PART II

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

OPERATING SEGMENT RESULTS

2007 vs. 2006

Net Sales

   Power Generation segment net sales increased over 2006, primarily due to increased sales of 31 percent in our commercial business, 39 percent in our alternator business and 10 percent in our consumer business as well as improved pricing in our commercial and alternator businesses. Our commercial business, the largest line of business in this segment, increased as the result of strong demand across most regions, especially EMEA, North America, India and Latin America. The alternator businesses also experienced strong international growth. Net sales benefited from favorable impacts from foreign currency translation.

Segment EBIT

   Power Generation segment EBIT improved over 2006, primarily due to the improved gross margin line as significant price realization, net of increased material costs and the absorption benefit from higher volumes improved segment earnings. Gross margin improved $147 million, or 35 percent, compared to 2006 and the gross margin percentage improved by 1.1 percentage points. Selling and administrative expenses increased $39 million, or 18 percent, compared to 2006, however, improved by 0.6 percentage points as a percentage of net sales. The increase in selling and administrative expenses was primarily due to higher payroll costs and increases in infrastructure investments including the number of employees to provide for the growing Power Generation business. Research and engineering expenses increased by $6 million, or 21 percent, compared to 2006 and remained flat as a percentage of net sales.

2006 vs. 2005

Net Sales

   Power Generation segment net sales increased over 2005, primarily due to increased demand in the commercial generator and alternator lines of business as well as improved pricing. Our commercial and alternator businesses were up in nearly all markets. Our consumer, power electronics, energy solutions and rental markets also saw modest increases. Partially offsetting the increased sales in these lines of business was the absence of sales from SEG as the business was sold in the fourth quarter of 2006.

Segment EBIT

   Power Generation segment EBIT improved over 2005, primarily due to strong commercial generator set and alternator sales across geographic markets, except China, as well as improved mix and price realization. While material costs, particularly copper, have increased year-over-year, the segment has been able to absorb these costs through improved pricing. Gross margin improved $92 million, or 28 percent, compared to 2005 and gross margin percentage improved nearly one percentage point. Selling and administrative expenses increased $29 million, or 15 percent, compared to 2005, however, selling and administrative expenses improved by 0.5 percentage points as a percentage of net sales. Research and engineering expenses increased $7 million, or 33 percent, compared to 2005 and increased slightly as a percentage of net sales.

Engine Net Sales by Market

   A summary of unit shipments used in power generation equipment by engine classification follows:

	Years ended December 31,						Favorable/ (Unfavorable)							Years ended December 31,						Favorable/ (Unfavorable)
	2007			2006			Amount			Percent				2006			2005			Amount			Percent
Midrange		31,700			29,200		2,500			9	%				29,200		21,300				7,900		37	%
Heavy-duty		8,000			6,800		1,200			18	%				6,800		7,200				(400	)	(6	)%
High-horsepower		10,500			9,300		1,200			13	%				9,300		8,300				1,000		12	%
Total unit shipments		50,200			45,300		4,900			11	%				45,300		36,800				8,500		23	%

Components Segment Results

   Financial data for the Components 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	$	2,007		$	1,473		$	534			36	%		$	1,473		$	1,324		$	149		11	%
Intersegment sales		925			808			117			14	%			808			676			132		20	%
Net sales		2,932			2,281			651			29	%			2,281			2,000			281		14	%
Depreciation and    amortization		59			57			(2	)		(4	)%			57			53			(4	)	(8	)%
Research and engineering    expenses		73			68			(5	)		(7	)%			68			56			(12	)	(21	)%
Investee equity, royalty and    other income		4			7			(4	)		(43	)%			7			8			(1	)	(13	)%
Interest income		3			2			1			50	%			2			1			1		100	%
Segment EBIT		153			107			46			43	%			107			89			18		20	%
Segment EBIT as a    percentage of net sales		5.2	%		4.7	%		0.5 percentage points							4.7	%		4.5	%	0.2 percentage points

   Net sales for our Components segment by business 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)
Turbochargers	$	860		$	608		$	252			41	%		$	608		$	516		$	92		18	%
Fuel Systems		409			395			14			4	%			395			325			70		22	%
Emission Solutions		448			148			300			203	%			148			103			45		44	%
Filtration		1,215			1,130			85			8	%			1,130			1,056			74		7	%
Total unit shipments	$	2,932		$	2,281		$	651			29	%		$	2,281		$	2,000		$	281		14	%

2007 vs. 2006

Net Sales

   Components segment net sales increased over 2006, primarily due to increased demand across all businesses and all geographic markets, but were primarily driven by strong demand in our emission solutions and turbocharger businesses. We also experienced increased sales in our filtration and fuel systems businesses. All of our businesses benefited from OEM sales of new products to allow their customers to meet new on-highway emissions standards in North America and Europe as well as from increases in aftermarket volume. We also experienced favorable impacts from foreign currency translation.

Segment EBIT

   Components segment EBIT improved over 2006, primarily due to increased volumes and gross margins in most Component businesses and the sale of a business. Gross margin improved $68 million, or 20 percent, compared to 2006, however, the gross margin percentage decreased 1.1 percentage points. Gross margin percentages were unfavorably impacted by higher metal costs and new product introduction costs. In addition, both our emission solutions and turbo technologies businesses experienced low margins as the result of costs associated with meeting extremely strong demand. Selling and administrative expenses increased $30 million, or 17 percent, compared to 2006, however, selling and administrative expense improved by 0.7 percentage points as a percentage of net sales. The increase in selling and administrative expenses was primarily due to higher payroll costs and increases in infrastructure investments including the number of employees to provide for the growing Components business. Research and engineering expenses increased by $5 million, or 7 percent, compared to 2006, however, research and engineering expenses improved by 0.5 percentage points as a percentage of net sales. Segment EBIT was also favorably impacted by the $10 million gain on the sale of Universal Silencer.

