SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

COMMISSION FILE NUMBER: 1-14097

SAUER-DANFOSS INC.

(Exact name of registrant as specified in its charter)

 

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 (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No o

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: x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act): Yes x No o

The aggregate market value of the voting stock of the Registrant held by nonaffiliates at June 30, 2004, was $171,721,315.

As of February 28, 2005, there were 47,484,732 shares of common stock, $0.01 par value, of the Registrant outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the annual meeting of stockholders to be held April 27, 2005 are incorporated by reference into Part III.

PART I

Item 1.    Business.

(a)   General Development of Business

Sauer-Danfoss Inc. (the Company), a U.S. Delaware corporation, and its predecessor organizations have been active in the mobile hydraulics industry since the 1960s. Sauer-Danfoss is a global leader in the development, manufacture, and marketing of advanced systems for the distribution and control of power in mobile equipment. The Company designs, manufactures, and markets hydraulic, electronic, electric, mechanical components, software and integrated systems, that generate, transmit, and control power in mobile equipment. Principal products are hydrostatic transmissions, gear pumps and motors, orbital motors, hydrostatic steering units, proportional load-sensing valves, microprocessor controls, electric drives, and electrohydraulics. The Company sells its products to original equipment manufacturers (OEMs) of highly engineered, off-road vehicles who use Sauer-Danfoss products to provide the hydraulic and electronic power for the propel, work, and control functions of their vehicles. The Company’s products are sold primarily to the agriculture, construction, road building, turf care, and specialty vehicle markets. The Company conducts its business globally under the Sauer-Danfoss name.

The Company exercised its option to acquire the remaining 15 percent of the outstanding shares of Comatrol S.p.A during the second quarter of 2004 for approximately $4.3 million. The Company has been consolidating the financial results of the business since the second quarter of 2003 when it increased its ownership to 85 percent. Prior to purchasing its controlling interest in Comatrol, the Company accounted for the results of its ownership interest under the equity method of accounting.

In 2003, the Company began projects to reorganize its European sales and distribution operations, and to implement a common business system. Significant progress was made on these projects in 2004, with the reorganization of the European sales and distribution operations substantially completed. The common business system was implemented as a pilot at one location in 2004. The Company implemented the system at two additional locations in January 2005 and plans to implement the system at three additional locations later in 2005. See further discussion of these projects in Management’s Discussion and Analysis presented in Item 7.

(b)   Financial Information About Segments

The Company reports its operating segments based on its various product lines of Propel, Work Function and Controls. Propel products include hydrostatic transmissions and related products that transmit the power from the engine to the wheel to propel a vehicle. Work Function products include steering motors as well as gear pumps and motors that transmit power for the work functions of the vehicle. Controls products include electrohydraulic controls, microprocessors, electric drives and valves that control and direct the power of a vehicle. Information about the Company’s reportable segments defined by product lines is set forth in Note 16 in the Notes to Consolidated Financial Statements on pages F-29 through F-31 of this report, and is incorporated herein by reference.

(c)   Description of Business

Information regarding the Company’s principal products, by segment, and the business in general is presented below. Information regarding sales by the Company’s segments and geographic regions is set forth in Note 16 in the Notes to Consolidated Financial Statements on pages F-29 through F-31, and is incorporated herein by reference. No individual customer, OEM or other, accounted for 10 percent or more of the Company’s total net sales in 2004, 2003 or 2002.

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Propel Segment

Hydrostatic Transmissions

Sauer-Danfoss designs, manufactures, and markets a range of closed circuit axial piston hydrostatic transmissions for the propulsion of mobile equipment in the Americas, Europe, and Asia-Pacific region. High-power (typically over 50 HP) and medium-power (typically 25 to 50 HP) applications for hydrostatic transmissions manufactured by the Company include construction, road building, specialty and agricultural mobile equipment. Light-power (typically 15 to 25 HP) and bantam-power (typically under 15 HP) applications for hydrostatic transmissions manufactured by the Company include light agricultural and turf care mobile equipment. The Company manufactures these hydrostatic transmissions at its facilities in Ames, Iowa; Lawrence, Kansas; Sullivan, Illinois; Neumunster, Germany; Dubnica nad Vahom, Slovakia; Povazská Bystrica, Slovakia; Shanghai, China; and Osaka, Japan.

Work Function Segment

Gear Pumps and Motors

Sauer-Danfoss designs, manufactures, and markets custom-designed gear pumps, as well as a broad range of high-performance standard gear pumps and motors. Gear pumps and motors are the most widely used type of mobile hydraulic pumps and motors in the industry. The Company manufactures gear pumps and motors at its Swindon, England; Lawrence, Kansas; Bologna, Italy; and Povazská Bystrica, Slovakia facilities.

Open Circuit Piston Pumps

Sauer-Danfoss designs, manufactures, and markets custom-designed open circuit piston pumps used to transform mechanical power from the engine to hydraulic power for the work function of the vehicle. The advantages of open circuit piston pumps compared to other types of pumps, such as vane or gear pumps, are the high degree of control within the work function hydraulic system and the more efficient use of engine power. These products are designed and manufactured at facilities in Ames, Iowa, and Povazská Bystrica, Slovakia.

Low Speed High Torque Motors

Sauer-Danfoss designs, manufactures, and markets a complete line of geroller and gerotor motors at its Nordborg, Denmark, facility. These motors are used for both the propel and work functions in all served markets.

Steering Units

Sauer-Danfoss designs, manufactures, and markets hydrostatic steering units to customers throughout the world. The Company manufactures steering units in Nordborg, Denmark, and Wroclaw, Poland. These steering units convert steering wheel motion into hydraulic flow and pressure to provide steering motion for agriculture tractors, combines, turf care, marine and earthmoving equipment.

Controls Segment

Mobile Electronics

Sauer-Danfoss designs, manufactures, and markets electrohydraulic valves and electronic controls, including microprocessor-based controls and electronic sensors through its electrohydraulics operations in Minneapolis, Minnesota and Almhult, Sweden and also designs electrohydraulic products in Neumunster, Germany; Stratford-Upon-Avon, United Kingdom; Cento, Italy; and Nordborg, Denmark. Electrohydraulic controls and sensors integrate hydraulics, hydrostatic transmissions, and mechanical

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components with electronic controls and are used by OEMs of mobile equipment to control the Company’s hydraulic systems, as well as the hydraulic systems of other manufacturers. The electrohydraulic products bring together the propulsion and work functions by providing standard or custom-designed controls.

Additionally, the Company designs and manufactures both alternating current (AC) and direct current (DC) electric motors, electronic motor controllers, inverters, and power units through its Electric Drives operations in Odense, Denmark; Berching, Germany; and Kaiserslautern, Germany.

Control Valves

Sauer-Danfoss designs, manufactures and markets a variety of spool type control valves to meet its customers’ needs, ranging from very sophisticated electrohydraulic valves for highly sophisticated forestry and agricultural harvesting equipment, to very simple low cost valves for turf care agricultural tractors. These products are manufactured in facilities located in Caxias do Sul, Brazil; Nordborg, Denmark; Easley, South Carolina; and Pune, India.

