Cummins Inc. (CMI) Q2 2011 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 Cummins Earnings Conference Call. My name is Derek, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Mr. Mark Smith, Executive Director, Investor Relations. Please proceed.

Thank you, Derek, and good morning. I'd like to welcome everyone to the teleconference, and we're pleased to share with you a brief business update and discuss Cummins second quarter performance, as well as our revised outlook for the full year. Also participating this morning is Tim Solso, our Chairman and Chief Executive Officer; Tom Linebarger our President and Chief Operating Officer; Marsha Hunt, our Vice President and Corporate Controller. Pat Ward, our Chief Financial Officer cannot be with us today due to a family bereavement. This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about forward-looking statements begins on Page 3 of our 2010 Form 10-K, and it applies to this teleconference. During the course of this call, we will be discussing certain non-GAAP financial measures, and we refer you to our website for the reconciliation of those measures to GAAP financial measures. Our press release with a copy of the financial statements and a copy of today's webcast presentation is available on our website at www.cummins.com under the heading of Investors and Media. With those formalities out of the way, we'll begin with the remarks from our President and Chief Operating Officer, Tom Linebarger.

Good morning, and thank you, Mark, it's nice to have you. I'll start this morning by sharing some thoughts on our performance in the second quarter and our outlook for certain markets for the rest of the year. Mark will then provide greater detail in the quarter and our updated 2011 outlook. As you can see, we had a very strong second quarter and delivered record sales and profits. We experienced growth in all major geographic regions, led by improvement in several of our end markets in the United States. Sales for the second quarter of $4.6 billion were 45% higher than the same period in 2010. All 4 business segments reported significantly higher sales led by the Engine and Components segments, which increased 53% and 42%, respectively. We reported EBIT for the quarter of $775 million, including a gain of $68 million related to the sale of the exhaust business. Excluding the gain, we reported EBIT of $707 million or 15.2% of sales in the second quarter. This represents an increase in EBIT of 76% year-over-year, continuing our trend of growing earnings faster than sales. Our Engine, Components and Distribution segments each reported record sales and record EBIT, and our Power Generation business also delivered strong growth and profitability. Sales in the U.S. increased 56%, with growth in a number of end markets. Our Engine business experienced strong growth in heavy- and medium-duty truck, bus, mining, oil and gas and construction markets. The Components business increased U.S. revenues by 44%, driven by increased demand in on-highway markets, and the Power Generation Distribution businesses also enjoyed strong growth. Staying on the topic of our U.S. business, I wanted to provide an update on our 2010 EPA-compliant engine launch, which continues to go extremely well. Through the end of June, we had shipped almost 126,000 medium- and heavy-duty engines equipped with Selective Catalytic Reduction aftertreatment devices to North American truck and bus customers. Based on testing conducted by Cummins and confirmed by head-to-head comparisons conducted by our customers, we are confident that we are meeting our commitment to provide a significant fuel economy improvement over our previous engine and that we are delivering the best fuel economy in the industry. Our market share in medium-duty trucks in the U.S. has increased to 52% due to the strong reliability of our engine and the significantly advanced fuel economy it has over the competition. In the heavy-duty market, we have increased our penetration at PACCAR and freight liner this year, and we expect our market share of the overall heavy-duty market to reach the mid-30s for the full year. Our revenues in international markets remain strong in the second quarter as well. Our consolidated revenues in Brazil grew 40%, India 17% and China 34% compared to a year ago. Brazil continues to be a very important market for us, with all 4 business segments reporting strong growth year-over-year. We delivered record results in India this quarter, and our penetration at Tata exceeded 80% for the first time in our history. I would like to provide a little more detail on our business in China and our outlook for the key end markets there. Before I comment on specific end markets though, I want to point out that we remain very optimistic about the long-term growth prospects for all of our businesses in China. We expect the Chinese economy to grow at a significantly faster rates than developed economies for many years to come. We also expected that the growth in GDP coupled with the need for a more efficient, clean power will continue to provide Cummins with significant growth opportunities in China. As you know, the Chinese government has taken a number of actions this year to control inflation. And probably as a result, demand softened in most on- and off-highway markets in the second quarter. You will also have read about power shortages in China, which have led to an increased demand for power generation equipment. Our full year guidance for the truck market in China, heavy and medium combined, is that it will be down 5% year-over-year. In the heavy-duty truck market, we saw significant increase in OEM inventory levels from the fourth quarter of 2010 to February of 2011. Inventory levels have declined significantly in last 4 months. We see the current reduction in industry orders as a correction, with the third quarter likely to represent the low point for the year followed by an improvement in the fourth quarter. In the construction market in China, approximately 60% of our revenues today come from sales of engines to excavator manufacturers. Industry sales of excavator equipment increased 29% in units for the first half of 2011 compared to the same period in 2010, but the second quarter declined 33% sequentially from the first quarter. You will recall that industry sales in the first quarter were extraordinarily high and are more than 60% higher than the first quarter of 2010. For the full year, we expect the excavator market size to be up 20%, with the second half lower than the first. The market share of domestic excavator manufacturers has held up better than some of the international brands, and this has helped reduce the impact on Cummins sales. Power shortages in China have driven strong demand for our products. Second quarter sales in Power Generation business increased 53% compared to the second quarter of 2010, and we now expect a full year increase in sales of 30%. We do expect the moderation demand in the fourth quarter as the power crisis starts to ease. To summarize, there are several reasons why our revenues in China continue to grow in the second quarter: increased demand for power generation equipment; shared gains for our OEM customers in truck and construction; our joint venture with Foton increased revenue in the second quarter in line with our previous guidance; continued strength in the mining and marine markets; and finally, the decline in excavator equipment sales in the second quarter did not immediately impact our engine sales but will start to have an effect in third quarter. Demand for our products in China remains very strong and we expect to grow total revenues, including our unconsolidated joint ventures, by 25% this year to around $3.8 billion, very close to our previous guidance and still a record year. We are experiencing strong demand for our products across multiple regions and markets. Our products are performing very well, and we have strong leadership positions in many markets. And we are delivering excellent levels of profitability in all 4 businesses. We also generated strong cash flow this quarter. Furthermore, we demonstrated our confidence in our future performance by increasing our dividends 52%, and we also increased our share repurchase program during the second quarter. Overall, I'm extremely pleased with the performance of the company as a whole and with each of the business segments. As a final note, we recently announced a transition in leadership, with Tim retiring at the end of the year. The company has a strong record of handling leadership changes very well. Tim and I worked very closely together for many years and a lot of time and thought has been put into this transition plan to ensure that the handover goes very smoothly. I can assure you that Cummins will not miss a beat in our strategic focus or execution of our profitable growth plans. Now I'll turn it over to Mark to go through the financials in more detail.

