UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 28, 2014
Commission File Number 1-4949
CUMMINS INC.
(Exact name of registrant as specified in its charter)
Indiana (State of Incorporation) | 35-0257090 (IRS Employer Identification No.) | |
500 Jackson Street
Box 3005
Columbus, Indiana 47202-3005
(Address of principal executive offices)
Telephone (812) 377-5000
(Registrant’s telephone number, including area code)
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that registrant was required to submit and post such files). 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, 2014, there were 182,691,807 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.
CUMMINS INC. AND SUBSIDIARIES
TABLE OF CONTENTS
QUARTERLY REPORT ON FORM 10-Q
Page | ||
Condensed Consolidated Statements of Income for the three and nine months ended September 28, 2014 and September 29, 2013 | ||
Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 28, 2014 and September 29, 2013 | ||
Condensed Consolidated Balance Sheets at September 28, 2014 and December 31, 2013 | ||
Condensed Consolidated Statements of Cash Flows for the nine months ended September 28, 2014 and September 29, 2013 | ||
Condensed Consolidated Statements of Changes in Equity for the nine months ended September 28, 2014 and September 29, 2013 | ||
2
PART I. FINANCIAL INFORMATION
ITEM 1. Condensed Consolidated Financial Statements
CUMMINS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Three months ended | Nine months ended | |||||||||||||||
In millions, except per share amounts | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
NET SALES (a) | $ | 4,890 | $ | 4,266 | $ | 14,131 | $ | 12,713 | ||||||||
Cost of sales (Note 2) | 3,606 | 3,185 | 10,543 | 9,570 | ||||||||||||
GROSS MARGIN | 1,284 | 1,081 | 3,588 | 3,143 | ||||||||||||
OPERATING EXPENSES AND INCOME | ||||||||||||||||
Selling, general and administrative expenses (Note 2) | 529 | 464 | 1,527 | 1,344 | ||||||||||||
Research, development and engineering expenses | 198 | 173 | 567 | 532 | ||||||||||||
Equity, royalty and interest income from investees (Note 5) | 99 | 91 | 294 | 281 | ||||||||||||
Other operating income (expense), net | 3 | (11 | ) | (4 | ) | — | ||||||||||
OPERATING INCOME | 659 | 524 | 1,784 | 1,548 | ||||||||||||
Interest income | 6 | 6 | 17 | 21 | ||||||||||||
Interest expense | 15 | 8 | 47 | 22 | ||||||||||||
Other income (expense), net | 19 | 6 | 68 | 25 | ||||||||||||
INCOME BEFORE INCOME TAXES | 669 | 528 | 1,822 | 1,572 | ||||||||||||
Income tax expense (Note 6) | 230 | 154 | 553 | 445 | ||||||||||||
CONSOLIDATED NET INCOME | 439 | 374 | 1,269 | 1,127 | ||||||||||||
Less: Net income attributable to noncontrolling interests | 16 | 19 | 62 | 76 | ||||||||||||
NET INCOME ATTRIBUTABLE TO CUMMINS INC. | $ | 423 | $ | 355 | $ | 1,207 | $ | 1,051 | ||||||||
EARNINGS PER COMMON SHARE ATTRIBUTABLE TO CUMMINS INC. | ||||||||||||||||
Basic | $ | 2.32 | $ | 1.91 | $ | 6.59 | $ | 5.61 | ||||||||
Diluted | $ | 2.32 | $ | 1.90 | $ | 6.58 | $ | 5.60 | ||||||||
WEIGHTED AVERAGE SHARES OUTSTANDING | ||||||||||||||||
Basic | 182.2 | 186.0 | 183.1 | 187.4 | ||||||||||||
Dilutive effect of stock compensation awards | 0.5 | 0.5 | 0.4 | 0.4 | ||||||||||||
Diluted | 182.7 | 186.5 | 183.5 | 187.8 | ||||||||||||
CASH DIVIDENDS DECLARED PER COMMON SHARE | $ | 0.78 | $ | 0.625 | $ | 2.03 | $ | 1.625 | ||||||||
_______________________________________________________
(a) Includes sales to nonconsolidated equity investees of $518 million and $1,656 million and $553 million and $1,681 million for the three and nine month periods ended September 28, 2014 and September 29, 2013, respectively.
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements.
3
CUMMINS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
Three months ended | Nine months ended | |||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
CONSOLIDATED NET INCOME | $ | 439 | $ | 374 | $ | 1,269 | $ | 1,127 | ||||||||
Other comprehensive income (loss), net of tax (Note 13) | ||||||||||||||||
Foreign currency translation adjustments | (172 | ) | 95 | (62 | ) | (101 | ) | |||||||||
Unrealized gain (loss) on derivatives | (5 | ) | 10 | — | (2 | ) | ||||||||||
Change in pension and other postretirement defined benefit plans | 14 | 16 | 28 | 56 | ||||||||||||
Unrealized gain (loss) on marketable securities | (1 | ) | 1 | (12 | ) | (2 | ) | |||||||||
Total other comprehensive income (loss), net of tax | (164 | ) | 122 | (46 | ) | (49 | ) | |||||||||
COMPREHENSIVE INCOME | 275 | 496 | 1,223 | 1,078 | ||||||||||||
Less: Comprehensive income attributable to noncontrolling interest | 10 | 10 | 59 | 45 | ||||||||||||
COMPREHENSIVE INCOME ATTRIBUTABLE TO CUMMINS INC. | $ | 265 | $ | 486 | $ | 1,164 | $ | 1,033 | ||||||||
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements.
