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CMI > SEC Filings for CMI > Form 10-K on 20-Feb-2013All Recent SEC Filings

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Form 10-K for CUMMINS INC


20-Feb-2013

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

ORGANIZATION OF INFORMATION

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") was prepared to provide the reader with a view and perspective of our business through the eyes of management and should be read in conjunction with our Consolidated Financial Statements and the accompanying notes to those financial statements. Our MD&A is presented in the following sections:


Executive Summary and Financial Highlights


2013 Outlook


Results of Operations


Restructuring and Other Charges


Operating Segment Results


Liquidity and Capital Resources


Contractual Obligations and Other Commercial Commitments


Application of Critical Accounting Estimates


Recently Adopted and Recently Issued Accounting Pronouncements

EXECUTIVE SUMMARY AND FINANCIAL HIGHLIGHTS

We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines and engine-related component products, including filtration, aftertreatment, turbochargers, fuel systems, controls systems, air handling systems and electric power generation 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 PACCAR Inc, Daimler Trucks North America, Chrysler Group, LLC, Volvo AB, Komatsu, Navistar International Corporation, Aggreko plc, Ford Motor Company and MAN Nutzfahrzeuge AG. We serve our customers through a network of approximately 600 company-owned and independent distributor locations and approximately 6,500 dealer locations in more than 190 countries and territories.

Our reportable operating segments consist of the following: Engine, Components, Power Generation and Distribution. This reporting structure is organized according to the products and markets each segment serves and 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. Our engines are used in trucks of all sizes, buses and recreational vehicles, as well as in various industrial applications, including construction, mining, agriculture, marine, oil and gas, rail and military equipment. The Components segment sells filtration products, aftertreatment, turbochargers and fuel systems. The Power Generation segment is an integrated provider of power systems which sells engines, generator sets and alternators. The Distribution segment includes wholly-owned and partially-owned distributorships engaged in wholesaling engines, generator sets and service parts, as well as performing service and repair activities on our products and maintaining relationships with various OEMs throughout the world.

Our financial performance depends, in large part, on varying conditions in the markets we serve, particularly the on-highway, construction and general industrial markets. Demand in these markets tends to fluctuate in response to overall economic conditions. Our sales may also be impacted by OEM inventory levels and production schedules and stoppages. Economic downturns in markets we serve


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generally result in reductions in sales and pricing of our products. As a worldwide business, our operations are also affected by currency, political, economic and regulatory matters, including adoption and enforcement of environmental and emission standards, in the countries we serve. As part of our growth strategy, we invest in businesses in certain countries that carry high levels of these risks such as China, Brazil, India, Mexico, Russia and countries in the Middle East and Africa. At the same time, our geographic diversity and broad product and service offerings have helped limit the impact from a drop in demand in any one industry or customer or the economy of any single country on our consolidated results.

The global economy continued to slow throughout 2012, although the impacts were partially offset by strong demand across several end markets in the U.S. and Canada (North America) in the first half of the year; however these markets weakened in the second half of the year, particularly the heavy-duty truck market. Economies in emerging markets, including China and Brazil experienced challenges throughout the year in most markets, especially the off-highway construction market in China and the medium-duty truck market in Brazil. Demand in India remained strong for power generation equipment; however, improved volumes were more than offset by unfavorable currency impacts. International (excludes the U.S. and Canada) off-highway construction markets have continued to deteriorate with engine shipments down 53 percent, including a 72 percent decline in China. The on-highway medium-duty truck market in Brazil declined as the result of the 2011 pre-buy ahead of the new 2012 emission requirements and one of our customers replacing our B6.7 engine with a proprietary engine in 2012 contributing to international medium-duty truck shipments being down 19 percent. North American demand for heavy-duty on-highway products increased 3 percent while medium-duty truck shipments increased 15 percent in 2012 compared to 2011; although demand in both of these markets declined in the second half of 2012. North American light-duty on-highway demand also improved with an increase in shipments to Chrysler of 37 percent in 2012 compared to 2011.

