIT

 

 

145

 

 

 

60

 

 

 

85

 

 

 

NM

 

 

Segment EBIT as a percentage of net sales

 

 

7.3

%

 

 

3.3

%

 

 

4.0 percentage points

 

 

The increase in net sales in this segment was primarily due to increased volumes as a result of strong demand in the commercial generator set (gen-set) markets and alternator markets. Pricing actions also contributed to the increase in net sales.

The improvement in segment EBIT was largely attributable to strong commercial generator set sales across all geographic markets, except China, and the related benefits of fixed cost absorption as well as price realization and cost reduction actions. These benefits were partially offset by increased costs of materials, primarily copper. Gross margin improved $67 million, or 25 percent, over 2004. Gross margin percentage improved over two percentage points compared to the prior period. Selling and administrative expenses decreased $3 million, or 2 percent, over 2004 and selling and administrative expenses as a percentage of net sales improved one percentage point compared to the prior period. Research and engineering expenses decreased $8 million, or 28 percent, compared to 2004 and research and engineering expenses as a percentage of net sales improved by 0.5 of a percentage point compared to the prior period.

42




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

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

Midrange

 

21,300

 

16,800

 

 

4,500

 

 

 

27

%

 

Heavy-duty

 

7,200

 

6,700

 

 

500

 

 

 

7

%

 

High-horsepower

 

8,300

 

7,400

 

 

900

 

 

 

12

%

 

Total unit shipments

 

36,800

 

30,900

 

 

5,900

 

 

 

19

%

 

 

2004 vs. 2003

The net sales, investee income and segment EBIT for Power Generation were as follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

Net sales

 

 

$

1,842

 

 

 

$

1,329

 

 

 

$

513

 

 

 

39

%

 

Investee equity, royalty and other income

 

 

6

 

 

 

3

 

 

 

3

 

 

 

100

%

 

Segment EBIT

 

 

60

 

 

 

(19

)

 

 

79

 

 

 

NM

 

 

Segment EBIT as a percentage of net sales

 

 

3.3

%

 

 

(1.4

%)

 

 

4.7 percentage points

 

 

The increase in net sales in this segment was primarily due to the improved economic conditions in the commercial, consumer and alternator product markets. Unit shipments of commercial generator drives (g-drives) and generator sets (gen-sets), alternators, and gen-sets for the consumer and mobile/RV markets increased significantly in 2004 because of strong demand. Additionally, approximately $90 million of the net sales increase resulted from the consolidation of new entities including those consolidated under FIN 46R.

The improvement in segment EBIT was largely attributable to strong commercial sales across all geographic markets and the related benefits of fixed cost absorption of $81 million as well as cost reduction actions of $29 million and price realization of $16 million. These benefits were partially offset by the unfavorable impact of foreign exchange rates, increased costs of steel and copper and higher selling, administrative and research and engineering expenses. Gross margin improved a robust $109 million, or 67 percent, over 2003. Gross margin percentage improved 2.5 percentage points over the prior period. Selling and administrative expenses increased $36 million, or 22 percent, over 2003, however selling and administrative expenses as a percentage of net sales improved 1.5 percentage points compared to 2003. Research and engineering expenses decreased $4 million, or 12 percent, compared to 2003, but improved almost a full percentage point as a percentage of net sales compared to the prior period.

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

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

Midrange

 

16,800

 

14,000

 

 

2,800

 

 

 

20

%

 

Heavy-duty

 

6,700

 

5,300

 

 

1,400

 

 

 

26

%

 

High-horsepower

 

7,400

 

5,200

 

 

2,200

 

 

 

42

%

 

Total unit shipments

 

30,900

 

24,500

 

 

6,400

 

 

 

26

%

 

 