2006 vs. 2005

Net Sales

   Components segment net sales increased over 2005 primarily due to strong demand in our turbocharger and fuel systems businesses. The segment had increased sales across all businesses and all geographic markets. In addition, the segment had strong growth in North America and Europe with increases in both aftermarket volume and OEM volume.

Segment EBIT

   Components segment EBIT improved over 2005, primarily due to increased volumes and gross margins. Gross margin increased $59 million, or 20 percent, compared to 2005 and the gross margin percentage improved nearly one percentage point, primarily due to improved volume and improved pricing. Selling and administrative expenses increased $26 million, or 17 percent, compared to 2005, and increased slightly as a percentage of net sales. Research and engineering expenses increased $12 million, or 21 percent, compared to 2005 and increased slightly as a percentage of net sales. Research and engineering expenses increased due to additional investment in the development of a number of new products and critical technologies that were launched in 2007 and beyond.

Distribution Segment Results

   Financial data for the Distribution 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	$	1,537		$	1,369		$	168			12	%		$	1,369		$	1,176		$	193		16	%
Intersegment sales		3			16			(13	)		(81	)%			16			15			1		7	%
Net sales		1,540			1,385			155			11	%			1,385			1,191			194		16	%
Depreciation and    amortization		11			11			—			—	%			11			15			4		27	%
Investee equity, royalty and    other income		92			54			38			70	%			54			34			20		59	%
Interest income		1			2			(1	)		(50	)%			2			3			(1	)	(33	)%
Segment EBIT		187			144			43			30	%			144			107			37		35	%
Segment EBIT as a    percentage of net sales		12.1	%		10.4	%		1.7 percentage points							10.4	%		9.0	%	1.4 percentage points

2007 vs. 2006

Net Sales

   Distribution segment net sales increased over 2006, primarily due to increased demand in Europe and the Middle East, despite the deconsolidation of one of our North American joint ventures in 2007. The net sales of this previously consolidated joint venture accounted for approximately $163 million, or 12 percent, of net sales for the Distribution segment for 2006. The strong organic growth was led by increases in power generation volumes in Europe and the Middle East, followed by engine and parts volumes and the favorable impact of foreign currency translation.

Segment EBIT

   Distribution segment EBIT improved over 2006, primarily due to investee equity, royalty and other income led by a $35 million increase from our North American Distributors. Gross margin improved $14 million, or 5 percent, compared to 2006, however, the gross margin percentage decreased 1.4 percentage points. The decrease in gross margin percentage was primarily due to the deconsolidation of one of our North American joint ventures in 2007. Selling and administrative expenses increased $15 million, or 6 percent, compared to 2006, however, selling and administrative expenses improved by 0.7 percentage points as a percentage of net sales. The increase in selling and administrative expenses was primarily due to higher payroll costs as the result of 2007 salary increases, an increase in infrastructure investments, including the number of employees to provide for the growing Distribution business and unfavorable foreign currency translation.

2006 vs. 2005

Net Sales

   Distribution net sales increased over 2005, primarily due to increased demand in the Middle East, Europe and the South Pacific. The higher net sales were led by increases in power generation volume followed by parts, service and engine volume. The Middle East was the primary driver for the higher power generation volume, accounting for over half of the increase. Parts and service and engine volumes were up throughout several geographic markets, most notably Europe, East Asia and the Middle East.

Segment EBIT

   Distribution segment EBIT improved over 2005, primarily due to higher gross margins resulting from increased demand for engines, parts and power generation equipment. Gross margin improved $37 million, or 14 percent, compared to 2005, however, the gross margin percentage decreased slightly due to an unfavorable shift in mix from parts to engines and generator sets. The increase in gross margin was partially offset by higher selling and administrative expenses. Selling and administrative expenses increased $25 million, or 12 percent compared to 2005, however, selling and administrative expenses improved by over 0.5 percentage points as a percentage of net sales. Also contributing to the increase in segment EBIT year-over-year was a $20 million increase in investee equity earnings primarily attributable to an $18 million increase in earnings at our North American distributors.

Geographic Markets

   Sales to international markets were 54 percent of total net sales in 2007, compared with 50 percent of total net sales in 2006 and 51 percent of total net sales in 2005.

   A summary of net sales (dollar amount and percentage of total) by geographic territory follows (dollars in millions):

	Years ended December 31,
	2007						2006						2005
(in millions) United States	$	6,007		46	%		$	5,719		50	%		$	4,832		49	%
Asia/Australia		2,444		19	%			1,794		16	%			1,682		17	%
Europe/CIS		2,326		18	%			1,633		14	%			1,406		14	%
Mexico/Latin America		1,171		9	%			886		8	%			819		8	%
Canada		405		3	%			743		7	%			728		7	%
Africa/Middle East		695		5	%			587		5	%			451		5	%
Total international		7,041		54	%			5,643		50	%			5,086		51	%
Total consolidated net sales	$	13,048		100	%		$	11,362		100	%		$	9,918		100	%

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