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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
LIQUIDITY AND CAPITAL RESOURCES
Management’s Assessment of Liquidity
We believe our financial condition and liquidity are strong. We assess our liquidity in terms of our ability to generate adequate cash to fund our operating, investing and financing activities. Cash provided by operations is our principal source of liquidity. At December 31, 2007, we believe our liquidity with cash and cash equivalents of $577 million, marketable securities of $120 million, $615 million available under our revolving credit facility, $277 million, based on eligible receivables, available under our accounts receivable program and $119 million available under international credit facilities together with our operating cash flows and borrowing capacity provide us with the financial flexibility needed to fund working capital, debt service obligations, capital expenditures, projected pension obligations, common stock repurchases, dividend payments and expansion in emerging markets. As of December 31, 2007, there were no amounts outstanding under our revolving credit facility or our receivable sales program.
Working Capital Summary
We fund our working capital with cash from operations and short-term borrowings when necessary. Various assets and liabilities, including short-term debt, can fluctuate significantly from month to month depending on short-term liquidity needs. As a result, working capital is a prime focus of management attention.
| 2007 | 2006 | ||||
| (in millions) | |||||
| Current assets | $ | 4,815 | $ | 4,488 | |
| Current liabilities | 2,711 | 2,399 | |||
| Working capital | $ | 2,104 | $ | 2,089 | |
| Current ratio | 1.78 | 1.87 | |||
| Days’ sales in receivables | 53 | 52 | |||
| Inventory turnover | 6.5 | 6.7 | |||
Current assets increased $327 million, primarily due to a $231 million increase in receivables driven by the increase in net sales and a $299 million increase in inventories. These increases were partially offset by a $263 million decline in cash and cash equivalents (see Cash Flows below).
Current liabilities increased $312 million, primarily due to an increase in accounts payables of $159 million and increases in accrued warranty, compensation and other accrued liabilities of $64 million, $56 million and $78 million, respectively, all due to business expansions. These increases were partially offset by a decline in short-term borrowings of $45 million.
Cash Flows
Cash and cash equivalents decreased by $263 million during the year ended December 31, 2007. The change in cash and cash equivalents is as follows:
| 2007 | 2006 | 2005 | ||||||||||
| (in millions) | ||||||||||||
| Net cash provided by operating activities | $ | 810 | $ | 840 | $ | 760 | ||||||
| Net cash used in investing activities | (515 | ) | (277 | ) | (212 | ) | ||||||
| Net cash used in financing activities | (576 | ) | (508 | ) | (372 | ) | ||||||
| Effect of exchange rate changes on cash | 18 | 6 | (8 | ) | ||||||||
| Net (decrease) increase in cash and cash equivalents | $ | (263 | ) | $ | 61 | $ | 168 | |||||
Cash From Operations
Net cash provided by operating activities declined $30 million in 2007, compared to 2006, primarily due to a $79 million decrease in the deferred income tax provision, partially offset by a $41 million decrease in cash used for working capital and a decrease in pension contributions of $16 million. Net changes in working capital utilized $150 million in cash during 2007, compared to utilizing $191 million in 2006. Cash utilized for working capital tends to fluctuate from period to period based on various factors including sales and production volumes as well as timing.
The funded status of our pension plans is dependent upon a variety of variables and assumptions including return on invested assets, market interest rates and levels of voluntary contributions to the plans. Better than expected investment returns and additional voluntary contributions have improved the funded status of all plans, helping to minimize future required funding.
We continued making additional pension contributions by contributing $250 million to our pension plans during the year. Our qualified pension plans are currently over 100 percent funded. We anticipate making contributions of $95 million to $105 million to our pension plans in 2008 and paying approximately $53 million in claims and premiums for other postretirement benefits. The $250 million of 2007 pension contributions included voluntary contributions of $220 million. These contributions and payments include payments from Company funds to either increase pension plan assets or to make direct payments to plan participants.
Net cash provided by operating activities improved $80 million in 2006, compared to 2005, primarily due to $165 million of higher net earnings and a $96 million decrease in cash utilized for working capital, partially offset by an increase in pension funding of $115 million and a decrease in cash provided by changes in long term liabilities of $65 million. Net changes in working capital utilized $191 million in cash during 2006 compared to utilizing $287 million in 2005, or a net decrease in cash utilized for working capital of $96 million year-over-year.