The Company also designs, manufactures and markets a complete line of cartridge valves and hydraulic integrated circuits in facilities located in Reggio Emilia, Italy; Hillsboro, Oregon; and Easley, South Carolina. Aerial lift platforms and road building equipment are examples of significant users of cartridge valves.

Major Markets and Applications

Construction and Road Building		Agriculture		Turf Care		Specialty Vehicles
Chip spreaders		Combines		Commercial wide-area, walk-		Fruit pickers
Concrete pumps		Cotton pickers		behind mowers		Industrial lift trucks
Concrete saws		Detasselers		Commercial zero-turn mowers		Logging equipment
Crawler dozers		Seeders		General turf maintenance		Marine equipment
Crawler loaders		Sprayers		Lawn and garden tractors		Mining equipment
Ditchers/trenchers		Tractors				Oil field equipment
Excavators		Windrowers				Railway maintenance vehicles
Grinders						Rough terrain fork lifts
Landfill compactors						Self-propelled boom aerial lifts
Oil distributors						Self-propelled scissor aerial lifts
Pavers						Snow groomers
Planers						Sweepers
Rollers						Tree shakers
Skid steer loaders						Truck and bus fan drives
Transit mixers
Utility tractors
Wheel loaders

 

General Characteristics

Sauer-Danfoss sells both standard and customized products, with most products being built to order. With respect to some of the most technologically demanding vehicles, such as those used in agriculture, forestry, construction, and road building, Sauer-Danfoss’ engineers work closely with customers from design through manufacture of the final product, a cycle that can take as long as four to six years for a major application.

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Sauer-Danfoss operates 26 manufacturing facilities in the Americas, Europe, and the Asia-Pacific region. The Company’s decentralized manufacturing capabilities allow it to adapt its products to local market needs and to provide flexibility to meet customer delivery requirements. In North America, the Company sells and distributes its products directly to large OEMs and through independent distributors to smaller OEMs. In Europe, South America, and the Asia-Pacific region, the Company sells and distributes its products either directly or through distributors.

In accordance with standard industry practice for the mobile equipment industry, the Company warrants its products to be free from defects in material and workmanship. The warranty period varies from one to three years, from the date of first use or date of manufacture, depending on the type of product or, in some cases, the application. The Company’s warranty expense has been less than 1.5 percent of net sales in each of the past three years.

Because many of its products are designed and developed in conjunction with its customers’ design teams to fit their specific needs and to minimize inventory levels, the Company primarily manufactures products to order. The Company typically machines components with long lead times according to a sales forecast and machines certain unique components for specific customers according to firm orders. Inventories at the Company’s manufacturing sites consist primarily of raw materials and machined iron housings and components. Limited amounts of assembled finished units are maintained in inventory at the manufacturing sites. Historically, inventories at the Company’s sales locations consisted mainly of finished units manufactured specifically for distribution to customers in those locations. As discussed in Management’s Discussion and Analysis on page 13 of this report, the Company has substantially completed the process to streamline its sales and distribution operations in Europe to reduce expenses and improve customer service and delivery. One result of this process is to reduce the amount of inventory held at the sales locations, as products will be shipped directly from the manufacturing site to the customer.

The Company does not normally accept orders subject to late delivery penalties. On occasion, the Company sells its products to government agencies, including those used for military applications, but it does not design its products to meet specific government standards and usually only enters into contracts for the supply of commercial products. There are no government contracts of material value to the Company.

Raw Materials

The Company purchases iron housings and components from various U.S., European, and Asian foundries. The principal materials used by the Company are iron, steel, brass, and aluminum. All materials used by the Company are generally available from a number of sources in quantities sufficient to meet current requirements. In 2004 the availability of steel was limited, and although the Company was able to obtain sufficient quantities of steel to meet its production needs, the cost of the material was higher than in the past due to limited supplies. The Company has in place a Global Supplier Quality Program called “Partners in Quality” that is the primary program used by the Company to ensure that all suppliers meet the Company’s quality expectations.

Patents, Trademarks, and Licenses

The Company owns or licenses rights to approximately 645 patents and trademarks relating to its business. While the Company considers its patents and trademarks important in the operation of its business and in protecting its technology from being used by competitors, its business is not dependent on any single patent or trademark or group of related patents or trademarks.

To ensure worldwide availability of the Company’s design of products, the Company has, in the past, licensed its technology to companies in certain countries. The Company currently has license agreements in place as part of joint venture agreements for the joint venture entity to manufacture or distribute the

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Company’s technology. In 2004, the Company signed a license agreement with an entity for the use and commercialization of digital hydraulic pump technology. The patented technology licensed in the agreement will be applied in the worldwide mobile equipment market.

Seasonality

Seasonal patterns in retail demand for agricultural, construction, road building, and turf care equipment sold by the Company’s customers result in variations in the volume and mix of products sold by the Company during various times of the year. Historically, the Company has higher sales levels in the first half of the year. Seasonal demand must be estimated in advance, and products must be manufactured in anticipation of such demand in order to achieve efficient utilization of labor and production resources.

Backlog

The amount of the Company’s backlog is significant because, among other factors, customer orders have historically involved long lead times and specific model types. At December 31, 2004 the Company’s backlog (consisting of accepted but unfilled customer orders primarily scheduled for delivery during 2005) was $508 million as compared with $409 million at December 31, 2003. However, orders can be canceled or rescheduled by customers. Thus, the level of orders currently in backlog could decline because of cancellation or rescheduling. Additionally, the level of reported backlog can be impacted by currency translation fluctuations and acquisitions. Excluding the impact of currency and acquisition, backlog at December 31, 2004 was $489 million. Customers’ ordering patterns can also impact the level of reported backlog. For example, the Company’s U.S. distributor customers are placing orders with shorter lead times due to the Company’s ability to fulfill such orders.

Competition

The mobile hydraulics industry is very competitive. Sauer-Danfoss competes based on technological product innovation, quality, and customer service. The Company believes that long-term successful suppliers to mobile equipment manufacturers will be those companies that have the ability to capitalize on the changing needs of the industry by providing technological innovation, shorter product development times, and reduced manufacturing lead times at globally competitive price levels.

Hydrostatic Transmission Market

The closed circuit hydrostatic transmission market is highly concentrated and intensely competitive. There are a small number of manufacturers of hydrostatic transmissions with which the Company competes worldwide that are not captive suppliers of OEMs. These include Bosch Rexroth AG, Eaton Corporation, and Linde AG. In addition, the Company competes with alternative products, such as mechanical transmissions of other manufacturers.

The Company competes with a number of smaller companies that typically offer a single, specialized product on a more limited geographic basis as a component of a closed circuit hydrostatic transmission system.

In terms of global supply of closed circuit hydrostatic transmissions, the Company believes it is the world leader in terms of product range, market share, and geographic coverage. Only Bosch Rexroth AG offers similar geographic coverage.

Open Circuit Piston Pumps and Gear Pumps and Motors Market

The open circuit work function market is fragmented with a large number of suppliers of all types of products, including open circuit piston pumps, gear pumps and motors, and with intensive competition on

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pricing at the component level. There are approximately ten major companies that compete on a global basis, including Bosch Rexroth AG, Parker Hannifin Corporation, and Eaton Corporation, and in Japan, Kayaba and Kawasaki. The supply of standard gear pumps and motors is particularly fragmented with more than 50 companies worldwide in each respective area. Most of these competitors have a limited product range and operate in a limited geographic market.

