**SECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

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FORM 10-K

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2004**

**COMMISSIONFILE NUMBER: 1-14097**

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SAUER-DANFOSS INC.

(Exact name of registrantas specified in its charter)

| **Delaware**(State or other jurisdiction of  incorporation or organization)                            | **36-3482074**(I.R.S. Employer  Identification No.) |
|--------------------------------------------------------------------------------------------------------|-----------------------------------------------------|
| **250 Parkway Drive, Suite 270,  Lincolnshire, Illinois**(Address of principal executive offices) | **60069**(Zip Code)                                 |
| **(515) 239-6000**(Registrant’s telephone number, including Area Code)                       |
| Securities  registered pursuant to Section 12(b) of the Act:                                 |
|                                                                                                        | Common  Stock, par value $0.01 per share            |   |   | New  York Stock Exchange  Frankfurt (Germany) Stock Exchange |   |
| (Title of each  class)                                                                                 | (Name of each  exchange on which registered)        |
| Securities  registered pursuant to Section 12(g) of the Act:                                 |
| ** **                                                                                             | **None**                                            | ** ** |
| (Title of class)                                                                                       |
|                                                                                                        |                                                     |  |  |  |  |  |  |

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days: Yes xNo o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K: x

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act): Yes xNo o

The aggregate market valueof 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 theRegistrant outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

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

 

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**PART I**

**Item 1.    Business.**

**(a)   GeneralDevelopment of Business**

Sauer-Danfoss Inc. (the Company), a U.S. Delawarecorporation, and its predecessor organizations have been active in the mobilehydraulics industry since the 1960s. Sauer-Danfoss is a global leader in thedevelopment, manufacture, and marketing of advanced systems for thedistribution and control of power in mobile equipment. The Company designs,manufactures, and markets hydraulic, electronic, electric, mechanicalcomponents, software and integrated systems, that generate, transmit, andcontrol power in mobile equipment. Principal products are hydrostatictransmissions, gear pumps and motors, orbital motors, hydrostatic steeringunits, proportional load-sensing valves, microprocessor controls, electricdrives, and electrohydraulics. The Company sells its products to originalequipment manufacturers (OEMs) of highly engineered, off-road vehicles who useSauer-Danfoss products to provide the hydraulic and electronic power for thepropel, work, and control functions of their vehicles. The Company’s productsare sold primarily to the agriculture, construction, road building, turf care,and specialty vehicle markets. The Company conducts its business globally underthe Sauer-Danfoss name.

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

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

**(b)   FinancialInformation About Segments**

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

**(c)   Descriptionof Business**

Information regarding theCompany’s principal products, by segment, and the business in general ispresented below. Information regarding sales by the Company’s segments andgeographic regions is set forth in Note 16 in the Notes to ConsolidatedFinancial Statements on pages F-29 through F-31, and is incorporatedherein by reference. No individual customer, OEM or other, accounted for10 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 hydrostatictransmissions 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 manufacturedby the Company include construction, road building, specialty and agriculturalmobile equipment. Light-power (typically 15 to 25 HP) and bantam-power(typically under 15 HP) applications for hydrostatic transmissions manufacturedby the Company include light agricultural and turf care mobile equipment. TheCompany manufactures these hydrostatic transmissions at its facilities in Ames,Iowa; Lawrence, Kansas; Sullivan, Illinois; Neumunster, Germany; Dubnica nadVahom, 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 rangeof high-performance standard gear pumps and motors. Gear pumps and motors arethe 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 totransform mechanical power from the engine to hydraulic power for the workfunction of the vehicle. The advantages of open circuit piston pumps comparedto other types of pumps, such as vane or gear pumps, are the high degree ofcontrol within the work function hydraulic system and the more efficient use ofengine power. These products are designed and manufactured at facilities inAmes, 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 itsNordborg, Denmark, facility. These motors are used for both the propel and workfunctions in all served markets.

**Steering Units**

Sauer-Danfoss designs,manufactures, and markets hydrostatic steering units to customers throughoutthe world. The Company manufactures steering units in Nordborg, Denmark, andWroclaw, Poland. These steering units convert steering wheel motion intohydraulic flow and pressure to provide steering motion for agriculturetractors, combines, turf care, marine and earthmoving equipment.

***Controls Segment***

**Mobile Electronics**

Sauer-Danfoss designs, manufactures, and marketselectrohydraulic valves and electronic controls, including microprocessor-basedcontrols and electronic sensors through its electrohydraulics operations inMinneapolis, Minnesota and Almhult, Sweden and also designs electrohydraulicproducts in Neumunster, Germany; Stratford-Upon-Avon, United Kingdom; Cento,Italy; and Nordborg, Denmark. Electrohydraulic controls and sensors integratehydraulics, hydrostatic transmissions, and mechanical 

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components with electroniccontrols and are used by OEMs of mobile equipment to control the Company’shydraulic systems, as well as the hydraulic systems of other manufacturers. Theelectrohydraulic products bring together the propulsion and work functions byproviding standard or custom-designed controls.

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

**Control Valves**

Sauer-Danfoss designs, manufactures and markets avariety of spool type control valves to meet its customers’ needs, ranging fromvery sophisticated electrohydraulic valves for highly sophisticated forestryand agricultural harvesting equipment, to very simple low cost valves for turfcare agricultural tractors. These products are manufactured in facilitieslocated 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 hydraulicintegrated circuits in facilities located in Reggio Emilia, Italy; Hillsboro,Oregon; and Easley, South Carolina. Aerial lift platforms and road buildingequipment are examples of significant users of cartridge valves.

**Major Markets andApplications**
| 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 customizedproducts, with most products being built to order. With respect to some of themost technologically demanding vehicles, such as those used in agriculture,forestry, construction, and road building, Sauer-Danfoss’ engineers workclosely with customers from design through manufacture of the final product, acycle that can take as long as four to six years for a major application.

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

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

Because many of its products are designed anddeveloped in conjunction with its customers’ design teams to fit their specificneeds and to minimize inventory levels, the Company primarily manufacturesproducts to order. The Company typically machines components with long leadtimes according to a sales forecast and machines certain unique components forspecific customers according to firm orders. Inventories at the Company’smanufacturing sites consist primarily of raw materials and machined ironhousings and components. Limited amounts of assembled finished units aremaintained in inventory at the manufacturing sites. Historically, inventoriesat the Company’s sales locations consisted mainly of finished unitsmanufactured specifically for distribution to customers in those locations. Asdiscussed in Management’s Discussion and Analysis on page 13 of thisreport, the Company has substantially completed the process to streamline itssales and distribution operations in Europe to reduce expenses and improvecustomer service and delivery. One result of this process is to reduce theamount of inventory held at the sales locations, as products will be shippeddirectly from the manufacturing site to the customer.

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

**Raw Materials**

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

**Patents, Trademarks, and Licenses**

The Company owns or licenses rights to approximately645 patents and trademarks relating to its business. While the Companyconsiders its patents and trademarks important in the operation of its businessand in protecting its technology from being used by competitors, its businessis not dependent on any single patent or trademark or group of related patentsor trademarks.

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

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Company’stechnology. In 2004, the Company signed a license agreement with an entity forthe use and commercialization of digital hydraulic pump technology. Thepatented technology licensed in the agreement will be applied in the worldwidemobile equipment market.

**Seasonality**

Seasonal patterns inretail demand for agricultural, construction, road building, and turf careequipment sold by the Company’s customers result in variations in the volumeand 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. Seasonaldemand must be estimated in advance, and products must be manufactured inanticipation of such demand in order to achieve efficient utilization of laborand production resources.

**Backlog**

The amount of the Company’sbacklog is significant because, among other factors, customer orders havehistorically involved long lead times and specific model types. At December 31,2004 the Company’s backlog (consisting of accepted but unfilled customer ordersprimarily scheduled for delivery during 2005) was $508 million as comparedwith $409 million at December 31, 2003. However, orders can becanceled or rescheduled by customers. Thus, the level of orders currently inbacklog could decline because of cancellation or rescheduling. Additionally,the level of reported backlog can be impacted by currency translationfluctuations and acquisitions. Excluding the impact of currency andacquisition, 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 leadtimes due to the Company’s ability to fulfill such orders.

**Competition**

The mobile hydraulicsindustry is very competitive. Sauer-Danfoss competes based on technologicalproduct innovation, quality, and customer service. The Company believes thatlong-term successful suppliers to mobile equipment manufacturers will be thosecompanies that have the ability to capitalize on the changing needs of theindustry by providing technological innovation, shorter product developmenttimes, and reduced manufacturing lead times at globally competitive pricelevels.

*HydrostaticTransmission Market*

The closed circuit hydrostatic transmission market ishighly concentrated and intensely competitive. There are a small number ofmanufacturers of hydrostatic transmissions with which the Company competesworldwide that are not captive suppliers of OEMs. These include BoschRexroth AG, Eaton Corporation, and Linde AG. In addition, the Company competeswith alternative products, such as mechanical transmissions of othermanufacturers.

The Company competes with a number of smallercompanies that typically offer a single, specialized product on a more limitedgeographic basis as a component of a closed circuit hydrostatic transmissionsystem.

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

*Open Circuit PistonPumps and Gear Pumps and Motors Market*

The open circuit workfunction market is fragmented with a large number of suppliers of all types ofproducts, including open circuit piston pumps, gear pumps and motors, and withintensive competition on 

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pricingat the component level. There are approximately ten major companies thatcompete on a global basis, including Bosch Rexroth AG, Parker HannifinCorporation, and Eaton Corporation, and in Japan, Kayaba and Kawasaki. Thesupply of standard gear pumps and motors is particularly fragmented with morethan 50 companies worldwide in each respective area. Most of these competitorshave a limited product range and operate in a limited geographic market.

*Low Speed HighTorque Motor Market*

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

*Steering UnitMarket*

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

*Mobile ElectronicsMarket*

In the mobile electronicsmarket, which covers both propulsion and work function systems, there are fewsuppliers of propulsion system controls and only three are worldwidecompetitors. The main competition in this area comes from major OEMs, whoproduce controls for their own use. In work function electrohydraulic valves,electronic sensors, and controls, there is a wide range of niche suppliers inlimited geographic markets. In recent years, larger companies have increasinglyacquired these niche or regional suppliers and thereby have improved theirability to offer integrated systems. The Company has closely watched the needsfor electric drives grow in the low power market segments. With the Company’saddition of alternating current (AC) and direct current (DC) motors andcontrols it is now well equipped to serve our customers in these segments witheither a hydraulic solution or an electric solution for their propel and workfunction needs. The Company believes it is well positioned to establish itselfas a technology leader in the work function and propel segments, as there is noclearly established technology in this sector that is deemed to be an industrystandard.

*Control ValvesMarket*

The control valvemarketplace is fragmented with a large number of suppliers who are primarilyfocused on limited valve types or flow ranges. Sauer-Danfoss provides acomprehensive line of both spool valves and cartridge valves to meet thespecific needs of its customers. Competitors who provide partial lines includeHydra-Force, Sterling Hydraulics, Husco, Sun Hydraulics, Integrated Hydraulics,Walvoil, and Oil Control, plus many others. Complete global control valve linecompetitors are limited to Parker-Hannifin Corporation, Bosch Rexroth AG, andEaton Corporation.

**Research and Development**

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

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**Environmental Matters**

In all countries in whichit operates, the Company is subject to environmental laws and regulations concerningemissions to air, discharge to waterways, and the generation, handling,storage, transportation, treatment, and disposal of waste materials. These lawsand regulations are constantly evolving, and it is impossible to predictaccurately the effect they will have on the Company in the future. Theregulations are subject to varying and conflicting interpretations andimplementation. In some cases, compliance can only be achieved by additionalcapital expenditures. The Company cannot accurately predict what capitalexpenditures, if any, may be required to comply with applicable environmentallaws and regulations in the future; however, the Company does not currentlyestimate that any future capital expenditures for environmental controlfacilities will be material. The Company is not currently subject to anygovernmental remediation order, nor is the Company aware of any environmentalproblems 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 7,200employees, respectively. Of its full time employees at December 31, 2004,approximately 2,800 were located in the Americas with the remaining located inEurope and Asia. From time to time, the Company also retains consultants,independent contractors, and temporary and part-time workers.

**FinancialInformation about Geographic Areas**

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

**Available Information**

The Company maintains an Internet Website and theaddress of that site is http://www.sauer-danfoss.com. The Company providesaccess 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 filedor furnished pursuant to Section 13(a) of the Securities Exchange Actof 1934 on its Internet website as soon as reasonably practicable after theCompany electronically files such material with, or furnishes it to, theSecurities and Exchange Commission (SEC). The SEC maintains an Internet Websitethat contains reports, proxy and information statements, and other informationregarding issuers that file electronically with the SEC. The address of the SECsite 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 UnitedStates, three each in Italy and Germany, two each in the United Kingdom,Denmark, and Slovakia, and one each in Brazil, China, India, Japan, Poland, andSweden. The Company leases approximately 15,000 square feet of office space inLincolnshire, Illinois, where its principal executive offices are located. Thefollowing table sets forth certain information relating to the Company’sprincipal 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.**            LegalProceedings.

From time to time, theCompany is involved in various legal matters considered normal in the course ofits 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 itis probable that a liability has been incurred and an amount can be reasonablyestimated. Although the outcome of such matters cannot be predicted withcertainty and no assurances can be given with respect to such matters, theCompany believes that the 

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

**Item4.**            Submissionof Matters to a Vote of Security Holders.

The Company did not submitany matter to a vote of security holders, through a solicitation of proxies orotherwise, during the fourth quarter of 2004.

**EXECUTIVE OFFICERS OF THE COMPANY**

Thefollowing table sets forth certain information regarding the executive officersof 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       |                |       |

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(1)          These executive officershave served in various capacities with the Company or its subsidiaries for morethan the past five years.

(2)          Prior to being appointedto a position with the Company, each of these executive officers served invarious capacities with Danfoss A/S or its subsidiaries for more than the pastfive years.

(3)          Prior to joining theCompany, Mr. Schmidt was employed by Degussa-Huls Corporation as VicePresident and Chief Financial Officer.

(4)          Prior to joining theCompany, Mr. Wilcox was employed by Omniquip — Textron asPresident — Material Handling unit.

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

(6)          Prior to joining theCompany, Mr. Zahalka was employed by Emerson Electric in various executivecapacities.

9

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**PART II**

**Item5.**            Marketfor the Company’s Common Stock and Related Stockholder Matters.

*Market and Dividend Information*

The Company’s Common Stock is traded on the New YorkStock 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 2005the Board of Directors approved paying a dividend ot $0.12 per share. 

Thefollowing table sets forth the high and low prices on the New York StockExchange for the Company’s Common Stock since January 1, 2003, and thequarterly 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.**            SelectedFinancial Data.

**SELECTED FINANCIALDATA**
| ** **                                   | ** ** | **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             |       |

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

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

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

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working capital requirements. The following tablefurther demonstrates how EBITDA is derived from cash flows from operatingactivities:
| ** **                                                                 | ** ** | **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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**Item7.   Management’s Discussion and Analysis of Financial Condition andResults of Operations.**

***Safe Harbor Statement***

*This Management’sDiscussion and Analysis of Financial Condition and Results of Operations, aswell as other portions of this annual report on Form 10-K, containstatements that constitute “forward-looking statements” within the meaning ofthe Private Securities Litigation Reform Act of 1995. Forward-lookingstatements provide current expectations of future events based on certainassumptions and include any statement that does not directly relate to anyhistorical or current fact. All statements regarding future performance,growth, sales and earnings projections, conditions or developments areforward-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 beintended to identify forward-looking statements.*

*Actual futureresults may differ materially from those described in the forward-lookingstatements due to a variety of factors, including the fact that the U.S.economy generally, and the agriculture, construction, road building, turf careand specialty vehicle markets specifically, has improved during 2004. It isdifficult to determine if past experience is a good guide to the future. Whilethe economy in the U.S. had been improving, it remains unstable due to theuncertainty surrounding continued job creation, interest rates, and the U.S.government’s stance on the weaker dollar. The economic situation in Europe hasnot necessarily followed the improvement that occurred in the U.S., and theeconomy in China has been slowed through government intervention. Any downturnin the Company’s business segments could adversely affect the Company’srevenues and results of operations. Other factors affecting forward-lookingstatements include, but are not limited to, the following: specific economicconditions in the agriculture, construction, road building, turf care andspecialty vehicle markets and the impact of such conditions on the Company’scustomers in such markets; the cyclical nature of some of the Company’sbusinesses; the ability of the Company to win new programs and maintainexisting programs with its original equipment manufacturer (OEM) customers; thehighly competitive nature of the markets for the Company’s products as well aspricing pressures that may result from such competitive conditions; the continuedoperation and viability of the Company’s significant customers; the Company’sexecution of internal performance plans; difficulties or delays inmanufacturing; cost-reduction and productivity efforts; competing technologiesand difficulties entering new markets, both domestic and foreign; changes inthe 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 suppliersto provide materials as needed and the Company’s ability to recover any priceincreases for materials and product pricing; the Company’s ability to attractand retain key technical and other personnel; labor relations; the failure ofcustomers to make timely payment; any inadequacy of the Company’s intellectualproperty protection or the potential for third-party claims of infringement;global economic factors, including currency exchange rates; general economicconditions, including interest rates, the rate of inflation, and commercial andconsumer confidence; energy prices; governmental laws and regulations affectingoperations, including tax obligations; changes in accounting standards;worldwide political stability; the effects of terrorist activities andresulting 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 ofcautionary statements and risk factors may not be exhaustive. The Companyexpressly disclaims any obligation or undertaking to release publicly anyupdates or changes to these forward-looking statements that may be made toreflect 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 andcomponents that generate, transmit and control power in mobile equipment. TheCompany’s products are used by original equipment manufacturers (OEMs) ofmobile equipment, including construction, road building, agricultural, turfcare 

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andspecialty equipment. The Company designs, manufactures and markets its productsin the Americas, Europe and the Asia-Pacific region, and markets its productsthroughout the rest of the world either directly or through distributors.

***Overview***

The general economy in the U.S. improved substantiallythroughout 2004. The European economy generally also grew in 2004, but atvarying degrees by country, and not as substantially as the growth experiencedin the U.S. The economy in the Asia-Pacific region remains mixed as Japan’seconomy appears stable but government intervention has intentionally slowed theeconomic growth activity in China.

In 2004 the Company introduced the PLUS 1TM operatingarchitecture system which customers integrated into their vehicle platforms. PLUS1 provides opportunities for growth in 2005, in addition to the new generationof hydrostatic transmissions for vehicle propel systems that the Company willintroduce in 2005. Expanding market share in the Asia-Pacific region andstrategic acquisitions provide additional growth opportunities for the Company.Challenges in 2004 included a worldwide shortage of raw materials, particularlysteel, and higher prices for these key materials. The Company was able torecover most of the increased cost of metals with price increases to customers.

The Company’s financialcondition remains strong at December 31, 2004. In 2004 the Companygenerated a record cash flow from operations of $124.8 million. The Company’sdebt 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’sstrong cash flow, strong earnings, and the positive long-term outlook for itsoperations, the Company’s Board of Directors approved an increase in thequarterly dividend declared in the third quarter to $0.10 per share, or a 43percent increase from the previous dividend level of $0.07 per share.

**ExecutiveSummary of 2004 Compared to 2003**

The nature of the Company’s operations as a globalproducer and supplier in the fluid power industry means the Company is impactedby changes in the local economies, including currency exchange ratefluctuations. In order to gain a better understanding of the Company’s baseresults, a financial statement user needs to understand the impact of thosecurrency exchange rate fluctuations as well as changes resulting from strategicacquisitions. The following table summarizes the change in the Company’sresults from operations by separately identifying changes due to currency fluctuations,acquisitions, and the

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underlying changein operations from 2003 to 2004. This analysis is more consistent with how theCompany’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 |   |

 

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(1)   Consistsof three months of operations of Comatrol, which was acquired in April 2003 andthe results of a Japanese manufacturing location which was accounted for underthe equity method of accounting in 2003.

The underlying growth in sales, which excludes theeffect 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 resultsin increased sales within the Americas, but also increased export business fromthe Company’s European and Asia-Pacific customers. The Company’s sales growthexceeded the market growth of 12 percent, which the Company determinedbased on the volume of units sold in the regions in which the Companydistributes its products. In the second half of 2004, the Company passed theincreased cost of metals used in the manufacture of its products on to itscustomers, resulting in additional revenue of approximately $11.0 million in2004. Margin on total net sales increased over two percentage points due toseveral factors, including spreading the fixed production costs over a highervolume of units produced, reduced field recall costs, and beginning to realizethe benefits of the restructurings which have occurred in recent years.Management of the Company generally targets overall margin improvement of 20 to25 percent on each dollar of incremental sales based on the cost structureit 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 netsales exceeded 36 percent.

The Company continues to pursue lean manufacturingefficiencies and expand the use of Six-Sigma quality tools to reduce waste andimprove processes throughout the Company. The Company’s continuing focus onquality reduced the level of field recalls in the current year with noindividually significant field recalls in 2004. In 2003 the Company incurredexpense of $6.2 million on a pre-tax basis due to five unrelated field recalls.Increased emphasis on global logistics, selective outsourcing, lower-costmanufacturing methods, and a consolidated network of authorized service centersalso contributed to the gross margin improving to 24.6 percent in 2004.

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Management is pleased with the improved profit marginsthat the Company achieved in 2004, however increased operating costs partiallyoffset 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 Europeansales and distributions operation, discussed below, and reorganization atcertain production locations. The management rationalization within the WorkFunction segment, partial consolidation of the non-manufacturing functions ofthe Controls segment within the U.S. and completion of the relocation of theWest Branch, Iowa, Work Function operations resulted in pre-tax costs of $2.4million. In 2003 pre-tax restructuring costs related to production locationstotaled $7.6 million. The lower restructuring costs in 2004 resulted in $2.4and $3.7 million improvement in cost of sales and loss on disposal of fixedassets respectively, compared to 2003. The costs in selling, general andadministrative related to restructuring were $0.9 million higher in 2004 thanin 2003.

Thefollowing table summarizes the significant costs, on a pretax basis, includedin the selling, general, and administrative line that contributed to the $31.8million increase in 2004 compared to 2003. Discussion of each item is includedin 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 anddistribution operations in Europe to consolidate inventory, warehouse anddistribution operations as well as streamline delivery directly from themanufacturing locations to the customer, which began in 2003, was substantiallycompleted in 2004. Also contributing to the increase in selling, general andadministrative costs in 2004 was the continuing development and implementationof a common business system to standardize business processes and provide asingle interface to direct OEM customers and suppliers. The investment in thecommon business system will drive improved operational efficiency, customerservice, and financial performance in future years after it is implemented atall Company locations over the three year period ending in 2008. As of thefirst quarter of 2005 three locations are operating on the new business systemand three additional locations will implement the new system later in 2005.

The improved financial performance of the Company in2004 resulted in additional costs associated with both its long-term andshort-term incentive plans. Based on established performance targets for theincentive plans and the Company’s outlook on future operating results theexpense in 2005 associated with the incentive plans is expected to approximatethe 2004 expense. The Company implemented a new Financial Reporting QualitySystem, an overall quality improvement system for finance and informationtechnology, to document and test internal controls as required under Section 404of the Sarbanes-Oxley Act of 2002. The $6.7 million of costs incurred in 2004for the Financial Reporting Quality System relate to fees paid to externalconsultants, in addition to increased external audit fees related to the reporton management’s assessment of internal controls over financial reporting thatis required under the Sarbanes-Oxley Act of 2002.

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The Companycontinues to deliver top line sales growth exceeding the market growth in themarkets that it serves. The Company’s 15 percent compound annual growthrate in reported sales over the past ten years has outpaced the general growthwithin the industry. To obtain the Company’s goal of gaining market share anddelivering long-term profitable growth the entire organization is focused onthe following strategic operating goals:

·       Increasethe component and system content on customers’ vehicles.

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

·       Continueto pursue optimal operating efficiencies though continued use of leanmanufacturing.

·       Furtherexpand the Company’s global presence.

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

**Operating Results —2004 Compared to 2003**

***SalesGrowth by Market***

Thefollowing table summarizes the Company’s sales growth by market. The table andfollowing discussion is on a comparable basis, which excludes the effects ofacquisitions 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 inthe Americas benefited from record crop production and strong livestock marketsin the U.S. in 2004. The general increase in the agriculture market resulted inlarge 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 theagricultural market than the Americas and Europe, the 54 percent increase in2004 sales represents continuing growth in this region, primarily in Japan. Theagriculture market in Europe remained flat in 2004, although sales growth didoccur in the fourth quarter due to increased sales to several OEMs.

*Construction*

Sales within theconstruction market increased by 34 percent in the Americas due to acombination of increased production by OEMs and share growth as Sauer-Danfossbegan to supply all hydraulic system content on an application produced by alarge OEM, including product previously supplied by a competitor. The Companyexperienced growth in Japan due to an increase in exports of skid steerloaders; however this increase was partially offset by the Chinese governmentintervention to slow down the economy. Exports also generated additional salesin the European region. Demand for transit mixers has had a positive effect onthe European sales in the construction market.

17

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*Road Building*

The Americas road buildingmarket experienced strong growth in 2004 with sales growth to all OEMs. Keycustomers in the Asia-Pacific region are located in China so the governmenteconomic restrictions in place during the last half of the year had a negativeeffect on sales growth; however growth was strong in the first half of theyear, resulting in growth for the full year of 13 percent. Increased customerexports contributed to the growth in European sales in the road building market.Sales to several European customers experienced strong growth in the fourthquarter of 2004.

