UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 1-9618

 

 

 

 

NAVISTAR INTERNATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

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

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common stock, par value $0.10 per share

 

Cumulative convertible junior preference stock, Series D (with $1.00 par value per share)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No  þ

 

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 and (2) has been subject to such filing requirements for the past 90 days.  Yes o       No  þ

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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

Large accelerated filer  þ      Accelerated filer  o     Non-accelerated filer  o

 

As of April 30, 2007, the aggregate market value of common stock held by non-affiliates of the registrant was $3.4 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant, and pension and 401-k plans of the registrant, have been deemed to be affiliates.

 

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

 

As of November 30, 2007, the number of shares outstanding of the registrant’s common stock was 70,236,415, net of treasury shares.

 

Documents incorporated by reference: None.

 

 

NAVISTAR INTERNATIONAL CORPORATION FISCAL YEAR 2005 FORM 10-K

 

TABLE OF CONTENTS

 

 

PART I

 

EXPLANATORY NOTE

 

On April 6, 2006, the management of Navistar International Corporation (“NIC”), with the concurrence of the audit committee of our Board of Directors, concluded that NIC’s previously issued consolidated financial statements for the years ended October 31, 2002 through 2004, and all previously issued quarterly consolidated financial statements for periods after October 31, 2004, should be restated. In addition, in April 2006, the audit committee of our Board of Directors dismissed our independent registered public accounting firm, Deloitte & Touche LLP, and approved the engagement of KPMG LLP as our independent registered public accounting firm. Also in April 2006, Deloitte & Touche LLP advised us that its previously issued independent auditors’ reports should not be relied upon.

 

This Annual Report on Form 10-K for the year ended October 31, 2005 is our first filing with the United States Securities and Exchange Commission (“SEC”) that includes comprehensive financial statements since our Quarterly Report on Form 10-Q for the quarter ended July 31, 2005. Unless otherwise stated, all financial information presented in this Annual Report on Form 10-K reflects restated consolidated financial statements for the years ended October 31, 2003 and 2004 and the first three quarters of the year ended October 31, 2005. The effect of the restatement on periods prior to 2003 has been presented as a reduction of stockholders’ equity as of November 1, 2002, the beginning of our 2003 year.

 

For additional information and a detailed discussion of the restatement, see Note 2, Restatement and reclassification of previously issued consolidated financial statements, to the accompanying consolidated financial statements and “Restatement and Re-Audit” within Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

 

NIC, incorporated under the laws of the state of Delaware in 1993, is a holding company whose principal operating subsidiaries are International Truck and Engine Corporation (“International”) and Navistar Financial Corporation (“NFC”). NFC files periodic reports with the SEC. References herein to “Navistar,” the “company,” “we,” “our” or “us” refer to NIC and its subsidiaries, and certain variable interest entities (“VIE”) of which we are the primary beneficiary. We report our annual results on a fiscal year end of October 31. As such, all references to 2005, 2004, 2003, and 2002 contained within this Annual Report on Form 10-K relate to the fiscal year unless otherwise indicated.

 

Our Operating Segments

 

We operate in four industry segments: Truck, Engine, Parts (collectively called “manufacturing operations”) and Financial Services, which consists of NFC and our foreign finance subsidiaries (collectively called “financial services operations”). Corporate contains those items that do not fit into our four segments. Selected financial data for each segment can be found in Note 19, Segment reporting, to the accompanying consolidated financial statements.

 

Truck Segment

 

The Truck segment manufactures and distributes a full line of class 4 through 8 trucks and buses in the common carrier, private carrier, government/service, leasing, construction, energy/petroleum, and student and commercial transportation markets under the International and IC Corporation (“IC”) brands. In addition, this segment also produces chassis for motor homes and commercial step-van vehicles under the Workhorse Custom Chassis (“WCC”) brand. The truck and bus manufacturing operations in the United States (“U.S.”), Canada, and Mexico consist principally of the assembly of components manufactured by our suppliers, although this segment also produces some sheet metal components, including truck cabs.

 

We compete primarily in the class 6 through 8 bus, medium and heavy truck markets within the U.S. and Canada, which we consider our “traditional” markets. We continue to grow in “expansion” markets which include Mexico, international export, military, recreational vehicles, and other class 4 through 8 truck and bus

markets. We market our truck products through our extensive dealer network in North America, which offers a comprehensive range of services and other support functions to our customers. Our trucks are distributed in virtually all key markets in the U.S. and Canada through our distribution and service network, composed of 841 U.S. and Canadian dealer and retail outlets and 81 Mexican dealer locations at the time of filing this Annual Report on Form 10-K. In addition, our network of used truck centers in the U.S. provides trade-in support to our dealers and national accounts group, and markets all makes and models of reconditioned used trucks to owner-operators and fleet buyers. The Truck segment is our largest operating segment, accounting for the majority of our total external sales and revenues in 2005.

 

The markets in which the Truck segment competes are subject to considerable volatility and move in response to cycles in the overall business environment. These markets are particularly sensitive to the industrial sector, which generates a significant portion of the freight tonnage hauled. Government regulation has impacted, and will continue to impact, trucking operations and the efficiency and specifications of equipment.

 

The class 6 through 8 truck and bus markets in the U.S., Canada, and Mexico are highly competitive. Major U.S. domestic competitors include PACCAR, Inc. (“PACCAR”), Ford Motor Company (“Ford”), and General Motors Corporation (“GM”). Competing foreign-controlled domestic manufacturers include: Freightliner, Sterling and Western Star (subsidiaries of Daimler-Benz AG), and Volvo and Mack (subsidiaries of Volvo Global Trucks). In addition, smaller, foreign-controlled market participants such as Isuzu Motors America, Inc. (“Isuzu”), Nissan North America, Inc. (“Nissan”), and Mitsubishi Motors North America, Inc. (“Mitsubishi”) are competing in the U.S. and Canadian markets with primarily imported products. In Mexico, the major domestic competitors are Kenmex (a subsidiary of PACCAR), GM, and Daimler-Benz AG (“Mercedes Benz”). In addition to the influence of price, market share is driven by product quality, engineering, styling, utility, fuel efficiency, and distribution.

 

Engine Segment

 

The Engine segment designs and manufactures diesel engines for use primarily in our class 6/7 medium trucks, buses, and selected class 8 heavy truck models, and for sale to original equipment manufacturers (“OEM”) in the U.S., Mexico, and Brazil. This segment also sells engines for industrial and agricultural applications, and supplies engines for WCC, Low-Cab Forward (“LCF”), and class 5 vehicles. The engine segment has made a substantial investment, together with Ford, in the Blue Diamond Parts (“BDP”) joint venture which is responsible for the sale of service parts to our OEM customers. The Engine segment is our second largest operating segment.

 

The Engine segment designs and manufactures diesel engines across the 50 through 375 horsepower range for use in our medium trucks, buses, and selected class 8 heavy truck models. According to data provided by independent market researchers, we are the world’s largest diesel engine maker across the 160 through 370 horsepower range. Our diesel engines are sold under the MaxxForce^tm brand as well as produced for other OEMs, principally Ford. According to 2005 data published by Wards Communications and R.L. Polk & Co., we have approximately a 46% share of the diesel pickup engine market in the U.S. and Canada, and approximately a 40% share of the engine market for medium-duty commercial trucks and buses in the U.S. and Canada. The U.S. and Canadian mid-range commercial truck diesel engine market has six major players: International, Cummins, Inc. (“Cummins”), Mercedes Benz, Caterpillar, Inc. (“Caterpillar”), Isuzu, and Hino (a subsidiary of Toyota). In the heavy pick up truck markets, International (Power Stroke^®) in the Ford Super Duty competes with Cummins in Dodge and GM/Isuzu (Duramax) in Chevrolet and GMC.

 

In South America, we have a substantial share of the diesel engine market in the mid-sized pick up and sport utility vehicle (“SUV”) markets as well as the mid-range diesel engines produced in that market. Our South American subsidiary MWM International Industria De Motores Da America Do Sul Ltda (“MWM”) competes with Mitsubishi and Toyota in the Mercosul pick up and SUV markets; Cummins and Mercedes Benz in the light truck market; Mercedes Benz in the bus market; and New Holland, Valtra, and John Deere in the agricultural markets.

Formed in 2005, MWM extends the Engine segment’s product line to provide customers with additional engine offerings in the agriculture, marine, and light truck markets. MWM is a leader in the Brazilian mid-range diesel engine market with products in more than thirty countries on five continents.

 

In the commercial truck market in Mexico, International competes in classes 4 through 8 with MaxxForce 5, 7, and 9 engines, facing competition from Detroit Diesel Corporation, Cummins, Caterpillar, Isuzu, Hino, Mercedes Benz, and Ford. The application of the new big-bore engines MaxxForce 11 and 13 in Mexico will depend on the availability of low sulfur diesel fuel throughout the country. In buses, we compete in classes 6 through 8 with I-6 MaxxForce 9 engines and I-4 MWM engines branded MaxxForce 4.8 imported from Brazil, having as a main competitor Mercedes Benz with 904 and 906 series engines.

 

We supply our V-8 diesel engine to Ford for use in all of Ford’s diesel-powered super-duty trucks and vans over 8,500 lbs. gross vehicle weight in North America. Shipments to Ford during the year ended October 31, 2005 account for 95% of our V-8 shipments and 68% of total shipments (including intercompany transactions). We are currently involved in litigation with Ford. For more information regarding our litigation with Ford, see Item 3, Legal Proceedings.

 

Our unit shipment of engines to customers other than Ford totaled 166,600 for the year ended October 31, 2005, a 63% increase over the engine units shipped to customers other than Ford for the year ended October 31, 2004. Total engine units shipped reached 522,600 in 2005, 21% higher than the 432,200 units shipped in 2004.

 

We also operate two U.S. foundries: Indianapolis Casting Corporation, located in Indianapolis, Indiana, which is a high volume grey iron foundry that casts large complex products such as cylinder heads and crankcases, and our ductile iron foundry located in Waukesha, Wisconsin which produces a variety of smaller components for the truck and diesel engine markets such as brackets and bedplates.

 

Parts Segment

 

The Parts segment provides customers with proprietary products needed to support International trucks, IC buses, WCC and the International MaxxForce engine lines, together with a wide selection of other standard truck, trailer, and engine aftermarket parts. We distribute service parts in virtually all key markets in the U.S., Canada, and Mexico through the same distribution and service network that serves our Truck segment, as well as through an expanding number of parts and service only locations. Through our acquisition of WCC in 2005, we also have a parts distribution network that supplies commercial fleets and recreational vehicle (“RV”) dealers.

 

Our sales force is focused on serving the dealer channel, and is based in five regions within the U.S., one in Canada, one in Mexico, and one for export business. In addition, we have a national account sales team, committed to serving major fleet customers throughout North America. At the time of filing this Annual Report on Form 10-K, we operate 11 regional parts distribution centers in the U.S., Canada, and Mexico in support of our customers and dealers.

 

Financial Services Segment

 

The 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. This segment also factors Ford receivables from the Engine segment, wholesale accounts, and selected retail accounts receivable. Our foreign finance subsidiaries’ primary business is to provide wholesale, retail, and lease financing to the Mexican operations’ dealers and retail customers.

 

Sales of new products (including trailers of other manufacturers) are also financed regardless of whether designed or customarily sold for use with our truck products. In 2005, retail, wholesale, and lease financing of products manufactured by others approximated 11% of the financial services segment’s total originations. This segment provided wholesale financing in 2005 for 96% of the new truck inventory sold by us to our dealers and distributors in the U.S. and provided retail and lease financing for 15% of all new truck units sold or leased by us to retail customers. For 2004, the Financial Services segment provided wholesale financing for

95% of our new truck inventory sold by us to our dealers and distributors in the U.S. and provided retail and lease financing for 16% of all new truck units sold or leased by us to retail customers.

 

Engineering and Product Development Costs

 

Our engineering and product development programs are focused on product improvements, innovations, and cost reductions. As a diesel engine manufacturer, we have incurred research, development, and tooling costs to design our engine product lines to meet United States Environmental Protection Agency (“U.S. EPA”) and California Air Resources Board (“CARB”) emission requirements. In 2005, our engineering and product development expenditures were $413 million compared to $287 million in 2004.

 

Acquisitions, Strategic Agreements and Joint Ventures

 

We continuously seek and evaluate opportunities in the marketplace that provide us with the ability to leverage new technology, expand our engineering expertise, provide entrees into “expansion” markets, and identify component and material sourcing alternatives. During the recent past, we have entered into a number of collaborative strategic relationships and have acquired businesses that allowed us to generate manufacturing efficiencies, economies of scale and market growth opportunities. We also routinely re-evaluate our existing relationships to determine whether they continue to provide the benefits we originally envisioned.

 

 

 

Government Contracts

 

By the end of 2005, we secured over $900 million of orders in the global military market. The major military contracts we secured by the end of 2005 are as follows:

 

 

The major military contracts we secured subsequent to the end of 2005 are as follows:

 

 

As a U.S. government contractor, we are subject to specific regulations and requirements as mandated by our contracts. These regulations include Federal Acquisition Regulations, Defense Federal Acquisition Regulations, and Code of Federal Regulations.

 

We are also subject to routine audits and investigations by U.S. Government agencies such as the Defense Contract Management Agency and Defense Contract Audit Agency. These agencies review and assess compliance with contractual requirements, cost structure, and applicable laws, regulations, and standards.