Slow growth in the U.S. economy and uncertainty driven by unresolved federal tax and budget issues caused businesses to hold back on capital expenditures in 2012, thus impacting demand for truck and power generation equipment. The governments of China and India have controlled inflation through tight monetary policies in the form of rising interest rates and tightening access to credit, although both countries began easing these policies in response to reduced inflationary concerns in 2012. Brazil also began easing their monetary policies in the second half of 2012. Easing monetary policies could enhance our end markets; however, there likely will be a delay between when these policies are implemented and when our end markets respond. The European economy remains uncertain with continued volatility in the Euro countries. Although we do not have any significant direct exposure to European sovereign debt, we generated approximately 8 percent of our net sales from Euro zone countries in 2012. As a result of a number of markets unexpectedly slowing in mid-2012, continued weak economic data in a number of regions and increasing levels of uncertainty regarding the direction of the global economy, we implemented a number of cost reduction initiatives in the second half of 2012. In October 2012, we announced strategic actions necessary to respond to the current environment by cutting costs while maintaining investments in key growth programs. Actions include a number of measures to reduce costs including planned work week reductions, shutdowns at some manufacturing facilities and some targeted workforce reductions. We reduced our workforce by 1,300 people in the fourth quarter and incurred total restructuring charges of $52 million ($35 million after-tax), or $0.18 per diluted share.


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The following table contains sales and EBIT results by operating segment for the years ended December 31, 2012 and 2011. Refer to the section titled "Operating Segment Results" for a more detailed discussion of net sales and EBIT by operating segment including the reconciliation of segment EBIT to income before taxes.

Operating Segments

                            2012                              2011                   Percent change
                           Percent                           Percent                 2012 vs. 2011
In millions     Sales     of Total      EBIT      Sales     of Total      EBIT      Sales       EBIT
Engine         $ 10,733          62 %  $ 1,248   $ 11,307          63 %  $ 1,384        (5 )%     (10 )%
Components        4,012          23 %      426      4,063          23 %      470        (1 )%      (9 )%
Power
Generation        3,268          19 %      285      3,498          19 %      373        (7 )%     (24 )%
Distribution      3,277          19 %      369      3,044          17 %      386         8 %       (4 )%
Intersegment
eliminations     (3,956 )       (23 )%       -     (3,864 )       (22 )%       -         2 %        -
Non-segment           -           -        (25 )        -           -        102         -         NM

Total          $ 17,334         100 %  $ 2,303   $ 18,048         100 %  $ 2,715        (4 )%     (15 )%


"NM"-not meaningful information.

Net income attributable to Cummins Inc. for 2012 was $1,645 million, or $8.67 per diluted share, on sales of $17.3 billion, compared to 2011 net income attributable to Cummins Inc. of $1,848 million, or $9.55 per diluted share, on sales of $18.0 billion. The decrease in income and earnings per share was driven by higher operating expenses, lower gross margins and lower equity, royalty and interest income from investees, partially offset by a lower effective tax rate of 23.5 percent versus 27.1 percent in 2011. In addition, the significant gains we recorded in 2011 for the disposition of certain assets and liabilities of our exhaust business and light-duty filtration business and flood damage recoveries did not repeat in 2012. Diluted earnings per share for 2012 benefited $0.06 from lower shares primarily due to the stock repurchase program.

In July 2012, we completed the acquisition of Hilite Germany GmbH (Hilite) in a cash transaction for $176 million. We also acquired an additional 45 percent interest in Cummins Central Power for consideration of approximately $20 million.

We generated $1.5 billion of operating cash flows in 2012, compared to $2.1 billion in 2011. Refer to the section titled "Operating Activities" in the "Liquidity and Capital Resources" section for a discussion of items impacting cash flows.

In February 2011, the Board of Directors approved a share repurchase program and authorized the acquisition of up to $1 billion of our common stock. We repurchased $256 million of common stock in 2012. In December 2012, the Board of Directors authorized the acquisition of up to $1 billion of our common stock upon completion of the 2011 repurchase program.