*Turf Care*

The Company’s primarybusiness within this market comes from products produced for the consumer andcommercial turf care markets in the Americas region. The consumer zero-turnradius machines continue to gain market share from traditional lawn and gardentractors, which has led to increased sales of the Company’s new zero-turntransaxle product that was introduced late in 2003. In addition, the Companyexperienced market share gains from sales of low speed, high torque motorsproduced in its Nordborg, Denmark, facility, which contributed to the 26percent growth in sales during 2004.

*Specialty Vehicles*

Sales into the specialtyvehicle markets increased in all regions in 2004. Growth in the aerial lift andforklift markets, after several years of decreased demand, contributed stronglyto the 20 percent growth in specialty vehicles. Sales growth is also occurringin the waste management and waste recycling markets in Asia-Pacific and thetelehandler and forestry markets in Europe. Sales in the European region, whichcomprises the majority of the specialty market, has not recovered as quickly asthe Americas and the Asia-Pacific markets.

*Distribution*

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

***Order Backlog***

Thefollowing table shows the Company’s order backlog and orders written activityfor 2003 and 2004, in addition to the reasons why the amounts fluctuatedbetween years. Order backlog represents the amount of customer orders receivedfor 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 theend of 2004 was $508.3 million, compared to $408.6 million at the endof 2003, an increase of 24 percent. On a comparable basis, excluding theimpact of currency fluctuation and acquisitions, order backlog increased 20percent over 2003. New sales orders written for 2004 were$1,487.3 million, an increase of 32 percent from 2003. Excluding theimpact of currencies and acquisitions, total orders written in 2004 were24 percent above the 2003 levels.

Backlog information hasbecome less reliable as an indicator of future sales expectations as customerscontinue to adjust orders closer to the scheduled production dates. Thedecrease in lead time may be due to customers taking advantage of reducedproduction cycles within the Company’s facilities or due to the customer’suncertainty on the outlook of their own markets. Although backlog does notpredict future sales levels as reliably as in the past, the increase in backlogat December 31, 2004 indicates that current demand is strong and suggestsstrong sales in future months.

***Business Segment Results***

Thefollowing discussion of operating results by reportable segment relates toinformation as presented in Note 16 in the Notes to Consolidated FinancialStatements. Segment income is defined as the respective segment’s portion ofthe total Company’s net income, excluding net interest expense, income taxes,minority interest, and global service expenses. Propel products includehydrostatic transmissions and related products that transmit the power from theengine to the wheel to propel a vehicle. Work Function products includesteering motors as well as gear pumps and motors that transmit power for thework functions of the vehicle. Controls products include electrohydraulic controls,microprocessors, electric drives and valves that control and direct the powerof a vehicle. The following table provides a summary of each segment’s netsales and segment income, separately identifying the impact of currencyfluctuations 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 | ) |

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

*Propel Segment*

The general improvement inthe economy contributed to increased sales as demand from large OEMs anddistributors increased. Increased sales of $40.0 million in the America’s turfcare market, as mentioned in the preceding Sales Growth by Market section, alsocontributed to the sales increase as consumers continue to move away frommechanical transmissions to hydrostatic transmissions. Sales, excludingincreases due to fluctuations in currency and acquisitions, increased by 25percent in 2004 compared to 2003 due to both increased sales volumes andprices.

The Propel segmentconverted the 25 percent underlying increase in sales to an increase in segmentincome of 66 percent, excluding the impact of currency fluctuations andacquisitions. This $33.0 million 

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

*Work Function Segment*

Sales in the Work Functionsegment increased by 11 percent, excluding the effect of currency fluctuationsand acquisitions in 2004 compared to 2003. Demand for Work Function product hasbeen high throughout 2004 resulting in production operating at near fullcapacity at certain Work Function locations. Due to high demand, the WorkFunction segment has incurred $3.4 million of airfreight costs in order to meetcustomer delivery requirements in 2004, which negatively impacted segmentincome. However the increased airfreight costs were more than offset by reducedrestructuring costs and the benefits that are beginning to be realized fromthis restructuring. In 2003 the Company incurred approximately $7.4 million ofcosts related to the relocation of operations from its facilities inSturtevant, Wisconsin, and West Branch, Iowa, to its locations in Nordborg,Denmark; Wroclaw, Poland; Freeport, Illinois; and Lawrence, Kansas. Therelocation of the West Branch location was completed in 2004, which, combinedwith additional reorganization within the Work Function segment resulted inapproximately $2.2 million of restructuring costs in 2004. In connection withthe restructuring, the Company rationalized and outsourced certain low-volumeproduct lines which is also contributing to the improved segment income in thecurrent year. Segment income in 2004, excluding the effect of currencyfluctuations and acquisitions, more than doubled from the 2003 level. Theincreased segment income derived from the underlying sales growth amounted toover 35 percent of the incremental sales growth, achieving management expectations.Management of the Company expects this improved profitability to continue asthe Work Function segment continues to realize the benefits from previousrestructurings.

*Controls Segment*

The Controls segmentexperienced sales growth of approximately 12 percent in 2004, excluding theeffect of currency fluctuations and acquisitions. The PLUS 1 vehiclearchitecture was introduced during 2004, and although sales for the year werenot a significant portion of the Controls Segment total sales, the introductionof the product has been well received. The $10.1 million increase in segmentincome 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 GlobalServices and other expenses, net relate to internal global service departments,along with the operating costs of the Company’s executive offices. Globalservices include costs such as consulting for special projects, tax andaccounting fees paid to outside third parties, certain insurance premiums, andthe amortization of intangible assets from certain business combinations. The$18.1 million increase in Global Services relates to three items. First, theCompany continues to incur costs, $3.5 million in 2004, to develop a commonbusiness system for all of the Company’s worldwide operations. Costs to developthe 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 in2004 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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requirementsto document and test internal controls under Section 404 of theSarbanes-Oxley Act of 2002 were $6.7 million in 2004, an increase of $6.2million compared to costs incurred in 2003.

***Income Taxes***

The Company’s effectivetax rate was 32.2 percent in 2004. A decrease of previously recorded accrualsfor outstanding IRS audit issues on prior year’s tax returns has reduced theeffective tax rate.

The American Job CreationsAct of 2004 introduced a limited time 85 percent dividends received deductionon the repatriation of certain foreign earnings. This deduction would result inan approximate 5.25 percent federal tax rate on the repatriated earnings. Toqualify for the deduction certain criteria must be met, including that theearnings must be reinvested in the U.S. pursuant to a domestic reinvestmentplan established by the company’s chief executive officer and approved by thecompany’s Board of Directors. The Company has started an evaluation of theeffects of the repatriation provision and may elect to apply the provision toqualifying earnings repatriations in 2005. However, the Company does not expectto be able to complete its evaluation until after Congress or the TreasuryDepartment provides additional clarifying language on key elements of theprovision. Assuming such clarifications are made, the Company expects tocomplete its evaluation of the effects of the repatriation provision by the endof the second quarter in 2005. The range of possible amounts that the Companyis considering for repatriation under this provision is between $0 and$148.0 million. While the Company estimates the related potential range ofadditional income tax is between $0 and $2.6 million, the range is subjectto change based on the technical correction legislation that is expected to bepassed.

**ExecutiveSummary of 2003 Compared to 2002**

Thefollowing table summarizes the Company’s 2003 and 2002 results from operationsby separately identifying the impact of currency fluctuations and acquisitions.This analysis is more consistent with how the Company internally evaluates itsresults.
| **(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 |   |

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(1)          Excludes results ofequity ownership in Comatrol.

(2)          Representsfull year results of Comatrol, which was accounted for under the equity methodin the first quarter of 2003 and consolidated the remainder of 2003, and thefirst quarter results of Thrige Electric, which was acquired in the secondquarter of 2002.

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

The most significant item to impact the Company’sfinancial performance in 2003 was the decision to close and relocate two of itsmanufacturing locations in the U.S. These facilities were located inSturtevant, Wisconsin, and West Branch, Iowa. The total costs incurred in 2003related to the closure of these facilities amounted to $7.6 million on apretax basis. These costs included impairment charges on property, plant andequipment, accelerated depreciation, employee severance costs, inventorydisposal costs, costs to move people and equipment to other facilities, andmanufacturing inefficiencies during the shut down and move of operations fromthese two facilities. Approximately $3.9 million was recorded as loss onfixed assets. The remaining $3.3 and $0.4 million affected the cost ofsales and selling, general and administrative lines, respectively, of theincome statement. The Company did not incur any restructuring costs in 2002 andexpects to incur only $0.7 million of costs related to the West Branchrestructuring in 2004.

The Company’s 2003 financial results were alsosignificantly impacted by several large field recall issues. The field recallsamounted to a total of $6.2 million on a pretax basis and impacted thegross profit line of both the Propel and Work Function segments. While theCompany was not pleased to have incurred these field recalls, they related tofive individual defects that were not interrelated. The Company is diligentlyworking to understand the root cause of these defects and to enhance itsprocesses in order to prevent this order of magnitude of field recall costsfrom occurring in the future. However, as the Company has identified under itsCritical Accounting Estimates, warranty and field recall costs can be arecurring part of its business due to the high-precision and technical natureof its products and processes. There can be no assurances as to the frequencyor 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 anddistribution operations in Europe, intended to reduce future operating costs bystreamlining delivery directly from the manufacturing locations to thecustomer. The Company incurred $2.2 million of expense to begin theimplementation of a common business system to standardize business processesand provide a single interface to direct OEM customers and suppliers. Theinvestment in the common business system will drive improved operationalefficiency, customer service, and financial performance in future years. In2003, the Company also incurred $0.5 million of outside consulting feesrelated to the initial work to comply with Section 404 of theSarbanes-Oxley Act of 2002. These costs are all reflected in the selling,general and administrative expenses line on the Consolidated Statement of Incomeand are anticipated to continue in 2004 at varying degrees.

The items discussed above negatively impacted incomefrom operations by $17.8 million. Excluding these items, the Company wouldhave experienced a $3.6 million increase in operating income on the salesincrease of $56.5 million, excluding the effects of currency andacquisitions, or approximately 6 percent of the incremental sales growth.The Company generally targets overall margin improvement of 20 to25 percent on each dollar of incremental sales based on the cost structureit has in place and the intent of reinvesting in the business for futuregrowth. Additionally, the Company experienced deterioration in gross profitmargins due to the impact of the weakening U.S. currency on product sold in theU.S. that was manufactured outside the U.S. (See further discussion of currencyrisk below under Market Risk.) Based on the 2003 ongoing operationalperformance, the Company is not meeting these internal targets.

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**OperatingResults — 2003 Compared to 2002**

***SalesGrowth by Market***

Thefollowing table summarizes the Company’s sales growth by market. The table andfollowing discussion is on a comparable basis, which excludes acquisitions andcurrency fluctuations.
| ** **    | ** ** | **Americas** | ** ** | **Asia-Pacific** | ** ** | **Europe** | ** ** | **Total** | ** ** |
|---------------|------------|--------------|------------|------------------|------------|------------|------------|-----------|------------|
| Agriculture   |       |         | 9          | %                |       |       | 76         | %         |       |   | 6 | % |   |   | 8 | % |   |
| Construction  |       |         | 8          |             |       |       | 41         |      |       |   | 4 |   |   |   | 9 |   |   |
| Road building |       |         | (7         | )                |       |       | 65         |      |       |   | (6 | ) |   |   | 1 |   |   |
| Turf care     |       |         | 15         |             |       |       | (9         | )         |       |   | (16 | ) |   |   | 14 |   |   |
| Specialty     |       |         | (7         | )                |       |       | (8         | )         |       |   | (1 | ) |   |   | (3 | ) |   |
| Distribution  |       |         | 4          |             |       |       | 17         |      |       |   | 8 |   |   |   | 7 |   |   |

 

*Agriculture*

The agriculture marketincreased in all regions of the world during 2003 after several years of verydepressed sales volumes. The Asia-Pacific region, while up significantly, isoff of a relatively small base compared to the rest of the world that theCompany serves. Of particular note is that the increase in Europe was drivenprimarily by new projects with several large customers that began productionduring 2003. In the Americas, the Company had increased business from all ofits major OEMs in the fourth quarter of 2003 compared to 2002.

*Construction*

In the constructionmarket, the Company also experienced sales gains in all regions of the world.The Americas’ construction market was moderately up over 2002, with the fourthquarter showing continued strengthening. In Europe, the increase in shipmentswas led by the smaller and mid-sized manufacturers in this market. In general,the outlook for this market in Europe is positive for many of the Company’smajor customers. The Asia-Pacific region was led by the strong transit mixerbusiness in Australia, which is expected to continue into the first half of2004.

*Road Building*

The road building marketwas weak in the Americas and Europe with both being down from 2002. In the Americas,this was driven primarily by a generally soft market and also by the lack offunding by state governments for highway projects. While the market in Europewas down, the outlook for 2004 is generally positive. Road building in theAsia-Pacific region was led by many large projects in China such as preparationfor the 2008 Olympics in Beijing, installing infrastructure for water transferfrom the south of China to the north, and for national highway projects. Thisincrease offset the declines in both the Americas and Europe.

*Turf Care*

The Company’s primarybusiness within this market comes from products produced for the consumer andcommercial turf care markets in the Americas region. Consumers continue to moveaway from mechanical transmissions on these machines and the introduction ofzero-turn radius machines being sold through retail outlets is helping tocontinue to fuel growth in this market.

*Specialty Vehicles*

Sales into the specialtyvehicle markets were down across all regions. This is a trend that has beenoccurring for the past couple of years, primarily in the aerial lift andforklift markets. Management believes 

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that theaerial lift market has finally stabilized in the Americas and that the outlookin Europe is for an upturn in the forklift market in 2004.

***Order Backlog***

Thefollowing table shows the Company’s order backlog and orders written activityfor 2002 and 2003, in addition to the reasons why the amounts fluctuatedbetween years. Order backlog represents the amount of customer orders receivedfor future shipment.
| **(in millions)**       | ** ** | ** ** | ** ** | **2002** | ** ** | **Currency  fluctuation** | ** ** | **Acquisitions** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2003** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|------------------|------------|--------------------------------------|------------|----------|------------|
| **Americas**                 |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Backlog at  December 31 |       | $          | 224.0      |     |       | $                         | 0.6        |             |       |                                 | $          | —   |       |   |   | $ | (0.2 | ) |   | $ | 224.4 |   |
| Orders written               |       | 472.9      |       |     | (1.0       | )                         |       |             | —     |                                 |       |     | 10.0       |   |   | 481.9 |   |
| **Asia-Pacific**             |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Backlog at  December 31 |       | 19.3       |       |     | 0.7        |                      |       |             | —     |                                 |       |     | 1.5        |   |   | 21.5 |   |
| Orders written               |       | 72.8       |       |     | 5.2        |                      |       |             | —     |                                 |       |     | 7.2        |   |   | 85.2 |   |
| **Europe**                   |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Backlog at  December 31 |       | 139.5      |       |     | 25.2       |                      |       |             | 2.8        |                                 |       |     | (4.8       | ) |   | 162.7 |   |
| Orders written               |       | 451.0      |       |     | 86.9       |                      |       |             | 26.7       |                                 |       |     | (5.9       | ) |   | 558.7 |   |
| **Total**                    |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Backlog at  December 31 |       | 382.8      |       |     | 26.5       |                      |       |             | 2.8        |                                 |       |     | (3.5       | ) |   | 408.6 |   |
| Orders written               |       | 996.7      |       |     | 91.1       |                      |       |             | 26.7       |                                 |       |     | 11.3       |   |   | 1,125.8 |   |
|                              |            |            |            |          |            |                           |            |                  |            |                                      |            |          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Total order backlog at the end of 2003 was$408.6 million, compared to $382.8 million at the end of 2002, anincrease of 6.7 percent. On a comparable basis, excluding the impact ofcurrency exchange fluctuation and acquisitions, order backlog remained flatwith year-end 2002 levels. New sales orders written for 2003 were$1,125.8 million, an increase of 13.0 percent from 2002. Excludingthe impact of currencies and acquisitions, total orders written in 2003 wereonly 1 percent above the 2002 levels. As the Company has noted in earliercommunications, customers continue to adjust orders closer to the scheduledproduction dates, often within the scheduled shipping month. In some cases,this is a result of the customer’s uncertainty with respect to the outlook oftheir own markets, but it is also a sign that customers are taking advantage ofreduced production cycles within the Company’s facilities. In either case, theCompany’s order and backlog information has become less reliable as anindicator of future expectations.

Overall, the Company hasbeen able to achieve solid sales growth through its strategies to continue todevelop new vehicle applications and to expand the content supplied for eachvehicle by selling system solutions and integrating electronics withhydraulics.

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***Business Segment Results***

Thefollowing table provides a summary of each segment’s sales and segment incomeon a comparable basis, excluding acquisitions and currency fluctuations.
| **(in millions)**                   | ** ** | ** ** | ** ** | **2002** | ** ** | **Currency  fluctuation** | ** ** | **Acquisitions** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|------------------|------------|--------------------------------------|------------|----------|------------|
| **Net sales**                            |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Propel                                   |       | $          | 440.2      |     |       | $                         | 25.9       |             |       |                                 | $          | —   |       |   |   | $ | 38.9 |   |   | $ | 505.0 |   |
| Work Function                            |       | 295.0      |       |     | 37.6       |                      |       |             | —     |                                 |       |     | 13.0       |   |   | 345.6 |   |
| Controls                                 |       | 217.1      |       |     | 28.2       |                      |       |             | 26.2       |                                 |       |     | 4.7        |   |   | 276.2 |   |
| **Segment  income (loss)**               |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Propel                                   |       | $          | 47.3       |     |       | $                         | 2.0        |             |       |                                 | $          | —   |       |   |   | $ | 0.8 |   |   | $ | 50.1 |   |
| Work Function                            |       | 19.0       |       |     | 2.4        |                      |       |             | —     |                                 |       |     | (12.1      | ) |   | 9.3 |   |
| Controls                                 |       | 5.8        |       |     | 2.9        |                      |       |             | 1.8        |                                 |       |     | 3.2        |   |   | 13.7 |   |
| Global Services  and other expenses, net |       | (22.9      | )          |     | (1.8       | )                         |       |             | —     |                                 |       |     | (4.8       | ) |   | (29.5 | ) |

 

*Propel Segment*

There are two primary reasons for the increase in thePropel segments net sales in 2003. The first reason is the continued growth inthe turf care market in the Americas. As mentioned in the preceding SalesGrowth by Market section, the move away from mechanical transmissions tohydrostatic transmissions and the zero-turn radius mowers are leading the wayfor this growth. The other factor of growth in the Propel segment during 2003came from the increased sales volume in the Asia-Pacific region as China andJapan experienced increased sales, primarily in the construction and roadbuilding markets as mentioned above.

The Propel segment incomegenerated on the increased sales only amounted to 2 percent of theincremental sales over 2002, which is considered very substandard by theCompany’s internal standards. During 2003, the Propel segment incurred$5.2 million of field recall costs as a result of four separate qualityissues at several large OEM customers. Each of these instances had its ownunique root cause and the Company is working diligently to put the proper processesand tools in place to ensure that these types of recalls do not occur in thefuture. Without these field recall costs, Propel segment income would haveincreased $6.0 million, or 13 percent of the incremental salesincrease. The Propel segment income has also been impacted by increased pricepressures which the Company has experienced in recent years. The Propel segmentis predominantly a mature product line with enhancements coming primarily fromthe addition of electronic controls. Consequently, customers in this markethave been very aggressive in demanding price concessions. To the extent theCompany concedes price reductions without offsetting these concessions withcost reductions, the price reduction negatively impacts the segmentprofitability. In order to combat this impact, the Propel segment is focused onutilizing global purchasing initiatives to lower part costs through sourcingcomponents to more cost effective global suppliers and to outsource componentswhere the Company does not believe there is a manufacturing advantage.

*Work FunctionSegment*

While the Work Functionsegment experienced net sales growth over the prior year of $13.0 million,segment income declined by $12.1 million from 2002. Of this decline,approximately $7.4 million was a result of the Company’s decision during2003 to shutdown and relocate two of its manufacturing plants in North America.In the second and third quarters of 2003, the Company shut down its steeringunit manufacturing operation in Sturtevant, Wisconsin, and relocated theoperations to its facilities in Nordborg, Denmark, and Wroclaw, Poland. Thecosts incurred for this closure, (net of savings realized 

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alreadyduring 2003) was approximately $1.4 million. During the third quarter of2003, the Company made the decision to shut down and relocate its West Branch,Iowa, plant. The majority of the costs to close and relocate this facility wereincurred in 2003 and amounted to approximately $6.0 million. The majorityof the manufacturing operations at West Branch were transferred to the Company’sFreeport, Illinois, and Lawrence, Kansas, facilities. In addition, the Companysuccessfully rationalized and outsourced certain low-volume product lines thatwill also help to improve profitability in this segment in future periods. TheWork Function segment also incurred $1.0 million of field recall costs dueto a quality problem with one particular product at one customer. This segmentis also working to implement the proper processes and tools to prevent costs ofthis magnitude in the future.

*Controls Segment*

The Controls segmentexperienced sales growth that was in line with the general market trend inwhich the Company operates. On the positive side, the Controls segment incomewas a very strong 67 percent of the incremental sales growth, much higherthan even the Company’s internal expectations. However, the Controls segmentincome in 2002 was negatively impacted by a $1.2 million productrationalization charge. Excluding this item, the Controls segment incomeincreased 41 percent of the incremental sales growth that still exceededthe Company’s internal expectations.

*Global Services andother expenses, net*

The Company’s GlobalServices and other expenses, net segment incurs costs related to internalglobal service departments, along with the operating costs of the Company’sexecutive offices that were established in 2002 in Lincolnshire, Illinois.Worldwide services such as tax and accounting fees paid to outside thirdparties, certain insurance premiums, and the amortization of intangible assetsfrom certain business combinations are also included in this classification.The majority of the increase in this area relates to three items: initial costsincurred to begin implementation of a common business system for all of theCompany’s worldwide operations, outside service costs to assist in meeting thenew requirements regarding internal controls under the Sarbanes-Oxley Act of2002, and the additional costs related to the Company’s executive office inplace for the full year of 2003 compared to only six months of 2002.

***IncomeTaxes***

The Company had a taxbenefit of $0.5 million in 2003 even though it reported pre-tax net incomeof $10.7 million. The tax benefit is due to two primary factors. First,the majority of the restructuring costs were incurred in the U.S., which arebenefited at an effective corporate tax rate of 39 percent; whereas, themajority of the earnings, primarily European based, are taxed at variousstatutory rates averaging approximately 30 percent. Second, the Company’soperations in China and Slovakia generated income in 2003 but there is no taxexpense on these amounts as both countries have tax loss carryforwards with nopreviously recorded tax benefit. The Company expects its overall tax rate toreturn to a rate closer to the statutory rate in 2004.

**Market**Risk**

The Company is naturallyexposed to various market risks, including changes in foreign currency exchangerates and, interest rates.

***ForeignCurrency Changes***

The Company has historically not entered into any typeof foreign currency hedging or derivative arrangements to manage its exposureto fluctuations in the foreign currency markets. However, during 2002, theCompany entered into a foreign currency forward contract to protect against theeffects of 

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foreign currencyfluctuations for a loan to the U. S. holding company from a Danish bankdenominated in euros. The Company adjusts the carrying value of the contract tomarket which resulted in offsetting approximately $2.8 million of foreigncurrency loss that would have resulted from the dollar weakening against theeuro during 2004.

The Company has operations and sells its products inmany different countries of the world and therefore, conducts its business invarious currencies. The Company’s financial statements, which are presented inU.S. dollars, can be impacted by foreign exchange fluctuations through bothtranslation risk and transaction risk. Translation risk is the risk that thefinancial statements of the Company, for a particular period or as of a certaindate, may be affected by changes in the exchange rates that are used totranslate the financial statements of the Company’s operations from foreigncurrencies into U.S. dollars. Transaction risk is the risk from the Companyreceiving its sale proceeds or holding its assets in a currency different fromthat in which it pays its expenses and holds its liabilities.

With respect to transaction risk, the impact on theCompany’s operating results has not historically been significant. In previousyears, the Company had been well balanced between its U.S. and Europeanoperations because the Company generated its sales in the same country in whichit incurred its expenses, or shipped products between geographic regions on abalanced basis. However, in recent years the balance is beginning to shift andthe amount of sales made in U.S. dollars is increasing, whereas the productioncosts are in a currency other than the U.S. dollar. In 2004 the Company sold atotal of $125.3 million into the U.S. of product that had been produced inEuropean based currencies compared to sales into Europe of $43.6 millionof product produced in U.S. dollars. This imbalance had a significant impact onthe bottom line results of the Company in 2004 as the dollar became weaker incomparison to other currencies during 2004. The Company produces and sells itsproduct in several regions of the world, however the U.S. and Europeantransactions comprise the majority of the imbalance between regions. TheCompany is currently taking steps to analyze and understand this impactglobally. Based on its analysis, the Company may decide to re-source certainoperations or use hedging instruments in the future in order to protect againstthis margin erosion.

Additionally, the Company is impacted by translationrisk in terms of comparing results from period to period.

Fluctuationsof currencies against the U.S. dollar can be substantial and thereforesignificantly impact comparisons with prior periods. The translation impact onmaking prior period comparisons with respect to the Company’s net sales can bematerial. As shown in the table below, the translation impact on net sales hasbeen significant in recent years.
| ** **                           | ** ** | **Percentage Sales Growth  Over Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                           | ** ** | **    2004    **         | ** ** | **    2003    ** | ** ** | **    2002    ** | ** ** |
| As Reported                          |       |                                                             | 24.6       | % |   |   | 18.3 | % |   |   | 11.4 | % |   |
| Without Currency  Translation Impact |       |                                                             | 18.5       |   |   |   | 8.7 |   |   |   | 8.6 |   |   |

 

During 2004, the U.S.dollar continued to weaken substantially against most foreign currencies,especially the euro. Between December 31, 2003 and December 31, 2004,the U.S. dollar weakened by 8 percent against the euro, which followed a20 percent and 15 percent weakening in the previous two years. This hasresulted in approximately 40 percent of the Company’s total balance sheet beingstated 8 percent higher than the prior year since roughly 40 percent of theCompany’s total assets and liabilities are denominated in the euro. As shownabove, translation does affect comparisons between periods.

