UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

 Commission File Number 1-4949

CUMMINS INC.

(Exact name of registrant as specified in its charter)

          

 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x Accelerated filer o           

Non-accelerated filer o  Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of September 28, 2008, there were 201,372,272 shares of common stock outstanding with a par value of $2.50 per share.

Website Access to Company's Reports

Cummins maintains an internet website at www.cummins.com. Investors can obtain copies of our filings from this website free of charge as soon as reasonably practicable after they are electronically filed with, or furnished to the Securities and Exchange Commission.

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CUMMINS INC. AND SUBSIDIARIES

TABLE OF CONTENTS

QUARTERLY REPORT ON FORM 10-Q

 

 

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PART I.  FINANCIAL INFORMATION

 

ITEM 1. Condensed Financial Statements

 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

(a) Includes sales to nonconsolidated equity investees of $554 million and $1,636 million and $458 million and $1,280 million for the three and nine months ended September 28, 2008, and September 30, 2007, respectively.

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

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CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

		September 28,					December 31,
		2008					2007
		in millions (except par value)
ASSETS
Current assets
Cash and cash equivalents			$	572				$	577
Marketable securities			83					120
Accounts and notes receivable, net
Trade and other			2,072					1,754
Nonconsolidated equity investees			231					244
Inventories (Note 6)			1,991					1,692
Deferred income taxes			308					276
Prepaid expenses and other current assets			191					152
Total current assets			5,448					4,815
Long-term assets
Property, plant and equipment			4,484					4,313
Accumulated depreciation			(2,744		)			(2,668		)
Property, plant and equipment, net			1,740					1,645
Investments and advances related to equity method investees			590					514
Goodwill and other intangible assets, net			577					538
Deferred income taxes and other assets			630					683
Total assets			$	8,985				$	8,195
LIABILITIES
Current liabilities
Current portion of long-term debt and loans payable			$	80				$	119
Accounts payable (principally trade)			1,446					1,263
Current portion of accrued product warranty			376					337
Accrued compensation, benefits and retirement costs			404					441
Other accrued expenses			672					551
Total current liabilities			2,978					2,711
Long-term liabilities
Long-term debt			587					555
Pensions and other postretirement benefits			571					633			13
Other liabilities and deferred revenue			704					594
Total liabilities			4,840					4,493
Commitments and contingencies (Note 9)			—					—
MINORITY INTERESTS			253					293
SHAREHOLDERS’ EQUITY
Common stock, $2.50 par value, 500 shares authorized, 221.5 and 220.4 shares issued			1,784					1,719
Retained earnings			3,281					2,660
Treasury stock, at cost, 20.2 and 18.2 shares			(711		)			(593		)
Common stock held by employee benefits trust, at cost, 5.6 and 6.5 shares			(68		)			(79		)
Unearned compensation			(6		)			(11		)
Accumulated other comprehensive loss
Defined benefit postretirement plans			(363		)			(378		)
Other			(25		)			91
Total accumulated other comprehensive loss			(388		)			(287		)
Total shareholders’ equity			3,892					3,409
Total liabilities, minority interests and shareholders’ equity			$	8,985				$	8,195

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

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CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

