PART II

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

RESULTS OF OPERATIONS

	Years ended December 31,						Favorable/ (Unfavorable)							Years ended December 31,						Favorable/ (Unfavorable)
	2007			2006			Amount			Percent				2006			2005			Amount			Percent
	(in millions)											(in millions)
Net sales	$	13,048		$	11,362		$	1,686		15	%			$	11,362		$	9,918		$	1,444			15	%
Cost of sales		10,492			8,897			(1,595	)	(18	)%				8,897			7,874			(1,023	)		(13	)%
Gross margin		2,556			2,465			91		4	%				2,465			2,044			421			21	%
Operating expenses and income    Selling and administrative expenses		1,296			1,153			(143	)	(12	)%				1,153			1,003			(150	)		(15	)%
Research and engineering expenses		329			321			(8	)	(2	)%				321			278			(43	)		(15	)%
Investee equity, royalty and other income		205			140			65		46	%				140			131			9			7	%
Other operating income, net		22			—			22		NM					—			—			—			NM
Operating earnings		1,158			1,131			27		2	%				1,131			894			237			27	%
Interest income		36			47			(11	)	(23	)%				47			24			23			96	%
Interest expense		58			96			38		40	%				96			109			13			12	%
Other income (expense), net		33			1			32		NM	%				1			(11	)		12			NM
Earnings before income taxes and minority    interests		1,169			1,083			86		8	%				1,083			798			285			36	%
Provision for income taxes		381			324			(57	)	(18	)%				324			216			(108	)		(50	)%
Minority interests in earnings of    consolidated subsidiaries		49			44			(5	)	(11	)%				44			32			(12	)		(38	)%
Net earnings	$	739		$	715		$	24		3	%			$	715		$	550		$	165			30	%

2007 vs. 2006

Net Sales

   Net sales increased due to record sales in all segments. Net sales changes by segment were as follows:

	2007 vs. 2006
	($ in millions)
	Change		% Change
Engine	$671		9%
Power Generation	644		27%
Components	651		29%
Distribution	155		11%

   Engine sales were higher due to improved pricing on our emission compliant engines, strong demand in almost all on-highway and off-highway markets and the favorable impact of foreign currency translation. Increased engine sales were due to market share gains in the heavy-duty on-highway engine market and were partially offset by decreased demand in our North American heavy-duty on-highway market as a result of the 2007 change in emissions standards. Engine and parts sales to industrial markets were 30 percent higher with increased volumes in all market segments. Power Generation sales increased due to improved pricing and strong organic growth led primarily by increases in commercial generator and alternator sales. Components sales increased primarily due to organic sales growth in our emission solutions, turbocharger and filtration businesses. Distribution sales increased primarily due to increased demand for power generation products followed by increased parts and engine sales which were partially offset by the deconsolidation of one of our North American joint ventures beginning in 2007. The net sales of this joint venture were approximately $163 million in 2006. See our ‘‘Operating Segment Results’’ section for further details on sales by segment.

Gross Margin

   Gross margins improved primarily due to new pricing and increased volumes which were partially offset by increased costs for new products, increased warranty expenses and the deconsolidation of one of our North American joint ventures. Significant drivers impacting gross margins were as follows:

	2007 vs. 2006
	(in millions) Change
Price	$	516
Volume		255
Incremental production costs		(419	)
Product mix		(97	)
Warranty expense		(87	)
Deconsolidation of a joint venture		(65	)
Other		(12	)
Total	$	91

   Gross margin as a percentage of sales declined by 2.1 percentage points as margin percentages declined in three of our segments, primarily driven by the Engine and Components segments. In the Engine segment, price increases for new products were offset by higher new product costs, increased warranty costs and the decreased heavy-duty engine volumes. In the Components segment, two of our businesses are experiencing low margins as a result of inefficient production costs associated with meeting extremely strong demand.