Thank you, Tom. Second quarter revenues were $4.6 billion, an increase of 45% from a year ago and 20% from the first quarter. These results reflect broad growth across all major regions in all business segments. Currency movements contributed just under 4% to revenue growth. Strengthening demand from our on-highway, oil and gas, mining and construction markets led to an increase in U.S. revenue of 56% from the prior year and 20% from the first quarter. International revenue increased 38% from the prior year and 20% sequentially. International growth was driven by on-highway demand in Brazil; demand for industrial engines and power generation equipment, particularly in China; and industrial demand in Europe ahead of the upcoming emissions change in 2012. We reported record revenues in China, India and Brazil. Gross margins improved to a record 25.9% of sales due to better operating leverage and stronger volumes, improved price realization and lower warranty expense as a percent of sales due to the strong performance of our EPA2010 engines in the field. Selling, admin and research and development costs were up 38% from the prior year and 20% sequentially. The largest increase was seen in R&E spending, which is up 64% over the same period last year and 22% from the prior quarter. As we've discussed on previous calls, we're investing to ensure we maintain our technologies and leadership and to drive profitable growth. The increase in our research and engineering spend was concentrated within the Engine and Components segments. We continue to broaden our product range and develop technology to meet increasing demand for cleaner and more efficient power across global markets. Joint venture income of $117 million was 21% higher than a year ago and 22% higher than the previous quarter. These increases are driven by strong oil and gas markets served by our North American distributors and strong demand for Power Gen and mining products seen in China by our joint venture Chongqing Cummins. Dongfeng Cummins in China also contributed to the sequential growth. Earnings before interest and tax were a record $707 million, excluding a $68 million gain from the divestiture of the exhaust business. This level of earnings in EBIT is an increase of 76% from the prior quarter and 33% from the first quarter. EBIT as a percent of sales reached 15.2% during the second quarter compared to 12.5% a year ago and 13.8% in the prior quarter. Currency did not have a significant impact at the EBIT level year-over-year. Earnings per share in the second quarter was $2.41, excluding the exhaust business transaction. This compares to $1.25 from a year ago. Now let me provide additional details on each of our operating segments, as well as provide an update on our full year 2011 revised guidance. In the Engine segment, second quarter sales were $2.9 billion, up 53% from the prior year and 21% sequentially. This increase is driven by a continued recovery of North American on-highway markets, strong worldwide oil and gas activity, infrastructure development in China, as well as elevated demand from industrial engines in Europe ahead of the Tier 4 Interim emissions change in 2012. Year-over-year joint venture income decreased 6% due to product mix at Dongfeng Cummins. Sequentially, however, earnings from our joint ventures increased 17%. This increase is driven by on-highway and industrial demand in China, particularly for high horsepower engines produced at Chongqing Cummins. Segment EBIT increased to a record $377 million or 13% of sales. This represents a 91% increase over the prior year and a 30% increase sequentially. This increase was driven by strong operating leverage, positive price realization and lower warranty expenses as a percent of sales. The continued strength of several end markets, including North America on-highway markets, global oil and gas and mining, along with strong on-highway demand in Brazil, requires us to increase our revenue and EBIT forecast for 2011. We are now forecasting Engine segment revenue to be up 45% over the prior year. Due to the improved revenue outlook and our improved forecast for warranty expense, we now forecast to earn EBIT of 12% to 13% of sales in the Engine segment. Moving on to the Power Generation segment. Second quarter revenue was $909 million, an increase of 28% over the prior year and 14% sequentially, driven largely by North America, Europe and China. Segment EBIT was $105 million or 11.6% of sales, representing an improvement over both the prior year and the prior quarter. Profitability was positively impacted by stronger volumes, price improvements and lower product coverage. We reaffirm our prior guidance for the Power Generation segment of achieving growth of 20% in revenue over the prior year and EBIT of 11% to 12%. In the Components segment, second quarter revenue was a record $1 billion, representing a 42% increase over the prior year and 12% sequentially. This is the first time that the Components segment has exceeded $1 billion in quarterly revenue, and all businesses within the segment saw year-over-year and sequential growth. This improvement is driven by continued recovery in North American and European on-highway markets. Segment EBIT was a record $120 million or 11.6% of sales. This compares to 10.3% of sales last year and 11.4% of sales in the prior quarter. Year-over-year and sequential improvement was driven by strong operating leverage from increased EPA 2010 volumes and operational improvements. We are confirming our 2011 guidance for record performance within the Components segment. We project revenue growth of 35% over the prior year and EBIT percent of 11% to 12% of sales. In the Distribution segment, second quarter revenue was $785 million, an increase of 36% over the prior year and 22% sequentially. Excluding the impact of acquisitions, the Distribution segment had organic growth of 26% over the prior year. This growth was driven by oil and gas markets in North America, increased power generation sales in Europe and the Middle East and stronger demand for parts and service. Segment EBIT margin was a record $106 million or 13.5% of sales. This compares to 12% in the previous year and 13.9% in the prior quarter. This improved profitability is the result of higher sales and increased joint venture income. Sequentially, we did see a change in mix as growth in whole goods exceeded our part sales as we expected. Due to improved demand for industrial engines and parts, we're increasing our guidance for the Distribution segment. We now forecast revenues will be up 30% over the prior year, and EBIT will be between 13% and 14% of sales. Now let me summarize our revised guidance for the company. We now expect revenues to grow 36% over the prior year and reach $18 billion. The benefits of high volumes will be partially offset in the second half of the year by higher product coverage and research and development spending. We expect to achieve full year EBIT of 14.5% of sales, which will be a record. Full year consolidated guidance, which we're providing, assumes product coverage to be 2.9% of sales for the full year, joint venture income to increase 19% over 2010 and research and engineering spending to be 3.5% of sales. The effective tax rate is forecasted to be 29.5%, excluding discrete items. During the second quarter, we did recognize a $68 million gain from the sale of the exhaust business. The annual guidance we're providing today excludes this gain and the expected gain from the sale of our light-duty filtration business, which we expect to complete in the second half of this year. During the second quarter, cash from operating activities was $656 million, a quarterly record. Our healthy balance sheet provides us with the ability to make the investments necessary to deliver profitable growth. Year-to-date, we've invested $215 million in capital spending and on track to spend a total of $600 million to $650 million during the year. Also, we will continue to mend the very high funding level of our pensions by contributing $130 million. As evidence of the company's liquidity, low debt to equity and strong financial performance, our credit rating was recently increased by Fitch to A-. This represents the highest rating achieved by the company since 1989. During the second quarter, the company repurchased an additional 1.6 million shares of our common stock. This brings our year-to-date repurchases to 3.5 million shares at a total cost of $373 million. In addition, the company's quarterly dividend was increased last month by 52% to further reward our shareholders. We have committed to delivering sustainable dividend growth. We are pleased with the strong growth and improved operating margins across our business. Before we open the call to your questions, Tim would like to make some concluding remarks.

