Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 31, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                    To                    

Commission file number 1-9618

 

 

LOGO

NAVISTAR INTERNATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware   36-3359573

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

4201 Winfield Road, P.O. Box 1488,

Warrenville, Illinois

  60555
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code (630) 753-5000

 

 

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  ¨.

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 definition of “larger accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  ¨

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

As of July 31, 2008, the number of shares outstanding of the registrant’s common stock was 71,174,848, net of treasury shares.

Documents incorporated by reference: None.

 

 

 


Table of Contents

NAVISTAR INTERNATIONAL CORPORATION FORM 10-Q

INDEX

 

          Page
PART I

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited)

   3
  

Consolidated Statements of Operations for the three and nine months ended July 31, 2008 and 2007

   3
  

Consolidated Balance Sheets as of July 31, 2008 and October 31, 2007

   4
  

Condensed Consolidated Statements of Cash Flows for the nine months ended July 31, 2008 and 2007

   5
  

Notes to Condensed Consolidated Financial Statements

   6

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   33

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   58

Item 4.

  

Controls and Procedures

   58
PART II

Item 1A.

  

Risk Factors

   61

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   62

Item 6.

  

Exhibits

   62
  

Signature

   63

 

2


Table of Contents

PART I

Item 1. Condensed Consolidated Financial Statements

Navistar International Corporation and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

 

     Three Months Ended
July 31,
    Nine Months Ended
July 31,
 
         2008             2007             2008             2007      
(in millions, except per share data)                         

Sales and revenues

        

Sales of manufactured products, net

   $ 3,879     $ 2,852     $ 10,592     $ 8,802  

Finance revenues

     75       104       265       292  
                                

Sales and revenues, net

     3,954       2,956       10,857       9,094  
                                

Costs and expenses

        

Costs of products sold

     3,115       2,428       8,762       7,505  

Selling, general and administrative expenses

     386       368       1,071       1,010  

Engineering and product development costs

     108       86       289       284  

Interest expense

     88       125       357       367  

Other income, net

     (5 )     (34 )     (10 )     (21 )
                                

Total costs and expenses

     3,692       2,973       10,469       9,145  

Equity in income of non-consolidated affiliates

     18       22       63       62  
                                

Income before income tax

     280       5       451       11  

Income tax expense

     (8 )     (9 )     (17 )     (28 )
                                

Net income (loss)

   $ 272     $ (4 )   $ 434     $ (17 )
                                

Basic earnings (loss) per share

   $ 3.85     $ (0.05 )   $ 6.16     $ (0.24 )

Diluted earnings (loss) per share

   $ 3.68     $ (0.05 )   $ 5.92     $ (0.24 )

Weighted average shares outstanding

        

Basic

     70.8       70.3       70.5       70.3  

Diluted

     74.0       70.3       73.3       70.3  

See Notes to Condensed Consolidated Financial Statements

 

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Table of Contents

Navistar International Corporation and Subsidiaries

Consolidated Balance Sheets

(Unaudited)

 

     As of  
     July 31,
2008
    October 31,
2007
 
(in millions, except per share data)             

ASSETS

    

Current assets

    

Cash and cash equivalents

   $ 678     $ 777  

Marketable securities

     18       6  

Finance and other receivables (net of allowance for losses of $74 and $60 as of July 31, 2008 and October 31, 2007, respectively)

     3,051       2,941  

Inventories

     1,544       1,412  

Deferred taxes, net

     116       115  

Other current assets

     171       194  
                

Total current assets

     5,578       5,445  

Restricted cash and cash equivalents

     687       419  

Finance and other receivables (net of allowance for losses of $28 and $41 as of July 31, 2008 and October 31, 2007, respectively)

     2,246       2,478  

Investments in and advances to non-consolidated affiliates

     177       154  

Property and equipment (net of accumulated depreciation and amortization of $2,347 and $2,199 as of July 31, 2008 and October 31, 2007, respectively)

     1,963       2,086  

Goodwill

     378       353  

Intangible assets (net of accumulated amortization of $71 and $53 as of July 31, 2008 and October 31, 2007, respectively)

     273       286  

Pension assets

     143       103  

Deferred taxes, net

     31       35  

Other noncurrent assets

     81       89  
                

Total assets

   $ 11,557     $ 11,448  
                

LIABILITIES AND STOCKHOLDERS’ DEFICIT

    

Liabilities

    

Current liabilities

    

Notes payable and current maturities of long-term debt

   $ 803     $ 798  

Accounts payable

     2,049       1,770  

Other current liabilities

     1,225       1,423  
                

Total current liabilities

     4,077       3,991  

Long-term debt

     5,730       6,083  

Postretirement benefits liabilities

     1,220       1,327  

Other noncurrent liabilities

     758       781  
                

Total liabilities

     11,785       12,182  

Stockholders’ deficit

    

Series D convertible junior preference stock

     4       4  

Common stock and additional paid in capital (par value $0.10 per share, 75.4 shares issued as of July 31, 2008 and October 31, 2007)

     2,103       2,101  

Accumulated deficit

     (2,091 )     (2,519 )

Accumulated other comprehensive loss

     (105 )     (155 )

Common stock held in treasury, at cost (4.2 and 5.1 shares as of July 31, 2008 and October 31, 2007, respectively)

     (139 )     (165 )
                

Total stockholders’ deficit

     (228 )     (734 )
                

Total liabilities and stockholders’ deficit

   $ 11,557     $ 11,448  
                

See Notes to Condensed Consolidated Financial Statements

 

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Table of Contents

Navistar International Corporation and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended
July 31,
 
     2008     2007  
(in millions)             

Cash flows from operating activities

    

Net income (loss)

   $ 434     $ (17 )
                

Adjustments to reconcile net income (loss) to cash provided by operating activities

    

Depreciation and amortization

     241       229  

Depreciation of equipment held for or under lease

     44       41  

Deferred taxes

     (3 )     (6 )

Amortization of debt issuance costs

     15       7  

Stock-based compensation

     2       6  

Provision for doubtful accounts

     51       23  

Equity in income of non-consolidated affiliates

     (63 )     (62 )

Dividends from non-consolidated affiliates

     54       74  

Gain on sales of affiliates

     (4 )     (9 )

Loss on sale of property and equipment

     —         8  

Loss on repurchases of debt

     —         31  

Changes in other assets and liabilities

     (124 )     (258 )
                

Total adjustments

     213       84  
                

Net cash provided by operating activities

     647       67  
                

Cash flows from investing activities

    

Purchases of marketable securities

     (43 )     (178 )

Sales or maturities of marketable securities

     31       309  

Net change in restricted cash and cash equivalents

     (268 )     69  

Capital expenditures

     (145 )     (207 )

Purchase of equipment held for or under lease

     (47 )     (41 )

Proceeds from sale of property and equipment

     22       16  

Investments and advances to non-consolidated affiliates

     (12 )     (5 )

Proceeds from sales of affiliates

     20       26  

Business acquisitions, net of cash acquired

     —         (7 )

Other investing activities

     5       6  
                

Net cash used in investing activities

     (437 )     (12 )
                

Cash flows from financing activities

    

Proceeds from issuance of securitized debt

     1,057       885  

Principal payments on securitized debt

     (1,448 )     (1,068 )

Proceeds from issuance of non-securitized debt

     161       1,566  

Principal payments on non-securitized debt

     (15 )     (1,558 )

Net decrease in notes and debt outstanding under revolving credit facilities

     (46 )     (357 )

Principal payments under financing arrangements and capital lease obligations

     (60 )     (36 )

Debt issuance costs

     (11 )     (24 )

Proceeds from exercise of stock options

     26       —    
                

Net cash used in financing activities

     (336 )     (592 )
                

Effect of exchange rate changes on cash and cash equivalents

     27       54  
                

Decrease in cash and cash equivalents

     (99 )     (483 )

Cash and cash equivalents at beginning of period

     777       1,157  
                

Cash and cash equivalents at end of the period

   $ 678     $ 674  
                

See Notes to Condensed Consolidated Financial Statements

 

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Table of Contents

Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. Summary of significant accounting policies

Organization and Description of the Business

Navistar International Corporation (“NIC”), incorporated under the laws of the state of Delaware in 1993, is a holding company whose principal operating subsidiaries are Navistar, Inc. and Navistar Financial Corporation (“NFC”). References herein to the “company,” “we,” “our,” or “us” refer collectively to NIC, its subsidiaries, and certain variable interest entities (“VIEs”) of which we are the primary beneficiary. We operate in four principal industry segments: Truck, Engine, Parts (collectively called “manufacturing operations”), and Financial Services. The Financial Services segment consists of NFC and our foreign finance operations (collectively called “financial services operations”).

Basis of Presentation and Consolidation

The accompanying unaudited condensed consolidated financial statements include the assets, liabilities, revenues, and expenses of our manufacturing operations, majority owned dealers, wholly-owned financial services subsidiaries, and VIEs of which we are the primary beneficiary. The effects of transactions among consolidated entities have been eliminated to arrive at the consolidated amounts. Certain reclassifications were made to prior year’s amounts to conform to the 2008 presentation.

We prepared the accompanying unaudited condensed consolidated financial statements in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X issued by the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and notes required by U.S. GAAP for comprehensive annual financial statements.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting policies described in the Annual Report on Form 10-K for the year ended October 31, 2007 and should be read in conjunction with the disclosures therein. In our opinion, these interim financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial position, results of operations, and cash flows for the periods presented. Operating results for interim periods are not necessarily indicative of annual operating results.

Accounting Changes

As of November 1, 2007, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109. See Note 9, Income taxes, for more information.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses. Significant estimates and assumptions are used for, but are not limited to, pension and other postretirement benefits, allowance for losses, sales of receivables, income tax contingency accruals and valuation allowances, product warranty accruals, asbestos accruals, asset impairment, and litigation-related accruals. Actual results could differ from our estimates.

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

Concentration Risks

Our financial position, results of operations, and cash flows are subject to concentration risks related to concentrations of union employees and two customers. As of July 31, 2008, approximately 6,300, or 64%, of our hourly workers and approximately 700, or 9%, of our salaried workers are represented by labor unions and are covered by collective bargaining agreements. See Note 13, Segment reporting, for discussions of customer concentration.

Revenue Recognition

Our manufacturing operations recognize revenue when we meet four basic criteria: (i) persuasive evidence that a customer arrangement exists, (ii) the price is fixed or determinable, (iii) collectability is reasonably assured, and (iv) delivery of product has occurred or services have been rendered.

Truck sales are generally recognized when risk of ownership passes. Sales to fleet customers and governmental entities are recognized in accordance with the terms of each contract. Revenue on certain customer requested bill and hold arrangements is not recognized until after the customer is notified that the product (i) has been completed according to customer specifications, (ii) has passed our quality control inspections, and (iii) is ready for delivery based upon the established delivery terms. Engine sales are generally recognized at the time of shipment or delivery in accordance with the shipping terms.

Parts sales are recognized at the time of shipment. Parts sales to governmental entities are recognized in accordance with the terms of each contract. An allowance for sales returns is recorded as a reduction to revenue based upon estimates using historical information about returns. For the sale of service parts that include a core component, we record revenue on a gross basis including the fair market value of the core. A core component is the basic forging or casting, such as an engine block, that can be remanufactured by a certified remanufacturing supplier. When a dealer returns a core within the specified eligibility period, we provide a core return credit. At times, we may mark up the core charge beyond the amount we are charged by the supplier. This mark up is recorded as a liability, as it represents the amount that will be paid to the dealer upon return of the core component and is in excess of the fair value to be received from the supplier.

Concurrent with our recognition of revenue, we recognize price allowances and the cost of incentive programs in the normal course of business based on programs offered to dealers. Estimates are made for sales incentives on certain vehicles in dealer stock inventory when special programs that provide a specific incentive to the dealer are offered in order to facilitate a sale to the end customer.

Truck sales to the U.S. government, of non-commercial products manufactured to the government’s specifications, are recognized using the units-of-delivery measure under the percentage-of-completion accounting method as units are delivered and accepted by the government. Revenue from service contracts with the U.S. government is generally recorded on a straight-line basis over the period of contract performance, unless otherwise agreed that the obligations are fulfilled upon achievement of an agreed milestone or occurrence of a specified event.

Modifications to U.S. government contracts, referred to as “change orders,” may be unpriced; that is, the work to be performed is defined, but the resulting contract price adjustment is to be negotiated at a later date. Revenue related to unpriced change orders is recognized when the price has been agreed with the government. Costs related to unpriced change orders are deferred when it is probable that the costs will be recovered through a contract price adjustment.

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

Shipping and handling amounts billed to our customers are included in Sales of manufactured products, net and the related shipping and handling costs incurred are included in Costs of products sold.

Financial services operations recognize revenue from retail notes, finance leases, wholesale notes, retail accounts, and wholesale accounts as Finance revenues over the term of the receivables utilizing the effective interest method. Certain direct origination costs and fees are deferred and recognized as an adjustment to yield and are reported as part of Finance revenues over the life of the receivable. Loans are considered to be impaired when we conclude there is a high likelihood the customer will not be able to make full payment after reviewing the customer’s financial performance, payment ability, capital-raising potential, management style, economic situation, etc. The accrual of interest on such loans is discontinued when the collection of the account becomes doubtful (“non-accrual status loans”). When the accrual of interest is discontinued, all unpaid accrued interest is charged against Finance revenues. Finance revenues on these loans are recognized only to the extent cash payments are received. We resume accruing interest on these accounts when payments are current according to the terms of the loans and future payments are reasonably assured.

Operating lease revenues are recognized on a straight-line basis over the life of the lease. Recognition of revenue is suspended when management determines the collection of future income is not probable. Income recognition is resumed if collection again becomes probable.

Selected receivables are securitized and sold to public and private investors with limited recourse. Our financial services operations continue to service the sold receivables and receive fees for such services. Gains or losses on sales of receivables that qualify for sales accounting treatment are credited or charged to Finance revenues in the period in which the sale occurs. Discount accretion is recognized on an effective yield basis and is included in Finance Revenues.

Product Warranty Liability

Accrued product warranty and deferred warranty revenue activity is as follows:

 

     Nine Months Ended
July 31,
 
       2008         2007    
(in millions)             

Balance, at beginning of period

   $ 677     $ 777  

Costs accrued and revenues deferred

     147       182  

Adjustments to pre-existing warranties(A)

     10       25  

Payments and revenues recognized

     (264 )     (265 )
                

Balance, at end of period

   $ 570     $ 719  
                

 

(A) Adjustments to pre-existing warranties reflect changes in our estimate of warranty costs for products sold in prior periods.