   Warranty expense as a percent of sales increased to 3.1 percent from 2.8 percent in 2006. The increase in warranty expense was expected as the mix of 2007 emissions compliant engines and components increased. As has been our practice and as described in our Critical Accounting Estimates, new product launches require a greater use of judgment in developing estimates until historical experience becomes available. Product specific claims experience is typically available four or five quarters after product launch, with a clear claims experience trend evident eight quarters after launch. We generally record warranty expense for new products upon shipment using a factor based upon historical experience only in the first year, a blend of actual product and historical experience in the second year and product specific experience thereafter.

Selling and Administrative Expenses

   Selling and administrative expenses increased primarily due to increases in infrastructure investments, including the number of employees to provide for our growing business, higher compensation and related expenses of approximately $116 million, which included salaries, variable compensation and fringe benefits, as a result of our improved financial performance. Other factors affecting selling and administrative expenses also included increased consulting fees and other outside services of $32 million. The remaining change in selling and administrative expenses is due to a combination of increases in various other miscellaneous expenses, none of which were individually significant. Overall selling and administrative expenses as a percentage of sales declined to 9.9 percent in 2007 from 10.1 percent in 2006.

Research and Engineering Expenses

   Research and engineering expenses increased primarily due to higher spending on new product development and critical technologies for 2010 and beyond, including product development for 2010 emissions standards and developing products for new growth areas. The Power Generation and Components segments accounted for $6 million and $5 million of the increase, respectively, which was partially offset by a $3 million decrease in the Engine segment. Fluctuations in other miscellaneous research and development expenses were not significant individually or in the aggregate.

Investee Equity, Royalty and Other Income

   Investee equity, royalty and other income increased primarily due to an increase in earnings at several of our equity investees, led by a $35 million increase in earnings from our North American distributors as the result of organic growth, acquisitions and the deconsolidation of a North American joint venture in 2007. In addition, DCEC increased $22 million, CCEC increased $7 million and Cummins MerCruiser Diesel increased $5 million, while the other joint ventures had slight increases.

Other Operating Income, Net

   The major components of other operating income are gain or loss on sale of fixed assets and businesses and royalty income. The increase in income over 2006 was primarily due to a $17 million increase in gain on sale of fixed assets. In addition, royalty income increased by approximately $2 million in 2007 and legal expenses decreased $3 million compared to 2006. Increases in miscellaneous operating expenses slightly offset the increase in income and were not material.

Interest Income

   Interest income decreased primarily due to lower average cash balances in 2007 compared to 2006. The lower average cash balances were due to significant spending for capital expenditures, repurchases of common stock and pension contributions.

Interest Expense

   Interest expense decreased primarily due to a decline of $137 million in debt balances, partially offset by higher interest rates.

Other Income (Expense), Net

   The major components of other income (expense) include foreign currency exchange gains and losses on translation and transactions, bank charges and other miscellaneous income and expenses. The increase in income in 2007, compared to 2006, is primarily due to a net increase in foreign currency exchange gains of approximately $28 million in 2007 as compared to $11 million in 2006, a $12 million loss on the early extinguishment of debt incurred when we repaid our $250 million 9.5% notes in December 2006 and a $3 million increase in dividend income in 2007. Partially offsetting these increases were several fluctuations in the components of miscellaneous other income and expenses, none of which were individually significant.

Provision for Income Taxes

   Our tax rates have been less than the 35 percent U.S. income tax rate primarily because of lower taxes on foreign earnings and research tax credits. Export tax benefits also reduced our tax rate prior to 2007.

   Our effective tax rate for 2007 was 32.6 percent compared to 29.9 percent for 2006. The increase is in part due to the full repeal after 2006 of U.S. export tax benefits which reduced our 2006 tax rate by 1.4 percent. Our income tax provision for 2006 also included a $28 million (2.6 percent) benefit for the favorable resolution of tax uncertainties related to prior years offset by a $12 million (1.1 percent) increase for the effect of new Indiana tax legislation.

   We expect our 2008 effective tax rate to be 35 percent excluding any discrete items that may arise. The research tax credit expired December 31, 2007 and has not yet been renewed by Congress. If the research credit is extended, we would anticipate the 2008 effective tax rate to drop to 34 percent.

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