		Nine months ended
		September 28,				September 30,
		2008				2007
CASH FLOWS FROM OPERATING ACTIVITIES		in millions
Net income		$	712				$	541
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		233					215
Net gain on disposal of property, plant and equipment		(3			)		(8		)
Deferred income taxes		38					69
Equity in earnings of investees, net of dividends		(80			)		(55		)
Minority interest in income of consolidated subsidiaries		47					34
Pension expense (Note 4)		54					73
Pension contributions		(94			)		(144		)
Other post-retirement benefits expense, net of cash payments		(11			)		(22		)
Stock-based compensation expense		27					20
Excess tax benefits on stock-based awards		(12			)		(11		)
Translation and hedging activities		15					(19		)
Changes in current assets and liabilities, net of acquisitions and dispositions:
Accounts and notes receivable		(310			)		(222		)
Inventories		(334			)		(329		)
Other current assets		(35			)		(22		)
Accounts payable		198					218
Accrued expenses		206					121
Changes in long-term liabilities		78					65
Other, net		(4			)		(1		)
Net cash provided by operating activities		725					523
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures		(330			)		(182		)
Investments in internal use software		(53			)		(46		)
Proceeds from disposals of property, plant and equipment		20					33
Investments in and advances to equity investees		(51			)		(27		)
Acquisition of businesses, net of cash acquired (Note 11)		(142			)		(20		)
Proceeds from the sale of an equity investment (Note 11)		64					—
Investments in marketable securities—acquisitions		(264			)		(307		)
Investments in marketable securities—liquidations		281					295
Purchases of other investments		(54			)		(52		)
Other, net		(23			)		(17		)
Net cash used in investing activities		(552			)		(323		)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from borrowings		91					3
Payments on borrowings and capital lease obligations		(111			)		(122		)
Net borrowings under short-term credit agreements		5					(14		)
Distributions to minority shareholders		(14			)		(15		)
Dividend payments on common stock		(86			)		(63		)
Proceeds from sale of common stock held by employee benefit trust		52					—
Repurchases of common stock		(123			)		(210		)
Excess tax benefits on stock-based awards		12					11
Other, net		3					(17		)
Net cash used in financing activities		(171			)		(427		)
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS		(7			)		11
Net decrease in cash and cash equivalents		(5			)		(216		)
Cash and cash equivalents at beginning of year		577					840
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$		572			$	624

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

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CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

(Unaudited)

 

(1) Comprised of defined benefit postretirement plans of $(363) million, foreign currency translation adjustments of $(23) million, unrealized gain on marketable securities of $2 million and unrealized loss on derivatives of $(4) million.

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

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CUMMINS INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

NOTE 1.  NATURE OF OPERATIONS

 

Cummins Inc. (“Cummins,” “the Company,” “the registrant,” “we,” “our,” or “us”) is 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 emissions solutions, fuel systems, controls and air handling systems. We were founded in 1919 as one of the first manufacturers of diesel engines and are headquartered in Columbus, Indiana. We sell our products to Original Equipment Manufacturers (OEMs), distributors and other customers worldwide. 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.

 

NOTE 2.  BASIS OF PRESENTATION

 

The unaudited Condensed Consolidated Financial Statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results of operations, financial position and cash flows. All such adjustments are of a normal recurring nature. The Condensed Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted as permitted by such rules and regulations. Certain reclassifications have been made to prior period amounts to conform to the presentation of the current period condensed financial statements.

 

Our reporting period ends on the Sunday closest to the last day of the quarterly calendar period. The third quarter of 2008 and 2007 ended on September 28, and September 30, respectively. The interim periods for both 2008 and 2007 contain 13 weeks. Our fiscal year ends on December 31, regardless of the day of the week on which December 31 falls.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts in the Condensed Consolidated Financial Statements. Significant estimates and assumptions in these Condensed Consolidated Financial Statements require the exercise of judgment and are used for, but not limited to, allowance for doubtful accounts, estimates of future cash flows and other assumptions associated with goodwill and long-lived asset impairment tests, useful lives for depreciation and amortization, warranty programs, determination of discount and other rate assumptions for pension and other postretirement benefit expenses, income taxes and deferred tax valuation allowances and contingencies. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be different from these estimates.

 

Comprehensive income is comprised of net income, as well as adjustments for foreign currency translation, marketable securities, derivative instruments designated as cash flow hedges and pension and other postretirement defined benefits. Total comprehensive income for the three and nine months ended September 28, 2008, was $110 million and $613 million, respectively. Total comprehensive income for the three and nine months ended September 30, 2007, was $225 million and $635 million, respectively.

 

You should read these interim condensed financial statements in conjunction with the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2007. Our interim period financial results for the three and nine month interim periods presented are not necessarily indicative of results to be expected for any other interim period or for the entire year. The year end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.

 

NOTE 3.   RECENTLY ADOPTED AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

Accounting Pronouncements Recently Adopted

 

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The adoption of SFAS 157, effective January 1, 2008, did not have a material impact on our Condensed Consolidated Financial Statements. See Note 10 for further information regarding the adoption of this standard.