4
CUMMINS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) | ||||||||
In millions, except par value | September 28, 2014 | December 31, 2013 | ||||||
ASSETS | ||||||||
Current assets | ||||||||
Cash and cash equivalents | $ | 2,328 | $ | 2,699 | ||||
Marketable securities (Note 7) | 53 | 150 | ||||||
Total cash, cash equivalents and marketable securities | 2,381 | 2,849 | ||||||
Accounts and notes receivable, net | ||||||||
Trade and other | 2,774 | 2,362 | ||||||
Nonconsolidated equity investees | 285 | 287 | ||||||
Inventories (Note 8) | 2,833 | 2,381 | ||||||
Prepaid expenses and other current assets | 795 | 760 | ||||||
Total current assets | 9,068 | 8,639 | ||||||
Long-term assets | ||||||||
Property, plant and equipment | 6,899 | 6,410 | ||||||
Accumulated depreciation | (3,435 | ) | (3,254 | ) | ||||
Property, plant and equipment, net | 3,464 | 3,156 | ||||||
Investments and advances related to equity method investees (Note 5) | 981 | 931 | ||||||
Goodwill | 465 | 461 | ||||||
Other intangible assets, net | 346 | 357 | ||||||
Prepaid pensions | 701 | 514 | ||||||
Other assets | 619 | 670 | ||||||
Total assets | $ | 15,644 | $ | 14,728 | ||||
LIABILITIES | ||||||||
Current liabilities | ||||||||
Loans payable | $ | 78 | $ | 17 | ||||
Accounts payable (principally trade) | 1,930 | 1,557 | ||||||
Current maturities of long-term debt (Note 9) | 27 | 51 | ||||||
Current portion of accrued product warranty (Note 10) | 351 | 360 | ||||||
Accrued compensation, benefits and retirement costs | 507 | 433 | ||||||
Deferred revenue | 328 | 285 | ||||||
Taxes payable (including taxes on income) | 134 | 99 | ||||||
Other accrued expenses | 683 | 566 | ||||||
Total current liabilities | 4,038 | 3,368 | ||||||
Long-term liabilities | ||||||||
Long-term debt (Note 9) | 1,584 | 1,672 | ||||||
Pensions | 234 | 232 | ||||||
Postretirement benefits other than pensions | 333 | 356 | ||||||
Other liabilities and deferred revenue | 1,358 | 1,230 | ||||||
Total liabilities | 7,547 | 6,858 | ||||||
Commitments and contingencies (Note 11) | ||||||||
EQUITY | ||||||||
Cummins Inc. shareholders’ equity | ||||||||
Common stock, $2.50 par value, 500 shares authorized, 222.3 and 222.3 shares issued | 2,125 | 2,099 | ||||||
Retained earnings | 9,243 | 8,406 | ||||||
Treasury stock, at cost, 39.6 and 35.6 shares | (2,779 | ) | (2,195 | ) | ||||
Common stock held by employee benefits trust, at cost, 1.1 and 1.3 shares | (14 | ) | (16 | ) | ||||
Accumulated other comprehensive loss (Note 13) | ||||||||
Defined benefit postretirement plans | (583 | ) | (611 | ) | ||||
Other | (244 | ) | (173 | ) | ||||
Total accumulated other comprehensive loss | (827 | ) | (784 | ) | ||||
Total Cummins Inc. shareholders’ equity | 7,748 | 7,510 | ||||||
Noncontrolling interests | 349 | 360 | ||||||
Total equity | 8,097 | 7,870 | ||||||
Total liabilities and equity | $ | 15,644 | $ | 14,728 | ||||
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements.
5
CUMMINS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) | ||||||||
Nine months ended | ||||||||
In millions | September 28, 2014 | September 29, 2013 | ||||||
CASH FLOWS FROM OPERATING ACTIVITIES | ||||||||
Consolidated net income | $ | 1,269 | $ | 1,127 | ||||
Adjustments to reconcile consolidated net income to net cash provided by operating activities | ||||||||
Depreciation and amortization | 330 | 305 | ||||||
Gain on fair value adjustment for consolidated investees (Note 3) | (38 | ) | (12 | ) | ||||
Deferred income taxes | (37 | ) | 78 | |||||
Equity in income of investees, net of dividends | (103 | ) | (98 | ) | ||||
Pension contributions in excess of expense (Note 4) | (154 | ) | (96 | ) | ||||
Other post-retirement benefits payments in excess of expense (Note 4) | (22 | ) | (20 | ) | ||||
Stock-based compensation expense | 27 | 29 | ||||||
Excess tax benefits on stock-based awards | (5 | ) | (13 | ) | ||||
Translation and hedging activities | (19 | ) | 26 | |||||
Changes in current assets and liabilities, net of acquisitions | ||||||||
Accounts and notes receivable | (236 | ) | (216 | ) | ||||
Inventories | (302 | ) | (206 | ) | ||||
Other current assets | (6 | ) | 182 | |||||
Accounts payable | 316 | 252 | ||||||
Accrued expenses | 162 | (146 | ) | |||||
Changes in other liabilities and deferred revenue | 184 | 147 | ||||||
Other, net | 22 | (6 | ) | |||||
Net cash provided by operating activities | 1,388 | 1,333 | ||||||
CASH FLOWS FROM INVESTING ACTIVITIES | ||||||||
Capital expenditures | (409 | ) | (417 | ) | ||||
Investments in internal use software | (40 | ) | (43 | ) | ||||
Investments in and advances to equity investees | (39 | ) | (12 | ) | ||||
Acquisitions of businesses, net of cash acquired (Note 3) | (266 | ) | (145 | ) | ||||
Investments in marketable securities—acquisitions (Note 7) | (213 | ) | (360 | ) | ||||
Investments in marketable securities—liquidations (Note 7) | 316 | 433 | ||||||
Cash flows from derivatives not designated as hedges | — | (15 | ) | |||||
Other, net | 11 | 14 | ||||||
Net cash used in investing activities | (640 | ) | (545 | ) | ||||
CASH FLOWS FROM FINANCING ACTIVITIES | ||||||||
Proceeds from borrowings | 39 | 987 | ||||||
Payments on borrowings and capital lease obligations | (72 | ) | (62 | ) | ||||
Net (payments) borrowings under short-term credit agreements | (41 | ) | 34 | |||||
Distributions to noncontrolling interests | (52 | ) | (53 | ) | ||||
Dividend payments on common stock | (370 | ) | (305 | ) | ||||
Repurchases of common stock | (605 | ) | (289 | ) | ||||
Excess tax benefits on stock-based awards | 5 | 13 | ||||||
Other, net | (3 | ) | 19 | |||||
Net cash (used in) provided by financing activities | (1,099 | ) | 344 | |||||
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS | (20 | ) | (2 | ) | ||||
Net (decrease) increase in cash and cash equivalents | (371 | ) | 1,130 | |||||
Cash and cash equivalents at beginning of year | 2,699 | 1,369 | ||||||
CASH AND CASH EQUIVALENTS AT END OF PERIOD | $ | 2,328 | $ | 2,499 | ||||
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements.