In July 2012, the Board of Directors authorized a dividend increase of 25 percent from $0.40 to $0.50 per share on a quarterly basis effective in the third quarter. Our debt to capital ratio (capital is defined as debt plus equity) at December 31, 2012, was 10.0 percent, compared to 11.8 percent at December 31, 2011. As of the date of filing of this Annual Report on Form 10-K, we had an 'A' credit rating with a stable outlook from Standard & Poor's Rating Services, an 'A' credit rating and a stable outlook from Fitch Ratings and a 'Baa1' credit rating with a positive outlook from Moody's Investors Service, Inc. In addition to our $1.6 billion in cash and marketable securities on hand, we have sufficient access to our credit facilities, if necessary, to meet currently anticipated investment and funding needs.


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On November 9, 2012, we entered into a five-year revolving credit agreement with a syndicate of lenders. The credit agreement provides us with a $1.75 billion senior unsecured revolving credit facility, the proceeds of which are to be used by us for working capital or other general corporate purposes.

Our global pension plans, including our unfunded non-qualified plans, were 98 percent funded at year-end 2012. Our U.S. qualified plan, which represents approximately 60 percent of our worldwide pension obligation, was 106 percent funded and our United Kingdom (U.K.) plan was 104 percent funded. Asset returns in 2012 for the U.S. qualified plan were 14 percent while the year-end 2012 discount rate was 3.95 percent, down 0.85 percentage points from the 2011 discount rate of 4.80 percent. We expect to contribute $170 million of cash to our global pension plans in 2013. We do not have a required minimum pension contribution obligation for our U.S. plans in 2013. We expect pension and other postretirement benefit expense in 2013 to increase by approximately $35 million pre-tax, or $0.14 per diluted share, when compared to 2012. Refer to application of critical accounting estimates within MD&A and Note 12, "PENSION AND OTHER POST RETIREMENT BENEFITS," to the Consolidated Financial Statements, for additional information concerning our pension and other post-retirement benefit plans.

2013 OUTLOOK

Near-Term

The global economy continued to slow throughout 2012, although the impacts were partially offset by strong demand across several end markets in North America in the first half of the year; however these markets weakened in the second half of the year, particularly the heavy-duty truck market. Economies in emerging markets, including China and Brazil experienced challenges throughout the year in most markets, especially the off-highway construction market in China and the medium-duty truck market in Brazil. Demand in India remained strong for power generation equipment; however, improved volumes were more than offset by unfavorable currency impacts.

We currently expect the following positive trends in 2013:


The Brazilian economy is expected to experience stronger growth in 2013 which is anticipated to result in improving demand in both truck and industrial markets over 2012 levels.


Demand in some of our markets is expected to improve in the second half of 2013 following a slower start in the first half of the year.


The new heavy-duty supply agreement with Navistar International Corporation is expected to have a positive impact on our heavy-duty truck engine and component sales.

We currently expect the following challenges to our business that may reduce our earnings potential in 2013:


Political decisions in the U.S. regarding federal tax and budget issues could continue to create economic uncertainty that may limit capital investments and negatively impact the overall North American economy in the first half of 2013.


We expect most of our markets to be weak in the first quarter of 2013 but should begin to improve in the second quarter, although remaining below 2012 levels in the first half of 2013.


Demand in certain European markets could continue to decline due to economic uncertainty.


Growth in international markets could be negatively impacted if emission regulations are not strictly enforced.


Demand for our products in certain industrial markets in China could remain low due to high equipment inventory levels.


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Currency volatility could continue to put pressure on earnings.


North American oil and gas markets could continue to remain weak.


Domestic and international mining markets could continue to deteriorate if commodity prices weaken.

Long-Term

We believe that, over the longer term, there will be economic improvements in most of our current markets and that our opportunities for long-term profitable growth will continue in the future as the result of the following four macroeconomic trends that will benefit our businesses:


tightening emissions controls across the world;


infrastructure needs in emerging markets;


energy availability and cost issues and


globalization of industries like ours.

