Print PagePART II
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
RESULTS OF OPERATIONS
Minority Interests in Earnings of Consolidated Subsidiaries
Minority interests are primarily attributable to CIL, a 51 percent owned subsidiary and Wuxi Holset Engineering Co. Ltd. (Wuxi), a 55 percent owned subsidiary. These two subsidiaries accounted for over 80 percent of the total minority interest in 2007. Earnings at these two subsidiaries increased this year resulting in a combined increase in minority interest earnings of $10 million for 2007 compared to 2006. These increases were partially offset by the deconsolidation of Cummins Eastern Canada LLP (CEC), a 51 percent owned subsidiary, on January 1, 2007. The remainder of the consolidated partially-owned subsidiaries had a combination of immaterial increases and decreases in earnings.
2006 vs. 2005
Net Sales
Net sales increased due to record sales in all segments. Net sales changes by segment were as follows:
| 2006 vs. 2005 | ||||
|---|---|---|---|---|
| ($ in millions) | ||||
| Change | % Change | |||
| Engine | $854 | 13% | ||
| Power Generation | 417 | 21% | ||
| Components | 281 | 14% | ||
| Distribution | 194 | 16% | ||
Engine sales were higher due to strong demand from heavy and medium-duty truck OEMs, higher engine volumes for industrial applications and increased shipments of light-duty engines. Engine and part sales to on-highway markets were 12 percent higher compared to 2005 with increased volumes in most market segments. Power Generation sales increased due to increased demand across all product lines. Components sales increased due to organic growth in all of our Components businesses. Distribution sales increased due to increased demand for power generation products followed by increased parts, service and engine volumes. See our ‘‘Operating Segment Results’’ section for further details on sales by segment.
Gross Margin
Gross margin improved primarily due to increased sales, the related absorption benefits on fixed manufacturing costs, and changes in sales mix. Significant drivers impacting gross margins were as follows:
| 2006 vs. 2005 (in millions) Change |
|||
|---|---|---|---|
| Volume | $415 | ||
| Price | 94 | ||
| Incremental product cost | (43 | ) | |
| Warranty expense | (53 | ) | |
| Product mix | (20 | ) | |
| Other | 28 | ||
| Total | $421 | ||
Gross margin as a percentage of sales increased by 1.1 percentage points as margin percentages increased in the Engine, Power Generation and Components segments. The increased margins in these segments were primarily the result of higher absorption of fixed manufacturing costs that resulted from higher demand, improved pricing, and manufacturing efficiencies.
Warranty expense as a percent of sales increased slightly to 2.8 percent in 2006 compared to 2.7 percent in 2005.
Selling and Administrative Expenses
Selling and administrative expenses increased primarily due to incremental staffing and higher compensation and related expenses of approximately $64 million, which included salaries, variable compensation and fringe benefits, as a result of our improved financial performance. Other factors affecting selling and administrative expenses included increased consulting fees and other outside services of $33 million, increased marketing and administrative expenses of $18 million and increased travel expenses of $16 million. The remaining change in selling and administrative expenses was due to a combination of increases in various other miscellaneous expenses, none of which were individually significant, partially offset by a favorable foreign currency impact. Overall, selling and administrative expenses as a percentage of sales remained flat at 10.1 percent for both 2006 and 2005.
Research and Engineering Expenses
Research and engineering expenses increased primarily due to higher compensation expense and consulting and outside services, as well as higher spending on development programs for future products. We had significant research and engineering expenses across the Engine and Components segments related to new product development for 2007 and beyond as well as research and engineering expenses for growth platforms across geographies. The Engine segment accounted for $24 million of the increase in research and engineering expenses along with an increase in the Components segment of $12 million. Fluctuations in other miscellaneous research and development expenses were not significant individually or in the aggregate.
Investee Equity, Royalty and Other Income
Investee equity, royalty and other income increased slightly primarily due to an increase in earnings at several of our equity investees, led by an $18 million increase in earnings from our North American distributors, a $6 million increase in earnings from Tata Cummins Ltd. and a $3 million increase in earnings from CCEC. These increases were partially offset by a $17 million decrease in earnings from DCEC, as a result of weakness in the medium-duty truck market, due to the continuous tonnage upgrade of China’s truck industry.
Other Operating Income, Net
The major components of other operating income are gain or loss on sale of fixed assets and businesses, royalty income and legal expenses. The 2006 results were flat compared to 2005 as a $10 million increase in gain on sale of fixed assets was offset by a $6 million decrease in royalty income, a $3 million increase in legal expenses and $1 million increase in miscellaneous expenses.
Interest Income
Interest income increased primarily due to higher average cash balances in 2006, compared to 2005. The higher average cash balances were due to increased earnings and stronger cash flows from operations in 2006.
Interest Expense
Interest expense decreased primarily due to lower debt balances in 2006, compared to 2005, partially offset by higher interest rates. The conversion of our $300 million 7% convertible subordinated debentures during the second quarter resulted in a reduction in interest expense of over $10 million for 2006.
Other Income (Expense), Net
The major components of other income (expense) include foreign currency exchange gains and losses, bank charges and other miscellaneous income and expenses. The increase in other income in 2006 compared to 2005 was due to a fluctuation in foreign currency exchange gains and losses from a loss of approximately $6 million in 2005 to a gain of approximately $11 million in 2006. These items were partially offset by a $12 million loss on the early extinguishment of debt incurred when we repaid our $250 million 9.5% notes in December 2006. In addition, miscellaneous expenses decreased $4 million compared to 2005 while miscellaneous income increased $3 million over 2005.
Provision for Income Taxes
Our tax rates have been less than the 35 percent U.S. income tax rate primarily because of lower taxes on foreign earnings, export tax benefits and research tax credits.
Our effective tax rate for 2006 was 29.9 percent. Our income tax provision for 2006 was impacted by a $12 million (1.1 percent) increase for the effect of new Indiana tax legislation, and a $28 million (2.6 percent) reduction for the favorable resolution of tax uncertainties related to prior years. Our effective tax rate for 2005 was 27.1 percent. Our 2005 provision was reduced by $16 million (2.0 percent) for the tax benefits of foreign dividend distributions which qualified for a special 85 percent deduction under The American Jobs Creation Act of 2004 and by $8 million (1.0 percent) due to the favorable resolution of prior year tax positions which had been in dispute. U.S. export tax benefits also reduced our 2005 tax rate by 2.5 percent compared to 1.4 percent for 2006. These benefits were phased down by The American Jobs Creation Act and repealed after 2006.
Minority Interests in Earnings of Consolidated Subsidiaries
Minority interests are primarily attributable to CIL, a 51 percent owned subsidiary, CEC, a 51 percent owned subsidiary, and Wuxi, a 55 percent owned subsidiary. These three subsidiaries accounted for over 90 percent of the total minority interest in 2006. Earnings at these three subsidiaries increased this year resulting in a combined increase in minority interest of $7 million for 2006 compared to 2005. In addition, earnings at SEG, a 51 percent owned subsidiary prior to its sale in the fourth quarter of 2006, improved resulting in a $3 million year-over-year increase in minority interests. The remainder of the consolidated partially-owned subsidiaries had a combination of immaterial increases and decreases in earnings.