Low Speed High Torque Motor Market

There are a limited number of competitors who can provide a complete line of low speed, high torque motors (LSHT). Competitors include Eaton Corporation, Bosch Rexroth AG, White Hydraulics, Parker-Hannifin Corporation, and M&S Hydraulics. This market is extremely price-competitive, and is growing, providing Sauer-Danfoss opportunity to develop new products to increase market share.

Steering Unit Market

Hydrostatic steering units are provided to the market from the same competitors as LSHT motors (above) plus Ognibene. Sauer-Danfoss has the largest European market share and a growing share globally. As steering systems grow and needs expand, Sauer-Danfoss is providing electronic control of steering and complete electrical steering solutions to meet the growing demands of the steering market. Today, Sauer-Danfoss believes that it leads the industry in this direction for steering technology.

Mobile Electronics Market

In the mobile electronics market, which covers both propulsion and work function systems, there are few suppliers of propulsion system controls and only three are worldwide competitors. The main competition in this area comes from major OEMs, who produce controls for their own use. In work function electrohydraulic valves, electronic sensors, and controls, there is a wide range of niche suppliers in limited geographic markets. In recent years, larger companies have increasingly acquired these niche or regional suppliers and thereby have improved their ability to offer integrated systems. The Company has closely watched the needs for electric drives grow in the low power market segments. With the Company’s addition of alternating current (AC) and direct current (DC) motors and controls it is now well equipped to serve our customers in these segments with either a hydraulic solution or an electric solution for their propel and work function needs. The Company believes it is well positioned to establish itself as a technology leader in the work function and propel segments, as there is no clearly established technology in this sector that is deemed to be an industry standard.

Control Valves Market

The control valve marketplace is fragmented with a large number of suppliers who are primarily focused on limited valve types or flow ranges. Sauer-Danfoss provides a comprehensive line of both spool valves and cartridge valves to meet the specific needs of its customers. Competitors who provide partial lines include Hydra-Force, Sterling Hydraulics, Husco, Sun Hydraulics, Integrated Hydraulics, Walvoil, and Oil Control, plus many others. Complete global control valve line competitors are limited to Parker-Hannifin Corporation, Bosch Rexroth AG, and Eaton Corporation.

Research and Development

The Company’s research and development expenditures during 2004, 2003, and 2002 were approximately $51.9 million, $43.5 million, and $37.8 million, respectively.

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Environmental Matters

In all countries in which it operates, the Company is subject to environmental laws and regulations concerning emissions to air, discharge to waterways, and the generation, handling, storage, transportation, treatment, and disposal of waste materials. These laws and regulations are constantly evolving, and it is impossible to predict accurately the effect they will have on the Company in the future. The regulations are subject to varying and conflicting interpretations and implementation. In some cases, compliance can only be achieved by additional capital expenditures. The Company cannot accurately predict what capital expenditures, if any, may be required to comply with applicable environmental laws and regulations in the future; however, the Company does not currently estimate that any future capital expenditures for environmental control facilities will be material. The Company is not currently subject to any governmental remediation order, nor is the Company aware of any environmental problems that would have a materially adverse effect on the Company.

Employees

As of December 31, 2004, 2003, and 2002 the Company had approximately 8,300, 7,400, and 7,200 employees, respectively. Of its full time employees at December 31, 2004, approximately 2,800 were located in the Americas with the remaining located in Europe and Asia. From time to time, the Company also retains consultants, independent contractors, and temporary and part-time workers.

Financial Information about Geographic Areas

Information regarding the Company’s net sales and long-lived assets by geographic area is set forth in Note 16 in the Notes to Consolidated Financial Statements on pages F-29 through F-31 of this report, and is incorporated herein by reference.

Available Information

The Company maintains an Internet Website and the address of that site is http://www.sauer-danfoss.com. The Company provides access to its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 on its Internet website as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC). The SEC maintains an Internet Website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of the SEC site is http://www.sec.gov.

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Item 2.            Properties.

Sauer-Danfoss Inc. conducts its manufacturing operations at 26 locations; eight in the United States, three each in Italy and Germany, two each in the United Kingdom, Denmark, and Slovakia, and one each in Brazil, China, India, Japan, Poland, and Sweden. The Company leases approximately 15,000 square feet of office space in Lincolnshire, Illinois, where its principal executive offices are located. The following table sets forth certain information relating to the Company’s principal manufacturing facilities:

	Location			Segment that Uses the Facility		Approx. Area in Sq. Ft.		Owned/Leased
United States
Ames, Iowa				Propel and Work Function		330,000			Owned
LaSalle, Illinois				Propel		325,000			Owned
Easley, South Carolina				Controls		184,000			Owned
Freeport, Illinois				Propel		183,000			Owned
Sullivan, Illinois				Propel		176,000			Owned
Lawrence, Kansas				Propel and Work Function		162,000			Owned
Minneapolis, Minnesota				Controls		75,000			Leased
Hillsboro, Oregon				Controls		60,000			Leased
South America
Caxias do Sul, Brazil				Controls		29,000			Leased
Europe
Nordborg, Denmark				Work Function and Controls		680,000			Leased
Neumünster, Germany				Propel and Controls		463,000			Owned
Povazská Bystrica, Slovakia				Propel, Work Function and Controls		351,500			Owned
Bologna, Italy				Work Function		246,000			Owned
Dubnica nad Váhom, Slovakia				Propel		236,000			Owned
Swindon, England				Work Function		229,000			Leased
Berching, Germany				Controls		131,000			Leased
Odense, Denmark				Controls		121,500			Leased
Reggio Emilia, Italy				Controls		76,500			Leased
Wroclaw, Poland				Work Function		41,000			Owned
Älmhult, Sweden				Controls		20,000			Owned
Kaiserslautern, Germany				Controls		8,500			Leased
Stratford-upon-Avon, England				Controls		5,000			Leased
Cento, Italy				Controls		3,500			Leased
India
Pune, India				Work Function		31,000			Leased
Asia
Shanghai/Pudong, China				Propel		105,000			Leased
Osaka, Japan				Propel		94,000			Leased
Total						4,366,500

 

Item 3.            Legal Proceedings.

From time to time, the Company is involved in various legal matters considered normal in the course of its business. The Company intends to vigorously defend against all such claims. It is the Company’s policy to accrue for amounts related to these matters if it is probable that a liability has been incurred and an amount can be reasonably estimated. Although the outcome of such matters cannot be predicted with certainty and no assurances can be given with respect to such matters, the Company believes that the

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outcome of these matters in which it is currently involved will not have a materially adverse effect on its results of operations, liquidity, or financial position.

Item 4.            Submission of Matters to a Vote of Security Holders.

The Company did not submit any matter to a vote of security holders, through a solicitation of proxies or otherwise, during the fourth quarter of 2004.