 

Backlog

 

Our worldwide backlog of unfilled truck orders (subject to cancellation or return in certain events) at October 31, 2007, 2006, 2005, 2004, and 2003, was 18,900, 43,900, 27,800, 27,900, and 23,400 units, respectively. Although the backlog of unfilled orders is one of many indicators of market demand, other factors such as changes in production rates, internal and supplier available capacity, new product introductions, and competitive pricing actions may affect point-in-time comparisons.

Employees

 

The following table outlines worldwide employees at October 31 for the periods as indicated:

 

 

Employees are considered inactive in certain situations including disability leave, leave of absence, layoffs, and work stoppages. Approximately 2,300 of the increase in employees for 2005 resulted from the various acquisitions that occurred during the year. Inactive employees as of October 31, 2007 include approximately 2,500 United Automobile, Aerospace and Agricultural Implement Workers of America (“UAW”) workers who have commenced a work stoppage as of October 23, 2007.

 

The following table outlines the number of active employees represented by the UAW, the National Automobile, Aerospace and Agricultural Implement Workers of Canada (“CAW”), and other unions, for the periods as indicated:

 

 

 

 

Our multi-site contract with the UAW expired on September 30, 2007. The represented workers continued to work without an extension of the contract until October 23, 2007 when they commenced a work stoppage. In April 2006, Navistar and the UAW agreed to hold early negotiations to reach a new agreement prior to the contract expiration date. A tentative agreement was reached with the UAW leadership in early June 2006, but a ratification vote failed with 87% voting against the proposed contract. Contract negotiations with UAW leadership re-commenced in late August 2007 and continued intermittently until October 23, 2007. Negotiations resumed on November 26, 2007. Our existing labor contract with the CAW runs through June 30, 2009. See Item 1A, Risk Factors, for further discussion related to the risk associated with labor and work stoppages.

 

Patents and Trademarks

 

We continuously obtain patents on our inventions and own a significant patent portfolio. Additionally, many of the components we purchase for our products are protected by patents that are owned or controlled by the component manufacturer. We have licenses under third-party patents relating to our products and their manufacture and grant licenses under our patents. The monetary royalties paid or received under these licenses are not material.

 

Our primary trademarks are an important part of our worldwide sales and marketing efforts and provide instant identification of our products and services in the marketplace. To support these efforts, we maintain, or have pending, registrations of our primary trademarks in those countries in which we do business or expect to do business. We grant licenses under our trademarks for consumer-oriented goods, such as toy trucks and apparel, outside the product lines which we manufacture. The monetary royalties received under these licenses are not material.

Supply

 

We purchase raw materials, parts, and components from numerous outside suppliers. To avoid duplicate tooling expenses and to maximize volume benefits, single-source suppliers fill a majority of our requirements for parts and components.

 

The impact of an interruption in supply will vary by commodity and type of part. Some parts are generic to the industry while others are of a proprietary design requiring unique tooling, which require additional effort to relocate. However, we believe our exposure to a disruption in production as a result of an interruption of raw materials and supplies is no greater than the industry as a whole. In order to alleviate losses resulting from an interruption in supply, we maintain contingent business interruption insurance for loss of earnings and/or extra expense directly resulting from physical loss or damage at a direct supplier location.

 

While we believe we have adequate assurances of continued supply, the inability of a supplier to deliver could have an adverse effect on production at certain of our manufacturing locations.

 

Impact of Government Regulation

 

Truck and engine manufacturers continue to face significant governmental regulation of their products, especially in the areas of environment and safety. New on-highway emissions standards that came into effect in the U.S. on January 1, 2007 reduced allowable particulate matter and allowable nitrogen oxide. This change in emissions standards resulted in a significant increase in the cost of our products to meet these emissions levels, which in turn drove a significant pre-buy for pre-2007 emissions vehicles in the U.S. in the periods leading up to December 31, 2006.

 

We have incurred research, development, and tooling costs to design and produce our engine product lines to meet U.S. EPA and CARB emission requirements that came into effect in calendar year 2004. The 2007 emission compliance standards require a more stringent reduction of nitrogen oxide and particulate matter with an additional reduction scheduled for January 1, 2010. Our 2007 emission compliant engines are already in market and we are developing products to meet the requirements of the 2010 phase-in. Separately, we have met all of the obligations we agreed to in a consent decree entered into in July 1999 with the U.S. EPA and in a settlement agreement with CARB concerning alleged excess emissions of nitrogen oxides.

 

Canadian heavy-duty engine emission regulations essentially mirror those of the U.S. EPA. In Mexico, heavy-duty engine emission requirements reflect EPA 98 or Euro 3 standards with which we are compliant. More stringent reductions of nitrogen oxide are required by 2010; however, compliance in Mexico is conditioned on availability of low sulfur diesel fuel which may not be available at that time.

 

Truck manufacturers are also subject to various noise standards imposed by federal, state, and local regulations. The engine is one of a truck’s primary sources of noise, and we therefore work closely with OEMs to develop strategies to reduce engine noise. We are also subject to the National Traffic and Motor Vehicle Safety Act (“Safety Act”) and Federal Motor Vehicle Safety Standards (“Safety Standards”) promulgated by the National Highway Traffic Safety Administration. We believe we are in substantial compliance with the requirements of the Safety Act and the Safety Standards.

 

Available Information

 

We are subject to the reporting and information requirements of the Securities Exchange Act of 1934 (“Exchange Act”), as amended and as a result, are obligated to file periodic reports, proxy statements and other information with the SEC. We make these filings available free of charge on our website, the URL of which is http://www.navistar.com, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The SEC maintains a website (http://www.sec.gov) that contains our annual, quarterly, and current reports, proxy, and information statements, and other information we file electronically with the SEC. You can read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1850, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Information on our website does not constitute part of this Annual Report on Form 10-K.

 

 

Forward-Looking Statements; Risk Factors

 

This document contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act of 1934 (“Exchange Act”), and the Private Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties. You should not place undue reliance on those statements because they are subject to numerous uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond our control, and such forward-looking statements only speak as of the date hereof. 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 based on assumptions that we have made in light of our experience in the industry as well as our perceptions of historical trends, current conditions, expected future developments, and other factors we believe are appropriate under the circumstances. As you read and consider the information contained herein, you should understand that these statements are not guarantees of performance or results. They involve risks, uncertainties, and assumptions. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors could affect our actual financial results and could cause these actual results to differ materially from those in the forward-looking statements. Some of these factors include:

 

Risks that Relate to Our Delay in Filing Timely Reports with the SEC, the Restatement of Our Consolidated Financial Statements, Accounting and Internal Controls, Our De-listing from the New York Stock Exchange (“NYSE”), and Our Trading on the Over-the-Counter Market (“OTC”).

 

we may be unable to provide financial information in a timely and reliable manner. Although we consistently review and evaluate our internal control systems to allow management to report on, and our independent auditors to attest to, the sufficiency of our internal control, we cannot assure you that we will not discover additional material weaknesses in our internal controls over financial reporting. Any such additional material weaknesses could adversely affect investor confidence in Navistar.

 

 

Risks that Relate to Business Operations and Liquidity.

 

 

 

 

 

 

 

 

All future written and oral forward-looking statements by us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to above. Except for our ongoing obligations to disclose material information as required by the federal securities laws, we do not have any

obligations or intention to release publicly any revisions to any forward-looking statements to reflect events or circumstances in the future or to reflect the occurrence of unanticipated events.

 

 

We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of 2005 that remain unresolved.

 

 

In North America, we operate twelve manufacturing and assembly facilities, which contain in the aggregate approximately 12 million square feet of floor space. Of these twelve facilities, ten are owned and two are subject to long-term leases. Seven plants manufacture and assemble trucks or buses, and assemble chassis for recreational and custom-made vehicles, and five plants are used to build engines. Of these five plants, three manufacture diesel engines, one manufactures grey iron castings, and one manufactures ductile iron castings. In addition, we own or lease other significant properties in the U.S. and Canada including vehicle and parts distribution centers, sales offices, two engineering centers which serve our Truck and Engine segments, and our headquarters which is located in Warrenville, Illinois. In addition, we own and operate manufacturing plants in both Brazil and Argentina, which contain a total of one million square feet of floor space for use by our South American engine subsidiaries.

 

The principal product development and engineering facility for our Truck segment is in Fort Wayne, Indiana, and for our Engine segment is in Melrose Park, Illinois. The Parts segment has seven distribution centers in the U.S., two in Canada and one in Mexico.

 

A majority of the activity of the Financial Services segment is conducted from leased headquarters in Schaumburg, Illinois. The Financial Services segment also leases two other office locations in the U.S. and one in Mexico.

 

All of our facilities are being utilized. We believe they have been adequately maintained, are in good operating condition, and are suitable for our current needs. These facilities, together with planned capital expenditures, are expected to meet our needs in the foreseeable future.

 

 

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.

 

Various claims and controversies have arisen between us and our former fuel system supplier, Caterpillar Inc. (“Caterpillar”), regarding the ownership and validity of certain patents covering fuel system technology used in our new version of diesel engines that were introduced in 2002. In June 1999, in the federal district court in Peoria, Illinois, Caterpillar sued Sturman Industries, Inc. (“Sturman”), our joint venture partner in developing fuel system technology, alleging that technology invented and patented by Sturman and licensed to us, belongs to Caterpillar. After a trial in July 2002, the jury returned a verdict in favor of Caterpillar finding that this technology belongs to Caterpillar under a prior contract between Caterpillar and Sturman. Sturman appealed the adverse judgment, and in October 2004, the appellate court vacated the jury verdict and ordered a new trial which began on October 31, 2005. On December 1, 2005, the jury returned a verdict in favor of Caterpillar finding that Sturman breached its contract with Caterpillar awarding $1.00 in damages. Following the verdict, Caterpillar asked the court to order that Sturman transfer the technology to Caterpillar.

 

In May 2003, in the federal district court in Columbia, South Carolina, Caterpillar sued us, our supplier of fuel injectors, and joint venture partner, Siemens Diesel Systems Technology, LLC, and Sturman for patent infringement alleging that the Sturman fuel system technology patents and certain Caterpillar patents are

infringed in the engines we introduced in 2002. In January 2002, Caterpillar sued us in the Circuit Court of Peoria County, Illinois, alleging we breached the purchase agreement pursuant to which Caterpillar supplied fuel systems for our prior version of diesel engines. Caterpillar’s claims involved a 1990 agreement to reimburse Caterpillar for costs associated with the delayed launch of our V-8 diesel engine program. Reimbursement of the delay costs had been made by a surcharge on each injector purchased and the purchase of certain minimum quantities of spare parts. In 1999, we concluded that, in accordance with the 1990 agreement, we had fully reimbursed Caterpillar for the delay costs and stopped paying the surcharge and purchasing the minimum quantities of spare parts. Caterpillar asserted that the surcharge and the spare parts purchase requirements continue throughout the life of the contract and sued us to recover these amounts, plus interest. Caterpillar also asserted that we failed to purchase all of our fuel injector requirements under the contract and, in collusion with Sturman, failed to pursue a future fuel systems supply relationship with Caterpillar. On August 24, 2006, we settled all pending litigation with Caterpillar and entered into a new ongoing business relationship that includes new licensing and supply agreements. The settlement, which included an upfront cash payment and a three year promissory note payable through August 2009, resulted in a pre-tax charge to earnings of $9 million for the year ended October 31, 2005, representing the difference between previously established accruals and the final settlement.

 

In December 2003, the U.S. EPA issued a Notice of Violation (“NOV”) to us in conjunction with the operation of our engine casting facility in Indianapolis, Indiana. Specifically, the U.S. EPA alleged that we violated applicable environmental regulations by failing to obtain the necessary permit in connection with the construction of certain equipment and not complying with the best available control technology for emissions from such equipment. In September 2005, we finalized a consent order with the U.S. EPA, agreeing to pay a civil penalty and fund certain Indianapolis metropolitan environmental projects at an aggregate cost of less than $1 million.

 

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 this current restatement. 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.

 

In July 2006, the Wisconsin Department of Natural Resources (“WDNR”) issued to us a NOV in conjunction with the operation of our foundry facility in Waukesha, Wisconsin. Specifically, the WDNR alleged that we violated applicable environmental regulations concerning implementation of storm water pollution prevention plans. Separately, WDNR also issued a NOV regarding the facility in November 2006, in which WDNR alleged that we failed to properly operate and monitor our operations as required by the air quality permit. In September 2007, WDNR referred the NOVs to the Wisconsin Department of Justice for further action. We do not expect that the resolution of these NOVs will have a material effect on our results of operations, cash flows, or financial condition.

 

In January 2007, a complaint was filed against us in Oakland County Circuit Court in Michigan by 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 (a) as we continue to sell engines to Ford at a price that Ford alleges is too high, and (b) as Ford pays its customers’ warranty claims, which Ford alleges are attributable to us. We disagree with Ford’s position, and intend to defend ourself 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, and we intend to vigorously defend ourselves. 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, and financial condition. On June 4, 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. On September 7, 2007, an Illinois Cook County Circuit Court judge dismissed our lawsuit against Ford, directing us to proceed with mediation. If mediation fails, we can re-file the lawsuit at a later date.

 

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 actual damages paid out to claimants have not been material to our results of operations, cash flows, or financial condition. 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.