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***InterestRate Changes***

The Company uses interest rate swap agreements on alimited basis to manage the interest rate risk on the total debt portfolio. TheCompany was a party to three interest rate swap agreements, with a combinednotional amount of 8.8 million euro, that require the Company to pay interestat a fixed rate and receive interest at a variable rate. The fair value of theinterest rate swap agreements is recorded as a liability of $0.6 million on thebalance sheet at December 31, 2004, with the offset recorded inaccumulated other comprehensive income as the derivatives are accounted forusing hedge accounting. The interest rate swap agreements mature at variousdates through March 2009.

Thefollowing table summarizes the maturity of the Company’s debt obligations forfixed and variable rate debt (amounts in millions):
| ** ** | ** ** | **Fixed Rate  Debt (1)** | ** ** | **Variable Rate  Debt** | ** ** |
|------------|------------|------------------------------------|------------|------------------------------|------------|
| 2005       |       |                               | $          | 63.5                         |       |   |   | $ | 181.5 |   |   |
| 2006       |       |                               | 15.3       |                         |       |   | 0.2 |   |   |
| 2007       |       |                               | 7.7        |                         |       |   | 6.5 |   |   |
| 2008       |       |                               | 14.7       |                         |       |   | — |   |   |
| 2009       |       |                               | 12.6       |                         |       |   | — |   |   |
| Thereafter |       |                               | 19.5       |                         |       |   | — |   |   |
| Total      |       |                               | $          | 133.3                        |       |   |   | $ | 188.2 |   |   |

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(1)          Includestotal principal repayments of $12.0 million on variable rate debt that the ratehas been fixed through the use of interest rate swaps.

**Liquidity and Capital Resources**

The Company’s principal sources of liquidity have beenfrom internally generated cash flows from operations and from borrowings underits committed and uncommitted, unsecured, credit facilities. Because of themultiple funding sources that have been and continue to be available to theCompany, the Company expects to have sufficient sources of liquidity to meetits funding needs.

The Company has historically accessed diverse fundingsources, including short-term and long-term unsecured bank lines of credit inthe United States, Europe and Asia, as well as private securitization marketsin the United States. In addition, the Company has access to unsecured banklines of credit with various banks from around the world (see Note 7 inthe Notes to Consolidated Financial Statements).

The Company has amulticurrency revolving credit facility that permits unsecured borrowings up to$250.0 million through September 2006. At December 31, 2004 theCompany had $129.0 million outstanding under the revolving credit facility,including amounts borrowed under ancillary facilities. The Company is requiredto pay a commitment fee on the unused portion of the credit facility. Thecommitment fee totaled $0.8 million in 2004. The Company is required to meetcertain financial covenants under this facility as described in Note 7 inthe Notes to Consolidated Financial Statements. The Company was in compliancewith the covenants at December 31, 2004 and is not aware of anycircumstances currently that would impact compliance during the next twelvemonths.

***CashFlows from Operations***

The Company’s cash provided from operations in 2004was a record $124.8 million, 31 percent higher than the $95.6 milliongenerated in 2003, primarily due to increased net income. Excluding the impactof currency fluctuations and acquisitions, the accounts receivable balanceincreased 16 percent in 2004 compared to 2003, due to the increased salesin 2004. At December 31, 2004 there was an additional 

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$23.8 millioninvested in inventories, excluding the impact of currency and acquisition,compared to December 31, 2003 as the Company has anticipated increaseddemand for product in early 2005 and has prepared to meet this demand. Theaccounts payable balance increased in fourth quarter due to the increasedinventory purchases.

Overall, the Company’scash balances decreased by $3.8 million which is in line with the Company’soverall goal to minimize the amount of cash on its balance sheet as long as ithas outstanding bank borrowings. At the end of 2004, over $5.9 million ofthe Company’s cash resided in China, and an additional $1.2 million waslocated in Brazil. These amounts were similar to the amounts of cash at each ofthese locations at the end of 2003. Due to the nature of governmental and otherregulatory controls, it is extremely difficult to move cash out of thesecountries for reasons other than payment for goods shipped into thesecountries. As the Company continues to look at expanding its manufacturingcapabilities in low cost regions, the Company will look to utilize the cashalready located in these countries to fund these expansions.

***Cash Usedin Investing Activities***

The Company has continued to selectively invest incapital equipment for its manufacturing plants for more efficient manufacturingprocesses and for new product development. In addition, in 2004 the Companyinvested over $13.2 million in the development of a new common businesssystem which will be implemented at all locations over the next three years.

During 2004 the Companycompleted the acquisition of a company, as the stock was purchased over threeyears. The final 15 percent ownership was purchased for a net cash outlay of$4.2 million. See the discussion of Business Combinations below andNote 2 in the Notes to Consolidated Financial Statements for furtherdiscussion.

***Cash Usedin Financing Activities***

The Company continues topay dividends to stockholders on a quarterly basis. The Company’s Board ofDirectors approved an increase in the quarterly dividend declared to $0.10 perquarter in the third quarter based on the Company’s strong cash flow, strongearnings, and the positive long-term outlook for its operations. This was a 43percent increase from the previous dividend level of $0.07 per quarter. Totaldividends paid in 2004 were $14.7 million. The Company has also repaid $23.9million of outstanding borrowings in 2004. In addition, the Companyperiodically makes distributions to its minority interest partners from itsvarious joint venture activities. The distributions can vary from year to yeardepending on the amount of undistributed earnings of the businesses and theneeds of the partners.

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***ContractualCash Obligations***

Themajority of the Company’s contractual obligations to make cash payments tothird parties are for financing obligations. These include future leasepayments under both operating and capital leases. The following table disclosesthe Company’s future commitments under contractual obligations as of December 31,2004:
| **Contractual Cash Obligations (3)** | ** ** | ** ** | ** ** | **Total** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
|-----------------------------------------------------|------------|------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Long-term debt                                      |       | $          | 321,483    |      | $          | 244,987  |       | $        | 15,458     |     | $          | 14,220   |       | $        | 14,683     |           | $          | 12,557 |   | $ | 19,578 |   |
| Interest on  long-term debt (1),(2)            |       | 31,795     |       | 11,236    |       | 8,875    |       | 3,991    |       | 3,205    |       | 2,122    |       | 2,366    |       |
| Capital leases                                      |       | 22,504     |       | 1,350     |       | 1,140    |       | 1,134    |       | 1,134    |       | 1,134    |       | 16,612   |       |
| Operating leases                                    |       | 57,827     |       | 12,318    |       | 10,759   |       | 5,801    |       | 2,420    |       | 1,853    |       | 24,676   |       |
| Rental agreements  with related party Danfoss A/S   |       | 75,900     |       | 7,603     |       | 7,486    |       | 7,397    |       | 7,293    |       | 7,282    |       | 38,839   |       |
| Total contractual cash  obligations                 |       | $          | 509,509    |      | $          | 277,494  |       | $        | 43,718     |     | $          | 32,543   |       | $        | 28,735     |           | $          | 24,948 |   | $ | 102,071 |   |

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The following assumptions areused in the calculation of the contractual cash obligations:

(1)         The annual amountborrowed under revolving credit agreements does not change from the $123.5 millionborrowed at December 31, 2004, through the maturity date of theagreements.

(2)         The rate of interest onvariable rate debt of 3.5 percent will not change from December 31, 2004.

(3)         Commitments denominatedin a currency other than the U.S. dollar are translated at the December 31,2004 exchange rate.

In addition to the abovecontractual obligations, the Company has certain other funding needs that arenon-contractual by nature, including funding of certain pension plans. For2005, the Company anticipates contributing $8.5 million to its U.S. andU.K. pension and health benefit plans. There are no plans to fund the Germanpension plan, which is customary in that country.

**Other Matters**

***CriticalAccounting Estimates***

The SEC’s guidance surrounding the disclosure ofcritical accounting estimates requires disclosures about estimates a companymakes in applying its accounting policies. However, such discussion is limitedto “critical accounting estimates,” or those that management believes meet twocriteria: 1) the accounting estimate must require a company to makeassumptions about matters that are highly uncertain at the time the accountingestimate is made, and 2) different estimates that the company reasonablycould have used for the accounting estimate in the current period, or changesin the accounting estimate that are reasonably likely to occur from period toperiod, must have a material impact on the presentation of the company’sfinancial condition, changes in financial condition or results of operations.

Besides the estimates that meet the two criteria for a“critical estimate” above, the Company makes many other accounting estimates inpreparing its financial statements and related disclosures. All estimates,whether or not deemed critical, can affect the reported amounts of assets,liabilities, revenues and expenses as well as disclosures of contingent assetsand liabilities. Estimates are based on experience and information availableprior to the issuance of the financial statements. Materially different resultscan occur as circumstances change and additional information becomes known,including estimates not deemed “critical” under the SEC’s guidance.

The discussionbelow should be read in conjunction with disclosures elsewhere in thisdiscussion and in the Notes to the Consolidated Financial Statements related toestimates, uncertainties, contingencies, 

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andnew accounting standards. Significant accounting policies are discussed inNote 1 to the Consolidated Financial Statements beginning on page F-5.The development and selection of accounting estimates, including those deemed “critical,”and the associated disclosures in this discussion, have been discussed bymanagement with the audit committee of the Board of Directors.

*Inventory Valuation*— As amanufacturer in the capital goods industry, inventory is a substantial portionof the assets of the Company, amounting to almost 20 percent of totalassets at December 31, 2004. The Company must periodically evaluate thecarrying value of its inventory to assess the proper valuation. This includesrecording period adjustments as needed to 1) cover losses in the normalcourse of operation, 2) provide for excess and obsolete inventory, and3) ensure that inventory is valued at the lower of cost or market. On aquarterly basis, management within each segment performs an analysis of theunderlying inventory to identify the need for appropriate writedowns to covereach of these items. In doing so, management applies consistent practices basedupon historical data such as actual loss experience, past and projected usage,actual margins generated from trade sales of its products, and finally its bestjudgment to estimate the appropriate carrying value of the inventory.

*Warranty Provisions*— TheCompany warrants its various products over differing periods depending upon thetype of product and application. Consequently, the Company records liabilitiesfor the estimated warranty costs that may be incurred under its basic warrantybased on past trends of actual warranty claims compared to the actual saleslevels to which those claims apply. These liabilities are accrued at the timethe sales of the products are recorded. Factors that affect the Company’swarranty liability include the number of units in the field currently underwarranty, historical and anticipated rates of warranty claims on those unitsand the cost per claim to satisfy the Company’s warranty obligation. Theanticipated rate of warranty claims is the primary factor impacting the Company’sestimated warranty obligation. Each quarter, the Company reevaluates itsestimates to assess the adequacy of its recorded warranty liabilities andadjusts the amounts as necessary.

In addition to itsnormal warranty liability, the Company, from time to time in the normal courseof business, incurs costs to repair or replace defective products with aspecific customer or group of customers. The Company refers to these as “fieldrecalls” and in these instances, the Company will record a specific provisionfor the expected costs it will incur to repair or replace these productsutilizing information from customers and internal information regarding thespecific cost of materials and labor. Typically, field recalls are infrequentin occurrence, however, when they occur, field recalls can be for a largenumber of units and quite costly to rectify. Because of the sporadic andinfrequent nature of field recalls, and due to the extreme range of costsassociated with field recalls, the Company cannot accurately estimate thesecosts at the time the products are sold. Therefore, these costs are recorded atthe time information becomes known to the Company. As the field recalls aresettled, the Company relieves the specific liability related to that fieldrecall. These specific field recall liabilities are reviewed at least on aquarterly basis.

*Long-Lived Asset Recovery*— Asignificant portion of the Company’s total assets consist of property, plantand equipment (PP&E) and definite life intangibles, as well as goodwill.Changes in technology or in the Company’s intended use of these assets, as wellas changes in the broad global economy in which the Company operates, may causethe estimated period of use or the carrying value of these assets to change.

This requires theCompany to periodically assess the estimated useful lives of its assets inorder to match, through depreciation and amortization, the cost of those assetswith the benefits derived over the period of usefulness. The useful lives ofthese assets can be shortened through greater use due to volume increases,rapidly changing technology such as the use of electronics andcomputer-operated controls, and through inadequate maintenance. Despitemanagement’s best efforts to determine the appropriate useful lives of itsequipment, certain situations arise that lead to an asset or group of assetsbecoming impaired, meaning their economic value becomes less than the value atwhich the Company is carrying the asset on 

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itsbooks. Examples of these situations are product rationalization efforts orrestructuring of manufacturing facilities. When these situations arise, theCompany tests the assets for impairment and will write down the asset in theperiod when the impairment becomes known. In addition, goodwill is tested forimpairment at least annually. If information would become known that wouldchange the depreciable rate of the Company’s assets by 10 percent,recorded depreciation expense would have been impacted by approximately$7.9 million.

*Valuation of Trade Receivables*—The Company records trade receivables due from its customers at the time a saleis recorded in accordance with its revenue recognition policy. The futurecollectability of these amounts can be impacted by the Company’s collectionefforts, the financial stability of its customers, and the general economicclimate in which it operates. The Company applies a consistent practice ofestablishing an allowance for accounts that it believes may becomeuncollectible through reviewing the historical aging of its receivables,looking at the historical losses incurred as a percentage of net sales, and bymonitoring the financial strength of its customers. In addition, localcustomary practices have to be taken into account due to varying payment termsbeing applied in various parts of the world where the Company conducts itsbusiness. If the Company becomes aware of a customer’s inability to meet itsfinancial obligations (e.g., where it has filed for bankruptcy), the Companyestablishes a specific allowance for the potential bad debt to reduce the netrecognized receivable to the amount it reasonably believes will be collected.The valuation of trade receivables is performed quarterly.

*WorkersCompensation*— The Company has an insurance policy tocover workers compensation claims in the United States, in which the Companypays the first $0.25 million per claim, per incident. The Companyestablishes its workers compensation reserve based on historic growth factorsof claims and an estimate of incurred, but not reported claims. This analysisis performed on a quarterly basis, or more frequently if factors dictate a morefrequent review.

*Pensions*— The Company has noncontributory defined benefitpension plans for a majority of its employees. In certain countries, such asthe United States and the United Kingdom, these plans are funded with planassets whereas in other countries such as Germany, the plans are completelyunfunded, which is customary. The measurement of the Company’s pensionobligations and costs is dependent on a variety of assumptions determined bymanagement and used by the Company’s actuaries. These assumptions includeestimates of the present value of projected future pension payments to all planparticipants, taking into consideration the likelihood of potential futureevents such as salary increases and other experience. These assumptions mayhave an effect on the amount and timing of future contributions. The plantrustee conducts an independent valuation of the fair value of pension planassets.

Theassumptions used in developing the required estimates include the following keyfactors:
| Discount rates   | Inflation                      |
|------------------|--------------------------------|
| Salary growth    | Expected return on plan assets |
| Retirement rates | Mortality rates                |

 

The Company bases the discount rate assumption oninvestment yields available at or near year-end on corporate long-term bondsrated AA. The inflation assumption is based on an evaluation of external marketindicators. The salary growth assumptions reflect the Company’s long-termactual experience, the near-term outlook and assumed inflation. The expectedreturn on plan assets reflects asset allocations, investment strategy and theviews of investment managers and other large pension plan sponsors. Retirementand mortality rates are based primarily on actual plan experience and standardindustry actuarial tables, respectively. The effects of actual resultsdiffering from our assumptions are accumulated and amortized over futureperiods and, therefore, generally affect our recognized expense in such futureperiods.

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The Company’s funding policy for the U.S. plans is tocontribute amounts sufficient to meet the minimum funding requirement of theEmployee Retirement Income Security Act of 1974, plus any additional amountsthe Company may deem to be appropriate. For 2005, the Company anticipatescontributing $5.9 million to its U.S. plans and $1.1 million to itsU.K. plans.

*PostretirementBenefits Other Than Pensions*— The Company providespostretirement health care benefits for certain employee groups in the UnitedStates. This plan is contributory and contains certain other cost-sharingfeatures such as deductibles and coinsurance. The Company does not pre-fundthis plan and has the right to modify or terminate this plan in the future.

The postretirement liability, which is determined onan actuarial basis, is recognized in the Company’s Consolidated Balance Sheetsand the postretirement expense is recognized in the Consolidated Statements ofIncome. The Company must determine the actuarial assumption for the discountrate used to reflect the time value of money in the calculation of theaccumulated postretirement benefit obligation for the end of the current yearand to determine the postretirement cost for the subsequent year. For guidancein determining this rate, the Company looks at investment yield trendsavailable near year-end on corporate bonds rated AA. In addition, the Companymust determine the actuarial assumption for the health care cost trend rateused in the calculation of the accumulated postretirement benefit obligationfor the end of the current year and to determine the net periodicpostretirement benefit cost for the subsequent year. See Note 8 in theNotes to Consolidated Financial Statements for information on the assumptionsused as of December 31, 2004. As of December 31, 2004, aone-percentage-point change in the assumed health care cost trend rate wouldimpact the expense recognized in 2005 by $0.2 million and would affect thepost-retirement benefit obligation by $2.1 million.

*Deferred Income Taxes*—Tax regulations may require items to be included in the tax return at differenttimes than the items are reflected in the financial statements. Some of thedifferences are permanent, such as expenses which are not deductible on a taxreturn, and some of the differences are temporary, such as depreciationexpense. Timing differences create deferred tax assets and liabilities.Deferred tax assets generally are attributable to items that can be used as atax deduction or credit in a tax return in future years but the amount hasalready been included as an expense in the financial statements. Deferred taxliabilities generally represent deductions which have been taken on the taxreturn but have not been recognized as expense in the financial statements.Valuation allowances are recorded to reduce deferred tax assets when it is morelikely than not that a tax benefit will not be realized.

***NewAccounting Policies***

In May 2004 the Financial Accounting StandardsBoard (FASB) issued Staff Position (FSP) 106-2, “Accounting andDisclosure Requirements Related to the Medicare Prescription Drug Improvementand Modernizaton Act of 2003” (the Act) which replaced FSP 106-1 of thesame name. The Act introduced a prescription drug benefit under Medicare Part D,as well as a federal subsidy to sponsors of retiree health care benefit plansthat provide a benefit that is at least actuarially equivalent to Medicare Part D.The Company believes its retiree health and accident plan is at leastactuarially equivalent to Medicare Part D and eligible for the federalsubsidy. The Company determined that the impact of the Act on the financialstatements is not material and therefore is not considered a significant event.The effects of the Act were incorporated in the measurement of plan assets andobligation that was completed as of December 31, 2004 resulting in adecrease of $1.2 million in the amount of unrecognized actuarial loss disclosedin Note 8. The effects of the Act will be amortized over the expectedremaining life of the Plan participants, resulting in a reduction to thepostretirement benefit expense of approximately $0.1 million annually through2012.

The FASB issued Interpretation (FIN) No. 46R, “Consolidationof Variable Interest Entities” in December 2003, which requires variableinterest entities to be consolidated by the party determined to be 

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the primary beneficiary. Aprimary beneficiary of a variable interest entity is the party that absorbs amajority of the entity’s expected losses, receives a majority of its expectedresidual returns, or both, as a result of holding the variable interest. TheCompany adopted FIN No. 46R in the first quarter of 2004, consolidatingone entity which was previously accounted for under the equity method ofaccounting, with no material effect on the financial statements.

In December 2004, the FASB issued Statement ofFinancial Accounting Standard (SFAS) No. 123R, “Share-Based Payment,”which is a revision of SFAS No. 123 “Accounting for Stock-BasedCompensation” and eliminates the alternative of accounting for share-basedcompensation using Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees.” The revised standard requires an entity tomeasure the cost of employee services received in exchange for the award ofequity instruments based on the fair value of the award at the date of grantwith the cost recognized over the period during which an employee is requiredto provide services in exchange for the award. The effective date for theCompany to adopt this standard is the third quarter of 2005. As the Company iscurrently accounting for stock based compensation in accordance with SFAS No. 123the impact of adopting SFAS No. 123R is not expected to be significant onthe Company’s financial position or net income.

In November 2004 theFASB issued SFAS No. 151, “Inventory Costs.” SFAS No. 151 amendsAccounting Research Bulleting No. 43, Chapter 4 on inventory pricing toclarify that abnormal amounts of idle facility expense, freight, handlingcosts, and wasted materials should be recognized as current-period charges. Inaddition SFAS No. 151 requires that allocation of fixed productionoverhead to the costs of conversion be based on the normal capacity of theproduction facilities. The Company is required to adopt SFAS No. 151 in2006. The Company has not yet completed its evaluation of the effects ofadopting this statement but it is not expected to have a significant effect onthe Company’s Consolidated Financial Statements.

***BusinessCombination***

During the second quarter2004, the Company exercised its option to acquire the remaining 15 percentof the outstanding shares of Comatrol S.p.A for approximately$4.3 million. In the second quarter of 2003, the Company purchased 40percent of the outstanding shares of Comatrol, increasing it ownership to85 percent and therefore began to consolidate the financial results of thebusiness. Prior to purchasing its controlling interest in Comatrol, the Companyaccounted for the results of its 45 percent ownership interest, acquired in thefirst quarter of 2002, under the equity method of accounting.

***Non-AuditServices of Independent Registered Public Accounting Firm***

The Company’s IndependentRegistered Public Accounting Firm, KPMG LLP, perform the following non-auditservices that have been approved by the Audit Committee of the Board ofDirectors: international and U.S. tax planning and compliance services;expatriate tax services; benefit plan audits, statutory audits and relatedmatters, and tax and accounting technical support.

***Outlook***

Management of the Companyanticipates that both the U.S. and European markets will continue to grow, butat a more moderate rate than the high growth experienced in 2004. The economy inthe Asia-Pacific region is also expected to grow in 2005. In 2005 theCompany will continue to increase production in low-cost regions, which in manycases is closer to the operations of the Company’s global customers. TheCompany will continue to incur costs related to the implementation of itscommon business system, however these costs are expected to be offset bysavings from recent restructurings, including the reorganization of theEuropean sales and distribution operations, and reduced general and 

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administrativecosts related to the implementation of the Sarbanes-Oxley Act of 2002. Thepositive financial results experienced in 2004 is expected to continuethroughout 2005.

**Item7A.   Quantitative and Qualitative Disclosures about Market Risk.**

Certain market risks arediscussed on pages 26-28 of this report, and the other disclosurerequirements are considered either not applicable or not material.

**Item8.   Financial Statements and Supplementary Data.**

The Consolidated FinancialStatements, Report of Management, and Report of Independent Registered PublicAccounting Firm are presented on pages F-1 through F-34 of this report.

**Item9A.   Controls and Procedures.**

*Conclusion Regardingthe Effectiveness of Disclosure Controls and Procedures*

At December 31, 2004the Registrant carried out an evaluation under the supervision and with theparticipation of the Registrant’s management, including the Registrant’s ChiefExecutive Office and Chief Financial Officer, of the effectiveness of thedesign and operation of the Registrant’s disclosure controls and procedurespursuant to Exchange Act Rule 13a-14. Based upon that evaluation,the Chief Executive Officer and Chief Financial Officer have concluded that theRegistrant’s disclosure controls and procedures are effective to ensure thatinformation required to be disclosed in the reports that the Registrant filesor submits under the Exchange Act is recorded, processed, summarized, and reportedas required and within the time periods specified in the SEC’s rules andforms. There have been no significant changes in the Registrant’s internalcontrols or in other factors that could significantly affect these controlssubsequent to the date of this evaluation with the exception of theimplementation of a new business system platform at two locations that provideimproved general information technology controls.

*Management’sReport on Internal Control Over Financial Reporting*

The Registrant’s management is responsible forestablishing and maintaining a system of internal controls over financialreporting, as such term is defined in Exchange Act Rules 13a-15(f). Thissystem is augmented by written policies and procedures, careful selection andtraining of financial management personnel, a continuing management commitmentto the integrity of the system, and through examinations by an internal auditfunction that coordinates its activities with the Company’s IndependentRegistered Public Accounting Firm.

Under the supervision and with the participation ofthe Registrant’s management, including the Registrant’s Chief Executive Officerand Chief Financial Officer, the Registant conducted an evaluation of theeffectiveness of the Registrant’s internal controls over financial reportingbased on the framework in Internal Control — Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission. Based on theRegistrant’s evaluation under the framework in Internal Control — IntegratedFramework, the Registrant’s management concluded that our internal control overfinancial reporting was effective as of December 31, 2004.

The Registrant’s management’s assessment of theeffectiveness of our internal control over financial reporting as of December 31,2004 has been audited by KPMG LLP, an independent registered public accountingfirm, as stated in their report which is presented on pages F-35 and F-36.

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**PART III**

**Item10.   Directors and Executive Officers of the Registrant**

Information regardingdirectors of the Company is set forth under the section entitled “ELECTION OFDIRECTORS” of the Company’s Proxy Statement for the annual meeting ofstockholders to be held April 27, 2005, and is incorporated herein byreference. Information regarding executive officers of the Company is set forthin Part I of this report under the caption “Executive Officers of theCompany.” Information regarding the Company’s code of conduct and code ofethics is set forth under the section entitled “GOVERNANCE OF THE COMPANY — Codeof Conduct and Code of Ethics” of the Company’s Proxy Statement for the annualmeeting of stockholders to be held April 27, 2005, and is incorporatedherein by reference. Copies of the Worldwide Code of Legal and Ethical BusinessConduct and the Code of Ethics for Chief Executive Officer, Chief FinancialOfficer, Chief Accounting Officer or Controller and other Senior FinancialStaff are posted on the Company’s website at www.sauer-danfoss.com, andprinted copies of such codes may be obtained, without charge, by writtenrequest addressed to Kenneth D. McCuskey, Corporate Secretary,2800 E. 13th Street, Ames, Iowa 50010.

