PART II

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

OPERATING SEGMENT RESULTS

   Our reportable operating segments consist of the following: Engine, Power Generation, Components, and Distribution. This reporting structure is organized according to the products and markets each segment serves. This type of reporting structure allows management to focus its efforts on providing enhanced service to a wide range of customers. The Engine segment produces engines and parts for sale to customers in on-highway and various industrial markets. The engines are used in trucks of all sizes, buses and RVs, as well as various industrial applications including construction, mining, agriculture, marine, oil and gas, rail and military. The Power Generation segment is an integrated provider of power systems which sells engines, generator sets and alternators and rents power equipment for both standby and prime power uses. The Components segment includes sales of filtration products, exhaust and aftertreatment systems, turbochargers and fuel systems. The Distribution segment includes wholly-owned and partially-owned distributorships engaged in wholesaling engines, generator sets, and service parts, as well as performing service and repair activities on our products and maintaining relationships with various OEMs.

   We use segment EBIT (defined as earnings before interest expense, taxes and minority interests) as a primary basis for the chief operating decision-maker to evaluate the performance of each of our operating segments. Segment amounts exclude certain expenses not specifically identifiable to segments.

   The accounting policies of our operating segments are the same as those applied in the Consolidated Financial Statements. We prepared the financial results of our operating segments on a basis that is consistent with the manner in which we internally disaggregate financial information to assist in making internal operating decisions. We have allocated certain common costs and expenses, primarily corporate functions, among segments differently than we would for stand-alone financial information prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). These include certain costs and expenses of shared services, such as information technology, human resources, legal and finance. We also do not allocate debt-related items, actuarial gains or losses, prior service costs or credits or income taxes to individual segments. Segment EBIT may not be consistent with measures used by other companies.

   A summary of operating results by segment for the years ended December 31, is shown below:

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	Engine				Power Generation				Components				Distribution				Non-segment items(1)				Total
	(in millions)
2007
External sales	$	7,129			$	2,375			$	2,007			$	1,537			$	—			$	13,048
Intersegment sales		1,053				685				925				3				(2,666	)			—
Net sales		8,182				3,060				2,932				1,540				(2,666	)			13,048
Depreciation and amortization(2)		176				42				59				11				—				288
Research and engineering    expenses		222				34				73				—				—				329
Investee equity, royalty and other    income		92				17				4				92				—				205
Interest income		26				6				3				1				—				36
Segment EBIT		589				334				153				187				(36				1,227
2006
External sales	$	6,640			$	1,880			$	1,473			$	1,369			$	—			$	11,362
Intersegment sales		871				536				808				16				(2,231	)			—
Net sales		7,511				2,416				2,281				1,385				(2,231	)			11,362
Depreciation and amortization(2)		192				36				57				11				—				296
Research and engineering    expenses		225				28				68				—				—				321
Investee equity, royalty and other    income		67				12				7				54				—				140
Interest income		36				7				2				2				—				47
Segment EBIT		733				220				107				144				(25				1,179
2005
External sales	$	5,836			$	1,582			$	1,324			$	1,176			$	—			$	9,918
Intersegment sales		821				417				676				15				(1,929	)			—
Net sales		6,657				1,999				2,000				1,191				(1,929	)			9,918
Depreciation and amortization(2)		182				45				53				15				—				295
Research and engineering    expenses		201				21				56				—				—				278
Investee equity, royalty and other    income		80				9				8				34				—				131
Interest income		17				3				1				3				—				24
Segment EBIT		582				145				89				107				(16	)			907

(1)	Includes intersegment sales and profit in inventory eliminations and unallocated corporate expenses.
(2)	Depreciation and amortization as shown on a segment basis excludes the amortization of debt discount that is included in the Consolidated Statements of Earnings as Interest expense.

   The tables below reconcile the segment information to the corresponding amounts in the

Consolidated Statements of Earnings:

	Years ended December 31,
	2007			2006			2005
	(in millions)
Segment EBIT	$	1,227		$	1,179		$	907
Less:    Interest expense		58			96			109
Earnings before income taxes and minority interests	$	1,169		$	1,083		$	798

Engine Segment Results

   Financial data for the Engine segment was as follows:

