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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
EXECUTIVE SUMMARY AND FINANCIAL HIGHLIGHTS
We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems and engine-related component products, including filtration and exhaust aftertreatment, fuel systems, controls and air handling systems. We sell our products to Original Equipment Manufacturers (OEMs), distributors and other customers worldwide. We have long-standing relationships with many of the leading manufacturers in the markets we serve, including Chrysler LLC, Daimler AG, Volvo AB, PACCAR Inc., International Truck and Engine Corporation (Navistar International Corporation), CNH Global N.V., Komatsu, Scania AB, Ford Motor Company and Volkswagen. We serve our customers through a network of more than 500 company-owned and independent distributor locations and approximately 5,200 dealer locations in more than 190 countries and territories.
Our reportable operating segments consist of the following: Engine, Power Generation, Components and Distribution. This reporting structure is organized according to the products and markets each segment serves. This type of reporting structure allows management to focus its efforts on providing enhanced service to a wide range of customers. The Engine segment produces engines and parts for sale to customers in on-highway and various industrial markets. The engines are used in trucks of all sizes, buses and RVs, as well as various industrial applications including construction, mining, agriculture, marine, oil and gas, rail and military. The Power Generation segment is an integrated provider of power systems which sells engines, generator sets and alternators and rents power equipment for both standby and prime power uses. The Components segment includes sales of filtration products, exhaust aftertreatment systems, turbochargers and fuel systems. 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 and is particularly sensitive to changes in interest rate levels. Our sales may also be impacted by OEM inventory levels and production schedules and stoppages. Economic downturns in markets we serve generally result in reductions in sales and pricing of our products. As a worldwide business, our operations are also affected by political, economic and regulatory matters, including environmental and emissions standards, in the countries we serve. However, our geographic diversity and broad product and service offerings have helped limit the impact of any one industry and the economy of any single country upon our consolidated results. This was effectively demonstrated in 2007 as we continued to experience strong sales and earnings despite the continued softness in the North American heavy-duty truck engine market which was down approximately 50 percent from 2006 levels. More than half of our 2007 sales came from countries other than the United States. The diversity of our business portfolio has contributed to the significant organic growth we have experienced over the past several years continuing into 2007.
Financial highlights for the last three years were as follows:
| Years ended December 31, | ||||||||||||
| Consolidated Results | 2007 | 2006 | 2005 | |||||||||
| (in millions, except earnings per share) | ||||||||||||
| Net sales | $ | 13,048 | $ | 11,362 | $ | 9,918 | ||||||
| Gross margin | 2,556 | 2,465 | 2,044 | |||||||||
| Investee equity, royalty and other income | 205 | 140 | 131 | |||||||||
| Operating earnings | 1,158 | 1,131 | 894 | |||||||||
| Net earnings | 739 | 715 | 550 | |||||||||
| Diluted earnings per share | $ | 3.70 | $ | 3.55 | $ | 2.75 | ||||||
We continued our strong performance of the past three years into 2007 with a fourth straight year of record net sales and net earnings. Net earnings were $739 million, or $3.70 per diluted share, on sales of $13.0 billion, compared to 2006 net earnings of $715 million, or $3.55 per diluted share, on sales of $11.4 billion. The earnings improvement was driven by a 15 percent increase in net sales and a 4 percent increase in gross margin, as we benefited from improved pricing and higher demand across most of our businesses, increased market share in a number of markets and focused cost reduction efforts. All of our segments reported sales increases for the year compared to 2006, with particularly strong demand in Power Generation’s commercial and alternator businesses where sales increased 31 percent and 39 percent, respectively, and Component’s emission solutions and turbocharger businesses, where sales increased 203 percent and 41 percent, respectively. Overall, our Engine segment net sales were up $671 million, or 9 percent year-over-year benefitting from market share gains in the heavy-duty on-highway market. In addition, net sales increased at our Power Generation segment (up $644 million, or 27 percent), Components segment (up $651 million, or 29 percent) and Distribution segment (up $155 million, or 11 percent) year-over-year.
During 2007, we continued our commitment to strengthening our balance sheet, investing in profitable growth around the globe and returning value to our shareholders. Key activities included:
Financing Matters
- The Board of Directors authorized a pair of two-for-one splits of Cummins common stock in 2007. The first split was authorized on March 8, 2007 and was distributed on April 9, 2007, to shareholders of record as of March 26, 2007. The second split was authorized on December 11, 2007 and was distributed on January 2, 2008, to shareholders of record as of December 21, 2007. All share and per share amounts in this filing have been adjusted to reflect both two-for-one stock splits.
- During the fourth quarter of 2007, we completed our previously announced share repurchase program. In July 2006, the Board of Directors authorized us to acquire up to eight million shares (adjusted for the impact of a two-for-one stock split on April 9, 2007 and an additionaltwo-for-one stock split on January 2, 2008) of Cummins common stock in addition to what had been acquired under previous authorizations. During 2007, we purchased six million shares for approximately $335 million. In July, the Board also voted to increase the quarterly cash dividend per share by 39 percent to $0.125 per share (adjusted for the two-for-one stock split on January 2, 2008).
- During 2007, we made contributions of approximately $250 million to our pension plans. As of the end of 2007, our global pension funding was more than 100 percent of our qualified pension obligation.
- We repaid $62 million of our $120 million 6.75% debentures on February 15, 2007, at the election of the debt holders. The debentures were repaid using cash generated from operations. Our level of debt at December 31, 2007, has decreased by $137 million since December 31, 2006 and our debt-to-capital ratio has improved to 16.5 percent at December 31, 2007, from 22.4 percent at December 31, 2006.
Business Expansion
- In 2007, we made global investments of $61 million in our unconsolidated joint ventures including $33 million in five new joint ventures and $28 million in additional investments to our existing joint venture businesses.
- After announcing a feasibility study in the spring of 2006, we signed an agreement in October 2006 with Beiqi Foton Motor Company (Beiqi Foton) to form a 50/50 joint venture, Beijing Foton Cummins Engine Company (BFCEC), to produce two families of Cummins light-duty, high performance diesel engines in Beijing. The engines will be used in light-duty commercial trucks, pickup trucks, multipurpose and sport utility vehicles. Certain types of marine, small construction equipment and industrial applications will also be served by this engine family. Cummins and Beiqi Foton will initially invest a combined $142 million into BFCEC, which is scheduled to begin production in 2009. In October of 2007, we received approval of the joint venture from the Chinese government and we invested $28 million during the year.
- In 2007, we made capital expenditures of $353 million which included expenditures of $80 million for the introduction of new products and $136 million to increase our manufacturing capacity around the world.
Business Divestiture
- 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.