The Company’s AuditCommittee Charter, Compensation Committee Charter, and Corporate GovernanceGuidelines are posted on the Company’s website set forth in the precedingparagraph. Also, printed copies of such charters and guidelines may beobtained, without charge, by sending a written request to the CorporateSecretary at the address set forth in the preceding paragraph.

**Item 11.   ExecutiveCompensation**

Information as toExecutive Compensation is set forth under the section entitled “ExecutiveCompensation” of the Company’s Proxy Statement for the annual meeting ofstockholders to be held April 27, 2005, and is incorporated herein byreference.

**Item12.   Security Ownership of Certain Beneficial Owners and Management**

Information regardingsecurities authorized for issuance under equity compensation plans is set forthunder the section entitled “EXECUTIVE COMPENSATION — Equity Compensation” ofthe Company’s Proxy Statement for the annual meeting of stockholders to be heldApril 27, 2005, and is incorporated herein by reference. Informationregarding security ownership is set forth under the section entitled “SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” of the Company’s ProxyStatement for the annual meeting of stockholders to be held April 27,2005, and is incorporated herein by reference.

**Item13.   Certain Relationships and Related Transactions**

In connection with theacquisition of Danfoss Fluid Power in May 2000 and the acquisition ofadditional assets and business operations of the fluid power business ofDanfoss A/S in January 2001, the Company has entered into severalagreements with Danfoss A/S to purchase ongoing operational services fromDanfoss A/S. Information regarding these relationships and agreements is setforth in Note 13 in the Notes to Consolidated Financial Statements on pageF-27 of this report, and is incorporated herein by reference. Informationregarding another related party transaction is set forth under the sectionentitled “GOVERNANCE OF THE COMPANY — Related Transaction” of the Company’sProxy Statement for the annual meeting of stockholders to be held April 27,2005.

**Item14.   Principal Accountant Fees and Services**

Information regardingaccounting services and fees is set forth under the section entitled “RATIFICATONOF APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM” of the Company’sProxy Statement for the annual meeting of stockholders to be held April 27,2005, and is incorporated herein by reference.

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**PART IV**

**Item 15.   Exhibits,Financial Statement Schedules, and Reports on Form 8-K.**

(a)           The following documentsare filed as a part of this report.

(1)   Thefollowing consolidated financial statements and related information, includedin Item 8, are filed as a separate section of this report:

Consolidated Statements of Income for the years ended December 31,2004, 2003, and 2002, on page F-1.

Consolidated Balance Sheets as of December 31,2004 and 2003, on page F-2.

Consolidated Statements of Stockholders’ Equity andComprehensive Income (Loss) for the years ended December 31, 2004, 2003,and 2002, on page F-3.

Consolidated Statements of Cash Flows for the yearsended December 31, 2004, 2003, and 2002, on page F-4.

Notes to Consolidated Financial Statements, December 31,2004, 2003, and 2002, on pages F-5 through F-31.

Report ofManagement and Reports of Independent Registered Public Accounting Firm, KPMGLLP, on pages F-32 through F-36.

(2)   Thefollowing schedule:

Schedule II, Valuation and Qualifying Accounts,on page F-37.

Report of Independent Registered Public AccountingFirm, KPMG LLP, on Schedule II, on page F-38.

All other schedules for which provision is made inRegulation S-X of the Securities and Exchange Commission, are not requiredunder the related instructions or are inapplicable and, therefore, have beenomitted.

(3)   Exhibits
| Exhibit   No. | ** ** | **Description of Document**                                                                                                                                                                                                                                                          |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1           |       | The Amended and  Restated Certificate of Incorporation of the Company dated May 3, 2000,  is attached as Exhibit 3.1 to the Company’s Form 10-Q filed on  August 16, 2000, and is incorporated herein by reference.                                         |
| 3.2           |       | The Amended and  Restated Bylaws of the Company dated May 5, 2004, is attached as  Exhibit 3.2 to the Company’s Form 10-Q filed on August 6, 2004,  and is incorporated herein by reference.                                                                |
| 4             |       | The form of  Certificate of the Company’s Common Stock, $.01 Par Value, is attached as  Exhibit 4 to the Company’s Form 10-Q filed on August 16, 2000  and is incorporated herein by reference.                                                             |
| 10.1(a)       |       | The Termination  Agreement and Release dated May 3, 2000 relating to the termination of a  Silent Partnership Agreement is attached as Exhibit 10.1(a) to the  Company’s Form 10-Q filed on August 16, 2000, and is incorporated  herein by reference. |
| 10.1(b)       |       | The Registration  Rights Agreement is attached as Exhibit 10.1(b) to Amendment  No. 1 to the Company’s Form S-1 Registration Statement filed on  April 23, 1998, and is incorporated herein by reference.                                              |

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| 10.1(c) |   | The form of  Indemnification Agreement entered into between the Company and each of its  directors and certain officers is attached as Exhibit 10.1(c) to  Amendment No. 1 to the Company’s Form S-1 Registration Statement  filed on April 23, 1998, and is incorporated herein by reference. |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(d) |   | The Lease  Agreement for the Company’s Osaka, Japan facility is attached hereto.                                                                                                                                                                                                                                        |
| 10.1(e) |   | The Lease  Agreement for the Company’s Swindon, England facility is attached as  Exhibit 10.1(g) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and is  incorporated herein by reference.                                                  |
| 10.1(f) |   | The Lease  Agreement for the Company’s Minneapolis, Minnesota, facility is attached as  Exhibit 10.1(h) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and is incorporated  herein by reference.                                           |
| 10.1(g) |   | The Lease  Agreement for the Company’s Berching, Germany, facility dated  November 15, 1996, is attached as Exhibit 10.1(g) to the  Company’s Form 10-K filed on March 12, 2003, and is incorporated  herein by reference.                                                                |
| 10.1(h) |   | The Lease  Agreement for the Company’s Shanghai/Pudong, China, facility is attached as  Exhibit 10.1(j) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and is  incorporated herein by reference.                                           |
| 10.1(i) |   | The Lease  Agreement for the Company’s Odense, Denmark, facility dated November 15,  1996, is attached as Exhibit 10.1(h) to the Company’s  Form 10-K filed on March 12, 2003, and is incorporated herein by  reference.                                                                  |
| 10.1(j) |   | The Indenture of  Lease agreement for the Company’s Nordborg, Denmark, facility effective  May 3, 2000, is attached as Exhibit 10.1(ah) to the Company’s  Form 10-K filed on March 30, 2001, and is incorporated herein by  reference.                                                         |
| 10.1(k) |   | The Lease  Agreement for the Company’s Hillsboro, Oregon, facility effective  January 19, 2001, is attached as Exhibit 10.1(ai) to the Company’s  Form 10-K filed on March 30, 2001, and is incorporated herein by  reference.                                                                 |
| 10.1(l) |   | The Lease  Agreement for the Company’s leased facility in Ames, Iowa, effective  April 1, 2002, is attached as Exhibit 10.1(am) to the Company’s  Form 10-Q filed on May 15, 2002, and is incorporated herein by  reference.                                                                   |
| 10.1(m) |   | The Office Lease  for the Company’s Chicago, Illinois, Executive Office effective June 1,  2002, is attached as Exhibit 10.1(an) to the Company’s Form 10-Q  filed on May 15, 2002, and is incorporated herein by reference.                                                                   |
| 10.1(n) |   | The Executive  Employment Agreement with David J. Anderson dated January 1, 2003, is  attached as Exhibit 10.1(m) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                |
| 10.1(o) |   | The Executive  Employment Agreement with Karl J. Schmidt dated January 1, 2003, is  attached as Exhibit 10.1(n) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                  |
| 10.1(p) |   | The Executive  Employment Agreement with James R. Wilcox dated January 1, 2003, is  attached as Exhibit 10.1(o) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                  |

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| 10.1(q)  |   | The Executive Employment Agreement with Hans J.  Cornett dated January 1, 2003, is attached as  Exhibit 10.1(p) to the Company’s Form 10-K filed on  March 12, 2003, and is incorporated herein by reference.                                                                                                |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(r)  |   | The Executive  Employment Agreement with Thomas Kittel dated January 1, 2003, is  attached as Exhibit 10.1(q) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                                  |
| 10.1(s)  |   | The Addendum to  Executive Employment Agreement, dated December 1, 2002, relating to the  Executive Employment Agreement referred to in 10.1(r) above with Thomas  Kittel is attached as Exhibit 10.1(r) to the Company’s  Form 10-K filed on March 12, 2003, and is incorporated herein by  reference. |
| 10.1(t)  |   | The Executive  Employment Agreement with Finn Lyhne dated January 1, 2003, is attached  as Exhibit 10.1(s) to the Company’s Form 10-K filed on  March 12, 2003, and is incorporated herein by reference.                                                                                                     |
| 10.1(u)  |   | The Addendum to  Executive Employment Agreement, dated December 1, 2002, relating to the  Executive Employment Agreement referred to in 10.1(t) above with Finn  Lyhne is attached as Exhibit 10.1(t) to the Company’s  Form 10-K filed on March 12, 2003, and is incorporated herein by  reference.    |
| 10.1(v)  |   | The Executive  Employment Agreement with Henrik Krabsen dated January 1, 2003, is  attached as Exhibit 10.1(v) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                                 |
| 10.1(w)  |   | The Executive  Employment Agreement with Kenneth D. McCuskey dated January 1, 2003, is  attached as Exhibit 10.1(w) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                            |
| 10.1(x)  |   | The Executive  Employment Agreement with Albert Zahalka dated January 1, 2003, is  attached as Exhibit 10.1(x) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                                                 |
| 10.1(y)  |   | The Executive  Employment Agreement with Ronald C. Hanson dated July 1, 2003, is  attached as Exhibit 10.1(z) to the Company’s Form 10-K filed  on March 15, 2004, and is incorporated herein by reference.                                                                                                  |
| 10.1(z)  |   | The Consulting  Agreement with Klaus Murmann dated May 5, 2004, is attached as  Exhibit 10.1(z) to the Company’s Form 10-Q filed on  August 6, 2004, and is incorporated herein by reference.                                                                                                                |
| 10.1(aa) |   | The Amended and  Restated Post-Retirement Care Agreement for Klaus Murmann, effective  May 3, 2000, is attached as Exhibit 10.1 (s) to the Company’s  Form 10-Q filed on August 16, 2000, and is incorporated herein by  reference.                                                                          |
| 10.1(ab) |   | The Sauer-Danfoss  Inc. Annual Management Performance Incentive Plan amended and restated as of  March 4, 2004, is attached as Exhibit 10.1(ab) to the Company’s  Form 10-Q filed on August 6, 2004, and is incorporated herein by  reference.                                                                    |
| 10.1(ac) |   | The  Sauer-Sundstrand Company Supplemental Retirement Benefit Plan for Certain Key  Executives is attached as Exhibit 10.1(t) to Amendment No. 1  to the Company’s Form S-1 Registration Statement filed on April 23,  1998, and is incorporated herein by reference.                                        |

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| 10.1(ad) |   | The First Amendment to the Sauer-Sundstrand Company  Supplemental Retirement Benefit Plan for Certain Key Executives referred to  in Exhibit 10.1(ac) above, which renames the Plan to the Sauer-Danfoss  Inc. Supplemental Retirement Benefit Plan for Certain Key Executives, is  attached as Exhibit 10.1(ad) to the Company’s Form Form 10-Q  filed on August 6, 2004, and is incorporated herein by reference. |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(ae) |   | The  Sauer-Sundstrand Company Supplemental Retirement Benefit Plan for Certain Key  Executives Previously Employed by the Sundstrand Corporation is attached as  Exhibit 10.1(u) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and is  incorporated herein by reference.                                                                                            |
| 10.1(af) |   | The  Sauer-Sundstrand Employees’ Savings & Retirement Plan is attached as  Exhibit 10.1(v) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and is  incorporated herein by reference.                                                                                                                                                                    |
| 10.1(ag) |   | The Amendment  Number One, effective December 15, 2000, to the Sauer-Sundstrand  Employees’ Savings and Retirement Plan referred to in Exhibit 10.1(af)  above, is attached as Exhibit 10.1(aj) to the Company’s Form 10-Q  filed on August 15, 2001, and is incorporated herein by reference.                                                                                                                 |
| 10.1(ah) |   | The Amendment  Number Two, effective January 1, 2002, to the Sauer-Danfoss Employees’  Savings Plan, (formerly the Sauer-Sundstrand Employees’ Savings and  Retirement Plan), referred to in Exhibit 10.1(af) above, is attached as  Exhibit 10.1(t) to the Company’s Form 10-K filed on  March 29, 2002, and is incorporated herein by reference.                                                   |
| 10.1(ai) |   | Amendment  No. 1 to the Compact Controls, Inc. 401(k) Plan and Amendment  No. 3 to the Sauer-Danfoss Employees’ Savings Plan, effective  December 23, 2001, is attached as exhibit 10.1(ah) to the Company’s  Form 10-K filed on March 15, 2004 and is incorporated herein by  reference.                                                                                                            |
| 10.1(aj) |   | Amendment Number  Four to the Sauer-Danfoss Employees’ Savings Plan, effective February 8,  2002, is attached as exhibit 10.1(ai) to the Company’s Form 10-K filed  on March 15, 2004 and is incorporated herein by reference.                                                                                                                                                                                           |
| 10.1(ak) |   | The Fifth  Amendment to the Sauer-Danfoss Employees’ Savings Plan, effective  February 25, 2002, is attached as exhibit 10.1(aj) to the Company’s  Form 10-K filed on March 15, 2004 and is incorporated herein by  reference.                                                                                                                                                                                           |
| 10.1(al) |   | Amendment  Number 6 to the Sauer-Danfoss Employees’ Savings Plan, effective  July 24, 2002, is attached as exhibit 10.1(ak) to the Company’s  Form 10-K filed on March 15, 2004 and is incorporated herein by  reference.                                                                                                                                                                                           |
| 10.1(am) |   | Amendment  Number 7 to the Sauer-Danfoss Employees’ Savings Plan, effective  January 20, 2003, is attached as exhibit 10.1(al) to the Company’s  Form 10-K filed on March 15, 2004 and is incorporated herein by  reference.                                                                                                                                                                                        |
| 10.1(an) |   | Amendment  Number Eight to the Sauer-Danfoss Employees’ Savings Plan, effective  January 24, 2003, is attached as exhibit 10.1(am) to the Company’s  Form 10-K filed on March 15, 2004 and is incorporated herein by  reference.                                                                                                                                                                                    |
| 10.1(ao) |   | Amendment  Number 9 to the Sauer-Danfoss Employees’ Savings Plan, effective December 18,  2003, is attached as exhibit 10.1(an) to the Company’s Form 10-K filed  on March 15, 2004 and is incorporated herein by reference.                                                                                                                                                                                        |
| 10.1(ap) |   | Amendment Number  Ten to the Sauer-Danfoss Employees’ Savings Plan, effective January 1,  2004, is attached hereto.                                                                                                                                                                                                                                                                                                                     |

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| 10.1(aq) |   | Amendment Number  Eleven to the Sauer-Danfoss Employees’ Savings Plan, effective  January 1, 2004, is attached hereto.                                                                                                                                                                                                                                                           |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(ar) |   | The European  Employees’ Pension Plan is attached as Exhibit 10.1(y) to Amendment  No. 1 to the Company’s Form S-1 Registration Statement filed on  April 23, 1998, and is incorporated herein by reference.                                                                                                                                            |
| 10.1(as) |   | The Sauer-Danfoss  Inc. 1998 Long-Term Incentive Plan is attached as  Exhibit 10.1(p) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and is  incorporated herein by reference.                                                                                                                                |
| 10.1(at) |   | The Amendment,  effective May 3, 2000, to the Sauer-Danfoss Inc. 1998 Long-Term  Incentive Plan referred to in 10.1(as) above is attached as Exhibit 10.1  (v) to the Company’s Form 10-Q filed on August 16, 2000,  and is incorporated herein by reference.                                                                                                |
| 10.1(au) |   | The Amendment to  the Sauer-Danfoss Inc. 1998 Long-Term Incentive Plan effective  December 4, 2002, is attached as Exhibit 10.1(bd) to the Company’s  Form 10-K filed on March 12, 2003, and is incorporated herein by  reference.                                                                                                                                |
| 10.1(av) |   | The Sauer-Danfoss  Inc. Non-employee Director Stock Option and Restricted Stock Plan is attached  as Exhibit 10.1(q) to Amendment No. 1 to the Company’s  Registration Statement filed on April 23, 1998, and is incorporated  herein by reference.                                                                                                               |
| 10.1(aw) |   | The Amendment,  effective May 3, 2000, to the Sauer-Danfoss Inc. Non-Employee Director  Stock Option and Restricted Stock Plan referred to in 10.1(av) above is  attached as Exhibit 10.1 (x) to the Company’s Form 10-Q filed  on August 16, 2000, and is incorporated herein by reference.                                                                 |
| 10.1(ax) |   | The Amendment to  the Sauer-Danfoss Inc. Non-Employee Director Stock Option and Restricted  Stock Plan effective December 4, 2002, is attached as  Exhibit 10.1(ak) to the Company’s Form 10-K filed on March 12,  2003, and is incorporated herein by reference.                                                                                                 |
| 10.1(ay) |   | The Trademark and  Trade Name Agreement dated May 3, 2000, between the Company and Danfoss  A/S is attached as Exhibit 10.1 (ac) to the Company’s Form 10-Q  filed on August 16, 2000, and is incorporated herein by reference.                                                                                                                                   |
| 10.1(az) |   | The Stock  Exchange Agreement dated January 22, 2000, by and among the Registrant,  Danfoss A/S, Danfoss Murmann Holding A/S. and K. Murmann  Verwaltungsgesellschaft mbH is attached as Annex A to the Company’s Proxy  Statement filed on March 28, 2000, and is incorporated herein by  reference.                                                                       |
| 10.1(ba) |   | The Sauer-Danfoss  Employees’ Retirement Plan as amended and restated, effective January 1,  2000, and renamed as of May 3, 2000, is attached as  Exhibit 10.1(ah) to the Company’s Form 10-Q filed on  November 15, 2000, and is incorporated herein by reference.                                                                                     |
| 10.1(bb) |   | The Amendment  Number One, effective December 15, 2000, to the Sauer-Danfoss Employees’  Retirement Plan referred to in Exhibit 10.1(ba) above, is attached as  Exhibit 10.1(ax) to the Company’s Form 10-Q filed on  August 15, 2001, and is incorporated herein by reference.                                                                         |
| 10.1(bc) |   | The Second  Amendment, effective March 26, 2001, to the Sauer-Danfoss Employees’  Retirement Plan, (formerly the Sauer-Sundstrand Employees’ Savings and  Retirement Plan), referred to in Exhibit 10.1(ba) above, is attached as  Exhibit 10.1(ag) to the Company’s Form 10-Q filed on  August 15, 2001, and is incorporated herein by reference. |

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| 10.1(bd) |   | The Third Amendment, effective January 1, 2001  to the Sauer-Danfoss Employees’ Retirement Plan, referred to in  Exhibit 10.1(ba) above, is attached hereto.                                                                                             |
|----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(be) |   | Amendment Number  Four, effective January 1, 2004 to the Sauer-Danfoss Employees’  Retirement Plan, referred to in Exhibit 10.1(ba) above, is attached  hereto.                                                                                          |
| 10.1(bf) |   | The First  Amendment to the Sauer-Danfoss LaSalle Factory Employee Savings Plan,  effective September 1, 1998, is attached hereto.                                                                                                                                 |
| 10.1(bg) |   | The Second  Amendment to the Sauer-Danfoss LaSalle Factory Employee Savings Plan, dated  December 1999, is attached hereto.                                                                                                                                        |
| 10.1(bh) |   | The Third  Amendment to the Sauer-Danfoss LaSalle Factory Employee Savings Plan,  effective January 1, 2001, is attached as Exhibit 10.1(al) to the  Company’s Form 10-Q filed on November 14, 2001, and is incorporated  herein by reference. |
| 10.1(bi) |   | Amendment Number  Four to the Sauer-Danfoss LaSalle Factory Employee Savings Plan, effective  February 8, 2002, is attached as Exhibit 10.1(ap) to the Company’s  Form 10-K filed on March 29, 2002, and is incorporated herein by  reference. |
| 10.1(bj) |   | The Fifth  Amendment to the Sauer-Danfoss LaSalle Factory Employee Savings Plan,  effective February 25, 2002, is attached as Exhibit 10.1(aq) to the  Company’s Form 10-K filed on March 29, 2002, and is incorporated  herein by reference.  |
| 10.1(bk) |   | Amendment  Number 6 to the Sauer-Danfoss LaSalle Factory Employee Savings Plan,  effective January 20, 2003, is attached as exhibit 10.1(bd) to the  Company’s Form 10-K filed on March 15, 2004, and is incorporated  herein by reference.    |
| 10.1(bl) |   | The Seventh  Amendment to the Sauer-Danfoss LaSalle Factory Employee Savings Plan,  effective January 1, 2004, is attached as exhibit 10.1(be) to the  Company’s Form 10-K filed on March 15, 2004, and is incorporated  herein by reference.       |
| 10.1(bm) |   | Amendment Number  Eight to the Sauer-Danfoss LaSalle Factory Employee Savings Plan, effective  January 1, 2004, is attached hereto.                                                                                                                                |
| 10.1(bn) |   | The Sauer-Danfoss  Racine Employees’ Savings Plan, effective December 1, 2000, is attached  as Exhibit 10.1(am) to the Company’s Form 10-Q filed on  November 14, 2001, and is incorporated herein by reference.                          |
| 10.1(bo) |   | The Sauer-Danfoss  Inc. Annual Officer Performance Incentive Plan amended and restated as of  March 4, 2003, is attached as Exhibit 10.1(bc) to the Company’s  Form 10-K filed on March 12, 2003 and is incorporated herein by  reference.     |
| 10.1(bp) |   | The Sauer-Danfoss  Inc. Deferred Compensation Plan for Selected Employees dated December 9,  2003, is attached as exhibit 10.1(bk) to the Company’s Form 10-K filed  on March 15, 2004, and is incorporated herein by reference.                    |
| 10.1(bq) |   | The Sauer-Danfoss  Inc. Supplemental Executive Savings & Retirement Plan, effective  January 1, 2004, is attached as exhibit 10.1(bk) to the Company’s  Form 10-Q filed on August 6, 2004, and is incorporated herein by  reference.       |
| 10.1(br) |   | Amendment Number  One to the Factory Pension Plan of Sauer-Danfoss (LaSalle) and International  Union, United Automobile, Aerospace and Agricuttural Implement Workers of  American and its Local Union No 285, effective September 1, 2001 is  attached hereto.   |
| 10.1(bs) |   | Amendment Number  Two to the Factory Pension Plan of Sauer-Danfoss (LaSalle) and International  Union, United Automobile, Aerospace and Agricuttural Implement Workers of American  and its Local Union No 285, effective January 1, 2002 is attached  hereto.     |

42

----

 
| 10.1(bt) |   | Amendment Number  Three to the Factory Pension Plan of Sauer-Danfoss (LaSalle) and  International Union, United Automobile, Aerospace and Agricuttural Implement  Workers of American and its Local Union No 285, effective January 1,  2000 is attached hereto.   |
|----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(bu) |   | Amendment Number  Four to the Factory Pension Plan of Sauer-Danfoss (LaSalle) and International  Union, United Automobile, Aerospace and Agricuttural Implement Workers of  American and its Local Union No 285, effective September 30, 2004 is  attached hereto. |
| 21       |   | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                        |
| 23.1     |   | Consent of KPMG LLP.                                                                                                                                                                                                                                                    |
| 31.1     |   | Certification by the  Chief Executive Officer Pursuant to Rule 13a-14(a).                                                                                                                                                                                          |
| 31.2     |   | Certification by  the Chief Financial Officer Pursuant to Rule 13a-14(a).                                                                                                                                                                                          |
| 32.1     |   | Certification by the  Chief Executive Officer Pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                                  |
| 32.2     |   | Certification by the  Chief Financial Officer Pursuant to 18 U.S.C. Section 1350.                                                                                                                                                                                  |

 

(b)          Theexhibits that are listed under Item 15(a)(3) above are filed orincorporated by reference hereunder.