6
CUMMINS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Unaudited)
In millions | Common Stock | Additional paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Loss | Treasury Stock | Common Stock Held in Trust | Total Cummins Inc. Shareholders’ Equity | Noncontrolling Interests | Total Equity | ||||||||||||||||||||||||||
BALANCE AT DECEMBER 31, 2012 | $ | 556 | $ | 1,502 | $ | 7,343 | $ | (950 | ) | $ | (1,830 | ) | $ | (18 | ) | $ | 6,603 | $ | 371 | $ | 6,974 | ||||||||||||||
Net income | 1,051 | 1,051 | 76 | 1,127 | |||||||||||||||||||||||||||||||
Other comprehensive income (loss) | (18 | ) | (18 | ) | (31 | ) | (49 | ) | |||||||||||||||||||||||||||
Issuance of shares | 5 | 5 | — | 5 | |||||||||||||||||||||||||||||||
Employee benefits trust activity | 18 | 2 | 20 | — | 20 | ||||||||||||||||||||||||||||||
Acquisition of shares | (289 | ) | (289 | ) | — | (289 | ) | ||||||||||||||||||||||||||||
Cash dividends on common stock | (305 | ) | (305 | ) | — | (305 | ) | ||||||||||||||||||||||||||||
Distribution to noncontrolling interests | — | (53 | ) | (53 | ) | ||||||||||||||||||||||||||||||
Stock based awards | 1 | 15 | 16 | — | 16 | ||||||||||||||||||||||||||||||
Other shareholder transactions | 13 | 13 | 5 | 18 | |||||||||||||||||||||||||||||||
BALANCE AT SEPTEMBER 29, 2013 | $ | 556 | $ | 1,539 | $ | 8,089 | $ | (968 | ) | $ | (2,104 | ) | $ | (16 | ) | $ | 7,096 | $ | 368 | $ | 7,464 | ||||||||||||||
BALANCE AT DECEMBER 31, 2013 | $ | 556 | $ | 1,543 | $ | 8,406 | $ | (784 | ) | $ | (2,195 | ) | $ | (16 | ) | $ | 7,510 | $ | 360 | $ | 7,870 | ||||||||||||||
Net income | 1,207 | 1,207 | 62 | 1,269 | |||||||||||||||||||||||||||||||
Other comprehensive income (loss) | (43 | ) | (43 | ) | (3 | ) | (46 | ) | |||||||||||||||||||||||||||
Issuance of shares | 8 | 8 | — | 8 | |||||||||||||||||||||||||||||||
Employee benefits trust activity | 19 | 2 | 21 | — | 21 | ||||||||||||||||||||||||||||||
Acquisition of shares | (605 | ) | (605 | ) | — | (605 | ) | ||||||||||||||||||||||||||||
Cash dividends on common stock | (370 | ) | (370 | ) | — | (370 | ) | ||||||||||||||||||||||||||||
Distribution to noncontrolling interests | — | (63 | ) | (63 | ) | ||||||||||||||||||||||||||||||
Stock based awards | (5 | ) | 21 | 16 | — | 16 | |||||||||||||||||||||||||||||
Other shareholder transactions | 4 | 4 | (7 | ) | (3 | ) | |||||||||||||||||||||||||||||
BALANCE AT SEPTEMBER 28, 2014 | $ | 556 | $ | 1,569 | $ | 9,243 | $ | (827 | ) | $ | (2,779 | ) | $ | (14 | ) | $ | 7,748 | $ | 349 | $ | 8,097 | ||||||||||||||
The accompanying notes are an integral part of the Condensed Consolidated Financial Statements.
7
CUMMINS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. NATURE OF OPERATIONS
Cummins Inc. (“Cummins,” “we,” “our” or “us”) was founded in 1919 as a corporation in Columbus, Indiana, as one of the first diesel engine manufacturers. We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines and engine-related component products, including filtration, aftertreatment, turbochargers, fuel systems, controls systems, air handling systems and electric power generation systems. We sell our products to original equipment manufacturers (OEMs), distributors and other customers worldwide. We serve our customers through a network of over 600 company-owned and independent distributor locations and over 6,800 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 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.
We revised the classification of certain amounts for "Cost of sales" and "Selling, general and administrative expenses" for 2014 and 2013. In connection with the integration of recently acquired North American distributors and anticipating the future acquisition and integration of the entire North American channel, our Distribution segment has developed a framework against which Distribution management intends to measure the performance of the distribution channel. The segment EBIT (defined as earnings before interest expense, taxes and noncontrolling interests) performance measure is unchanged, however, certain activities that were previously classified in "Selling, general and administrative expenses" will be classified as "Cost of sales" to align with the new framework and allow for consistent treatment across the channel. We revised the expense presentation of our Condensed Consolidated Statements of Income for the periods presented to follow the new cost framework. The net impact of this revision for the six months ended June 29, 2014 was $39 million and for the three and nine months ended September 29, 2013, were $28 million and $76 million , respectively. The revision had no impact on reported net income, cash flows or the balance sheet.
Additionally, certain other reclassifications have been made to prior period amounts to conform to the presentation of the current period condensed financial statements.
Our reporting period usually ends on the Sunday closest to the last day of the quarterly calendar period. The third quarters of 2014 and 2013 ended on September 28 and September 29, respectively. The interim periods for both 2014 and 2013 contained 13 weeks, while the nine month periods both contained 39 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, lease classifications and contingencies. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be different from these estimates.
The weighted-average diluted common shares outstanding exclude the anti-dilutive effect of certain stock options since such options had an exercise price in excess of the monthly average market value of our common stock. The options excluded from diluted earnings per share for the three and nine month periods ended September 28, 2014 and September 29, 2013, were as follows:
8
Three months ended | Nine months ended | ||||||||||
September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||
Options excluded | 225,773 | 184,775 | 110,488 | 479,276 | |||||||
These interim condensed financial statements should be read in conjunction with the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013. 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 Consolidated Balance Sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.
NOTE 3. ACQUISITIONS
In September 2013, we announced our intention to acquire the equity that we do not already own in most of our partially-owned United States and Canadian distributors over the next three to five years. In each acquisition we recorded a gain related to the remeasurement of our existing ownership interest to fair value in accordance with GAAP. We believe the price paid to the former principal is representative of fair value. As such, we valued our existing ownership interest by applying the price paid to the former principal to our existing ownership on a relative basis. The amount paid to the former principal is determined in accordance with a pre-existing agreement that attempts to value the business on a fair value basis. Gains recognized in the remeasurement are included in other income (expense), in the Condensed Consolidated Statements of Income. The following is a summary of the acquisition activity for the first nine months of 2014 and 2013.