EXECUTIVE OFFICERS OF THE COMPANY

The following table sets forth certain information regarding the executive officers of the Company:

Name				Age		Position		Year Appointed
David J. Anderson (1)				57		President and Chief Executive Officer			2000
Hans J. Cornett (2)				54		Executive Vice President — Sales and Marketing			2000
Karl J. Schmidt (3)				51		Executive Vice President and Chief Financial Officer, Treasurer			2002
James R. Wilcox (4)				59		Executive Vice President and Chief Operating Officer			2000
Ron Hanson (5)				42		Vice President — Human Resources			2003
Thomas K. Kittel (1)				56		Vice President — Propel Products			2000
Henrik Krabsen (2)				43		Vice President — Valves			2000
Finn Lyhne (2)				50		Vice President — Work Function Products			2000
Kenneth D. McCuskey (1)				50		Vice President and Chief Accounting Officer, Secretary			2000
Albert Zahalka (6)				53		Vice President — Mobile Electronics			2000

(1)          These executive officers have served in various capacities with the Company or its subsidiaries for more than the past five years.

(2)          Prior to being appointed to a position with the Company, each of these executive officers served in various capacities with Danfoss A/S or its subsidiaries for more than the past five years.

(3)          Prior to joining the Company, Mr. Schmidt was employed by Degussa-Huls Corporation as Vice President and Chief Financial Officer.

(4)          Prior to joining the Company, Mr. Wilcox was employed by Omniquip — Textron as President — Material Handling unit.

(5)          Prior to joining the Company, Mr. Hanson was employed by Maytag Corporation as Vice President, Human Resources from January 2001 through January 2003. Prior to being employed by Maytag, Mr. Hanson served as the Director of Human Resources for the Company’s U.S. operations.

(6)          Prior to joining the Company, Mr. Zahalka was employed by Emerson Electric in various executive capacities.

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PART II

Item 5.            Market for the Company’s Common Stock and Related Stockholder Matters.

Market and Dividend Information

The Company’s Common Stock is traded on the New York Stock Exchange and the Frankfurt (Germany) Stock Exchange. As of February 28, 2005, there were approximately 240 stockholders of record.

The Company is currently paying a quarterly dividend, which is subject to Board of Directors approval. In the first quarter of 2005 the Board of Directors approved paying a dividend ot $0.12 per share.

The following table sets forth the high and low prices on the New York Stock Exchange for the Company’s Common Stock since January 1, 2003, and the quarterly cash dividends declared in 2004 and 2003:

		1st			2nd			3rd			4th			Full Year
2004
High		$	16.80		$	17.14		$	18.64		$	22.15		$	22.15
Low		$	12.30		$	13.62		$	15.66		$	16.80		$	12.30
Dividends		$	0.07		$	0.07		$	0.10		$	0.10		$	0.34
2003
High		$	9.58		$	11.90		$	15.16		$	16.97		$	16.97
Low		$	7.44		$	7.55		$	10.18		$	13.40		$	7.44
Dividends		$	0.07		$	0.07		$	0.07		$	0.07		$	0.28

 

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Item 6.            Selected Financial Data.

SELECTED FINANCIAL DATA

		2004			2003			2002			2001			2000 (1)
		(in millions except per share and employee data)
Operating Data:
Net sales		$	1,404.2		$	1,126.8		$	952.3		$	855.3		$	782.5
Gross profit		346.1			252.4			219.0			192.6			199.4
Selling, general and administrative		200.2			156.7			128.6			122.8			98.2
Research and development		51.9			43.4			37.8			38.1			29.9
Loss on disposal of fixed assets		2.1			5.3			0.4			0.6			—
Total operating expenses		254.2			205.4			166.8			161.5			128.1
Total interest expense, net		17.4			17.4			17.2			17.4			11.2
Net income		33.2			11.2			13.7			4.3			26.0
Per Share Data:
Income per common share, basic and diluted		$	0.70		$	0.24		$	0.29		$	0.09		$	0.66
Cash dividends declared per share		$	0.34		$	0.28		$	0.28		$	0.28		$	0.28
Weighted average basic shares outstanding		47.4			47.4			47.4			47.0			39.2
Weighted average diluted shares outstanding		47.5			47.5			47.4			47.0			39.2
Balance Sheet Data:
Inventories		$	241.6		$	198.9		$	164.7		$	141.7		$	146.2
Property, plant and equipment, net		478.5			452.9			435.1			422.5			422.7
Total assets		1,211.6			1,101.8			970.5			884.3			840.7
Total debt		345.1			355.5			318.3			298.8			245.7
Stockholders’ equity		444.1			397.2			367.3			345.8			341.4
Debt to debt plus equity (2)		41.6		%	45.3		%	44.7		%	44.6		%	39.8		%
Other Data:
Backlog (at year-end)		$	508.3		$	408.6		$	382.8		$	319.9		$	375.1
Depreciation and amortization		82.4			80.4			72.6			69.9			53.6
Capital expenditures		79.3			60.0			42.3			69.7			67.9
EBITDA (3)		170.2			124.0			121.8			102.1			117.1
Cash flows from (used in):
Operating activities		124.8			95.6			98.3			67.3			81.9
Investing activities		(75.5		)	(65.0		)	(66.3		)	(110.1		)	(62.3		)
Financing activities		(53.3		)	(28.8		)	(34.4		)	33.5			5.4
Number of employees (at year-end)		8,275			7,409			7,207			6,790			6,733

(1)          Includes results of Danfoss Fluid Power since May 3, 2000.

(2)          The debt to debt plus equity ratio represents the percentage of total capital attributable to external financing. As such, the denominator of the ratio includes the total debt and total stockholders’ equity shown here as well as the minority interest presented on the balance sheet.

(3)          EBITDA represents net income plus net interest expense, income tax expense (benefit), depreciation and amortization, and minority interest. EBITDA may not be comparable to similarly titled measures reported by other companies. While EBITDA should not be construed as a substitute for operating income or a better indicator of liquidity than cash flow from operating activities, which are determined in accordance with accounting principles generally accepted in the United States, it is included herein to provide additional information as management of the Company believes it provides an indication with respect to the ability of Sauer-Danfoss to meet its future debt service, capital expenditures, and

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working capital requirements. The following table further demonstrates how EBITDA is derived from cash flows from operating activities:

		2004			2003			2002			2001			2000
Cash flows from operating activities		$	124.8		$	95.6		$	98.3		$	67.3		$	81.9
Cumulative effect of change in accounting principle		—			—			(0.7		)	—			—
Increase (decrease) in working capital, excluding effects of acquisitions
Accounts receivable, net		30.8			5.6			(2.8		)	(4.1		)	(15.4		)
Inventories		24.3			7.6			(1.1		)	(11.4		)	20.9
Accounts payable		(22.7		)	(6.1		)	(2.5		)	16.5			6.9
Accrued liabilities		(10.2		)	(6.2		)	(4.1		)	(0.3		)	(17.8		)
Deferred income taxes and other		(9.9		)	10.6			10.3			14.1			12.2
Interest expense, net		17.4			17.4			17.2			17.4			11.2
Tax expense (benefit)		15.7			(0.5		)	7.2			2.6			17.2
EBITDA		$	170.2		$	124.0		$	121.8		$	102.1		$	117.1

 

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

Safe Harbor Statement

This Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as other portions of this annual report on Form 10-K, contain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. All statements regarding future performance, growth, sales and earnings projections, conditions or developments are forward-looking statements. Words such as “anticipates,” “in the opinion,” “believes,” “intends,” “expects,” “may,” “will,” “should,” “could,” “plans,” “forecasts,” “estimates,” “predicts,” “projects,” “potential,” “continue,” and similar expressions may be intended to identify forward-looking statements.