43

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                            | SAUER-DANFOSS INC. |
|----------------------------|-------------------------|
|                       | BY:                     | /s/  KENNETH D. MCCUSKEY |
|                       |                    | Kenneth D.  McCuskey |
|                       |                    | *Vice  President and Chief Accounting Officer, Secretary* |
| Date: March 14,  2005 |                    |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated. Each person signing below alsohereby appoints David J. Anderson and Kenneth D. McCuskey, and eachof them singly, his or her lawful attorney-in-fact with full power to executeand file any and all amendments to this report together with exhibits theretoand generally to do all such things as such attorney-in-fact may deemappropriate to enable Sauer-Danfoss Inc. to comply with the provisions ofthe Securities Exchange Act of 1934 and all requirements of the Securities andExchange Commission.
|                                     | Signature | ** **                           | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------------------|-----------|--------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/  DAVID J. ANDERSON         |      | Director and President  and Chief    |       | March 14,  2005 |
| David J.  Anderson             |      | Executive Officer                    |       |                 |
| /s/  KARL J. SCHMIDT           |      | Executive Vice President  and Chief  |       | March 14,  2005 |
| Karl J.  Schmidt               |      | Financial Officer,  Treasurer        |       |                 |
| /s/  KENNETH D. MCCUSKEY       |      | Vice President and Chief  Accounting |       | March 14,  2005 |
| Kenneth D.  McCuskey           |      | Officer, Secretary                   |       |                 |
| /s/  OLE  STEEN  ANDERSEN |      | Director                             |       | March 14,  2005 |
| Ole Steen  Andersen                 |      |                                 |       |                 |
| /s/  JØRGEN M. CLAUSEN    |      | Director                             |       | March 14,  2005 |
| JØrgen M.  Clausen        |      |                                 |       |                 |
| /s/  NICOLA  KEIM              |      | Director                             |       | March 14,  2005 |
| Nicola Keim                         |      |                                 |       |                 |
| /s/  JOHANNES F. KIRCHHOFF     |      | Director                             |       | March 14,  2005 |
| Johannes F.  Kirchhoff         |      |                                 |       |                 |

44

----

 
| /s/ HANS  KIRK               |   | Director |   | March 14,  2005 |
|-----------------------------------|--------|----------|--------|----------------------|
| Hans Kirk                         |   |     |   |                 |
| /s/ F. JOSEPH  LOUGHREY |   | Director |   | March 14,  2005 |
| F. Joseph Loughrey           |   |     |   |                 |
| /s/ KLAUS H. MURMANN         |   | Director |   | March 14,  2005 |
| Klaus H. Murmann             |   |     |   |                 |
| /s/  SVEN  MURMANN           |   | Director |   | March 14,  2005 |
| Sven Murmann                      |   |     |   |                 |
| /s/  STEVEN H. WOOD          |   | Director |   | March 14,  2005 |
| Steven H.  Wood              |   |     |   |                 |

 

45

----

**Sauer-Danfoss Inc.and SubsidiariesConsolidated Statements of Income(in thousands, except per share data)**
| ** **                                                                 | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                                                      | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Net  Sales**                                                             |       | $                                                             | 1,404,159  |   | $ | 1,126,774 |   | $ | 952,308 |   |
| **Costs and Expenses:**                                                    | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of sales                                                              |       | 1,058,075                                                     |       | 874,410 |   | 733,316 |   |
| Selling, general and administrative                                        |       | 200,142                                                       |       | 156,658 |   | 128,646 |   |
| Research and development                                                   |       | 51,913                                                        |       | 43,456 |   | 37,806 |   |
| Loss on disposal of fixed assets                                           |       | 2,119                                                         |       | 5,328 |   | 381 |   |
| Total costs and expenses                                                   |       | 1,312,249                                                     |       | 1,079,852 |   | 900,149 |   |
| Operating income                                                           |       | 91,910                                                        |       | 46,922 |   | 52,159 |   |
| **Nonoperating  Income (Expenses):**                                       | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                           |       | (18,403                                                       | )          | (18,748 | ) | (22,510 | ) |
| Interest income                                                            |       | 988                                                           |       | 1,348 |   | 5,291 |   |
| Other, net                                                                 |       | (4,052                                                        | )          | (3,358 | ) | (2,224 | ) |
| Nonoperating expenses, net                                                 |       | (21,467                                                       | )          | (20,758 | ) | (19,443 | ) |
| **Income Before Income Taxes and Minority Interest**                       |       | 70,443                                                        |       | 26,164 |   | 32,716 |   |
| **Minority  Interest and Equity Income, net**                              |       | (21,522                                                       | )          | (15,405 | ) | (11,099 | ) |
| **Income Before Income Taxes**                                             |       | 48,921                                                        |       | 10,759 |   | 21,617 |   |
| **Income  Tax Benefit (Expense)**                                          |       | (15,735                                                       | )          | 474 |   | (7,217 | ) |
| **Net Income Before Cumulative Effect of Change in  Accounting Principle** |       | 33,186                                                        |       | 11,233 |   | 14,400 |   |
| **Cumulative  Effect of Change in Accounting Principle**                   |       | —                                                        |       | — |   | (695 | ) |
| **Net Income**                                                             |       | $                                                             | 33,186     |   | $ | 11,233 |   | $ | 13,705 |   |
| Net Income per common  share, basic and diluted                            |       | $                                                             | 0.70       |   | $ | 0.24 |   | $ | 0.29 |   |
| Weighted average  basic shares outstanding                                 |       | 47,409                                                        |       | 47,401 |   | 47,395 |   |
| Weighted average diluted  shares outstanding                               |       | 47,510                                                        |       | 47,516 |   | 47,404 |   |

 

See accompanying notes to consolidated financial statements.

F-1

----

**Sauer-Danfoss Inc.and SubsidiariesConsolidated Balance Sheets(in thousands, except per share data)**
| ** **                                                                                                                                         | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| **Assets**                                                                                                                                         | ** ** | ** **                            | ** ** | ** ** |   |
| **Current Assets:**                                                                                                                                | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                         |       | $                                     | 11,273     | ** ** | $ | 15,086 | ** ** |
| Accounts  receivable (net of allowance for doubtful accounts of $4,671 and $4,144 in  2004 and 2003, respectively)                            |       | 233,146                               | ** ** | 186,293 | ** ** |
| Inventories                                                                                                                                        |       | 241,562                               | ** ** | 198,870 | ** ** |
| Other current  assets                                                                                                                              |       | 40,131                                | ** ** | 32,965 | ** ** |
| Total current  assets                                                                                                                              |       | 526,112                               | ** ** | 433,214 | ** ** |
| **Property,  Plant and Equipment, net**                                                                                                            |       | 478,543                               | ** ** | 452,913 | ** ** |
| **Other Assets:**                                                                                                                                  | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Goodwill                                                                                                                                           |       | 129,554                               | ** ** | 119,654 | ** ** |
| Other intangible  assets, net                                                                                                                      |       | 33,357                                | ** ** | 35,265 | ** ** |
| Deferred income  taxes                                                                                                                             |       | 32,990                                | ** ** | 39,258 | ** ** |
| Other                                                                                                                                              |       | 11,025                                | ** ** | 21,450 | ** ** |
| Total other assets                                                                                                                                 |       | 206,926                               | ** ** | 215,627 | ** ** |
|                                                                                                                                               |       | $                                     | 1,211,581  | ** ** | $ | 1,101,754 | ** ** |
| **Liabilities and Stockholders’ Equity**                                                                                                      | ** ** | ** **                            | ** ** | ** ** | ** ** |
| **Current Liabilities:**                                                                                                                           | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Notes payable and  bank overdrafts                                                                                                                 |       | $                                     | 23,609     | ** ** | $ | 35,666 | ** ** |
| Long-term debt due  within one year                                                                                                                |       | 244,987                               | ** ** | 189,377 | ** ** |
| Accounts payable                                                                                                                                   |       | 130,071                               | ** ** | 93,793 | ** ** |
| Accrued salaries  and wages                                                                                                                        |       | 38,637                                | ** ** | 28,558 | ** ** |
| Accrued warranty                                                                                                                                   |       | 16,392                                | ** ** | 17,196 | ** ** |
| Other accrued  liabilities                                                                                                                         |       | 44,291                                | ** ** | 36,208 | ** ** |
| Total current  liabilities                                                                                                                         |       | 497,987                               | ** ** | 400,798 | ** ** |
| **Long-Term  Debt**                                                                                                                                |       | 76,496                                | ** ** | 130,408 | ** ** |
| **Other Liabilities:**                                                                                                                             | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Long-term pension  liability                                                                                                                       |       | 57,148                                | ** ** | 41,937 | ** ** |
| Postretirement benefits  other than pensions                                                                                                       |       | 18,545                                | ** ** | 17,779 | ** ** |
| Deferred income  taxes                                                                                                                             |       | 48,454                                | ** ** | 56,126 | ** ** |
| Other                                                                                                                                              |       | 28,949                                | ** ** | 25,139 | ** ** |
| Total other  liabilities                                                                                                                           |       | 153,096                               | ** ** | 140,981 | ** ** |
| **Minority  Interest in Net Assets of Consolidated Companies**                                                                                     |       | 39,927                                | ** ** | 32,353 | ** ** |
| **Stockholders’ Equity:**                                                                                                                     | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Preferred stock,  par value $.01 per share, authorized 4,500 shares, no shares issued or  outstanding                                         |       | —                                | ** ** | — | ** ** |
| Common stock, par  value $.01 per share, authorized 75,000 shares in 2004 and 2003; issued  and outstanding 47,446 in 2004 and 47,432 in 2003 |       | 474                                   | ** ** | 474 | ** ** |
| Additional paid-in  capital                                                                                                                        |       | 319,871                               | ** ** | 314,319 | ** ** |
| Retained earnings                                                                                                                                  |       | 62,257                                | ** ** | 45,202 | ** ** |
| Accumulated other  comprehensive income                                                                                                            |       | 61,710                                | ** ** | 37,376 | ** ** |
| Unamortized  restricted stock compensation                                                                                                         |       | (237                                  | )          | (157 | ) |
| Total  stockholders’ equity                                                                                                                   |       | 444,075                               | ** ** | 397,214 | ** ** |
|                                                                                                                                               |       | $                                     | 1,211,581  | ** ** | $ | 1,101,754 | ** ** |

 

See accompanying notes toconsolidated financial statements.

F-2

----

**Sauer-Danfoss Inc.and SubsidiariesConsolidated Statements of Stockholders’ Equity and Comprehensive Income(in thousands, except per share data)**
| ** **                                | ** ** | **Number of   Shares  Outstanding** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained   Earnings ** | ** ** | **Accumulated  Other  Comprehensive   Income (Loss)** | ** ** | **Unamortized  Restricted  Stock  Compensation** | ** ** | **Total**  | ** ** |
|-------------------------------------------|------------|-----------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|
| **Year Ended December 31, 2002:**    | ** ** |                                          | ** ** | ** **        |       |                             | ** ** | ** **                         |       |                                                            | ** ** | ** **                                       |       |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   | ** ** |   |
| Beginning balance                         |       |                                          | 47,411     | ** **        |       |                             | $          | 474                                | ** ** |                                                            |       | $                                                | 313,662    | ** ** |       |   | $ | 47,442 |   |   |   | $ | (15,663 | ) |   |   | $ | (92 | ) |   | $ | 345,823 |   |
| Comprehensive income (loss):              |       |                                          |       | ** **        |       |                             |       | ** **                         |       |                                                            |       | ** **                                       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | 13,705     |   |   |   | — |   |   |   | — |   |   | — |   |
| Pension adjustment                        |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | (1,353 | ) |   |   | — |   |   | — |   |
| Unrealized gains  on hedging activities   |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | 1,427 |   |   |   | — |   |   | — |   |
| Currency  Translation                     |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | 20,935 |   |   |   | — |   |   | — |   |
| Total  comprehensive income               |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 34,714 |   |
| Restricted stock  grant                   |       |                                          | 8          | ** **        |       |                             | —     | ** **                         |       |                                                            | 98         | ** **                                       |       |       | —     |   |   |   | — |   |   |   | (98 | ) |   | — |   |
| Restricted stock  compensation            |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | — |   |   |   | 71 |   |   | 71 |   |
| Cash dividends  declared ($.28 per share) |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | (13,277    | ) |   |   | — |   |   |   | — |   |   | (13,277 | ) |
| Ending balance                            |       |                                          | 47,419     | ** **        |       |                             | 474        | ** **                         |       |                                                            | 313,760    | ** **                                       |       |       | 47,870     |   |   |   | 5,346 |   |   |   | (119 | ) |   | 367,331 |   |
| **Year Ended December 31, 2003:**    | ** ** |                                          | ** ** | ** **        |       |                             | ** ** | ** **                         |       |                                                            | ** ** | ** **                                       |       |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   | ** ** |   |
| Comprehensive income (loss):              |       |                                          |       | ** **        |       |                             |       | ** **                         |       |                                                            |       | ** **                                       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | 11,233     |   |   |   | — |   |   |   | — |   |   | — |   |
| Pension adjustment                        |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | (1,935 | ) |   |   | — |   |   | — |   |
| Unrealized losses  on hedging activities  |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | (1,360 | ) |   |   | — |   |   | — |   |
| Currency  Translation                     |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | 35,325 |   |   |   | — |   |   | — |   |
| Total  comprehensive income               |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 43,263 |   |
| Stock incentive  expense                  |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | 423        | ** **                                       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 423 |   |
| Restricted stock  grant                   |       |                                          | 13         | ** **        |       |                             | —     | ** **                         |       |                                                            | 136        | ** **                                       |       |       | —     |   |   |   | — |   |   |   | (136 | ) |   | — |   |
| Restricted stock  compensation            |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | — |   |   |   | 98 |   |   | 98 |   |
| Deemed dividend                           |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | (621       | ) |   |   | — |   |   |   | — |   |   | (621 | ) |
| Cash dividends  declared ($.28 per share) |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | (13,280    | ) |   |   | — |   |   |   | — |   |   | (13,280 | ) |
| Ending balance                            |       |                                          | 47,432     | ** **        |       |                             | 474        | ** **                         |       |                                                            | 314,319    | ** **                                       |       |       | 45,202     |   |   |   | 37,376 |   |   |   | (157 | ) |   | 397,214 |   |
| **Year Ended December 31, 2004:**    | ** ** |                                          | ** ** | ** **        |       |                             | ** ** | ** **                         |       |                                                            | ** ** | ** **                                       |       |       | ** ** |   |   |   | ** ** |   |   |   | ** ** |   |   | ** ** |   |
| Comprehensive income (loss):              |       |                                          |       | ** **        |       |                             |       | ** **                         |       |                                                            |       | ** **                                       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | 33,186     |   |   |   | — |   |   |   | — |   |   | — |   |
| Pension adjustment                        |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | (7,655 | ) |   |   | — |   |   | — |   |
| Unrealized losses  on hedging activities  |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | (538 | ) |   |   | — |   |   | — |   |
| Currency  Translation                     |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | 32,527 |   |   |   | — |   |   | — |   |
| Total  comprehensive income               |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 57,520 |   |
| Performance unit  compensation            |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | 5,344      | ** **                                       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 5,344 |   |
| Restricted stock  grant                   |       |                                          | 14         | ** **        |       |                             | —     | ** **                         |       |                                                            | 208        | ** **                                       |       |       | —     |   |   |   | — |   |   |   | (208 | ) |   | — |   |
| Restricted stock  compensation            |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | —     |   |   |   | — |   |   |   | 128 |   |   | 128 |   |
| Cash dividends  declared ($.34 per share) |       |                                          | —     | ** **        |       |                             | —     | ** **                         |       |                                                            | —     | ** **                                       |       |       | (16,131    | ) |   |   | — |   |   |   | — |   |   | (16,131 | ) |
| Ending balance                            |       |                                          | 47,446     | ** **        |       |                             | $          | 474                                | ** ** |                                                            |       | $                                                | 319,871    | ** ** |       |   | $ | 62,257 |   |   |   | $ | 61,710 |   |   |   | $ | (237 | ) |   | $ | 444,075 |   |

 

See accompanying notes to consolidated financial statements.

F-3

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**Sauer-Danfoss Inc. and Subsidiaries**

**Consolidated Statements of Cash Flows**

**(in thousands)**
| ** **                                                                                         | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Cash Flows from Operating  Activities:**                                                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                         |       | $                                         | 33,186     |   | $ | 11,233 |   | $ | 13,705 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating  activities: |       |                                      |       |   |   |   |   |
| Cumulative effect of change in accounting principle                                                |       | —                                    |       | — |   | 695 |   |
| Depreciation and amortization                                                                      |       | 82,363                                    |       | 80,377 |   | 72,593 |   |
| Minority interest and equity income, net                                                           |       | 21,522                                    |       | 15,405 |   | 11,099 |   |
| (Increase)  decrease in working capital, excluding effects of acquisitions —                  |       |                                      |       |   |   |   |   |
| Accounts receivable, net                                                                           |       | (30,780                                   | )          | (5,542 | ) | 2,763 |   |
| Inventories                                                                                        |       | (24,287                                   | )          | (7,616 | ) | 1,146 |   |
| Accounts payable                                                                                   |       | 22,705                                    |       | 6,121 |   | 2,465 |   |
| Accrued liabilities                                                                                |       | 10,191                                    |       | 6,188 |   | 4,106 |   |
| Change in deferred income taxes                                                                    |       | (2,174                                    | )          | (12,371 | ) | (6,813 | ) |
| Other (1)                                                                                          |       | 12,086                                    |       | 1,763 |   | (3,476 | ) |
| Net cash provided by operating activities                                                          |       | 124,812                                   |       | 95,558 |   | 98,283 |   |
| **Cash  Flows from Investing Activities:**                                                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of property, plant and equipment                                                         |       | (79,257                                   | )          | (59,991 | ) | (42,278 | ) |
| Payments for acquisitions and license rights, net of  cash acquired                                |       | (5,656                                    | )          | (7,202 | ) | (25,084 | ) |
| Proceeds from sales of property, plant and equipment                                               |       | 9,367                                     |       | 2,204 |   | 1,090 |   |
| Net cash used in investing activities                                                              |       | (75,546                                   | )          | (64,989 | ) | (66,272 | ) |
| **Cash  Flows from Financing Activities:**                                                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net borrowings (repayments) on notes payable and  bank overdrafts                                  |       | (14,978                                   | )          | 1,120 |   | (6,025 | ) |
| Net borrowings (repayments) on revolving credit  facility                                          |       | 33,420                                    |       | 33,018 |   | (45,950 | ) |
| Net borrowings (repayments) of long-term debt                                                      |       | (42,355                                   | )          | (34,200 | ) | 40,460 |   |
| Payments for debt financing costs                                                                  |       | —                                    |       | (1,824 | ) | — |   |
| Cash dividends                                                                                     |       | (14,706                                   | )          | (13,280 | ) | (13,277 | ) |
| Distribution to minority interest partners                                                         |       | (14,711                                   | )          | (13,667 | ) | (9,625 | ) |
| Net cash used in financing activities                                                              |       | (53,330                                   | )          | (28,833 | ) | (34,417 | ) |
| **Effect of Exchange Rate Changes on Cash**                                                        |       | 251                                       |       | 953 |   | 479 |   |
| **Cash  and Cash Equivalents:**                                                                    | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net increase (decrease) during the year                                                            |       | (3,813                                    | )          | 2,689 |   | (1,927 | ) |
| Beginning balance                                                                                  |       | 15,086                                    |       | 12,397 |   | 14,324 |   |
| Ending balance                                                                                     |       | $                                         | 11,273     |   | $ | 15,086 |   | $ | 12,397 |   |
| **Supplemental  Cash Flow Disclosures:**                                                           | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest paid                                                                                      |       | $                                         | 17,984     |   | $ | 18,581 |   | $ | 20,775 |   |
| Income taxes paid                                                                                  |       | $                                         | 12,324     |   | $ | 12,825 |   | $ | 11,083 |   |

----

(1)   Primarilyrelated to Long-Term Incentive Plan in 2004.

See accompanying notes to consolidated financial statements.

F-4

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1) Summary ofSignificant Accounting Policies:**

*Basis ofPresentation and Principles of Consolidation —*

Sauer-Danfoss Inc., a U.S. Delaware corporation,and subsidiaries (the Company) is a worldwide leader in the design,manufacture, and sale of engineered hydraulic and electronic systems andcomponents that generate, transmit and control power in mobile equipment. TheCompany’s products are used by original equipment manufacturers of mobileequipment, including construction, road building, agricultural, turf care, andspecialty vehicle equipment. The Company’s products are sold throughout theworld either directly or through distributors.

The consolidated financialstatements represent the consolidation of all companies in which the Companyhas a controlling interest and are stated in accordance with accountingprinciples generally accepted in the United States. All significantintercompany balances, transactions and profits have been eliminated in theconsolidated financial statements.

*Use ofEstimates —*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results may differ from those estimates.

*RevenueRecognition —*

Net sales are recorded atthe time of shipment to customers along with related expenses includingestimates for future warranty expense. This is consistent with when the risksand rewards of ownership and title to the product have transferred to thecustomer.

*Cash and CashEquivalents —*

Cash equivalents areconsidered by the Company to be all highly liquid instruments purchased withoriginal maturities of three months or less.

*Trade Receivables —*

The Company records tradereceivables due from its customers at the time sales are recorded in accordancewith its revenue recognition policy. The future collectibility of these amountscan be impacted by the Company’s collection efforts, the financial stability ofits customers, and the general economic climate in which it operates. TheCompany applies a consistent practice of establishing an allowance for accountsthat it believes may become uncollectible through reviewing the historical agingof its receivables and by monitoring the financial strength of its customers.If the Company becomes aware of a customer’s inability to meet its financialobligations (e.g., where it has filed for bankruptcy), the Company establishesa specific allowance for the potential bad debt to reduce the net recognizedreceivable to the amount it reasonably believes will be collected. Thevaluation of trade receivables is performed quarterly.

F-5

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1)Summary of Significant Accounting Policies: (Continued)**

*Inventories —*

Inventories are valued atthe lower of cost or market, using various cost methods, and include the costof material, labor and factory overhead. The last-in, first-out (LIFO) methodwas adopted in 1987 and is used to value inventories at the U.S. locationswhich existed at that time. Inventories at all of the non-U.S. locations andthe U.S. locations obtained through acquisition after 1987, which produceproducts different than those produced at U.S. locations existing at 1987, arevalued under the inventory valuation method in place prior to acquisition,either weighted average or first-in, first-out (FIFO). The percentage ofyear-end inventory valued under the LIFO, FIFO, and average cost methods was17%, 42%, and 41%, respectively, for 2004 and 18%, 39%, and 43%, respectively,for 2003.

*Property, Plant andEquipment and Depreciation —*

Property, plant andequipment are stated at historical cost, net of accumulated depreciation.Depreciation is generally computed using the straight-line method for buildingequipment and buildings over 10 to 37 years and for machinery andequipment over 3 to 8 years (3 to 12 years for additions in 1999 andprior). Additions and improvements that substantially extend the useful life ofa particular asset are capitalized. Repair and maintenance costs ($36,533,$27,208, and $20,264 in 2004, 2003, and 2002, respectively) are charged toexpense. When property, plant and equipment are retired or otherwise disposedof, the cost and related accumulated depreciation are removed from the accountsand any gain or loss is included in the consolidated statements of income.

*Goodwill and OtherIntangible Assets —*

Goodwill represents theexcess of the purchase price over the estimated fair values of net assetsacquired in the purchase of businesses. The Company accounts for intangibleassets in accordance with Statement of Financial Accounting Standards (SFAS) No. 142,“Goodwill and Other Intangible Assets,” which requires that goodwill is notamortized, but tested for impairment at least annually. Intangible assetsconsist primarily of trade names, technology, and customer relationships andare recorded at cost or fair value at the time of acquisition. Intangibleassets are amortized on a straight-line basis over their legal or estimateduseful lives, which range from three to thirty-five years.

*ProductWarranty —*

The Company warrants its various products overdiffering periods depending upon the type of product and application.Consequently, the Company records warranty liabilities for the estimated coststhat may be incurred under its basic warranty based on past trends of actualwarranty claims compared to the actual sales levels to which those claimsapply. These liabilities are accrued at the time the sales of the products arerecorded. Factors that affect the Company’s warranty liability include thenumber of units in the field currently under warranty, historical andanticipated rates of warranty claims on those units and the cost per claim tosatisfy the Company’s warranty obligation. The anticipated rate of warrantyclaims is the primary factor impacting the Company’s estimated warrantyobligation. Each quarter, the Company reevaluates its estimates to assess theadequacy of its recorded warranty liabilities and adjusts the amounts asnecessary.

F-6

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1)Summary of Significant Accounting Policies: (Continued)**

In addition to its normalwarranty liability, the Company, from time to time in the normal course ofbusiness, incurs costs to repair or replace defective products with a specificcustomer or group of customers. The Company refers to these as field recallsand in these instances, the Company records a specific provision for theexpected costs it will incur to repair or replace these products utilizinginformation from customers and internal information regarding the specific costof materials and labor. Due to the sporadic and infrequent nature of fieldrecalls, and the potential for a range of costs associated with field recalls,the Company cannot accurately estimate these costs at the time the products aresold. Therefore, these costs are recorded at the time information becomes knownto the Company. As the field recalls are carried out, the Company relieves thespecific liability related to that field recall. These specific field recallliabilities are reviewed on a quarterly basis, if not more frequently. Thefollowing table presents the activity in the accrued warranty and field recallaccounts for the years ended December 31, 2004, 2003 and 2002:
| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                      | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2002** | ** ** |
| Balance at  January 1                      |       | $                                     | 17,196     |   | $ | 14,242 |   | $ | 8,472 |   |
| Amounts assumed  in acquisition                 |       | —                                |       | — |   | 434 |   |
| Charged to costs  and expenses                  |       | 2,930                                 |       | 8,757 |   | 7,482 |   |
| Settlement of  warranty and field recall claims |       | (4,318                                | )          | (6,979 | ) | (2,763 | ) |
| Effect of  exchange rate changes                |       | 584                                   |       | 1,176 |   | 617 |   |
| Balance at  December 31                    |       | $                                     | 16,392     |   | $ | 17,196 |   | $ | 14,242 |   |

 

*Impairment ofLong-Lived Assets and Assets to be Disposed Of —*

Consistent with therequirements of SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” the Company periodically assesses whether events orcircumstances have occurred that may indicate the carrying value of itslong-lived tangible and intangible assets may not be recoverable. The carryingvalue of long-lived tangible and intangible assets to be held and used isevaluated based on the expected future undiscounted operating cash flows. Whenevents or circumstances indicate the carrying value of an asset is impaired,the Company recognizes an impairment loss to the extent that the carrying valueof the assets exceeds the fair value of the assets.