Cummins Eastern Canada LP
On August 4, 2014, we acquired the remaining 50 percent interest in Cummins Eastern Canada LP (Eastern Canada) from the former distributor principal. The preliminary purchase consideration was $62 million, which included $22 million in cash and an additional $32 million to eliminate outstanding debt. The remaining $8 million will be paid in future periods. The intangible assets are primarily customer related, the majority of which will be amortized within one year subject to customary purchase price adjustments. The acquisition was accounted for as a business combination and the results of the acquired entity were included in the Distribution operating segment subsequent to the acquisition date. As a result of this transaction, third quarter 2014 Distribution segment results included an $18 million gain, as we were required to re-measure our pre-existing 50 percent ownership interest in Eastern Canada to fair value in accordance with GAAP. The transaction generated $5 million of goodwill based on the preliminary purchase price allocation. Net sales for Eastern Canada were $228 million for the year ended December 31, 2013. This amount is not fully incremental to our consolidated sales as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.
Cummins Power Systems LLC
On May 5, 2014, we acquired the remaining 30 percent interest in Cummins Power Systems LLC (Power Systems) from the former distributor principal for consideration of approximately $14 million in cash. The entity was previously consolidated and, as a result, the acquisition was accounted for as an equity transaction instead of a business combination.
Cummins Southern Plains LLC
On March 31, 2014, we acquired the remaining 50 percent interest in Cummins Southern Plains LLC (Southern Plains) from the former distributor principal. The purchase consideration was $92 million as presented below, which included $42 million in cash and an additional $48 million paid to eliminate outstanding debt as of September 28, 2014. The intangible assets are primarily customer related and are being amortized over periods ranging from one to five years. The acquisition was accounted for as a business combination and the results of the acquired entity were included in the Distribution operating segment subsequent to the acquisition date. As a result of this transaction, second quarter 2014 Distribution segment results included a $13 million gain, as we were required to re-measure our pre-existing 50 percent ownership interest in Southern Plains to fair value in accordance with GAAP. The transaction generated less than $1 million of goodwill. Net sales for Southern Plains were $433 million for the year ended December 31, 2013. This amount is not fully incremental to our consolidated sales as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.
9
The final purchase price allocation was as follows:
In millions | |||
Accounts receivable | $ | 63 | |
Inventory | 59 | ||
Fixed assets | 47 | ||
Intangible assets | 11 | ||
Other current assets | 9 | ||
Current liabilities | (53 | ) | |
Total business valuation | 136 | ||
Fair value of pre-existing 50 percent interest | (44 | ) | |
Purchase price | $ | 92 | |
Cummins Mid-South LLC
On February 14, 2014, we acquired the remaining 62.2 percent interest in Cummins Mid-South LLC (Mid-South) from the former distributor principal. The purchase consideration was $118 million as presented below, which included $32 million in cash paid in the first quarter along with an additional $61 million paid to eliminate outstanding debt. As of September 28, 2014, an additional $23 million had been paid. The intangible assets are primarily customer related and are being amortized over periods ranging from one to five years. The acquisition was accounted for as a business combination and the results of the acquired entity were included in the Distribution operating segment subsequent to the acquisition date. As a result of this transaction, first quarter 2014 Distribution segment results included a $6 million gain, as we were required to re-measure our pre-existing 37.8 percent ownership interest in Mid-South to fair value in accordance with GAAP. In the second quarter of 2014, we recognized an additional $1 million gain as the result of the final valuation. The transaction generated $4 million of goodwill. Net sales for Mid-South were $368 million for the year ended December 31, 2013. This amount is not fully incremental to our consolidated sales as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.
The final purchase price allocation was as follows:
In millions | |||
Accounts receivable | $ | 71 | |
Inventory | 70 | ||
Fixed assets | 37 | ||
Intangible assets | 8 | ||
Goodwill | 4 | ||
Other current assets | 10 | ||
Current liabilities | (43 | ) | |
Other long-term liability | (4 | ) | |
Total business valuation | 153 | ||
Fair value of pre-existing 37.8 percent interest | (35 | ) | |
Purchase price | $ | 118 | |
Cummins Rocky Mountain LLC
In May 2013, we acquired the remaining 67 percent interest in Cummins Rocky Mountain LLC (Rocky Mountain) from the former distributor principal for consideration of approximately $62 million in cash and an additional $74 million in cash paid to creditors to eliminate all debt related to the entity. The purchase price was approximately $136 million as presented below. The intangible assets are primarily customer related and are being amortized over periods ranging from one to four years. The acquisition was accounted for as a business combination, with the results of the acquired entity included in the Distribution operating segment subsequent to the acquisition date. Distribution segment results also included a $5 million gain, as we were required to re-measure our pre-existing 33 percent ownership interest in Rocky Mountain to fair value in accordance with GAAP. Net sales for Rocky Mountain were $384 million for the year ended December 31, 2012. This amount is not fully incremental to our consolidated sales as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.
10
The final purchase price allocation was as follows:
In millions | |||
Accounts receivable | $ | 48 | |
Inventory | 100 | ||
Fixed assets | 34 | ||
Intangible assets | 8 | ||
Goodwill | 10 | ||
Other current assets | 8 | ||
Current liabilities | (41 | ) | |
Total business valuation | 167 | ||
Fair value of pre-existing 33 percent interest | (31 | ) | |
Purchase price | $ | 136 | |
Cummins Northwest LLC
In January 2013, we acquired the remaining 50 percent interest in Cummins Northwest LLC (Northwest) from the former distributor principal for consideration of approximately $18 million. We immediately formed a new partnership with a new distributor principal and sold 20.01 percent to the new distributor principal. We retained a new ownership in Northwest of 79.99 percent. The acquisition was accounted for as a business combination, with the results of the acquired entity included in the Distribution segment subsequent to the acquisition date. Distribution segment results also included a $7 million gain, as we were required to re-measure our pre-existing 50 percent ownership interest in Northwest to fair value in accordance with GAAP. The transaction generated $3 million of goodwill. Net sales for Northwest were $137 million for the year ended December 31, 2012. This amount is not fully incremental to our consolidated sales as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.
In July 2013, we acquired the remaining 20.01 percent from the new distributor principal for an additional $4 million. Since the entity was already consolidated, the acquisition was accounted for as an equity transaction instead of a business combination.
