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Item 1. Business
Power Generation Segment
The Power Generation segment represented 19 percent of our total sales before intersegment eliminations in 2007. 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 Onan brand 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.
Cummins Generating Technologies (CGT) is a leader in the alternator industry and supplies its products internally as well as to other generator set assemblers. CGT products are sold under the Stamford, AVK and Markon brands and range in output from 0.6kVA 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 leverage business partnerships to develop cost-effective and environmentally sound power solutions.
Our customer base for power generation products is highly diversified, with customer groups varying based on their power needs. The U.K., Europe, India and the Middle East 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. Volvo and DaimlerAG, 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 and other regional generator set assemblers. CGT competes globally with Emerson Electric Co., Marathon Electric and Meccalte, among others.
Components Segment
Our Components segment produces filters, fuel systems, aftertreatment systems, intake and exhaust systems and is the largest worldwide supplier of turbochargers for commercial applications.
Components 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. In addition, we develop aftertreatment and exhaust systems to help our customers meet increasingly stringent emissions standards and fuel systems which to date have primarily supplied our Engine segment. In 2007, our
Components segment accounted for approximately 19 percent of our total sales before intersegment eliminations.
Our filtration business is the world’s leading supplier of filtration, exhaust, coolant and chemical products offering over 27,000 products including air, coolant, fuel and hydraulic filters, antifreeze and coolant additives, catalysts, particulate filters, controllers and other filtration systems to OEMs, dealer/ distributors and end-user markets. Our products are produced and sold in global markets, including North America, South America, Europe, Asia, Africa and Australia. Filtration also makes products for the automotive specialty filtration market and the industrial filtration market through our Kuss subsidiary, located in Findlay, Ohio.
Our turbo technologies business designs, manufactures and markets turbochargers for commercial and light-duty diesel applications with manufacturing facilities in five countries and sales and distribution worldwide. Cummins Turbo Technologies 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.
Our 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 XPI Manufacturing LLP (Cummins-Scania XPI) joint venture was formed to design, develop and manufacture the next generation of fuel systems for use in 2007 and beyond.
Our emissions solutions business designs and manufactures aftertreatment and exhaust systems to help our customers meet increasingly stringent emissions standards. We believe we are the leading supplier of aftertreatment products for EPA 2007 emissions standards in North America and for Euro IV standards in Europe. During 2007, Cummins Emission Solutions secured an agreement to supply emission management technology for Tier 4 emissions standards. Emissions solutions is expanding its international manufacturing capabilities with new leases signed in 2007 in Sao Paulo, Brazil and Beijing, China with production in these facilities intended for use on Cummins engines meeting Euro IV emissions standards beginning in 2009 and 2011, respectively.
Customers of our Components segment generally include truck manufacturers and other OEMs, many of which are also customers of our Engine segment, such as CNH Global N.V., International Truck and Engine, Volvo and other manufacturers that use Cummins filtration products in their product platforms. Components products are sold to truck manufacturers and OEMs for use on both Cummins engines and other proprietary engine lines. Our customer base for replacement filtration parts is highly fragmented and primarily consists of various end-users of filtration systems. In addition, Components sells products to the Engine and Power Generation segments to complement their products and to the Distribution segment for sale to their customers.
Our Components segment competes with other manufacturers of filtration, exhaust and fuel systems and turbochargers. Our primary competitors in these markets include Donaldson Company, Inc., Clarcor Inc., Mann+Hummel Group, Tokyo Roki Co., Ltd., Borg-Warner, Bosch, Tenneco and Honeywell International.
In November 2007, we sold certain assets of our Universal Silencer (USI) subsidiary, based in Stoughton, Wisconsin, to Stirling Group, LLC. The sale closed in the fourth quarter of 2007 for approximately $36 million and resulted in a pre-tax gain of approximately $10 million. USI, which was part of our Components segment, specializes in designing and manufacturing noise control and air filtration products for industrial equipment. Total assets of USI were approximately $24 million at the date of the transaction and $15 million at December 31, 2006, which is less than 1.8 percent of our total assets at those dates. Total sales of USI were approximately $54 million and $47 million, for the ten months ended October 31, 2007 and for the year ended December 31, 2006, respectively, which is less than 0.5 percent of our total company consolidated net sales for both periods.
Distribution Segment
In 2007, Distribution segment sales accounted for 10 percent of our total sales before intersegment eliminations. Our Distribution segment consists of 17 company-owned and 15 joint venture distributors that distribute the full range of our products and services to end-users at approximately 300 locations in over 70 countries and territories. In North America, this network is mostly 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 India, China, Japan, Australia, Europe, the Middle East and South Africa. Our distributors also serve and develop dealers, predominantly OEM dealers, in their territories by providing technical support, tools, training, parts and product information.
In addition to managing our investments in wholly-owned and partially-owned distributors, our Distribution segment is responsible for managing the performance and capabilities of our independent distributors. Our distributors collectively serve a highly diverse customer base with approximately 47 percent of their revenues being from the wholesale of new power equipment (engines and power generation equipment) and the other portion consisting of parts and service repairs.
The distributors that we own or operate compete with distributors or dealers that offer similar products. In many cases, these competing distributors or dealers are owned by, or affiliated with, the companies that are listed above as competitors of the Engine, Power Generation or Components segments. These competitors vary by geographical location.
In January 2007, an economic transaction with an equity owner in one of our North American joint ventures resulted in a deconsolidation of this joint venture in 2007 under the Financial Accounting Standards Board (FASB) Interpretation No. 46R, ‘‘Consolidation of Variable Interest Entities,’’ (FIN 46R). In addition, and in line with our North American strategy, we formed a joint venture with a previously independent distributorship. We also formed joint ventures in Nigeria and Thailand. The results of these three joint ventures are accounted for under the equity method and are not consolidated.
SEGMENT FINANCIAL INFORMATION
Financial information about our operating segments is incorporated by reference from Note 21 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 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 70 and 80 percent of our total raw material and component purchases in 2007 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, we established a process to annually review our sourcing strategies with a focus on the reduction of risk, which has led us to dual source critical components. 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. Our supply agreements typically include standard terms relating to cost (cost reduction targets and total cost of ownership), quality (quality targets and recovery of cost of poor quality) and delivery (on-time delivery targets and lead times). 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 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 2007, all of our significant long term suppliers signed our Supplier Code of Conduct.
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. Chrysler is our largest customer, accounting for approximately 8 percent of our consolidated net sales in 2007, primarily relating to sales of our ISB engine for use in Dodge Ram trucks. While a significant number of our sales to Chrysler are under long-term supply agreements, these agreements provide for the supply of Chrysler’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 Chrysler 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 Chrysler for nearly 20 years. A summary of principal customers for each operating segment is included in our segment discussion.
In addition to our agreements with Chrysler, we have long-term heavy-duty engine supply agreements with PACCAR, Volvo Trucks North America and International Truck and Engine Corporation. We also have mid-range supply agreements with PACCAR, as their exclusive engine supplier, Daimler Trucks North America and Ford. Collectively, our net sales to these five customers was less than 21 percent of consolidated net sales in 2007 and individually, was less than 7 percent of consolidated net sales for each customer. As with Chrysler, 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 price and operations agreements that assure the availability of our products to each customer through the duration of the respective agreements. 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.