 

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Accounting Pronouncements Issued But Not Yet Effective

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS 141R), which is effective for fiscal years beginning after December 15, 2008. SFAS 141R makes significant changes to both the accounting and disclosures related to the acquisition of a business and could materially impact how we account for future business combination transactions. Because the standard will only impact transactions entered into after January 1, 2009, SFAS 141R will not impact our Condensed Consolidated Financial Statements upon adoption.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (SFAS 160), which is effective for fiscal years beginning after December 15, 2008. SFAS 160 amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (ARB 51) and establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the accounting for future ownership changes with respect to those subsidiaries. For Cummins, the most significant impact of the standard, at adoption, will be to reclassify our minority interests ($253 million at September 28, 2008) to be included as a part of equity, which may affect certain performance and equity ratios. We are currently evaluating the potential additional impact that SFAS 160 may have on our Condensed Consolidated Financial Statements.

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (SFAS 161), which is effective for fiscal years beginning after November 15, 2008. SFAS 161 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133) and requires enhanced disclosures about a company’s derivative and hedging activities. We do not expect the adoption of SFAS 161 to have a material impact on our Condensed Consolidated Financial Statements, but are still evaluating the additional disclosure requirements.

 

NOTE 4.  PENSION AND OTHER POSTRETIREMENT BENEFITS

 

We sponsor both funded and unfunded domestic and foreign defined benefit pension and other postretirement plans. Cash contributions to these plans for the three and nine month periods ended September 28, 2008 and September 30, 2007, respectively, were as follows:

 

		Three months ended						Nine months ended
		September 28,			September 30,			September 28,			September 30,
		2008			2007			2008			2007
Defined benefit pension and postretirement plans:		in millions
Voluntary		$	46		$	22		$	70		$	82
Mandatory		21			31			51			99
Total defined benefit plans		$	67		$	53		$	121		$	181
Defined contribution pension plans		$	6		$	4		$	24		$	19

 

We presently anticipate contributing $95 million to $105 million to our defined benefit pension plans in 2008 and paying approximately $60 million in claims and premiums for other postretirement benefits. The $95 million to $105 million of contributions for the full year include voluntary contributions of $70 million to $75 million. These contributions and payments include payments from Company funds either to increase pension assets or to make direct payments to plan participants.

 

We have adopted the measurement date provisions of SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS 158), effective January 1, 2008. The majority of our pension and other postretirement plans previously used a November 30 measurement date. All plans are now measured at December 31, consistent with the company’s fiscal year end. The non-cash effect of the adoption of the measurement date provisions of SFAS 158 decreased shareholders’ equity by approximately $7 million ($5 million after-tax) and increased long-term liabilities by approximately $10 million. There was no effect on our results of operations.

 

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The components of net periodic pension and other postretirement benefit cost under our plans consisted of the following:

 

		Pension												Other Postretirement
		U.S. Plans						Non-U.S. Plans						Benefits
		Three months ended
		September 28,			September 30,			September 28,			September 30,			September 28,			September 30,
		2008			2007			2008			2007			2008			2007
		in millions
Service cost		$	12		$	12		$	6		$	8		$	—		$	—
Interest cost		28			26			17			16			8			8
Expected return on plan assets		(37		)	(35		)	(18		)	(18		)	—			—
Amortization of prior service cost (credit)		—			—			—			1			(2		)	(2		)
Recognized net actuarial loss (gain)		5			8			5			6			—			(1		)
Net periodic benefit cost		$	8		$	11		$	10		$	13		$	6		$	5

 

		Pension													Other Postretirement
			U.S. Plans						Non-U.S. Plans						Benefits
			Nine months ended
			September 28,			September 30,			September 28,			September 30,			September 28,			September 30,
			2008			2007			2008			2007			2008			2007
			in millions
Service cost			$	36		$	35		$	20		$	24		$	—		$	—
Interest cost			86			80			49			47			24			23
Expected return on plan assets			(113		)	(105		)	(56		)	(53		)	—			—
Amortization of prior service cost (credit)			—			(1		)	2			3			(7		)	(7		)
Recognized net actuarial loss (gain)			15			24			15			19			(1		)	(1		)
Net periodic benefit cost			$	24		$	33		$	30		$	40		$	16		$	15