Actual future results may differ materially from those described in the forward-looking statements due to a variety of factors, including the fact that the U.S. economy generally, and the agriculture, construction, road building, turf care and specialty vehicle markets specifically, has improved during 2004. It is difficult to determine if past experience is a good guide to the future. While the economy in the U.S. had been improving, it remains unstable due to the uncertainty surrounding continued job creation, interest rates, and the U.S. government’s stance on the weaker dollar. The economic situation in Europe has not necessarily followed the improvement that occurred in the U.S., and the economy in China has been slowed through government intervention. Any downturn in the Company’s business segments could adversely affect the Company’s revenues and results of operations. Other factors affecting forward-looking statements include, but are not limited to, the following: specific economic conditions in the agriculture, construction, road building, turf care and specialty vehicle markets and the impact of such conditions on the Company’s customers in such markets; the cyclical nature of some of the Company’s businesses; the ability of the Company to win new programs and maintain existing programs with its original equipment manufacturer (OEM) customers; the highly competitive nature of the markets for the Company’s products as well as pricing pressures that may result from such competitive conditions; the continued operation and viability of the Company’s significant customers; the Company’s execution of internal performance plans; difficulties or delays in manufacturing; cost-reduction and productivity efforts; competing technologies and difficulties entering new markets, both domestic and foreign; changes in the Company’s product mix; future levels of indebtedness and capital spending; claims, including, without limitation, warranty claims, field retrofit claims, product liability claims, charges or dispute resolutions; ability of suppliers to provide materials as needed and the Company’s ability to recover any price increases for materials and product pricing; the Company’s ability to attract and retain key technical and other personnel; labor relations; the failure of customers to make timely payment; any inadequacy of the Company’s intellectual property protection or the potential for third-party claims of infringement; global economic factors, including currency exchange rates; general economic conditions, including interest rates, the rate of inflation, and commercial and consumer confidence; energy prices; governmental laws and regulations affecting operations, including tax obligations; changes in accounting standards; worldwide political stability; the effects of terrorist activities and resulting political or economic instability; natural catastrophes; U.S. military action overseas; and the effect of acquisitions, divestitures, restructurings, product withdrawals, and other unusual events.

The Company cautions the reader that these lists of cautionary statements and risk factors may not be exhaustive. The Company expressly disclaims any obligation or undertaking to release publicly any updates or changes to these forward-looking statements that may be made to reflect any future events or circumstances.

About the Company

Sauer-Danfoss Inc. and subsidiaries (the Company) is a worldwide leader in the design, manufacture, and sale of engineered hydraulic and electronic systems and components that generate, transmit and control power in mobile equipment. The Company’s products are used by original equipment manufacturers (OEMs) of mobile equipment, including construction, road building, agricultural, turf care

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and specialty equipment. The Company designs, manufactures and markets its products in the Americas, Europe and the Asia-Pacific region, and markets its products throughout the rest of the world either directly or through distributors.

Overview

The general economy in the U.S. improved substantially throughout 2004. The European economy generally also grew in 2004, but at varying degrees by country, and not as substantially as the growth experienced in the U.S. The economy in the Asia-Pacific region remains mixed as Japan’s economy appears stable but government intervention has intentionally slowed the economic growth activity in China.

In 2004 the Company introduced the PLUS 1™ operating architecture system which customers integrated into their vehicle platforms. PLUS 1 provides opportunities for growth in 2005, in addition to the new generation of hydrostatic transmissions for vehicle propel systems that the Company will introduce in 2005. Expanding market share in the Asia-Pacific region and strategic acquisitions provide additional growth opportunities for the Company. Challenges in 2004 included a worldwide shortage of raw materials, particularly steel, and higher prices for these key materials. The Company was able to recover most of the increased cost of metals with price increases to customers.

The Company’s financial condition remains strong at December 31, 2004. In 2004 the Company generated a record cash flow from operations of $124.8 million. The Company’s debt to debt plus equity ratio decreased to 41.6 percent at December 31, 2004 compared to 45.3 percent at December 31, 2003. Based on the Company’s strong cash flow, strong earnings, and the positive long-term outlook for its operations, the Company’s Board of Directors approved an increase in the quarterly dividend declared in the third quarter to $0.10 per share, or a 43 percent increase from the previous dividend level of $0.07 per share.

Executive Summary of 2004 Compared to 2003

The nature of the Company’s operations as a global producer and supplier in the fluid power industry means the Company is impacted by changes in the local economies, including currency exchange rate fluctuations. In order to gain a better understanding of the Company’s base results, a financial statement user needs to understand the impact of those currency exchange rate fluctuations as well as changes resulting from strategic acquisitions. The following table summarizes the change in the Company’s results from operations by separately identifying changes due to currency fluctuations, acquisitions, and the

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underlying change in operations from 2003 to 2004. This analysis is more consistent with how the Company’s management internally evaluates results.

(in millions)				2003			Currency  fluctuations					Acquisitions (1)					Underlying increase (decrease)					2004
Net sales				$	1,126.8			$	68.4				$	11.4				$	197.6			$	1,404.2
Gross profit				252.4				19.3					2.0					72.4				346.1
% of Net Sales				22.4		%																24.6		%
Selling, general and administrative				156.7				10.3					1.4					31.8				200.2
Research and development				43.5				2.6					0.1					5.7				51.9
Loss on disposal of fixed assets				5.3				0.1					—					(3.3		)		2.1
Total operating costs				205.5				13.0					1.5					34.2				254.2
Operating income				46.9				6.3					0.5					38.2				91.9
% of Net Sales				4.2		%																6.5		%
Net interest expense				(17.4		)		(0.9		)			—					0.9				(17.4		)
Other expense, net				(3.4		)		(1.3		)			0.4					0.2				(4.1		)
Income before taxes and minority interest				26.1				4.1					0.9					39.3				70.4
Minority interest and equity income, net				(15.4		)		—					(0.7		)			(5.4		)		(21.5		)
Earnings before taxes				10.7				4.1					0.2					33.9				48.9
% of Net Sales				1.0		%																3.5		%
Income tax benefit (expense)				0.5				(1.2		)			(0.1		)			(14.9		)		(15.7		)
Net income				$	11.2			$	2.9				$	0.1				19.0				$	33.2

 

(1)   Consists of three months of operations of Comatrol, which was acquired in April 2003 and the results of a Japanese manufacturing location which was accounted for under the equity method of accounting in 2003.