The amount of deferred revenue related to extended warranty programs as of July 31, 2008 and October 31, 2007 was $124 million and $127 million, respectively. Revenue recognized under our extended warranty programs was $12 million and $10 million, and $35 million and $21 million for the three months and nine months ended July 31, 2008 and 2007, respectively.

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

New Accounting Pronouncements

Accounting pronouncements issued by various standard setting and governmental authorities that have not yet become effective with respect to our condensed consolidated financial statements are described below, together with our assessment of the potential impact they may have on our financial position, results of operations, or cash flows:

 

Pronouncement

  

Effective Date

  

Impact on Our Financial Condition

and Results of Operations

Emerging Issues Task Force Issue No. 08-3, Accounting by Lessees for Nonrefundable Maintenance Deposits    Effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. Early adoption is not permitted. Our effective date is November 1, 2009.    We are evaluating the potential impact, if any.
FASB Staff Position No. FAS 142-3, Determination of the Useful Life of Intangible Assets    Effective for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. Our effective date is November 1, 2009.    We are evaluating the potential impact, if any.
FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities—An Amendment of FASB Statement No. 133    Effective for fiscal years and interim reporting periods beginning after November 15, 2008. Our effective date is February 1, 2009.    When effective, we will comply with the disclosure provisions of this Statement.
FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements—An Amendment of ARB No. 51    Effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008. Our effective date is November 1, 2009.    We are evaluating the potential impact, if any.
FASB Statement No. 141(R), Business Combinations    Applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity may not apply it before that date. Our effective date is November 1, 2009.    We will adopt this Statement on a prospective basis.
Emerging Issues Task Force Issue No. 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities    Effective for financial statements issued for fiscal years beginning after December 15, 2007. Our effective date is November 1, 2008.    We are evaluating the potential impact, if any.

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

Pronouncement

  

Effective Date

  

Impact on Our Financial Condition

and Results of Operations

FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities    Effective as of the beginning of the first fiscal year beginning after November 15, 2007. If we adopt the Fair Value Option, our effective date is November 1, 2008.    We are evaluating the potential impact, if any. We have not determined whether to adopt the fair value option.
FASB Statement No. 157, Fair Value Measurements    Effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. Our effective date is November 1, 2008.    We are evaluating the potential impact, if any.

2. Disposal of business

In December 2007, we sold all of our interests in a heavy duty truck parts remanufacturing business. In connection with the sale, we received gross proceeds of $22 million, including liabilities assumed, resulting in a gain of $4 million.

3. Finance and other receivables, net

Information regarding impaired finance receivables is as follows:

 

     As of
     July 31,
2008
   October 31,
2007
(in millions)          

Outstanding balances with specific loss reserves

   $  59    $ 52

Specific loss reserves

     13      11

Outstanding balances on non-accrual status loans

     45      39

Average balance of impaired finance receivables

     55      42

Outstanding balances with payments over 90 days past due

     28      120

Impaired receivables include accounts identified as “critical accounts” as a result of financial difficulties and accounts that are on a non-accrual status. In certain cases, we continue to collect payments on our impaired receivables.

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

The activity related to our allowance for losses for finance and other receivables is summarized as follows:

 

     Three Months Ended
July 31,
    Nine Months Ended
July 31,
 
     2008     2007     2008     2007  
(in millions)                         

Balance, at beginning of period

   $ 93     $ 80     $ 101     $ 75  

Provision for doubtful accounts

     34       8       52       23  

Charge-off of accounts, net of recoveries

     (25 )     (6 )     (51 )     (16 )
                                

Balance, at end of period

   $ 102     $ 82     $ 102     $ 82  
                                

Repossessions

We repossess leased and sold trucks on defaulted finance receivables and leases, and place them into Inventories. We liquidate these repossessions to partially recover the credit losses in our portfolio. Losses, recognized at the time of repossession and charged against the allowance for losses, for the three months ended July 31, 2008 and 2007 were $10 million and $4 million, and for the nine months ended July 31, 2008 and 2007 were $26 million and $11 million, respectively. Losses, recognized upon the sale of repossessed vehicles, for the three months ended July 31, 2008 and 2007 were $2 million and $1 million, and for the nine months ended July 31, 2008 and 2007 were $7 million and $2 million, respectively. Impairment losses on repossessed vehicles for the three and nine months ended July 31, 2008 were $2 million and $5 million, respectively. No impairments were recorded on repossessed vehicles in 2007.

A summary of the activity related to repossessed vehicles is as follows:

 

     Three Months Ended
July 31,
    Nine Months Ended
July 31,
 
     2008     2007     2008     2007  
(in millions)                         

Repossessed vehicles, at beginning of period

   $ 48     $ 17     $ 25     $ 6  

Repossessions

     25       9       84       32  

Liquidations

     (30 )     (10 )     (66 )     (22 )
                                

Repossessed vehicles, at end of period

   $ 43     $ 16     $ 43     $ 16  
                                

4. Sales of receivables

The primary business of our financial services operations is to provide wholesale, retail, and lease financing for new and used trucks sold by us and our dealers and, as a result, our finance receivables and leases have a significant concentration in the trucking industry. On a geographic basis, there is not a disproportionate concentration of credit risk in any area of the U.S. or other countries where we have financial service operations. We retain as collateral an ownership interest in the equipment associated with leases and, on behalf of the various trusts we maintain, a security interest in equipment associated with wholesale notes and retail notes.

NFC finances receivables through Navistar Financial Retail Receivables Corporation (“NFRRC”), Navistar Financial Securities Corporation (“NFSC”), Truck Retail Accounts Corporation (“TRAC”), Truck Retail Instalment Paper Corporation (“TRIP”), and International Truck Leasing Corporation (“ITLC”), which are all special purpose, wholly-owned subsidiaries (“SPEs”) of NFC. In accordance with FASB Statement No. 140,

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, these transactions are accounted for either as a sale with gain or loss recorded at the date of sale and a retained interest recorded, or as secured borrowings. We provide limited recourse for all subordinated receivables. The recourse is limited to our retained interest and relates to credit risk only.

Off-Balance Sheet Securitizations

The NFSC trust owned $848 million of wholesale notes, which includes $122 million of receivables with dealer operations (“Dealcors”), and $66 million of marketable securities as of July 31, 2008, and $1.1 billion of wholesale notes which includes $171 million of receivables with Dealcors and $85 million of marketable securities as of October 31, 2007. In the three months ended July 31, 2008, the NFSC trust repaid $200 million of an investor certificate that expired in July 2008.

Components of available wholesale note trust funding certificates related to NFSC were as follows:

 

          As of  
     Maturity    July 31,
2008
    October 31,
2007
 
(in millions)                  

Investor certificate

   July 2008    $ —       $ 200  

Investor certificate

   February 2010      212       212  

Variable funding certificate

   November 2008      800       800  
                   

Total funding available

        1,012       1,212  

Funding utilized

        (762 )     (982 )
                   

Unutilized funding

      $ 250     $ 230  
                   

All of the unutilized funding is related to the variable funding certificate (“VFC”). Our retained interest was $152 million and $200 million as of July 31, 2008 and October 31, 2007, respectively.

The TRAC trust owned $125 million of retail accounts and $23 million of marketable securities as of July 31, 2008, and $155 million of retail accounts and $26 million of marketable securities as of October 31, 2007.

The amount of available retail accounts funding related to TRAC was as follows:

 

          As of  
     Maturity    July 31,
2008
    October 31,
2007
 
(in millions)                  

Funding conduit

   October 2008    $ 100     $ 100  

Funding utilized

        (35 )     (60 )
                   

Unutilized funding

      $ 65     $ 40  
                   

In August 2008, the TRAC funding conduit, which was due to expire in August 2008, was extended to October 7, 2008.

Our retained interest was $111 million and $119 million as of July 31, 2008 and October 31, 2007, respectively.

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

For the three months ended July 31, 2008 and 2007, proceeds from the sale of finance receivables with off-balance sheet treatment were $1.2 billion and $1.1 billion, respectively. For the nine months ended July 31, 2008 and 2007, proceeds from the sale of finance receivables with off-balance sheet treatment were $3.0 billion and $3.9 billion, respectively.

Retained Interests

The SPEs’ assets are available to satisfy their creditors’ claims prior to such assets becoming available for the SPEs’ own uses or to NFC or affiliated companies. NFC is under no obligation to repurchase any sold receivable that becomes delinquent in payment or otherwise is in default. The terms of receivable sales generally require NFC to provide credit enhancements in the form of excess seller’s interest and/or cash reserves with the trusts and conduits. The use of such cash reserves by NFC is restricted under the terms of the securitized sales agreements. The maximum exposure under all receivable sale recourse provisions was $263 million and $319 million as of July 31, 2008 and October 31, 2007, respectively.

The following is a summary of amounts due from sales of receivables (retained interest):

 

     As of
     July 31,
2008
   October 31,
2007
(in millions)          

Excess seller’s interest

   $ 248    $ 296

Interest only strip

     6      11

Restricted cash reserves

     9      12
             

Total amounts due from sales of receivables

   $ 263    $ 319
             

The key economic assumptions used in valuing our retained interests are as follows:

 

     As of  
     July 31,
2008
    October 31,
2007
 

Discount rate (annual)

   10.6 to 18.5 %   10.3 to 18.8 %

Estimated credit losses

   0 to 0.18 %   0 to 0.18 %

Payment speed (percent of portfolio per month)

   10.3 to 83.0 %   9.9 to 69.2 %

The lower end of the discount rate assumption range and the upper end of the payment speed assumption range were used to value the $111 million retained interests in the TRAC retail account securitization The upper end of the discount rate assumption range and the lower end of the payment speed assumption range were used to value the $152 million retained interests in the NFSC wholesale note securitization facility.

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

The following tables reconcile the total serviced portfolio to NFC’s on-balance sheet portfolio, net of unearned income:

 

     Retail
Notes
   Finance
Leases
   Wholesale
Notes
    Accounts
Receivable
    Total  
(in millions)                             

As of July 31, 2008

            

Total portfolio

   $ 2,549    $ 126    $ 881     $ 291     $ 3,847  

Less: Sold receivables and retained interest

     —        —        (726 )     (125 )     (851 )
                                      

Total on balance sheet

   $ 2,549    $ 126    $ 155     $ 166     $ 2,996  
                                      

As of October 31, 2007

            

Total portfolio

   $ 3,012    $ 157    $ 1,025     $ 424     $ 4,618  

Less: Sold receivables and retained interest

     —        —        (919 )     (155 )     (1,074 )
                                      

Total on balance sheet

   $ 3,012    $ 157    $ 106     $ 269     $ 3,544  
                                      

Securitization Income

The following table sets forth the activity related to off-balance sheet securitizations, which are reported in Finance revenues:

 

     Three Months Ended
July 31,
    Nine Months Ended
July 31,
 
     2008     2007     2008     2007  
(in millions)                         

Fair value adjustments to retained interests

   $ —       $ 5     $ 5     $ 11  

Excess spread income

     4       10       15       41  

Servicing fees revenue

     2       3       8       11  

Losses on sales of receivables

     (5 )     (1 )     (12 )     (6 )

Investment revenue

     1       2       4       5  
                                

Securitization income

   $ 2     $ 19     $ 20     $ 62  
                                

5. Inventories

The components of inventories are as follows:

 

     As of
     July 31,
2008
   October 31,
2007
(in millions)          

Finished products

   $ 831    $ 851

Work in process

     190      210

Raw materials

     438      293

Costs deferred related to unpriced change orders

     25      —  

Supplies

     60      58
             

Total inventories

   $ 1,544    $ 1,412
             

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

6. Investments in and advances to non-consolidated affiliates

Investments in and advances to non-consolidated affiliates is comprised of a 49 percent ownership interest in Blue Diamond Parts (“BDP”), a 51 percent ownership interest in Blue Diamond Truck (“BDT”), and fourteen other partially-owned affiliates. We do not control these affiliates, but have the ability to exercise significant influence over their operating and financial policies. Our ownership percentages in the fourteen other affiliates range from 9.9 percent to 51 percent. Our investment in these affiliates is an integral part of our operations, and we account for them using the equity method of accounting.

Presented below is summarized financial information for BDP, which is considered a significant unconsolidated affiliate. BDP manages sourcing, merchandising, and distribution of various replacement parts. The following table summarizes results of operations information of BDP:

 

     Three Months Ended
July 31,
   Nine Months Ended
July 31,
     2008    2007    2008    2007
(in millions)                    

Net service revenue

   $ 51    $ 49    $ 159    $ 158

Net expenses

     8      8      24      26

Income before tax expense

     43      41      135      132

Net income

     43      41      134      131

7. Debt

NFC’s Revolving Credit Agreement (“Credit Agreement”), as amended in March 2007, has two primary components, a term loan of $620 million and a revolving bank loan of $800 million. The latter has a Mexican sub-revolver ($100 million), which may be used by NIC’s Mexican financial services operations.

The Credit Agreement requires both NIC and NFC to file with the SEC and provide to NFC’s lenders copies of their respective Annual Reports on Form 10-K for each year, their Quarterly Reports on Form 10-Q for each of the first three quarters of each year, and the related financial statements on or before the dates specified in the Credit Agreement. Failure to do so results in a default under the Credit Agreement, during which NFC may not incur any additional indebtedness under the Credit Agreement until the default is cured or waived, and which would give rise to a cross-default to NIC’s $1.5 billion five-year term loan facility and synthetic revolving facility.

NFC received a series of waivers extending through December 31, 2007, which waived any default or event of default that would result solely from NFC’s and NIC’s failure to meet the filing requirements of Sections 13 and 15 of the Securities Exchange Act of 1934, as amended, with respect to their Annual Reports on Form 10-K for 2005 and 2006 and certain of their Quarterly Reports on Form 10-Q.

In December 2007, NFC received a fifth waiver to the Credit Agreement extending the waiver period through November 30, 2008. This waiver expands the scope of certain reporting default conditions to include the Annual Report on Form 10-K for 2007 and the Quarterly Reports on Form 10-Q for 2008. The fifth waiver continues the 0.25% rate increase through the waiver’s expiration.

In November and December 2007, NFC obtained waivers for the private retail securitizations and the VFC portion of the wholesale note securitizations. These waivers are similar in scope to the Credit Agreement waivers and expire upon the earlier of November 30, 2008, or the date on which NIC and NFC each shall have timely filed a report on Form 10-K or Form 10-Q with the SEC, which will occur on the filing of this Form 10-Q.