*Income Taxes —*

The provision for income taxes has been determinedusing the asset and liability approach of accounting for income taxes. Underthis approach, deferred taxes represent the future tax consequences expected tooccur when the reported amounts of assets and liabilities are recovered orpaid. The provision for income taxes represents income taxes paid or payablefor the current year plus the change in deferred taxes during the year.Deferred taxes result from differences between the financial and tax bases ofthe Company’s assets and liabilities, net operating loss carryforwards, and taxcredit carryforwards and are adjusted for changes in tax rates and tax lawswhen changes are enacted. Valuation allowances are recorded to reduce deferredtax assets when it is more likely than not that a tax benefit will not berealized.

F-7

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1)Summary of Significant Accounting Policies: (Continued)**

*Income PerShare —*

Basic net income percommon share is based on the weighted average number of common sharesoutstanding in each year. Diluted net income per common share assumes thatoutstanding common shares were increased by shares issuable upon (i) exerciseof restricted stock shares, and (ii) granting of shares under thelong-term incentive plan, after it becomes certain that the performancerequirements needed to be met in accordance with the incentive plan will beachieved. Shares under both the restricted stock plan and the long termincentive plan have an exercise price of zero.

*Fair Value ofFinancial Instruments —*

The carrying values of cash and cash equivalents,accounts and other receivables, notes payable and bank overdrafts, and accountspayable approximate fair value because of the short-term nature of theseinstruments.

The fair value oflong-term debt is calculated by discounting scheduled cash flows throughmaturity using estimated market discount rates. The discount rate is estimatedusing the rates currently offered for long-term debt of similar remainingmaturities. At December 31, 2004, the Company estimated the fair value ofits long-term debt, including amounts due within one year, at $327,378 comparedto its carrying value of $321,483. The estimated fair value of long-term debtat December 31, 2003 was $325,473 compared to its carrying value of$319,785. These estimates are subjective in nature and involve uncertaintiesand matters of significant judgment and, therefore, cannot be determined withprecision. Changes in assumptions could significantly affect these estimates.

*Translation ofNon-U.S. Currencies —*

Assets and liabilities ofconsolidated non-U.S. subsidiaries are translated into U.S. dollars at exchangerates in effect at the end of each period, while revenues and expenses aretranslated at average exchange rates prevailing during the period. Theresulting translation adjustments are included in stockholders’ equity. Gainsor losses on transactions denominated in non-U.S. currencies and the relatedtax effects are reflected in the consolidated statements of income. Due tochanges in translation rates between periods, comparisons of balances andrevenue and expense activity between periods may not be meaningful.

*Derivatives andHedging —*

Derivative financial instruments are accounted forunder SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as amended. Under SFAS 133, all derivatives are recorded on thebalance sheet as assets or liabilities and measured at fair value.

Interest rate swaps, which are designated as cash flowhedges, are used by the Company to establish fixed interest rates onoutstanding borrowings. At December 31, 2004, the Company has threeinterest rate swaps outstanding that mature at various dates through March 2009.The combined notional amount of the three contracts is 8,852 euros at December 31,2004. There is no ineffectiveness of the interest rate 

F-8

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1)Summary of Significant Accounting Policies: (Continued)**

swaps and therefore, thechanges in fair value of the derivatives is recorded in accumulated othercomprehensive income (loss).

The Company entered into aforeign currency contract to protect against the effects of foreign currencyfluctuations for a loan to the U.S. holding company from a Danish bankdenominated in euros. At December 31, 2004 the notional amount of thiscontract, which expires in January 2005, was 25,350 euros. Themark-to-market gain or loss due to currency fluctuations on both the loan andthe currency contract are reported in other income (expense) in theconsolidated statements of income with the asset and liability in the consolidatedbalance sheets adjusted to fair value.

*New AccountingPrinciples —*

In May 2004 the Financial Accounting StandardsBoard (FASB) issued Staff Position (FSP) 106-2, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug Improvement andModernizaton Act of 2003” (the Act) which replaced FSP 106-1 of the same name.The Act introduced a prescription drug benefit under Medicare Part D, aswell as a federal subsidy to sponsors of retiree health care benefit plans thatprovide a benefit that is at least actuarially equivalent to Medicare Part D.The Company believes its retiree health and accident plan is at leastactuarially equivalent to Medicare Part D and eligible for the federalsubsidy. The Company determined that the impact of the Act on the financialstatements is not material and therefore is not considered a significant event.The effects of the Act were incorporated in the measurement of plan assets andobligation that was completed as of December 31, 2004 resulting in adecrease of $1,214 in the amount of unrecognized actuarial loss disclosed inNote 8. The effects of the Act will be amortized over the expected remaininglife of the Plan participants, resulting in a reduction to the postretirementbenefit expense of $145 annually through 2012.

The FASB issued Interpretation (FIN) No. 46R, “Consolidationof Variable Interest Entities” in December 2003, which requires variableinterest entities to be consolidated by the party determined to be the primarybeneficiary. A primary beneficiary of a variable interest entity is the partythat absorbs a majority of the entity’s expected losses, receives a majority ofits expected residual returns, or both, as a result of holding the variableinterest. The Company adopted FIN No. 46R in the first quarter of 2004,consolidating one entity which was previously accounted for under the equitymethod of accounting, with no material effect on the financial statements.

The Company adopted SFAS No. 148, “Accounting forStock-Based Compensation — Transition and Disclosure” in 2003. SFAS No. 148,which amended SFAS No. 123, provides alternative methods of transition forcompanies that voluntarily change to the fair value based method of accountingfor stock-based compensation. The Company adopted the recognition provisions ofSFAS No. 123 as of January 1, 2003 using the fair-value method. Inaccordance with SFAS No. 148, the Company selected the prospective methodof reporting this change in accounting principle, which allowed the Company toapply the recognition provisions to all employee awards granted, modified orsettled after January 1, 2003. In December 2004, the FASB issued SFASNo. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123“Accounting for Stock-Based Compensation” and eliminates the alternative ofaccounting for share-based compensation using Accounting Principles Board (APB)Opinion No. 25, “Accounting for 

F-9

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1)Summary of Significant Accounting Policies: (Continued)**

Stock Issued to Employees.”The revised standard requires an entity to measure the cost of employeeservices received in exchange for the award of equity instruments based on thefair value of the award at the date of grant with the cost recognized over theperiod during which an employee is required to provide services in exchange forthe award. The effective date for the Company to adopt this standard is thethird quarter of 2005. As the Company is currently accounting for stock basedcompensation in accordance with SFAS No. 123 the impact of adopting SFAS No. 123Ris not expected to be significant on the Company’s financial position or netincome.

The Company adopted SFAS No. 132R, “Employers’Disclosures about Pensions and Other Postretirement Benefits — an amendmentof FASB Statements No. 87, 88, and 106” in 2003, with additionaldisclosure provided in 2004. This statement added certain disclosurerequirements for the major categories of plan assets, the accumulated pensionbenefit obligations, the measurement date used, the benefits expected to bepaid to plan participants during the next ten years, the employer’scontributions expected to be paid to the plans during the next fiscal year, andinterim disclosures of the components of the benefit costs along with anyrevisions to the contributions expected to be paid to the plans for the currentfiscal year. This statement required additional disclosure only, as provided inNote 8, and had no effect on the Company’s financial position or net income.

In May 2003 the FASB issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity.” SFAS No. 150 requires companies to classify certain financialinstruments as liabilities that may previously have been classified as equity.The Company adopted SFAS No. 150 in 2003 and reviewed all joint ventureagreements that may require different accounting treatment under SFAS No. 150than previously adopted.

Effective January 1, 2002 the Company adoptedSFAS No. 141, “Business Combinations,” which requires the purchase methodof accounting be used for all business combinations, and SFAS No. 142, “Goodwilland Other Intangible Assets,” which requires that goodwill and intangibleassets with indefinite useful lives no longer be amortized, but instead betested for impairment annually. In connection with the adoption of SFAS No. 142,the Company performed an evaluation of goodwill as of January 1, 2002,which indicated that goodwill related to the open circuit reporting unit withinthe Work Function segment was impaired. The Company recognized a $695 noncashafter-tax charge as a cumulative effect of change in accounting principle forthe write-off of goodwill related to the open circuit reporting unit. Each yearsince adoption, the Company has completed its annual test for potentialgoodwill impairment consistent with the methodology applied upon adoption in2002. No additional impairment was indicated as a result of these tests.

In November 2004 the FASB issued SFAS No. 151,“Inventory Costs.” SFAS No. 151 amends Accounting Research Bulleting No. 43,Chapter 4 on inventory pricing to clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted materials should berecognized as current-period charges. In addition, SFAS No. 151 requiresthat allocation of fixed production overhead to the costs of conversion bebased on the normal capacity of the production facilities. The Company isrequired to adopt SFAS No. 151 in 2006. The Company has not yet completedits evaluation of the effects of adopting this 

F-10

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(1)Summary of Significant Accounting Policies: (Continued)**

statementbut it is not expected to have a significant effect on the Company’sconsolidated financial statements.

*Reclassifications —*

Certain previouslyreported amounts have been reclassified to conform to the current periodpresentation.

**(2) BusinessCombinations:**

During the second quarter of 2004, the Companyexercised its option to acquire the remaining 15% of Comatrol S.p.A forapproximately $4,300. The Company acquired Comatrol, located in Reggio Emilia,Italy, with approximately 100 employees and $22,000 in annual sales, for itsmanufacturing and product technology. In the second quarter of 2003, theCompany purchased 40% of the outstanding shares of Comatrol, increasing itsownership percentage to 85%, and therefore began to consolidate the financialresults of the business. Prior to purchasing the controlling interest inComatrol, the Company accounted for the results of its 45% ownership interest,acquired in the first quarter 2002, under the equity method of accounting. TheCompany completed the allocation of the purchase price in 2004, resulting in$1,042 being reclassified from intangible assets to goodwill. The totalpurchase price paid to acquire Comatrol was approximately $22,100. The Companyrecognized intangible assets of approximately $600 and $2,200 for technologyand customer relationships, respectively, in connection with the Comatrolacquisition. The transaction also resulted in recognizing approximately $14,500of goodwill.

In 2003, the Company completed the allocation ofpurchase price for the acquisition of Thrige Electric, a low voltage motorbusiness, which was acquired in the second quarter of 2003. The final purchaseprice allocation resulted in $2,554 being reclassified from goodwill tointangible assets.

Thechanges in the carrying amount of goodwill for the years ended December 31,2003 and 2004 are as follows:
| ** **                                | ** ** | **Propel  Segment** | ** ** | **Work Function  Segment** | ** ** | **Controls  Segment** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|---------------------|------------|---------------------------------|------------|-----------------------|------------|-----------|------------|
| Balance as of  January 1, 2003       |       | $                   | 32,030     |                            |       | $                     | 19,121     |      |       | $ | 54,137 |   | $ | 105,288 |   |
| Goodwill acquired  during period          |       | —              |       |                            | —     |                  |       | 9,431     |       | 9,431 |   |
| Reclassify  goodwill to intangible assets |       | —              |       |                            | —     |                  |       | (2,554    | )          | (2,554 | ) |
| Translation  adjustment                   |       | 2,139               |       |                            | 1,277      |                  |       | 4,073     |       | 7,489 |   |
| Balance as of  December 31, 2003     |       | 34,169              |       |                            | 20,398     |                  |       | 65,087    |       | 119,654 |   |
| Goodwill acquired  during period          |       | —              |       |                            | —     |                  |       | 4,009     |       | 4,009 |   |
| Reclassify  intangible assets to goodwill |       | —              |       |                            | —     |                  |       | 1,042     |       | 1,042 |   |
| Translation  adjustment                   |       | 1,329               |       |                            | 793        |                  |       | 2,727     |       | 4,849 |   |
| Balance as of  December 31, 2004     |       | $                   | 35,498     |                            |       | $                     | 21,191     |      |       | $ | 72,865 |   | $ | 129,554 |   |

 

F-11

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(3) RestructuringCharges:**

TheCompany began to restructure its European sales and distribution operationsduring 2003, which continued throughout 2004. During 2003 the Company relocatedthe operations of its Sturtevant, Wisconsin, and West Branch, Iowa, locationsto other existing facilities and outsourced certain processes to reduce costsand increase efficiencies. The West Branch operations relocation was completedin 2004 in addition to management reorganizations within the Work Functionsegment. The costs related to the Sturtevant and West Branch restructuringswere included in the Work Function segment. The charges related to the Europeansales and distribution restructuring were allocated to all segments. Thefollowing table summarizes the restructuring charges incurred in 2004 and 2003:
| ** **                                              | ** ** | **Work Function** | ** ** | **European Sales  Operations** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|-------------------------------------|------------|
| ** **                                              | ** ** | **2004**               | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Employee  termination costs                             |       | $                      | 1,338      |                                | $          | 863 |   | $ | 2,323 |   | $ | 1,195 |   |
| Employee  retraining & relocation costs        |       | 148                    |       | 237                                 |       | 176 |   | 62 |   |
| Property and  equipment impairment and loss on disposal |       | 131                    |       | 3,879                               |       | — |   | — |   |
| Coordinating team                                       |       | —                 |       | —                              |       | 1,166 |   | — |   |
| Equipment  relocation costs                             |       | 136                    |       | 1,527                               |       | — |   | — |   |
| Other costs                                             |       | 470                    |       | 1,129                               |       | 743 |   | 64 |   |
| Total                                                   |       | $                      | 2,223      |                                | $          | 7,635 |   | $ | 4,408 |   | $ | 1,321 |   |

 

In addition to the Work Function and European salesand distribution restructuring, the Company incurred $165 of employeetermination costs related to the partial consolidation of the U.S.non-manufacturing functions within the Controls segment. The cost forrestructuring in 2004 totaled $6,796 consisting of $1,320, $5,345, and $131included in cost of sales, selling, general and administrative expenses, andloss on disposal of fixed assets, respectively. The cost for restructuring in2003 totaled $8,956 consisting of $3,281, $1,796, and $3,879 included in costof sales, selling, general and administrative expenses, and loss on disposal offixed assets, respectively.

The West Branch andSturtevant relocations were completed in March 2004 and June 2003,respectively. The European sales and distribution restructuring will becompleted in early 2005; additional costs are not expected to be significant.

**(4) Inventories:**

Thecomposition of inventories is as follows:
| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Raw materials             |       | $                     | 93,275     |   | $ | 73,311 |   |
| Work in process           |       | 57,561                |       | 38,862 |   |
| Finished goods  and parts |       | 102,115               |       | 95,781 |   |
| LIFO allowance            |       | (11,389               | )          | (9,084 | ) |
| Total                     |       | $                     | 241,562    |   | $ | 198,870 |   |

 

F-12

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(5) Property, Plantand Equipment and Property Held for Disposal:**

Thecost and related accumulated depreciation of property, plant and equipment aresummarized as follows:
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Cost —                                |       |                  |       |   |   |
| Land and improvements                           |       | $                     | 14,346     |   | $ | 13,547 |   |
| Buildings and improvements                      |       | 109,845               |       | 107,646 |   |
| Machinery and equipment                         |       | 1,006,162             |       | 938,069 |   |
| Construction in progress                        |       | 52,502                |       | 33,342 |   |
| Plant and  equipment under capital leases       |       | 17,888                |       | 16,519 |   |
| Total cost                                      |       | 1,200,743             |       | 1,109,123 |   |
| Less — accumulated depreciation. |       | (722,200              | )          | (656,210 | ) |
| Net property,  plant and equipment              |       | $                     | 478,543    |   | $ | 452,913 |   |

 

Depreciation expense for 2004, 2003, and 2002 was$79,307, $77,584, and $68,951, respectively.

During 2001, the Company closed a manufacturingfacility in Racine, Wisconsin, as part of a restructuring related to anacquisition. This property, with a carrying value of $6,900, was classified asa current asset on the consolidated balance sheets at December 31, 2003and included in Global Services for segment reporting. In 2004 this propertywas sold and a gain on sale of approximately $600 was recognized in the incomestatement.

In connection with theWest Branch relocation discussed in Note 3 the Company determined the landand building at that location would be sold. In 2003, the Company reduced thecarrying value of the property to approximately $3,600 and recorded an impairmentcharge of approximately $1,500, which was included in loss on disposal of fixedassets on the consolidated statements of income. At December 31, 2003 thebuilding was included in property, plant and equipment of the Work Functionsegment. The Company also has an undeveloped piece of land in Brooklyn Park,Minnesota, which has a carrying value of approximately $3,000. These twoproperties are classified as other current assets on the consolidated balancesheets at December 31, 2004 and are included in Work Function and GlobalServices, respectively, for segment reporting. The land in Minnesota was alsoclassified as a current asset at December 31, 2003. Based upon its mostrecent analysis, the Company believes that no further impairments existed at December 31,2004.

F-13

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(6) Intangible Assets**

Thefollowing table summarizes the components of the other intangible assetbalances at December 31, 2004 and 2003:
| ** **                    | ** ** | **Trade  Name** | ** ** | **Technology** | ** ** | **Customer  Relationships** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-------------------------------|------------|-----------------|------------|----------------|------------|-----------------------------|------------|-----------|------------|-----------|------------|
| *December 31, 2004*      | * *   | * *        | * *   |           | * *   | * *                    |       |      | * *   | * *  |       | * * | * * | * * | * * |
| Cost                          |       | $               | 19,000     |           |       | $                           | 11,346     | * *  |       |      | $          | 6,889 | * * |   | $ | 7,786 |   | $ | 45,021 |   |
| Accumulated  amortization     |       | 2,172           |       |           | 3,163      | * *                    |       |      | 1,710      | * *  |       | 4,619 |   | 11,664 |   |
| Other intangible  assets, net |       | $               | 16,828     |           |       | $                           | 8,183      | * *  |       |      | $          | 5,179 | * * |   | $ | 3,167 |   | $ | 33,357 |   |
| *December 31,  2003*     | * *   | * *        | * *   |           | * *   | * *                    |       |      | * *   | * *  |       | * * | * * | * * | * * |
| Cost                          |       | $               | 19,000     |           |       | $                           | 11,358     | * *  |       |      | $          | 7,271 | * * |   | $ | 6,272 |   | $ | 43,901 |   |
| Accumulated  amortization     |       | 1,629           |       |           | 2,254      | * *                    |       |      | 433        | * *  |       | 4,320 |   | 8,636 |   |
| Other intangible assets,  net |       | $               | 17,371     |           |       | $                           | 9,104      | * *  |       |      | $          | 6,838 | * * |   | $ | 1,952 |   | $ | 35,265 |   |

 

Amortization of intangibleassets was $3,056, $2,793 and $3,642 in 2004, 2003 and 2002, respectively. Amortizationexpense is expected to be approximately $2,500, $2,200, $1,800, $1,600, and$1,500 in 2005 through 2009.

**(7) Long-Term Debt:**

Long-term debt outstandingat December 31, 2004 and 2003 consisted of the following:
| ** **                                              | ** ** | **2004**                                                | ** ** | **2003**                        | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **Long-term debt  due within one  year** | ** ** | ** Long-term  debt ** | ** ** | **Long-term debt  due within one  year** | ** ** | **Long-term  debt** | ** ** |
| Multicurrency  Revolving Facility                       |       |                                                    | $          | 123,528                         |       |   |   | $ | — |   |   |   | $ | 84,855 |   |   | $ | — |   |
| German Long-Term  Bank Facilities maturing through 2018 |       |                                                    | 4,577      |                            |       |   | 33,030 |   |   |   | 3,276 |   |   | 29,700 |   |
| Danish Bank  Facility                                   |       |                                                    | 111,944    |                            |       |   | — |   |   |   | 84,908 |   |   | 50,693 |   |
| U.S. 1997 Senior  Notes, due through 2007               |       |                                                    | 4,000      |                            |       |   | 8,000 |   |   |   | 3,000 |   |   | 13,000 |   |
| U.S. 2000 Senior  Notes, due through 2010               |       |                                                    | —     |                            |       |   | 35,000 |   |   |   | — |   |   | 35,000 |   |
| U.S. Industrial  Development Revenue Bonds         |       |                                                    | —     |                            |       |   | — |   |   |   | 8,530 |   |   | — |   |
| Other borrowings                                        |       |                                                    | 938        |                            |       |   | 466 |   |   |   | 4,808 |   |   | 2,015 |   |
| Total                                                   |       |                                                    | $          | 244,987                         |       |   |   | $ | 76,496 |   |   |   | $ | 189,377 |   |   | $ | 130,408 |   |

 

*Multicurrency andNon-U.S. Bank Facilities*

In September 2003 the Company entered into aMulticurrency Revolving Facility Agreement (the Agreement). Under the Agreementthe Company may borrow up to $250,000 through September, 2006. Debt issuancecosts of approximately $1,800 were capitalized and are being amortized tointerest expense over the Agreement’s three-year term. The Agreement includes amaterial adverse change clause, which 

F-14

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(7)Long-Term Debt: (Continued)**

combined with the rolloverof borrowings for intervals less than 360 days, requires all borrowingsunder the facility, except for the German long-term debt of $5,492 discussedbelow, to be classified as current.

Borrowings under the Agreement bear interest equal tothe relevant interbank offering rate plus a margin ranging from 0.65% to 1.65%(0.95% at December 31, 2004), depending on the Company’s ratio of net debtto EBITDA, as defined. The weighted average interest rate on outstandingborrowings under the Agreement was approximately 3.5% at December 31,2004. The Company is required to pay a commitment fee on the unused portion ofthe Agreement. As of December 31, 2004, this fee was 0.43% and the Companyhad incurred $787 and $288 of commitment fee expense in 2004 and 2003,respectively. The Agreement contains financial covenants relating to theCompany’s EBITDA to net interest expense and net debt to EBITDA, as defined.The Company was in compliance with the covenants at December 31, 2004.

The German Long-Term Bank Facilities represent aseries of long-term and short-term bank loans. Included in the $37,607outstanding under the German Facilities at December 31, 2004 is $5,492that is treated as a reduction of the available funds under the $250,000Agreement discussed above. Included in the balance of $37,607 is a loan withapproximately $14,000 outstanding at December 31, 2004 that is secured byproperty. Interest on the German facilities may be either fixed or variabledepending on the individual loan. Interest rates range from 2.6% to 6.6% at December 31,2004. These facilities contain a variety of repayment schedules and have finalmaturities ranging from June 2005 through June 2018.

The Danish Bank Facilityrepresents a revolving credit facility for 800,000 krones that is availablethrough June 2006. At December 31, 2004 the Company had 188,465krones or $34,470 available under the facility. The outstanding borrowings at December 31,2004 are expected to be repaid in 2005 and therefore are classified as current.The interest rates charged on this facility range from 3.15% to 5.15% at December 31,2004. In addition, the Company is required to pay a commitment fee on theunused portion of this credit facility, which was 0.50% at December 31,2004. The Company incurred $19 of expense in 2004 as a result of thiscommitment fee. No commitment fees were paid in 2003 under this facility. TheDanish Long-Term Facility requires the Company to maintain certain minimumlevels of profitability and equity, as defined. The Company was in compliancewith the requirements at December 31, 2004.

*U.S. Borrowings*

On December 15, 1997, the Company issued $25,000of 6.68% Senior Notes (1997 Senior Notes), of which $12,000 remains outstandingat December 31, 2004. The 1997 Senior Notes have remaining annualrepayments from December 15, 2005 through 2007. The 1997 Senior Notescontain certain restrictions and require the maintenance of minimum tangiblenet worth and maximum leverage, as defined. At December 31, 2004, theCompany was in compliance with these requirements.

On October 1, 2000, the Company issued $35,000 of8.07% Senior Notes (2000 Senior Notes). The 2000 Senior Notes have scheduledannual payments starting on September 30, 2008, through September 30,2010. The 2000 Senior Notes contain certain restrictions and require themaintenance of certain financial ratios that are similar to the 1997 SeniorNotes. At December 31, 2004, the Company was in compliance with theserequirements.

F-15

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(7)Long-Term Debt: (Continued)**

Payments required to bemade on long-term debt outstanding as of December 31, 2004, during theyears ending 2005 through 2009 and for years thereafter, are $244,987, $15,458,$14,220, $14,683 $12,557, and $19,578, respectively.

**(8) Pension andPostretirement Benefits other than Pensions:**

The Company hasnoncontributory defined benefit pension plans covering a significant number ofits employees. The benefits under these plans are based primarily on years ofservice and compensation levels. The Company also provides health benefits forcertain retired employees and certain dependents when the employee becomeseligible for these benefits by satisfying plan provisions that include certainage and service requirements. The measurements for the U.S. pension and healthbenefits plans were performed at December 31, 2004 and 2003.

*Pension Benefits*

The Company’s funding policy for pension plans outsideof Germany is to contribute annually an amount that falls within the rangedetermined to be deductible for income tax purposes. The net pension liabilitiesreflected in the accompanying consolidated balance sheets result principallyfrom unfunded pension plans of the Company’s operations in Germany, where it iscommon practice to fund pension obligations at the time payments are made toretirees, and the unfunded portion of the U.S. plan.