RESULTS OF OPERATIONS

                                                                Favorable/(Unfavorable)
                      Years ended December 31,           2012 vs. 2011           2011 vs. 2010
In millions
(except per
share amounts)       2012        2011       2010      Amount      Percent      Amount     Percent
NET SALES          $  17,334   $ 18,048   $ 13,226   $    (714 )        (4 )% $  4,822          36 %
Cost of sales         12,826     13,459     10,058         633           5 %    (3,401 )       (34 )%

GROSS MARGIN           4,508      4,589      3,168         (81 )        (2 )%    1,421          45 %

OPERATING
EXPENSES AND
INCOME
Selling, general
and
administrative
expenses               1,900      1,837      1,487         (63 )        (3 )%     (350 )       (24 )%
Research,
development and
engineering
expenses                 728        629        414         (99 )       (16 )%     (215 )       (52 )%
Equity, royalty
and interest
income from
investees                384        416        351         (32 )        (8 )%       65          19 %
Gain on sale of
businesses                 6        121          -        (115 )       (95 )%      121         100 %
Other operating
income
(expense), net           (16 )       21        (16 )       (37 )        NM          37          NM

OPERATING INCOME       2,254      2,681      1,602        (427 )        16 %     1,079          67 %
Interest income           25         34         21          (9 )       (26 )%       13          62 %
Interest expense          32         44         40          12          27 %        (4 )       (10 )%
Other income
(expense), net            24          -         34          24         100 %       (34 )      (100 )%

INCOME BEFORE
INCOME TAXES           2,271      2,671      1,617        (400 )        15 %     1,054          65 %
Income tax
expense                  533        725        477         192          26 %      (248 )       (52 )%

CONSOLIDATED NET
INCOME                 1,738      1,946      1,140        (208 )        11 %       806          71 %
Less: Net income
attributable to
noncontrolling
interests                 93         98        100           5           5 %         2           2 %

NET INCOME
ATTRIBUTABLE TO
CUMMINS INC.       $   1,645   $  1,848   $  1,040   $    (203 )       (11 )% $    808          78 %

Diluted earnings
per common share
attributable to
Cummins Inc.       $    8.67   $   9.55   $   5.28   $   (0.88 )        (9 )% $   4.27          81 %


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                                                                 Favorable/(Unfavorable)
                                                                    Percentage Points
Percent of sales                  2012     2011     2010    2012 vs. 2011      2011 vs. 2010
Gross margin                       26.0 %   25.4 %   24.0 %            0.6                1.4
Selling, general and
administrative expenses            11.0 %   10.2 %   11.2 %           (0.8 )              1.0
Research, development and
engineering expenses                4.2 %    3.5 %    3.1 %           (0.7 )             (0.4 )

2012 vs. 2011

Net Sales

Net sales decreased versus 2011 and was primarily driven by the following:


Engine segment sales decreased by 5 percent due to weakness in industrial demand, especially in international construction markets, and lower volumes in the Brazilian medium-duty truck market, which were partially offset by growth in the North American on-highway markets in the first half of the year, led by the heavy-duty business.


Foreign currency fluctuations unfavorably impacted sales by 2 percent.


Power Generation segment sales decreased by 7 percent due to lower demand in the generator technologies, power solutions and power systems businesses, which were partially offset by growing demand in the power product business, especially in North America.


Components segment sales, excluding acquisitions, decreased by 2 percent due to $126 million of sales in 2011 related to assets sold in 2011 and lower demand in the turbo technologies, filtration and fuel systems businesses, which were partially offset by higher demand in the emission solutions business, primarily in North America and Brazil.

The decreases above were partially offset as Distribution segment sales, excluding acquisitions, increased by 2 percent due to higher demand for parts and filtration products especially in North and Central America, increased power generation growth in East Asia, increased demand in the South Pacific and higher service demand from South Pacific mining customers, which were partially offset by lower engine product sales due to a slowdown in the North American oil and gas markets.

A more detailed discussion of sales by segment is presented in the
"OPERATING SEGMENT RESULTS" section.

Sales to international markets were 49 percent of total net sales in 2012, compared with 56 percent of total net sales in 2011.

Gross Margin

Gross margin decreased by $81 million and as a percentage of sales increased by 0.6 percentage points. The increase in gross margin as a percentage of sales was primarily due to lower material costs, improved price realization, lower warranty costs and favorable product mix, which were partially offset by lower volumes, unfavorable foreign currency fluctuations and restructuring charges of $29 million.