 

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In February 2008, April 2008, and July 2008, NFC completed separate securitization transactions for the sale of retail notes and issued secured borrowings related to these transactions in the amount of $536 million, $247 million, and $239 million, respectively. These transactions do not qualify for sale treatment under FASB Statement No. 140. Through July 31, 2008, NFC also utilized an additional $252 million of the bank revolving credit facility.

In March 2008, NFC received an Acknowledgement and Consent from the lenders under the Credit Agreement, whereby the filing of the audited financial statements for 2006 on a Current Report on Form 8-K filed March 6, 2008 was deemed satisfactory by the lenders.

In April 2008, NFC received a second Acknowledgement and Consent from the lenders under the Credit Agreement acknowledging that the method used in calculating various financial covenants was in accordance with the Credit Agreement.

We are required under certain agreements with public and private lenders of NFC to ensure that NFC and its subsidiaries maintain consolidated income before interest expense and income tax at not less than 125% of their interest expense. Under these agreements, if NFC and its subsidiaries consolidated income before interest expense and income taxes is less than 125% of their interest expense, NIC or Navistar, Inc. must make payments to NFC to achieve the required ratio. In May 2008, NFC received a third Acknowledgement and Consent from the lenders under the Credit Agreement that clarified certain definitions used to measure the fixed charge coverage ratio. This Acknowledgement and Consent allows NFC to include contributions made by NIC in NFC’s calculation of consolidated income before interest expense and income taxes. During July 2008, $25 million of such payments were required and made from Navistar, Inc. to NFC to maintain compliance with the covenant. No such contributions were made during the three and nine month periods ended July 31, 2007.

8. Postretirement benefits

Defined Benefit Plans

Generally, our pension plans are non-contributory. Our policy is to fund the pension plans in accordance with applicable U.S. and Canadian government regulations and to make additional contributions from time to time. For the three months and nine months ended July 31, 2008, we contributed $6 million and $27 million, respectively, to our pension plans to meet regulatory minimum funding requirements. For the three and nine months ended July 31, 2007, we contributed $6 million and $21 million, respectively, to meet minimum funding requirements. We currently anticipate additional contributions of approximately $67 million during the remainder of 2008.

On December 16, 2007, the majority of company employees represented by the United Automobile, Aerospace and Agriculture Implement Workers of America (“UAW”) voted to ratify a new contract that will run through September 30, 2010. Among the changes from the prior contract was the cessation of annual lump sum payments that had been made to certain retirees. We accounted for these payments as a defined benefit plan based on the historical substance of the underlying arrangement. The elimination of these payments and other changes resulted in a net settlement and curtailment of the plan resulting in income of $42 million, which is presented as a reduction of Selling, general and administrative expenses, for the nine months ended July 31, 2008.

 

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We primarily fund other post-employment benefit (“OPEB”) obligations, such as retiree medical, in accordance with a 1993 legal agreement, which requires us to fund a portion of the plans’ annual service cost. For the three months and nine months ended July 31, 2008, we contributed $1 million and $3 million, respectively, to our OPEB plans to meet legal funding requirements. For the three and nine months ended July 31, 2007, we contributed $1 million and $4 million, respectively, to our OPEB plans to meet legal funding requirements. We currently anticipate additional contributions of approximately $1 million during the remainder of 2008.

Components of Net Postretirement Benefits (Income) Expense

Net postretirement benefits (income) expense included in our consolidated statements of operations is composed of the following:

 

     Three Months Ended July 31,     Nine Months Ended July 31,  
     Pension
Benefits
    Health and
Life Insurance
Benefits
    Pension
Benefits
    Health and
Life Insurance
Benefits
 
     2008     2007     2008     2007     2008     2007     2008     2007  
(in millions)                                                 

Service cost for benefits earned during the period

   $ 6     $ 6     $ 3     $ 4     $ 18     $ 19     $ 9     $ 12  

Interest on obligation

     56       55       28       28       168       165       85       84  

Amortization of net cumulative losses

     3       15       —         5       10       45       —         16  

Amortization of prior service cost (benefit)

     1       1       (1 )     (2 )     2       3       (3 )     (6 )

Settlements and curtailments

     —         —         —         —         (42 )     —         (1 )     —    

Premiums on pension insurance

     —         —         —         —         1       —         —         —    

Expected return on assets

     (81 )     (69 )     (17 )     (14 )     (243 )     (208 )     (51 )     (42 )
                                                                

Net postretirement benefits (income) expense

   $ (15 )   $ 8     $ 13     $ 21     $ (86 )   $ 24     $ 39     $ 64  
                                                                

Defined Contribution Plans

Our defined contribution plans cover a substantial portion of domestic salaried employees and certain domestic represented employees. The defined contribution plans contain a 401(k) feature and provide most participants with a matching contribution from the company. Many participants covered by the plan receive annual company contributions to their retirement account based on an age-weighted percentage of the participant’s eligible compensation for the calendar year.

Defined contribution expense pursuant to these plans was $7 million and $6 million for the three months ended July 31, 2008 and 2007, respectively, and $19 million and $18 million for the nine months ended July 31, 2008 and 2007, respectively.

9. Income taxes

Under Accounting Principles Board Opinion No. 28, Interim Financial Reporting, we compute on a quarterly basis an estimated annual effective tax rate considering ordinary income and related income tax expense. Ordinary income refers to income before income tax expense excluding significant unusual or infrequently occurring items. The tax effect of an unusual or infrequently occurring item is recorded in the interim period in which it occurs. For our domestic tax jurisdictions, we cannot reliably estimate annual projected taxes. Therefore taxes on ordinary income for such jurisdictions are reported in the period in which they are

 

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(Unaudited)

 

incurred. Other items included in income tax expense in the periods in which they occur include the cumulative effect of changes in tax laws or rates, foreign exchange gains and losses, adjustments to our accruals for uncertain tax positions, and adjustments to our valuation allowance due to changes in our judgment regarding the realizability of deferred tax assets in future years.

We have assessed the need to maintain a valuation allowance for deferred tax assets based on an assessment of whether it is more likely than not that deferred tax benefits will be realized through the generation of future taxable income. Appropriate consideration is given to all available evidence, both positive and negative, in assessing the need for a valuation allowance. Due to our recent history of U.S. operating and taxable losses, the inconsistency of U.S. profits, and the uncertainty of our U.S. financial outlook, we continue to maintain a full valuation allowance against our domestic deferred tax assets.

On November 1, 2007, we adopted FASB Interpretation No. 48, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FASB Interpretation No. 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FASB Interpretation No. 48 also provides guidance on de-recognition, classification, interest and penalties on income taxes, and accounting in interim periods. Upon adoption, we increased our liability for uncertain tax positions by $5 million, resulting in a comparable increase to Accumulated deficit. As of November 1, 2007, after adoption of FASB Interpretation No. 48, the amount of the liability for uncertain tax positions was $107 million, $105 million of which, if recognized, would favorably affect the income tax rate. This liability was subsequently reduced by $18 million as the result of a settlement of a foreign audit.

We recognize interest and penalties related to uncertain tax positions as part of Income tax expense. Total interest and penalties recognized in the consolidated balance sheet at November 1, 2007 were $15 million.

While it is probable that the liability for uncertain tax positions may increase or decrease during the next 12 months, we do not expect any such change would have a material effect on our financial condition or results of operations.

We have open tax years from 1993 to 2007 with significant tax jurisdictions in the U.S., Canada, Mexico, and Brazil.

Congress recently enacted the Housing Assistance Tax Act of 2008, which provides a one-time refund of a portion of cumulative research tax credits and alternative minimum tax credits. Through the third quarter, we reported a $2 million tax benefit from these refundable credits.

10. Fair value of financial instruments

In January 2007, we signed a definitive loan agreement for a five-year senior unsecured term loan facility and synthetic revolving facility in the aggregate principal amount of $1.5 billion (“Facilities”). The Facilities were arranged by JP Morgan Chase Bank and a group of lenders that included Credit Suisse, Banc of America Securities, and Citigroup Global Markets. The Facilities are guaranteed by Navistar, Inc. The outstanding balance of the Facilities as of July 31, 2008 and October 31, 2007 was $1.3 billion. The fair value of the Facilities as of

 

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(Unaudited)

 

July 31, 2008 and October 31, 2007 was $1.2 billion and $1.3 billion, respectively, resulting in a decline in the fair value of $103 million over the nine month period. This decline in the fair value is due to the increase in the discount rate as a result of current credit market conditions.

11. Financial instruments

We use derivative financial instruments as part of our overall interest rate and foreign currency risk management strategy to reduce our interest rate exposure, to potentially increase the return on invested funds, and to reduce exchange rate risk for transactional exposures denominated in currencies other than the functional currency. From time to time, we also use commodity forward contracts to manage variability related to exposure to certain commodity price risk.

Our financial services operations manage exposure to fluctuations in interest rates by limiting the amount of fixed rate assets funded with variable rate debt. This is accomplished by funding fixed rate receivables utilizing a combination of fixed rate debt and variable rate debt and derivative financial instruments. These derivative financial instruments may include interest rate swaps, interest rate caps, and forward contracts. The fair value of these instruments is estimated based on quoted market prices and is subject to market risk, as the instruments may become less valuable due to changes in market conditions or interest rates. Notional amounts of derivative financial instruments do not represent exposure to credit loss.

In connection with a sale of retail notes, our financial services operations entered into additional interest rate swap agreements during the nine month period ending July 31, 2008. The purpose and structure of these swaps is to convert the floating rate portion of the asset-backed securities into fixed rate swap interest to match the interest basis of the receivables pool sold to the owner trust and to protect our financial services operations from interest rate volatility.

As of July 31, 2008, the net fair value of our derivative financial instruments was $37 million, consisting of $39 million recorded in Other noncurrent assets, $75 million in Other noncurrent liabilities and $1 million in Other current liabilities. The net fair value of our derivatives as of October 31, 2007 was $18 million, consisting of $20 million recorded in Other noncurrent assets, $37 million in Other noncurrent liabilities, and $1 million in Other current liabilities. The maturities of these derivatives range from 2008 through 2018.

Interest expense includes mark to market (gains) losses under our interest rate swap agreements of $1 million and $40 million for the three month and nine month periods ended July 31, 2008, respectively, and $(1) million and $(2) million for the three month and nine month periods ended July 31, 2007, respectively.

12. Commitments and contingencies

Legal Proceedings

Overview

We are subject to various claims arising in the ordinary course of business, and are parties to various legal proceedings that constitute ordinary, routine litigation incidental to our business. The majority of these claims and proceedings relate to commercial, product liability, and warranty matters. In our opinion, apart from the actions set forth below, the disposition of these proceedings and claims, after taking into account recorded accruals and the availability and limits of our insurance coverage, will not have a material adverse effect on our business or our results of operations, cash flows, or financial condition.

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

Ford Litigation

In January 2007, a complaint was filed against us in Oakland County Circuit Court in Michigan by Ford Motor Company (“Ford”) claiming damages relating to warranty and pricing disputes with respect to certain engines purchased by Ford from us. While Ford’s complaint did not quantify its alleged damages, we estimate that Ford may be seeking in excess of $500 million, and that this amount may increase (i) as we continue to sell engines to Ford at a price that Ford alleges is too high and (ii) as Ford pays its customers’ warranty claims, which Ford alleges are attributable to us. We disagree with Ford’s position and are defending ourselves vigorously in this litigation. We have filed an answer to the complaint denying Ford’s allegations in all material respects. We have also asserted affirmative defenses to Ford’s claims, as well as counterclaims alleging that, among other things, Ford has materially breached contracts between it and us in several different respects. Based on our investigation to date, we believe we have meritorious defenses to this matter. There can be no assurance, however, that we will be successful in our defense, and an adverse resolution of the lawsuit could have a material adverse effect on our results of operations, cash flows, or financial condition. In June 2007, we filed a separate lawsuit against Ford in the Circuit Court of Cook County, Illinois, for breach of contract relating to the manufacture of new diesel engines for Ford for use in vehicles including the F-150 pickup truck. In that case, we are seeking unspecified damages. In September 2007, the judge dismissed our lawsuit against Ford, directing us to proceed with mediation. In February 2008, we re-filed the lawsuit against Ford because the parties were unable to resolve the dispute through mediation.

Securities and Exchange Commission Investigations

In October 2004, we received a request from the staff of the SEC to voluntarily produce certain documents and information related to our accounting practices with respect to defined benefit pension plans and other postretirement benefits. We are fully cooperating with this request. Based on the status of the inquiry, we are not able to predict the final outcome of this matter.

In January 2005, we announced that we would restate our financial results for 2002 and 2003 and the first three quarters of 2004. Our restated Annual Report on Form 10-K was filed in February 2005. The SEC notified us on February 9, 2005, that it was conducting an informal inquiry into our restatement. On March 17, 2005, we were advised by the SEC that the status of the inquiry had been changed to a formal investigation. On April 7, 2006, we announced that we would restate our financial results for 2002 through 2004 and for the first three quarters of 2005. We were subsequently informed by the SEC that it was expanding the investigation to include that restatement. Our 2005 Annual Report on Form 10-K, which included the restated financial statements, was filed in December 2007. We have been providing information to and fully cooperating with the SEC on this investigation. Based on the status of the investigation, we are not able to predict its final outcome.

Litigation Relating to Accounting Controls and Financial Restatement

In December 2007, a complaint was filed against us by Norfolk County Retirement System and Brockton Contributory Retirement System (collectively “Norfolk”). In March 2008, an additional complaint was filed by Richard Garza. Each of these matters is pending in the United States District Court, Northern District of Illinois.

The plaintiffs in the Norfolk case allege they are shareholders suing on behalf of themselves and a class of other shareholders who purchased shares of the company’s common stock between February 14, 2003 and July 17, 2006. The complaint alleges that the defendants, which include the company, one of its executive officers, two of its former executive officers, and the company’s former independent accountants, Deloitte & Touche LLP, violated federal securities laws by making false and misleading statements about the company’s

 

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financial condition during that period. In March 2008, the court appointed Norfolk County Retirement System and the Plumbers Local Union 519 Pension Trust as joint lead plaintiffs. The plaintiffs’ in this matter seek compensatory damages and attorneys’ fees among other relief.