The underlying growth in sales, which excludes the effect of currency fluctuations and acquisitions, exceeded 17 percent in 2004, in large part due to the improving economy in the U.S., which not only results in increased sales within the Americas, but also increased export business from the Company’s European and Asia-Pacific customers. The Company’s sales growth exceeded the market growth of 12 percent, which the Company determined based on the volume of units sold in the regions in which the Company distributes its products. In the second half of 2004, the Company passed the increased cost of metals used in the manufacture of its products on to its customers, resulting in additional revenue of approximately $11.0 million in 2004. Margin on total net sales increased over two percentage points due to several factors, including spreading the fixed production costs over a higher volume of units produced, reduced field recall costs, and beginning to realize the benefits of the restructurings which have occurred in recent years. Management of the Company generally targets overall margin improvement of 20 to 25 percent on each dollar of incremental sales based on the cost structure it has in place and the intent of reinvesting in the business for future growth. This target was met in 2004 as the margin on the underlying increase in net sales exceeded 36 percent.

The Company continues to pursue lean manufacturing efficiencies and expand the use of Six-Sigma quality tools to reduce waste and improve processes throughout the Company. The Company’s continuing focus on quality reduced the level of field recalls in the current year with no individually significant field recalls in 2004. In 2003 the Company incurred expense of $6.2 million on a pre-tax basis due to five unrelated field recalls. Increased emphasis on global logistics, selective outsourcing, lower-cost manufacturing methods, and a consolidated network of authorized service centers also contributed to the gross margin improving to 24.6 percent in 2004.

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Management is pleased with the improved profit margins that the Company achieved in 2004, however increased operating costs partially offset the increased gross profit. In 2004, the Company incurred a total of $6.8 million of restructuring costs on a pre-tax basis related to the European sales and distributions operation, discussed below, and reorganization at certain production locations. The management rationalization within the Work Function segment, partial consolidation of the non-manufacturing functions of the Controls segment within the U.S. and completion of the relocation of the West Branch, Iowa, Work Function operations resulted in pre-tax costs of $2.4 million. In 2003 pre-tax restructuring costs related to production locations totaled $7.6 million. The lower restructuring costs in 2004 resulted in $2.4 and $3.7 million improvement in cost of sales and loss on disposal of fixed assets respectively, compared to 2003. The costs in selling, general and administrative related to restructuring were $0.9 million higher in 2004 than in 2003.

The following table summarizes the significant costs, on a pretax basis, included in the selling, general, and administrative line that contributed to the $31.8 million increase in 2004 compared to 2003. Discussion of each item is included in the previous paragraph or in the paragraphs following the table:

In millions				2004			2003			Increase
Manufacturing location restructuring				$	1.4		$	0.5			$	0.9
European sales and distribution operations restructuring				4.0			1.3				2.7
Development of common business system				3.5			2.2				1.3
Management incentive plans				16.9			3.6				13.3
Sarbanes-Oxley Section 404 compliance				6.7			0.5				6.2
Total				$	32.5		$	8.1			$	24.4

 

The restructuring of the Company’s sales and distribution operations in Europe to consolidate inventory, warehouse and distribution operations as well as streamline delivery directly from the manufacturing locations to the customer, which began in 2003, was substantially completed in 2004. Also contributing to the increase in selling, general and administrative costs in 2004 was the continuing development and implementation of a common business system to standardize business processes and provide a single interface to direct OEM customers and suppliers. The investment in the common business system will drive improved operational efficiency, customer service, and financial performance in future years after it is implemented at all Company locations over the three year period ending in 2008. As of the first quarter of 2005 three locations are operating on the new business system and three additional locations will implement the new system later in 2005.

The improved financial performance of the Company in 2004 resulted in additional costs associated with both its long-term and short-term incentive plans. Based on established performance targets for the incentive plans and the Company’s outlook on future operating results the expense in 2005 associated with the incentive plans is expected to approximate the 2004 expense. The Company implemented a new Financial Reporting Quality System, an overall quality improvement system for finance and information technology, to document and test internal controls as required under Section 404 of the Sarbanes-Oxley Act of 2002. The $6.7 million of costs incurred in 2004 for the Financial Reporting Quality System relate to fees paid to external consultants, in addition to increased external audit fees related to the report on management’s assessment of internal controls over financial reporting that is required under the Sarbanes-Oxley Act of 2002.

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The Company continues to deliver top line sales growth exceeding the market growth in the markets that it serves. The Company’s 15 percent compound annual growth rate in reported sales over the past ten years has outpaced the general growth within the industry. To obtain the Company’s goal of gaining market share and delivering long-term profitable growth the entire organization is focused on the following strategic operating goals:

·       Increase the component and system content on customers’ vehicles.

·       Develop uses for the Company’s technology on new types of mobile applications.

·       Continue to pursue optimal operating efficiencies though continued use of lean manufacturing.

·       Further expand the Company’s global presence.

·       Pursue appropriate acquisition targets to compliment the Company’s product portfolio.

Operating Results — 2004 Compared to 2003

Sales Growth by Market

The following table summarizes the Company’s sales growth by market. The table and following discussion is on a comparable basis, which excludes the effects of acquisitions and currency fluctuations.

		Americas				Asia-Pacific				Europe				Total
Agriculture			21	%			54	%			(1	)%			7	%
Construction			34				6				20				24
Road building			41				13				8				18
Turf care			26				—				—				26
Specialty			36				37				16				20
Distribution			23				15				7				15

 

Agriculture

The agricultural market in the Americas benefited from record crop production and strong livestock markets in the U.S. in 2004. The general increase in the agriculture market resulted in large sales increases to the large OEMs in the Americas market for all products. Although Asia-Pacific provides a smaller portion of the Company’s sales in the agricultural market than the Americas and Europe, the 54 percent increase in 2004 sales represents continuing growth in this region, primarily in Japan. The agriculture market in Europe remained flat in 2004, although sales growth did occur in the fourth quarter due to increased sales to several OEMs.

Construction

Sales within the construction market increased by 34 percent in the Americas due to a combination of increased production by OEMs and share growth as Sauer-Danfoss began to supply all hydraulic system content on an application produced by a large OEM, including product previously supplied by a competitor. The Company experienced growth in Japan due to an increase in exports of skid steer loaders; however this increase was partially offset by the Chinese government intervention to slow down the economy. Exports also generated additional sales in the European region. Demand for transit mixers has had a positive effect on the European sales in the construction market.

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Road Building

The Americas road building market experienced strong growth in 2004 with sales growth to all OEMs. Key customers in the Asia-Pacific region are located in China so the government economic restrictions in place during the last half of the year had a negative effect on sales growth; however growth was strong in the first half of the year, resulting in growth for the full year of 13 percent. Increased customer exports contributed to the growth in European sales in the road building market. Sales to several European customers experienced strong growth in the fourth quarter of 2004.

Turf Care

The Company’s primary business within this market comes from products produced for the consumer and commercial turf care markets in the Americas region. The consumer zero-turn radius machines continue to gain market share from traditional lawn and garden tractors, which has led to increased sales of the Company’s new zero-turn transaxle product that was introduced late in 2003. In addition, the Company experienced market share gains from sales of low speed, high torque motors produced in its Nordborg, Denmark, facility, which contributed to the 26 percent growth in sales during 2004.