Thank you, Mark, and good morning. Recently, I announced my retirement from Cummins effective December 31 this year. I have worked in Cummins for 40 years, the last 12 as Chief Executive Officer and Chairman. I will also be 65 years of age next March. The company is operating extremely well right now and is positioned for even better performance in the future. So this is a good time for me to retire. I've been working with the board on this transition for some time. In Tom, we have a proven leader with an outstanding record of performance. Tom has built a very experienced and talented management team that is the strongest I've seen in my 40 years with Cummins. I am extremely confident in Cummins future. We have a strong balance sheet. Our global footprint is well-established and growing, particularly in the emerging markets of China, India, Russia and Brazil. We have 56 joint venture partnerships and a global distribution network that is envied by many in our business. Our revenues grew 22% in 2010, and we are forecasting a 36% increase with revenues this year. I would like to echo the comments from Tom and Mark about the strength of our financial performance this quarter. For the last 10 years, we have been driving the company to diversify and profitability grow revenues across geographies and end markets. The performance in the second quarter demonstrates how successful we've been. Revenues in all major geographic markets grew significantly, and all 4 of the business segments reported very strong operating margins, with 3 of the 4 businesses delivering record quarterly performance. For the first time, all 4 business segments will deliver double-digit EBIT margins for the full year. I believe Tom and his leadership team will drive the company to new heights of financial performance and global leadership. I am more excited about the growth prospects for the company than I have ever been. Our products are performing extremely well. We continue to invest in new technology, and we have formed great partnerships around the world. I look forward to seeing many of you at our Analyst Day in New York on September 13, when we will share with you our new long-term targets for growth and profitability. I want to thank you for your interest in Cummins and your support through the years. Now I will hand it back over to Mark before we take your questions.

Thank you, Tim. Consideration to who are with us on the call, I would ask that you limit yourself to one question and a related follow-up. If you have additional questions, you're free to rejoin the queue. Derek, we are now ready for our first question.

[Operator Instructions] Our first question is coming from the line of Timothy Denoyer from Wolfe Trahan.