 

 

No matters were submitted to a vote of security holders during the three-month period ended October 31, 2005.

 

PART II

 

 

Prior to February 14, 2007, our common stock was listed on the NYSE, the Chicago Stock Exchange, and the Pacific Stock Exchange under the abbreviated stock symbol “NAV.” Effective February 14, 2007, our common stock was de-listed from the aforementioned exchanges and now trades on the OTC under the symbol “NAVZ”. As of November 30, 2007, there were approximately 13,900 holders of record of our common stock.

 

The following is the high and low market price per share of our common stock from the NYSE for each quarter of 2003 through 2006, the 1^st quarter of 2007 and part of the 2^nd quarter of 2007. Also included are the highs and lows from the OTC for part of the 2^nd quarter of 2007 and the 3^rd and 4^th quarters of 2007. The OTC market quotations in the table below reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not represent actual transactions.

 

 

Holders of our common stock are entitled to receive dividends when and as declared by the Board of Directors out of funds legally available therefor, provided that, so long as any shares of our preferred stock and preference stock are outstanding, no dividends (other than dividends payable in common stock) or other distributions (including purchases) may be made with respect to the common stock unless full cumulative dividends, if any, on our shares of preferred stock and preference stock have been paid. Under the General Corporation Law of the State of Delaware, dividends may only be paid out of surplus or out of net profits for the year in which the dividend is declared or the preceding year, and no dividend may be paid on common stock at any time during which the capital of outstanding preferred stock or preference stock exceeds our net assets.

 

Payments of cash dividends and the repurchase of common stock are currently limited due to restrictions contained in our $1.5 billion credit agreement dated January 19, 2007. We have not paid dividends on our common stock since 1980 and do not expect to pay cash dividends on our common stock in the foreseeable future.

 

Our directors who are not employees receive an annual retainer and meeting fees payable at their election in shares of common stock of the company or in cash. The Board of Directors mandates that at least one-fourth of the annual retainer be paid in the form of our common stock. However, on October 17, 2006, our Board of Directors agreed to issue a cash award to each non-employee director in lieu of the non-employee directors’ annual stock option grant for 2006.

 

For the period covered by this report, receipt of 1,787 shares was deferred as payment for the 2005 annual retainer and meeting fees. In each case, the shares were acquired at prices ranging from $26.15 to $34.13 per share, which represented the fair market value of such shares on the date of acquisition. We claim exemption from registration of the shares under Section 4(2) of the Securities Act of 1933, as amended.

 

The following table sets forth information with respect to purchases of shares of our common stock made during the quarter ended October 31, 2005, by us or on our behalf.

 

Issuer Purchase of Equity Securities

 

 

 

 

 

We derived the selected historical consolidated financial data presented below from our audited consolidated financial statements and related notes included elsewhere in this filing. You should refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the notes to the accompanying consolidated financial statements for additional information regarding the financial data presented below, including matters that might cause this data not to be indicative of our future financial condition or results of operations. In addition, you should note the following information regarding the selected historical consolidated financial data presented below.

 

October 31, 2004 and 2003, respectively. We have also adjusted our November 1, 2002 accumulated deficit to recognize corrected items that related to prior periods, increasing the deficit by $1.7 billion.

 

 

We operate in four industry segments: Truck, Engine, Parts, and Financial Services. A detailed description of our segments, products, and services, as well as additional selected financial data is included in “Our Operating Segments” in Item 1 and in Note 19, Segment reporting, to the accompanying consolidated financial statements.

 

Three-Year Summary of Selected Financial and Statistical Data (Unaudited)

 

 

 

 

 

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 this Annual Report on Form 10-K. Information in this Item is intended to assist the reader in obtaining an understanding of our consolidated financial statements, the changes in certain key items in those financial statements from year to year, the primary factors that accounted for those changes, any known trends or uncertainties that we are aware of that may have a material affect on our future performance, as well as how certain accounting principles affect Navistar’s consolidated financial statements. In addition, this Item provides information about our business segments and how the results of those segments impact the results of operations and financial condition of Navistar as a whole. MD&A includes the following sections:

 

 

 

 

 

 

Highlights and Executive Summary

 

We are an international manufacturer of class 4 through 8 trucks and buses and diesel engines, and a provider of proprietary and aftermarket parts for all-makes of trucks and trailers. 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, and Financial Services.

 

Since January 2006, we have focused a substantial amount of attention and resources addressing various accounting and financial issues. During that time, we determined it was necessary to restate financial results for 2003 and 2004 as well as for the first three quarters of 2005. The effects of the restatement on periods prior to 2003 have been presented as reductions of stockholders’ equity as of November 1, 2002, the beginning of our 2003 year. For further detail on the impact of the restatement on our previously stated financial results see Note 2, Restatement and reclassification of previously issued consolidated financial statements, to the accompanying consolidated financial statements in this Annual Report on Form 10-K. Except as otherwise specified, all information presented in this Item, the accompanying consolidated financial statements, and the related notes include all such restatements. The process of restating and re-auditing the consolidated financial

statements required considerable efforts at a significant financial cost to us. For a description of the costs related to these efforts, see “Key Trends and Business Outlook” in this Item.

 

Our business is heavily influenced by the overall performance of the “traditional” medium and heavy truck industry, which includes vehicles in weight classes 6 through 8, including buses. These markets are typically cyclical in nature but in 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 the U.S. EPA. To reduce cyclicality, our strategy is to grow our Parts segment and our presence in non-cyclical “expansion” markets such as the military, RV and export markets. In addition, we continue to focus on improving the cost structure in our Truck and Engine segments while delivering products of distinction.

 

Unit growth in both the Truck and Engine segments was strong in 2005 and 2004, indicating strong fundamentals in the markets we served. World-wide Truck segment units invoiced to customers were 130,100 in 2005, an increase of 18.4% compared to 2004. Likewise, world-wide Truck segment units invoiced to customers were 109,900 in 2004, an increase of 30.2% compared to 2003. World-wide order backlogs were 27,800 units at the end of 2005, and 27,900 units in 2004 as compared to 23,400 in 2003. Total Engine segment units, which include units delivered both to OEMs and to our Truck segment, were 522,600 in 2005 and 432,200 in 2004, compared to 394,900 in 2003. Strategic acquisitions also allowed us to further our growth strategy. In 2005, we completed the acquisitions of MWM, a leading Brazilian diesel engine producer; WCC, a leading manufacturer of chassis for motor homes and commercial step vans; and Uptime Parts, a parts distribution network that supplies commercial fleets and RV dealers.

 

In 2005 and 2004, unit volume growth was the major factor of our sales performance with pricing on new trucks also contributing to growth in our net sales and revenues. The traditional truck retail industry experienced a recovery in 2005 and 2004 from the bottom-of-the-cycle periods experienced in 2003 and immediately prior. In addition, we also benefited in 2005 from our acquisition of MWM, which contributed the majority of our other non-Ford customer growth of 64,500 units as compared to 2004. Consolidated net sales and revenues grew steadily to $12.1 billion in 2005 from $9.7 billion in 2004 and $7.7 billion in 2003, representing an increase of 57.6% over two years.

 

Our results improved from year-to-year during the years ended October 31, 2005 and 2004. In 2005, we achieved net income of $139 million, compared to a loss of $44 million in 2004 and a loss of $333 million in 2003. The progressive improvements were accomplished by achieving operating improvements year-over-year and overcoming the significant engineering, product development, selling, general and administrative, and warranty costs associated with the introduction of our 2004 emissions-compliant engine into the marketplace. Since then, our focus on reliability and quality has produced a significantly improved 2007 emissions-compliant engine, currently in the market, along with our MaxxForce brand engines and our ProStar^tm long-haul truck. We also grew our business through our strategy of leveraging our acquisitions and strategic relationships. Diluted earnings per share was $1.90 in 2005, compared to losses per share of $0.64 and $4.86 in 2004 and 2003, respectively, reflecting an improvement of $6.76 per share on a diluted basis from 2003 to 2005.

A summary of our consolidated earnings, including diluted earnings per share, for the years 2005 through 2003, are as follows:

 

Consolidated Results of Operations

 

 

Overview

 

Our Business

 

NIC is a holding company whose individual units provide integrated and best-in-class transportation solutions. Based in Warrenville, Illinois, we produce International brand commercial trucks, International and MaxxForce brand diesel engines, IC brand buses, and WCC brand chassis for motor homes and step-vans. We are a private-label designer and manufacturer of diesel engines for the pickup truck, van, and SUV markets. We also provide truck and diesel engine service parts. A wholly owned subsidiary offers financing services.

 

Restatement and Re-audit

 

This Annual Report on Form 10-K for the year ended October 31, 2005 is our first filing with the SEC that includes comprehensive financial statements since our Quarterly Report on Form 10-Q for the quarter ended July 31, 2005. All information presented in this Annual Report on Form 10-K reflects restated consolidated financial statements for the years ended October 31, 2002 through 2004 and the first three quarters of the year ended October 31, 2005.

 

The restatement resulted in a cumulative net reduction to stockholders’ equity of $2.4 billion and $2.0 billion as of October 31, 2004 and 2003, respectively, and a reduction in previously reported net income of $291 million and $312 million for the years ended October 31, 2004 and 2003, respectively. Our restated quarterly results of operations and financial condition are provided in this Item, within “2005 Quarterly Results (unaudited).” The impact of restatement adjustments is detailed in Note 2, Restatement and reclassification of previously issued consolidated financial statements, to the accompanying consolidated financial statements. We have also adjusted our November 1, 2002 accumulated deficit to recognize corrected items that related to prior periods, increasing the deficit by $1.7 billion.

 

For additional information and a detailed discussion of the restatement, see Note 2, Restatement and reclassification of previously issued consolidated financial statements, to the accompanying consolidated financial statements.

 

Key Trends and Business Outlook

 

Vision and Strategy

 

We plan to leverage our investments and those of our strategic partners in product development and facilities that have already been established. Our strategy is to make products of distinction in a competitive cost structure while growing profitably. We intend to accomplish this by:

 

 

 

Leveraging the strength of our large dealer network allows us to have a competitive advantage over other OEMs. Our truck products are distributed in virtually all key markets in the U.S. and Canada. Regional operations in the U.S. and general offices in Canada and Mexico support retail dealer activity. We have an extensive dealer network in Mexico and export markets worldwide, including in Latin America, the Middle East, Africa and Pacific Asia. These dealers provide a full range of services, including new truck sales, parts, and technical service support to fleet and other customers in their respective markets.

 

We also have a national account sales group, responsible for major U.S. national account customers, and a network of used truck centers in the U.S. that provides trade-in support to our dealers and national accounts group for all markets and makes and models of reconditioned used trucks to owner-operators and fleet buyers. In support of our dealer network and fleet customers we also operate regional parts distribution centers that are strategically located in key areas within North America offering a wide range of proprietary and standard service parts, order status information, and technical support. In addition, we provide retail, wholesale and lease financing of products sold by the truck segment and its dealers within the U.S. and Mexico.

 

Acquisitions, Strategic Agreements and Joint Ventures

 

We continuously seek and evaluate opportunities in the marketplace that provide us with the ability to leverage new technology, expand our engineering expertise, provide entry into “expansion” markets, and identify component and material sourcing alternatives. During the recent past, we have entered into a number of collaborative strategic relationships and have acquired businesses that allowed us to generate manufacturing efficiencies, economies of scale and market growth opportunities. We also routinely re-evaluate our existing relationships to determine whether they continue to provide the benefits we originally envisioned.

 

In 2005, we completed two acquisitions that furthered our growth strategy and expanded our product offerings. In the second quarter of 2005, we acquired MWM, a Brazilian entity, which produces a broad line of medium and high-speed diesel engines across the 50 to 310 horsepower range. The acquisition adds to our engineering capability, allows us to better serve customers in the South American market and broadens our customer base with other OEMs. In the fourth quarter of 2005, we acquired WCC, a U.S. manufacturer of chassis for motor homes and commercial step-van vehicles and Uptime, a U.S. parts distribution network that supplies commercial fleets and RV dealers. These acquisitions represent strategic investments in businesses that are in new markets, and provide the opportunity to grow our sales of diesel engines and parts.

 

Also in 2005, we entered into a strategic agreement in Europe and a joint venture in Asia that furthered our growth and competitive cost structure strategies. In the first quarter of 2005, we signed an agreement with a German engine producer, MAN, to develop and produce MaxxForce Big-Bore engines in the 11 and 13 liter range to be offered in our class 8 highway tractors and severe service trucks starting in the fourth quarter of 2007. This agreement allows us to grow the diesel engine business while controlling costs by leveraging the existing investment that MAN has made in the development of these engines. In December 2005, we finalized our first joint venture with Mahindra & Mahindra, Ltd., a leading Indian manufacturer of multi-utility vehicles and tractors. This venture operates under the name of Mahindra International, Ltd. and will be used to produce and market light, medium and heavy commercial vehicles in India and other export markets beginning in 2007. This collaboration also provides us the opportunity to use India as a significant supply base for the

global sourcing of components and materials and provides a strategic partner for engineering services. We have a 49% interest in this venture.

 

In July 2007, Core Molding Technologies, Inc. (CMT) repurchased 3.6 million shares of its common stock from us. As a result of this repurchase transaction, our ownership interest in CMT was reduced to 9.9%.