NOTE 4. PENSION AND OTHER POSTRETIREMENT BENEFITS
We sponsor funded and unfunded domestic and foreign defined benefit pension and other postretirement plans. Contributions to these plans were as follows:
Three months ended | Nine months ended | |||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
Defined benefit pension and other postretirement plans | ||||||||||||||||
Voluntary contribution | $ | 34 | $ | 33 | $ | 109 | $ | 110 | ||||||||
Mandatory contribution | 7 | 7 | 88 | 51 | ||||||||||||
Defined benefit pension contributions | 41 | 40 | 197 | 161 | ||||||||||||
Other postretirement plans | 12 | 11 | 35 | 37 | ||||||||||||
Total defined benefit plans | $ | 53 | $ | 51 | $ | 232 | $ | 198 | ||||||||
Defined contribution pension plans | $ | 16 | $ | 14 | $ | 57 | $ | 50 | ||||||||
We anticipate making additional defined benefit pension contributions and other postretirement benefit payments during the remainder of 2014 of $8 million and $11 million, respectively. The $205 million of pension contributions for the full year include voluntary contributions of approximately $111 million. These contributions and payments may be made from trusts or company funds either to increase pension assets or to make direct benefit payments to plan participants.
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The components of net periodic pension and other postretirement benefit costs under our plans were as follows:
Pension | ||||||||||||||||||||||||
U.S. Plans | U.K. Plans | Other Postretirement Benefits | ||||||||||||||||||||||
Three months ended | ||||||||||||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||||||||
Service cost | $ | 16 | $ | 17 | $ | 7 | $ | 5 | $ | — | $ | — | ||||||||||||
Interest cost | 26 | 23 | 16 | 14 | 4 | 4 | ||||||||||||||||||
Expected return on plan assets | (43 | ) | (42 | ) | (23 | ) | (17 | ) | — | — | ||||||||||||||
Recognized net actuarial loss | 8 | 16 | 7 | 6 | — | 2 | ||||||||||||||||||
Net periodic benefit cost | $ | 7 | $ | 14 | $ | 7 | $ | 8 | $ | 4 | $ | 6 | ||||||||||||
Pension | ||||||||||||||||||||||||
U.S. Plans | U.K. Plans | Other Postretirement Benefits | ||||||||||||||||||||||
Nine months ended | ||||||||||||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||||||||
Service cost | $ | 50 | $ | 52 | $ | 19 | $ | 15 | $ | — | $ | — | ||||||||||||
Interest cost | 79 | 70 | 49 | 42 | 13 | 12 | ||||||||||||||||||
Expected return on plan assets | (131 | ) | (126 | ) | (66 | ) | (53 | ) | — | — | ||||||||||||||
Recognized net actuarial loss | 23 | 47 | 20 | 18 | — | 5 | ||||||||||||||||||
Net periodic benefit cost | $ | 21 | $ | 43 | $ | 22 | $ | 22 | $ | 13 | $ | 17 | ||||||||||||
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 | |||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
Distribution Entities | ||||||||||||||||
North American distributors | $ | 27 | $ | 34 | $ | 89 | $ | 98 | ||||||||
Komatsu Cummins Chile, Ltda. | 8 | 6 | 22 | 17 | ||||||||||||
All other distributors | — | 1 | 2 | 1 | ||||||||||||
Manufacturing Entities | ||||||||||||||||
Dongfeng Cummins Engine Company, Ltd. | 15 | 13 | 51 | 45 | ||||||||||||
Chongqing Cummins Engine Company, Ltd. | 13 | 15 | 39 | 44 | ||||||||||||
Beijing Foton Cummins Engine Co., Ltd. (Light-duty) | 10 | 4 | 24 | 14 | ||||||||||||
Shanghai Fleetguard Filter Co., Ltd. | 3 | 4 | 9 | 11 | ||||||||||||
Tata Cummins, Ltd. | 2 | 1 | 6 | 4 | ||||||||||||
Cummins Westport, Inc. | 2 | 2 | 3 | 5 | ||||||||||||
Beijing Foton Cummins Engine Co., Ltd. (Heavy-duty) | (5 | ) | (4 | ) | (18 | ) | (14 | ) | ||||||||
All other manufacturers | 13 | 7 | 36 | 29 | ||||||||||||
Cummins share of net income | 88 | 83 | 263 | 254 | ||||||||||||
Royalty and interest income | 11 | 8 | 31 | 27 | ||||||||||||
Equity, royalty and interest income from investees | $ | 99 | $ | 91 | $ | 294 | $ | 281 | ||||||||
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NOTE 6. INCOME TAXES
Our effective tax rate for the year is expected to approximate 29.5 percent, excluding any one-time items that may arise. The expected tax rate does not include the benefits of the research tax credit which expired December 31, 2013 and has not yet been renewed by Congress. Our tax rate is generally less than the 35 percent U.S. statutory income tax rate primarily due to lower tax rates on foreign income.
The effective tax rates for the three and nine month periods ended September 28, 2014, were 34.4 percent and 30.4 percent, respectively. The tax rate for the three months ended September 28, 2014, included a $19 million discrete tax expense to reflect the reduction in value of state tax credits as a result of a favorable state tax rate change that will lower future taxes. Additionally, the tax rate for the nine month period included a second quarter $2 million discrete tax benefit for the release of reserves for uncertain tax positions related to multiple state audit settlements, a first quarter $12 million discrete tax expense attributable primarily to state deferred tax adjustments, as well as a first quarter $6 million discrete net tax benefit resulting from a $70 million dividend paid from China earnings generated prior to 2012.
Our effective tax rates for the three and nine month periods ended September 29, 2013, were 29.2 percent and 28.3 percent, respectively. These tax rates include a $7 million discrete net tax expense for the third quarter tax adjustments: $4 million expense attributable to prior year tax return true-up adjustments, $1 million benefit related to release of prior year tax reserves and a discrete tax charge for $4 million related to a third quarter enactment of U.K. tax law changes. In addition, the nine month tax rate includes a discrete tax benefit in the first quarter of 2013 of $28 million attributable to the reinstatement of the research credit back to 2012, as well as a discrete tax expense in the first quarter of 2013 of $17 million, which primarily relates to the write-off of a deferred tax asset deemed unrecoverable.
The increase in the three month effective tax rate from 2013 to 2014 is primarily due to unfavorable changes in the jurisdictional mix of pre-tax income and the 2014 unfavorable discrete tax items.
We anticipate that we may resolve tax matters related primarily to certain tax credits presently under examination in U.S. federal and state tax jurisdictions. As of September 28, 2014, we estimate that it is reasonably possible that unrecognized tax benefits may decrease in an amount ranging from $0 to $75 million in the next 12 months due to the resolution of these issues. We do not expect this resolution to have a material impact on our results of operations.