A question on the Power Gen guidance. That was an area that last quarter you had cited as a place where there could be some upside as the year progresses. Can you talk a little bit more about how those demand trends are going? It seems like from the 20% revenue growth guidance that essentially implies that the revenue should be at or below the 2Q level in the second half in the third and fourth quarter?

As we've talked about, we're seeing strong demand in China. But of course, as a percent of our total segment revenue, that didn't shift the needle a lot. The U.S., while it showed good growth in the first half from very low levels over the first half of last year, doesn't show a great amount of growth in the second half of the year. And then with China, we do see demand easing off there as the power crisis improves. So overall, we haven't changed the guidance.

Okay. And then kind of separately in terms of the -- can you talk about the longer-term strategy in light duty in the U.S., specifically with the development of the Nissan Titan program? And would you ever get into sort of a light-vehicle diesel more broadly in terms of the growing turbo market there and increased diesel penetration?

We sure hope so. As we've talked about before, we have a significant investment in light-duty diesel engine that we think could make significant penetration especially in lighter trucks than we're in today and in SUVs. And our view is given the fuel economy needs and greenhouse gas concerns that clean diesel is a good addition to transportation portfolio. So we're pushing hard for that to happen. There's still -- it's still not clear about what the rate and pace if that's going to happen, but I agree with your comments that there is more interest, both in terms of the DOE and as well as customers and manufacturers. The past 2 car business, as you know, has been a relatively rough area for the last several years so I think resources are limited compared to what they were maybe 5 or 10 years ago but they're coming back. And so we're hopeful. We're still working aggressively on finding the right set of partners for our light-duty diesel engine, and we're cautiously optimistic about it but we're not going to get ahead of ourselves.

Okay. And that light duty, it will be the 4-cylinder that was talked about in the second quarter, a government conference with Nissan. Is that commercial at this point?

I think, Tim -- I think you and I talked about this. We do a lot of programs with customs [ph] on development side. It doesn't necessarily mean it's moved into a commercial -- you've got copy of a DOE presentation, and I think we've got no news to announce here. Tom has given you the overview.

Yes, it's basically research program at this point.

Your next question is coming from the line of Jamie Cook from Credit Suisse. Jamie Cook - Crédit Suisse AG: A couple of quick questions. Same question which I sort of ask every quarter. I guess relative to your expectations in the second quarter, what is surprising you? Is it market share? Is it market growth? Is it execution pricing? Just run through sort of where you see the expectations on Q2. And then just my second question, you guys increased your outlook on truck in North America. PACCAR, at the same time this morning, lowered their outlook. So I'm just trying to get a feel for why you're more optimistic. Is it market share? Is it the truck OEs are dealing with supplier constraints that you're not dealing with? I'm just trying to understand the disconnect between you and another big truck OE?

Jamie, let me just first comment on the broad point about what caused a surprise. Off-highway engines are the most positive surprise. You talked about mining and oil and gas before. In fact, construction equipment engines were also stronger. We expected China will start to head down. In fact, it's been stronger longer than we thought. So those are all the sort of the positive surprises. With regard to North American heavy-duty trucks, we are expecting the full year to be a little bit better for our production than we put in the pen but not a lot more, and the first half was actually slightly worse. The second quarter was about on and first quarter was a little bit below. But trying to calibrate with PACCAR might be a little more difficult. I don't know, Mark, if you have anything to add there?

Yes, because BNZ [ph] had a slightly different definition. So I've just seen that this morning, so I'll need to look at how their dicing the market.

But broadly speaking, we see the North American heavy-duty truck as having a lot of positive momentum in terms of order rates and some difficulty in the supply chain to actually produce the customer demand, which, on the one hand, I'm sure is very frustrating for PACCAR, which is making good improvement. I think we'd like to do more good improvement in terms of their revenues, but they're running into constraints. And at this point, it's not us, which is really important for us, obviously. But they are running into those, and I think that's probably frustrating them a little bit. But broadly speaking, I think order rates are good and outlook remains about like we expected. Jamie Cook - Crédit Suisse AG: All right. So in summary, it sounds more supplier issues versus there's nothing on the macro front that you're seeing at this point that's causing any concern. Besides, you talked about China and it sounds like things get worse in Q3 and then eventually improve. But outside of that, you're not seeing anything macro that's sort of really concerning to you?

No. I mean, as you know, the general uncertainty in the economy is not making any of us feel really great. But from a truck market point of view, no. Jamie Cook - Crédit Suisse AG: Okay. I look forward to your long-term targets in September.

Your next question is from the line of Henry Kirn from UBS.

Could you touch on -- and I think Jamie started to touch on it, but could you talk about any supply-chain impact to you? And then maybe how you expect to manage input costs in the back half of the year?