 

As disclosed in prior filings, we entered into a joint venture with Ford in September 2001 to capitalize on our mutual medium truck volumes. The BDT joint venture was formed to produce class 3 through 7 commercial vehicles; marketed independently under International and Ford brand names. On September 28, 2007, we informed Ford of our decision to terminate this agreement effective on September 28, 2009. However, upon either party’s request and under commercially reasonable terms, we will continue to supply each other components and products from the effective date for up to four additional years.

 

In September 2007, we sold our ownership interest in Siemens Diesel Systems Technology, LLC (“SDST”) to our joint venture partner, Siemens VDO Automotive Corporation (“SVDO”).

 

In November 2007, we signed a second joint venture agreement with Mahindra & Mahindra, Ltd. of India to produce diesel engines for medium and heavy commercial trucks and buses in India. We have a 49% ownership in this joint venture. This joint venture will afford us the opportunity to enter a market in India that has significant growth potential for commercial vehicles and diesel power.

 

Key Trends

 

For periods subsequent to 2005, certain factors are expected to affect results of operations as compared to results reported herein for 2003 through 2005. Some of these factors are as follows:

 

 

 

These external resource costs are in addition to the costs of approximately 100 people we added to our internal staff in the U.S. since the restatement process began. We expect that these professional fees will decline significantly after we become current with our SEC filings.

 

 

 

Results of Operations and Segment Review

 

The following table summarizes our consolidated statements of operations and illustrates the key financial indicators used to assess the consolidated financial results. Financial information is presented for the years ended October 31, 2005, 2004, and 2003, as prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).

 

Results of Operations:

 

 

Results of Operations for 2005 as Compared to 2004

 

 

Sales and Revenues

 

In 2005, we grew net sales and revenues 25.3% as compared to 2004. This increase was attributed primarily to our Truck and Engine segments which increased net sales and revenues by $1.8 billion and $0.6 billion, respectively, over 2004.

 

Our Truck segment was our largest segment as measured in net sales and revenues, representing 65.6% and 64.0% of total consolidated net sales and revenues for 2005 and 2004, respectively. Sales and revenue growth at this segment was 28.3% in 2005 as compared to 2004. In both 2005 and 2004, the Truck segment

benefited from an increase in the overall “traditional” markets which was experiencing an upswing in the cycle after rebounding from the bottom-of-the-cycle periods experienced in 2003 and immediately prior. This industry upswing was attributable, in part, to strong underlying economic growth and the need to replace aging fleets of trucks. Share gains in the bus and class 8 severe service markets compared to 2004 also contributed to sales growth at this segment. In 2005, the Truck segment’s Bus, Medium and Severe Service classes all led their markets with the greatest relative retail market share in each of their classes. Furthermore, price performance and growth in our “expansion” markets contributed, although to a lesser extent, to overall sales and revenue growth. Growth in our expansion markets was primarily the result of strength in the Mexican truck industry and other export markets.

 

Our Engine segment was our second largest segment in net sales and revenues, representing an increase of 24.2% for 2005 as compared to 2004. During 2005, we acquired MWM, which expanded our customer base and contributed a majority of the 64,500 other non-Ford customer unit growth compared to 2004. An increase in the relative ratio of diesel to gas trucks produced in the heavy duty pick-up truck market from 65% in 2004 to 71% in 2005 provided a substantial increase in units shipped to Ford in North America compared to the prior year. In addition, the Engine segment also benefited from an increase in other non-Ford OEM sales attributable to strength in the truck industry, and was further bolstered by improvements in our engine reliability and quality metrics compared to the prior year.

 

Our Parts segment grew net sales 12.2% in 2005 as compared to 2004. This growth was partially due to favorable economic factors that impacted the service parts industry, such as an increase in the amount of freight tonnage hauled and number of trucks in operation. Growth was further attributable to this segment’s ability to reach new markets. In 2005, 17 new dealer-owned or joint venture parts and service locations were opened, bringing the total locations in operation to 33 at October 31, 2005. In addition, the Parts segment grew net sales and revenues at existing locations. This was achieved by our ability to enhance the fleet customer experience and to expand product offerings that broadened our scope and distribution network.

 

Our Financial Services segment grew net revenues 10.6% in 2005 as compared to 2004. During this time, sold receivables were at an all-time high of $1.9 billion, attributable in part to strength in the truck industry. Also contributing to revenue growth was a more attractive purchase financing environment for equipment users influenced by lower net interest rates, greater industry sales incentives, and a stronger used vehicle market. This shift from a strong operating lease environment to a purchase financing environment was evidenced by a decrease in rental income of 31.5% in 2005 compared to 2004.

 

Costs and Expenses

 

Cost of products sold increased 24.0% for 2005 as compared to 2004. As a percentage of net sales of manufactured products, Cost of products sold decreased from 88.1% in 2004 to 86.7% in 2005. Included in Cost of products sold are product warranty costs and postretirement expense. Product warranty costs, net of vendor recoveries and excluding extended warranty program costs, was $372 million in 2005 and $389 million in 2004. Postretirement expense, included in Cost of products sold, inclusive of company 401(k) contributions were $75 million in 2005 and $78 million in 2004. Excluding warranty costs, net of vendor recoveries and extended warranty program costs, and postretirement expense, Cost of products sold as a percentage of net sales of manufactured products decreased slightly from 83.1% in 2004 to 82.9% in 2005. A combination of design changes, material substitution, resourcing, global sourcing, and price performance offset a steady rise in commodity and direct material costs. In addition, we also experienced decreases in our product liability and asbestos-related expenses in 2005 as compared to 2004.

 

The decrease in product warranty costs, excluding extended warranty program costs and net of vendor recoveries, of $17 million from 2004 to 2005 was primarily the result of lower expenses associated with 2005 model-year products at the Truck and Engine segments, partially offset by the impact of higher volumes. In 2005 we incurred $110 million of product warranty costs associated with adjustments to pre-existing warranties. These adjustments reflect changes in our estimate of warranty costs for sales recognized in prior

years. Approximately $74 million of the $110 million was expensed at the Engine Segment and $36 million was expensed at the Truck Segment.

 

In 2004, product warranty costs, excluding extended warranty program expenses and net of vendor recoveries, at the Engine segment were $227 million, $54 million higher than 2005. These higher costs were associated with the launch of our 2004 emissions-compliant engines. In 2005, significant resources were dedicated to mitigating warranty claims and controlling the quality of the 2004 emissions-compliant engines. As a result, net warranty costs were significantly improved in 2005 as compared to 2004. Increases in volumes at the Engine segment in 2005 as compared to 2004 also had the effect of increasing net product warranty costs, as costs are accrued per unit based on expected warranty claims that incorporate historical information and forward assumptions about the nature, frequency, and average cost of warranty claims. We accrue warranty related costs under standard warranty terms and for claims that we choose to pay as an accommodation to our customers even though we are not contractually obligated to do so (“out-of-policy”). For more information, see Note 1, Summary of significant accounting policies, to the accompanying consolidated financial statements. Product warranty costs, excluding extended warranty program expenses and net of vendor recoveries, at the Truck segment were $194 million in 2005, an increase of $38 million compared to the prior year. These increases were primarily attributable to increased volumes at the Truck segment in 2005 compared to 2004 as well as higher levels of out-of-policy claims.

 

In 2005, total postretirement expenses, inclusive of company 401(k) contributions, were $246 million, relatively unchanged from the $237 million incurred in 2004. Postretirement expenses are included in Cost of products sold, Selling, general and administrative expense, and Engineering and product development costs, at approximately 30%, 65%, and 5% of total expenses, respectively. Included in these expenses are lower costs associated with the Medicare subsidy which was applied in 2004, as well as lower annual expenses associated with a longer amortization period on our hourly non-contributory plan. The longer amortization period was the result of a 2002 early-retirement program which indirectly resulted in an increase in the remaining service period of the remaining plan participants. For more information regarding the Medicare subsidy, see Note 12, Postretirement benefits, to the accompanying consolidated financial statements.

 

Direct costs were also impacted by industry-wide increases in commodity and fuel prices which affected the Engine, Truck and Parts segments. Costs related to steel, precious metals, resins and petroleum products increased in 2005 and 2004, as compared to the respective prior year. However, we generally we have been able to mitigate the effects by our efforts to reduce costs through a combination of design changes, material substitution, resourcing, global sourcing, and price performance.

 

Selling, general and administrative expense increased 13.6% in 2005 as compared to 2004. This increase was primarily a result of the acquisition of four International dealer operations (“Dealcor”) in 2005. In an effort to strengthen and maintain our dealer network, our Truck segment occasionally acquires and operates dealer locations for the purpose of transitioning ownership or providing temporary operational assistance. In addition, increases in Selling, general and administrative expense were also attributable to the acquisition of Brazilian engine manufacturer MWM in the second quarter of 2005, and to a lesser degree, WCC in the fourth quarter of 2005. Also included in Selling, general and administrative expense is a portion of the total postretirement expense. This total declined slightly in 2005 from 2004 levels. Net sales and revenues growth, however, outpaced increases in Selling, general and administrative expense. As such, our ratio of Selling, general and administrative expense to net sales and revenues improved by approximately one percentage point from 9.7% in 2004 to 8.8% in 2005. It is typical that we will experience an improvement in this ratio in “traditional” market industry upswing years, and the inverse in downturn years.

 

Engineering and product development costs increased 43.9% in 2005 as compared to 2004. Engineering and product development costs were primarily incurred by our Truck and Engine segments for innovation and cost reduction, and to provide our customers with product and fuel-usage efficiencies. In 2005, a significant amount of our Engineering and product development costs were incurred for the purpose of making significant improvements in the quality and reliability of our 2004 emissions-compliant engines and vehicles. Engineering and product development costs incurred at our Engine segment increased $72 million or 57.1% in 2005 as compared to the prior year 2004. This increase was due primarily to our improving the quality of our 2004

emissions-compliant engines. The result of these efforts was greater reliability, higher quality, and a decrease in 2005 warranty cost, that lowered the Cost of products sold at this segment. During 2005, we incurred a higher level of costs than in 2004 associated with the development of the MaxxForce Big-Bore engine line and our 2007 emissions-compliant products. Engineering and product development costs incurred at the Truck segment were $54 million or 36.2% higher in 2005 as compared to 2004, due primarily to the development of our ProStar class 8 long haul truck. In addition, we also incurred higher costs in 2005 than in 2004 related to the development of our 2007 emissions-compliant products.

 

In 2000 and 2002, our Board of Directors approved separate plans (“Plans of Restructuring”) to restructure certain manufacturing and corporate operations. During 2005, we realized a $2 million net reduction to our restructuring reserves. This reduction was substantially attributed to revised estimates of our lease obligation related to our prior corporate office in Chicago, Illinois, and lower exit and closure costs than previously estimated for facility closures. In 2004, the additional charge of $8 million was primarily related to amounts we contractually owed to suppliers related to Ford’s cancellation of the V-6 diesel engine supply program. See Note 14, Restructuring and program termination charges to the accompanying consolidated financial statements for more information.

 

Interest expense increased 30.0% in 2005, as compared to 2004. Approximately half of this increase was a result of higher debt levels by our manufacturing operations. The remainder of the increase was incurred by our Financial Service segment from a combination of increased levels of funding and higher interest rates on existing debt. For more information, see Note 11, Debt, to the accompanying consolidated financial statements.

 

Other expense (income), net amounted to $10 million of expense in 2004, which included $30 million from Ford due to the discontinuance of a product program; recognition of the income occurred upon expiration of a contingency provision. For further detail, see Note 14, Restructuring and program termination charges, to the accompanying consolidated financial statements. Other expense (income), net in 2005 amounted to $33 million of expense.

 

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 eight other partially-owned affiliates. We reported $90 million of income in 2005, as compared to $36 million in 2004. A significant reason for the change is that we recorded a $27 million loss on an investment when we discontinued purchasing certain engine components from one of our non-consolidated affiliates and agreed to reimburse the affiliate for the unamortized value of related equipment. For more information, see Note 10, Investments in and advances to non-consolidated affiliates, to the accompanying consolidated financial statements.

 

Income Taxes

 

Income tax expense was $6 million in 2005 as compared to $9 million in 2004. The Income tax expense for 2005 and 2004 was favorably impacted by the release of $67 million and $36 million, respectively, of valuation allowances with respect to foreign operations. The valuation allowance was decreased in 2005 by $32 million and increased in 2004 by $98 million with respect to domestic operations. Until we are able to release the valuation allowance, income tax expense will generally be limited to current state taxes, federal alternative minimum taxes, and foreign taxes.

Net Income and Earnings Per Share

 

For the year ended October 31, 2005, we recorded net income of $139 million, an improvement of $183 million as compared to the prior year.

 

Diluted earnings per share for 2005 was $1.90, calculated on approximately 76 million shares. For 2004, our diluted loss per share was $0.64, calculated on approximately 70 million shares. Diluted shares reflect the impact of our convertible securities including common stock options, convertible debt and exchangeable debt in accordance with the treasury stock and if-converted methods. The increase of approximately 6 million diluted shares from 2004 to 2005 was primarily the result of including the dilutive effect of stock options not included in the 2004 calculation because they would have had an anti-dilutive effect in 2004. For further detail on the calculation of diluted earnings per share, see Note 21, Earnings (loss) per share, to the accompanying consolidated financial statements.