Investing Activities
Net cash used in investing activities increased $238 million in 2007, compared to 2006. The increase was primarily due to a $104 million increase in capital expenditures, a $57 million outflow for the purchase of long-term investments, an increase of $48 million in cash used for investments in and advances to equity investees and an increased outflow of $18 million for the acquisition of businesses, the majority of which was to acquire the remaining 50 percent equity ownership in a 50/50 joint venture.
Capital expenditures for 2007 increased 42 percent to support our growth, and included investments to increase capacity and to fund development of our new products. Our investments in capacity improvements and development of new products are accelerating across all of our businesses and are designed for future growth opportunities. We continue to invest at least half of our capital in low-cost regions of the world to further leverage our opportunities for cost reduction and future growth opportunities. Capital expenditures for all of 2007 were $353 million to support these initiatives. We expect capital expenditures to total approximately $550 million to $600 million in 2008. In addition, we expect to invest approximately $70 million on new and existing joint ventures in 2008.
Net cash used in investing activities increased $65 million in 2006 compared to 2005. The increase was primarily due to higher capital expenditures of $76 million, which includes an increase in investments in internal use software of $13 million. Net cash utilized for purchases of marketable securities in 2006 was $30 million as we increased our short term investment holdings as opposed to 2005 when we were in a net liquidation of securities position with net cash proceeds of $3 million. Significant sources of cash from investing activities year-over-year included increased proceeds from the disposal of equipment of $28 million as well as $24 million of proceeds from the sale of SEG.
The majority of our capital spending in 2006 was primarily for new product introduction, capacity expansion, manufacturing equipment, and tooling for new products.
Financing Activities
Net cash used in financing activities increased $68 million in 2007, compared to 2006. The majority of the increase in cash outflows is due to the increase in repurchases of common stock of $214 million and a decrease in the proceeds from borrowings of $79 million, which was partially offset by a $256 million decrease in payments on borrowings and capital leases.
In the first quarter of 2007, approximately $62 million of our $120 million 6.75% debentures were repaid on February 15, 2007, at the election of the debt holders. Our total debt was $674 million as of December 31, 2007, compared with $811 million at December 31, 2006. Total debt as a percent of our total capital, including total long-term debt, was 16.5 percent at December 31, 2007, compared to 22.4 percent at December 31, 2006. Included in long-term debt at December 31, 2007 and 2006, was $49 million and $60 million, respectively, attributable to consolidating a leasing entity under the provisions of FIN 46R (see Notes 3 and 10 to the Consolidated Financial Statements). Also included in short-term and long-term debt at December 31, 2007, was $25 million from the consolidation of a joint venture consolidated under the provisions of FIN 46R (see Note 3 to the Consolidated Financial Statements). The consolidation of these entities did not materially impact our 2007 or 2006 net earnings nor did it affect compliance with any of our debt covenants. We do not expect the consolidation of these entities to have a material impact on net earnings or affect our compliance with debt covenants in future periods. As of December 31, 2006, short-term and long-term debt also included amounts from the FIN 46R consolidation of CEC which was deconsolidated in 2007 (see Note 3 to the Consolidated Financial Statements for additional information on the deconsolidation).
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 additional two-for-one stock split on January 2, 2008) of Cummins common stock. In 2007, we repurchased approximately $335 million of common stock, at an average cost of $55.76 per share (adjusted for the impact of both two-for-one stock splits), representing approximately six million shares. This concluded the share repurchase program authorized by the Board of Directors in July 2006. As of December 31, 2006, two million shares (adjusted for the impact of both two-for-one stock splits announced in 2007) had been purchased under the plan. In December 2007, the Board of Directors authorized the acquisition of up to $500 million worth of Cummins common stock which we plan to begin purchasing in 2008. The share repurchase program is expected to be a significant use of our cash flows in 2008 and future years, however, total repurchases may vary quarter to quarter depending on other investing and financing activities, market conditions, or restrictions.
In July 2007, the Board of Directors voted to increase the quarterly cash dividend per share by 39 percent and increased cash dividends to $0.125 per common share (adjusted for the two-for-one stock split on January 2, 2008) in the third and fourth quarter of 2007. Dividends per share paid to common shareholders for the years ended December 31, were as follows:
| Quarterly Dividends (adjusted for the two-for-one) stock splits in 2007 and 2008 |
||||||||
| 2007 | 2006 | 2005 | ||||||
| First Quarter | $0.09 | $0.075 | $0.075 | |||||
| Second Quarter | 0.09 | 0.075 | 0.075 | |||||
| Third Quarter | 0.125 | 0.09 | 0.075 | |||||
| Fourth Quarter | 0.125 | 0.09 | 0.075 | |||||
Total dividends paid to common shareholders for the years ended December 31, 2007, 2006 and 2005 were $89 million, $66 million, and $56 million, respectively. Declaration and payment of dividends in the future depends upon earnings and liquidity position, among other factors.