Yes, let me start with your first question about supply chain. As we've talked about, we're really -- since the beginning of the recovery for Cummins, which is all the way back in the second half of '09, we started to ramp a little bit and then by 2010, we were ramping pretty quickly. We've had to deal with supply-chain constraints, really dozens of them, from all over the place. We have a very global supply chain. And so trying to make sure people ramped up with us has been a challenge really since then. We started with high horsepower engines, trying to get people back in the game. We have the Japan issues to deal with. So what I would say is there's no single thing which stands out today as a unique problem with one supply chain or one area. I think it's a little bit easier, at least from what I heard from the truck companies, they're pretty clear about the 1 or 2 that are shorting them today, but they're kind of dealing with one set of products for one market and we're talking a broad whole bunch of engines from a whole bunch of different parts of the world. So it's a little bit more -- it's still difficult to say this is the problem or that's the problem. But we are actively managing supply-chain constraints. I mean, we have implemented some new processes to track where supplier capacity is. We've helped suppliers with funding, tooling early in their ramp up so they could be ready, lots of programs like that to make sure -- and right now, we feel, as I mentioned, that we're in reasonably good shape. We've brought down our lead times to market lead times in every one of our engines where we don't feel like we're holding up any of the industry in the truck side. So again, I don't want to -- it's always a struggle so I don't want to get too far ahead of myself. But right now, we feel good about that. On the material cost side, definitely commodities are rising this year. That is a challenge for us to manage. As we've talked about on this call before, we have delays between when the commodity start to go up in price and when we start to see them in our purchases in significant numbers, with the exception of a few places we see. We have precious metals in our emissions equipment, and we have copper and electrical steel pretty close to the raw commodity in our Power Generation business. And so those places, we see pretty quick cost increases, most of the other places we see delays, and we negotiate for as long with delays as we can. And then, of course, we also try to adjust prices wherever we can. And so all those kind of things make them spread. That will happen this year, and then we go for price decreases. So broadly, as a company, we think the commodity thing will largely become neutral for us across the year. But that isn't true in the Power Generation business where, in fact, we are seeing some increases, which is giving us a little bit increase in material costs in the second half.

So I think, just to remind you, for the full year, we said we'd expect net 1% price increase across the company and about a gross 1.3% commodity costs challenge, partially offset by internal cost improvements and is pretty much playing out the way we had said for the full year so far.

Your next question is coming from the line of Adam Uhlman from Cleveland Research.

Could we dig into the Brazil market trends a little bit? The outlook there has been picking up to 30% growth from 20%, and we have this emissions change over that's coming up next year. So I'm wondering, how much the market might be down next year and then any platform changes that might be occurring next year that we should keep our eye on?

Adam, this is Mark. Yes, we've definitely seen an increase in demand for truck engines in Brazil. And while we started the year thinking there wasn't going to be a significant pre-buy impact because OEMs are pretty tight on capacity, it seems like we've been able to find a little more. We estimate maybe up to 10,000 or 11,000 units increase in the second half of the year. Of course, for next year, we're not really getting into guidance for 2012 at this point in time. We update that later in the year, but we're definitely seeing a ramp up.

And the only thing I'd add, Adam, is we definitely will see changes in engines because we will be moving to Euro V. So those are programs we've been working on, as you guessed, for some time. We're also introducing some truck, introducing some new engines over the next several years but not is all happening as a result of the Euro V implementation. But we are upgrading all of our engines that are there to meet Euro V, and that is occurring in January. So that all is going through.

Okay, got it. And then just a clarification on the Components guidance for the year did not change even though the Engine segment revenues are going to be up. Is that all due to the divestiture?

No, that's not really -- that's not the big driver. The big thing, Adam, is a lot of the growth in on-highway markets, today, aren't as significant for Components as off-highway. The aftertreatment system will come on for Tier 4 Final, which is the single biggest ticket item on revenue. China is down a bit, which is a consolidated part of the business in Components. So those are the biggest reasons why we haven't changed significantly.

So again, just thinking about it a little bit, I mentioned to you that the truck market is a little bit ahead of our guidance for the full year but not much. What's really been different is off-highway markets where, as Mark says, we don't have as many of the emissions components on, for example, aftertreatment so much on off-highway yet. It's growing as you know because of the implementation Tier 4, but it's not yet a big factor. And the China comment he made, we have a very significant turbocharger operation in China. It's a very strong market participant. And that business goes pretty close to the automotive business in China, which, as we mentioned, is a little bit down for the second half. Does that help?

Your next question is coming from the line of Andy Casey from Wells Fargo.

I wish to add my good luck to Tim and Tom and thanks for explaining how you intend to grow despite the China outlook. Can you talk about what you're seeing in Brazil outside of truck? We've heard some commentary through previous earnings about a slowdown second half versus first half. Are you seeing any of that?

Yes. Not a significant effect for us, I mean, we're still seeing our business Power Gen. Off-highway still remain strong and about the same, so no major change there for us yet. Mark?

And those Power Gen and on-highway, our biggest segments for Brazil for those.

Right.

And then, a similar question of Europe outside of truck?

We've seen -- well, construction's picked up to some -- we believe there's some pre-buy going on, on the below 174-horsepower construction. I think truck continues to improve a little bit but nothing dramatic but no significant negative signs.

And with the Power Gen business has not really recovered significantly, that's one of areas where it really hasn't recovered very much yet still, is in Europe.

Russia will be the exception where we've seen strong growth across a number of end markets.

Yes, related to oil and gas.

Thanks, and please pass on our condolences for Pat and his family.

Thanks, Andy.

Your next question is from the line of Tim Thein from Citigroup.

First question was just on the JV income forecast where you took that up from 15% to 19%. It looks like the unconsolidated sales targets for India and China were essentially left unchanged from last quarter. So I guess, should we assume that the majority of the increase is driven more by distribution versus the equipment ops?