The plaintiff in the Garza case brought a derivative claim on behalf of the company against one of the company’s executive officers, two of its former executive officers, and certain of its directors, alleging that (i) all of the defendants violated their fiduciary obligations under Delaware law by willfully ignoring certain accounting and financial reporting problems at the company; thereby knowingly disseminating false and misleading financial information about the company, (ii) that certain of the defendants were unjustly enriched in connection with their sale of company stock during the December 2002 to January 2006 period, and (iii) that defendants violated Delaware law by failing to hold an annual meeting of shareholders. In connection with this last allegation, the plaintiff seeks an order requiring defendants to schedule an annual meeting of shareholders. Otherwise, the plaintiffs in this matter seek compensatory damages, disgorgement of the proceeds of defendants’ profits from the sale of company stock, attorneys’ fees, and other equitable relief.

We strongly dispute the allegations in these complaints and will vigorously defend ourselves.

Guarantees

We occasionally provide guarantees that could obligate us to make future payments if the primary entity fails to perform under its contractual obligations. As described below, we have recognized liabilities for some of these guarantees in our consolidated balance sheets as they meet the recognition and measurement provisions of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees Including Indirect Guarantees of the Indebtedness of Others. In addition to the liabilities that have been recognized as described below, we are contingently liable for other potential losses under various guarantees. We do not believe that claims that may be made under such guarantees would have a material effect on our financial position, results of operations, or cash flows.

We have issued residual value guarantees in connection with various leases that extend through 2010. The amounts of the guarantees are estimated and recorded as liabilities, and were $25 million as of July 31, 2008. Our guarantees are contingent upon the fair value of the leased assets at the end of the lease term.

We obtain certain stand-by letters of credit and surety bonds from third party financial institutions in the ordinary course of business when required under contracts or to satisfy insurance-related requirements. Outstanding stand-by letters of credit and surety bonds were $50 million at July 31, 2008.

As of July 31, 2008, our Canadian operating subsidiary was contingently liable for the residual value, calculated at inception, of $23 million of retail customers’ contracts and $42 million of retail leases that are financed by a third party. These amounts approximate the estimated future resale market value of the collateral underlying these contracts and leases at their inception. As of July 31, 2008, we have recorded accruals totaling $5 million and $7 million for potential losses on the retail customers’ contracts and retail leases, respectively.

We extend credit commitments to certain truck fleet customers, which allow them to purchase parts and services from participating dealers. The participating dealers receive accelerated payments from us with the result that we carry the receivables and absorb the credit risk related to these customers. As of July 31, 2008, we have $41 million of unused credit commitments outstanding under this program.

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

In addition, we have entered into various guarantees for purchase commitments, credit guarantees, and contract cancellation fees with various expiration dates through 2012 totaling $61 million at July 31, 2008. In the ordinary course of business, we also provide routine indemnifications and other guarantees, the terms of which range in duration and often are not explicitly defined. We do not believe these will result in claims that would have a material impact on our financial position, results of operations, or cash flows.

Environmental Liabilities

We have been named a potentially responsible party (“PRP”), in conjunction with other parties, in a number of cases arising under an environmental protection law, the Comprehensive Environmental Response, Compensation, and Liability Act, popularly known as the Superfund law. These cases involve sites that allegedly received wastes from current or former company locations. Based on information available to us which, in most cases, consists of data related to quantities and characteristics of material generated at current or former company locations, material allegedly shipped by us to these disposal sites, as well as cost estimates from PRPs and/or federal or state regulatory agencies for the cleanup of these sites, a reasonable estimate is calculated of our share, if any, of the probable costs and accruals are recorded in our condensed consolidated financial statements. These accruals are generally recognized no later than completion of the remedial feasibility study and are not discounted to their present value. We review all accruals on a regular basis and believe that, based on these calculations, our share of the potential additional costs for the cleanup of each site will not have a material effect on our financial position, results of operations, or cash flows.

Four sites formerly owned by us, Wisconsin Steel in Chicago, Illinois, Solar Turbines in San Diego, California, West Pullman Plant in Chicago, Illinois, and the Canton Plant in Canton, Illinois, were identified as having soil and groundwater contamination. While investigations and cleanup activities continue at all sites, we believe that we have adequate accruals to cover costs to complete the cleanup of these sites.

In 2007, a former facility location in the City of Springfield, Ohio, which we voluntarily demolished in 2004 and conducted environmental sampling on, was sold to the City of Springfield. The city has obtained funds from the U.S. Environmental Protection Agency and the State of Ohio to address relatively minor soil contamination prior to commercial/industrial redevelopment of the site.

Also in 2007, we engaged the City of Canton, Illinois in a remediation plan for the environmental clean-up of a former company facility. We anticipate that execution of this plan will not have a material effect on our financial position, results of operations, or cash flows.

We have accrued $17 million and $22 million for these environmental matters, which are included within Other current liabilities and Other noncurrent liabilities, as of July 31, 2008 and October 31, 2007, respectively. As of July 31, 2008, the majority of these accrued liabilities are expected to be paid out during the period from 2008 through 2011.

Along with other vehicle manufacturers, we have been subject to an increase in the number of asbestos-related claims in recent years. In general, these claims relate to illnesses alleged to have resulted from asbestos exposure from component parts found in older vehicles, although some cases relate to the alleged presence of asbestos in our facilities. In these claims, we are not the sole defendant, and the claims name as defendants numerous manufacturers and suppliers of a wide variety of products allegedly containing asbestos. We have strongly disputed these claims, and it has been our policy to defend against them vigorously. Historically, the

 

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actual damages paid out to claimants have not been material in any year to our financial position, results of operations, or cash flows. It is possible that the number of these claims will continue to grow, and that the costs for resolving asbestos related claims could become significant in the future.

13. Segment reporting

The following is a description of our four reporting segments:

 

   

Our Truck segment manufactures and distributes a full line of class 4 through 8 trucks, buses under the International and IC Bus, LLC (“IC”) brands, and Navistar Defense military vehicles. We also produce chassis for motor homes and commercial step-van vehicles under the Workhorse Custom Chassis, LLC (“WCC”) brand. In an effort to strengthen and maintain our dealer network, this segment occasionally acquires and operates dealer locations for the purpose of transitioning ownership or providing temporary operational assistance.

 

   

Our Engine segment designs and manufactures diesel engines for use primarily in our class 6 and 7 medium trucks and buses and selected class 8 heavy truck models, and for sale to original equipment manufacturers (“OEMs”) primarily in North America. In addition, we produce diesel engines in Brazil primarily for distribution in South America under the MWM International (“MWM”) brand and for sale to OEMs.

 

 

 

Our Parts segment provides customers with products needed to support the International truck, IC bus, WCC chassis, Navistar Defense military vehicle, and the MaxxForceTM engine lines, together with a wide selection of other standard truck, trailer, and engine aftermarket parts.

 

   

Our Financial Services segment provides retail, wholesale, and lease financing of products sold by the Truck segment and its dealers within the U.S. and Mexico as well as financing for wholesale accounts and selected retail accounts receivable.

Corporate contains those items that do not fit into our four segments.

 

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Segment Profit (Loss)

We define segment profit (loss) as adjusted earnings (loss) before income tax. Our results for interim periods are not necessarily indicative of results for a full year. Beginning in 2008, the sales from the Parts segment to the Truck segment, specifically our Dealcors, are recorded as intersegment sales, which are eliminated within “Corporate and Eliminations.” Previously, such sales were eliminated within the Truck segment’s external sales and revenues. As such, the Parts and Truck segment sales and revenues, in the amounts of $62 million and $187 million for the three months and nine months ended July 31, 2007, respectively, have been revised to conform to the 2008 presentation. Selected financial information is as follows:

 

     Truck     Engine    Parts    Financial
Services(A)
    Corporate
and
Eliminations
    Total
(in millions)                                 

Three Months Ended July 31, 2008

              

External sales and revenues, net

   $ 2,921     $ 580    $ 378    $ 75     $ —       $ 3,954

Intersegment sales and revenues

     1       228      66      20       (315 )     —  
                                            

Total sales and revenues, net

   $ 2,922     $ 808    $ 444    $ 95     $ (315 )   $ 3,954
                                            

Depreciation and amortization

   $ 46     $ 40    $ 2    $ 6     $ 5     $ 99

Interest expense

     —         —        —        57       31       88

Equity in income (loss) of non-consolidated affiliates

     (3 )     20      1      —         —         18

Segment profit (loss)

     357       5      51      (1 )     (132 )     280

Capital expenditures

     17       21      1      25       (2 )     62

Three Months Ended July 31, 2007

              

External sales and revenues, net

   $ 1,714     $ 795    $ 343    $ 104     $ —       $ 2,956

Intersegment sales and revenues

     1       176      62      29       (268 )     —  
                                            

Total sales and revenues, net

   $ 1,715     $ 971    $ 405    $ 133     $ (268 )   $ 2,956
                                            

Depreciation and amortization

   $ 41     $ 40    $ 2    $ 5     $ 4     $ 92

Interest expense

     —         —        —        74       51       125

Equity in income of non-consolidated affiliates

     2       18      1      —         1       22

Segment profit (loss)

     7       65      43      40       (150 )     5

Capital expenditures

     46       24      1      6       3       80

 

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(Unaudited)

 

     Truck       Engine      Parts     
 
Financial
Services(A)
 
 
   
 
 
Corporate
and
Eliminations
 
 
 
    Total
(in millions)               

Nine Months Ended July 31, 2008

              

External sales and revenues, net

   $ 7,521     $ 1,965    $ 1,106    $ 265     $ —       $ 10,857

Intersegment sales and revenues

     1       568      177      63       (809 )     —  
                                            

Total sales and revenues, net

   $ 7,522     $ 2,533    $ 1,283    $ 328     $ (809 )   $ 10,857
                                            

Depreciation and amortization

   $ 132     $ 116    $ 6    $ 16     $ 15     $ 285

Interest expense

     —         —        —        243       114       357

Equity in income (loss) of non-consolidated affiliates

     (6 )     66      3      —         —         63

Segment profit (loss)

     591       90      156      (7 )     (379 )     451

Capital expenditures

     85       60      3      42       2       192

Nine Months Ended July 31, 2007

              

External sales and revenues, net

   $ 5,755     $ 2,081    $ 966    $ 292     $ —       $ 9,094

Intersegment sales and revenues

     5       491      187      104       (787 )     —  
                                            

Total sales and revenues, net

   $ 5,760     $ 2,572    $ 1,153    $ 396     $ (787 )   $ 9,094
                                            

Depreciation and amortization

   $ 117     $ 120    $ 6    $ 15     $ 12     $ 270

Interest expense

     —         —        —        220       147       367

Equity in income of non-consolidated affiliates

     3       55      3      —         1       62

Segment profit (loss)

     132       71      120      124       (436 )     11

Capital expenditures

     157       46      5      29       11       248

As of July 31, 2008

              

Segment assets

     3,051       2,267      617      5,131       491       11,557

As of October 31, 2007

              

Segment assets

     2,696       2,151      550      5,292       759       11,448

 

(A) Total sales and revenues in the Financial Services segment include interest revenues of $91 million and $303 million for the three months and nine months ended July 31, 2008, respectively, and $112 million and $330 million for the same periods in 2007, respectively.

Following is information about our two customers from which we derive more than 10% of our consolidated Sales and revenues, net:

 

   

Sales of vehicles and service parts to the U.S. government were 32% and 27% of consolidated sales and revenues for the three months and nine months ended July 31, 2008, respectively, and 3% for the same periods in 2007. U.S. government receivable balances, related to sales of vehicle and service parts, totaled $446 million and $93 million as of July 31, 2008 and October 31, 2007, respectively.

 

   

Sales of diesel engines to Ford were 5% and 9% of consolidated sales and revenues for the three months and nine months ended July 31, 2008, and 17% and 14% for the same periods in 2007, respectively. Ford accounted for 31.8% and 47.6% of our diesel unit volume (including intercompany transactions) for the three months and nine months ended July 31, 2008, and 60.4% and 59.2% for the same periods in 2007, respectively. Ford receivable balances totaled $52 million and $245 million as of July 31, 2008 and October 31, 2007, respectively.

 

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In May 2008, Ford announced that it planned to reduce its pickup truck production levels due to current economic conditions. Due to the reduction in Ford’s pickup production levels, which has resulted in a decrease of our engine shipments to Ford, the Engine segment’s Indianapolis Plant has laid off over 400 employees during the third quarter of 2008. This has resulted in $10 million of employee benefit expenses recorded in the third quarter of 2008. A prolonged reduction in Ford’s demand for our engines or the early termination or non-renewal of our agreement with Ford could have a material impact on our financial position, results of operations, or cash flows.

Strategic Agreements

In June 2008, we announced that we entered into a memorandum of understanding with Caterpillar Inc. to pursue a strategic alliance, involving our Truck and Engine segments, in the mutual development of on-highway truck business opportunities and global truck collaboration. The strategic alliance would include the cooperative development of mid-range diesel engines and access to global distribution centers. This transaction is subject to completion of due diligence, execution of definitive agreements, and regulatory approvals.

14. Comprehensive income

Total comprehensive income is summarized as follows:

 

     Three Months Ended 
July 31,
    Nine Months Ended 
July 31,
 
     2008    2007     2008     2007  
(in millions)                        

Net income (loss)

   $ 272    $ (4 )   $ 434     $ (17 )

Other comprehensive income (loss)

         

Foreign currency translation adjustments

     38      32       53       50  

Pension amortization and settlements, net of tax

     3      —         (3 )     —    

Other

     —        1       —         5  
                               

Total other comprehensive income

     41      33       50       55  
                               

Total comprehensive income

   $ 313    $ 29     $ 484     $ 38  
                               

15. Stockholders’ deficit

In July 2008, we announced a share repurchase program as authorized by our Board of Directors to acquire up to $36 million of our common stock. This repurchase program expires in July 2009. As of July 31, 2008, we have not repurchased any of our common stock under the program.

In the third quarter of 2008, certain current and former employees of the company exercised 1,289,302 stock options. As a result of these exercises, we received proceeds of $26 million, retained 357,226 shares as settlements in lieu of cash, and issued 932,076 shares of treasury stock. As of July 31, 2008, Stockholders’ deficit decreased by $21 million, due to the exercise of these options.

 

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16. Earnings (loss) per share

The following table shows the information used in the calculation of our basic and diluted earnings (loss) per share:

 

     Three Months Ended
July 31,
    Nine Months Ended
July 31,
 
     2008    2007     2008    2007  
(in millions, except per share data)                       

Numerator:

          

Net income (loss) available to common stockholders

   $ 272    $ (4 )   $ 434    $ (17 )
                              

Denominator:

          

Weighted average shares outstanding

Basic

     70.8      70.3       70.5      70.3  

Effect of dilutive securities

     3.2      —         2.8      —    
                              

Diluted

     74.0      70.3       73.3      70.3  
                              

Basic earnings (loss) per share

   $ 3.85    $ (0.05 )   $ 6.16    $ (0.24 )

Diluted earnings (loss) per share

   $ 3.68    $ (0.05 )   $ 5.92    $ (0.24 )

Shares not included in the computation of diluted earnings (loss) per share, as they would be anti-dilutive, were 3.3 million and 1.9 million for the three months and nine months ended July 31, 2007, respectively. There were no anti-dilutive shares in 2008.