 

Results of Operations for 2004 as Compared to 2003

 

 

Sales and Revenues

 

In 2004, net sales and revenues grew 25.8% as compared to 2003. This increase was attributed primarily to our Truck and Engine segments, which increased net sales and revenues by $1.6 billion and $0.4 billion, respectively, over 2003.

 

Our Truck segment was our largest segment as measured in net sales and revenues, representing 64.0% and 59.5% of total consolidated net sales and revenues for 2004 and 2003, respectively. Net sales and revenues growth was 35.4% in 2004 as compared to 2003. In 2004, the Truck segment benefited from an increase in the overall “traditional” market industry which was experiencing an upswing in the cycle after rebounding from the bottom-of-the-cycle periods experienced in 2003 and immediately prior. This industry upswing was attributable, in part, to strong underlying economic growth and the need to replace aging fleets of trucks. Retail market share gains in 2004 in the class 8 heavy truck market more than offset the market share losses in the bus and medium 6/7 market classes. Heavy truck market share increased from 13.9% in 2003 to 17.1% in 2004, as we aggressively pursued market share growth through competitive actions. During this time we also announced our commitment to develop and manufacture the ProStar class 8 long haul truck, our first redesign of this class model in over 35 years. Market share loss in the bus and medium 6/7 classes was primarily attributable to increased competitive pressures. Furthermore, pricing and performance growth in our expansion markets, primarily Mexican markets, contributed to a lesser extent to overall sales and revenues growth.

Our Engine segment was our second largest segment as measured in net sales and revenues, representing an increase of 16.7% for 2004 as compared to 2003. In 2004, the Engine segment shipped 432,200 engines, the highest level of unit shipments in our history at the time. The relative ratio of diesel to gas trucks produced in the heavy duty pick-up truck market increased substantially from 60% in 2003 to 65% in 2004. Units shipped to Ford accounted for approximately 71.5% of the 37,300 increase in units shipped in 2004 compared to 2003. The remaining portion of the unit growth was derived from intercompany and other non-Ford OEM sales and was attributed to strength in the truck industry as mentioned above.

 

Our Parts segment grew net sales 13.5% in 2004 as compared to 2003. This growth was due to favorable economic factors that impacted the service parts industry such as an increase in the amount of freight tonnage hauled and number of trucks in operation. Additionally, we were able to grow the business by focusing on market penetration through the introduction of new product offerings, acquiring new fleet business and better supporting our existing fleet business and instituting improvements in our customer service operations.

 

In 2004, the Financial Services segment’s net revenue declined 5.3% as compared to the prior year. This decline was primarily attributable to lower market interest rates and the subsequent shift of new business away from traditional operating leases towards purchase finance leases.

 

Costs and Expenses

 

Cost of products sold increased 24.0% for 2004 as compared to 2003. As a percentage of net sales of manufactured products, Cost of products sold decreased from 90.5% in 2003 to 88.1% in 2004, attributed primarily to cost reduction initiatives, pricing performance, economies of scale and decreases in our product liability and asbestos-related expenses. Included in Cost of products sold are net product warranty costs and postretirement expense. Product warranty costs, net of vendor recoveries and extended warranty program expense, were $389 million in 2004 and $197 million in 2003. Postretirement expense, included in Cost of products sold, inclusive of company 401(k) contributions, were $78 million in 2004 and $112 million in 2003. Excluding warranty costs, net of vendor recoveries and extended warranty program expense, and postretirement expense, Cost of products sold as a percentage of net sales of manufactured products decreased from 86.3% in 2003 to 83.1% in 2004.

 

The increase in warranty costs of $192 million, net of vendor recoveries and extended warranty program costs, was primarily the result of higher costs associated with 2004 emissions-compliant engines and trucks as well as the impact of higher volumes. In 2004, product warranty costs, net of vendor recoveries and extended warranty program expense, at the Engine segment were $227 million, $135 million higher than 2003. 2004 emission standard regulations were the most stringent encountered to that time and required significant modifications to our engines in order to meet nitrogen oxide and particulate matter reduction requirements. Increases in volumes at the Engine segment in 2004 increased product warranty costs, as costs are accrued for each unit sold. Product warranty costs, net of vendor recoveries and extended warranty program expense, at the Truck segment were $156 million, an increase of $61 million compared to the prior year. The increase was primarily attributable to the integration of the 2004 emissions-compliant engine into our trucks as well as greater volumes sold at the Truck segment in 2004 as compared to 2003.

 

In 2004 postretirement expense, inclusive of company 401(k) contributions, was $237 million, an improvement of $137 million compared to 2003. Postretirement expense is included in Cost of products sold, Engineering and product development costs, and Selling, general and administrative expense, at approximately 30%, 65%, and 50% of total expenses, respectively. This improvement in postretirement expense from 2003 to 2004 was attributable to a combination of higher returns on plan assets, lower expense associated with the retroactive application of the Medicare subsidy, and lower annual expense associated with a longer amortization period on our hourly noncontributory plan. The longer amortization period was the result of a 2002 early retirement program which indirectly resulted in an increase in the remaining service period of the remaining

plan participants. For more information regarding the Medicare subsidy, see Note 12, Postretirement benefits, to the accompanying consolidated financial statements.

 

Other than net warranty costs and postretirement expenses, direct costs were impacted by industry-wide increases in commodity and fuel prices which affected the Engine, Truck, and Parts segments. Cost increases related to steel, precious metals, resins, and petroleum products increased in 2004 and 2003, as compared to the respective prior year. However, we generally have been able to mitigate the effects by our efforts to reduce costs through a combination of design changes, material substitution, resourcing, global sourcing, and price performance.

 

Selling, general and administrative expense increased 4.0% in 2004 as compared to 2003. This increase in Selling, general and administrative expense primarily resulted from increases in labor costs needed to support our net sales growth and the acquisition of four new Dealcor facilities in 2004. Also included in Selling, general and administrative expense is a portion of the total postretirement expense. This expense improved in 2004 by $99 million from 2003 levels as discussed above. Despite these higher costs, our net sales and revenue growth outpaced our increases in Selling, general, and administrative expense. As such, our ratio of Selling, general and administrative expense to net sales and revenues improved by two percentage points from 11.7% in 2003 to 9.7% in 2004.

 

Engineering and product development costs increased 6.3% in 2004 as compared to 2003. Engineering and product development costs were primarily incurred by our Truck and Engine segments. In 2004, our consolidated Engineering and product development costs were $287 million as compared to $270 million in 2003. The Truck segment had a $32 million, or 27.4%, increase in Engineering and product development costs in 2004 as compared to 2003, due primarily to the development of our ProStar class 8 long haul truck which began in 2004. In addition, we incurred costs related to the development of our 2007 emissions-compliant vehicles at a greater level in 2004 than in 2003. Our Engine segment Engineering and product development costs decreased $13 million in 2004, as compared to 2003. This decrease was due primarily to the fact that costs associated with the development of the 2004 emissions-compliant engine were incurred in 2003 but were not incurred in 2004. Partially offsetting this decrease was the cost of development related to our 2007 emissions-compliant engines and the Maxxforce Big-Bore engine line, as well as our ongoing efforts to provide our customers with product improvements and cost reductions.

 

In 2004, we recorded Restructuring and program termination charges of $8 million, primarily related to amounts that we contractually owed to suppliers impacted by Ford’s cancellation of our V-6 diesel engine supply contract. In 2003, we recorded Restructuring and program termination charges of $28 million, of which $10 million was included in Cost of products sold and $18 million was included in Restructuring and program termination charges (credits). This charge was driven by a curtailment loss of $25 million related to the early retirement of certain UAW employees, a $20 million charge related to amounts that we contractually owed to suppliers impacted by Ford’s cancellation of our V-6 diesel engine supply contract, offset by the reversal of $27 million of employee severance reserves related to our decision to keep our Chatham, Ontario plant open, as well as other changes in expected employee reductions. See Note 14, Restructuring and program termination charges, to the accompanying consolidated financial statements for additional information.

 

Interest expense decreased 11.2% in 2004 as compared to 2003. The reduction in Interest expense was due to a reduction in market interest rates on outstanding debt. Additionally, the effects of favorable interest rates on certain finance lease transactions in 2003 contributed to the Interest expense reduction. For more information, see Note 11, Debt, to the accompanying consolidated financial statements.

 

Other expense (income), net amounted to $64 million of income in 2003, which included $65 million received from Ford due to the discontinuance of a product program. Other expense (income), net in 2004 amounted to $10 million of expense, which included $30 million from that program discontinuance; recognition of the income occurred upon expiration of a contingency provision. For further detail, see Note 14, Restructuring and program termination charges, to the accompanying consolidated financial statements.

Equity in income of non-consolidated affiliates

 

Equity in income of non-consolidated affiliates declined by $17 million in 2004 compared to 2003. A majority of this decline was attributed to the recognition of a $27 million loss on an investment as a result of the discontinuance of purchasing certain engine components from one of our non-consolidated affiliates and our agreement to reimburse this affiliate for the unamortized value of the related equipment. For more information, see Note 10, Investments in and advances to non-consolidated affiliates, to the accompanying consolidated financial statements.

 

Income Tax

 

Income tax expense was $9 million in 2004 as compared to $17 million in 2003. The income tax expense for 2004 was favorably impacted by the release of $36 million of valuation allowances with respect to foreign operations. The valuation allowance was increased in 2004 and 2003 by $98 million and $97 million, respectively, with respect to domestic operations. Until we are able to release the valuation allowance, income tax expense will generally be limited to current state taxes, federal alternative minimum taxes, and foreign taxes.

 

Net Income and Earnings Per Share

 

For the year ended October 31, 2004, we recorded a Net loss of $44 million, an improvement of $289 million as compared to the prior year.

 

Diluted loss per share for 2004 was $0.64, calculated on approximately 70 million shares. For 2003, our Diluted loss per share was $4.86, calculated on approximately 69 million shares. Stock options were not included in the 2004 and 2003 calculations of Diluted loss per share because they would have had an anti-dilutive effect. For further detail on the calculation of diluted earnings per share, see Note 21, Earnings (loss) per share, to the accompanying consolidated financial statements.

 

Segment Results of Operations

 

The following sections analyze operating results as they relate to our four industry segments.

 

Truck Segment

 

The Truck segment manufactures and distributes a full line of class 4 through 8 trucks and buses in the common carrier, private carrier, government/service, leasing, construction, energy/petroleum, and student transportation markets under the International and IC brands. We also produce chassis for motor homes and commercial step-van vehicles under the WCC brand.

 

The following tables summarize our Truck segment’s financial and key operating results for the years ended October 31:

 

 

 

 

 

 

Truck Segment Sales

 

In 2005 and 2004, the Truck segment grew net sales 28.3% and 35.4% over the prior year, respectively. Net sales growth was primarily the result of a strong retail industry and positive trends in market share among the four main vehicle classes that we serve: bus, class 6/7 medium, heavy and severe service trucks. In addition, new truck pricing performance and growth in our expansion markets also drove net sales growth, although to a lesser extent. The “traditional” market, which we define as U.S. and Canadian class 6-8 trucks and buses, are subject to considerable volatility, but operate in a cyclical manner typically spanning 5 to 10 year periods from peak to peak. Key economic indicators that point to growth in the truck industry such as gross domestic product, industrial production and freight tonnage hauled were strong in 2005 and 2004 compared to historical levels. In turn, we observed that the cycle was experiencing an upswing in 2005 and 2004 after rebounding from the bottom-of-the-cycle periods experienced in 2003 and immediately prior. Retail industry units delivered were 414,500 in 2005, and 344,700 in 2004, increases of 20.3% and 30.9% compared to the prior year, respectively. “Traditional” market retail deliveries are categorized by relevant class in the table below. The Truck segment participated in this industry strength and grew “traditional” market sales units by 15,800 units, or 15.7%, and 25,000 units, or 33.0%, in 2005 and 2004, respectively, as shown in the above table.

The following table summarizes industry retail deliveries, in the “traditional” truck markets in the U.S. and Canada, in units, according to Wards Communications and R.L. Polk & Co., for the years ended October 31.

 

 

The following table summarizes our retail delivery market share percentages, for the years ended October 31.

 

 

We view retail market share as a key metric that allows us to obtain a quantitative measure of our relative competitive performance in the marketplace. This metric is one of many which we rely upon to determine performance, and our focus on market share is concentrated, in general, on the individual performance of the classes that comprise our “traditional” truck market. An output of this is a consolidated traditional truck market share figure which is subject to the effects of portfolio mix and, as such, is a less meaningful metric for us to determine overall relative competitive performance.