That's exactly it, and then that's the main driver. Tim, you've got it, and then our Chongqing Cummins joint venture, which is more related nonconstruction. Off-highway is also pretty strong in the second half, but distribution is the biggest point. You're exactly right.

Okay. Okay, and switching gears, you highlighted oil and gas several times and I wanted to -- again, maybe this is hopefully not to steal any thunder from your September meeting, but some of the major oilfield services companies have highlighted how the greater horsepower requirements and service intensity tied to the horizontal drilling is helping them achieve some pretty significant increases in revenue per rig. And I would assume that this plays right into your hands but hoping you could provide some color in terms of your revenue and margin opportunity, given your position today in well servicing but also as you look forward to the launch of your transmission and larger displacement engine?

Yes, you could have written a brochure for us there, Tim. We definitely do see it as an opportunity. Of course, in our -- in the scheme of our revenue, it's still a smaller portion. And so I think some of the companies that you may listen too, of course, have a bigger position and may be bigger numbers in it. But we feel like we've got a good position there and it's growing. And so we are making significant investments. As you did mention, our transmission but also in our -- in moving up in horsepower range in the engine side. We are also putting a lot of dedicated resources towards packages, creating packages for the oil and gas industry so purchasers can get closer to what they want right from us rather than having to do a lot of secondary engineering and dealing with quality issues, et cetera, which has been well-received. So we are making significant investments in the oilfields. And as you said, the higher horsepower needs and the urgency with which operators are trying to make sure they understand and make productive shale gas finds that I think are -- it's definitely serving equipment producers well.

Your next question is from the line of Ann Duignan from JPMorgan. Ann Duignan - JP Morgan Chase & Co: I suppose -- most of my nitty-gritty questions have been answered but maybe you could update us on your warranty accrual costs in Q2 '11? And you noted that the engine seem to be performing better or at least in line with expectations. Is there a chance that warranty accruals could go down next year or we could see some reversals?

I think either is possible but I think basically, as we've said, the performance is really good and that really led to some favorable adjustments here in the second quarter. Over and above that, we do have some campaigns and repair practices on our older engines and they were very low in the second quarter compared to historical trends. So we think that that's not a normal run rate. But overall, the confidence in the product is very high and our goal is to find the problems and fix them as quickly as possible to minimize the costs. And I think we're doing a pretty good job of that.

As a business -- Ann, we are very really pleased from the point of view of the 2010 launch and how well the results are coming in from a warranty point of view. It's not a place you ever want to get ahead of yourself, but we feel very good about where we are. And we have a pretty conservative and stringent way with which we adjust accruals, and we'll continue to follow that. So even -- we're not going to get ahead of ourself financially, but we feel great business-wise about where we are. Ann Duignan - JP Morgan Chase & Co: Okay, that's helpful color. And so we shouldn't take Q2 and apply that going forward necessarily, is that what you're saying?

No, the second half is going to be a little bit higher. That's what the guidance implies here. Ann Duignan - JP Morgan Chase & Co: And then, can you talk a little bit about how the expansion plans and where you might be running up close to full capacity and where your priorities are in the near term?

Yes, from a capacity point of view, as I talked about, and the supply chain point of view, we have been managing bottlenecks throughout the supply chain in a whole bunch of different areas, both components and engines, not so much in genset, but in components and engines, now for several years and we've been moving them up. And they're not typically assembly issues, right? So we don't have assembly capacity point constraints in very many places. I can't think of any to be honest. It's almost all supply chain-related, and it's mostly components and it's not even the same components by engine. So that's really what we're managing from a capacity point of view. As you guessed, heavy-duty trucks, if we meet the forecast that we expect by the middle of next year, we'll be tight. And so we've been doing a lot of work on that now for more than 12 months, figuring out how we make sure we have enough capacity, not just on average for the year, but for any week or any quarter anybody needs a lot of them, how we're going to make sure. And so we've been using inventory, as well as capacity expansion, as well as shift patterns, et cetera, to manage that as an example. But then in high horsepower engine has also been managing capacity to make sure that we have enough of what engines are selling the best. We talked a little there about mining and oil and gas, which grew a little faster than we expected this year. So more demand for those particular models of the high horsepower engines has meant that we've had to get some capacity in those models. So a lot of work. But again, I would say to you that I don't feel against it in the sense that we're in a desperate situation anywhere but it's taken a lot of work across all of our product lines.

I think the other thing I would add, Ann, is obviously at Tata Cummins joint venture, we've added 60,000 units of capacity this year. And at Dongfeng Cummins, we've also been working on adding additional 50,000, and you'll recall we're pretty much sold out last year.

Yes, those are examples, I think, like the Dongfeng Cummins ones to where, okay, demand is falling in China so why would you add capacity? And the idea there is that we think it's the correction, and we want to make sure we have capacity when the demand comes back. So that's an example of kind of our strategy to make sure that we don't get behind. We stay up and where we have assembly capacity we've got in place because it's in the broad scheme of things, relatively inexpensive relative to the revenue opportunity we have. And then, it's about managing the supply chain to make sure they keep up. Ann Duignan - JP Morgan Chase & Co: Okay. And just a real quick follow-up on that. Given everything you've said there, would you expect CapEx going into 2012 to remain at or above 2011 levels? Or is this you're kind of -- because of all of the capacity your putting in emerging markets, is this year kind of the peak?