	Years ended December 31,						Favorable/ (Unfavorable)							Years ended December 31,						Favorable/ (Unfavorable)
	2007			2006			Amount			Percent				2006			2005			Amount			Percent
	(in millions)													(in millions)
External sales	$	7,129		$	6,640		$	489		7	%			$	6,640		$	5,836		$	804		14	%
Intersegment sales		1,053			871			182		21	%				871			821			50		6	%
Net sales		8,182			7,511			671		9	%				7,511			6,657			854		13	%
Depreciation and    amortization		176			192			16		8	%				192			182			(10	)	(5	)%
Research and engineering    expenses		222			225			3		1	%				225			201			(24	)	(12	)%
Investee equity, royalty and    other income		92			67			25		37	%				67			80			(13	)	(16	)%
Interest income		26			36			(10	)	(28	)%				36			17			19		NM	%
Segment EBIT		589			733			(144	)	(20	)%				733			582			151		26	%
Segment EBIT as a    percentage of net sales		7.2	%		9.8	%	(2.6) percentage points								9.8	%		8.7	%	1.1 percentage points

2007 vs. 2006

Net Sales

   Engine segment net sales increased over 2006 primarily due to strong demand across most markets, excluding the on-highway heavy-duty truck market, and improved pricing on our new emissions compliant engines. The North American on-highway heavy-duty truck market was down as a result of the 2007 emissions standards change. Total on-highway-related sales were 56 percent of Engine segment net sales in 2007 compared with 63 percent last year. Industrial markets were strong in 2007 compared to 2006, with increased volumes in most markets, led by construction, mining, marine, agriculture and oil and gas.

Segment EBIT

   Engine segment EBIT decreased over 2006 primarily due to lower engine volumes in the heavy-duty on-highway markets, the accompanying gross margin impact of lower absorption of fixed manufacturing costs, higher product costs and warranty accrual rates for new emissions compliant products and increased selling and administrative expenses. Gross margins decreased $113 million, or 8 percent, compared to 2006 and the gross margin percentage decreased 2.9 percentage points. Gross margin was lower due to higher material and warranty costs associated with the new 2007 engines. The increase in warranty expense was expected as the mix of 2007 emissions compliant engines 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. Selling and administrative expense increased $64 million, or 12 percent, compared to 2006 and remained flat as a percentage of net sales. The 2007 increases in selling and administrative expenses were primarily due to higher payroll costs as the result of 2007 salary increases and an increase in infrastructure investments including the number of employees to provide for the Engine segment’s growing business. Research and engineering expenses decreased by $3 million, or 1 percent, compared to 2006 and decreased slightly as a percentage of net sales. These overall increased segment expenses were partially offset by higher earnings from joint ventures over last year, primarily due to a $22 million improvement in earnings at DCEC due to strong demand in the Chinese truck market.

2006 vs. 2005

Net Sales

   Engine segment net sales increased over 2005 primarily due to strong demand across most markets, particularly the North American heavy-duty truck market, the stationary power market due to the strong performance of our Power Generation segment and strong industrial market sales. Total on-highway-related sales were 63 percent of Engine segment net sales during 2006 and 2005.

Segment EBIT

   Engine segment EBIT improved over 2005 primarily due to the higher engine volumes across all major markets, the accompanying gross margin benefits of higher absorption of fixed manufacturing costs and improved pricing and manufacturing efficiencies. Gross margin increased $229 million, or 20 percent, compared to 2005 and the gross margin percentage increased over one percentage point. Selling and administrative expenses increased $69 million, or 15 percent, compared to 2005 and increased slightly as a percentage of net sales. Research and engineering expenses increased $24 million, or 12 percent, compared to 2005 and remained flat as a percentage of net sales. In addition, earnings from joint ventures decreased $13 million compared with 2005, primarily due to a $17 million decrease in earnings at DCEC as a result of weakness in the medium-duty truck market, due to the continuous tonnage upgrade of China’s truck industry.

Engine Net Sales by Market

   A summary and discussion of Engine segment net sales by market follows:

	Years ended December 31,						Favorable/ (Unfavorable)							Years ended December 31,						Favorable/ (Unfavorable)
	2007			2006			Amount			Percent				2006			2005			Amount			Percent
	(in millions)													(in millions)
Heavy-duty truck	$	1,948		$	2,498		$	(550	)	(22	)%			$	2,498		$	2,139		$	359		17	%
Medium-duty truck and bus		1,284			971			313		32	%				971			904			67		7	%
Light-duty automotive and RV		1,340			1,261			79		6	%				1,261			1,178			83		7	%
Total on-highway		4,572			4,730			(158	)	(3	)%				4,730			4,221			509		12	%
Industrial		2,676			2,063			613		30	%				2,063			1,791			272		15	%
Stationary power		934			718			216		30	%				718			645			73		11	%
Total net sales	$	8,182		$	7,511		$	671		9	%			$	7,511		$	6,657		$	854		13	%

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