The provision for warranties issued as a percentage of sales was 2.1 percent in both 2012 and 2011. A more detailed discussion of margin by segment is presented in the "OPERATING SEGMENT RESULTS" section.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased primarily due to higher consulting of $45 million, restructuring and other charges of $20 million and an increase of $19 million in compensation and related expenses, which were partially offset by reduced discretionary spending in the


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second half of the year. Higher compensation expense was primarily due to increased headcount to support our strategic growth initiatives launched prior to a number of markets unexpectedly slowing in mid-2012. Compensation and related expenses include salaries, fringe benefits and variable compensation. Variable compensation related to 2012 performance decreased $87 million over variable compensation related to 2011 performance. In the third quarter of 2012, we implemented a number of cost reduction initiatives to align our cost structure with the slowdown in demand at several of our key markets in the second half of the year. Overall, selling, general and administrative expenses, as a percentage of sales, increased to 11.0 percent in 2012 from 10.2 percent in 2011.

Research, Development and Engineering Expenses

Research, development and engineering expenses increased primarily due to an increase of $54 million in compensation and related expenses and increased consulting of $32 million. Higher compensation expense was primarily due to increased headcount to support our strategic growth initiatives. Compensation and related expenses include salaries, fringe benefits and variable compensation. Variable compensation related to 2012 performance decreased $25 million over variable compensation related to 2011 performance. Research, development and engineering expenses in 2012 also included restructuring and other charges of $3 million. Overall, research, development and engineering expenses, as a percentage of sales, increased to 4.2 percent in 2012 from 3.5 percent in 2011. Research activities continue to focus on development of new products to meet future emission standards around the world and improvements in fuel economy performance.

Equity, Royalty and Interest Income From Investees

    Equity, royalty and interest income from investees decreased primarily due
to the following:

                                                             2012 vs. 2011
    In millions                                           Increase/(Decrease)
    Dongfeng Cummins Engine Company, Ltd. (DCEC)             $             (28 )
    Chongqing Cummins Engine Company, Ltd. (CCEC)                           (7 )
    Beijing Foton Cummins Engine Co., Ltd. (BFCEC)                          12
    North American distributors                                             13
    All other                                                              (18 )

    Cummins share of net income                                            (28 )
    Royalty and interest income                                             (4 )

    Equity, royalty and interest income from investees       $             (32 )

The decreases above were primarily due to lower sales in China at DCEC and CCEC, which were partially offset by growth in North American distributors and higher sales at BFCEC.

Gain on Sale of Businesses

In the second quarter of 2011, we sold certain assets and liabilities of our exhaust business which manufactures exhaust products and select components for emission systems for a variety of applications not core to our other product offerings. This business was historically included in our Components segment. The sales price was $123 million. We recognized a gain on the sale of $68 million ($37 million after-tax), which included a goodwill allocation of $19 million. The gain was excluded from segment results as it was not considered in our evaluation of operating results for the year ended December 31, 2011.

Sales for this business were $62 million and $171 million in 2011 (through closing) and 2010, respectively. Income before income taxes for this business were approximately $9 million and $22 million in 2011 (through closing) and 2010, respectively.


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During the fourth quarter of 2011, we sold certain assets and liabilities of our light-duty filtration business which manufactures light-duty automotive and industrial filtration solutions. The sales price was $90 million and included a note receivable from the buyer of approximately $1 million. There are no earnouts or other contingencies associated with the sales price. We recognized a gain on the sale of $53 million ($33 million after-tax), which included a goodwill allocation of $6 million. The gain was excluded from segment results as it was not considered in our evaluation of operating results for the year ended December 31, 2011.

Sales for this business were $64 million and $74 million in 2011 (through closing) and 2010, respectively. Income before income taxes for this business were approximately $13 million and $9 million in 2011 (through closing) and 2010, respectively.

In the second quarter of 2012, we recorded an additional $6 million gain ($4 million after-tax) related to final purchase price adjustments for our 2011 divestitures. The gain was excluded from segment results as it was not considered in our evaluation of operating results for the year ended . . .

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