Well, I don't want to get ahead of guidance, obviously, but let me just give you a broad view, which is I don't see us at any peak kind of idea now. I mean, we're going to continue to try to manage in our sort of 3% to 4% of revenue band, and we see ourselves growing now for several years and of course we'll talk a lot about that in September, about the rates of growth that we think they're going to be significant. So we'll be putting in the capacity to make sure that we can meet it. So definitely, I don't see that as a peak but we're going to be continue to manage our capital spending with discipline while still making sure we've got capacity to grow.

Your next question is coming from the line of Eli Lustgarten from Longbow Security.

Congratulations, Tim. We're going to miss you. It's been a privilege to work with you for the last decade.

Thank you, Eli.

One thing that strikes me, I mean, it's hard to pick on anything in this quarter. Business is just spectacular. But the back of the envelope, incremental margins for all the sectors are almost uniformly similar. They go from like 14%-something to 18%, which is so much concern around the street about incremental margin. Are we sort of limiting in the profitability improvement we can get at this point? Did you have to fight for it? And what can we expect as we look out to this year into next year from that incremental dollar sales across the company because it's awfully uniformed per sector?

Yes. Pat talked about this a little bit but we definitely see one of the fundamental challenges for us. One of the things that we think is critical to achieving our target is to continue to generate incremental margins so that we can grow earnings faster than sales and that the incremental margin generation is kind of what really makes the targets. So we're very focused on them. So we don't think they're over or somehow we're not going to be able to get them anymore. That's kind of what our management team focuses on is how to grow but still grow in a way that we can generate those kind of incremental margins that we've been generating and will continue generating. You know that at the start of a -- after the anniversary [ph] at the start of ramp up, you get a little bit better incremental margins. But then after that, these things start to average out as you grow, and we think we can do that over a sustained period of time.

And I think the thing that I'd point out here, Eli, is we're growing the incremental EBIT margins. At the same time, we're having a heavy investment in R&E to fund that future growth. So the gross margin expansion is good and from then the growth at the same time.

And I guess, we can expect that profile as sort of the norm. We're just trying to keep as the norm in the next couple of years at this point?

That's exactly -- yes, that's exactly right, Eli. That's what you'll see when we talk in September, we talk about the targets. That's really going be what they're going to say. And of course, to say it is one thing, to do is another, but that's what our management team is focused on.

On that point can we sort of -- I mean, it would seem that the component sector probably has the most leverage for improvement in the profitability. Of course, you have the divisions where you have mentioned the booming, Power Gen is quite strong but components seemed to be almost as if -- it's always been the step child. Is that area that could have the most improvement in profitability in the next couple of years?

I think Annad Hasim [ph] might take issue with the step child characterization there. But I get where you're going. They are now in double-digit return level. We're very, very happy with where we are now from a profitability point of view. Of course, we think they can improve. But I think -- the other thing to think with them is that we also think they have potential growth, higher growth. So we'll be balancing how much we're expecting from incremental margins and how much we want growth. For example, there we're likely to increase engineering spending at a higher rate because we think we've got an opportunity to launch a lot more products, especially in developing countries, so we'll be balancing that. So I guess I wouldn't say that that's the area where all the incremental -- a lot of the incremental EBIT level. We'll be looking for good incremental margins across all 4 segments and growth rates, good growth rates are across all 4 segments but a little higher growth rate in the Components business.

Your next question is from the line of Jerry Revich from Goldman Sachs.

Tom, can you give us an update on your light-duty diesel turbo and high horsepower engine development programs? When do you expect to start commercial production? And in case you're feeling generous, what range of annual sales contributions are you targeting from those platforms?

Light-duty diesel, first of all, is still in the stage where we're looking for partners before we can say we're going to production. So we have an engine, it's designed. We have a plant or at least 90% of a plant. So we are ready to partner up. There'll be some engineering to do to finalize with our partners to get it launched. But right now, we have partners interested. The combination of those partners together does not reach commercial viability. So we're a significant partner short of being able to launch. And that we've been actively exploring partners now for the last several months. We have some good leads. We got -- deepened some conversations. So as I said, I'm cautiously optimistic that we'll find something but don't want to get ahead of myself. So that's light-duty diesel and I don't -- that's where it is. With regard to the high horsepower engine, we have a planned introduction and announcement about timing and things like that I'm ahead of now. So I don't want to say much more about that other than to say we are working on a larger engine. We will be looking to grow revenues. But that announcement has yet to come. Jerry, I don't know if you -- were you asking a little bit about the 2.8 and 3.8 that we've got with our Foton joint venture?

I was asking about the turbochargers that you're developing to go in line with the Foton joint venture.

Okay, the turbocharger. This is the small turbochargers. Okay, I'm sorry, I missed your question. Well, you got a lot information, you didn't need then. Let's see if we can get you information you do need.

So I think, Jerry, this is Mark, so the big ramp up in those turbos is going to be around the next emissions change in China. You will see some modest volumes here in the fourth quarter and then start to build up next year.

Yes, and remember that's Euro IV or whatever the China equivalent of Euro IV is. And that right now is scheduled to be the first of 2012. But there's debate about when the actual implementation will be, and we just don't know. But most market expectations I've heard are somewhere between January 2012 and January 2013. Again, everybody has a point to pick on the calendar but it's somewhere between those 2. And that will be a significant launch for the Components segment, I think you know that Jerry that's a small turbo but lots of volume. So a significant opportunity for us for growth there.