Pensionexpense for 2004, 2003, and 2002 for these defined benefit plans consists ofthe following components:
| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
| Service cost                        |       | $                     | 4,250      |   | $ | 4,001 |   | $ | 3,538 |   |
| Interest cost                       |       | 9,945                 |       | 9,054 |   | 7,919 |   |
| Expected return  on plan assets     |       | (7,528                | )          | (6,811 | ) | (6,824 | ) |
| Amortization of  prior service cost |       | 530                   |       | 657 |   | 562 |   |
| Amortization of  net loss           |       | 1,476                 |       | 630 |   | 267 |   |
| Net periodic  pension expense       |       | $                     | 8,673      |   | $ | 7,531 |   | $ | 5,462 |   |

 

F-16

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(8) Pension and Postretirement Benefits other thanPensions:** (Continued)

The following table sets forththe plans’ funded status as of the respective balance sheet dates:
| ** **                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Reconciliation  of benefit obligation:**        |       |                  |       |   |   |
| Benefit obligation  at January 1             |       | $                     | (165,536   | ) | $ | (141,676 | ) |
| Service cost                                      |       | (4,250                | )          | (4,001 | ) |
| Interest cost                                     |       | (9,945                | )          | (9,054 | ) |
| Plan participant  contributions                   |       | (463                  | )          | (479 | ) |
| Actuarial loss                                    |       | (16,326               | )          | (10,485 | ) |
| Benefit payments                                  |       | 6,818                 |       | 9,334 |   |
| Effect of exchange  rate changes                  |       | (6,447                | )          | (9,175 | ) |
| Benefit  obligation at December 31           |       | (196,149              | )          | (165,536 | ) |
| **Reconciliation  of fair value of plan assets:** |       |                  |       |   |   |
| Fair value of  plan assets at January 1      |       | 100,888               |       | 83,668 |   |
| Actual return on  plan assets                     |       | 10,978                |       | 13,627 |   |
| Employer  contributions                           |       | 6,594                 |       | 8,295 |   |
| Effect of  exchange rate changes                  |       | 2,477                 |       | 2,956 |   |
| Plan  participants’ contributions            |       | 463                   |       | 479 |   |
| Benefit payments                                  |       | (5,262                | )          | (8,137 | ) |
| Fair value of  plan assets at December 31    |       | 116,138               |       | 100,888 |   |
| Funded status at  December 31                |       | (80,011               | )          | (64,648 | ) |
| Unrecognized  actuarial (gain) loss               |       | 38,607                |       | 24,464 |   |
| Unrecognized  prior service cost                  |       | 3,364                 |       | 3,792 |   |
| Net amount recognized                             |       | $                     | (38,040    | ) | $ | (36,392 | ) |

 

Amounts recognized in theconsolidated balance sheets as of:
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Long-term pension  liability, net (1) |       | $                     | (51,407    | ) | $ | (35,579 | ) |
| Current pension  liability                 |       | (4,590                | )          | (7,258 | ) |
| Intangible asset                           |       | 3,459                 |       | 2,394 |   |
| Accumulated other  comprehensive income    |       | 14,498                |       | 4,051 |   |
| Net amount recognized                      |       | $                     | (38,040    | ) | $ | (36,392 | ) |

----

(1)          Includes plan assets of$5,741 and $6,358 in 2004 and 2003, respectively for the U.K. plan that isincluded in other assets.

F-17

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(8) Pensionand Postretirement Benefits other than Pensions: (Continued)**

Significant assumptionsused in determining pension expense and related pension obligations are asfollows:
| ** **                                          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
| Discount  rates —                         |       |                  |       |   |   |   |   |
| United States                                       |       | 6.00                  | %          | 6.25 | % | 7.00 | % |
| Germany                                             |       | 4.75                  |       | 5.30-6.00 |   | 5.80-6.50 |   |
| United Kingdom                                      |       | 5.25                  |       | 5.50 |   | 5.50 |   |
| Rates of increase  in compensation levels —    |       |                  |       |   |   |   |   |
| United States                                       |       | 3.50                  |       | 3.50 |   | 4.50 |   |
| Germany                                             |       | 2.50                  |       | 2.50 |   | 2.50 |   |
| United Kingdom                                      |       | 4.00                  |       | 4.00 |   | 3.50 |   |
| Expected long-term  rate of return on assets — |       |                  |       |   |   |   |   |
| United States                                       |       | 8.50                  |       | 8.50 |   | 8.50 |   |
| United Kingdom                                      |       | 6.20                  |       | 6.00 |   | 6.50 |   |

 

The target asset allocation for the U.S. pensionassets, on average, is 60% in equity securities and 40% in fixed incomesecurities. This allocation is expected to earn an average annual rate ofreturn of approximately 8.5% measured over a planning horizon of twenty yearswith reasonable and acceptable levels of risk. This expected level will beobtained, with an allowance for expenses, and cash investments, if equitysecurities realize an average annual return of 11% and fixed income securitiesproduce an average annual yield of 6%. The target asset allocation for the U.K.pension assets, on average, is 56% in equity securities, 43% in fixed incomesecurities and 1% in cash. This allocation is expected to earn an averageannual rate of return of approximately 6.2%.

The weighted average assetallocations by asset category for the U.S. and U.K. pension plans at December 31are as follows:
| ** **        | ** ** | **U.S. Plan** | ** ** | **U.K. Plan** | ** ** |
|-------------------|------------|--------------------|------------|--------------------|------------|
| ** **        | ** ** | **2004**           | ** ** | **2003**           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Equity securities |       | 60                 | %          | 50                 | %          | 61 | % | 60 | % |
| Debt securities   |       | 37                 |       | 46                 |       | 38 |   | 39 |   |
| Other             |       | 3                  |       | 4                  |       | 1 |   | 1 |   |
| Total             |       | 100                | %          | 100                | %          | 100 | % | 100 | % |

 

*PostretirementBenefits*

The health benefit plans covering certain groups ofU.S. employees are contributory, with contributions reviewed annually andadjusted as appropriate. These plans contain other cost-sharing features suchas deductibles and coinsurance. The Company does not pre-fund these plans andhas the right to modify or terminate any of these plans in the future. Healthbenefits for retirees of 

F-18

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(8)Pension and Postretirement Benefits other than Pensions: (Continued)**

non-U.S. operations, whereapplicable, are provided through government-sponsored plans to whichcontributions by the Company are required.

Thecomponents of the postretirement benefit expense of the Company-sponsoredhealth benefit plans for 2004, 2003, and 2002, were as follows:
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service cost                    |       | $        | 621        |     | $          | 539      |       | $ | 528 |   |
| Interest cost                   |       | 1,753    |       | 1,636    |       | 1,476    |       |
| Net deferral and  amortization  |       | 543      |       | 322      |       | 158      |       |
| Postretirement benefit  expense |       | $        | 2,917      |     | $          | 2,497    |       | $ | 2,162 |   |

 

Thefunded status of the Company-sponsored health benefit plans was as follows:
| ** **                                                        | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Reconciliation  of benefit obligation:**                        |       |                  |       |   |   |
| Accumulated  postretirement benefit liability at January 1   |       | $                     | (27,153    | ) | $ | (22,306 | ) |
| Service cost                                                      |       | (621                  | )          | (539 | ) |
| Interest cost                                                     |       | (1,753                | )          | (1,636 | ) |
| Actuarial loss                                                    |       | (2,102                | )          | (4,167 | ) |
| Benefit payments                                                  |       | 2,127                 |       | 1,495 |   |
| Accumulated  postretirement benefit liability at December 31 |       | (29,502               | )          | (27,153 | ) |
| **Reconciliation of fair value of plan assets:**                  |       |                  |       |   |   |
| Fair value of  plan assets at January 1                      |       | —                |       | — |   |
| Employer  contributions                                           |       | 2,127                 |       | 1,495 |   |
| Benefit payments                                                  |       | (2,127                | )          | (1,495 | ) |
| Fair value of  plan assets at December 31                    |       | —                |       | — |   |
| Funded status                                                     |       | (29,502               | )          | (27,153 | ) |
| Unrecognized  actuarial loss                                      |       | 10,957                |       | 9,374 |   |
| Postretirement benefit  liability                                 |       | $                     | (18,545    | ) | $ | (17,779 | ) |

 

The assumed weighted average annual rate of increasein the per capita cost of medical benefits is 10.0% for 2005 and is assumed todecrease ratably in 2006 through 2010 and remain level at 4.5% thereafter.

U.S. employees retiring after March 1, 1993, andhired prior to January 1, 1993, will receive the standard health benefitsup to age 65 and then will be eligible for a Medicare reimbursement allowancebased on years of service. U.S. employees hired after January 1, 1993,will only be eligible after age 65 for a Medicare reimbursement allowance basedon years of service.

A one percent increase or decrease in the annualhealth care trend rates would have increased or decreased the accumulatedpostretirement benefit obligation at December 31, 2004, by $2,142, and 

F-19

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(8)Pension and Postretirement Benefits other than Pensions: (Continued)**

increased or decreasedpostretirement benefit expense for 2004 by $190. The weighted average discountrate used to estimate the accumulated postretirement benefit obligation was6.0%, 6.25%, and 7.0%, for 2004, 2003, and 2002, respectively.

The benefits expected tobe paid from the benefit plans, which reflect expected future years of service,and the Medicare subsidy expected to be received are as follows:
| ** **   | ** ** | **Pensions** | ** ** | **Health Care** | ** ** | **Health care  subsidy  receipts (1)** | ** ** |
|--------------|------------|--------------|------------|----------------------|------------|--------------------------------------------------|------------|
| 2005         |       | $            | 4,739      |                 |       | $                                                | 1,460      |   |   |   | $ | — |   |   |
| 2006         |       | 5,071        |       |                 | 1,616      |                                             |       |   | 58 |   |   |
| 2007         |       | 5,538        |       |                 | 1,802      |                                             |       |   | 65 |   |   |
| 2008         |       | 5,944        |       |                 | 1,907      |                                             |       |   | 69 |   |   |
| 2009         |       | 6,404        |       |                 | 1,969      |                                             |       |   | 71 |   |   |
| 2010 to 2014 |       | 40,267       |       |                 | 10,940     |                                             |       |   | 388 |   |   |
|              |            |              |            |                      |            |                                                  |            |  |  |  |  |  |  |  |

----

(1)          See discussion ofMedicare subsidy provided by the Medicare Prescription Drug Improvement andModernization Act of 2003 in Note 1.

The Company plans to contribute approximately $8,500to the Company pension and health benefit plans in 2005.

The Company also maintainsthe Sauer-Danfoss Employees’ Savings Plan and the Sauer-Danfoss LaSalle FactoryEmployee Savings Plan for eligible employees. Company contributions includeboth base and matching amounts. The Company contributed approximately $1,900 tothese plans in both 2004 and 2003, and $1,800 to these plans in 2002.

**(9) IncomeTaxes:**

TheCompany’s income (loss) before income taxes is as follows:
| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | ** 2004 **                        | ** ** | ** 2003 ** | ** ** | ** 2002 ** | ** ** |
| United States       |       | $                                           | (4,973     | ) | $ | (26,545 | ) | $ | (2,556 | ) |
| European and  other |       | 53,894                                      |       | 37,304 |   | 23,478 |   |
| Total               |       | $                                           | 48,921     |   | $ | 10,759 |   | $ | 20,922 |   |

 

The Company’s primary German operation is treated as aflow-through entity for United States tax purposes. The above analysis ofpretax income and the following analysis of the income tax provision by taxingjurisdiction are therefore not directly related.

F-20

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(9) IncomeTaxes:** (Continued)

Thebenefit (expense) for income taxes by taxing jurisdiction is as follows:
| ** **                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current:                            |       |                                        |       |   |   |   |   |
| United States                       |       |                                        |       |   |   |   |   |
| Federal                             |       | $                                           | 2,411      |   | $ | — |   | $ | 424 |   |
| State                               |       | (100                                        | )          | — |   | (966 | ) |
| European and other                  |       | (21,294                                     | )          | (8,403 | ) | (9,498 | ) |
| Total current                       |       | (18,983                                     | )          | (8,403 | ) | (10,040 | ) |
| Deferred:                           |       |                                        |       |   |   |   |   |
| United States                       |       |                                        |       |   |   |   |   |
| Federal                             |       | 3,130                                       |       | 6,519 |   | 1,744 |   |
| State                               |       | (563                                        | )          | 1,179 |   | 278 |   |
| European and other                  |       | 681                                         |       | 1,179 |   | 801 |   |
| Total deferred                      |       | 3,248                                       |       | 8,877 |   | 2,823 |   |
| Total income tax benefit  (expense) |       | $                                           | (15,735    | ) | $ | 474 |   | $ | (7,217 | ) |

 

A reconciliation of taxexpense calculated using the U.S. statutory tax rate and recorded income taxexpense based on the Company’s income before income taxes is as follows:
| ** **                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Tax expense based on  U.S. statutory tax rate                                      |       | $                                           | (17,124    | ) | $ | (3,765 | ) | $ | (7,323 | ) |
| Deferred tax benefit not  previously recognized                                    |       | —                                      |       | 1,886 |   | — |   |
| Reduction of income tax  accrued liability                                         |       | 2,600                                       |       | — |   | — |   |
| Goodwill and  nondeductible expenses                                               |       | —                                      |       | — |   | (454 | ) |
| European and Asian  locations’ losses not tax  benefited                      |       | (1,435                                      | )          | (424 | ) | (380 | ) |
| Taxes on non-U.S.  locations’ income at rates which differ from the U.S. rate |       | 3,806                                       |       | 1,473 |   | 1,801 |   |
| State income taxes                                                                 |       | (431                                        | )          | 766 |   | (409 | ) |
| Tax effect of minority  interest                                                   |       | (1,085                                      | )          | (730 | ) | (363 | ) |
| Other                                                                              |       | (2,066                                      | )          | 1,268 |   | (89 | ) |
| Total income tax benefit  (expense)                                                |       | $                                           | (15,735    | ) | $ | 474 |   | $ | (7,217 | ) |

 

F-21

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(9)Income Taxes: (Continued)**

The components of theCompany’s net deferred tax assets and liabilities, determined on ajurisdictional and entity basis, are attributable to the following:
| ** **                                                                        | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                                                                        | ** ** | **Assets**            | ** ** | **Liabilities** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** |
| Net operating  loss (NOL) and tax credit carryforwards                            |       | $                     | 26,720     |   | $ | — |   | $ | 38,651 |   | $ | — |   |
| Deferred  compensation, post-retirement medical and accrued pension benefits |       | 19,466                |       | — |   | 11,827 |   | (1,909 | ) |
| Fixed asset basis  differences                                                    |       | 1,468                 |       | (32,784 | ) | 1,623 |   | (42,694 | ) |
| Inventory and  warranty accruals                                                  |       | 8,385                 |       | (3,913 | ) | 8,187 |   | (1,304 | ) |
| Intangible asset  fair market value step-up                                       |       | —                |       | (11,507 | ) | — |   | (7,781 | ) |
| Other items                                                                       |       | 10,565                |       | (250 | ) | 8,796 |   | (2,438 | ) |
| Gross deferred  tax assets/liabilities                                            |       | 66,604                |       | (48,454 | ) | 69,084 |   | (56,126 | ) |
| Valuation  allowance                                                              |       | (22,667               | )          | — |   | (22,661 | ) | — |   |
| Net deferred tax  assets/liabilities                                              |       | 43,937                |       | (48,454 | ) | 46,423 |   | (56,126 | ) |
| Less-current  portion                                                             |       | (10,947               | )          | — |   | (7,165 | ) | — |   |
| Net deferred tax  assets/liabilities, long-term                                   |       | $                     | 32,990     |   | $ | (48,454 | ) | $ | 39,258 |   | $ | (56,126 | ) |

 

The valuation allowance of $22,667 at December 31,2004 has been established against NOL and tax credit carryforwards. All of theU.S. NOL carryforward tax benefits were recorded through a business  acquisition; therefore Internal Revenue Code Section 382will limit the amount of NOL carryforwards that may be used to offset futuretaxable income in any one year. To the extent the unrecognized tax benefit ofcertain acquired NOL carryforwards are recognized in the future, the taxbenefits of such recognition will reduce goodwill. Approximately $17,000 and$5,600 of the valuation allowance related to the acquired NOL carryforwards andto foreign tax and research credits, respectively. See further discussion ofthe tax return carryforwards below.

As of December 31, 2004 and 2003, the Company hadnot provided U.S. federal income taxes on $190,629 and $149,247 ofundistributed earnings recorded by certain subsidiaries outside the UnitedStates since these earnings were deemed permanently invested. Although it isnot practicable to determine the deferred tax liability on the unremittedearnings, foreign tax credits would be available to reduce U.S. tax liabilityif these foreign earnings were remitted.

F-22

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(9) IncomeTaxes: (Continued)**

The Company had thefollowing tax return carryforwards available to offset future years’ taxableincome at December 31, 2004:
| ** **                                            | ** ** | **Amount** | ** ** | **Expiration Dates** | ** **     |
|-------------------------------------------------------|------------|------------|------------|---------------------------|----------------|
| German NOL —  National                           |       | $          | 87,033     |                      |           | None |   |   |
| German NOL —  Local                              |       | 27,167     |       |                      | None           |   |   |
| U.S. NOL                                              |       | 50,332     |       |                      | 2006—2019 |   |   |
| Other non-U.S.  NOL                                   |       | 8,671      |       |                      | 2006—2014 |   |   |
| Foreign tax credits  (available to offset U.S. taxes) |       | 7,157      |       |                      | 2011—2014 |   |   |
|                                                       |            |            |            |                           |                |  |  |  |

 

The German NOLs reflected above have reduced U.S.income taxes in prior years due to the treatment of the Company’s primaryGerman operations as a flow-through entity for U.S. tax purposes. Accordingly,no net deferred tax asset has been established for the German NOLcarryforwards.

The ultimate realization of net deferred tax assets isdependent upon the generation of future taxable income during (i) theyears in which temporary differences reverse and (ii) the years prior tothe expiration of NOL and credit carryforwards. Management considers projectedfuture taxable income and tax planning strategies in making this assessment.Based on these factors, management believes it is more likely than not that theCompany will realize benefits of the net deferred tax assets as of December 31,2004.

The American Jobs Creation Act of 2004 (AJCA)increased the number of years allowed for carryforward of foreign tax credits. TheAJCA also introduced a limited time 85% dividends received deduction on therepatriation of certain foreign earnings. This deduction would result in anapproximate 5.25% federal tax rate on the repatriated earnings. To qualify forthe deduction certain criteria must be met, including that the earnings must bereinvested in the U.S. pursuant to a domestic reinvestment plan established bythe Company’s chief executive officer and approved by the Company’s Board ofDirectors.  The Company has started anevaluation of the effects of the repatriation provision and may elect to applythe provision to qualifying earnings repatriations in 2005. However, theCompany does not expect to be able to complete its evaluation until afterCongress or the Treasury Department provides additional clarifying language onkey elements of the provision. Assuming such clarifications are made, theCompany expects to complete its evaluation of the effects of the repatriationprovision by the end of the second quarter in 2005. The range of possibleamounts that the Company is considering for repatriation under this provisionis between $0 and $148,000. While the Company estimates the related potentialrange of additional income tax is between $0 and $2,600, the range is subjectto change based on the technical correction legislation that is expected to bepassed.

The Internal RevenueService (IRS) has audited the Company’s federal income tax returns for years1997 through 2001. The Company received notices of proposed tax adjustments forthose years and filed appeals in response to those IRS notices. Final proposedadjustments have been received for these years. The Company has reached atentative settlement for the items under appeal. The Company has reduced itsaccrued liability for income taxes by $2,600 in 2004 to reflect the expectedsettlement.

F-23

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(10) Minority Interests:**

Minority interestsin net assets and income reflected in the accompanying consolidated financialstatements consists of:

a)               A 40% minorityinterest held by Agri-Fab, Inc. in Hydro-Gear Limited Partnership, a U.S.limited partnership, for 2004, 2003 and 2002.

b)              A 40% minorityinterest held by Shanghai Hydraulics and Pneumatics in Sauer Shanghai HydraulicTransmission Co., Ltd., a Chinese equity business venture for 2004, 2003,and 2002.

c)               A 35% minorityinterest held by Daikin Industries Ltd. inSauer-Danfoss-Daikin, Ltd., a Japanese corporation, for 2004, 2003, and2002.

d)              A 49.9% minorityinterest held by Topcon Laser Systems in TSD Integrated Controls LLC, a U.S.limited partnership, for 2004, 2003, and 2002.

e)               A 55% minorityinterest held by Daikin Industries Ltd. in Daikin-Sauer-DanfossManufacturing, Ltd., a Japanese corporation, for 2004. Prior to 2004 thisentity was accounted for under the equity method but was consolidated in 2004in accordance with the requirements of FIN No. 46R as discussed in Note 1.

f)                 A 15% minorityinterest held by Mr. Mose Natale Arduini in Comatrol S.p.A., an Italian corporation,from April 10, 2003 through April 30, 2004.

The following tables setforth the components of minority interest in the consolidated balance sheets:
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Hydro-Gear  Limited Partnership                |       | $                     | 25,467     |   | $ | 22,250 |   |
| Sauer Shanghai  Hydraulic Transmission Company |       | 3,248                 |       | 2,310 |   |
| Sauer-Danfoss-Daikin,  Ltd.                    |       | 6,452                 |       | 5,270 |   |
| TSD Integrated  Controls LLC                   |       | 687                   |       | 542 |   |
| Daikin-Sauer-Danfoss  Manufacturing, Ltd.      |       | 4,073                 |       | — |   |
| Comatrol S.p.A.                                |       | —                |       | 1,981 |   |
| Total                                          |       | $                     | 39,927     |   | $ | 32,353 |   |

 

The Company has a limited partnership agreement thatindicates a termination date of December 31, 2035. This entity isconsolidated in the Company’s financial statements. The agreement indicatesthat if the partnership were to terminate the assets would be distributed inaccordance with each partner’s ownership percentage. In accordance with SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of BothLiabilities and Equity”, management of the Company has estimated the currentmarket value of the partnership. Based on this estimate, if the partnershipwere to terminate the Company would distribute approximately $80,000 to theminority interest owner.

Until May 3, 2000, the Company was the generalpartner and 80% owner of the German Operating Company. The Murmann LimitedPartners had certain rights, which included an annual cash payment 

F-24

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(10)Minority Interests: (Continued)**

equal to 7.6% of theincome of Sauer Inc. and subsidiaries before taxes and the Murmann LimitedPartnership Interests and the right to consent to certain actions of the GermanOperating Company. However, the Company had the right to elect by the action ofits independent directors or the holders of its common stock other than theMurmann family to terminate the Murmann Limited Partnership Interests inexchange for 2,250 shares of common stock of Sauer Inc. As such, theCompany controlled and consolidated the German Operating Company.

As a result of the DanfossFluid Power acquisition, the Company elected, by the action of its independentdirectors, to terminate the limited partnership interests. Pursuant to theterms of the agreement creating the limited partnership, in exchange for thetermination of the limited partnership interests, the Company issued 2,250shares of its common stock and paid the balance of the current accounts of theLimited Partners of $3,873. The difference between the fair market value of theshares issued and the historical basis of the limited partnership interest wasconsidered to be a deemed dividend of $17,337 under common control accounting.In addition, the agreement required the Company to pay an amount in cash equalto the income tax payable as a result of the exchange of the shares of common stockof the Company for the limited partnership interests, but not to exceed 11,942euros, $16,241 at December 31, 2004, using an exchange rate of 1.36 eurosto the U.S. dollar. As of December 31, 2002, the Company had paid $3,254toward this tax liability. However, as of that date, the Murmann LimitedPartners were in dispute in the German tax courts over the total amount of taxliability related to this transaction. In 2003, the Murmann Limited Partnersincurred an additional tax liability of $621, which the Company, pursuant tothe terms of the agreement, paid to the Murmann Limited Partners. The Companyrecorded this amount as a deemed dividend in 2003.

**(11) Accumulated Other Comprehensive Income(Loss):**

Thechanges in accumulated other comprehensive income (loss) for the years ended December 31,2002, 2003, and 2004 follows:
| ** **                            | ** ** | **Currency   Translation ** | ** ** | **Pension   Adjustment ** | ** ** | **Hedging   Activities ** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|-----------------------------------------------------------|------------|
| Balance as of  January 1, 2002   |       |                                  | $          | (14,961                             | )          |                                |       | $                                                         | (702       | ) |   |   | $ | — |   |   |   | $ | (15,663 | ) |   |
| Change in period                      |       |                                  | 20,935     |                                |       |                                | (2,003     | )                                                         |       |   | 1,427 |   |   |   | 20,359 |   |   |
| Income tax  benefit                   |       |                                  | —     |                                |       |                                | 650        |                                                      |       |   | — |   |   |   | 650 |   |   |
| Balance as of  December 31, 2002 |       |                                  | 5,974      |                                |       |                                | (2,055     | )                                                         |       |   | 1,427 |   |   |   | 5,346 |   |   |
| Change in period                      |       |                                  | 35,325     |                                |       |                                | (2,370     | )                                                         |       |   | (1,360 | ) |   |   | 31,595 |   |   |
| Income tax  benefit                   |       |                                  | —     |                                |       |                                | 435        |                                                      |       |   | — |   |   |   | 435 |   |   |
| Balance as of  December 31, 2003 |       |                                  | 41,299     |                                |       |                                | (3,990     | )                                                         |       |   | 67 |   |   |   | 37,376 |   |   |
| Change in period                      |       |                                  | 32,527     |                                |       |                                | (9,458     | )                                                         |       |   | (674 | ) |   |   | 22,395 |   |   |
| Income tax  benefit                   |       |                                  | —     |                                |       |                                | 1,803      |                                                      |       |   | 136 |   |   |   | 1,939 |   |   |
| Balance as of  December 31, 2004 |       |                                  | $          | 73,826                              |       |                                |       | $                                                         | (11,645    | ) |   |   | $ | (471 | ) |   |   | $ | 61,710 |   |   |

 

F-25

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(12) Long-Term Incentive Plan:**

The Company’s Long-Term Incentive Plan provides forthe grant of stock options, stock appreciation rights, restricted stock,performance units, performance shares and other incentive awards to officersand key employees and for the reimbursement to certain participants for thepersonal income tax liability resulting from such awards. The total number ofshares of common stock that may be subject to awards or be issued under theLong-Term Incentive Plan shall not exceed 2,400 shares, of which no more than1,200 shares may be issued as restricted stock.