Net cash used in financing activities increased $136 million in 2006, compared to 2005. In 2006, we repaid our $250 million 9.5% notes while in 2005 we repaid our $225 million 6.45% notes. The other significant use of cash in financing activities when comparing 2006 to 2005 relates to repurchases of our common stock. In 2006, we completed our previously announced $100 million stock repurchase and we began repurchasing stock under a new repurchase plan that began in the third quarter of 2006. Year-over-year our stock repurchases increased $83 million. Also contributing to the increase, to a lesser extent, was a decrease in the proceeds from the issuance of common stock of $21 million and an increase in dividend payments due to the 20 percent increase in quarterly dividends that the board approved in July 2006.
During the third quarter of 2006, we extended a lease related to a portion of our rental business by six years. The lease was set to expire on September 30, 2006. Instead of paying a balloon payment of approximately $42 million on September 30, 2006, the amount was financed over a six year term at a fixed rate. In addition to extending this lease, we reduced the interest rate by approximately 2 percentage points. During the fourth quarter of 2006, we refinanced a lease related to another portion of our rental business. Under the terms of the agreement which was effective as of January 1, 2007, the new lease has a six year term and the interest rate is approximately 2 percentage points lower than the existing lease. The total amount refinanced was approximately $28 million. Both leases were treated as capital leases both before and after the changes. For more information regarding our rental business and related lease agreements, see Note 19 to the Consolidated Financial Statements.
In July 2006, we amended and extended the lease on our corporate headquarters facility to 2019. The total rental payments to be made over the revised lease term are approximately $59 million. As a result of this extension, we were required to re-evaluate the classification of this lease. Based on the terms of the extension, this lease is now classified as a capital lease. As a result, our long-term debt increased by approximately $40 million.
On May 8, 2006, the Board of Directors approved our plan to redeem all of the 7% convertible quarterly income preferred securities that were issued in June 2001. On May 9, 2006, we gave the trustee our formal irrevocable notification of our intent to redeem the preferred securities. This notification provided the holders of the preferred securities 30 days in which to convert their securities into shares of common stock. Upon expiration of the notification period, all remaining securities not converted were redeemed for cash at a premium above liquidation value. Substantially all of the $300 million 7% convertible subordinated debentures outstanding were converted into shares of our common stock during the second quarter of 2006. As a result of the conversion, approximately 25.2 million shares (adjusted for the impact of a two-for-one stock split on April 9, 2007 and an additional two-for-one stock split on January 2, 2008) of common stock were issued during the second quarter which resulted in an increase of approximately $15 million to common stock outstanding and an increase of approximately $276 million to additional paid-in-capital. Since substantially all holders converted their preferred securities to common stock, the loss on extinguishment of this debt was insignificant.
In September 2005, we announced our intention to repay the $250 million 9.5% notes in December 2006, the first call date for the debt. The notes were issued in November 2002 and were repaid in December 2006 using cash generated from operations. We paid a premium of approximately $12 million due to the early retirement of this debt.
Financial Covenants and Credit Rating
A number of our contractual obligations and financing agreements, such as our revolving credit facility and our equipment sale-leaseback agreements have restrictive covenants and/or pricing modifications that may be triggered in the event of downward revisions to our corporate credit rating. There have been no events in 2007 to impede our compliance with these covenants.
On July 20, 2007, Fitch upgraded our senior unsecured debt ratings from ‘‘BBB-’’ to ‘‘BBB’’ and revised our outlook to stable citing the continued improvement in Cummins’ balance sheet, increased sales diversification, an improved competitive profile and solid operating performance in North America in 2007 despite the downturn in the heavy truck cycle, among other factors. On August 16, 2007, Standard & Poor’s (S&P) upgraded our outlook from stable to positive as S&P cited Cummins’ prospects for continued good operating performance and its improved financial profile resulting from a steady reduction in financial leverage over the last several years.
Our current ratings and outlook from each of the credit rating agencies are shown in the table below.
| Credit Rating Agency | Senior L-T Debt Rating |
S-T Debt Rating |
Outlook | ||
| Moody’s Investors Service, Inc. | Baa3 | Non-Prime | Stable | ||
| Standard & Poor’s | BBB- | NR | Positive | ||
| Fitch | BBB | BBB | Stable |