And, Tom, on that note, any opportunity to sell that turbo to other engine makers? And on that note, can you talk about if you see any incremental emissions solution sales opportunities to other engine OEMs in China and Brazil with your foreign national standards in '12?

Yes, no question about it, Jerry. We have already been talking with other potential customers for that turbocharger. We have, as you guessed, the development is a major activity for us. We're kind of doing things step-by-step but there's no question there'll be other opportunities for sale there, and they're significant. And, then on the aftertreatment side, we do believe that aftertreatment has significant growth potential in China. That's was when I was talking to Eli, that was one of the points I was making about growth in the Components business is that the developing countries like China, that as they begin to implement standards from Euro IV on, now they're having to add equipment that will help the engines meet emissions, and we are working actively on FCR and other aftertreatment devices that we believe a lot of engine makers will use and we think we'll have significant business growth as a result.

The next question is coming from the line of Basili Alukos from Morning Star.

Just one broad question that's kind of following up on other questions, people have asked just about your guidance. I'd like to call myself an optimist, but all the news that you read in the paper, columns just had a few articles recently about China, India, as well as Brazil, as far as inflation, the Chinese PMI was about at 50. Obviously, what's going on in the U.S. with the debt. And then in Europe, they're struggling yet when you read your release and see that you've raised revenue guidance for the second time, just trying to figure it all out in light of the context of what's going on in the rest of the world. How you have such strength and is it mostly market share? Obviously, your share has been up so there's greater penetration which explains why the Distribution -- or excuse me, why the Components business was doing well. But just trying to kind of to figure it all out in light of kind of backdrops that don't seem as positive?

Yes, let give me you 2 general thoughts, and then we can see if I can -- we can be more specific. But generally speaking, as I talked about China as an example, which to your point there's been a lot of news about China and is it getting worse. A lot the news, I think, is about momentum. It's about the fact that is it going to get worse than it's been growing. And it's been growing at 9% or 10% GDP a year. And so the government has said we need to control inflation because they're getting housing cost inflation and other forms of inflation, which look like they could create problems for them long run. So they're watching out for bubbles. But they have a strong incentive to keep GDP growth up above 8%. So their playing a fine line between how much they restrain growth and how much they allow growth. But suffice it to say that there's significant growth still going on in China. And remember that even if they get down to 7% growth compared to 1% or 2% in the U.S., so these are other markets that are growing very, very quickly. And even the comparisons, if you look -- I've mentioned talked about the excavator market, which has clearly fallen off from very, very high construction equipment purchases driven by stimulus and just the general GDP growth, still we're talking about levels that are in Q1 was 60% higher than just one year before in China, which was already huge. So the growth rates are so big that even if they start to tail off a little bit, you're talking about gigantic business for Cummins. So there's definitely share gains in there. There a trends which are favoring local producers versus importers and we're, of course, a local producer and supplying local producers. We're growing our -- the size of our engines. We're adding the Foton joint venture, which is giving us new engines in China. We're bringing new products to India, same thing. So those are influencing it to but broadly speaking, I think when you look on the margin, you might say hey this looks a little bit worse, but when you step back from it you say what's the opportunity for Cummins, it's slowing down slightly but not very much. We can barely keep up. So that's the first point. The second point is I do think there is general uncertainty in the U.S. and Europe, and I don't know what to say to you about that other than I do think that some of our businesses like Power Gen still have more room to recover. And if things got better, if we started to see positive momentum in the U.S. and Europe and more confidence. We'd see those -- that business improve further. So we have more upside than we think we were experiencing. But there is that cloud hanging over that's I think keeping the growth of capital businesses like Power Gen slower. And then truck, on the other hand, which maybe could be slower too, is fast because for so many years people delay truck purchases. Now they're just desperate, they need new trucks because the cost of their old ones is now exceeded the cost of buying new ones from a total cost point of view, so they're buying new ones even in the face of some uncertainty in the economy. So I guess what I'm try to give these our business is going very well in I agree some uncertain times but it's mostly because we're positioned in these developing economies that are growing much faster and because some of our end markets are growing despite the uncertainty. I think when things get more confident, you're going to see even more growth for us.

I appreciate it. That kind of helps round out the story. And I guess just a follow-up on that, and I think before Cummins has said that most of the segments with the exception of the Power Gen, tend to be leading or at least concurrent. And I'm just wondering kind of given that ECRI too has seen a slowdown but maybe some of the segments are kind of more concurrent to lagging versus leading. And maybe that's the reason why the potential slowdown might not necessarily be reflected in your numbers as you've increase your...

Basili, it's Mark. I think, obviously, in the U.S., the truck cycle, the age of the fleets who have been on a depressed level or demand for a number of years and that's -- when you talk about components, that's a big driver. So the recovery in trucks in North America and a little bit in Europe is going to be driving that we believe we're in the front end of a multiyear cycle there. That's a particular reason why Components is picking up with the extra content at each at different emissions level.

And at this time, I am showing we are at the top of the hour.

Thank you.

Okay. Well, thank you very much for your time today, and I will be available for calls shortly. Thank you.

Ladies and gentlemen, that concludes today's conference call. We thank you for your participation. You may now disconnect. Have a good day.