PART II

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

OPERATING SEGMENT RESULTS

A summary of unit shipments by engine classification (including unit shipments to Power Generation) 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)
Midrange		486,800			459,900		26,900			6	%				459,900		419,200				40,700		10	%
Heavy-duty		91,400			123,400		(32,000	)		(26	)%				123,400		107,600				15,800		15	%
High-horsepower		18,500			16,300		2,200			13	%				16,300		14,400				1,900		13	%
Total unit shipments		596,700			599,600		(2,900	)		—	%				599,600		541,200				58,400		11	%

   A summary of changes in unit shipments by market follows:

	Unit Shipments by Market Percent Change
	2007 vs. 2006								2006 vs. 2005
	North American			International		Global			North American		International			Global
Heavy-duty truck	(44	)%		37%		(34	)%		18%		11	%		17	%
Medium-duty truck	1	%		27%		16	%		36%		(20	)%		(3	)%
Bus	37	%		58%		48	%		56%		(10	)%		12	%
Light-duty automotive	(12	)%		13%		(10	)%		1%		24	%		3	%
RV	(16	)%		658%		(14	)%		41%		(89	)%		33	%
Industrial	1	%		31%		15	%		10%		29	%		18	%
Total unit shipments	(15	)%		30%		(2	)%		11%		7	%		10	%
Note: The total percent of shipments were 62% and 71% to North America and 38% and 29% to International, for 2007 and 2006, respectively.

2007 vs. 2006

Heavy-Duty Truck

   The decrease in heavy-duty truck market sales was primarily driven by the North American truck market as OEMs experienced reduced demand from truck fleets, following increased purchases in 2006 to replace trucks ahead of the 2007 change in emissions standards, the softer U.S. economy, and the weak freight environment. The decline in the North American truck market sales was partially offset by strong growth in our international sales and North American market share gains.

Medium-Duty Truck and Bus

   The increase in medium-duty truck and bus sales was due to increased demand for medium-duty truck engines internationally and increased shipments of bus engines in North America and internationally compared to 2006. International medium-duty truck sales improved due to continued growth in Latin America and Europe, while international bus sales have continued to grow in Chinese and Eastern European markets. The increase in overall North American bus sales is being driven by market share gains within the school bus market. Significant market share gains in the North American medium-duty truck market resulted in a sales increase despite a 28 percent decline in the market itself.

Light-Duty Automotive and RV

   The increase in light-duty automotive sales was primarily due to higher pricing for the 2007 emissions compliant product which was partially offset by decreased demand from Chrysler due to the softening of the U.S. economy in the fourth quarter of 2007. The 2007 total Chrysler unit shipments decreased over last year by approximately 19,800 units, or 12 percent. Global engine shipments to recreational vehicle OEMs decreased compared with 2006 as a result of increased engine purchases in 2006 ahead of the 2007 change in emissions standards.

   Industrial sales increased in most markets over last year, primarily due to stronger demand. A summary and discussion of changes in Industrial unit sales by market follows:

	Industrial Unit Shipments by Market Percent Change 2007 vs. 2006
	North American			International			Global
Agriculture	2	%		17	%		5%
Construction	—	%		32	%		17%
Government	61	%		64	%		62%
Marine	(20	)%		30	%		16%
Mining	(1	)%		25	%		18%
Oil & Gas	6	%		72	%		7%
Rail	131	%		(9	)%		5%
Total unit shipments	1	%		31	%		15%

   The total percentage of shipments to North America in 2007 was 45 percent as compared to 52 percent in 2006. The overall change in the geographic sales mix was due to the continued strength of the international construction market which was being driven by strong demand in Europe, East Asia, and Latin America. The international mining market demand was up as the strength in commodity prices was driving investment in mining capacity. Sales to the oil and gas market and the commercial marine market increased as sustained oil and natural gas prices continued to drive activity and investments in new equipment and offshore supply vessels. The rail market was up due to increased demand in North America.

Stationary Power

   The increase in sales to stationary power markets is due to the increased intersegment sales to our Power Generation segment. These intersegment sales are eliminated in our Consolidated Statements of Earnings. See the Power Generation Segment Results for a discussion of the increase in net sales.

2006 vs. 2005

Heavy-Duty Truck

   The increase in sales to the heavy-duty truck market was primarily driven by the North American truck market as OEMs work to meet growing demand from truck fleets replacing trucks ahead of the 2007 change in emissions standards.

Medium-Duty Truck and Bus

   The increase in medium-duty truck and bus revenues was due to strong demand ahead of the 2007 change in emissions standards and our growing market share position with North American OEMs in the medium duty truck and bus markets. The increase in medium-duty truck and bus engine shipments in North America is due to our increased penetration in this market and an overall increase in demand ahead of the emissions standard changes. The decrease in shipments to international medium-duty truck OEMs is primarily due to changes in emissions standards in Brazil to Euro III, effective January 1, 2006. The decrease in international bus engine shipments year-over-year is due to a large purchase made in 2005 by a customer in China.

Light-Duty Automotive and RV

   Sales of light-duty automotive engines increased as a result of higher volumes. The majority of the light-duty automotive and RV volumes was driven by demand from DaimlerChrysler with shipments of approximately 162,000 units, or a 1 percent increase compared to 2005. Engine shipments to recreational vehicle OEMs increased compared with 2005 due to new product introductions and growing penetration at key OEMs.

Industrial

   Industrial sales increased in most markets over last year, primarily due to stronger demand in those markets. A summary and discussion of changes in Industrial unit sales by market follows:

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	Industrial Unit Shipments by Market Percent Change 2006vs. 2005
	North American			International			Global
Agriculture	(3	)%		21	%		1%
Construction	10	%		31	%		20%
Government	98	%		232	%		136%
Marine	39	%		—	%		9%
Mining	11	%		11	%		11%
Oil & Gas	39	%		26	%		39%
Rail	6,600	%		78	%		97%
Total unit shipments	10	%		29	%		18%

   The total percentage of shipments to North America in 2006 was 52 percent, as compared to 56 percent in 2005. The overall change in the geographic sales mix was due to the continued strength of the international construction market which was being driven by strong demand in the Middle East and Asia. Total shipments to the construction market increased largely because of the increase in international shipments. The international mining market demand was up as the strength in commodity prices was driving investment in mining capacity. The shipments to the oil and gas market have increased as sustained oil and natural gas prices continue to drive activity and investments in new equipment. In addition, we continue to penetrate this market further with the release of more engine platforms to this application. Other industrial markets had modest increases in shipments compared to 2005.

Stationary Power

   The increase in sales to stationary power markets is due to the increased intersegment sales to our Power Generation segment. These intersegment sales are eliminated in our Consolidated Statements of Earnings. See the Power Generation Segment Results for a discussion of the increase in net sales.

Power Generation Segment Results

   Financial data for the Power Generation 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	$	2,375		$	1,880		$	495			26	%		$	1,880		$	1,582		$	298		19	%
Intersegment sales		685			536			149			28	%			536			417			119		29	%
Net sales		3,060			2,416			644			27	%			2,416			1,999			417		21	%
Depreciation and    amortization		42			36			(6	)		(17	)%			36			45			9		20	%
Research and engineering    expenses		34			28			(6	)		(21	)%			28			21			(7	)	(33	)%
Investee equity, royalty and    other income		17			12			5			42	%			12			9			3		33	%
Interest income		6			7			(1	)		(14	)%			7			3			4		NM	%
Segment EBIT		334			220			114			52	%			220			145			75		52	%
Segment EBIT as a    percentage of net sales		10.9	%		9.1	%		1.8 percentage points							9.1	%		7.3	%	1.8 percentage points

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