NOTE 7. MARKETABLE SECURITIES
A summary of marketable securities, all of which are classified as current, was as follows:
September 28, 2014 | December 31, 2013 | |||||||||||||||||||||||
In millions | Cost | Gross unrealized gains/(losses) | Estimated fair value | Cost | Gross unrealized gains/(losses) | Estimated fair value | ||||||||||||||||||
Available-for-sale | ||||||||||||||||||||||||
Level 1(1) | ||||||||||||||||||||||||
Debt mutual funds | $ | 26 | $ | — | $ | 26 | $ | 72 | $ | — | $ | 72 | ||||||||||||
Equity securities and other | 7 | — | 7 | 10 | 13 | 23 | ||||||||||||||||||
Total level 1 | 33 | — | 33 | 82 | 13 | 95 | ||||||||||||||||||
Level 2(2) | ||||||||||||||||||||||||
Debt mutual funds | 14 | 1 | 15 | 27 | 2 | 29 | ||||||||||||||||||
Bank debentures | 3 | — | 3 | 2 | — | 2 | ||||||||||||||||||
Certificates of deposit | — | — | — | 22 | — | 22 | ||||||||||||||||||
Government debt securities-non-U.S. | 3 | (1 | ) | 2 | 3 | (1 | ) | 2 | ||||||||||||||||
Total level 2 | 20 | — | 20 | 54 | 1 | 55 | ||||||||||||||||||
Total marketable securities | $ | 53 | $ | — | $ | 53 | $ | 136 | $ | 14 | $ | 150 | ||||||||||||
________________________________________________________________________________________
(1) The fair value of Level 1 securities is estimated primarily by referencing quoted prices in active markets for identical assets.
(2) The fair value of Level 2 securities is estimated primarily using actively quoted prices for similar instruments from brokers and observable inputs, including market transactions and third-party pricing services. We do not currently have any Level 3 securities, and there were no transfers into or out of Level 2 or 3 during the first nine months of 2014 and 2013.
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The proceeds from sales and maturities of marketable securities and gross realized gains and losses from the sale of available-for-sale securities were as follows:
Three months ended | Nine months ended | |||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
Proceeds from sales and maturities of marketable securities | $ | 137 | $ | 153 | $ | 316 | $ | 433 | ||||||||
Gross realized gains from the sale of available-for-sale securities | 1 | 1 | 14 | 12 | ||||||||||||
At September 28, 2014, the fair value of available-for-sale investments in debt securities that utilize a Level 2 fair value measure by contractual maturity was as follows:
Maturity date | Fair value (in millions) | |||
1 year or less | $ | 16 | ||
1 - 5 years | 3 | |||
5 - 10 years | 1 | |||
Total | $ | 20 | ||
NOTE 8. INVENTORIES
Inventories are stated at the lower of cost or market. Inventories included the following:
In millions | September 28, 2014 | December 31, 2013 | ||||||
Finished products | $ | 1,775 | $ | 1,487 | ||||
Work-in-process and raw materials | 1,182 | 1,005 | ||||||
Inventories at FIFO cost | 2,957 | 2,492 | ||||||
Excess of FIFO over LIFO | (124 | ) | (111 | ) | ||||
Total inventories | $ | 2,833 | $ | 2,381 | ||||
NOTE 9. DEBT
A summary of long-term debt was as follows:
In millions | September 28, 2014 | December 31, 2013 | ||||||
Long-term debt | ||||||||
Senior notes, 3.65%, due 2023 (1) | $ | 500 | $ | 500 | ||||
Debentures, 6.75%, due 2027 | 58 | 58 | ||||||
Debentures, 7.125%, due 2028 (1) | 250 | 250 | ||||||
Senior notes, 4.875%, due 2043 | 500 | 500 | ||||||
Debentures, 5.65%, due 2098 (effective interest rate 7.48%) | 165 | 165 | ||||||
Credit facilities related to consolidated joint ventures | 7 | 92 | ||||||
Other | 38 | 65 | ||||||
1,518 | 1,630 | |||||||
Unamortized discount | (47 | ) | (48 | ) | ||||
Fair value adjustments due to hedge on indebtedness (1) | 51 | 49 | ||||||
Capital leases | 89 | 92 | ||||||
Total long-term debt | 1,611 | 1,723 | ||||||
Less: Current maturities of long-term debt | (27 | ) | (51 | ) | ||||
Long-term debt | $ | 1,584 | $ | 1,672 | ||||
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___________________________________________________________________________________
(1) In February 2014, we settled our November 2005 interest rate swap which previously converted our $250 million debt issue, due in 2028, from a fixed rate to a floating rate based on a LIBOR spread. We are amortizing the $52 million gain realized upon settlement over the remaining 14-year term of related debt. Also, in February 2014, we entered into a series of interest rate swaps to effectively convert our September 2013, $500 million debt issue, due in 2023, from a fixed rate of 3.65 percent to a floating rate equal to the one-month LIBOR plus a spread. See Note 12, "DERIVATIVES" for further details.
Principal payments required on long-term debt during the next five years are as follows:
Required Principal Payments | ||||||||||||||||||||
In millions | 2014 | 2015 | 2016 | 2017 | 2018 | |||||||||||||||
Payment | $ | 11 | $ | 22 | $ | 32 | $ | 12 | $ | 16 | ||||||||||
Fair Value of Debt
Based on borrowing rates currently available to us for bank loans with similar terms and average maturities, considering our risk premium, the fair value and carrying value of total debt, including current maturities, was as follows:
In millions | September 28, 2014 | December 31, 2013 | ||||||
Fair value of total debt(1) | $ | 1,922 | $ | 1,877 | ||||
Carrying value of total debt | 1,689 | 1,740 | ||||||
_________________________________________________
(1)The fair value of debt is derived from Level 2 inputs.