 

NOTE 5.  EQUITY, ROYALTY AND INTEREST INCOME FROM INVESTEES

 

Equity, royalty and interest income from investees included in our Condensed Consolidated Statements of Income for the interim reporting periods was as follows:

 

		Three months ended						Nine months ended
		September 28,			September 30,			September 28,			September 30,
		2008			2007			2008			2007
		in millions
North American distributors		$	26		$	22		$	72		$	59
Dongfeng Cummins Engine Company, Ltd		16			12			50			29
Chongqing Cummins Engine Company, Ltd		9			5			23			15
Shanghai Fleetguard Filter Co. Ltd.		2			1			7			4
Tata Cummins Ltd.		—			3			7			9
Cummins MerCruiser Diesel Marine LLC.		(1		)	2			5			9
All others		9			9			22			12
Cummins share of net earnings		61			54			186			137
Royalty and interest income		5			4			16			9
Equity, royalty and interest income from investees		$	66		$	58		$	202		$	146

 

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NOTE 6.  INVENTORIES

 

Inventories included the following:

      

		September 28,			December 31,
		2008			2007
		in millions
Finished products		$	958		$	770
Work-in-process and raw materials		1,126			1,007
Inventories at FIFO cost		2,084			1,777
Excess of FIFO over LIFO		(93		)	(85			)
Total inventories		$	1,991		$		1,692

 

NOTE 7.  REVOLVING CREDIT FACILITY

 

On June 30, 2008, we entered into a Three-Year Revolving Credit Agreement, (the “Credit Agreement”), with a syndicate of lenders and issuers named therein. The Credit Agreement provides a $1.1 billion senior unsecured revolving credit facility (the “Credit Facility”), the proceeds of which are to be used to provide for working capital or for other general corporate purposes of Cummins.

 

The Credit Facility matures on June 30, 2011. The Credit Facility is unsecured and amounts payable under it will rank pro rata with all other unsecured, unsubordinated indebtedness of Cummins. Borrowings under the Credit Facility will primarily be denominated in U.S. dollars. A portion of the Credit Facility, up to $200 million, is available for Letters of Credit denominated in U.S. dollars or Alternate Currencies. In addition, up to $200 million of the Revolving Credit Facility will be available in Pounds Sterling or Euros. A portion of the Credit Facility, up to $100 million, is available for swingline loans denominated in U.S. dollars. Loans will bear interest at (i) a base rate or (ii) a rate equal to LIBOR plus an applicable margin based on the credit ratings of Cummins outstanding senior unsecured long-term debt. Based on our current long-term debt ratings, the applicable margin on LIBOR loans will be 0.75 percent per annum as of September 28, 2008. Loans may be prepaid without premium or penalty, subject to customary breakage costs.

 

The Credit Facility replaces $650 million in aggregate principal amount of a revolving credit facility (Former Credit Agreement) maintained by Cummins which was terminated effective June 30, 2008.

 

The Credit Agreement includes covenants substantially similar to those in the Former Credit Agreement, including, among others, (a) a leverage ratio, (b) fixed charge coverage ratio, (c) limitations on priority indebtedness, (d) limitations on our ability to consummate a merger, consolidation or sale of all or substantially all of our assets and (e) limitations on our ability to change the nature of our business.

 

The obligation of Cummins to pay amounts outstanding under the Credit Facility may be accelerated upon the occurrence of an “Event of Default” as defined in the Credit Agreement. Such Events of Default include, among others, (a) Cummins failure to pay the principal of, or interest on, borrowings under the Credit Facility, (b) any representation or warranty of Cummins in the Credit Agreement proving to be materially false or misleading, (c) Cummins breach of any of its covenants contained in the Credit Agreement and (d) the bankruptcy or insolvency of Cummins.