Specialty Vehicles

Sales into the specialty vehicle markets increased in all regions in 2004. Growth in the aerial lift and forklift markets, after several years of decreased demand, contributed strongly to the 20 percent growth in specialty vehicles. Sales growth is also occurring in the waste management and waste recycling markets in Asia-Pacific and the telehandler and forestry markets in Europe. Sales in the European region, which comprises the majority of the specialty market, has not recovered as quickly as the Americas and the Asia-Pacific markets.

Distribution

Products related to all of the above markets are sold to distributors, who then serve smaller OEMs.

Order Backlog

The following table shows the Company’s order backlog and orders written activity for 2003 and 2004, in addition to the reasons why the amounts fluctuated between years. Order backlog represents the amount of customer orders received for future shipment.

(in millions)				2003			Currency fluctuation					Acquisitions					Underlying increase (decrease)					2004
Americas
Backlog at December 31				$	224.4			$	0.3				$	—				$	61.4			$	286.1
Orders written				481.9				0.9					—					194.4				677.2
Asia-Pacific
Backlog at December 31				21.5				0.4					1.1					(4.8		)		18.2
Orders written				85.2				5.8					6.5					3.6				101.1
Europe
Backlog at December 31				162.7				17.3					—					24.0				204.0
Orders written				558.7				63.3					6.1					80.9				709.0
Total
Backlog at December 31				408.6				18.0					1.1					80.6				508.3
Orders written				1,125.8				70.0					12.6					278.9				1,487.3

 

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Total order backlog at the end of 2004 was $508.3 million, compared to $408.6 million at the end of 2003, an increase of 24 percent. On a comparable basis, excluding the impact of currency fluctuation and acquisitions, order backlog increased 20 percent over 2003. New sales orders written for 2004 were $1,487.3 million, an increase of 32 percent from 2003. Excluding the impact of currencies and acquisitions, total orders written in 2004 were 24 percent above the 2003 levels.

Backlog information has become less reliable as an indicator of future sales expectations as customers continue to adjust orders closer to the scheduled production dates. The decrease in lead time may be due to customers taking advantage of reduced production cycles within the Company’s facilities or due to the customer’s uncertainty on the outlook of their own markets. Although backlog does not predict future sales levels as reliably as in the past, the increase in backlog at December 31, 2004 indicates that current demand is strong and suggests strong sales in future months.

Business Segment Results

The following discussion of operating results by reportable segment relates to information as presented in Note 16 in the Notes to Consolidated Financial Statements. Segment income is defined as the respective segment’s portion of the total Company’s net income, excluding net interest expense, income taxes, minority interest, and global service expenses. Propel products include hydrostatic transmissions and related products that transmit the power from the engine to the wheel to propel a vehicle. Work Function products include steering motors as well as gear pumps and motors that transmit power for the work functions of the vehicle. Controls products include electrohydraulic controls, microprocessors, electric drives and valves that control and direct the power of a vehicle. The following table provides a summary of each segment’s net sales and segment income, separately identifying the impact of currency fluctuations and acquisitions in 2004.

(in millions)				2003			Currency fluctuation					Acquisitions (1)					Underlying increase (decrease)					2004
Net sales
Propel				$	505.0			$	20.3				$	5.1				$	126.1			$	656.5
Work Function				345.6				27.6					—					38.9				412.1
Controls				276.2				20.5					6.3					32.6				335.6
Segment income (loss)
Propel				$	50.1			$	8.0				$	0.2				$	33.0			$	91.3
Work Function				9.3				(1.0		)			—					13.6				21.9
Controls				13.7				0.2					0.7					10.1				24.7
Global Services and other expenses, net				(29.5		)		(2.4		)			—					(18.1		)		(50.0		)

(1)          Consists of three months of operations of Comatrol, which was acquired in April 2003 and the results of a Japanese manufacturing location which was accounted for under the equity method of accounting in 2003.

Propel Segment

The general improvement in the economy contributed to increased sales as demand from large OEMs and distributors increased. Increased sales of $40.0 million in the America’s turf care market, as mentioned in the preceding Sales Growth by Market section, also contributed to the sales increase as consumers continue to move away from mechanical transmissions to hydrostatic transmissions. Sales, excluding increases due to fluctuations in currency and acquisitions, increased by 25 percent in 2004 compared to 2003 due to both increased sales volumes and prices.

The Propel segment converted the 25 percent underlying increase in sales to an increase in segment income of 66 percent, excluding the impact of currency fluctuations and acquisitions. This $33.0 million

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increase in underlying segment income is 26 percent of the underlying sales increase, meeting the Company’s internal expectations. The increase in segment income was partly due to spreading fixed costs over a higher volume of units produced. However, the Company has also continued to identify process improvements and cost reduction opportunities through the use of Six-Sigma quality tools and the pursuit of lean manufacturing efficiency. In recent years Propel segment income has been negatively impacted by increased price pressures due to customers demanding price concessions. In 2004, a focus on global purchasing initiatives reduced material costs by sourcing components to global suppliers who were more cost effective than previous suppliers and to outsource the manufacturing of components when it was cost effective to do so. In 2003, the Propel segment incurred $5.2 million of field recall costs as a result of four separate quality issues. The Company focused on revising processes to reduce the level of field recall costs which contributed to the improved segment income in 2004.

Work Function Segment

Sales in the Work Function segment increased by 11 percent, excluding the effect of currency fluctuations and acquisitions in 2004 compared to 2003. Demand for Work Function product has been high throughout 2004 resulting in production operating at near full capacity at certain Work Function locations. Due to high demand, the Work Function segment has incurred $3.4 million of airfreight costs in order to meet customer delivery requirements in 2004, which negatively impacted segment income. However the increased airfreight costs were more than offset by reduced restructuring costs and the benefits that are beginning to be realized from this restructuring. In 2003 the Company incurred approximately $7.4 million of costs related to the relocation of operations from its facilities in Sturtevant, Wisconsin, and West Branch, Iowa, to its locations in Nordborg, Denmark; Wroclaw, Poland; Freeport, Illinois; and Lawrence, Kansas. The relocation of the West Branch location was completed in 2004, which, combined with additional reorganization within the Work Function segment resulted in approximately $2.2 million of restructuring costs in 2004. In connection with the restructuring, the Company rationalized and outsourced certain low-volume product lines which is also contributing to the improved segment income in the current year. Segment income in 2004, excluding the effect of currency fluctuations and acquisitions, more than doubled from the 2003 level. The increased segment income derived from the underlying sales growth amounted to over 35 percent of the incremental sales growth, achieving management expectations. Management of the Company expects this improved profitability to continue as the Work Function segment continues to realize the benefits from previous restructurings.

Controls Segment

The Controls segment experienced sales growth of approximately 12 percent in 2004, excluding the effect of currency fluctuations and acquisitions. The PLUS 1 vehicle architecture was introduced during 2004, and although sales for the year were not a significant portion of the Controls Segment total sales, the introduction of the product has been well received. The $10.1 million increase in segment income is 31 percent of the underlying sales increase of $32.6 million, which is in line with management’s expectations.