 

In 2005, our bus, medium and severe service classes all led their markets with the greatest retail market share in each of their classes. Our strategy is to maintain and grow these market share positions while aggressively pursuing market share gains in the heavy truck class, the class in which we have the lowest market share. Beginning in 2004, we demonstrated our long-term commitment to the heavy truck market by announcing our intention to develop and manufacture the ProStar class 8 long haul truck, our first redesign of this class model in over 35 years. Our reengagement in this class allowed us to grow market share, establish scale and supplier relationships, and set the stage for the introduction of the ProStar truck, which was placed into production in January of 2007. As a result, our class 8 heavy truck market share grew 3.2 points to 17.1% in 2004 compared to 2003 and was maintained at this higher level in 2005. Market share in the Bus class of 64.5% in 2005 was primarily attributable to our distribution strategy and our on-going efforts to further engage and support our dealer and customer networks. In addition, we demonstrated to our customers the advantages of our dominant market share position in this class. These strategies were implemented in 2004 in an attempt to regain market share lost to competitive pricing pressures, the result of which was market share gains in 2005 beyond both 2004 and 2003 levels. Market share in the medium 6/7 class declined progressively from 2003 to 2005 as a result of aggressive pricing strategies by competitors and new entrants into this class. Beginning in 2005, we adjusted our pricing and profitability strategies in response to aggressive competition from Ford, Paccar, and Hino. Our severe service class market share grew 0.6 points in 2005 and remained flat in 2004, as compared to the prior year amidst strong industry growth driven by residential and non-residential construction spending and federal transportation spending on highways, bridges, and development and safety

public works. We were able to increase market share in this class in 2005 by targeting these sectors and heavily supporting our dealer network.

 

Net sales grew in our “expansion” markets, which include Mexico, international export, military, recreational vehicles and other truck and bus classes. During 2005, the Mexican truck market grew 28.3% compared to the prior year and experienced moderate growth in 2004, as compared to 2003. During this time we maintained a market share of between approximately 27% and 29%. New products such as the Low-Cab Forward (LCF) vehicle, class 4/5 small bus, and our RV products, as well as our entrance into the military market contributed moderately to sales growth during this time. It is our strategy to grow in these “expansion” markets aggressively in future periods. Pricing also contributed to sales growth in 2005 and 2004 as compared to 2003, to a lesser extent. In general, favorable pricing performance has allowed us to recover some increases in commodity and direct material costs as well as costs associated with emissions compliance.

 

Truck Segment Profit

 

The Truck segment grew to profitability of $142 million from a loss of $17 million in 2004, and a loss of $227 million in 2003. This growth was attributable to our ability to achieve net cost reductions in manufacturing and material costs and to deliver margin benefits associated with the absorption of fixed manufacturing costs over higher volumes. These costs were particularly elevated in 2003 through 2005 compared to historical levels. Net warranty costs are included in Cost of products sold. Generally, we offer one-to-five year warranty coverage for our trucks, although the terms and conditions can vary. In addition, in an effort to strengthen and grow relationships with our customer base we may incur warranty costs for claims that are outside of the contractual obligation period. Warranty costs, net of vendor recoveries, incurred at the truck segment were $194 million, $156 million and $95 million in 2005, 2004 and 2003, respectively. In 2005 and 2004 we incurred higher levels of warranty costs than in 2003, primarily attributed to the launch of 2004 emissions-compliant trucks and standard coverage terms, claims outside of the contractual obligation period, as well as some minor recalls which impacted warranty costs to a lesser extent. Total postretirement benefits expense incurred by the Truck segment, which includes active and retiree pensions and healthcare benefits, were $131 million, $113 million and $164 million in 2005, 2004 and 2003, respectively. Other than warranty costs and postretirement expenses, Cost of products sold for the Truck segment grew at a rate slightly greater than the rate of sales growth in 2005 and 2004. This variance was attributable to the impact of higher material costs, net of cost reductions and fixed costs absorption benefits.

 

In addition to providing efficiencies in our manufacturing process, our strategic relationships also contribute product design and development benefits. In the 2005, 2004, and 2003, the Truck segment’s Engineering and product development costs approximated $203 million, $149 million and $117 million, respectively. Approximately half of our total consolidated Engineering and product development costs were incurred at the Truck segment in 2003 through 2005. During this time, our top developmental priority was establishing our ProStar class 8 long-haul truck and developing our 2007 engine emissions-compliant vehicles, both of which required significant labor, material, outside engineering and prototype tooling. Besides innovation, we also focus resources on continuously improving our existing products as a means of streamlining our manufacturing process, keeping down warranty costs, and providing our customers with product and fuel-usage efficiencies. Selling, general and administrative expense was $606 million, $516 million, and $429 million in 2005, 2004 and 2003, respectively. Increases in Selling, general and administrative expense were primarily attributable to the addition of four new Dealcor facilities added in both 2004 and 2005, the integration of WCC in the fourth quarter of 2005, segment overhead and infrastructure enhancements in support of higher sales levels, and postretirement benefit expense. During this time, our relative ratio of Selling, general and administrative expense to net sales and revenues improved from 9.4% in 2003, to 8.3% in 2004 and 7.6% in 2005.

 

Engine Segment

 

The Engine segment designs and manufactures diesel engines across the 50 through 375 horsepower range for use in our medium class 6/7 trucks, buses, and selected class 8 heavy truck models. Additionally, we

produce diesel engines for other OEM customers, principally Ford, and diesel engines for various industrial and agricultural applications and produce engines for WCC, LCF, and class 5 vehicles.

 

The Engine segment has made a substantial investment, together with Ford, in the BDP joint venture which is responsible for the sale of service parts to our OEM customers. We continue to invest resources in the future development of fuel efficient engines that are emission-compliant without the sacrifice of performance.

 

The following table summarizes our Engine segment’s financial results and sales data for the years ended October 31.

 

 

Engine Segment Sales

 

The Engine segment continues to be our second largest segment as measured in net sales and revenues, representing 26.4% and 26.7% of total consolidated net sales and revenues for 2005 and 2004. The Engine segment grew dollar sales by 24.2% and 16.7% compared to prior year in 2005 and 2004, respectively, driven primarily by unit volume growth. A total of 522,600 units were sold during 2005, which amounted to an increase of 90,400 units compared to 2004. An increase in dieselization rate, the ratio of diesel to gas trucks produced in the heavy duty pickup truck market drove an increase of 25,900 units shipped to Ford in 2005. While units shipped to Ford grew 7.8% in 2005 compared to the prior year, the integration of MWM units had a dilutive effect upon the significance of Ford. Sales of engines to Ford represented 68% of our unit volume in 2005 which compares to 76% for 2004. Sales to other non-Ford customers including intercompany sales, increased approximately 64,500 units largely from the integration of the Brazilian subsidiary, MWM, which we acquired in April of 2005. The acquisition of MWM makes us the leading diesel engine manufacturer in South America. Intercompany units sold to our Truck and Parts segments grew by 3,300 units compared to the prior year, driven by overall demand in the truck industry. Intercompany sales between segments are eliminated upon consolidation of financial results.

 

Total unit sales for 2004 grew 37,300 units compared to 2003. Unit shipments to Ford in 2004 were 26,600 higher than 2003 due to an increase in dieselization rate in the heavy duty pickup truck market. In addition, units shipped to Ford in 2003 were depressed in anticipation of the launch of a new emissions-compliant engine introduced in 2004. Intercompany units sold to the Truck and Parts segments and units sold to other OEM customers, besides Ford, grew in 2004 by 10,600 units driven by increased demand in the overall truck industry.

 

Engine Segment Loss

 

Despite the increasing sales volumes during the three year period ended October 31, 2005, the Engine segment recorded losses for each year during this period. These losses were reduced by income from our Equity in income of non-consolidated affiliates, primarily the BDP joint venture. Losses for the Engine segment amounted to $179 million in 2005, $208 million in 2004, and $60 million in 2003. These losses were attributable to numerous factors which included the following: substantial increases in warranty costs associated with the introduction of the emission-compliant engine in 2004; ongoing engineering and product development costs related to design changes and our commitment to engine reliability improvements;

escalating raw material costs; certain termination charges and an impairment write down in 2005 of certain assets in our Huntsville, Alabama facility; and increasing selling, general and administrative expense associated with the increased sales volumes and the integration of MWM. A sharp increase in expenses in 2004, primarily attributed to increased warranty costs associated with the introduction of the 2004 emissions-compliant engines, resulted in a greater loss in this segment than in 2005 or 2003. In 2005, margins improved compared to the prior year and returned to 2003 levels as we focused on driving improvements at this segment.

 

Net warranty costs in 2004 approximated $227 million, an increase of $135 million compared to 2003, primarily related to the introduction and design of engines manufactured to meet or exceed the newly instituted emissions standards. Our focus during 2005 was to correct for certain performance and design issues with the 2004 emissions-compliant engines which allowed us to provide greater reliability and higher quality performance. The result of these improvements was a more reliable and better performing engine along with a corresponding reduction in our service cost requirements and a decrease in our net warranty costs of $54 million in 2005 compared to 2004.

 

Engineering and product development has been and will continue to be a significant component of our Engine segment. We continue to focus substantial effort on the development of fuel efficient engines with enhanced performance and reliability while meeting or exceeding stricter emission compliance requirements. Beginning in 2002 and continuing throughout 2003, these efforts were primarily directed toward the development of an emissions-compliant diesel engine that met strict 2004 EPA standards. The emission requirements that came into effect in 2004 required a significant effort on our part. Engineering and product development costs for 2005, 2004 and 2003, were $198 million, $126 million and $139 million, respectively. In total, during the three-year period ended October 31, 2005, the Engine segment incurred over $450 million for engineering and product development resources directed towards providing our customers with enhanced product improvements, innovations, and value while improving the reliability and quality of our 2007 emissions compliant engines. The Engine segment’s Engineering and product development costs represented approximately half of our total consolidated Engineering and product development costs for the period 2003 through 2005. Beginning in 2005, our top developmental priorities focused on further design changes to our 2004 diesel engines, the creation of next generation emission-compliant engines for introduction in 2007, and the establishment of our MaxxForce brand engines. Each of these developments required significant resources, outside engineering assistance, and prototype tooling. We introduced the next generation emission-compliant engine late in 2006 and have already begun development on new products that will meet the requirements of the 2010 emissions regulations.

 

We try to anticipate price increases for the purchase of component parts used in the production of our engines. In certain instances, we are able to pass commodity price increases on to our customers if our contracts contain escalation clauses. During the three year period ended October 31, 2005, we were exposed to commodity price increases, particularly for aluminum, copper, precious metals, resins, and steel. In addition to the commodity price increases, we also observed increases in fuel prices which contributed to higher transportation costs for the delivery of these component parts. Generally, we were able to offset some of these increases through pricing. However, we were unable to pass on many of these increases to Ford, our single largest customer. Subsequent to 2005, we renegotiated our contract with Ford to provide terms beneficial to both parties.

 

In 1999, we entered into an agreement with Ford to develop and manufacture a V-6 diesel engine to be used in specific Ford vehicles. In 2002, Ford advised us that its business case for a V-6 diesel engine was not viable and discontinued its program for the use of these engines. We recognized program termination charges, net of adjustments, amounting to $7 million in 2004 and $22 million in 2003 for amounts contractually owed to our suppliers for the Ford V-6 diesel engine program. In 2003, we entered into a settlement agreement with Ford, related to the discontinuance of the V-6 diesel engine program, pursuant to which we received from Ford $95 million to cover certain costs incurred by us associated with the program. Of the $95 million, $30 million was received subject to a contingency provision requiring us to repay that amount to Ford if it was to initiate a new program through us utilizing the V-6 diesel engine by March 15, 2004. We recognized $65 million of income in 2003 and $30 million of income in 2004 following the expiration of the contingency period. In

addition, we recorded a long-lived asset impairment charge in February 2005 amounting to $23 million related to the write down of certain manufacturing assets that have been idle and were effectively abandoned at the Huntsville, Alabama assembly plant. It was determined that these assets had no value since they provided no future service potential. For additional information, see Note 8, Property and Equipment, net and Note 18, Commitments and contingencies, to the accompanying financial statements.

 

Total Selling, general and administrative expense was $146 million in 2005, $108 million in 2004, and $110 million in 2003. Selling, general and administrative expense increased $38 million for 2005 when compared to 2004 primarily as a result of additional expense attributed to the acquisition of MWM in April 2005 and increased legal expense primarily related to the litigation with Caterpillar. In August 2006, we settled all pending litigation with Caterpillar and entered into a new ongoing business relationship that included new licensing and supply agreements. For additional information, see Item 3, Legal Proceedings, in this Annual Report on Form 10-K. Selling, general and administrative expense decreased approximately $2 million for 2004 when compared to 2003.

 

Portions of the total postretirement benefits expense are included in our Cost of products sold, Selling, general and administrative expense, and Engineering and product development costs. Total postretirement benefits expense incurred by the Engine segment, which includes active and retiree pensions and other healthcare benefits, was $53 million, $43 million and $70 million in 2005, 2004 and 2003, respectively.

 

The Engine segment has made substantial investments in various affiliated entities and joint ventures. The most significant Engine segment joint venture in terms of income is BDP. We account for BDP and the other entities using the equity method of accounting and our percentage share of the income associated with these affiliates amounted to $82 million in 2005, $30 million in 2004, and $46 million in 2003. In 2004, income from these affiliates amounted to $57 million but was offset by a $27 million loss on investment associated with our decision to discontinue purchasing certain engine components from one of these affiliates and our agreement to reimburse the affiliate for the unamortized value of the related equipment.

 

Parts Segment

 

The Parts segment provides customers with parts needed to support our International truck and engine lines, International Military Group, IC buses, WCC lines, and the MaxxForce engine lines. In addition, the Parts segment provides customers with a wide selection of standard truck, engine, and trailer aftermarket parts. At the time of filing this Annual Report on Form 10-K, we operate 11 distribution centers strategically located within North America. Through this network we deliver service parts to dealers and customers throughout the US, Canada, and Mexico, as well as to over 50 countries around the world.