 

NOTE 8.  PRODUCT WARRANTY LIABILITY

 

We charge the estimated costs of warranty programs, other than product recalls, to income at the time products are shipped to customers. We use historical claims experience to develop the estimated liability. We review product recall programs on a quarterly basis, and if necessary, record a liability when we commit to an action. We also sell extended warranty coverage on several engines. The following is a tabular reconciliation of the product warranty liability, including the deferred revenue related to our extended warranty coverage:

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		Nine months ended
		September 28,			September 30,
		2008			2007
		in millions
Balance, beginning of period		$	749		$	652
Provision for warranties issued		319			298
Deferred revenue on extended warranty contracts sold		73			47
Payments		(258		)	(229		)
Amortization of deferred revenue on extended warranty contracts		(47		)	(37		)
Changes in estimates for pre-existing warranties		63			(14		)
Foreign currency translation		(10		)	5
Balance, end of period		$	889		$	722

 

The amount of deferred revenue related to extended coverage programs at September 28, 2008, was $212 million. At September 28, 2008, we had $15 million of receivables related to estimated supplier recoveries of which $6 million was included in “Trade and other” receivables and $9 million was included in “Deferred income taxes and other assets” on our Condensed Consolidated Balance Sheets.

 

NOTE 9.  COMMITMENTS AND CONTINGENCIES

 

We are defendants in a number of pending legal actions, including actions related to the use and performance of our products. We carry product liability insurance covering significant claims for damages involving personal injury and property damage. We also establish reserves for these and other matters in which losses are probable and can be reasonably estimated. In the event we are determined to be liable for damages in connection with actions and proceedings, the unaccrued portion of such liability is not expected to be material. We also have been identified as a potentially responsible party at several waste disposal sites under U.S. and related state environmental statutes and regulations and may have joint and several liability for any investigation and remediation costs incurred with respect to such sites. We deny liability with respect to many of these legal actions and environmental proceedings and are vigorously defending such actions or proceedings. We have established reserves that we believe are adequate for our expected future liability in such actions and proceedings where the nature and extent of such liability can be reasonably estimated based upon presently available information.

 

U.S. Distributor Guarantees

 

Since 1997 we have had an operating agreement with a financial institution that requires us to guarantee revolving loans, equipment term loans and leases, real property loans and letters of credit made by the financial institution to certain independent Cummins distributors in the United States, and to certain distributors in which we own an equity interest. In the first quarter of 2006, we amended, restated and simplified the terms of the operating agreement and removed the Cummins guarantee of distributor borrowings.

 

If any distributor defaults under its financing arrangement with the financial institution, and the maturity of amounts owed under the agreement is accelerated, then we are required to purchase from the financial institution at amounts approximating fair market value certain property, inventory and rental generator sets manufactured by Cummins that are secured by the distributor's financing agreement.

 

The operating agreement will continue to be in effect until February 7, 2009.

 

Residual Value Guarantees

 

We have various residual value guarantees on equipment leased under operating leases. The total amount of these residual value guarantees at September 28, 2008, was $8 million.

 

Other Guarantees

 

In addition to the guarantees discussed above, from time to time we enter into other guarantee arrangements, including guarantees of non-U.S. distributor financing and other miscellaneous guarantees of third-party obligations. The maximum potential loss related to these other guarantees is $36 million at September 28, 2008 ($33 million of which relates to the Beijing Foton discussion below).

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We have arrangements with certain suppliers that require us to purchase minimum volumes or be subject to monetary penalties. The penalty amounts are less than our purchase commitments and essentially allow the supplier to recover their tooling costs in most instances. At September 28, 2008, if we were to stop purchasing from each of these suppliers, the amount of the penalty would be approximately $103 million, of which $87 million relates to a six year contract with an engine parts supplier that extends from 2008 to 2013. Based on current forecasts, we do not anticipate paying any penalties under these contracts. This arrangement enables us to secure critical components important to our growth.