The Company also has a Nonemployee Director StockOption and Restricted Stock Plan which permits the granting of non-qualifiedstock options and restricted common stock to directors of the Company who arenot employees of the Company. The total number of shares of common stock to beissued under this plan shall not exceed 250 shares.

Prior to 2003, the Company accounted for employeestock awards under the recognition and measurement provisions of APB Opinion No. 25,“Accounting for Stock Issued to Employees.” Effective January 1, 2003, theCompany adopted the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation” prospectively to all employee awards granted,modified, or settled after January 1, 2003. Awards previously made underthe Non-employee Director Stock Option and Restricted Stock plan vested over athree-year period and the effect of applying the fair value recognitionprovisions of SFAS No. 123 were not considered significant. TheCompany selected the prospective method under SFAS No. 148 for reportingthis change in accounting principle.

On February 25, 2004 the Board of Directorsapproved granting 323 performance units under the Plan to replace allperformance units and stock options previously granted, as the original targetsestablished for those grants were no longer deemed reasonable due to unforeseeneconomic conditions. In addition, on that date, the Board of Directors approvedgranting an additional 385 performance units under the Plan. The performanceunits vest over one to three years and entitle the participants to receive anamount equal to the Company’s dividends during the vesting period. Thesettlement of performance units is in shares of company stock or cash asdetermined by the Compensation Committee of the Board of Directors.

Compensation cost related to the units to bedistributed in company stock and in cash has been recognized based on the fairvalue of the equity instruments at the performance unit grant date and fairvalue at December 31, 2004, respectively. Compensation cost for theremaining performance units continues to be recognized over the vesting periodusing the estimate that one-third of the units will settle in cash andtwo-thirds of the units will be settled by distributed stock. The liability forthe portion of the units expected to be settled in cash is adjusted based onfluctuations in the market price of company stock over the vesting period. Compensationexpense for the units expected to be settled in company shares is measuredbased on the market price of the stock at date of grant, with an offsettingincrease to additional paid in capital. During 2003 and 2002 the Companyawarded performance units to employees totaling 306 and 242, respectively. Asnoted above, the 2004 performance units awarded replaced the performance unitsawarded in 2003 and 2002. Compensation expense recognized in selling, general,and administrative expenses in conjunction with the performance unitsoutstanding was $10,458, $368 and $985 in 2004, 2003 and 2002, respectively.

F-26

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(12)Long-Term Incentive Plan: (Continued)**

On March 5, 2003, the Board granted 339 stockoptions to certain members of management. As discussed above, the stock optionswere replaced by performance units in 2004. At December 31, 2003, 339stock options were outstanding and none of the options were exercisable. TheCompany recognized compensation expense for stock options over the vestingperiod based on its best estimate of the number of options that were expectedto ultimately vest. Expense recognized in 2003 related to the stock options was$177.

Under the NonemployeeDirector Stock Option and Restricted Stock Plan the Company awarded 14, 13, and8 shares of restricted stock to nonemployee directors in 2004, 2003, and2002, respectively. The restricted stock awards entitle the participants tofull dividend and voting rights. Unvested shares are restricted as to dispositionand subject to forfeiture under certain circumstances. The value of each awardwas established based on the market value of the stock as of the grant date.The shares vest over three years. Unearned compensation related to therestricted stock is shown as a reduction of stockholders’ equity in theaccompanying consolidated balance sheets and is being amortized ratably overthe vesting period of the grants. Unearned compensation was computed based onthe market value of the restricted shares. Compensation expense recognized inconjunction with the restricted stock outstanding in 2004, 2003, and 2002amounted to $128, $98, and $71, respectively.

**(13) Related Party Transactions:**

In connection with the acquisition of Danfoss FluidPower on May 3, 2000, the Company entered into several agreements withDanfoss A/S to purchase ongoing operational services fromDanfoss A/S. These services include rental of shared facilities,administrative support and information technology support. These fees are paidon a monthly basis. Total expense recognized for goods and services purchasedfrom Danfoss A/S for 2004, 2003, and 2002 was approximately $51,800,$47,300, and $36,900, respectively. At December 31, 2004 approximately$12,000 owed to Danfoss, A/S is included in accounts payable on theconsolidated balance sheet. Payments required under these agreements as of December 31,2004, during the years ending 2005 though 2009 and for years thereafter, are$7,603, $7,486, $7,397, $7,293, $7,282, and $38,839, respectively.

The Company purchases inventory components fromShanghai Hydraulics and Pneumatics, a minority interest owner in an entityincluded in the Company’s  consolidatedfinancial statements. Purchases were approximately $2,600, $1,600, and $1,300in 2004, 2003,  and 2002, respectively.

In addition, the Company sold product totalingapproximately $6,000 in 2004, to Daikin Industries Ltd. (Daikin)., a minorityinterest owner in an entity consolidated by the Company.  The Company also purchases inventory componentsand ongoing operational services from Daikin. These services include sharedfacilities and administrative support. Total expense recognized for goods andservices purchased from Daikin in 2004 was approximately $6,900.

The Company had advertising expense of $150 and $300in 2004 and 2003, respectively, to sponsor a competitive sailing yacht owned bya director of the Company.

F-27

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(14) Commitments, Contingencies, and Guarantees:**

The Company leases certain facilities and equipmentunder operating leases, many of which contain renewal options. Total rentalexpense on all operating leases during 2004, 2003, and 2002, was $19,615,$15,132, and $11,513, respectively.

Minimum future rental commitments under allnoncancelable operating leases as of December 31, 2004, during the yearsending 2005 through 2009 and for the years thereafter, are $12,318, $10,759,$5,801, $2,420, $1,853, and $24,676, respectively.

The Company also leases certain facilities andequipment under capital leases. The liability related to these capital leasesis included in current other accrued liabilities and other long-termliabilities on the consolidated balance sheets. Minimum future lease paymentsunder all noncancelable capital leases as of December 31, 2004, during theyears ending 2005 through 2009 and for the years thereafter, are $1,350,$1,140, $1,134, $1,134, $1,134, and $16,612, respectively.

The Company, from time to time, is involved in variouslegal matters considered normal in the course of its business. The Companyintends to vigorously defend against all such claims. It is the Company’spolicy to accrue for amounts related to these matters if it is probable that aliability has been incurred and an amount can be reasonably estimated. Althoughthe outcome of such matters cannot be predicted with certainty and noassurances can be given with respect to such matters, the Company believes thatthe outcome of these matters in which it is currently involved will not have amaterially adverse effect on its results of operations, liquidity or financialposition.

F-28

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(15)Quarterly Financial Data (Unaudited):**

Summarizedquarterly data is set forth in the following table:
| ** **                                                | ** ** | **Quarter** | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|
| ** **                                                | ** ** | **First**   | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| **2004**                                                  |       |        |       |   |   |   |   |   |   |   |   |
| Net sales                                                 |       | $           | 361,054    |   | $ | 379,117 |   | $ | 324,729 |   | $ | 339,259 |   | $ | 1,404,159 |   |
| Gross profit                                              |       | 87,677      |       | 106,187 |   | 77,811 |   | 74,409 |   | 346,084 |   |
| Net income (loss)                                         |       | 11,023      |       | 21,607 |   | 7,744 |   | (7,188 | ) | 33,186 |   |
| Basic and diluted  net income (loss) per common share     |       | $           | 0.23       |   | $ | 0.46 |   | $ | 0.16 |   | $ | (0.15 | ) | $ | 0.70 |   |
| **2003**                                                  |       |        |       |   |   |   |   |   |   |   |   |
| Net sales                                                 |       | $           | 300,425    |   | $ | 308,462 |   | $ | 255,370 |   | $ | 262,517 |   | $ | 1,126,774 |   |
| Gross profit                                              |       | 71,674      |       | 77,295 |   | 51,964 |   | 51,431 |   | 252,364 |   |
| Net income (loss)                                         |       | 10,165      |       | 11,262 |   | (2,229 | ) | (7,965 | ) | 11,233 |   |
| Basic and diluted  net income (loss) per common share (1) |       | $           | 0.21       |   | $ | 0.24 |   | $ | (0.05 | ) | $ | (0.17 | ) | $ | 0.24 |   |
| **2002**                                                  |       |        |       |   |   |   |   |   |   |   |   |
| Net sales                                                 |       | $           | 243,048    |   | $ | 264,117 |   | $ | 223,920 |   | $ | 221,223 |   | $ | 952,308 |   |
| Gross profit                                              |       | 58,932      |       | 67,984 |   | 47,474 |   | 44,602 |   | 218,992 |   |
| Net income (loss)                                         |       | 6,688       |       | 9,327 |   | (586 | ) | (1,724 | ) | 13,705 |   |
| Basic and diluted net  income (loss) per common share     |       | $           | 0.14       |   | $ | 0.20 |   | $ | (0.01 | ) | $ | (0.04 | ) | $ | 0.29 |   |

----

(1)          Basicand diluted net income (loss) per common share is computed independently foreach of the periods presented. Accordingly, the sum of the quarterly basic anddiluted net income (loss) per common share may not agree to the annual total.

**(16) Segment and Geographic Information:**

The Company reports its operating segments around itsvarious product lines of Propel, Work Function and Controls. Propel productsinclude hydrostatic transmissions and related products that transmit the powerfrom the engine to the wheel to propel a vehicle. Work Function productsinclude steering motors as well as gear pumps and motors that transmit powerfor the work functions of the vehicle. Controls products includeelectrohydraulic controls, microprocessors, electric motors, and valves thatcontrol and direct the power of a vehicle. Segment costs in Global Servicesrelate to internal global service departments and include costs such as consultingfor special projects, tax and accounting fees paid to outside third parties,certain insurance premiums and amortization of intangible assets from certainbusiness combinations.

F-29

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(16)Segment and Geographic Information: (Continued)**

The accounting policies ofthe segments are the same as those described in the summary of significantaccounting policies. The Company evaluates individual segment performance basedon segment income or loss defined as the respective segment’s portion of thetotal Company's net income, excluding net interest expense, income taxes,minority interest, and equity in net earnings of affiliates. The followingtable presents the significant items by operating segment for the results ofoperations for the years ended December 31, 2004, 2003, and 2002,respectively:
| ** **                             | ** ** | ** ** | ** ** | ** **             | ** ** | ** **   | ** ** | **Global**   | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------|------------|--------------|------------|--------------|------------|------------|------------|
| ** **                             | ** ** | **Propel** | ** ** | **Work Function** | ** ** | **Controls** | ** ** | **Services** | ** ** | **Total**  | ** ** |
| **2004**                               | ** ** | ** ** | ** ** |                   | ** ** | ** **   |       | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Trade sales                            |       | $          | 656,482    |                   |       | $            | 412,046    | ** **   |       | $          | 335,631    |   | $ | — |   | $ | 1,404,159 |   |
| Segment income (loss)                  |       | 91,316     |       |                   | 21,828     | ** **   |       | 24,687       |       | (49,973    | )          | 87,858 |   |
| Interest expense                       |       |       |       |                   |       | ** **   |       |         |       |       |       | (18,403 | ) |
| Interest income                        |       |       |       |                   |       | ** **   |       |         |       |       |       | 988 |   |
| Minority interest and  equity income   |       |       |       |                   |       | ** **   |       |         |       |       |       | (21,522 | ) |
| Income before income  taxes            |       |       |       |                   |       | ** **   |       |         |       |       |       | 48,921 |   |
| Depreciation and amortization  expense |       | 34,564     |       |                   | 24,466     | ** **   |       | 14,789       |       | 8,544      |       | 82,363 |   |
| Total assets                           |       | 417,684    |       |                   | 340,272    | ** **   |       | 269,378      |       | 184,247    |       | 1,211,581 |   |
| Capital expenditures                   |       | 28,156     |       |                   | 21,838     | ** **   |       | 14,122       |       | 15,141     |       | 79,257 |   |
| **2003**                               | ** ** | ** ** | ** ** |                   | ** ** | ** **   |       | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Trade sales                            |       | $          | 505,012    |                   |       | $            | 345,536    | ** **   |       | $          | 276,226    |   | $ | — |   | $ | 1,126,774 |   |
| Segment income (loss)                  |       | 50,101     |       |                   | 9,287      | ** **   |       | 13,659       |       | (29,483    | )          | 43,564 |   |
| Interest expense                       |       |       |       |                   |       | ** **   |       |         |       |       |       | (18,748 | ) |
| Interest income                        |       |       |       |                   |       | ** **   |       |         |       |       |       | 1,348 |   |
| Minority interest and  equity income   |       |       |       |                   |       | ** **   |       |         |       |       |       | (15,405 | ) |
| Income before income  taxes            |       |       |       |                   |       | ** **   |       |         |       |       |       | 10,759 |   |
| Depreciation and  amortization expense |       | 34,100     |       |                   | 23,563     | ** **   |       | 14,614       |       | 8,100      |       | 80,377 |   |
| Total assets                           |       | 375,977    |       |                   | 301,066    | ** **   |       | 234,896      |       | 189,815    |       | 1,101,754 |   |
| Capital expenditures                   |       | 16,056     |       |                   | 18,102     | ** **   |       | 14,634       |       | 11,199     |       | 59,991 |   |
| **2002**                               |       |       |       |                   |       | ** **   |       |         |       |       |       |   |   |
| Trade sales                            |       | $          | 440,221    |                   |       | $            | 294,952    | ** **   |       | $          | 217,135    |   | $ | — |   | $ | 952,308 |   |
| Segment income (loss)                  |       | 47,269     |       |                   | 19,046     | ** **   |       | 5,804        |       | (22,879    | )          | 49,240 |   |
| Interest expense                       |       |       |       |                   |       | ** **   |       |         |       |       |       | (22,510 | ) |
| Interest income                        |       |       |       |                   |       | ** **   |       |         |       |       |       | 5,291 |   |
| Minority interest and  equity income   |       |       |       |                   |       | ** **   |       |         |       |       |       | (11,099 | ) |
| Income before income  taxes            |       |       |       |                   |       | ** **   |       |         |       |       |       | 20,922 |   |
| Depreciation and  amortization expense |       | 32,586     |       |                   | 19,469     | ** **   |       | 10,950       |       | 9,588      |       | 72,593 |   |
| Total assets                           |       | 351,458    |       |                   | 264,107    | ** **   |       | 188,291      |       | 166,659    |       | 970,515 |   |
| Capital expenditures                   |       | 10,936     |       |                   | 17,000     | ** **   |       | 10,581       |       | 3,761      |       | 42,278 |   |

 

F-30

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2004, 2003, and 2002 (in thousands, except per share data)**

**(16)Segment and Geographic Information: (Continued)**

A summary of the Company’snet sales and long-lived assets by geographic area is presented below:
| ** **      | ** ** | **Net Sales (1)** | ** ** | **Long-Lived Assets (2)** | ** ** |
|-----------------|------------|-----------------------------|------------|-------------------------------------|------------|
| ** **      | ** ** | **2004**                    | ** ** | **2003**                            | ** ** | **2002** | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States   |       | $                           | 598,007    |                                | $          | 455,520 |   | $ | 418,692 |   | $ | 169,896 |   | $ | 183,609 |   |
| Germany         |       | 134,513                     |       | 108,654                             |       | 87,234 |   | 77,267 |   | 70,001 |   |
| Italy           |       | 100,072                     |       | 82,663                              |       | 65,254 |   | 34,006 |   | 29,397 |   |
| France          |       | 76,142                      |       | 60,963                              |       | 46,311 |   | 1,092 |   | 1,080 |   |
| Japan           |       | 60,896                      |       | 43,820                              |       | 35,379 |   | 3,962 |   | 2,396 |   |
| United Kingdom  |       | 57,448                      |       | 50,420                              |       | 51,468 |   | 23,290 |   | 24,196 |   |
| Sweden          |       | 52,475                      |       | 42,788                              |       | 34,024 |   | 6,731 |   | 4,501 |   |
| Denmark (3)     |       | 22,187                      |       | 19,020                              |       | 15,090 |   | 218,736 |   | 193,530 |   |
| Slovakia (3)    |       | 1,223                       |       | 1,021                               |       | 1,063 |   | 58,117 |   | 52,669 |   |
| Other countries |       | 301,196                     |       | 261,905                             |       | 197,793 |   | 59,382 |   | 67,903 |   |
| Totals          |       | $                           | 1,404,159  |                                | $          | 1,126,774 |   | $ | 952,308 |   | $ | 652,479 |   | $ | 629,282 |   |

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(1)          Net sales are attributedto countries based on location of customer.

(2)          Long-lived assetsinclude property, plant and equipment net of accumulated depreciation,goodwill, intangible assets net of accumulated amortization, and certain otherlong-lived assets.

(3)          Majority of this country’ssales are shipped outside of the home country where the product is produced.

No single customeraccounted for 10% or more of total consolidated sales in any year presented.

**(17) Subsequent event:**

In February 2005 the Compensation Committee of theBoard of Directors determined that the remaining performance units outstandingwould be completely settled in company stock, but a value withheld to meet theminimum statutory withholding requirements of the Company in the countrieswhere the individual participants pay tax. In accordance with SFAS No. 123R, “Share-BasedPayment,” which the Company will adopt in 2005, this change represents amodification of the original award and therefore these units will be accountedfor as equity units with compensation expense recognized based on the fairvalue of the Company’s stock price at the modification date. The liabilityaccrued at the date of modification will be reclassified as additional paid-incapital upon modification of the awards.

F-31

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**Report of Management**

**Management Oversight**

Sauer-Danfoss believes that good corporate governancepromotes ethical business practices, demands meticulous accounting policies andprocedures, and includes a structure with effective checks and balances. Themanagement of Sauer-Danfoss Inc. is responsible for the integrity andobjectivity of the financial information presented in this annual overviewreport. Sauer-Danfoss believes that the consolidated financial statements havebeen prepared in conformity with accounting principles generally accepted inthe United States applying certain estimates and judgments as required.

Our management is responsible for establishing andmaintaining a system of internal controls over financial reporting. This systemis augmented by written policies and procedures, careful selection and trainingof financial management personnel, a continuing management commitment to theintegrity of the system, and through examinations by an internal audit functionthat coordinates its activities with the Company’s independent auditors.

Under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, we conducted an evaluation of the effectiveness ofour internal controls over financial reporting based on the framework inInternal Control — Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on our evaluation under theframework in Internal Control — Integrated Framework, our management concludedthat our internal control over financial reporting was effective as of December 31,2004.

**Independent Oversight**

All of our directors are skilled business leaders. Themembers of the Board and each committee have express authority to retainoutside advisors. The Board and each committee perform annual self-evaluationsin order to assess their performance and to ensure that the Board and committeestructure is providing effective oversight of corporate management.

Our Audit Committee iscomposed entirely of independent outside directors. The Committee meetsperiodically with management, internal auditors, and the independent auditors,both separately and jointly, to discuss internal accounting controls and thequality of financial reporting. To ensure complete independence, the internalauditors and representatives of KPMG LLP have full access to meet with theAudit Committee, with or without management representatives present, to discussthe results of their audits and their opinions on the adequacy of internalcontrols and the quality of financial reporting. The Audit Committee has thedirect responsibility for the appointment of the independent accounting firm tobe retained for the coming year, subject to stockholder approval.

**Disclosure Controls**

We have establishedrigorous procedures to ensure that we provide complete and accurate disclosurein our publicly filed documents. Our Disclosure Committee, made up of keyindividuals from various corporate functions, has been in place for the pastfew years. This Committee meets at least quarterly to review public filings, andearnings releases, and to discuss any potential disclosure issues that mayarise. We have established a “whistle-blower” hotline for employees, customers,suppliers or any stakeholder anywhere in the world to anonymously submit anyconcern they may have regarding corporate controls or ethical breaches. Allcomplaints are investigated, and where necessary, concerns involving ourfinancial statements, public disclosures or management are directed to ourAudit Committee.

F-32

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**Codeof Legal and Ethical Business Conduct**

The Sauer-Danfoss Code ofLegal and Ethical Business Conduct is based not just solely on what we have aright to do, but even more importantly, on what is the right thing to do. Annually,we reiterate the vital importance of our Code of Legal and Ethical BusinessConduct by requiring employees is key functional areas to certify theircompliance with the standards of the Code.

| David J. Anderson                | Karl J. Schmidt                                                |
|---------------------------------------|---------------------------------------------------------------------|
| President and Chief Executive Officer | Executive Vice President and  Chief Financial Officer and Treasurer |

 

F-33

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**Report of Independent Registered Public AccountingFirm**

To the Shareholders of Sauer-Danfoss Inc.:

We have audited the accompanying consolidated balancesheets of Sauer-Danfoss Inc. (a Delaware corporation) and subsidiaries asof December 31, 2004 and 2003, and the related consolidated statements ofincome, stockholders’ equity and comprehensive income and cash flows for eachof the years in the three-year period ended December 31, 2004. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audits to obtain reasonableassurance about whether the consolidated financial statements are free frommaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of Sauer-Danfoss Inc. and subsidiaries as of December 31,2004 and 2003, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2004 inconformity with U.S. generally accepted accounting principles.

As described innote 12 to the consolidated financial statements, in 2003 the Companychanged its method of accounting for stock compensation expense. As describedin note 1 to the consolidated financial statements, in 2002 the Companychanged its method of accounting for goodwill and other intangibles.

Wealso audited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2004, based on criteriaestablished in *Internal Control — Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report datedMarch 14, 2005, expressed an unqualified opinion on management’s assessment of,and effective operation of, internal control over financial reporting.
| /s/ KPMG LLP        |
|---------------------|
| Des Moines, Iowa    |
| March 14, 2005 |

 

F-34

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**Reportof Independent Registered Public Accounting Firm**

TheBoard of Directors andStockholders of Sauer-Danfoss Inc:

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting appearing under Item 9A, that Sauer-Danfoss Inc. (a Delawarecorporation) and subsidiaries (the Company) maintained effective internal controlover financial reporting as of December 31, 2004, based on criteria establishedin *Internal Control — Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). The Company’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on the effectivenessof the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluating management’sassessment, testing and evaluating the design and operating effectiveness ofinternal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (2) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment thatSauer-Danfoss Inc. and subsidiaries maintained effective internal control overfinancial reporting as of December 31, 2004, is fairly stated, in all materialrespects, based on criteria established in *Internal Control — IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). Also, in our opinion, the Company maintained in allmaterial respects, effective internal control over financial reporting as ofDecember 31, 2004, based on criteria established in *Internal Control— Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

F-35

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We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Sauer-Danfoss Inc. andsubsidiaries as of December 31, 2004 and 2003, and the related consolidatedstatements of income, stockholders’ equity and comprehensive income and cashflows for each of the years in the three-year period ended December 31, 2004,and our report dated March 14, 2005 expressed an unqualified opinion on thoseconsolidated financial statements.
| /s/ KPMG LLP     |
|------------------|
| Des Moines, Iowa |
| March 14, 2005   |

 

F-36

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**Schedule IISauer-Danfoss Inc. and SubsidiariesValuation and Qualifying AccountsYears Ended December 31, 2002, 2003, and 2004(in thousands)**
| ** **                                   | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Receivables  Written  Off/  Settlement  of Claims** | ** ** | **Balance  Recorded on  Acquisition** | ** ** | **Foreign  Currency  Translation  Adjustment** | ** ** | **Balance at  End of  Year** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------|------------|
| For the year ended  December 31, 2002:  |       |                                         |       |                                          |       |                                                       |       |                                       |       |                                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts             |       |                                         | $          | 5,570                                         |       |                                                       |       | 103                                        |       |                                           |       | (2,626                                 | )          |   |   | 132 |   |   |   | 193 |   |   |   | $ | 3,372 |   |   |
| For the year  ended  December 31, 2003: |       |                                         |       |                                          |       |                                                       |       |                                       |       |                                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts             |       |                                         | $          | 3,372                                         |       |                                                       |       | 497                                        |       |                                           |       | (487                                   | )          |   |   | 330 |   |   |   | 432 |   |   |   | $ | 4,144 |   |   |
| For the year  ended  December 31, 2004: |       |                                         |       |                                          |       |                                                       |       |                                       |       |                                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful  accounts             |       |                                         | $          | 4,144                                         |       |                                                       |       | 411                                        |       |                                           |       | (147                                   | )          |   |   | — |   |   |   | 263 |   |   |   | $ | 4,671 |   |   |

 

F-37

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**Report of Independent Registered Public AccountingFirm on Financial Statement Schedule**

To the Shareholders ofSauer-Danfoss Inc.:

Under date of March 14, 2005, we reported on theconsolidated balance sheets of Sauer-Danfoss Inc. and subsidiaries as of December 31,2004 and 2003, and the related consolidated statements of income, stockholders’equity and comprehensive income, and cash flows for each of the years in thethree-year period ended December 31, 2004, which are included in this Form 10-K.In connection with our audits of the aforementioned consolidated financialstatements, we also audited the related consolidated financial statementschedule as listed in Item 15.(a)(2) of this Form 10-K. Thisfinancial statement schedule is the responsibility of the Company’s management.Our responsibility is to express an opinion on the financial statement schedulebased on our audits.

In our opinion, thefinancial statement schedule, when considered in relation to the 2004, 2003,and 2002 basic consolidated financial statements taken as a whole, presentsfairly, in all material respects, the information set forth therein.

Wealso audited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of the Company’s internalcontrol over financial reporting as of December 31, 2004, based on criteria establishedin *Internal Control — Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO),and our report dated March 14, 2005, expressed an unqualified opinion on  management’s assessment of, and effective operationof, internal control over financial reporting.
| /s/ KPMG LLP        |
|---------------------|
| Des Moines, Iowa    |
| March 14, 2005 |

 

F-38

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