 

The following table summarizes our Parts segment’s financial results for the years ended October 31.

 

 

Parts Segment Sales

 

In 2005 and 2004, the Parts segment delivered sales growth of 12.2% and 13.5%, respectively, due primarily to the execution of our strategies, and in collaboration with our dealers, an increase in our penetration in existing markets, expansion into additional product lines, and growth with new and current fleets. The parts aftermarket is a highly competitive, mature industry where improvements in new truck reliability and durability along with new technologies have extended truck-repair and maintenance cycles, limiting the growth of the parts market. We have focused our strategies on growing our sales through our dealer network.

 

The extensive dealer network gives us an advantage in serving our customers. Goods are delivered to our customers either through one of our parts distribution centers or through direct shipment from our suppliers for

parts not generally stocked at our distribution centers. Our distribution network supports a dedicated parts sales team in five regions within the US, one in Canada, one in Mexico, three national account teams focused on large fleet customers, one export team, one government and military team as well as the Truck sales and Technical Service groups. This integrated team works in conjunction to find solutions to support our customers, who include dealers, fleets, other OEMs, and government purchasers of service parts.

 

Parts Segment Profit

 

For 2005 and 2004, profits grew by 17.8% and 21.6% respectively, driven primarily by the implementation of our strategies to increase volume and sell a higher mix of proprietary parts, as discussed above. During this period, our pricing efforts were mostly offset by an escalation in direct costs resulting from increases for steel, resins, and petroleum-based products which have contributed to cost pressures across the industry. We implemented strategies to recover or offset the effects of these cost increases by utilizing global sourcing and working closely with our suppliers to ensure the lowest possible cost, without compromising our shared objectives in quality, delivery, technology, customer market requirements, and overall performance. We strive to work with suppliers who also service our Truck and Engine segments, wherever possible, in order to achieve additional economies of scale.

 

Our relative ratio of Selling, general and administrative expense to net sales and revenues was approximately 11.3% in 2003 and continued to progressively improve by one half percentage point in 2004 and 2005, despite an increase in facilities capacity to support growth in sales and new business development. In addition, we continued to focus on lowering our Selling, general and administrative expense as a strategy to mitigate industry-wide increases in product costs.

 

Financial Services Segment

 

The Financial Services segment provides wholesale, retail, and lease financing to support sales of new and used trucks sold by us and through our dealers in the U.S. and Mexico. This segment also finances our wholesale accounts and selected retail accounts receivable. Sales of new products (including trailers) of other manufacturers by other OEMs are also financed regardless of whether designed or customarily sold for use with our truck products.

 

The following table summarizes this segment’s financial results for the years ended October 31.

 

 

In 2005, the Financial Services segment grew net revenues by 10.6% compared to the prior year with strong growth in finance interest revenue offsetting decreases in rental income. Financial Services revenues include revenues from retail notes and finance leases, operating lease revenues, wholesale notes and retail and wholesale accounts, and loan servicing income. Net revenues in 2005 were higher as compared to 2004 from the combined impact of higher market interest rates to customers and improved note and lease originations and the associated fees. This growth was partially offset by decreases in rental income on operating leases which were down 31.5% compared to 2004. The decline in rental income reflects a shift towards a more attractive purchase financing environment for equipment users resulting from lower interest rates, higher customer incentives and a stronger used vehicle market. Additionally, the Financial Services segment sold receivables at a record level of $1.9 billion in 2005.

 

Financial Services revenues decreased in 2004, as compared to 2003, reflecting steady interest rates and a marginal decrease in note and lease originations. Furthermore, rental income on operating leases was down 15.4% compared to the prior year, also as a result of a shift in customer movement towards a more attractive purchase financing environment. Despite these factors, the segment experienced profit growth in 2004 as compared to the prior year as depreciation expense, Selling, general and administrative expense, and property taxes declined.

The Financial Services segment also receives interest income from the Truck and Parts segments and corporate relating to financing of wholesale notes, wholesale accounts, and retail accounts. The Financial Services segment receives interest income at agreed upon interest rates applied to the average outstanding balances less interest amounts paid by dealers on wholesale notes and wholesale accounts. This income is eliminated upon consolidation of financial results. Substantially all revenues earned on wholesale accounts and retail accounts are received from other segments. Aggregate interest revenue provided by the Truck and Parts segments and corporate was $90 million in 2005, $58 million in 2004, and $47 million in 2003.

 

We may be liable for certain losses on finance receivables and investments in equipment on operating leases and may be required to repurchase the repossessed collateral at the receivable principal value. In 2005, 2004, and 2003, losses totaled $3 million, $5 million and $14 million, respectively.

 

Contractual maturities of finance receivables for our financial services segment as of October 31, 2005 are summarized as follows:

 

 

Investments in operating leases at October 31 were as follows:

 

 

Future minimum rental income from investments in operating leases are as follows: 2006, $19 million; 2007, $16 million; 2008, $12 million; 2009, $8 million; 2010, $4 million; and $2 million thereafter.

 

Liquidity and Capital Resources

 

Cash Requirements

 

The company generates cash flow primarily from the sale of trucks, diesel engines and service parts. In addition, we generate cash flow from product financing provided to our dealers and retail customers by the Financial Services segment. It is our opinion that, in the absence of significant unanticipated cash demands, current and forecasted cash flow from our Manufacturing Operations, Financial Services Operations and financing capacity will provide sufficient funds to meet anticipated operating requirements, capital expenditures, equity investments and strategic acquisitions. We also believe that collections on the outstanding receivables portfolios as well as funds available from various funding sources will permit the Financial

Services Operations to meet the financing requirements of our dealers and retail customers. The Manufacturing Operations are generally able to access sufficient sources of financing to support our business plan.

 

Sources and Uses of Cash

 

 

We ended 2005 with $829 million of cash and cash equivalents, an increase from $603 million at the end of 2004 and $441 million at the end of 2003. Working capital, the excess of current assets over current liabilities, was $164 million at the end of 2005, compared with negative $680 million at the end of 2004.

 

Cash Flow from Operating Activities

 

Cash provided by operating activities was $275 million for 2005, compared with $298 million for 2004 and $190 million for 2003. The decrease in operating cash flows for 2005 compared to 2004 was due primarily to decrease in operating liabilities which was partially offset by an increase in net income. The increase in operating cash flows for 2004, compared with 2003, was due primarily due to a smaller net loss, partially offset by a net decrease in cash provided from changes in operating assets and liabilities.

 

Net income increased to $139 million for 2005 compared with a loss of $44 million in 2004 and a loss of $333 million in 2003. The net change in operating assets and liabilities was due primarily to continued growth in receivables and, to a lesser extent, payables. The changes in receivables and payables in 2004, compared with 2003, were pronounced due to the turnaround in the North American truck market coming out of the 2003 industry trough. While receivables and payables balances grew in 2005, compared with 2004, reflective of increased truck sales volume, the rate of growth was lower than the change from 2004 compared with 2003 due to the unusually low levels of working capital in 2003.

 

Cash Flow from Investing Activities

 

Cash used in investing activities was $1.1 billion for 2005 compared with $238 million provided by investing activities in 2004 and $1.0 billion used in investing activities in 2003. The increase in cash used in investing activities for 2005, compared with 2004, was due primarily to the acquisitions of MWM and WCC and higher restricted cash and cash equivalents balances, partially offset by higher net sales or maturities of marketable securities. The increase in cash provided by investing activities for 2004, compared with 2003, was due primarily to reduced levels of restricted cash and cash equivalents in 2004, compared with 2003.

 

Cash Flow from Financing Activities

 

Cash flow provided by financing activities was $996 million for 2005, compared with net cash used in financing activities of $375 million for 2004 and net cash provided by financing activities of $652 million for 2003. The increase in cash provided by financing activities for 2005, compared with 2004, was due primarily to an increase in net proceeds from the issuance of securitized debt in our financial services operations and lower principal payments on debt, partially offset by a decrease in revolving debt borrowings. The decrease in

cash provided by financing activities for 2004, compared with 2003, was due primarily to net payments on securitized debt at our financial services operations in 2004 and the lack of one-time proceeds in 2004 from the sale of stock to the retirement benefit plans that occurred in 2003. These decreases were partially offset by lower net long-term debt payments in 2004 compared with 2003.

 

Manufacturing Operations Debt

 

In July 2005, one of our subsidiaries repurchased $18 million of our 4.75% Subordinated Exchangeable Notes due 2009 and $7 million of our 9.375% Senior Notes due 2006. The effect of these repurchases on operating income was negligible. The repurchase of the 4.75% Subordinated Exchangeable Notes due 2009 had the effect of reducing the number of shares included in the calculation of diluted earnings per share, beginning in July 2005, by approximately 323,000 shares.

 

In March 2005, we sold $400 million in Senior Notes due 2012 (original notes). The original notes were sold in a Rule 144A and Regulation S private unregistered offering and were priced to yield 6.25%. In June 2005, we offered to exchange these original notes for a like amount of the company’s new 6.25%, Senior B, Senior Notes due 2012 (exchange notes). The exchange notes were registered under the Securities Act. The terms of the exchange notes issued in the exchange offer are substantially identical to the original notes, except that the transfer restrictions and registration rights provisions relating to the original notes will not apply to the exchange notes. The exchange notes were guaranteed on a senior unsecured basis by International. The exchange notes were a senior unsecured obligation and rank in right of payment behind all of our future secured debt and equally in right of payment to all of our existing and future senior unsecured debt. We exchanged in excess of 99.9% of the original notes for the exchange notes when the exchange offer expired in July 2005.

 

In June 2004, we issued $250 million in 7.5% Senior Notes due in 2011 and used the proceeds to finance the offer to purchase and redeem the outstanding 8% Senior Subordinated Notes due in 2008. We obtained certain amendments from existing bondholders of our $400 million 9.375% Senior Notes due in 2006 that permitted the refinancing and the amendment of other covenant limitations. The new Senior Notes were priced at a discount with a coupon rate of 7.5% to yield 7.625%.

 

In June 2004, our manufacturing operations assumed $220 million of 4.75% Subordinated Exchangeable Notes due in 2009 from NFC. As compensation for the assumption of this debt, NFC paid manufacturing operations approximately $170 million in cash. Manufacturing operations had previously received $50 million from NFC as compensation for providing NFC our common stock in case the Notes converted to NIC common stock. We used a portion of the proceeds from this transaction to increase our 2004 pension contribution and for general corporate purposes.

 

In December 2002, we completed the private placement of $190 million 2.5% Senior Convertible Notes due 2007. These notes are convertible at any time prior to maturity into shares of our common stock at a conversion price of approximately $34.71 per share. Simultaneous with the issuance of the Senior Convertible Notes, we entered into two call option derivative contracts, the impact of which was to minimize the potential share dilution upon conversion of the note.

 

Financial Services Operations Debt

 

During 2005, NFC entered into the Amended and Restated Revolving Credit Agreement (“Credit Agreement”). The new contractually committed credit facility has two primary components, a term loan ($400 million originally) and a revolving bank loan ($800 million). The latter has a Mexican sub-revolver ($100 million), which may be used by the company’s three Mexican finance subsidiaries. The entire credit facility matures July 1, 2010, however the term loan is to be repaid in 19 consecutive quarterly amounts of $1 million and a final payment of $381 million on July 1, 2010. The first quarterly payment was paid on October 31, 2005. Unlike the revolving portion, payments of the term loan may not be re-borrowed. Under the terms of the Credit Agreement, NFC is required to maintain a debt to tangible net worth ratio of no greater than 6.0 to 1.0, a twelve month rolling fixed charge coverage ratio of no less than 1.25 to 1.0, and a twelve month rolling combined retail/lease losses to liquidations ratio of no greater than 6%. The Credit Agreement grants security interest in substantially all of NFC’s non-securitized assets to the participants in the Credit Agreement.

Truck Retail Instalment Paper Corporation (“TRIP”), a wholly owned special purpose subsidiary of NFC, issued $500 million senior and subordinated floating rate asset-backed notes in June 2005. The proceeds were used in October 2005 to retire the previous notes for the revolving retail warehouse facility. The new notes mature in June 2010 and are subject to optional early redemption in full without penalty or premium upon satisfaction of certain terms and conditions on any date on or after April 15, 2010. NFC uses TRIP to temporarily fund retail notes and retail leases, other than fair market value leases. This facility is used primarily during the periods prior to a securitization of retail notes and finance leases. The asset backed debt is issued by consolidated SPEs and is payable out of collections on the finance receivables sold to the SPEs. This debt is the legal obligation of the SPEs and not NFC. The balance outstanding was $2.8 billion and $2.0 billion as of October 31, 2005 and 2004, respectively.

 

Our Mexican financial services operations borrowed $375 million of funds denominated in U.S. dollars and Mexican pesos to be used to acquire receivables from our Mexican manufacturing operation, its dealers and others. As of October 31, 2005, borrowings outstanding under these arrangements were $303 million, of which 15% were denominated in dollars and 85% in pesos. The interest rates on the dollar denominated debt are at a negotiated fixed rate or at a variable rate based on LIBOR. On peso denominated debt, the interest rate is based on the Interbank Interest Equilibrium Rate. The effective interest rate for the combined dollar and peso denominated debt was 8.4% for 2005 and 6.6% for 2004. As of October 31, 2005, $149 million of our Mexican financial service operation subsidiary’s receivables were pledged as collateral for certain bank borrowings.