17. Stock-based compensation plans

We have various stock-based compensation plans, approved by the Compensation Committee of the Board of Directors, which provide for granting of stock awards and options to employees and directors for purchase of our common stock at the fair market value of the stock on the date of grant. The grants generally have a 10-year contractual life.

Since March 1, 2006, we have been subject to the blackout trading rules of Regulation BTR of the SEC, which prohibits our directors or Section 16 officers from acquiring or selling any equity security of the company (other than exempt securities) during a “blackout period” as defined in Regulation BTR (“Blackout Period”). The Blackout Period started as a result of the delay in filing the NIC Annual Report on Form 10-K for the year ended October 31, 2005 and will extend until the decision of the independent fiduciary appointed for our 401(k) Plans is made to lift the Blackout Period.

In April 2008, the Board of Directors approved the 2008 Emergence Long-Term Incentive Grant, under the 2004 Performance Incentive Plan, to certain employees, consultants, and non-employee directors. The grant will take the form of restricted stock units or restricted stock and will vest 25% on the first anniversary of the grant date, 25% on the second anniversary, and 50% on the third anniversary. The grant is expected to be made to an estimated 250 participants five business days following the expiration of the Blackout Period and is estimated to include approximately 510,000 units or shares to be granted at the market price of the stock on the date of grant. The Long-Term Incentive Grant is primarily to replace equity-based compensation forgone during the Blackout Period.

 

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18. Condensed consolidating guarantor and non-guarantor financial information

The following tables set forth condensed consolidating balance sheets as of July 31, 2008 and October 31, 2007, condensed consolidating statements of operations for the three months and nine months ended July 31, 2008 and 2007, and condensed consolidating statements of cash flows for the nine months ended July 31, 2008 and 2007. The information is presented as a result of Navistar, Inc.’s guarantee, exclusive of its subsidiaries, of NIC’s indebtedness under its 7.5% Senior Notes due 2011. Navistar, Inc. is a direct wholly-owned subsidiary of NIC. None of NIC’s other subsidiaries guarantee any of these notes. The guarantee is full and unconditional. Separate financial statements and other disclosures concerning Navistar, Inc. have not been presented because management believes that such information is not material to investors. Within this disclosure only, “NIC” includes the consolidated financial results of the parent company only, with all of its wholly-owned subsidiaries accounted for under the equity method. Likewise, “Navistar, Inc.,” for purposes of this disclosure only, includes the consolidated financial results of its wholly-owned subsidiaries accounted for under the equity method. “Non-Guarantor Subsidiaries” includes the combined financial results of all other non-guarantor subsidiaries. “Eliminations and Other” includes all eliminations and reclassifications to reconcile to the condensed consolidated financial statements. NIC files a consolidated U.S. federal income tax return that includes Navistar, Inc. and its U.S. subsidiaries, and NIC’s U.S. subsidiaries. Navistar, Inc. is party to a tax allocation agreement (“Tax Agreement”) with NIC which requires Navistar, Inc. to compute its separate federal income tax liability and remit any resulting tax liability to NIC. Tax benefits that may arise from net operating losses of Navistar, Inc. are not refunded to Navistar, Inc. but may be used to offset future required tax payments under the Tax Agreement. The effect of the Tax Agreement is to allow NIC, the parent company, rather than Navistar, Inc., to realize the benefit of current U.S. taxable losses of Navistar, Inc. and all other direct or indirect subsidiaries of NIC.

 

    NIC     Navistar,
Inc.
  Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                            

Condensed Consolidating Statement of Operations for the Three Months Ended July 31, 2008

         

Sales and revenues, net

  $ —       $ 2,047   $ 3,655     $ (1,748 )   $ 3,954  
                                     

Costs of products sold

    —         1,834     2,989       (1,708 )     3,115  

All other operating expenses (income)

    (13 )     411     202       (23 )     577  
                                     

Total costs and expenses

    (13 )     2,245     3,191       (1,731 )     3,692  

Equity in income (loss) of non-consolidated affiliates

    262       426     18       (688 )     18  
                                     

Income (loss) before income tax

    275       228     482       (705 )     280  

Income tax benefit (expense)

    (3 )     6     (11 )     —         (8 )
                                     

Net income (loss)

  $ 272     $ 234   $ 471     $ (705 )   $ 272  
                                     

 

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(Unaudited)

 

    NIC     Navistar,
Inc.
  Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                            

Condensed Consolidating Statement of Operations for the Nine Months Ended July 31, 2008

         

Sales and revenues, net

  $ —       $ 5,566   $ 9,752     $ (4,461 )   $ 10,857  
                                     

Costs of products sold

    —         5,053     8,100       (4,391 )     8,762  

All other operating expenses (income)

    (124 )     1,126     655       50       1,707  
                                     

Total costs and expenses

    (124 )     6,179     8,755       (4,341 )     10,469  

Equity in income (loss) of non-consolidated affiliates

    313       860     62       (1,172 )     63  
                                     

Income (loss) before income tax

    437       247     1,059       (1,292 )     451  

Income tax benefit (expense)

    (3 )     1     (15 )     —         (17 )
                                     

Net income (loss)

  $ 434     $ 248   $ 1,044     $ (1,292 )   $ 434  
                                     

 

    NIC     Navistar,
Inc.
    Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                              

Condensed Consolidating Balance Sheet as of July 31, 2008

         

Assets

         

Cash, cash equivalents, and marketable securities

  $ 304     $ 43     $ 1,036     $ —       $ 1,383  

Finance and other receivables, net

    —         288       5,015       (6 )     5,297  

Inventories

    —         614       992       (62 )     1,544  

Goodwill

    —         —         378       —         378  

Property and equipment, net

    —         794       1,173       (4 )     1,963  

Investments in and advances to non-consolidated affiliates

    (2,230 )     3,859       243       (1,695 )     177  

Deferred taxes, net

    55       114       (20 )     (2 )     147  

Other

    20       204       443       1       668  
                                       

Total assets

  $ (1,851 )   $ 5,916     $ 9,260     $ (1,768 )   $ 11,557  
                                       

Liabilities and stockholders’ equity (deficit)

         

Debt

  $ 1,345     $ 337     $ 5,080     $ (229 )   $ 6,533  

Postretirement benefits liabilities

    —         1,062       159       (1 )     1,220  

Amounts due to (from) affiliates

    (4,078 )     5,743       (1,713 )     48       —    

Other liabilities

    1,110       1,220       1,800       (98 )     4,032  
                                       

Total liabilities

    (1,623 )     8,362       5,326       (280 )     11,785  
                                       

Stockholders’ equity (deficit)

    (228 )     (2,446 )     3,934       (1,488 )     (228 )
                                       

Total liabilities and stockholders’ equity (deficit)

  $ (1,851 )   $ 5,916     $ 9,260     $ (1,768 )   $ 11,557  
                                       

 

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Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

    NIC     Navistar,
Inc.
    Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                              

Condensed Consolidating Statement of Cash Flows for the Nine Months Ended July 31, 2008

         

Net cash provided by (used in) operations

  $ 107     $ 743     $ 925     $ (1,128 )   $ 647  
                                       

Cash flow from investment activities

         

Net change in restricted cash and cash equivalents

    1       7       (276 )     —         (268 )

Net increase in marketable securities

    (12 )     —         —         —         (12 )

Capital expenditures

    —         (20 )     (172 )     —         (192 )

Other investing activities

    (226 )     (909 )     (148 )     1,318       35  
                                       

Net cash provided by (used in) investment activities

    (237 )     (922 )     (596 )     1,318       (437 )
                                       

Cash flow from financing activities

         

Net borrowings (repayments) of debt

    —         169       (366 )     (165 )     (362 )

Other financing activities

    26       —         25       (25 )     26  
                                       

Net cash provided by (used in) financing activities

    26       169       (341 )     (190 )     (336 )
                                       

Effect of exchange rate changes on cash and cash equivalents

    —         —         27       —         27  
                                       

Cash and cash equivalents

         

Increase (decrease) during the period

    (104 )     (10 )     15       —         (99 )

At beginning of the period

    391       47       339       —         777  
                                       

Cash and cash equivalents at end of the period

  $ 287     $ 37     $ 354     $ —       $ 678  
                                       

 

    NIC     Navistar,
Inc.
    Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                              

Condensed Consolidating Statement of Operations for the Three Months Ended July 31, 2007

         

Sales and revenues, net

  $ —       $ 1,625     $ 2,299     $ (968 )   $ 2,956  
                                       

Costs of products sold

    —         1,437       1,943       (952 )     2,428  

All other operating expenses (income)

    (25 )     295       203       72       545  
                                       

Total costs and expenses

    (25 )     1,732       2,146       (880 )     2,973  

Equity in income (loss) of non-consolidated affiliates

    (29 )     14       19       18       22  
                                       

Income (loss) before income tax

    (4 )     (93 )     172       (70 )     5  

Income tax benefit (expense)

    —         4       (13 )     —         (9 )
                                       

Net income (loss)

  $ (4 )   $ (89 )   $ 159     $ (70 )   $ (4 )
                                       

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

    NIC     Navistar,
Inc.
    Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                              

Condensed Consolidating Statement of Operations for the Nine Months Ended July 31, 2007

         

Sales and revenues, net

  $ —       $ 5,356     $ 6,959     $ (3,221 )   $ 9,094  
                                       

Costs of products sold

    —         4,835       5,829       (3,159 )     7,505  

All other operating expenses (income)

    (39 )     871       617       191       1,640  
                                       

Total costs and expenses

    (39 )     5,706       6,446       (2,968 )     9,145  

Equity in income (loss) of non-consolidated affiliates

    (58 )     166       55       (101 )     62  
                                       

Income (loss) before income tax

    (19 )     (184 )     568       (354 )     11  

Income tax benefit (expense)

    2       —         (30 )     —         (28 )
                                       

Net income (loss)

  $ (17 )   $ (184 )   $ 538     $ (354 )   $ (17 )
                                       

 

    NIC     Navistar,
Inc.
    Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                              

Condensed Consolidating Balance Sheet as of October 31, 2007

         

Assets

         

Cash, cash equivalents, and marketable securities

  $ 396     $ 60     $ 746     $ —       $ 1,202  

Finance and other receivables, net

    —         179       5,253       (13 )     5,419  

Inventories

    —         560       910       (58 )     1,412  

Goodwill

    —         —         353       —         353  

Property and equipment, net

    —         889       1,199       (2 )     2,086  

Investments in and advances to non-consolidated affiliates

    (2,503 )     2,239       149       269       154  

Deferred taxes, net

    (1 )     171       (19 )     (1 )     150  

Other

    26       204       442       —         672  
                                       

Total assets

  $ (2,082 )   $ 4,302     $ 9,033     $ 195     $ 11,448  
                                       

Liabilities and stockholders’ equity (deficit)

         

Debt

  $ 1,345     $ 390     $ 5,375     $ (229 )   $ 6,881  

Postretirement benefits liabilities

    —         1,170       157       —         1,327  

Amounts due to (from) affiliates

    (3,272 )     4,900       (1,657 )     29       —    

Other liabilities

    579       1,291       2,193       (89 )     3,974  
                                       

Total liabilities

    (1,348 )     7,751       6,068       (289 )     12,182  
                                       

Stockholders’ equity (deficit)

    (734 )     (3,449 )     2,965       484       (734 )
                                       

Total liabilities and stockholders’ equity (deficit)

  $ (2,082 )   $ 4,302     $ 9,033     $ 195     $ 11,448  
                                       

 

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Navistar International Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements—(Continued)

(Unaudited)

 

    NIC     Navistar,
Inc.
    Non-Guarantor
Subsidiaries
    Eliminations
and Other
    Consolidated  
(in millions)                              

Condensed Consolidating Statement of Cash Flows for the Nine Months Ended July 31, 2007

         

Net cash provided by (used in) operations

  $ (837 )   $ (483 )   $ 981     $ 406     $ 67  
                                       

Cash flow from investment activities

         

Net change in restricted cash and cash equivalents

    —         29       40       —         69  

Net decrease in marketable securities

    104       —         27       —         131  

Capital expenditures

    —         (65 )     (183 )     —         (248 )

Other investing activities

    240       (138 )     (435 )     369       36  
                                       

Net cash provided by (used in) investment activities

    344       (174 )     (551 )     369       (12 )
                                       

Cash flow from financing activities

         

Net borrowings (repayments) of debt

    (78 )     778       (514 )     (778 )     (592 )

Other financing activities

    —         —         —         —         —    
                                       

Net cash provided by (used in) financing activities

    (78 )     778       (514 )     (778 )     (592 )
                                       

Effect of exchange rate changes on cash and cash equivalents

    —         —         51       3       54  
                                       

Cash and cash equivalents

         

Increase (decrease) during the period

    (571 )     121       (33 )     —         (483 )

At beginning of the period

    814       20       323       —         1,157  
                                       

Cash and cash equivalents at end of the period

  $ 243     $ 141     $ 290     $ —       $ 674  
                                       

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements; Risk Factors

Information provided and statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (“Securities Act”), Section 21E of the Securities Exchange Act of 1934 (“Exchange Act”), and the Private Securities Litigation Reform Act of 1995. Such forward-looking statements only speak as of the date of this report and the company assumes no obligation to update the information included in this report. Such forward-looking statements include information concerning our possible or assumed future results of operations, including descriptions of our business strategy. These statements often include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” or similar expressions. These statements are not guarantees of performance or results and they involve risks, uncertainties, and assumptions. For a further description of these factors, see Item 1A. Risk Factors in PART II of this Form 10-Q and Item 1A. Risk Factors included within our Form 10-K for the year ended October 31, 2007, which was filed on May 29, 2008. Although we believe that these forward-looking statements are based on reasonable assumptions, there are many factors that could affect our actual financial results or results of operations and could cause actual results to differ materially from those in the forward-looking statements.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide information that is supplemental to, and should be read together with, our consolidated financial statements and the accompanying notes contained in the “Financial Statements and Supplementary Data” section of our 2007 Annual Report on Form 10-K. Information in this Item is intended to assist the reader in obtaining an understanding of our condensed consolidated financial statements, information about our business segments and how the results of those segments impact our results of operations and financial condition as a whole, and how certain accounting principles affect the company’s condensed consolidated financial statements. Our MD&A includes the following sections:

 

   

Executive Summary

 

   

Results of Operations and Segment Results of Operations

 

   

Liquidity and Capital Resources

 

   

Other Information

 

   

Critical Accounting Policies

 

   

New Accounting Pronouncements

Executive Summary

We are an international manufacturer of International brand commercial trucks, IC brand buses, MaxxForce and MWM brand diesel engines, WCC brand chassis for motor homes and step vans, Navistar Defense military vehicles, and a provider of service parts for all makes of trucks and trailers. Additionally, we are a private-label designer and manufacturer of diesel engines for the pickup truck, van, and SUV markets. We also provide retail, wholesale, and lease financing of our trucks, and financing for our wholesale accounts and selected retail accounts receivable. We operate in four industry segments: Truck, Engine, Parts (referred to as our “manufacturing segments”), and Financial Services. Corporate contains those items that do not fit into our four segments. Selected financial data for each segment can be found in Note 13, Segment reporting, to the accompanying condensed consolidated financial statements.