43




Outlook for 2006

Power Generation experienced a dramatic recovery in financial performance in 2004 and 2005 due to a combination of an improved economic environment in key markets and actions implemented in mid-2003, including cost reductions and pricing initiatives. In 2006, we expect continued growth across most power generation markets. We anticipate strong growth in North America and the Middle East and forecast growth in market share through our new lower cost products, especially in Europe and Latin America. We believe the softer levels experienced in the China power generation market in the latter half of 2005 will continue in 2006. We expect continued growth for 2006 in the commercial international markets for power generation and alternators, except for China, and strong growth in domestic markets. In our consumer business, we expect the markets to be relatively flat, compared to 2005, however, we anticipate a more favorable sales mix from market share gains in marine and our recently launched portable generator set products. As a result of the growth anticipated in a broad range of markets and improved sales mix, Power Generation revenues and profitability are expected to exceed 2006.

Components Results and Outlook

2005 vs. 2004

The net sales, investee income and segment EBIT for Components were as follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2005

 

2004

 

Amount

 

Percent

 

Net sales

 

 

$

2,000

 

 

 

$

1,783

 

 

 

$

217

 

 

 

12

%

 

Investee equity, royalty and other income

 

 

8

 

 

 

9

 

 

 

(1

)

 

 

(11

%)

 

Segment EBIT

 

 

89

 

 

 

84

 

 

 

5

 

 

 

6

%

 

Segment EBIT as a percentage of net sales

 

 

4.5

%

 

 

4.7

%

 

 

(0.2) percentage points

 

 

Components net sales increased across all geographic markets primarily due to strong demand in the U.S., Latin America, and Asia. Sales of our turbochargers increased due to higher aftermarket sales to OEMs, partially offset by lower demand in China.

Segment EBIT improved slightly, compared with 2004, primarily due to improved volume, however EBIT as a percentage of net sales declined slightly due to a lower gross margin percentage resulting from higher steel prices used in exhaust products and manufacturing filters as well as production inefficiencies from capacity constraints. Gross margin increased $33 million, or 11 percent, over 2004, however gross margin percentage decreased slightly. In addition, higher selling and administrative expenses and increases in research and engineering expenses contributed to the reduction in segment EBIT as a percentage of net sales. Selling and administrative expenses increased $18 million, or 10 percent, over 2004, but remained relatively flat year-over-year as a percentage of net sales. Research and engineering expenses increased due to the development of a number of new products that will be launched in 2006 and beyond. Research and engineering expenses increased $6 million, or 12 percent, compared to 2004 and remained flat year-over-year as a percentage of net sales.

44




2004 vs. 2003

The net sales, investee income and segment EBIT for Components were as follows (dollars in millions):

 

 

Years ended
December 31,

 

Change

 

 

 

2004

 

2003

 

Amount

 

Percent

 

Net sales

 

 

$

1,783

 

 

 

$

1,292

 

 

 

$

491

 

 

 

38

%

 

Investee equity, royalty and other income

 

 

9

 

 

 

7

 

 

 

2

 

 

 

29

%

 

Segment EBIT

 

 

84

 

 

 

86

 

 

 

(2

)

 

 

(2

)%

 

Segment EBIT as a percentage of net sales

 

 

4.7

%

 

 

6.7

%

 

 

(2.0) percentage points

 

 

This segment achieved higher net sales in 2004 reflecting demand improvement from OEMs and increased market share. Net sales increased in most geographic markets including the U.S., Europe, Asia, and Australia, with small declines in Canada. Sales of our turbochargers increased primarily due to higher aftermarket sales to OEMs and strong demand from our joint ventures in China.

Segment EBIT declined slightly, compared with 2003, primarily due to a lower gross margin percentage resulting from higher steel prices used in manufacturing filters and exhaust products which approximated $17 million, net of $7 million in price recovery, as well as production inefficiencies from capacity constraints of $21 million. Gross margin increased $36 million, or 14 percent, over 2003, however gross margin percentage declined over 3.5 percentage points in the same period. In addition, higher selling and administrative expenses and increases in research and engineering expenses contribu