 

Subsequent events

 

We experienced a significant change in our debt composition after October 31, 2005. As a result of the delay in filing NIC’s 2005 Form 10-K and subsequent filings, the majority of NIC’s public debt went into default in the first several months of calendar year 2006, thereby giving the holders of that debt the right, under certain circumstances, to accelerate the maturity of the debt and to demand repayment. To provide for the timely repayment of that debt and for the smooth transition to a new capital structure and, in the event it became necessary to repay the holders of the public debt, NIC entered into a three-year $1.5 billion Loan Facility (“Loan Facility”) in February 2006. Throughout 2006, as described below, five different series of public notes were repaid using the proceeds of the Loan Facility. In January 2007, NIC entered into a new $1.5 billion five-year facility (the “facilities”). Borrowings under the January 2007 facilities were used to repay the February 2006 Loan Facility. As of November 30, 2007, borrowings under the January 2007 facilities totaled $1.330 billion. The January 2007 facilities provide for repeated repayments and subsequent borrowings and matures in January 2012. Additional information about this facility is presented below in the Manufacturing Operations discussion.

 

The Financial Services Operations, principally NFC, was affected by the delay in filing NIC’s and NFC’s 2005 Form 10-K and subsequent filings. The principal impact was to create the possibility of a default in NFC’s $1.2 billion Credit Agreement (see below). NFC remedied this possibility by obtaining a series of waivers from lenders to the Credit Agreement, as more fully described below. As of the date of this 2005 Form 10-K, NFC is not in default under the Credit Agreement. The fifth waiver (see below) grants NIC and NFC until November 30, 2008 to become current in their SEC filings. At this time, management expects that its SEC filings will be current by November 30, 2008.

 

Manufacturing Operations Debt

 

In January 2006, we received a notice from purported holders of more than 25% of our $220 million 4.75% Subordinated Exchangeable Notes due April 2009 (“Exchangeable Notes”) asserting that we were in default of a financial reporting covenant under the indenture governing the Exchangeable Notes, for failing to timely provide the trustee for the Exchangeable Notes an Annual Report on Form 10-K for the year ended October 31, 2005. On February 3, 2006, we received notices from BNY Midwest Trust Company, as trustee under the applicable indentures for each of the following series of our long-term debt: (i) 2.5% Senior Convertible Notes due December 2007; (ii) 9.375% Senior Notes due June 2006; (iii) 6.25% Senior Notes due March 2012; and (iv) 7.5% Senior Notes due June 2011, asserting that we were in default of a financial reporting covenant under the applicable indentures for failing to furnish the trustee a copy of our Annual

Report on Form 10-K for the year ended October 31, 2005. On March 22, 2006, we received a notice of acceleration from holders of our $400 million, 6.25% Senior Notes due March 2012.

 

In February 2006, we obtained a three-year senior unsecured term loan facility (the “Loan Facility”) in the aggregate principal amount of $1.5 billion. Borrowings under the Loan Facility were available to repurchase or refinance our 9.375% Senior Notes due June 2006, 6.25% Senior Notes due March 2012, 7.5% Senior Notes due June 2011, 2.5% Senior Convertible Notes due December 2007, and/or our 4.75% Subordinated Exchangeable Notes due April 2009. Borrowings accrue interest at an adjusted London Interbank Offered Rate (“LIBOR”) plus a spread ranging from 475 to 725 basis points based on our credit ratings from time to time, and increase by an additional 50 basis points at the end of the twelve-month period following the date of the first borrowing and by an additional 25 basis points at the end of each subsequent six-month period, and are subject to further increases under certain other circumstances. The Loan Facility includes restrictive covenants which, among other things, limit our ability to incur additional indebtedness, pay dividends, and repurchase stock. The Loan Facility also requires that we maintain a fixed charge coverage ratio of not less than 1.1 to 1.0. The Loan Facility was subsequently amended on August 2, 2006, to permit borrowings under the Loan Facility through August 9, 2006 for the purpose of placing funds borrowed into an escrow account to subsequently repay, discharge or otherwise cure by December 21, 2006, any existing default under our outstanding 2.5% Senior Convertible Notes due December 2007.

 

In March 2006, we borrowed an aggregate principal amount of $545 million under the Loan Facility to repurchase $276 million principal amount of our outstanding $393 million 9.375% Senior Notes due June 2006 and to repurchase $234 million principal amount of our outstanding $250 million 7.5% Senior Notes due June 2011 and to repurchase $7 million of our 9.375% Senior Notes due June 2006 held by our affiliate and to pay accrued interest as well as certain fees incurred in connection with the Loan Facility and the repurchase of such Senior Notes. On March 7, 2006, we executed supplemental indentures relating to such Senior Notes which, among other provisions, waived any and all defaults and events of default existing under the indentures, eliminated substantially all of the material restrictive covenants, specified affirmative covenants and certain events of default, and rescinded any and all prior notices of default and/or acceleration delivered to us.

 

In March 2006, we borrowed an aggregate principal amount of $614 million under the Loan Facility to repurchase pursuant to a tender offer, $198 million principal amount of our outstanding $202 million 4.75% Subordinated Exchangeable Notes due April 2009 and to retire all of our outstanding $400 million 6.25% Senior Notes due March 2012 and to pay accrued interest and certain fees incurred in connection with the Loan Facility and the repurchase of such notes. On March 24, 2006, we executed a supplemental indenture relating to our 4.75% Subordinated Exchangeable Notes due April 2009. This supplemental indenture, among other provisions, waived any and all defaults and events of default existing under the indenture, eliminated substantially all of the material restrictive covenants, specified affirmative covenants and certain events of default, and rescinded any and all prior notices of default and/or acceleration delivered to us. In June 2006 we repurchased $2 million principal of the notes in private transactions. In 2007 less than $1 million principal of the notes were converted into 11,069 shares of our common stock.

 

In April 2006, we borrowed an aggregate principal amount of $21 million under the Loan Facility to replace funds previously used to retire $20 million of principal amount of our outstanding 4.75% Subordinated Exchangeable Notes due April 2009 and $1 million of principal amount of our 7.5% Senior Notes due June 2011 along with accrued interest on the notes.

 

In June 2006, we borrowed an aggregate principal amount of $125 million under the Loan Facility to repurchase the remaining outstanding balance of the 9.375% Senior Notes due June 2006, including all accrued interest and certain fees incurred in connection with the Loan Facility and the repurchase of such notes.

 

In August 2006, we borrowed an aggregate principal amount of $195 million under the Loan Facility to repurchase $190 million principal amount of our outstanding 2.5% Senior Convertible Notes due December 2007 and to pay accrued interest on the notes as well as certain fees incurred in connection with the Loan Facility and the repurchase of the notes. On August 9, 2006, we executed a supplemental indenture to the indenture dated December 16, 2002, relating to our 2.5% Senior Convertible Notes due December 2007. The supplemental indenture, among other things, waived any and all defaults and events of default existing under

the Senior Notes indenture, eliminated specified affirmative covenants and certain events of default and related provisions in the Senior Notes indenture and rescinded any and all prior notices of default and/or acceleration delivered to us pursuant to the Senior Notes indenture.

 

In December 2006, we voluntarily repaid $200 million of the $1.5 billion Loan Facility.

 

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 (the “facilities”). In January 2007, we borrowed an aggregate principal amount of $1.3 billion under the facilities. The proceeds were used to repay all amounts outstanding under the Loan Facility and certain fees incurred in connection therewith.

 

All borrowings under the facilities accrue interest at a rate equal to a base rate or an adjusted LIBOR plus a spread. The spread, which is based on our credit rating in effect from time to time, ranges from 200 basis points to 400 basis points. The loan facilities contain customary provisions for financings of this type, including, without limitation, representations and warranties, affirmative and negative covenants and events of default and cross-default. The facilities also require that we maintain a fixed charge coverage ratio of not less than 1.1 to 1.0. All draws under the loan facilities are subject to the satisfaction of customary conditions precedent for financings of this type, including, without limitation, certain officers’ certificates and opinions of counsel and the absence of any material adverse change since October 31, 2004 except for previously disclosed items.

 

In June 2007, we signed a definitive loan agreement relating to a five-year senior inventory secured, asset-based revolving credit facility in an aggregate principal amount of $200 million. This new loan facility matures in June 2012 and is secured by our domestic manufacturing plant and service parts inventory as well as our used truck inventory. All borrowings under this new loan facility accrue interest at a rate equal to a base rate or an adjusted LIBOR plus a spread. The spread, which is based on an availability-based measure, ranges from 25 basis points to 75 basis points for Base Rate borrowings and from 125 basis points to 175 basis points for LIBOR borrowings. The initial LIBOR spread is 150 basis points. Borrowings under the facility are available for general corporate purposes.

 

Financial Services Operations Debt

 

The Credit Agreement requires both the company and NFC to file and provide to NFC’s lenders copies of their respective Annual Reports on Form 10-K for each year and their Quarterly Reports on Form 10-Q for each of the first three quarters of each year and the related consolidated 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.

 

In January 2006, NFC received a waiver that waived through May 31, 2006, (i) the defaults created under the Credit Agreement by the failure of the company and NFC to file and deliver such reports and financial statements, (ii) the potential defaults that would otherwise be created by their failure to provide such reports and financial statements to the lenders in the future as required under the Credit Agreement and (iii) the cross default to certain indebtedness of the company created by such failures provided the applicable lenders did not have the right to accelerate the applicable debt.

 

In March 2006, NFC received a second waiver, which extended the existing waivers through January 31, 2007, and expanded the waivers to include the failure of the company and NFC to file their Quarterly Reports on Form 10-Q and to deliver the related financial statements through the date thereof. The second waiver also waived the default, if any, created by the right of the holders of Navistar’s long-term debt to accelerate payment of that debt as a result of the failure of the company to file the required reports.

 

In November 2006, NFC received a third waiver that extended the existing waivers through October 31, 2007, and expanded the waivers to include any default or event of default that would result solely from company’s or NFC’s failure to meet the filing requirements of Sections 13 and 15 of the Exchange Act, with respect to their Annual Reports on Form 10-K for 2005 and 2006 and their Quarterly Reports on Form 10-Q for the periods from November 1, 2005 through July 31, 2007.

In March 2007, NFC executed the First Amendment to its Credit Agreement. The First Amendment increased the term loan component of the Credit Agreement from $400 million to $620 million and created a $220 million Tranche A Term Loan. The First Amendment also increased the maximum permitted consolidated leverage ratio from 6:1 to 7:1 through November 1, 2007, and from 6:1 to 6.5:1 for the period from November 1, 2007 through April 30, 2008. After April 30, 2008, the ratio returns to 6:1 for all periods thereafter. In addition, the First Amendment increased the amount of dividends permitted to be paid to the parent company to $400 million plus net income and any non-core asset sale proceeds from May 1, 2007, through the date of such payment.

 

In October 2007, NFC executed a Second Amendment to its Credit Agreement and received a fourth waiver. The fourth waiver extends through December 31, 2007, and expands the previous waivers which waive any default or event of default that would result solely from NFC’s and the company’s failure to meet the timely filing requirements mentioned in the third waiver and including Sections 13 and 15 of the Exchange Act with respect to their Annual Reports on Form 10-K for 2007 and certain of their quarterly reports on Form 10-Q. During the period from November 1, 2007 until the waiver terminates, interest rates on certain loans under the Agreement shall be increased by 0.25%.

 

In December 2007, NFC received a fifth waiver expanding the scope of certain default conditions covered by the waiver therein until November 30, 2008. NFC has also obtained waivers for the private retail transactions and the private portion of the wholesale note transaction. These waivers are similar in scope to the Credit Agreement waivers and expire November 30, 2008.

 

Funding of Financial Services

 

The Financial Services segment, mainly NFC, has traditionally obtained the funds to provide financing to our dealers and retail customers from sales of finance receivables, short and long-term bank borrowings and medium and long-term debt. As of October 31, 2005, NFC’s funding consisted of sold finance receivables of $2.8 billion, bank and other borrowings of $1.1 billion, and secured borrowings of $123 million. NFC securitizes and sells receivables through Navistar Financial Retail Receivables Corp. (“NFRRC”), Navistar Financial Securities Corp. (“NFSC”), Truck Retail Accounts Corp. (“TRAC”), Truck Engine Receivables Financing Co. (“TERFCO”) and Truck Retail Instalment Paper Corporation (“TRIP”), all special purpose entities (“SPE”) and wholly owned subsidiaries of NFC. The sales of finance receivables in each securitization except for NFRRC and TRIP constitute sales under GAAP, with the result that the sold receivables are removed from NFC’s balance sheet and the investors’ interests in the interest bearing securities issued to effect the sale are not recognized as liabilities.

 

During 2005, NFC securitized $1.9 billion of retail notes and finance leases through NFRRC through on-balance sheet arrangements. As of October 31, 2005, the remaining shelf registration available to NFRRC for the public issuance of asset-backed securities was $2.5 billion. The shelf registration expired March 31, 2006, without any further issuances pursuant to it since October 31, 2005. NFC is in the process of preparing a new registration statement that will comply with a recently released SEC regulation known as “Regulation AB”. NFC expects a preliminary filing of the new registration statement in 2008.

The following are the funding facilities that NFC and its related affiliates have in place as of October 31, 2005.