Our business is heavily influenced by the overall performance of the “traditional” medium and heavy truck markets within U.S. and Canada, which includes vehicles in weight classes 6 through 8, including school buses. Sales from foreign locations are considered rest of world (“ROW”) sales, which allows us to expand our sales while leveraging existing resources. The U.S., Canadian, and ROW markets are typically cyclical in nature but in

 

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certain years they have also been impacted by accelerated purchases of trucks (“pre-buy”) in anticipation of higher prices due to stricter emissions standards imposed by various domestic and foreign federal regulatory agencies, as was particularly evident throughout the U.S. in 2006. In turn, the U.S. market has experienced corresponding periods of delayed purchases of trucks during the last three quarters of 2007 and into 2008. In addition, beginning in 2008, the inefficient credit markets and the challenging economic environment in the U.S. began to impact customer purchases, further decreasing demand for new trucks. To minimize the impact of the “traditional” markets cyclicality, our continuing strategy incorporates further growth in U.S. military sales, our Parts segment, and an increased presence in “expansion” markets such as the non-U.S. military, recreational vehicle, commercial step-van, and export markets. We have placed emphasis on building strategic alliances and joint ventures to strengthen and expand into existing and global economies. In addition, within the “traditional” markets, we continue to focus on market share expansion to further mitigate the impact of “traditional” markets volatility. Furthermore, we continue to focus on improving the cost structure in our Truck and Engine segments while delivering products of distinction and evaluating opportunities to contain our legacy costs, utilize our deferred tax assets, and return to a more conventional capital structure.

In December of 2007, we entered into a non-binding memorandum of understanding with GM to purchase certain assets, intellectual property, and distribution rights for the GMC and Chevrolet class 4 through 8 truck business, as well as related GM service parts business. Due to significant marketplace and economic changes, we have mutually decided not to renew the non-binding memorandum of understanding, which has expired.

We experienced a decline in unit volumes in both the Truck and Engine segments during the nine month period ended July 31, 2008 compared to the same period in 2007 despite an increase in unit volumes within the Truck segment for the third quarter of 2008, primarily due to growth in U.S. military units. Worldwide Truck segment units invoiced to customers were 27,000 (an increase of 9.8%) and 73,500 (a decrease of 15.1%) for the quarter and the nine month period ended July 31, 2008, respectively, compared to the same three month and nine month periods in 2007. Total Engine segment units were 79,300 (a decrease of 26.7%) and 267,600 (a decrease of 12.8%) during the third quarter and year-to-date 2008, respectively, which compares to 108,200 and 307,000 in the same periods of 2007, primarily due to a decrease in Ford’s production requirements. During the third quarter of 2008, to match Ford’s production schedules, the Engine segment’s Indianapolis plant laid off over 400 employees. A prolonged reduction in Ford’s demand for our engines or the early termination or non-renewal of our agreement with Ford could have a material impact on our financial position, results of operations, or cash flows.

During the quarter ended July 31, 2008, the “traditional” truck retail industry, as well as the heavy duty pickup market, remained depressed, which is reflected in the 62,700 retail units sold during this period compared to 63,300 units sold in the third quarter of 2007. Total “traditional” truck industry units sold during the nine month period ended July 31, 2008 amounted to 181,000 compared to 255,300 units for the same nine month period in 2007. The depressed sales in the retail truck industry and heavy duty diesel pick-up truck market decreased our total engine volumes in the third quarter of 2008 but were partially offset by volume growth with OEMs other than Ford.

Despite the continuation of the downturn experienced throughout the “traditional” truck markets during the third quarter of 2008, we attained consolidated net sales and revenues for the quarter and the nine month period ended July 31, 2008 of $4.0 billion and $10.9 billion, respectively, which compares with $3.0 billion and $9.1 billion for the same respective periods in 2007. Growth in our U.S. military sales, the introduction of new products, competitive pricing strategies, and an increase in sales in our ROW markets contributed to overall sales and revenue growth during the third quarter and year-to-date 2008 compared to the same periods in 2007. U.S. military sales included in our consolidated net sales and revenues were $1.2 billion and $2.8 billion in the third quarter and year-to-date 2008, respectively, compared to $59 million and $166 million for the comparable periods in 2007.

Excluding the $42 million net gain from the settlement and curtailment of one plan that was recognized in the first quarter of 2008, we recognized income of $2 million and $5 million for the third quarter and year-to-date

 

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periods ended July 31, 2008, compared to an expense of $29 million and $88 million for the same periods in 2007. This benefit resulted from better than expected return on assets and a significant reduction in the projected benefit obligation resulting from fully insuring our Medicare eligible population in our largest postretirement medical plan.

Included in the change in our results were professional, consulting, and auditing expenses of $33 million in the third quarter of 2008 as compared to expense of $54 million in the same period in 2007. Included in the change in our results were the following significant items in the year-to-date ended July 31, 2008: non-cash mark to market charge on our interest rate swap agreements of $40 million during the nine months ended July 31, 2008 as compared to a benefit of $2 million in the same period in 2007, a $42 million reduction in postretirement expense due to a net settlement and curtailment gain due to changes in our UAW agreement, professional, consulting, and auditing expenses of $138 million in the nine months ended July 31, 2008 as compared to expenses of $140 million in the same period in 2007, and debt refinancing and restructuring costs of $31 million that did not recur in the nine months ended July 31, 2008.

For the quarter and nine month period ended July 31, 2008, we realized net income of $ 272 million and $434 million, respectively, compared to net losses of $4 million and $17 million for the respective periods in 2007. Our diluted earnings were $3.68 per share for the quarter ended July 31, 2008 compared to a diluted loss of $0.05 per share for the same period in 2007. Our diluted earnings were $5.92 per share for the nine month period ended July 31, 2008 compared to a diluted loss of $0.24 per share for the same period in 2007. During the third quarter and year-to-date 2008, we incurred an expense of $8 million and $17 million, respectively, for state, local, and foreign income taxes.

A summary of our condensed results of operations, including diluted earnings (loss) per share, is as follows:

 

     Three Months Ended
July 31,
    Nine Months Ended
July 31,
 
         2008            2007             2008            2007      
(in millions, except per share data)                       

Sales and revenues, net

   $ 3,954    $ 2,956     $ 10,857    $ 9,094  

Total costs and expenses

     3,692      2,973       10,469      9,145  

Equity in income of non-consolidated affiliates

     18      22       63      62  

Income before income tax

     280      5       451      11  

Net income (loss)

     272      (4 )     434      (17 )

Diluted earnings (loss) per share

     3.68      (0.05 )     5.92      (0.24 )

Results of Operations and Segment Results of Operations

The following tables summarize our consolidated statements of operations and illustrate the key financial indicators used to assess the consolidated financial results. Financial information is presented for the quarters and nine month periods ended July 31, 2008 and 2007, as prepared in accordance with U.S. GAAP for interim financial information.

 

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Results of Operations

 

     Three Months Ended
July 31,
    Change     Percentage
Change
 
         2008             2007          
(in millions, except per share data and percentage change)                         

Sales and revenues, net

   $ 3,954     $ 2,956     $ 998     33.8  
                          

Costs of products sold

     3,115       2,428       687     28.3  

Selling, general and administrative expenses

     386       368       18     4.9  

Engineering and product development costs

     108       86       22     25.6  

Interest expense

     88       125       (37 )   (29.6 )

Other income, net

     (5 )     (34 )     29     (85.3 )
                          

Total costs and expenses

     3,692       2,973       719     24.2  

Equity in income of non-consolidated affiliates

     18       22       (4 )   (18.2 )
                          

Income before income tax

     280       5       275     N.M.  

Income tax expense

     (8 )     (9 )     1     (11.1 )
                          

Net income (loss)

   $ 272     $ (4 )   $ 276     N.M.  
                          

Diluted earnings (loss) per share

   $ 3.68     $ (0.05 )   $ 3.73     N.M.  

 

     Nine Months Ended
July 31,
    Change     Percentage
Change
 
         2008             2007          
(in millions, except per share data and percentage change)                         

Sales and revenues, net

   $ 10,857     $ 9,094     $ 1,763     19.4  
                          

Costs of products sold

     8,762       7,505       1,257     16.7  

Selling, general and administrative expenses

     1,071       1,010       61     6.0  

Engineering and product development costs

     289       284       5     1.8  

Interest expense

     357       367       (10 )   (2.7 )

Other income, net

     (10 )     (21 )     11     (52.4 )
                          

Total costs and expenses

     10,469       9,145       1,324     14.5  

Equity in income of non-consolidated affiliates

     63       62       1     1.6  
                          

Income before income tax

     451       11       440     N.M.  

Income tax expense

     (17 )     (28 )     11     (39.3 )
                          

Net income (loss)

   $ 434     $ (17 )   $ 451     N.M.  
                          

Diluted earnings (loss) per share

   $ 5.92     $ (0.24 )   $ 6.16     N.M.  

 

N.M. Not meaningful.

Net Sales and Revenues

Our net sales and revenues are comprised of the following:

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         
(in millions, except percentage change)                       

Sales of manufactured products, net – U.S. and Canada

   $ 3,155    $ 2,293    $ 862     37.6  

Sales of manufactured products, net – ROW

     724      559      165     29.5  
                        

Total sales of manufactured products, net

     3,879      2,852      1,027     36.0  

Finance revenues

     75      104      (29 )   (27.9 )
                        

Sales and revenues, net

   $ 3,954    $ 2,956    $ 998     33.8  
                        

 

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     Nine Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         
(in millions, except percentage change)                       

Sales of manufactured products, net – U.S. and Canada

   $ 8,722    $ 7,296    $ 1,426     19.5  

Sales of manufactured products, net – ROW

     1,870      1,506      364     24.2  
                        

Total sales of manufactured products, net

     10,592      8,802      1,790     20.3  

Finance revenues

     265      292      (27 )   (9.2 )
                        

Sales and revenues, net

   $ 10,857    $ 9,094    $ 1,763     19.4  
                        

Our Truck segment was our largest segment as measured in net sales and revenues, representing 73.9% and 58.0% of total consolidated net sales and revenues for the third quarter of 2008 and 2007, respectively, and 69.3% and 63.3% of total consolidated net sales and revenues for the nine month period ended July 31, 2008 and 2007, respectively. Net sales and revenues increased within this segment by $1.2 billion or 70.4% during the third quarter of 2008 as compared to the same period in 2007. Net sales and revenues increased by $1.8 billion or 30.6% for the nine month period ended July 31, 2008 as compared to the same period in 2007. Contributing to the increase in net sales and revenues were the combination of growth in our U.S. military sales, the success of our ProStar products, and ROW sales all of which offsets weakness in our “traditional” school bus, Class 6 and 7 medium trucks, and Class 8 heavy trucks markets. While our share of retail deliveries by “traditional” truck class fluctuated in 2008 and 2007, the Truck segment’s bus, Class 6 and 7 medium and Class 8 severe service trucks continue to lead their markets with the greatest relative retail market share in each of their classes by brand.

Our Engine segment was our second largest segment in net sales and revenues with $808 million and $2.5 billion in the third quarter and year-to-date 2008 that compares with $971 million and $2.6 billion for the same respective periods in 2007. Due to the decrease in demand for heavy duty pickup trucks, engine units shipped to Ford in North America during the quarter ended July 31, 2008 decreased by 40,900 units or 68.3% compared to the prior year quarter ended July 31, 2007, and the nine months ended July 31, 2008 decreased by 56,300 units or 34.1% as compared to the nine month period ended July 31, 2007. The Engine segment was able to partially mitigate the third quarter 2008 reduction in shipments to Ford North America through growth of MWM shipments of 10.9% or 3,600 units as compared to the same period in 2007. Intersegment sales began to recover in the third quarter of 2008 primarily due to shipments to the truck segment for sales to the U.S. military.

Our Parts segment grew net sales 9.6% and 11.3% in the quarter and nine month period ended July 31, 2008 as compared to the same respective periods in 2007. This increase was primarily due to growth in our U.S. military sales and improved pricing.

Our Financial Services segment net revenues declined by 28.6% and 17.2% in the third quarter and year-to-date 2008 as compared to the same respective periods in 2007. Revenue for the three and nine month periods ended July 31, 2007 included higher levels of revenue related to the financing of dealer inventory. In the three and nine month periods ended July 31, 2008, there were reduced financing opportunities resulting from fewer purchases of vehicles and components due to reduced customer demand, which we attribute to higher interest rates, current tightening of the credit markets, and increased diesel fuel prices.