 

In July 2008, Beijing Foton Cummins Engine Company, a 50 percent owned entity accounted for under the equity method, entered into a line of credit agreement with a borrowing capacity of up to $176 million (at current exchange rates). The line will be used primarily to fund equipment purchases for a new manufacturing plant. As a part of this transaction, we guaranteed 50 percent of any outstanding borrowings up to a maximum guarantee of $88 million (at current exchange rates). As of September 30, 2008, outstanding borrowings under this agreement were $65 million and our guarantee was $33 million (at current exchange rates). We recorded a liability for the fair value of this guarantee in accordance with FASB Interpretation No. 45, “Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others—an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34.” The amount of the liability was less than $1 million. The offset to this liability was an increase in our investment in the joint venture.

 

Indemnifications

 

Periodically, we enter into various contractual arrangements where we agree to indemnify a third-party against certain types of losses. Common types of indemnifications include:

• product liability and license, patent or trademark indemnifications,

• asset sale agreements where we agree to indemnify the purchaser against future environmental exposures related to the asset sold and

• any contractual agreement where we agree to indemnify the counter-party for losses suffered as a result of a misrepresentation in the contract.

 

We regularly evaluate the probability of having to incur costs associated with these indemnifications and accrue for expected losses that are probable. Because the indemnifications are not related to specified known liabilities and due to their uncertain nature, we are unable to estimate the maximum amount of the potential loss associated with these indemnifications.

 

Joint Venture Commitments

 

As of September 28, 2008, we have committed to invest $3 million into existing joint ventures. It is expected that $1 million will be funded in 2008, while $2 million will be funded in 2009.

 

NOTE 10.  FAIR VALUE OF FINANCIAL INSTRUMENTS

 

In September 2006, the FASB issued SFAS 157, which defines fair value, establishes a market-based framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures. SFAS 157 is effective for financial assets and financial liabilities for fiscal years beginning after November 15, 2007. FASB Staff Position (FSP) 157-2 “Partial Deferral of the Effective Date of Statement No. 157” (FSP 157-2), deferred the effective date of SFAS 157 for most non-financial assets and non-financial liabilities to fiscal years beginning after November 15, 2008. We adopted this statement prospectively for our fiscal year beginning January 1, 2008, except for non-financial assets and non-financial liabilities as deferred until January 1, 2009, by FSP 157-2. SFAS 157 does not require retroactive restatement of prior periods. The adoption of SFAS 157 did not materially impact our consolidated financial statements.

 

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As defined in SFAS 157, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). We utilize market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable. We primarily apply the market approach for recurring fair value measurements and utilize the best available information. Accordingly, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The company is able to classify fair value balances based on the observability of those inputs. SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurement). The three levels of the fair value hierarchy defined by SFAS 157 are as follows:

 

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis. Level 1 primarily consists of financial instruments such as exchange-traded derivatives, listed equities and publicly traded bonds.

 

Level 2 – Pricing inputs are other than quoted prices in active markets included in level 1, which are either directly or indirectly observable as of the reported date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors, and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace throughout the full term of the instrument, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace. Instruments in this category include non-exchange-traded derivatives such as over-the-counter forwards and options.

 

Level 3 – Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management’s best estimate of fair value. At each balance sheet date, the company performs an analysis of all instruments subject to SFAS 157 and includes, in level 3, all of those whose fair value is based on significant unobservable inputs. At September 28, 2008, we did not have any level 3 financial assets or liabilities.

 

The majority of the assets and liabilities we carry at fair value are available-for-sale (AFS) securities and derivatives. AFS securities are derived from level 1 or level 2 inputs. The predominance of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services.

 

The fair value measurement of derivatives results primarily from level 2 inputs. Many of our derivative contracts are valued utilizing publicly available pricing data of contracts with similar terms. In other cases, the contracts are valued using current spot market data adjusted for the appropriate current forward curves provided by external financial institutions. We participate in commodity swap contracts, currency forward contracts, and interest rate swaps. We enter into hedging transactions with banking institutions that have strong credit ratings, and thus the credit risk associated with these contracts is not considered significant. For more discussion regarding our derivative instruments, see Note 18 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2007.