Global Services and other expenses, net

Segment costs in Global Services and other expenses, net relate to internal global service departments, along with the operating costs of the Company’s executive offices. Global services include costs such as consulting for special projects, tax and accounting fees paid to outside third parties, certain insurance premiums, and the amortization of intangible assets from certain business combinations. The $18.1 million increase in Global Services relates to three items. First, the Company continues to incur costs, $3.5 million in 2004, to develop a common business system for all of the Company’s worldwide operations. Costs to develop the common business system increased by $1.3 million from the 2003 amount of $2.2 million. Second, due to the Company’s improved financial performance in 2004 costs related to the Company’s incentive plans increased by $13.5 million. Outside service costs to assist in implementing the new

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requirements to document and test internal controls under Section 404 of the Sarbanes-Oxley Act of 2002 were $6.7 million in 2004, an increase of $6.2 million compared to costs incurred in 2003.

Income Taxes

The Company’s effective tax rate was 32.2 percent in 2004. A decrease of previously recorded accruals for outstanding IRS audit issues on prior year’s tax returns has reduced the effective tax rate.

The American Job Creations Act of 2004 introduced a limited time 85 percent dividends received deduction on the repatriation of certain foreign earnings. This deduction would result in an approximate 5.25 percent federal tax rate on the repatriated earnings. To qualify for the deduction certain criteria must be met, including that the earnings must be reinvested in the U.S. pursuant to a domestic reinvestment plan established by the company’s chief executive officer and approved by the company’s Board of Directors. The Company has started an evaluation of the effects of the repatriation provision and may elect to apply the provision to qualifying earnings repatriations in 2005. However, the Company does not expect to be able to complete its evaluation until after Congress or the Treasury Department provides additional clarifying language on key elements of the provision. Assuming such clarifications are made, the Company expects to complete its evaluation of the effects of the repatriation provision by the end of the second quarter in 2005. The range of possible amounts that the Company is considering for repatriation under this provision is between $0 and $148.0 million. While the Company estimates the related potential range of additional income tax is between $0 and $2.6 million, the range is subject to change based on the technical correction legislation that is expected to be passed.

Executive Summary of 2003 Compared to 2002

The following table summarizes the Company’s 2003 and 2002 results from operations by separately identifying the impact of currency fluctuations and acquisitions. This analysis is more consistent with how the Company internally evaluates its results.

(in millions)				2002 (1)			Currency fluctuations					Acquisitions (2)					Underlying increase (decrease)					2003
Net sales				$	952.3			$	91.8				$	26.2				$	56.5			$	1,126.8
Gross profit				219.0				23.4					4.9					5.1				252.4
% of Sales				23.0		%																22.4		%
Selling, general and administrative				128.7				12.4					2.3					13.3				156.7
Research and development				37.8				3.7					0.8					1.2				43.5
Loss on disposal of fixed assets				0.4				0.1					—					4.8				5.3
Total operating costs				166.9				16.2					3.1					19.3				205.5
Operating income				52.1				7.2					1.8					(14.2		)		46.9
% of Sales				5.5		%																4.2		%
Net interest expense				(17.2		)		(1.6		)			(0.1		)			1.5				(17.4		)
Other expense, net				(2.9		)		(1.9		)			—					1.4				(3.4		)
Income before taxes and minority interest				32.0				3.7					1.7					(11.3		)		26.1
Minority interest and equity income, net				(11.6		)		0.4					—					(4.2		)		(15.4		)
Earnings before taxes				20.4				4.1					1.7					(15.5		)		10.7
% of Sales				2.1		%																1.0		%
Income tax benefit (expense)				(7.2		)		(0.6		)			(0.8		)			9.1				0.5
Net income				$	13.2			$	3.5				$	0.9				$	(6.4	)		$	11.2

(1)          Excludes results of equity ownership in Comatrol.

(2)          Represents full year results of Comatrol, which was accounted for under the equity method in the first quarter of 2003 and consolidated the remainder of 2003, and the first quarter results of Thrige Electric, which was acquired in the second quarter of 2002.

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The Company exceeded its own expectations in terms of sales growth by posting a 6 percent sales growth, excluding the effects of currency fluctuations and acquisitions in 2003 over 2002. This sales increase exceeded the market growth of approximately 2 percent, which the Company determined based on the volume of units sold in the regions in which the Company distributes its products. However, the margin returns on the increased sales levels in 2003 did not meet the Company’s expectations. Operating margins and net income margins were all lower in 2003 than in 2002, due in part to some strategic business decisions that the Company made during the year that were not originally planned, but also due to unexpected costs. These items are discussed in more detail below.

The most significant item to impact the Company’s financial performance in 2003 was the decision to close and relocate two of its manufacturing locations in the U.S. These facilities were located in Sturtevant, Wisconsin, and West Branch, Iowa. The total costs incurred in 2003 related to the closure of these facilities amounted to $7.6 million on a pretax basis. These costs included impairment charges on property, plant and equipment, accelerated depreciation, employee severance costs, inventory disposal costs, costs to move people and equipment to other facilities, and manufacturing inefficiencies during the shut down and move of operations from these two facilities. Approximately $3.9 million was recorded as loss on fixed assets. The remaining $3.3 and $0.4 million affected the cost of sales and selling, general and administrative lines, respectively, of the income statement. The Company did not incur any restructuring costs in 2002 and expects to incur only $0.7 million of costs related to the West Branch restructuring in 2004.

The Company’s 2003 financial results were also significantly impacted by several large field recall issues. The field recalls amounted to a total of $6.2 million on a pretax basis and impacted the gross profit line of both the Propel and Work Function segments. While the Company was not pleased to have incurred these field recalls, they related to five individual defects that were not interrelated. The Company is diligently working to understand the root cause of these defects and to enhance its processes in order to prevent this order of magnitude of field recall costs from occurring in the future. However, as the Company has identified under its Critical Accounting Estimates, warranty and field recall costs can be a recurring part of its business due to the high-precision and technical nature of its products and processes. There can be no assurances as to the frequency or significance of these costs in the future.

In addition to the above items, the Company incurred $1.3 million of expense to begin the restructuring of its sales and distribution operations in Europe, intended to reduce future operating costs by streamlining delivery directly from the manufacturing locations to the customer. The Company incurred $2.2 million of expense to begin the implementation of a common business system to standardize business processes and provide a single interface to direct OEM customers and suppliers. The investment in the common business system will drive improved operational efficiency, customer service, and financial performance in future years. In 2003, the Company also incurred $0.5 million of outside consulting fees related to the initial work to comply with Section 404 of the Sarbanes-Oxley Act of 2002. These costs are all reflected in the selling, general and administrative expenses line on the Consolidated Statement of Income and are anticipated to continue in 2004 at varying degrees.

The items discussed above negatively impacted income from operations by $17.8 million. Excluding these items, the Company would have experienced a $3.6 million increase in operating income on the sales increase of $56.5 million, excluding the effects of currency and acquisitions, or approximately 6 percent of the incremental sales growth. The Company generally targets overall margin improvement of 20 to 25 percent on each dollar of incremental sales based on the cost structure it has in place and the intent of reinvesting in the business for future growth. Additionally, the Company experienced deterioration in gross profit margins due to the impact of the weakening U.S. currency on product sold in the U.S. that was manufactured outside the U.S. (See further discussion of currency risk below under Market Risk.) Based on the 2003 ongoing operational performance, the Company is not meeting these internal targets.

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