 

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Costs and Expenses

The following tables summarize the key components of Costs of products sold:

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         
(in millions, except percentage change)                       

Costs of products sold, excluding items presented separately below

   $ 3,067    $ 2,369    $ 698     29.5  

Postretirement benefits expense allocated to costs of products sold

     1      11      (10 )   (90.9 )

Product warranty costs

     47      48      (1 )   (2.1 )
                        

Total costs of products sold

   $ 3,115    $ 2,428    $ 687     28.3  
                        

 

     Nine Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         
(in millions, except percentage change)                       

Costs of products sold, excluding items presented separately below

   $ 8,617    $ 7,312    $ 1,305     17.8  

Postretirement benefits expense allocated to costs of products sold

     11      35      (24 )   (68.6 )

Product warranty costs

     134      158      (24 )   (15.2 )
                        

Total costs of products sold

   $ 8,762    $ 7,505    $ 1,257     16.7  
                        

Costs of products sold increased 28.3% and 16.7% for the quarter and nine month period ended July 31, 2008, respectively, as compared to the same respective periods in 2007. As a percentage of net sales of manufactured products, Costs of products sold decreased to 80.3% and 82.7% for the quarter and nine month period ended July 31, 2008 from 85.1% and 85.3% for the same respective periods in 2007. Product warranty costs, including extended warranty program costs and net of vendor recoveries (“product warranty costs”), were $47 million and $134 million for the third quarter and year-to-date 2008, respectively, and $48 million and $158 million for the comparable periods of 2007. Postretirement benefits expense included in Costs of products sold, inclusive of company 401(k) contributions, was $1 million and $11 million for the quarter and nine month period ended July 31, 2008 that compares with $11 million and $35 million for the same respective periods in 2007. Apart from product warranty costs and postretirement benefits expense, Costs of products sold as a percentage of net sales of manufactured products decreased to 79.1% and 81.4% during the third quarter and year-to-date 2008 from 83.1% for both of the same respective periods in 2007. The decrease in costs of products sold as a percentage of net sales of manufactured products between the quarters and the nine month periods ended July 31, 2008 and 2007 was primarily due to increased sales in U.S. military and ProStar vehicles, improved pricing, and improvement in manufacturing performance.

Product warranty costs decreased by $1 million for the three months ended July 31, 2008 and by $24 million for the nine month period ended July 31, 2008 as compared to the same respective periods in 2007. The decrease in product warranty costs for the three and nine months ended July 31, 2008 as compared to the same respective period in 2007 was primarily the result of lower volumes, lower per unit costs, and the impact of changes to pre-existing warranties partially offset by an increase in extended warranty program costs. During the third quarter and year-to-date 2008, we incurred $6 million and $10 million of warranty expense associated with adjustments to pre-existing warranties compared to a nominal amount and $25 million in expense for the same respective periods in 2007. These adjustments reflect changes in our estimate of warranty costs for sales recognized in prior years associated with products at the Truck and Engine segments attributed to eliminating or rectifying warranty related issues earlier in the product life cycle. For more information regarding product warranty costs, see Note 1, Summary of significant accounting policies, to the accompanying condensed consolidated financial statements.

 

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Our direct material costs have been impacted by industry-wide increases in commodity and fuel prices, which affected all of our manufacturing operations. We believe our costs related to steel, precious metals, resins, and petroleum products increased by $22 million during the quarter ended July 31, 2008 and $42 million on a year-to-date basis. However, we believe we generally have been able to mitigate the effects by our efforts to reduce costs through a combination of design changes, material substitution, alternative supplier resourcing, global sourcing, and price performance. We expect our direct material costs will increase or decrease in price as the global demand for these commodities change.

Selling, general and administrative expenses, including certain key items, are highlighted in the following tables:

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008             2007         
(in millions, except percentage change)                        

Selling, general and administrative expenses, excluding items presented separately below

   $ 248     $ 215    $ 33     15.3  

Professional consulting and auditing fees

     33       54      (21 )   (38.9 )

Postretirement benefits expense allocated to selling, general and administrative expenses

     3       21      (18 )   N.M.  

Dealcor expenses

     45       70      (25 )   (35.7 )

Incentive compensation and profit-sharing

     23       —        23     N.M.  

Provision for losses on receivables

     34       8      26     N.M.  
                         

Total selling, general and administrative expenses

   $ 386     $ 368    $ 18     4.9  
                         
     Nine Months Ended
July 31,
   Change     Percentage
Change
 
         2008             2007         
(in millions, except percentage change)                        

Selling, general and administrative expenses, excluding items presented separately below

   $ 689     $ 579    $ 110     19.0  

Professional consulting and auditing fees

     138       140      (2 )   (1.4 )

Postretirement benefits (income) expense allocated to selling, general and administrative expenses

     (41 )     62      (103 )   N.M.  

Dealcor expenses

     165       207      (42 )   (20.3 )

Incentive compensation and profit-sharing

     68       —        68     N.M.  

Provision for losses on receivables

     52       22      30     136.4  
                         

Total selling, general and administrative expenses

   $ 1,071     $ 1,010    $ 61     6.0  
                         

Selling, general and administrative expenses amounted to $386 million and $1.1 billion for the quarter and nine month period ended July 31, 2008, respectively, that compares to $368 million and $1.0 billion for the same respective periods in 2007. Our Truck segment occasionally acquires and operates dealer locations for the purpose of transitioning ownership or providing temporary operational assistance, which may increase or decrease Selling, general and administrative expenses in the period of acquisitions and disposals. Provision for losses on receivables is primarily driven by our Financial services segment. We provide for certain losses related to the potential repossession and liquidation of collateral underlying finance receivables with dealers and retail customers. We have experienced an increase in repossessions and delinquencies due to the weakness in the trucking economy coupled with the sub-prime mortgage crisis resulting in an increase in our provision for losses on receivables. Our ratio of Selling, general and administrative expenses to net sales and revenues decreased by 2.6 percentage points to 9.8% for the quarter ended July 31, 2008 as compared to 12.4% for the same period in 2007. This ratio of Selling, general and administrative expenses as a percentage of net sales and revenues

 

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decreased by 1.2 percentage points to 9.9% for the nine month period ended July 31, 2008 compared to 11.1% for the same period in 2007. After separating the effects of professional, consulting, and auditing fees, postretirement benefits (income) expense, Dealcor expenses, incentive compensation and profit sharing, and provision for losses on receivables, Selling, general and administrative expenses as a percentage of net sales and revenues decreased from 7.3% during the quarter ended July 31, 2007 to 6.3% for the same period in 2008 and decreased from 6.4% for the nine month period ended July 31, 2007 to 6.3% for the same period in 2008. The remaining differences that impacted Selling, general and administrative expenses were increases in new business development, litigation expenses, and overhead and infrastructure enhancements in support of the company’s growth initiatives. It is not uncommon for Selling, general and administrative expenses as a percentage of net sales to increase in periods of lower sales and to decrease in periods of higher sales.

Engineering and product development costs increased by 25.6% during the third quarter of 2008 and by 1.8% during the nine month period ended July 31, 2008 as compared to the same respective periods in 2007. Engineering and product development costs were primarily incurred by our Truck and Engine segments for product innovation and cost reduction, and to provide our customers with product and fuel-usage efficiencies. Engineering and product development costs incurred at our Engine segment increased $21 million or 50.0% and $19 million or 13.4% during the third quarter and year-to-date 2008, respectively, as compared to the same respective periods in 2007. This increase in costs is a result of our efforts to develop 2010 emissions-compliant engines, new engine products, and MWM Euro IV emission-compliant engines. Engineering and product development costs incurred at the Truck segment were $45 million and $128 million for the third quarter and year-to-date 2008, which compares to the $41 million and $132 million incurred in the same respective periods of 2007, and relate primarily to the further development of our ProStar class 8 long-haul truck. In addition, the Truck segment also incurred costs, to a lesser extent, in 2007 related to the development and roll-out of our 2007 emissions-compliant products and the development of the LoneStar class 8 tractor.

The following tables present the amounts of postretirement benefits (income) expenses allocated between Costs of products sold, Selling, general and administrative expenses, and Engineering and product development costs:

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         
(in millions, except percentage change)                       

Postretirement benefits expense included in:

          

Cost of products sold

   $ 1    $ 11    $ (10 )   (90.9 )

Selling, general and administrative expenses

     3      21      (18 )   (85.7 )

Engineering and product development costs

     1      3      (2 )   (66.7 )
                        

Total postretirement benefits expense

   $ 5    $ 35    $ (30 )   (85.7 )
                        

 

     Nine Months Ended
July 31,
   Change     Percentage
Change
 
         2008             2007         
(in millions, except percentage change)                        

Postretirement benefits (income) expense included in:

         

Cost of products sold

   $ 11     $ 35    $ (24 )   (68.6 )

Selling, general and administrative expenses (income) expense

     (41 )     62      (103 )   N.M.  

Engineering and product development costs

     2       9      (7 )   (77.8 )
                         

Total postretirement benefits (income) expense

   $ (28 )   $ 106    $ (134 )   N.M.  
                         

 

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Total postretirement benefits (income) expense includes defined benefit plans (pensions and post-employment benefits primarily health and life insurance) and defined contribution plans (401(k) contributions for active employees) as described in Note 8, Postretirement benefits, to the accompanying condensed consolidated financial statements.

We recognized income related to our postretirement benefits from defined benefit plans of $2 million in the third quarter of 2008 compared to an expense of $29 million for the same period in 2007. The $31 million reduction in defined benefit plan expense resulted from better than expected return on assets and a significant reduction in the projected benefit obligation resulting from fully insuring our Medicare eligible population in our largest postretirement medical plan. Each of these actions occurred in 2007 and represent variances from prior actuarial estimates. These variances significantly reduced the cumulative loss pool during 2007. Such costs amortize into income in the subsequent years as a component of postretirement benefits (income) expense. Amortization of the loss pool for pension and health and welfare plans was $3 million in the third quarter of 2008 compared to $20 million for the same period in 2007. Additionally, the growth in the asset base from the better than expected asset returns during 2007 had the effect of increasing the expected return on plan assets in 2008 (another component of postretirement benefits (income) expense). The expected return on plan assets for pension and health and welfare plans in the first quarter of 2008 was $98 million compared to $83 million for the same period in 2007. See Note 8, Postretirement benefits, to the accompanying condensed consolidated financial statements for further information on postretirement benefits.

We recognized income related to our postretirement benefits from defined benefit plans of $47 million in the nine months ended July 31, 2008 compared to an expense of $88 million for the same period in 2007. On December 16, 2007, the majority of company employees represented by the UAW voted to ratify a new contract that will run through September 30, 2010. Among the changes from the prior contract was the cessation of annual lump sum payments that had been made to certain retirees. We previously accounted for these payments as a defined benefit plan based on the historical substance of the underlying arrangement. The elimination of these payments and other changes resulted in a net settlement and curtailment of the plan resulting in income of $42 million during the three months ended January 31, 2008.

Excluding the effects of the plan settlement and curtailment described above, postretirement benefits income from defined benefit plans was $5 million in the nine months ended July 31, 2008. The $93 million reduction in defined benefit plan expense resulted from better than expected returns and a significant reduction in the projected benefit obligation resulting from fully insuring our Medicare eligible population in our largest postretirement medical plan. Each of these actions took place in 2007 and represent variances from prior actuarial estimates. These variances significantly reduced the cumulative loss pool during 2007. Such costs amortize into income in the subsequent years as a component of postretirement benefits (income) expense. Amortization of the loss pool for pension and health and welfare plans was $10 million for the nine months ended July 31, 2008 compared to $61 million for the same period in 2007. Additionally, the growth in the asset base from the better than expected returns during 2007 had the effect of increasing the expected return on plan assets in 2008 (another component of postretirement benefits (income) expense). The expected return on plan assets for pension and health and welfare plans for the nine months ended July 31, 2008 was $294 million compared to $250 million for the same period in 2007. See Note 8, Postretirement benefits, of the condensed consolidated financial statements for further information on postretirement benefits.

Postretirement benefits expense resulting from the defined contribution plans was $7 million and $6 million for the three months ended July 31, 2008 and 2007, respectively, and $19 million and $18 million for the nine months ended July 31, 2008 and 2007, respectively.

 

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The following tables represent the components of Interest expense:

 

     Three Months Ended
July 31,
    Change     Percentage
Change
 
         2008            2007          
(in millions, except percentage change)                        

Manufacturing operations debt

   $ 31    $ 51     $ (20 )   (39.2 )

Financial Services operations debt

     56      75       (19 )   (25.3 )

Non-cash mark to market charge (income) on our interest rate swaps agreements

     1      (1 )     2     N.M.  
                         

Total Interest expense

   $ 88    $ 125     $ (37 )   (29.6 )
                         

 

     Nine Months Ended
July 31,
    Change     Percentage
Change
 
         2008            2007          
(in millions, except percentage change)                        

Manufacturing operations debt

   $ 114    $ 147     $ (33 )   (22.4 )

Financial Services operations debt

     203      222       (19 )   (8.6 )

Non-cash mark to market charge (income) on our interest rate swaps agreements

     40      (2 )     42     N.M.  
                         

Total Interest expense

   $ 357    $ 367     $ (10 )   (2.7 )
                         

The overall decrease in the three month period ended July 31, 2008, compared to the same period in 2007, was primarily due to a decrease in interest rates and lower debt balances. The overall decrease for the nine month period ended July 31, 2008, compared to the same period in 2007, was primarily due to a decrease in interest rates and lower debt balances at the Financial Services segment partially offset by non-cash mark to market adjustments in our interest rate swap agreements in the Financial Services segment. For more information, see Note 10, Debt, included in the Annual Report on Form 10-K for 2007 and see Note 11, Financial instruments, to the accompanying condensed consolidated financial statements.

Other income, net amounted to $5 million and $10 million for the quarter and nine month period ended July 31, 2008, respectively, and compares with $34 million and $21 million of other income for the quarter and nine month period ended July 31, 2007, respectively. The primary drivers in Other income, net were foreign exchange gain and interest income. Foreign exchange gain decreased by $17 million and $24 million during the third quarter and year-to-date ended July 31, 2008, as compared to the same periods in 2007, respectively. Interest income decreased by $6 million and $12 million during the third quarter and year-to-date ended July 31, 2008, respectively, as compared to same periods in 2007. In addition, included in Other income, net for the nine month period ended July 31, 2007 was $31 million of expense related to the early extinguishment of debt, which did not recur in the same comparable period in 2008.

Equity in income of non-consolidated affiliates

Income and losses reported in Equity in income of non-consolidated affiliates are derived from our ownership interest in BDP, BDT, and fourteen other partially-owned affiliates. We reported $18 million and $63 million of income for the quarter and nine month period ended July 31, 2008 as compared to $22 million and $62 million for the quarter and nine month period ended July 31, 2007 with a majority of the income throughout these periods being derived from BDP. For more information, see Note 6, Investments in and advances to non-consolidated affiliates, to the accompanying condensed consolidated financial statements.

Income tax expense

Income tax expense, primarily consisting of foreign taxes, was $8 million and $17 million for the third quarter and year-to-date 2008 as compared to $9 million and $28 million for the comparable periods in 2007. Our

 

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income tax expense each quarter is affected by various items, including deferred tax asset valuation allowances, research and development credits, Medicare reimbursements, and other items. We have $1.0 billion of U.S. federal net operating losses as of October 31, 2007. We are able to offset our current U.S. federal taxable income with these net operating losses, which should result in minimal U.S. federal income tax cash payments. For additional information, see Note 9, Income taxes, to the accompanying condensed consolidated financial statements.