 

The following table summarizes the fair value of our financial instruments at September 28, 2008:

 

		Fair Value Measurements Using
		Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Total
		in millions
Available-for-sale securities		$	40		$	43		$	—		$	83
Net derivative asset (1)		—			7			—			7
Total		$	40		$	50		$	—		$	90
(1) Includes approximately $16 million of Level 2 derivative liabilities, which are netted against derivative assets.

 

 

 

 

 

 

 

 

 

 

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NOTE 11.  ACQUISITIONS AND INVESTMENTS

 

During the first nine months of 2008, we purchased a majority interest in three previously independent North American distributors in order to increase our ownership interests in key portions of the distribution channel. The acquisitions were accounted for under the purchase method of accounting and resulted in an aggregate purchase price of $81 million which we funded with $54 million of borrowings and $27 million of cash. The assets of the acquired businesses were primarily accounts receivable, inventory and fixed assets. There was less than $1 million of goodwill generated from these transactions. During the first three months of 2007, we purchased the remaining interest in a manufacturing joint venture and acquired ownership of an international independent distributor for approximately $20 million. We recorded goodwill of $13 million for these two transactions.

 

In July 2008, we entered into a transaction with two Fiat group companies to (1) sell our one-third interest in the European Engine Alliance (EEA) joint venture and simultaneously (2) purchase the remaining 50 percent interest in Consolidated Diesel Corporation (CDC). As a result, we now own 100 percent of CDC and no longer have an ownership interest in EEA. CDC was previously included in our consolidated results as we were considered the primary beneficiary under FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN 46R). We sold our remaining interest in EEA for $64 million and subsequently purchased the remaining interest in CDC for $61 million, however, because the transactions were entered into simultaneously with the same counterparty, it is considered a non-monetary exchange for accounting purposes. Thus, we accounted for the transactions at fair value in accordance with FASB Statement 153 "Exchanges of Nonmonetary Assets." Because fair value and book value were reasonably close, there was no material gain or loss recorded on the sale of EEA. In addition, there were no significant adjustments from book value for any assets or liabilities of CDC recorded upon the acquisition of the remaining 50 percent interest.

 

NOTE 12.  FLOOD DAMAGE

 

In June 2008, Columbus, Indiana experienced significant flooding which impacted some of our facilities. One manufacturing facility was partially flooded. Our technical center, which houses engineering staff and contains dynamometer test cells and labs, was more severely impacted by the event which caused temporary displacement of the engineering workforce and suspension of testing for approximately five weeks. Critical testing was transferred to other Cummins facilities and external suppliers to minimize the interruption.

 

The physical damage to the facilities, costs of clean up and repair and business interruption were covered by insurance, subject to a deductible, which limited the economic impact of this event to the company. As of September 28, 2008, we recorded a net charge of $6 million for this event. The total clean up costs incurred as of September 28, 2008, were $26 million. The remaining clean up costs are estimated to range from $25 million to $35 million and will be spent during the next two quarters. We estimate the replacement value of assets impacted was approximately $90 million and we anticipate that asset replacements will be reflected in capital spending over the next five quarters. Most of these assets were fully depreciated at the time of the flood. Although this claim is significant, we believe we have sufficient insurance coverage after this claim for any future events. As of September 28, 2008, we have received $30 million in insurance recoveries.

 

We used our research and engineering facilities in other regions, not impacted by the flood, to continue our engineering and development activities while our research facilities in Columbus, Indiana were being repaired.

 

We are confident that our insurance coverage will limit the impact of this event.

 

NOTE 13.  OPERATING SEGMENTS

 

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. We use segment EBIT (defined as earnings before interest expense, income taxes and minority interests) as the primary basis for the chief operating decision-maker to evaluate the performance of each operating segment.  

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A summary of operating results by segment for the three and six month periods is shown below:

 

		Engine					Power Generation					Components				Distribution				Non-segment items(1)				Total
		in millions
Three months ended September 28, 2008
External sales		$	1,927				$		653			$	535			$	578			$	—			$	3,693
Intersegment sales			352						235				266				3				(856	)			—
Total sales			2,279						888				801				581				(856	)			3,693
Depreciation and amortization(2)		43					9					16				6				—				74
Research, development and engineering expense		75					11