NOTE 10. PRODUCT WARRANTY LIABILITY
We charge the estimated costs of warranty programs, other than product recalls, to income when the sale is recorded. 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, or when they become probable and estimable, which is reflected in the provision for warranties issued line. We also sell extended warranty coverage on several engines. A tabular reconciliation of the product warranty liability, including the deferred revenue related to our extended warranty coverage and accrued recall programs was as follows:
Nine months ended | ||||||||
In millions | September 28, 2014 | September 29, 2013 | ||||||
Balance, beginning of year | $ | 1,129 | $ | 1,088 | ||||
Provision for warranties issued | 307 | 317 | ||||||
Deferred revenue on extended warranty contracts sold | 175 | 138 | ||||||
Payments | (313 | ) | (312 | ) | ||||
Amortization of deferred revenue on extended warranty contracts | (109 | ) | (84 | ) | ||||
Changes in estimates for pre-existing warranties | 28 | (26 | ) | |||||
Foreign currency translation | (4 | ) | (3 | ) | ||||
Balance, end of period | $ | 1,213 | $ | 1,118 | ||||
15
Warranty related deferred revenue, supplier recovery receivables and the long-term portion of the warranty liability on our September 28, 2014, balance sheet were as follows:
In millions | September 28, 2014 | Balance Sheet Location | ||||
Deferred revenue related to extended coverage programs | ||||||
Current portion | $ | 159 | Deferred revenue | |||
Long-term portion | 401 | Other liabilities and deferred revenue | ||||
Total | $ | 560 | ||||
Receivables related to estimated supplier recoveries | ||||||
Current portion | $ | 9 | Trade and other receivables | |||
Long-term portion | 3 | Other assets | ||||
Total | $ | 12 | ||||
Long-term portion of warranty liability | $ | 302 | Other liabilities and deferred revenue | |||
NOTE 11. COMMITMENTS AND CONTINGENCIES
We are subject to numerous lawsuits and claims arising out of the ordinary course of our business, including actions related to product liability; personal injury; the use and performance of our products; warranty matters; patent, trademark or other intellectual property infringement; contractual liability; the conduct of our business; tax reporting in foreign jurisdictions; distributor termination; workplace safety; and environmental matters. We also have been identified as a potentially responsible party at multiple waste disposal sites under U.S. federal 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 have denied liability with respect to many of these lawsuits, claims and proceedings and are vigorously defending such lawsuits, claims and proceedings. We carry various forms of commercial, property and casualty, product liability and other forms of insurance; however, such insurance may not be applicable or adequate to cover the costs associated with a judgment against us with respect to these lawsuits, claims and proceedings. We do not believe that these lawsuits are material individually or in the aggregate. While we believe we have also established adequate accruals for our expected future liability with respect to pending lawsuits, claims and proceedings, where the nature and extent of any such liability can be reasonably estimated based upon then presently available information, there can be no assurance that the final resolution of any existing or future lawsuits, claims or proceedings will not have a material adverse effect on our business, results of operations, financial condition or cash flows.
We conduct significant business operations in Brazil that are subject to the Brazilian federal, state and local labor, social security, tax and customs laws. While we believe we comply with such laws, they are complex, subject to varying interpretations and we are often engaged in litigation regarding the application of these laws to particular circumstances.
U.S. Distributor Commitments
Our distribution agreements with independent and partially-owned distributors generally have a renewable three-year term and are restricted to specified territories. Our distributors develop and maintain a network of dealers with which we have no direct relationship. Our distributors are permitted to sell other, noncompetitive products only with our consent. We license all of our distributors to use our name and logo in connection with the sale and service of our products, with no right to assign or sublicense the trademarks, except to authorized dealers, without our consent. Products are sold to the distributors at standard domestic or international distributor net prices, as applicable. Net prices are wholesale prices we establish to permit our distributors an adequate margin on their sales. Subject to local laws, we can generally refuse to renew these agreements upon expiration or terminate them upon written notice for inadequate sales, change in principal ownership and certain other reasons. Distributors also have the right to terminate the agreements upon 60-day notice without cause, or 30-day notice for cause. Upon termination or failure to renew, we are required to purchase the distributor’s current inventory, signage and special tools and may, at our option purchase other assets of the distributor, but are under no obligation to do so.
16
Other Guarantees and Commitments
In addition to the matters discussed above, from time to time we enter into other guarantee arrangements, including guarantees of non-U.S. distributor financing, residual value guarantees on equipment under operating leases and other miscellaneous guarantees of third-party obligations. As of September 28, 2014, the maximum potential loss related to these other guarantees was $8 million.
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. As of September 28, 2014, if we were to stop purchasing from each of these suppliers, the aggregate amount of the penalty would be approximately $86 million, of which $47 million relates to a contract with an engine parts supplier that extends to 2016. These arrangements enable us to secure critical components. We do not currently anticipate paying any penalties under these contracts.
During the second quarter of 2014, we began entering into physical forward contracts with suppliers of platinum and palladium to purchase minimum volumes of the commodities at contractually stated prices for various periods, not to exceed two years. As of September 28, 2014, the total commitments under these contracts were $51 million. These arrangements enable us to fix the prices of these commodities, which otherwise are subject to market volatility.
We have guarantees with certain customers that require us to satisfactorily honor contractual or regulatory obligations, or compensate for monetary losses related to nonperformance. These performance bonds and other performance-related guarantees were $80 million at September 28, 2014 and $66 million at December 31, 2013.
Indemnifications
Periodically, we enter into various contractual arrangements where we agree to indemnify a third-party against certain types of losses. Common types of indemnities 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 indemnities 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, 2014, we have committed to invest an additional $4 million in existing joint ventures, of which $1 million is expected to be funded in 2014.
NOTE 12. DERIVATIVES
We are exposed to financial risk resulting from volatility in foreign exchange rates, commodity prices and interest rates. This risk is closely monitored and managed through the use of financial derivative instruments including foreign currency forward contracts, commodity zero-cost collars and interest rate swaps. These instruments, as further described below, are accounted for as cash flow or fair value hedges or as economic hedges not designated as hedges for accounting purposes. Financial derivatives are used expressly for hedging purposes and under no circumstances are they used for speculative purposes. When material, we adjust the estimated fair value of our derivative contracts for counter-party or our credit risk. None of our derivative instruments are subject to collateral requirements. Substantially all of our derivative contracts are subject to master netting arrangements which provide us with the option to settle certain contracts on a net basis when they settle on the same day with the same currency. In addition, these arrangements provide for a net settlement of all contracts with a given counterparty in the event that the arrangement is terminated due to the occurrence of default or a termination event.
17
Commodity Price Risk
During the second quarter of 2014, we chose to de-designate and unwind all of our cash flow hedges for platinum and palladium. As of the de-designation date, we had an unrealized net gain of $2 million in "Accumulated other comprehensive loss" (AOCL) that will be reclassified to income during the next year as the related purchases are made. See Note 11, "COMMITMENTS AND CONTINGENCIES" for additional information on new platinum and palladium purchase committments.
Interest Rate Risk
We are exposed to market risk from fluctuations in interest rates. We manage our exposure to interest rate fluctuations through the use of interest rate swaps. The objective of the swaps is to more effectively balance our borrowing costs and interest rate risk.