Net income (loss) and Diluted earnings (loss) per share

For the quarter and nine month period ended July 31, 2008, we recorded net income of $272 million and $434 million, respectively, which compares to net losses of $4 million and $17 million for the quarter and nine month period ended July 31, 2007, respectively. Diluted earnings for the quarter and nine month period ended July 31, 2008 were $3.68 and $5.92 per share, respectively, calculated on approximately 74.0 and 73.3 million shares, respectively. For the quarter and nine month period ended July 31, 2007, our diluted loss was $0.05 and $0.24 per share, respectively, calculated on approximately 70.3 million shares for both periods. Diluted shares reflect the impact of common stock options in accordance with the treasury stock method.

Segment Results of Operations

We define segment profit (loss) as adjusted income (loss) before income tax. Our results for interim periods are not necessarily indicative of results for a full year. Beginning in 2008, the sales from the Parts segment to the Truck segment, specifically our Dealcors, are recorded as intersegment sales, which are eliminated within “Corporate and Eliminations.” Previously, such sales were eliminated within the Truck segment’s external sales and revenues. As such, the Parts and Truck segments sales and revenues in the amounts of $62 million and $187 million for the three months and nine months ended July 31, 2007, respectively, have been restated to conform to the 2008 presentation. The following sections analyze operating results as they relate to our four industry segments.

Truck Segment

The following tables summarize our Truck segment’s financial and key operating results:

 

     Three Months Ended
July 31,
   Change    Percentage
Change
         2008            2007          
(in millions, except percentage change)                    

Segment sales

   $ 2,922    $ 1,715    $ 1,207    70.4

Segment profit

     357      7      350    N.M.

 

     Nine Months Ended
July 31,
   Change    Percentage
Change
         2008            2007          
(in millions, except percentage change)                    

Segment sales

   $ 7,522    $ 5,760    $ 1,762    30.6

Segment profit

     591      132      459    N.M.

 

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Chargeouts are defined by management as trucks that have been invoiced to customers with units held in dealer inventory primarily representing the difference between retail deliveries and chargeouts. The following tables reflect our chargeouts in units:

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         

“Traditional” Markets (U.S. and Canada)

          

School buses

   2,700    3,200    (500 )   (15.6 )

Class 6 and 7 medium trucks

   5,800    5,600    200     3.6  

Class 8 heavy trucks

   4,500    2,600    1,900     73.1  

Class 8 severe service trucks(A)

   5,100    3,900    1,200     30.8  
                  

Sub-total combined class 8 trucks

   9,600    6,500    3,100     47.7  
                  

Total “Traditional” Markets

   18,100    15,300    2,800     18.3  

Total “Expansion” Markets

   8,900    9,300    (400 )   (4.3 )
                  

Total Worldwide Units

   27,000    24,600    2,400     9.8  
                  

 

(A) Includes 1,800 and 400 units in the three months ended July 31, 2008 and 2007, respectively, related to U.S. military contracts.

 

     Nine Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         

“Traditional” Markets (U.S. and Canada)

          

School buses

   9,100    10,700    (1,600 )   (15.0 )

Class 6 and 7 medium trucks

   15,800    22,100    (6,300 )   (28.5 )

Class 8 heavy trucks

   11,000    14,100    (3,100 )   (22.0 )

Class 8 severe service trucks(B)

   14,200    11,800    2,400     20.3  
                  

Sub-total combined class 8 trucks

   25,200    25,900    (700 )   (2.7 )
                  

Total “Traditional” Markets

   50,100    58,700    (8,600 )   (14.7 )

Total “Expansion” Markets

   23,400    27,900    (4,500 )   (16.1 )
                  

Total Worldwide Units

   73,500    86,600    (13,100 )   (15.1 )
                  

 

(B) Includes 5,100 and 1,100 units in the nine months ended July 31, 2008 and 2007, respectively, related to U.S. military contracts.

Truck segment sales

 

     Three Months Ended
July 31,
   Change    Percentage
Change
         2008            2007          
(in millions, except percentage change)                    

Truck segment sales of manufactured products, net – U.S. and Canada

   $ 2,562    $ 1,415    $ 1,147    81.1

Truck segment sales of manufactured products, net – ROW

     360      300      60    20.0
                       

Total truck segment sales of manufactured products, net

   $ 2,922    $ 1,715    $ 1,207    70.4
                       

 

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     Nine Months Ended
July 31,
   Change    Percentage
Change
         2008            2007          
(in millions, except percentage change)                    

Truck segment sales of manufactured products, net – U.S. and Canada

   $ 6,593    $ 4,893    $ 1,700    34.7

Truck segment sales of manufactured products, net – ROW

     929      867      62    7.2
                       

Total truck segment sales of manufactured products, net

   $ 7,522    $ 5,760    $ 1,762    30.6
                       

During the three months and nine months ended July 31, 2008, the Truck segment’s net sales increased from the same respective periods in 2007 primarily due to sales growth in U.S. military, ProStar, and a slight increase in ROW.

We observed that the “traditional” markets began to experience a downturn at the end of our first quarter of 2007 and continued into 2008. Strongly influencing this downturn was a combination of the industry-wide increase in demand for vehicles containing the pre-2007 emissions-compliant engines ahead of the implementation of stricter engine emissions requirements and a challenging economic environment. Strength in our U.S. military sales, partially offset by the weakness across the industry, are the key drivers in the change in sales between our third quarter and year-to-date 2008 and 2007 results. “Traditional” market retail deliveries for the three and nine months ended July 31, 2008 and 2007 are categorized by relevant class in the tables below. The Truck segment “traditional” retail units sold increased by 1,800 units or 10.5% and decreased by 11,700 units or 18.0% during the third quarter and year-to-date 2008, as compared to same periods in 2007, respectively.

The following tables summarize industry retail deliveries, in the “traditional” truck markets in the U.S. and Canada, in units, according to Wards Communications and A.C.T. Research Company, LLC (“ACT”):

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         

“Traditional” Markets (U.S. and Canada)

          

School buses

   5,600    5,400    200     3.7  

Class 6 and 7 medium trucks

   15,300    18,600    (3,300 )   (17.7 )

Class 8 heavy trucks

   26,400    24,900    1,500     6.0  

Class 8 severe service trucks

   15,400    14,400    1,000     6.9  
                  

Sub-total combined class 8 trucks

   41,800    39,300    2,500     6.4  
                  

Total “Traditional” Truck Markets

   62,700    63,300    (600 )   (0.9 )
                  

 

    Nine Months Ended
July 31,
  Change     Percentage
Change
 
        2008            2007        

“Traditional” Markets (U.S. and Canada)

        

School buses

  16,800    17,900   (1,100 )   (6.1 )

Class 6 and 7 medium trucks

  46,200    68,400   (22,200 )   (32.5 )

Class 8 heavy trucks

  75,100    119,500   (44,400 )   (37.2 )

Class 8 severe service trucks

  42,900    49,500   (6,600 )   (13.3 )
                

Sub-total combined class 8 trucks

  118,000    169,000   (51,000 )   (30.2 )
                

Total “Traditional” Truck Markets

  181,000    255,300   (74,300 )   (29.1 )
                

 

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The following tables summarize our retail delivery market share percentages based on market-wide information from Wards Communications and ACT:

 

     Three Months Ended
July 31,
     2008    2007

“Traditional” Markets (U.S. and Canada)

     

School buses

   48.2    59.3

Class 6 and 7 medium trucks

   39.2    34.4

Class 8 heavy trucks

   18.9    15.3

Class 8 severe service trucks

   34.4    26.4

Sub-total combined class 8 trucks

   24.6    19.3

Total “Traditional” Truck Markets

   30.3    27.2

Impact of excluding U.S. military deliveries

     

Class 8 severe service trucks, exclusive of U.S. military deliveries

   25.7    24.3

Sub-total combined class 8 trucks, exclusive of U.S. military deliveries

   21.3    18.5

Total “Traditional” Truck Markets, exclusive of U.S. military deliveries

   28.2    26.7

 

     Nine Months Ended
July 31,
     2008    2007

“Traditional” Markets (U.S. and Canada)

     

School buses

   54.2    59.8

Class 6 and 7 medium trucks

   35.9    35.2

Class 8 heavy trucks

   16.6    14.6

Class 8 severe service trucks

   35.2    25.9

Sub-total combined class 8 trucks

   23.4    17.9

Total “Traditional” Truck Markets

   29.4    25.5

Impact of excluding U.S. military deliveries

     

Class 8 severe service trucks, exclusive of U.S. military deliveries

   26.5    24.2

Sub-total combined class 8 trucks, exclusive of U.S. military deliveries

   19.9    17.3

Total “Traditional” Truck Markets, exclusive of U.S. military deliveries

   27.4    25.1

For the three months and nine months ended July 31, 2008, our school bus, class 6 and 7 medium class, and severe service brands all led their markets with the greatest retail market share in each of their categories. Our continuing strategy is to maintain and grow these market share positions at our required margins while aggressively pursuing market share gains in the heavy truck market, the category in which we have the lowest market share. We continue to demonstrate our long-term commitment to the heavy truck market through our 2008 introduction of the LoneStar class 8 long-haul truck.

Our market share in the school bus class was 48.2% and 54.2% for the three months and nine months ended July 31, 2008, respectively, and 59.3% and 59.8% for the same respective periods in 2007. Market share in the school bus class declined over the reporting period as a result of competitive pricing strategies and our desire to collect for the intrinsic value of our product. We believe the school bus market share will return to our normalized share due to our recent sales agreement with the largest student transportation company. Market share in class 6 and 7 medium increased to 39.2% from 34.4% during the third quarter of 2008 compared to the respective quarter in 2007 and increased slightly during the nine months period ended July 31, 2008 and the same respective period in 2007. We have been able to mitigate the impact of new entrants into this class and discount programs instituted by our competitors due to our brand value and extensive dealer network. Our class 8 heavy truck market share rose by 3.6 and 2.0 percentage points for the three months and nine months ended July 31, 2008, respectively, compared to the same periods in 2007, due to our reengagement in this class with new models, re-established scale, and increased supplier relationships. Our severe service class market share

 

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increased 8.0 and 9.3 percentage points during the third quarter and year-to-date 2008, respectively, as compared to the three months and nine months ended July 31, 2007, despite the industry downturn in residential and non-residential construction, primarily due to an increase in U.S. military sales.

Net chargeouts declined during the third quarter and year-to-date 2008 in our “expansion” markets when compared to the same respective periods in 2007. The “expansion” markets include Mexico, international export, non-U.S. military, recreational vehicle, commercial step-van, and other truck and bus classes. Products such as the Low-Cab Forward vehicle, class 4 and 5 small bus, and our recreational vehicle products, as well as our entrance into the military market contributed to incremental sales within these quarters in addition to our traditional markets. It is our goal to continue to diversify into these “expansion” markets in future periods. The Mexican truck market increased 8.9% and decreased 5.3% in the three months and nine months ended July 31, 2008, respectively, compared to the same respective periods in 2007. Our Mexican truck market share was 36.1% and 22.3% for the quarters ended July 31, 2008 and 2007, respectively, and 33.4% and 31.3% for the nine months ended July 31, 2008 and 2007, respectively.

Truck segment costs and expenses

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
     2008    2007     
(in millions, except percentage change)                       

Costs of products sold, excluding items presented separately below

   $ 2,314    $ 1,481    $ 833     56.2  

Postretirement benefits expenses allocated to costs of products sold

     5      9      (4 )   (44.4 )

Product warranty costs

     35      36      (1 )   (2.8 )
                        

Total costs of products sold

   $ 2,354    $ 1,526    $ 828     54.3  
                        

 

     Nine Months Ended
July 31,
   Change     Percentage
Change
 
     2008    2007     
(in millions, except percentage change)                       

Costs of products sold, excluding items presented separately below

   $ 6,204    $ 4,898    $ 1,306     26.7  

Postretirement benefits expenses allocated to costs of products sold

     14      27      (13 )   (48.1 )

Product warranty costs

     94      107      (13 )   (12.2 )
                        

Total costs of products sold

   $ 6,312    $ 5,032    $ 1,280     25.4  
                        

Our Costs of products sold as a percentage of net sales of manufactured products decreased to 80.6% and 83.9% in the third quarter and year-to-date 2008, respectively, from 89.0% and 87.4% during the same respective periods in 2007. Product warranty costs are included in Costs of products sold. We generally offer one- to five-year warranty coverage for our trucks, although the terms and conditions can vary. Product warranty costs at the Truck segment were 1.5% of Truck segment’s costs of products sold for both the three months and nine months ended July 31, 2008, respectively, compared to 2.4% and 2.1% of Truck segment’s costs of products sold for the same respective periods in 2007. We accrue warranty related costs under standard warranty terms and for claims that we may choose to pay in an effort to strengthen and grow relationships with our customer base even though we are not contractually obligated to do so (“out-of-policy”). Our warranty costs declined primarily as a result of a reduction in truck shipments and quality improvements for the nine month period ended July 31, 2008, as compared to the same respective period in 2007. In addition to quality improvements, we achieved reductions in the levels of adjustments related to pre-existing warranties of $6 million and $18 million during the third quarter and year-to-date 2008, and reduced levels of out-of-policy claims have allowed us to mitigate our warranty cost for the third quarter and year-to-date 2008. Our Costs of products sold as a percentage of net sales of manufactured products, exclusive of product warranty costs and postretirement benefits expenses, decreased by 7.2 percentage points for the third quarter of 2008 compared to the same period in 2007 primarily due to

 

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increased sales in U.S. military and ProStar vehicles, improved pricing and operating efficiency. Our Costs of products sold as a percentage of net sales of manufactured products, exclusive of product warranty costs and postretirement benefits expense, decreased by 2.6 percentage points for the year-to-date period ended July 31, 2008 compared to the same period in 2007 primarily due to sales in U.S. military and ProStar vehicles, improved pricing mitigating the impact of lower volumes and the associated decline in operating efficiency.

 

     Three Months Ended
July 31,
   Change     Percentage
Change
 
         2008            2007         
(in millions, except percentage change)                       

Selling, general and administrative expenses, excluding items presented separately below

   $ 104    $ 84    $ 20     23.8  

Postretirement benefits expense allocated to selling, general and administrative expenses

     —        2      (2 )   (100.0 )

Dealcor selling, general and administrative expenses

     45      70      (25 )   (35.7 )

Provision for losses on receivables

     10      3      7     233.3  
                        

Total selling, general and administrative expenses

   $ 159    $ 159    $   —       —    
                        

 

     Nine Months Ended
July 31,
   Change     Percentage
Change
 
         2008