In February 2014, we settled our November 2005 interest rate swap which previously converted our $250 million debt issue, due in 2028, from a fixed rate to a floating rate based on a LIBOR spread. We are amortizing the $52 million gain realized upon settlement over the remaining 14-year term of related debt.
Also, in February 2014, we entered into a series of interest rate swaps to effectively convert our September 2013, $500 million debt issue, due in 2023, from a fixed rate of 3.65 percent to a floating rate equal to the one-month LIBOR plus a spread. The terms of the swaps mirror those of the debt, with interest paid semi-annually. The swaps were designated, and will be accounted for, as fair value hedges under GAAP. The gain or loss on these derivative instruments, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk, are recognized in current income as “Interest expense.” The net swap settlements that accrue each period are also reported in interest expense.
The following table summarizes these gains and losses for the three and nine month periods presented below:
Three months ended | Nine months ended | |||||||||||||||||||||||||||||||
In millions | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||||||||||||||||||
Income Statement Classification | Gain/(Loss) on Swaps | Gain/(Loss) on Borrowings | Gain/(Loss) on Swaps | Gain/(Loss) on Borrowings | Gain/(Loss) on Swaps | Gain/(Loss) on Borrowings | Gain/(Loss) on Swaps | Gain/(Loss) on Borrowings | ||||||||||||||||||||||||
Interest expense(1) | $ | — | $ | 2 | $ | (6 | ) | $ | 6 | $ | 8 | $ | (5 | ) | $ | (34 | ) | $ | 34 | |||||||||||||
(1)The difference between the gain/(loss) on swaps and borrowings represents hedge ineffectiveness.
Cash Flow Hedging
The following table summarizes the effect on our Condensed Consolidated Statements of Income for derivative instruments classified as cash flow hedges for the three and nine month periods presented below:
In millions(1) | Three months ended | Nine months ended | ||||||||||||||
Derivatives in cash flow hedging relationships | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
Gain/(loss) reclassified from AOCL into income - Net sales(2) | $ | 1 | $ | (2 | ) | $ | 6 | $ | (4 | ) | ||||||
Gain/(loss) reclassified from AOCL into income - Cost of sales(3) | 1 | (2 | ) | (2 | ) | 1 | ||||||||||
Total | $ | 2 | $ | (4 | ) | $ | 4 | $ | (3 | ) | ||||||
_____________________________________________________
(1)The table does not include amounts related to ineffectiveness or the effective portion of gain (loss) recognized in AOCL as they were not material for the periods presented.
(2)Includes foreign currency forward contracts.
(3)Includes commodity swap contracts.
18
Derivatives Not Designated as Hedging Instruments
The following table summarizes the effect on our Condensed Consolidated Statements of Income for derivative instruments not classified as cash flow hedges for the three and nine month periods presented below:
In millions | Three months ended | Nine months ended | ||||||||||||||
Derivatives not designated as hedging instruments | September 28, 2014 | September 29, 2013 | September 28, 2014 | September 29, 2013 | ||||||||||||
Gain/(loss) recognized in income - Cost of sales(1) | $ | 1 | $ | (1 | ) | $ | (2 | ) | $ | (2 | ) | |||||
Gain/(loss) recognized in income - Other income (expense), net(2) | (12 | ) | 19 | (5 | ) | (3 | ) | |||||||||
Total | $ | (11 | ) | $ | 18 | $ | (7 | ) | $ | (5 | ) | |||||
_________________________________________________
(1) Includes foreign currency forward contracts and commodity zero-cost collars.
(2) Includes foreign currency forward contracts.
Fair Value Amount and Location of Derivative Instruments
The following table summarizes the location and fair value of interest rate swap contracts, foreign currency forward contracts, commodity swap contracts and commodity zero-cost collars on our Condensed Consolidated Balance Sheets:
Derivatives Designated as Hedging Instruments | Derivatives Not Designated as Hedging Instruments | |||||||||||||||
In millions | September 28, 2014 | December 31, 2013 | September 28, 2014 | December 31, 2013 | ||||||||||||
Notional amount(1) | $ | 603 | $ | 425 | $ | 747 | $ | 547 | ||||||||
Derivative assets recorded in: | ||||||||||||||||
Prepaid expenses and other current assets | — | 5 | — | 6 | ||||||||||||
Other assets | 5 | 49 | — | — | ||||||||||||
Total derivative assets(2) | $ | 5 | $ | 54 | $ | — | $ | 6 | ||||||||
Derivative liabilities recorded in: | ||||||||||||||||
Other accrued expenses | 2 | 5 | 1 | 5 | ||||||||||||
Total derivative liabilities(2) | $ | 2 | $ | 5 | $ | 1 | $ | 5 | ||||||||
______________________________________________
(1)Commodity zero-cost collars are not designated as hedging instruments and had a notional quantity of 4,578 and 5,421 metric tons of copper at September 28, 2014 and December 31, 2013, respectively. These instruments are not included in the notional amounts above as they were subject to a USD denominated cap and floor; however, they are included in the total asset and liability balances as appropriate. The average cap and floor at September 28, 2014 and December 31, 2013 were $7,265 and $6,619 and $7,639 and $6,978, respectively.
(2)Estimates of the fair value of all derivative assets and liabilities above are derived from Level 2 inputs, which are estimated primarily using actively quoted prices for similar instruments from brokers and observable inputs, including market transactions and third-party pricing services. We do not currently have any Level 3 input measures and there were no transfers into or out of Level 2 or 3 during the first nine months of 2014 and 2013.
We have elected to present our derivative contracts on a gross basis in our Condensed Consolidated Balance Sheets. Had we chosen to present on a net basis, we would have derivatives in a net asset position of $4 million and $53 million and derivatives in a net liability position of $2 million and $3 million at September 28, 2014 and December 31, 2013, respectively.
19
NOTE 13. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
Following are the changes in accumulated other comprehensive income (loss) by component for the three and nine months ended:
Three months ended | ||||||||||||||||||||||||||||
In millions | Change in pensions and other postretirement defined benefit plans | Foreign currency translation adjustment | Unrealized gain (loss) on marketable securities | Unrealized gain (loss) on derivatives | Total attributable to Cummins Inc. | Noncontrolling interests | Total | |||||||||||||||||||||
Balance at June 30, 2013 | $ | (754 | ) | $ | (338 | ) | $ | 5 | $ | (12 | ) | $ | (1,099 | ) | ||||||||||||||
Other comprehensive income before reclassifications | ||||||||||||||||||||||||||||